In addition, you will find information about your company's strategies and initiatives in the 2010 Annual 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 2010 Annual Report on Form 10-K, these documents comprise a package of information similar to what appeared in our previous annual reports.
February 25, 2011
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, 2010. 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 April 30, 2011, are incorporated by reference into Part III of this Form 10-K. Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 2 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 39 states. Our headquarters is in Fairfield, Ohio. At year-end 2010, we employed 4,060 associates, with 2,838 headquarters associates providing support to 1,222 field associates.
At year-end 2010, 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 Corporation 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 agencies, their clients and other customers.
Our filings with the U.S. Securities and Exchange Commission (SEC) are available, free of charge, on our website, 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 websites. These websites, 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 accounting basis. When we provide our results on a comparable statutory accounting 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 over 60 years ago by four independent insurance agents. They established the mission that continues to guide all of the companies in the Cincinnati Financial Corporation 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 39 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 38 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 3 Three competitive advantages distinguish our company, positioning us to build shareholder value and to be successful overall:
Independent
Insurance Agency Marketplace
The U.S. property casualty insurance industry is a highly competitive marketplace with more than 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, most of which are 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 through 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 providing standard market property casualty insurance products, we opened our own excess and surplus lines insurance brokerage firm so that we could offer our excess and surplus lines products exclusively to the independent agencies 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. Offering insurance solutions beyond our standard market property casualty insurance products helps our agencies meet the broader needs of their clients, and also serves to increase and diversify agency revenues and profitability.
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 characteristics of the insured person or organization that are caused by nature, the insured's claim history or the characteristics of their business. We established an excess and surplus lines operation in response to requests to help meet the needs of agency clients when insurance is unavailable in the standard market. By providing superior service, we can help our agencies grow while also profitably growing our property casualty business. Insurers operating in the excess and surplus lines marketplace generally market business through excess and surplus lines insurance brokers, whether they are small specialty insurers or specialized divisions of larger insurance organizations.
At year-end 2010, our 1,245 property casualty agency relationships were marketing our standard market insurance products out of 1,544 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 39 active states. At year-end 2009, our 1,180 agency relationships had 1,463 reporting locations. At year-end 2008, our 1,133 agency relationships had 1,387 reporting locations.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 4 We made 93, 87 and 76 new agency appointments in 2010, 2009 and 2008, respectively. Of these new appointments, 70, 65 and 52, respectively, were new relationships. The remainder included new branch offices opened by existing Cincinnati agencies and appointment of agencies that merged with a Cincinnati agency. These new appointments and other changes in agency structures or appointment status led to a net increase in agency relationships of 65, 47 and 41 and a net increase in reporting agency locations of 81, 76 and 60 in 2010, 2009 and 2008, respectively.
On average, we have a 12.4 percent share of the standard lines property casualty insurance purchased through our reporting agency locations. Our share is 17.7 percent in reporting agency locations that have represented us for more than 10 years; 6.7 percent in agencies that have represented us for six to 10 years; 4.1 percent in agencies that have represented us for one to five years; and 0.8 percent in agencies that have represented us for less than one year.
Our largest single agency relationship accounted for approximately 1.2 percent of our total property casualty earned premiums in 2010. No aggregate locations under a single ownership structure accounted for more than 2.2 percent of our earned premiums in 2010.
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.
While the prospect exists for short-term financial performance variability due to our exposures to potential catastrophes or significant capital market losses, the rating agencies consistently have asserted that we have built appropriate financial strength and flexibility to manage that variability. 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.
We use various principles and practices such as diversification and enterprise risk management to maintain strong capital. This includes maintaining a diversified investment portfolio by reviewing and applying diversification parameters and tolerances.
Strong liquidity increases our flexibility through all periods to maintain our cash dividend and to continue to invest in and expand our insurance operations. At December 31, 2010, we held $1.042 billion of our cash and invested assets at the parent company level, of which $763 million, or 73.2 percent, was invested in common stocks, and $38 million, or 3.6 percent, was cash or cash equivalents.
We minimize reliance on debt as a source of capital, maintaining the ratio of debt-to-total-capital below 20 percent. At December 31, 2010, this ratio at 14.3 percent was well below the target limit as capital remained strong while debt levels were unchanged from year-end 2009. Our long-term debt consists of three non-convertible, non-callable debentures, two due in 2028 and one in 2034.
At year-end 2010 and 2009, 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 5 |
The consolidated property casualty insurance group's ratio of investments in common stock to statutory surplus was 55.3 percent at year-end 2010 compared with 58.4 percent at year-end 2009. The life insurance company's ratio was 29.6 percent compared with 32.2 percent a year ago.
Cincinnati Financial Corporation's senior debt is rated by four independent rating firms. In addition, the rating 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 ratings agency, and each rating should be evaluated independently of any other rating.
All of our insurance subsidiaries continue to be highly rated. During 2010, Standard & Poor's Rating Services lowered our ratings as described below. No other rating agency actions occurred during 2010.
As of February 25, 2011, our insurer financial strength ratings were:
On December 13, 2010, A.M. Best affirmed our ratings that it had assigned in February 2010, continuing its stable outlook. A.M. Best cited our superior risk-adjusted capitalization, conservative reserving philosophy and successful distribution within our targeted regional markets. Concerns noted by A.M. Best included geographic concentration, underwriting losses that began in 2008 and common stock leverage of approximately 50 percent of statutory surplus. A.M. Best said its concerns are offset by our conservative underwriting and reserving philosophies, with loss reserves more than fully covered by a highly rated, diversified bond portfolio, and by strategic initiatives to improve underwriting results.
On September 2, 2010, Fitch Ratings affirmed our ratings that it had assigned in August 2009, continuing its stable outlook. Fitch noted that ratings strengths include conservative capitalization, moderate holding company leverage, ample liquidity and competitive advantages from our distribution system. Fitch said the ratings recognize our steps taken to rebalance our common stock portfolio to reduce volatility of capital and earnings. Fitch noted concerns principally related to challenges from competitive market conditions and exposure to regional natural catastrophes and weather-related losses.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 6 On July 19, 2010, Standard & Poor's Ratings Services lowered the insurer financial strength ratings to A (Strong) from A+ (Strong) on our standard market property casualty companies and our life insurance subsidiary, and raised its outlook to stable. S&P said its actions reflected the recent decline in our earnings and deterioration of underwriting performance from historical levels. Standard & Poor's noted our very strong capitalization and strong competitive position, supported by a very loyal and productive agency force and low-cost infrastructure. S&P also cited our improved enterprise risk management, including a more conservative and risk-averse investment portfolio, which supports capital stability.
Our debt ratings are discussed in Item 7, Liquidity and Capital Resources, Additional Sources of Liquidity, Page 79.
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, 956 reporting agency locations wrote 67.1 percent of our 2010 consolidated property casualty earned premium volume compared with 933 locations and 68.1 percent in 2009.
Property Casualty Insurance Earned Premiums by State
Field Focus
We rely on our force of 1,222 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 loss control field 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 7 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:
Agencies
access our systems and other electronic services via their agency management
systems or CinciLink®, our
secure agency-only website. 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 763 locally based field claims associates 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 also can 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 identify through mapping technologies the expected number of our policyholders that may be impacted by the event and 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 8 increasing overall premiums. Our SIU also operates a computer forensics lab, using sophisticated software to recover data and mitigate the cost of computer-related claims for business interruption and loss of records.
Insurance Products
We actively market property casualty insurance in 39 states through a select group of independent insurance agencies. For most agencies that represent us, we believe we offer insurance solutions for approximately 75 percent of the typical insurable risks of their clients. Our standard market commercial lines products are marketed in all 39 states while our standard market personal lines products are marketed in 29. At year-end 2010, CSU Producer Resources marketed our excess and surplus lines products in 38 states to agencies that represent Cincinnati Insurance. We discuss our commercial lines, personal lines and excess and surplus lines insurance operations and products in Commercial Lines Property Casualty Insurance Segment, Page 12, Personal Lines Property Casualty Insurance Segment, Page 15, and Excess and Surplus Lines Property Casualty Insurance Segment, Page 16.
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, the wholly owned insurance brokerage subsidiary of parent-company Cincinnati Financial Corporation.
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 for travel-related expenses to 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 available non-insurance financial services. 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.
Strategic Initiatives
Management has identified strategies that can position us for long-term success. The board of directors and management expect execution of our strategic plan to create significant value for shareholders over time. We broadly group these strategies into two areas of focus – improving insurance profitability and driving premium growth – correlating with the primary ways we measure our progress toward our long-term financial objectives.
Effective capital management is an important part of creating shareholder value, serving as a foundation to support other strategies focused on profitable growth of our insurance business, with the overall objective of long-term benefit for shareholders. Our capital management philosophy is intended to preserve and build 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.
Our strategies seek to position us to compete successfully in the markets we have targeted while optimizing the balance of risk and returns. We believe successful implementation of key initiatives that support our
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 9
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 36.
Improve Insurance Profitability
Implementation of the three initiatives below is intended to improve pricing capabilities for our property casualty business, improving our ability to manage our business while also enhancing our efficiency. By improving pricing capabilities through the use of analytics tools, we can better manage profit margins. By improving agency-level planning, we can develop and execute growth and profitability plans that enhance our ability to achieve objectives at all levels in the organization. By improving internal processes and further developing performance metrics, we can be more efficient and effective. These initiatives also support the ability of the agencies that represent us to grow profitably by allowing them to serve clients faster and more efficiently manage expenses. The primary initiatives for 2011 to improve insurance profitability are:
We measure the overall success of our strategy to improve insurance profitability primarily through our GAAP combined ratio for property casualty results, which we believe can be consistently below 100 percent for 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 2010, we again earned that
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 10 rank in approximately 75 percent of the agencies that have represented Cincinnati Insurance for more than five years, based on 2009 premiums. We are working to increase the percentage of agencies where we achieve that rank.
Drive Premium Growth
Implementation of the operational initiatives below is intended to further penetrate each market we serve through our independent agency network. We expect strategies aimed at specific market opportunities, along with service enhancements, to help our agents grow and increase our share of their business. The primary initiatives to drive premium growth are:
We measure the overall success of this strategy to drive premium growth primarily through changes in net written premiums, which we believe can grow faster than the industry average over any five-year period. On a compound annual growth rate basis over the five-year period 2006 through 2010, our property casualty net written premiums registered negative 0.7 percent, compared with an estimated negative 0.5 percent for the industry. Our premium mix is more heavily weighted in commercial lines, relative to the industry, and premium growth rates for the commercial lines segment of the industry have lagged the personal lines segment in recent years.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 11 Our Segments
Consolidated financial results primarily reflect the results of our five reporting segments. In the fourth quarter of 2010, we revised our reportable operating segments to include excess and surplus lines. This segment includes results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources. Historically, the excess and surplus lines results were reflected in Item 7, Other. We began offering excess and surplus lines insurance products in 2008. The line continues to grow since inception and separating it into a reportable segment allows readers to view this business in a manner similar to how it is managed internally when making operating decisions. Prior period data included in this annual report has been recasted to represent this new segment. 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 127. 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 36.
Commercial
Lines Property Casualty Insurance Segment
The commercial lines property casualty insurance segment contributed net earned premiums of $2.154 billion to consolidated total revenues, or 57.1 percent of that total, and reported a gain before income taxes of $15 million in 2010. Commercial lines net earned premiums declined 2 percent in 2010, 5 percent in 2009 and 4 percent in 2008.
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 — 2010 Annual Report on 10-K — Page 12 institutions, metalworkers, printers, religious institutions, or smaller main street businesses. Businessowners policies, which combine property, liability and business interruption coverages for small businesses, are included in specialty packages.
Our emphasis is on products that agents can market to small to midsized businesses in their communities. Of our 1,544 reporting agency locations, 16 market only our surety and executive risk products and 11 market only our personal lines products. The remaining 1,517 locations, located in all states in which we actively market, offer some or all of our standard market commercial insurance products.
In 2010, our 10 highest volume commercial lines states generated 64.3 percent of our earned premiums compared with 65.3 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 4 percent in 2010 and increased 1 percent in the remaining 29 states. The number of reporting agency locations in our 10 highest volume states increased to 954 in 2010 from 933 in 2009.
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,
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 13 answering underwriting questions, helping to determine underwriting eligibility and assisting with the mechanics of premium determination.
Our emphasis on small to midsized businesses is reflected in the mix of our commercial lines premium volume by policy size. Nearly 90 percent of our commercial in-force policies have annual premiums of $10,000 or less, accounting in total for approximately one-third of our 2010 commercial lines premium volume. The remainder for policies with annual premiums greater than $10,000 includes in-force policies with annual premiums greater than $100,000 that account for slightly less than 15 percent of our 2010 commercial lines premium volume.
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 2010 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, underwriters and Target Markets department associates 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 Target Markets department analyzes opportunities and develops new products and services, new coverage options and improvements to existing insurance products.
We support our commercial lines operations with a variety of technology tools. e-CLAS® CPP for commercial package and auto coverages now has rolled out to all of our appointed agencies in 30 states. It is being developed for additional coverages and states that will be deployed over time. Since the initial deployment of e-CLAS in late 2009, approximately one-third of our non-workers' compensation commercial lines policies in force at the end of 2010 have been processed through e-CLAS. Due to the three-year policy term for much of our commercial lines business, some policies will not be due for renewal processing in e-CLAS until 2012. In addition to increasing efficiency for our associates, the 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 tasks and allows seamless quoting, rating and issuance capability.
Cincinnati Financial Corporation — 2010 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 $721 million to consolidated total revenues, or 19.1 percent of the total, and reported a loss before income taxes of $54 million in 2010. Personal lines net earned premiums grew 5 percent in 2010, after declining less than 1 percent in 2009 and 3 percent in 2008.
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 1,123 or approximately 73 percent of our 1,544 reporting agency locations. The 1,123 personal lines agency locations are in 29 of the 39 states in which we offer standard market commercial lines insurance and represent nearly 80 percent of the reporting agency locations in the 29 states. During 2010, we largely completed an initiative that began in 2008 to appoint for personal lines existing agencies marketing only our commercial lines insurance products. We continue to evaluate opportunities to expand our marketing of personal lines to other states. Primary factors considered in the evaluation of a potential new state include weather-related catastrophe history and the legal climate. The number of reporting agency locations in our 10 highest volume states increased 5 percent to 749 in 2010 from 711 in 2009.
In 2010, our 10 highest volume personal lines states generated 82.2 percent of our earned premiums compared with 84.1 percent in the prior year. Earned premiums in the 10 highest volume states increased 3 percent in 2010 while increasing 18 percent in the remaining states, reflecting progress toward our long-term objective of geographic diversification through new states for our personal lines operation.
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. At year-end, we had
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 15
seven full-time personal lines marketing representatives who have underwriting authority and visit agencies on a regular basis. They focus primarily on key states targeted for growth, reinforcing the advantages of our personal lines products and offering training in the use of our processing system.
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 web-based real-time personal lines policy processing system that supports and allows streamlined processing. Diamond incorporates features frequently requested by our agencies such as pre-filling of selected data for improved efficiency, easy-to-use screens, 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.
Excess and Surplus Lines Property Casualty Insurance Segment
The excess and surplus lines property casualty segment contributed net earned premiums of $49 million to consolidated total revenues, or 1.3 percent of the total, and reported a loss before income taxes of $8 million in 2010, its third year of operation. Excess and surplus lines net earned premium increased 81 percent in 2010. Net earned premiums increased 440 percent to $27 million in 2009.
Our excess and surplus lines policies typically cover business risks with unique characteristics, such as the nature of the business or its claim history, that are difficult to profitably insure in the standard commercial lines market. Excess and surplus lines insurers have more flexibility in coverage terms and rates compared with standard lines companies, generally resulting in policies with higher rates and terms and conditions customized for specific risks, including restricted coverage where appropriate. We target small to midsized risks, seeking to avoid those we consider exotic in nature. Our average excess and surplus lines policy size is approximately $5,000 in annual premiums, and policyholders in many cases also have standard market insurance with one of The Cincinnati Insurance Companies. Approximately 80 percent of our 2010 premium volume for the excess and surplus lines segment provided commercial casualty coverages and about 20 percent provided commercial property coverages. Those coverages are described below.
At the end of 2010, we marketed excess and surplus lines insurance products in 38 of the 39 states in which we offer standard market commercial lines insurance. Offering excess and surplus lines helps agencies representing The Cincinnati Insurance Companies meet the insurance needs of their clients when coverage is unavailable in the standard market. By providing outstanding service, we can help agencies grow and prosper while also profitably growing our property casualty business.
In 2010, our 10 highest volume excess and surplus lines states generated 65.1 percent of our earned premiums compared with 74.2 percent in the prior year.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 16 Excess and Surplus Lines Earned Premiums by State
Agencies representing The Cincinnati Insurance Companies write over $2 billion in annual premiums for excess and surplus lines business for all carriers in total that they represent. We estimate that approximately half of that premium volume matches the targeted business types and coverages we offer through our excess and surplus lines segment. We structured the operations of this segment to meet the needs of these agencies and market exclusively through them.
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 The Cincinnati Specialty Underwriters Insurance Company and maintains appropriate agent and surplus lines licenses to process non-admitted business.
We seek to earn a share of each agency's best excess and surplus lines accounts by offering several unique benefits. 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 agencies' broader Cincinnati relationships to bring their policyholders services such as experienced and responsive loss control and claims handling. CSU Producer Resources gives extra support to our producers by remitting surplus lines taxes and stamping fees and retaining admitted market diligent search affidavits, where required. Agencies marketing through CSU Producer Resources generally receive a higher commission because use of our internal brokerage subsidiary eliminates some of the intermediary costs. This business is also factored in their profit-sharing agreement with The Cincinnati Insurance Companies.
We use a web-based excess and surplus lines 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 real-time processing of policies and billing. It provides a specimen policy detailing coverages when a policy is quoted and delivers electronic copies of policies to producers within minutes of underwriting approval and policy issue. In 2010, more than 95 percent of policies were issued within 24 hours of a request to bind a policy. Also in 2010, we received the Celent Model Insurer Award, recognizing our efficient use of technology. We successfully leveraged our policy administration system to quickly enter a new market, developing our miscellaneous errors and omissions product in only three months and then issuing the first 50 policies within two weeks.
Life Insurance Segment
The life insurance segment contributed $158 million of net earned premiums, representing 4.2 percent of consolidated total revenues, and $7 million of income before income taxes in 2010. Life insurance segment profitability is discussed in detail in Item 7, Life Insurance Results of Operations, Page 73. Life insurance net earned premiums grew 10 percent in 2010, 13 percent in 2009 and less than 1 percent in 2008.
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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 17
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.
Life
Insurance Business Lines
Four lines of business – term insurance, universal life insurance, worksite products and whole life insurance – account for approximately 96.9 percent of the life insurance segment's revenues:
In addition, Cincinnati Life markets:
Life Insurance Distribution
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 2010, almost 90 percent of our 1,544 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:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 18 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 5. Our life insurance company has chosen not to establish a Moody's rating.
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.
Our investment department operates under guidelines set forth in our investment policy statement along with oversight of the investment committee of our board of directors. These guidelines set parameters for risk tolerances governing, among other items, the allocation of the portfolio as well as security and sector concentrations. These parameters are part of an integrated corporate risk management program.
The fair value of our investment portfolio was $11.424 billion and $10.562 billion at year-end 2010 and 2009, respectively. The overall portfolio remained in an unrealized gain position as strong returns in the equity and corporate bond markets more than offset a decline in the municipal bond market.
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. During 2010, approximately one-quarter of new cash flow was invested in equity securities, consistent with our long-term average. We consider internal measures, as well as insurance department regulations and rating 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 2010, 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 46, and Item 8, Note 3 of the Consolidated Financial Statements Page 114, for additional discussion of our valuation techniques.
In addition to securities held in our investment portfolio, at year-end 2010, other invested assets included $40 million of life policy loans, $28 million of venture capital fund investments, $5 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-
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 19 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 2010, this portfolio's fair value was 106.3 percent of book value, up from last year due to both a decline in the general level of treasury rates and a continued tightening of credit spreads.
The portfolio grew in 2010 due to a large volume of purchases. These purchases were most concentrated in the investment grade corporate bond market. Although the average rating of our bond portfolio remained unchanged, the number of bonds rated Aaa/AAA decreased and the number of bonds rated Aa/AA increased. The rating distribution change was driven by net redemptions of U.S. agency (government-sponsored enterprises) bonds due to call activity and an increase in purchases of Build America Bonds. 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 at year-end 2010 for the fixed-maturity and short-term portfolios were:
Our fixed-maturity portfolio as of December 31, 2010, included approximate maturing amounts with pretax average yields-to-book value as follows: 3.4 percent maturing in 2011 with a 5.9 percent yield, 5.4 percent in 2012 with a 5.5 percent yield, and 8.6 in 2013 percent with a 4.7 percent yield, Additional maturity periods for our fixed-maturity portfolio are shown in Item 8, Note 2 of the Consolidated Financial Statements, Page 111. Attributes of the fixed-maturity portfolio include:
Taxable Fixed Maturities
Our $5.533 billion taxable fixed-maturity portfolio (at fair value) at year-end 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 issues, no individual issuer's securities accounted for more than 1.1 percent of the taxable fixed-maturity portfolio at year-end 2010. Investment grade corporate bonds had an average rating of Baa1 by Moody's or BBB+ by Standard & Poor's and represented 84.8 percent of the taxable fixed maturity portfolio's fair value at year end 2010, compared with 80.9 percent in 2009.
The investment-grade corporate bond portfolio is most heavily concentrated in the financial-related sectors, including banking, financial services and insurance. The financial sectors represented 28.9 percent of fair value of this portfolio at year-end 2010, compared with 25.3 percent, at year-end 2009. 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 was the only other
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 20 sector that exceeded 10 percent of our investment-grade corporate bond portfolio, at 10.0 percent of fair value at year-end 2010.
Most of the $293 million of securities issued by states, municipalities and political subdivisions securities included in our taxable fixed maturity portfolio at the end of 2010 were Build America Bonds.
Tax-exempt
Fixed Maturities
Our tax-exempt fixed maturity portfolio's fair value was $2.850 billion at December 31, 2010. We traditionally have purchased municipal bonds focusing on general obligation and essential services, such as sewer, water or others. The portfolio is well diversified among approximately 1,000 municipal bond issuers. No single municipal issuer accounted for more than 0.7 percent of the tax-exempt fixed maturity portfolio at year-end 2010. Municipal bond holdings in our larger states were:
At year-end 2010, our tax-exempt fixed maturity portfolio, with a fair value of $2.850 billion, had an average rating of Aa2/AA. Almost 80 percent or $2.245 billion of the portfolio is insured, and approximately 93 percent of the insured portion carried an underlying rating of at least A3 or A- by Moody's or Standard & Poor's at year end. We strongly prefer general obligation or essential services bonds, which we believe provide a superior risk profile.
Equity Investments
After covering both our intermediate and long-range insurance obligations with fixed-maturity investments, we historically used available cash flow to invest in equity securities. Investment in equity securities has played an important role in achieving our portfolio objectives and has contributed to portfolio appreciation. We remain committed to our long-term equity focus, which we believe is key to our company's long-term growth and stability.
Common Stocks
Our cash allocation for common stock purchases is implemented only after we ensure that insurance reserves are adequately covered by our fixed-maturity investments. We believe our strategy of primarily investing in a diversified selection of larger capitalization, high quality, dividend-increasing companies generally results in reduced volatility relative to the broader equity markets.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 21 At December 31, 2010, one holding had a fair value equal to or greater than 5 percent of our publicly traded common stock portfolio compared with two holdings at that level at year-end 2009. The Procter & Gamble Company (NYSE:PG) is our largest single common stock investment, comprising 5.2 percent of the publicly traded common stock portfolio and 1.3 percent of the investment portfolio.
At year-end 2010, 26.0 percent of our common stock holdings (measured by fair value) were held at the parent company level.
Common
Stock Portfolio Industry Sector Distribution
Preferred Stocks
We evaluate preferred stocks in a manner similar to our evaluation of fixed-maturity investments, seeking attractive relative yields. We generally focus on investment-grade preferred stocks issued by companies with strong histories 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 re-evaluate the riskiness of all preferred securities, particularly those of banking institutions. As a result, during 2009 we downsized this portfolio by $82 million of fair value to $93 million. We made no additional purchases or sales for this portfolio during 2010.
Short-Term Investments
At December 31, 2010, we had no short-term investments, compared with $6 million at year-end 2009. Our short-term investments consisted primarily of commercial paper, demand notes or bonds purchased within one year of maturity.
Additional information about the composition of investments is included in Item 8, Note 2 of the Consolidated Financial Statements, Page 111. A detailed listing of our portfolio is updated on our website, www.cinfin.com/investors, each quarter when we report our quarterly financial results.
Other
We report as Other the non-investment operations of the parent company and its subsidiary CFC Investment Company. This subsidiary offers commercial leasing and financing services to our agencies, their clients and other customers. As of year-end 2010, CFC Investment Company had 2,227 accounts and $73 million in receivables, compared with 2,286 accounts and $75 million in receivables at year-end 2009.
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, 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 — 2010 Annual Report on 10-K — Page 22
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 23
Although the federal government and its regulatory agencies generally do not directly regulate the business of insurance, federal legislation and administrative rules adopted to implement them do affect our business. Privacy laws, such as the Gramm-Leach-Bliley Act, the Fair Credit Reporting Act and the Health Insurance Portability and Accounting Act (HIPAA) are the federal laws that most affect our day-to-day operations. These apply to us because we gather and use personal non-public information to underwrite insurance and process claims. We also are subject to other federal laws, such as the Terrorism Risk Insurance Act (TRIA), anti-money laundering statute (AML), and the rules and regulations of the Office of Foreign Assets Control (OFAC).
Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) created the Federal Insurance Office to monitor the insurance industry and gather information to identify issues or gaps in the regulation of insurers that could contribute to a systemic crisis in the insurance industry of the United States financial system, and to recommend to the Financial Stability Oversight counsel that it designate an insurer as a systemically significant entity requiring additional supervision by the Federal Reserve Board. Although rules have not yet been proposed or implemented to govern the determination that a non-bank financial company, such as an insurance company, presents systemic risk, we do not expect such rules, when adopted, to result in federal oversight of our operations as a systemically significant entity.
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 adopted relating to the protection of the environment. We currently do not have any material estimated capital expenditures for environmental control facilities.
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 36, for a discussion of those strategies.
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'
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 24 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, including:
A reduction in the number of independent agencies marketing our products, the failure of agencies to successfully market our products or pay their accounts due to us, 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, terrorism or pandemic 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. Various scientists and other experts believe that changing climate conditions have added to the unpredictability, frequency and severity of such natural disasters in certain parts of the world and have created additional uncertainty as to future trends and exposures. We cannot predict the impact that changing climate conditions may have on our results of operations nor can we predict how any legal, regulatory or social responses to concerns about climate change may impact our business.
The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Our ability to appropriately manage catastrophe risk depends partially on catastrophe models, the accuracy of which may be 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 39 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.
Cincinnati Financial Corporation — 2009 Annual Report on 10-K — Page 25 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 may 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 or other companies and other investors 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 standard market property casualty insurance products in 39 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 2010, 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. Amounts related to the other two treaties are immaterial.
In the event of a severe catastrophic event or terrorist attack elsewhere in the world, our insurance losses may be immaterial. However, the companies in which we invest might be severely affected, which could affect our financial condition and results of operations. Our reinsurers might experience significant losses, potentially jeopardizing their ability to pay losses we cede to them. We also may be exposed to state guaranty fund assessments if other carriers in a state cannot meet their obligations to policyholders. A catastrophe or epidemic event also could affect our operations by damaging our headquarters facility, injuring associates and visitors at our Fairfield, Ohio, headquarters or disrupting our associates' ability to perform their assigned tasks.
Our ability to achieve our performance objectives could be affected by changes in the financial, credit and capital markets or the general economy.
We invest premiums received from policyholders and other available cash to generate investment income and capital appreciation, while also 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 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 example, a significant increase in the general level of interest rates could lead to falling bond values. For more detailed discussion of risks associated with our investments, please refer to Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 93.
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 the jurisdiction for which the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded. We could experience losses if the assets in the accounts 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 47.
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 2010, common stock holdings made up 25.5 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 75, and Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 93, for discussion of our investment activities.
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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 26 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, properly analyze and use data to make decisions and take appropriate action; 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:
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, Excess and Surplus 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 27 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 105, and Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves and Life Insurance Policy Reserves, Page 41 and Page 44.
Our most critical accounting estimate is loss reserves. Loss reserves are the amounts we expect to pay for covered claims and expenses we incur to settle those claims. The loss reserves we establish in our financial statements represent an estimate of amounts needed to pay and administer claims arising from insured events that have already occurred, including events that have not yet been reported to us. Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability. 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 process used to determine our loss reserves is discussed in Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves and Life Insurance Policy Reserves, Page 41 and Page 44.
Unforeseen losses, the type and magnitude of which we cannot predict, may emerge in the future. These additional losses could arise from changes in the legal environment, laws and regulations, climate change, catastrophic events, increases in loss severity or frequency, or other causes. Such future losses could be substantial. Inflationary scenarios may cause the cost of claims, especially medical claims, to rise, impacting reserve adequacy and our results of operations.
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 and earnings volatility 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.
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 2010, 19 percent, or $110 million, of our total reinsurance receivables were related to USAIG, primarily for events of September 11, 2001, offset by $118 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 $230 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, 2011 Reinsurance Programs, Page 90, 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 28 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, laws 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 sometime 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.
We are required to adopt new or revised accounting standards issued by recognized authoritative organizations, including the Financial Accounting Standards Board and the SEC. Future changes required to be adopted could change the current accounting treatment that we apply and could result in material adverse effects on our results of operations and financial condition.
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 measures under the Dodd-Frank Act that establish the Federal Insurance Office and provide for a determination that a non-bank financial company presents systemic risk and therefore should be subject to heightened supervision by the Federal Reserve Board. Adoption or implementation of any of these measures may restrict our ability to conduct our insurance business, govern our corporate affairs or increase our cost of doing business.
The effects of such changes could adversely affect our results of operations. Please see Item 7, Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves and Life Insurance Policy Reserves, Page 41 and Page 44, for a discussion of our reserving practices.
Managing technology initiatives and meeting new data security requirements are significant challenges.
While technology can streamline many business processes and ultimately reduce the cost of operations, technology initiatives present short-term cost, and also have 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 9 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 22, and Item 8, Note 9 of the Consolidated Financial Statements, Page 118, for discussion of insurance holding company dividend regulations.
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 $159 million as of December 31, 2010, 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 $5 million as of December 31, 2010, and is classified as an other invested asset. Unaffiliated tenants occupy approximately 5 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 $11 million as of December 31, 2010, 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. (Removed and Reserved)
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 30 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 as of December 31, 2010. This number does not represent the total number of shareholders because some shares are beneficially held in "street name" by brokers and others on behalf of individual owners of our shares. Many of our independent agent representatives and most of the 4,060 associates of our subsidiaries own the company's common stock.
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 78. 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 118.
The following summarizes securities authorized for issuance under our equity compensation plans as of December 31, 2010:
The number of securities remaining available for future issuance includes: 5,627,553 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; 83,904 shares of stock options available for issuance under the Cincinnati Financial Corporation Stock Option Plan VII and 268,690 shares available for issuance of share grants under the Director's Stock Plan of 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 125.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 31 We did not sell any of our shares that were not registered under the Securities Act during 2010. The board of directors has authorized share repurchases since 1996. Purchases are expected to be made generally through open market transactions. The board gives management discretion to purchase shares at reasonable prices in light of circumstances at the time of purchase, subject to U.S. Securities and Exchange Commission (SEC) regulations. During 2010, we repurchased 377,748 shares at an average cost of $26.49 per share.
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. Neither the 2005 nor 1999 program had an expiration date, but no further repurchases will occur under the 1999 program.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 32 Cumulative Total Return
As depicted in the graph below, the five–year total return on a $100 investment made December 31, 2005, assuming the reinvestment of all dividends, was a negative 10.3 percent for Cincinnati Financial Corporation's common stock compared with a negative 12.9 percent for the Standard & Poor's Composite 1500 Property & Casualty Insurance Index and a 12.0 percent return for the Standard & Poor's 500 Index.
The Standard & Poor's Composite 1500 Property & Casualty Insurance Index includes 25 companies: Ace Ltd., Allstate Corporation, Amerisafe Inc., W. R. Berkley Corporation, Berkshire Hathaway, Chubb Corporation, Cincinnati Financial Corporation, Employers Holdings Inc., Fidelity National Financial Inc., First American Financial 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 and XL Capital Ltd.
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 — 2010 Annual Report on 10-K — Page 33 Item 6. Selected Financial Data
Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2010.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 34
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 35 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of
Operations
Introduction
The purpose of Management's Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation's consolidated results of operations and financial condition. Our Management's Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Page 34 and Page 35, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 105. 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 accounting basis. When we provide our results on a comparable statutory accounting 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 2009 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 39 states as discussed in Item 1, Our Business and Our Strategy, Page 3.
Although recent years have been difficult 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 — 2010 Annual Report on 10-K — Page 36
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 2010, the company has increased the indicated annual cash dividend rate for 50 consecutive years, a record we believe is matched by only 10 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 78.
Strategic
Initiatives Highlights
Management has worked to identify a strategy that can lead to long-term success, with concurrence by the board of directors. Our strategy is intended to position us to compete successfully in the markets we have targeted while appropriately managing risk. We discuss our long-term, proven strategy in Item 1, Our Business and Our Strategy, Page 3. We believe successful implementation of initiatives that support our strategy will help us better serve our agent customers and reduce volatility in our financial results while we also grow earnings and book value over the long-term, successfully navigating challenging economic, market or industry pricing cycles.
We discuss these strategic initiatives, along with related metrics to assess progress, in Item 1, Strategic Initiatives, Page 9.
Factors
Influencing Our Future Performance
In 2010, our value creation ratio of 11.1 percent was slightly below our target annual average of 12 percent to 15 percent for the period 2010 through 2014. In 2009, the ratio exceeded our target and in 2008, it was below our target, as discussed in the review of our financial highlights below. For the year 2011, we believe our value creation ratio may be below our long-term target for several reasons.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 37
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 2011. Second, we assume that the economy can continue on a growth track during 2011. 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 target include:
We discuss in our Item 1A, Risk Factors, Page 24, 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 provides 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 48, and Liquidity and Capital Resources, Page 78.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 38 Corporate Financial Highlights
The value creation ratio discussed in the Executive Summary, Page 36, was 11.1 percent in 2010, 19.7 percent in 2009 and negative 23.5 percent in 2008. The book value per share growth component of the value creation ratio was 5.7 percent during 2010 and 13.6 percent during 2009, largely reflecting improved valuation of our investment portfolio in addition to earnings. In 2008, a decline in unrealized gains on our investment portfolio was the most significant factor in the 27.9 percent decline in book value. Net income declined 13 percent in 2010 after growing 1 percent in 2009, reflecting lower realized investment gains. In 2008, net income was down 47 percent. Cash dividends declared per share rose approximately 1 percent in 2010, 1 percent in 2009 and 10 percent in 2008.
Balance Sheet Data
Invested assets grew significantly during both 2010 and 2009 primarily due to strong performance in the financial markets, reversing the trend of 2008 from lower fair values for portfolio investments, largely due to economic factors. Entering 2011, the portfolio continues to be well-diversified and we believe it is well-positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, Page 19, and results for the segment in Investment Results of Operations, Page 75.
Our ratio of debt to total capital (debt plus shareholders' equity) decreased in both 2010 and 2009 and is comfortably within our target range.
Income Statement and Per Share Data
Net income in 2010 was $55 million or 13 percent lower than in 2009, due primarily to the after-tax effects of net realized investment gains that were $114 million lower, partially offset by a $53 million improvement from property casualty underwriting results plus $9 million growth in investment income. Net income increased $3 million in 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.
Weighted average shares outstanding may fluctuate from period to period due to repurchases of shares under board authorizations or issuance of shares through equity compensation plans. Weighted average shares outstanding on a diluted basis increased by less than 1 million in 2010, after declining by less than 1 million in 2009 and by 9 million in 2008.
As discussed in Investment Results of Operations, Page 75, security sales led to realized investment gains in all three years, although 2008 gains were tempered by $510 million in other-than-temporary impairment (OTTI) 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 39 Higher interest income drove 3 percent growth in 2010 pretax investment income. Lower income from common stock dividends led to a 7 percent decline in 2009 pretax net investment income, improving on a 12 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 sold or reduced.
Contribution
from Insurance Operations
Property casualty written premiums grew 2 percent in 2010, reversing the trend of 3 percent declines in both 2009 and 2008. Earned premiums also reversed the prior year trend, growing slightly in 2010. Trends and related factors discussed in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 54, Page 64 and Page 70, respectively.
Our property casualty insurance operations reported an underwriting loss in each of the last three years, but the amount of loss in 2010 was less than half that of 2009. 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. Our combined ratio was over 100 percent in each of the last three years. Initiatives to improve our combined ratio are discussed in Item 1, Strategic Initiatives, Page 9. In 2010, 2009 and 2008, favorable development on reserves for claims that occurred in prior accident years helped offset other incurred loss and loss expenses. Reserve development is discussed further in Property Casualty Loss and Loss Expense Obligations and Reserves, beginning on Page 82. Losses from weather-related catastrophes are another important item influencing the combined ratio and are discussed along with other factors in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 54, Page 64 and Page 70, respectively.
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 73. 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 105. In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company's critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 40 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 $4.137 billion at year-end 2010 compared with $4.096 billion at year-end 2009.
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. Field claims managers supervise and review all claims with case reserves less than $35,000. Experienced headquarters claims supervisors review individual case reserves greater than $35,000 that were established by field claims representatives. Headquarters claims managers also review case reserves greater than $100,000.
Our claims representatives base their case reserve estimates primarily upon case-by-case evaluations that consider:
Case reserves of all sizes are subject to review on a 90-day cycle, or more frequently if new information about a loss becomes available. As part of the review process, we monitor industry trends, cost trends, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional loss exposures.
We also establish 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 address these uncertainties in the reserving process in a variety of ways.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 41 Our actuarial staff bases its IBNR reserve estimates for these losses primarily on the indications of methods and models that analyze accident year data. Accident year is the year in which an insured claim, loss, or loss expense occurred. The specific methods and models that our actuaries have used for the past several years are:
Our actuarial staff uses diagnostics provided by stochastic reserving software to evaluate the appropriateness of the models and methods listed above. The software's diagnostics have indicated that the appropriateness of these models and methods for estimating IBNR reserves for our lines of business tends to depend on a line's tail. Tail refers to the time interval between a typical claim's occurrence and its settlement. For our long-tail lines such as workers' compensation and commercial casualty, models from the probabilistic trend family tend to provide superior fits and to validate well compared with models underlying the loss development and Bornhuetter-Ferguson methods. The loss development and Bornhuetter-Ferguson methods, particularly the reported loss variations, tend to produce the more appropriate IBNR reserve estimates for our short-tail lines such as homeowner and commercial property. For our mid-tail lines such as personal and commercial auto liability, all models and methods provide useful insights.
Our actuarial staff also devotes significant time and effort to the estimation of model and method parameters. The loss development and Bornhuetter-Ferguson methods require the estimation of numerous loss development factors. The Bornhuetter-Ferguson methods also involve the estimation of numerous ultimate loss ratios by accident year. Models from the probabilistic trend family require the estimation of development trends, calendar year inflation trends and exposure levels. Consequently, our actuarial staff monitors a number of trends and measures to gain key business insights necessary for exercising appropriate judgment when estimating the parameters mentioned.
These
trends and measures include:
These trends and measures also support the estimation of ultimate accident year loss ratios needed for applying the Bornhuetter-Ferguson methods and for assessing the reasonability of all IBNR reserve estimates computed. Our actuarial staff reviews these trends and measures quarterly, 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 42 Due to the uncertainties described above, our ultimate loss experience could prove better or worse than our carried reserves reflect. To the extent that reserves are inadequate and increased, the amount of the increase is a charge in the period that the deficiency is recognized, raising our loss and loss expense ratio and reducing earnings. To the extent that reserves are redundant and released, the amount of the release is a credit in the period that the redundancy is recognized, reducing our loss and loss expense ratio and increasing earnings.
Key Assumptions — Loss Reserving
Our actuarial staff makes a number of key assumptions when using their methods and models to derive IBNR reserve estimates. Appropriate reliance on these key assumptions essentially entails determinations of the likelihood that statistically significant patterns in historical data may extend into the future. The four most significant of the key assumptions used by our actuarial staff and approved by management are:
These key assumptions have not changed since 2005, when our actuarial staff began using probabilistic trend family models to estimate IBNR reserves.
Paid losses, reported losses and paid allocated loss expenses are subject to random as well as systematic influences. As a result, actual paid losses, reported losses and paid allocated loss expenses are virtually certain to differ from projections. Such differences are consistent with what specific models for our business lines predict and with the related patterns in the historical data used to develop these models. As a result, management does not closely monitor statistically insignificant differences between actual and projected data.
Reserve Estimate Variability
Management believes that the standard error of a reserve estimate, a measure of the estimate's variability, provides the most appropriate measure of the estimate's sensitivity. The reserves we establish depend on the models we use and the related parameters we estimate in the course of conducting reserve analyses. 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 by property casualty line of business and in total for 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 43 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 83, 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.
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 2010, consolidated fixed maturity investments exceeded total insurance reserves (including life policy reserves) by $2.149 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, 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, signs indicating that the carrying amount may not be recoverable, or changes in legal factors or in the business climate.
The application of our impairment policy resulted in OTTI charges that reduced our income before income taxes by $36 million in 2010, $131 million in 2009 and $510 million in 2008. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee's judgment, the value is not expected to be recouped within a designated recovery period. OTTI losses represent non-cash charges to income and are reported as realized investment losses.
Our investment 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 44 taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing organization. Managers review quantitative measurements such as a declining trend in fair value, the extent of the fair value decline and the length of time the value of the security has been depressed, as well as qualitative measures such as pending events, credit ratings and issuer liquidity. We are even more proactive when these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and market conditions. We provide information about valuation of our invested assets in Item 8, Note 2 of the Consolidated Financial Statements, Page 111.
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.
When evaluating for OTTI, 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 and other factors discussed below, 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, 2010, 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. 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 2010 in Item 7A, Application of Asset Impairment Policy, Page 96. 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 (AOCI), net of tax, and have no impact on net income.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 45 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 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 114.
Level 1 and Level 2 Valuation Techniques
Over 99 percent of the $11.424 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.
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 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, 2010, 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 have generally 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 that was modified during 2008; refer to Item 8, Note 13 of the Consolidated Financial Statements, Page 121, for additional information. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates, expected return on plan assets and compensation increase rates, 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 2010 net pension obligation for our qualified plan were a 5.85 percent discount rate and rates of compensation increases ranging from 3.50 percent to 5.50 percent. Key assumptions used in developing the 2010 net pension expense for our qualified plan were a 6.10 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 121, for additional information on assumptions.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 46 In 2010, the net pension expense was $12 million. In 2011, we expect the net pension expense to be $13 million.
Holding all other assumptions constant, a 0.5 percentage-point decrease in the discount rate would decrease our 2011 income before income taxes by $1 million. A 0.5 percentage point decrease in the expected return on plan assets would decrease our 2011 income before income taxes by $1 million.
The fair value of the plan assets was $30 million less than the accumulated benefit obligation at year-end 2010 and $42 million less at year-end 2009. The fair value of the plan assets was $62 million less than the projected plan benefit obligation at year-end 2010 and $77 million less at year-end 2009. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. On February 1, 2011, we contributed $35 million to our qualified plan.
Deferred Acquisition Costs
We establish a deferred asset for costs that vary with, and are primarily related to, acquiring property casualty and life insurance business. These costs are principally agent commissions, premium taxes and certain underwriting costs, which are deferred and amortized into 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 property casualty insurance operations consist of three segments, commercial lines, personal lines and excess and surplus lines. For life insurance 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. 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 $77 million in 2010 contributed 2.6 percentage points to the property casualty combined ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would affect 2011 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 2011, the account holder would not pay a surrender charge. The surrender charge is zero for 2011 and beyond.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 47 At year-end 2010, net unamortized realized losses amounted to $2 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 $7 million before tax in the separate account portfolio, which had a book value of $583 million at year-end 2010.
Recent Accounting Pronouncements
Information about recent accounting pronouncements is provided in Item 8, Note 1 of the Consolidated Financial Statements, Page 105. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
Results Of Operations
Consolidated financial results primarily reflect the results of our five 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 subsidiary, CFC Investment Company.
We measure profit or loss for our commercial lines, personal lines and excess and surplus property casualty and life insurance segments based upon underwriting results (profit or loss), which represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also frequently evaluate results for our consolidated property casualty insurance operations, which is the total of our commercial, personal, and 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 127. The following sections review results of operations for each of the five segments. Commercial Lines Insurance Results of Operations begins on Page 54, Personal Lines Insurance Results of Operations begins on Page 64, Excess and Surplus Lines Insurance Results of Operations begins on Page 70, Life Insurance Results of Operations begins on Page 73, and Investment Results of Operations begins on Page 75. We begin with an overview of our consolidated property casualty operations.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 48 Consolidated
Property Casualty Insurance Results Of Operations
Our consolidated property casualty operations grew earned premiums slightly in 2010 and lowered its underwriting loss, reversing the lower revenue and deteriorating profitability trends of 2008 and 2009. While soft market conditions persisted for commercial lines, our largest operating segment, several profit improvement and premium growth initiatives began to be evident in results for 2010.
In addition to the factors discussed in Commercial Lines, Personal Lines and Excess and Surplus Lines Insurance Results of Operations, beginning on Page 54, Page 64 and Page 70, respectively, overall growth and profitability for our consolidated property casualty insurance operations were affected by a number of common factors. Targeted growth, seeking to grow premiums where we believe profit margins are acceptable, has been an area of strategic focus in recent years. Development and use of enhanced technology has also been emphasized, helping us to grow premiums as agencies embrace greater ease of use of our policy administration software. Better technology also can improve efficiency for agencies and associates, helping to lower expenses. Careful expense management, spending more in areas of strategic importance and trimming costs in other areas, kept the 2010 expense ratio flat. Slightly lower losses from weather-related catastrophes and a slowly recovering economy also benefited our operating results. The table below highlights property casualty results of operations, with analysis and discussion in the sections that follow. Overview — Three-Year Highlights
Performance highlights for consolidated property casualty operations include:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 49
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 50 Catastrophe Losses Incurred
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 51 Consolidated Property Casualty 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. Most of the incurred losses and loss expenses shown in the three-year highlights table on Page 49 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid losses, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 78.1 percent accident year 2009 loss and loss expense ratio reported as of December 31, 2009, developed favorably by 6.5 percentage points to 71.6 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2010. Accident years 2009 and 2008 have both developed favorably, as indicated by the progression over time for the ratios in the table.
Catastrophe loss trends, discussed above, explain some of the accident year loss and loss expenses trend for years 2008 through 2010. Catastrophe losses added 5.6 for 2010, 5.9 for 2009 and 6.8 percentage points for 2008 to the respective consolidated property casualty accident year loss and loss expense ratios in the table above.
The trend for our 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 for much of our property casualty business that began in 2005 and continued through 2010. Refinements made to the allocation of IBNR reserves by accident year, totaling $69 million, contributed 2.3 percentage points to the 2008 ratio.
Reserve development on prior accident years continued to net to a favorable amount in 2010, as $304 million was recognized, similar to $323 million in 2008. During 2009, the $188 million of net favorable development recognized was lower, due primarily to unfavorable development of $48 million for our workers' compensation line of business, as discussed in Commercial Lines Insurance Segment Reserves, Page 85.
Consolidated Property Casualty Insurance Losses by Size
In 2010, total large losses incurred decreased by $112 million or 16 percent, helping to lower the corresponding ratio by 4.0 percentage points. Large loss trends are further analyzed in the segment discussion below. 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 aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs. Beginning in 2009, we raised the casualty treaty retention to $6 million from $5 million and raised the property treaty retention to $5 million from $4 million.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 52 Consolidated Property Casualty Insurance Underwriting Expenses
Commission expenses include our profit-sharing, or contingent commissions, which are primarily based on the profitability of an agency's business. The aggregate profit trend for agencies that earn these profit-based commissions can differ from the aggregate profit trend for all agencies reflected in our consolidated property casualty results. In 2010, lower contingent commissions drove the lower ratio for property casualty commission expenses, and higher contingent commissions drove the increase in 2009.
In 2010, non-commission expenses were up $13 million or 3 percent, primarily due to a first-quarter 2010 provision for matters involving prior years and related to Note 16, Commitments and Contingent Liabilities, Page 125. The increase outpaced earned premiums, which grew less than 1 percent. In 2009, non-commission expenses declined $14 million, primarily due to a change in our pension plan that added 0.5 percentage points to the 2008 non-commission underwriting expense ratio.
Discussions below of our property casualty insurance segments provide additional detail about our results.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 53 Commercial Lines Insurance Results Of Operations
Overview — Three-Year Highlights
Performance highlights for the commercial lines segment include:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 54 claims following the historically high level of mortgage defaults in 2008, driving an unusually high industry combined ratio for 2008.
Commercial Lines Insurance Premiums
Due to the highly competitive commercial lines markets of several years, we have focused on leveraging our local relationships to benefit from the efforts of our agents and the teams that work with them. We seek to maintain appropriate pricing discipline for both new and renewal business as management emphasizes the importance of assessing account quality to our agencies and underwriters, for careful decisions on a case-by-case basis whether to write or renew a policy. Rate credits may be used to retain renewals of quality business and to earn new business, but we do so selectively in order to avoid commercial accounts that we believe have insufficient profit margins. In recent years we experienced that typically the larger the account, the higher the credits needed to write or retain it, with variations by geographic region and class of business.
In addition to targeting adequate premium per exposure, we also pursue non-pricing means of enhancing longer-term profitability. Non-pricing means have included deliberate reviews to assess each risk, determine limits of insurance and establish appropriate terms and conditions. We continue to adhere to our underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions, leveraging the local presence of our field staff. Our field marketing representatives continue to underwrite new business and meet with local agencies to reaffirm agreements regarding the extent of 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.
In recent years, both renewal and new business premium volume reflected the effects of the economic slowdown in many regions, as exposures declined and policyholders became increasingly focused on reducing insurance costs and other expenses. Insured exposures for overall commercial lines were estimated to be down somewhat for the year 2010, but appeared to be flattening by the end of the year. For commercial accounts, we usually 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 also have other exposures requiring insurance, such as commercial auto or commercial property, in addition to general liability and workers' compensation. Premium levels for these other types of coverages generally are not linked directly to sales or payroll volumes.
In 2010, we estimated that policyholders with a contractor-related ISO general liability code accounted for approximately 33 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 44 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 2 percent decline in 2010 agency renewal written premiums largely reflects pricing and exposure declines, while policy retention rates remained fairly stable. Our headquarters underwriters talk regularly with agents about renewal business. 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 both 2010 and 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 resulting from audits that confirmed or adjusted premiums based on initial estimates of policyholder sales and payrolls affected premium trends in recent years. Written premiums from audits decreased $29 million and $5 million, respectively, for the years 2010 and 2009,
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 55 while earned premiums from audits decreased $40 million and $26 million. Compared with late 2009 and early 2010, premiums from audits by the end of 2010 represented only a slight drag, or unfavorable effect, on total commercial lines written and earned premiums, and we expect the effect to become favorable at some point in 2011.
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. Some of our new business comes from accounts that are 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.
New business premium volume in recent years has been significantly influenced by new agency appointments. All agencies newly appointed since the beginning of 2009 generated commercial lines new business written premiums of $40 million during 2010, up $26 million from 2009, while all other agencies contributed the remaining $249 million, which was down 12 percent.
Many of the recently appointed agencies are in Texas, which we entered in late 2008, or Colorado, which we entered in 2009. Those two states accounted for over 9 percent of the $289 million 2010 new business volume. On a net written premium basis, agencies in Texas and Colorado contributed $40 million of commercial lines volume during 2010, up $28 million from 2009. The size of the Texas insurance market, relative to most other states, represents significant potential for long-term premium growth.
The table below summarizes the Texas and Colorado agents' contribution to our commercial lines new business and net written premiums. Net written premiums are earned over the term covered by insurance policies and are an important leading indicator of earned premium revenue trends.
In both 2010 and 2009, other written premiums had less of a downward effect on commercial lines net written premiums compared with the prior year. Written premiums ceded to reinsurers were approximately the same for both years. Both 2010 and 2009 had a more favorable adjustment, compared with the prior year, for estimated premiums of policies in effect but not yet processed. The adjustment for estimated premiums had an immaterial effect on earned premiums.
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. Most of the incurred losses and loss expenses shown in the three-year highlights table above on Page 54 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than half of our consolidated property casualty current accident year incurred losses and loss expenses represents net paid losses, the majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 75.5 percent accident year 2009 loss and loss expense ratio reported as of December 31, 2009, developed favorably by 8.0 percentage points to 67.5 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2010. Accident years 2009 and 2008 for the commercial lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 56 Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 49, explain some of the movement in accident year loss and loss expense ratios among years 2008 through 2010. Catastrophe losses added 4.7 percentage points for 2010, 3.0 points for 2009 and 4.6 points for 2008 to the respective commercial lines accident year loss and loss expense ratios in the table above.
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 2010, as discussed above in Commercial Lines Insurance Premiums. In addition, previously discussed refinements made to the allocation of IBNR reserves by accident year increased the 2008 ratio.
Commercial lines reserve development on prior accident years continued to net to a favorable amount in 2010, as $269 million was recognized, similar to $273 million in 2008. During 2009, the $147 million of net favorable development recognized was lower, due primarily to unfavorable development of workers' compensation reserves totaling $48 million, including strengthening of reserves by $49 million in first half of the year, as discussed in Commercial Lines Insurance Results of Operations, Commercial Lines of Business Analysis, Page 58.
Most of the commercial lines reserve development on prior accident years reported in years 2008 through 2010 occurred in our commercial casualty line of business. Development by line of business and other trends for commercial lines loss and loss expenses and the related ratios are further analyzed in Commercial Lines of Business Analysis, beginning on Page 58.
Commercial Lines Insurance Losses by Size
In 2010, total large losses incurred decreased by $115 million or 19 percent, helping to lower the corresponding ratio by 4.9 percentage points. The majority of the decrease was for claims related to general liability coverages, largely included in our commercial casualty line of business. The 2009 decline of $16 million or 3 percent for total large losses incurred was more than offset by a larger decline in commercial lines earned premiums, causing an increase in the 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 aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs. In 2009, we raised the casualty treaty retention to $6 million from $5 million and raised the property treaty retention to $5 million from $4 million.
Commercial Lines Insurance Underwriting Expenses
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 57 Commercial lines commission expenses as a percent of earned premium declined during 2010, primarily due to lower agency contingent commissions. Non-commission underwriting expenses rose 2 percent in 2010 but were lower than the 2008 level. The 2010 ratio rose primarily due to lower earned premiums.
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 2010, based on the total loss and loss expense ratio, commercial casualty, our largest line of business, continued to be highly profitable. Workers' compensation and specialty packages had 2010 total loss and loss expense ratios significantly higher than we desired. As discussed below, we are taking actions to improve pricing and reduce loss costs to benefit future profitability trends.
Commercial Casualty
Commercial casualty is our largest line of business and has in recent years maintained a very satisfactory total loss and loss expense ratio. The rate of decline in commercial casualty premiums slowed in 2010, despite ongoing pressure from market competition. Economic trends showed modest improvement during the year, causing corresponding changes in underlying insured 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 2010 calendar year total loss and loss expense ratio improved somewhat, largely due to a higher level, compared with 2009, of favorable development on prior accident year reserves. Factors contributing to the higher level of favorable prior accident year reserve development included a moderation in trend for future umbrella coverage payments and less volatility in the trend estimates for future commercial multiple peril payments.
The 2010 current accident year loss and loss expense ratio before catastrophe losses deteriorated by 3.9 percentage points compared with accident year 2009, reflecting lower pricing per exposure and normal loss cost inflation.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 58 Commercial Property
Commercial property is our second largest line of business. Net written premiums for 2010 were up, largely due to an $8 million or 14 percent increase in new business written premiums.
The 2010 calendar year total loss and loss expense ratio was higher than the very profitable level of 2009, primarily due to higher catastrophe losses and large losses for fires and non-catastrophe weather.
The 2010 current accident year loss and loss expense ratio before catastrophe losses also was higher, compared with accident year 2009, due to higher large losses for fires and non-catastrophe weather, in addition to lower pricing per exposure and normal loss cost inflation. In 2011 we plan to improve pricing precision for commercial property as we begin using predictive modeling tools. In addition, we have increased our loss control staff and are studying methods for improving the effectiveness of conducting property inspections for both new and renewal business.
Commercial Auto
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 for this line of business sooner than for other lines. Commercial auto also experiences pricing pressure because it often represents the largest portion of insurance costs for many commercial policyholder accounts.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 59 The calendar year total loss and loss expense ratio improved during 2010 due to a higher amount of favorable development on prior accident year reserves. The ratio was at a profitable level for both 2009 and 2010.
The 2010 accident year loss and loss expense ratio was up slightly compared with accident year 2009, as a lower level of large losses partially offset lower pricing per exposure and higher physical damage losses.
Workers’ Compensation
Workers' compensation net written premiums for 2010 were down $13 million, largely due to an $8 million or 17 percent decrease in new business written premiums. Premiums resulting from audits of initially recorded premiums, based on policyholder payroll levels, also lowered net written premiums, reflecting the slow economy of recent years. Net written premiums declined sharply in 2009, primarily due to economically-related lower insured exposures and more selective underwriting resulting in the non-renewal of a number of policies in our worst pricing tiers.
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 adequacy. Predictive modeling increases pricing adequacy and 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 to 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.
The calendar year total loss and loss expense ratio improved during 2010 primarily due to $39 million of favorable development on prior accident year reserves. Most of the favorable reserve development was for accident year 2009; approximately half of the favorable development was for losses and the other half was for loss adjustment expenses related to reserves for our claims staff to settle outstanding claims. In 2009, we recognized $48 million in unfavorable reserve development on accident years 2005 and prior as discussed below.
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. The higher estimates of loss cost inflation derived from analyses during 2009 affected reserves
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 60 estimated for many prior accident years, resulting in $48 million of net unfavorable development on prior accident year reserves.
The 2010 accident year loss and loss expense ratio of 106.5 percent was down slightly from accident year 2009 of 108.8 percent estimated as of December 31, 2009. We believe the improvement is due to initiatives begun early in 2010 as mentioned above. Reserve development is further discussed in Commercial Lines Insurance Segment Reserves, beginning on Page 85.
Specialty Packages
Specialty packages premiums were up slightly over the three-year period.
The calendar year and accident year loss and loss expense ratios reflected a high level of catastrophe losses for each year in the three-year period. Losses for 2010 also reflected a higher level of large losses for fires and non-catastrophe weather, increasing both the calendar year and accident year ratios for 2010. In addition, pricing reductions and normal loss cost inflation continued to put upward pressure on the ratios. Our adverse loss experience has been primarily driven by our Religious Institutions Program as our other specialty programs have generally performed adequately. We are working to improve this program, including enhanced pricing precision through predictive models and greater attention as management of the program shifts to our Target Markets department. Improved pricing precision and additional loss control actions will be used later for the other programs in our Specialty Packages line of business as well.
Surety and Executive Risk
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 61 Surety and executive risk premiums declined in both 2010 and 2009, primarily due to our non-renewal of many policies as we improved the quality of the financial institution portion of this book of business.
Director and officer liability coverage accounted for 59.8 percent of surety and executive risk net written premiums in 2010 compared with 60.5 percent in 2009 and 63.0 percent in 2008. We have actively managed the potentially high risk of writing director and officer liability by:
The calendar year total loss and loss expense ratio improved during 2010 due to lower losses for accident year 2010 that were partially offset by unfavorable development on prior accident year reserves.
The 2010 accident year loss and loss expense ratio improved compared with accident year 2009 due in part to a lower level of large losses. Both the calendar year and current accident year loss and loss expense ratios for 2009 were relatively high, primarily due to director and officer large losses 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.
Machinery and Equipment
Machinery and equipment premiums continued to rise over the three year period, reflecting our superior service, including experienced specialist who support agencies in writing this line of business. The calendar year and accident year loss and loss expense ratios were low for 2010 and 2009, although they can fluctuate substantially due to the relatively small size of this business line.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 62 Commercial Lines Insurance Outlook
Industrywide commercial lines written premiums are projected to increase less than 1 percent in 2011 with the industry statutory combined ratio estimated at approximately 110 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 pricing analytics and careful risk selection. While competition remains intense, pricing changes seem to be leveling off. Despite challenging market conditions, we believe we can manage our business and execute strategic initiatives to offset market pressures to some extent and still profitably grow our commercial lines segment.
We intend to continue marketing our products to a broad range of business classes with a package approach, while improving our pricing precision. 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 2011, in part due to small average pricing declines on policies renewed during 2010 for which premiums will be earned during 2011.
In Item 1, Strategic Initiatives, Page 9, 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 36.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 63 Personal Lines Insurance Results Of Operations
Overview — Three-Year Highlights
Performance
highlights for the personal lines segment include:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 64 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 more of our agents' preferred business.
The 7 percent increase in 2010 agency renewal written premiums reflected various rate changes that were implemented beginning in October 2009. Increases for the homeowner line of business averaging approximately 5 percent, with some individual policy rate increases in the double-digit range, should improve loss ratios as the increases are earned. Similar rate changes, with a slightly higher average rate increase, were implemented in the fourth quarter of 2010 for states representing the majority of our personal lines business. Rate changes for our personal auto line of business implemented during the fourth quarter of 2010 represented an average rate increase in the low-single-digit range. The 2010 personal auto rate changes reflected enhanced pricing precision enabled by the recent deployment of predictive models. Predictive modeling tools also influenced policy pricing and various rate changes during 2008 through 2010 for our homeowner line of business.
In 2010, our personal lines new business premiums written by our agencies grew 20 percent. We believe the main drivers for the growth were more attractive pricing, plus ease of use and efficiency gained by agencies from the new version of our Diamond personal lines policy processing system deployed in early 2010. New business also rose strongly 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. Seven states where we began writing business or significantly expanded our personal lines product offerings and automation capabilities, beginning in 2008, accounted for $13 million of the 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. Most of the incurred losses and loss expenses shown in the three-year highlights table above on Page 64 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since approximately two-thirds of our personal lines current accident year incurred losses and loss expenses represent net paid losses, the remaining one-third represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 86.3 percent accident year 2009 loss and loss expense ratio reported as of December 31, 2009, developed favorably by 1.8 percentage points to 84.5 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2010. Accident years 2009 and 2008 for the personal lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 65 Catastrophe losses, as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 49, explain some of the movement in accident year loss and loss expense ratios among the years 2008 through 2010. Catastrophe losses added 8.8 percentage points for 2010, 15.4 points for 2009 and 14.4 points for 2008 to the respective personal lines accident year loss and loss expense ratios in the table above. 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 49.
The trend for our personal lines current accident year loss and loss expense ratio before catastrophe losses over the past three years reflected normal loss cost inflation, better risk selection and improved pricing, as discussed above in Personal Lines Insurance Premiums. Higher non-catastrophe weather-related losses also affected trends, particularly for 2008 and 2009, and large losses described below also were a factor. In addition, previously discussed refinements made to the allocation of IBNR reserves by accident year increased the 2008 ratio.
Personal lines reserve development on prior accident years continued to net to a favorable amount in 2010, as $34 million was recognized, somewhat lower than $40 million in 2009 and $50 million in 2008. Most of the personal lines reserve development on prior accident years for years 2008 through 2010 occurred in our other personal line of business, primarily for personal umbrella liability coverage. Development by line of business and other trends for personal lines loss and loss expenses and the related ratios are further analyzed in Personal Lines of Business Analysis, beginning on Page 67, and in Personal Lines Insurance Segment Reserves, Page 87.
Personal Lines Insurance Losses by Size
In 2010, total large losses incurred decreased by $12 million or 13 percent, helping to lower the corresponding ratio by 2.1 percentage points. The majority of the decrease was for claims related to our personal auto line of business. In 2009 the total large losses incurred ratio was higher than it was in 2008, primarily due to more homeowner fire losses. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. We believe the inherent volatility of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the volatility in addition to general inflationary trends in loss costs.
Personal Lines Insurance Underwriting Expenses
Personal lines commission expense as a percent of earned premium increased slightly in 2010 and 2009, primarily due to higher agency contingent commissions.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 66 Other underwriting expenses grew $17 million or 22 percent, primarily due to a first-quarter 2010 provision for matters involving prior years and related to Note 16, Commitments and Contingent Liabilities, Page 125. They declined in 2009 primarily due to lower depreciation expense on previously capitalized software expenditures. An unusual expense of $3 million due to a pension charge was included in the 2008 ratio.
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 2010, the homeowner line of business had a total loss and loss expense ratio significantly higher than desired. As discussed below, we are taking actions to improve pricing and reduce loss costs that we expect to benefit future profitability trends.
Personal Auto
Net written premiums for personal auto increased significantly in 2010, in part due to strong new business growth.
The calendar year total 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. Pricing precision is being improved through use of the recently deployed predictive modeling tool. In addition to using the tool as part of rate changes implemented in the fourth quarter of 2010, we expect another round of rate changes, representing another net increase in rates on average, effective late 2011.
The 2010 current accident year loss and loss expense ratio before catastrophe losses deteriorated slightly compared with accident year 2009, primarily due to earned pricing changes.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 67 Homeowner
Net written premiums for homeowner increased significantly in 2010, in part due to strong new business growth. Premiums ceded for reinsurance, which reduce premium revenue, were $18 million in 2010, $22 million in 2009, and $26 million in 2008, including a 2008 reinstatement premium of $8 million. 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 in both late October 2010 and 2009, including rate increases that respond in part to weather-related loss trends as well as other trends in loss costs. The 2009 increases for the homeowner line of business averaged approximately 6 percent in affected states and 5 percent overall, although some individual policies experienced renewal increases in the double-digit range. The average effect of the 2010 rate changes were approximately the same as 2009 and should lower loss ratios as the rate increases are earned. We also continue our gradual geographic diversification into states less prone to catastrophe losses, which we believe will reduce variability in the long-term future catastrophe loss ratio. These actions are important steps we are taking to improve homeowner results.
The calendar year total loss and loss expense ratio over the past three years fluctuated with catastrophe losses, non-catastrophe weather-related losses and other large losses. A $5 million increase in 2010 large losses, compared with 2009, contributed 1.7 percentage points to the homeowner loss ratio. The 2010 catastrophe loss effect of 17.9 percentage points returned to a level near historical averages. In 2008 and 2009, our catastrophe loss ratio averaged 34.5 percent, compared with a 10-year average through 2007 of 17.4 percent.
The current accident year loss and loss expense ratio before catastrophe losses remained high in 2010, in part due to the same non-catastrophe weather related losses and other large losses that affected the calendar year result.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 68 Other Personal
Other personal premiums increased in 2010 and 2009, generally tracking with 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 continued to improve in 2010 and has been at a very profitable level the past two years. Reserve development on prior accident years can fluctuate significantly for this business line because personal umbrella liability coverage is a major component of other personal losses.
Personal Lines Insurance Outlook
A.M. Best projects industrywide personal lines written premiums may rise approximately 3 percent in 2011, with an industry statutory combined ratio estimated at 98.5 percent. With our improvement in new business levels and our strong policy retention rate, along with rate increases effected in late 2010, we expect our growth rate to be higher than the industry projection for 2011. In Item 1, Strategic Initiatives, Page 9, 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 to enhance our response to the changing marketplace. 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 36.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 69 Excess and Surplus Lines Insurance Results of Operations
Overview — Three-Year Highlights
Performance highlights for the excess and surplus lines segment include:
Excess and Surplus Lines Insurance Premiums
The $19 million increase in renewal premiums in 2010 was primarily a result of the opportunity to renew more policies that represented new business in 2009, when new business written premiums grew by $18 million. Renewal pricing changes also accounted for some of the increase, as our excess and surplus lines policies averaged estimated price increases that were flat to slightly up in the second half of 2010. We measure average changes in excess and surplus 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.
New business written premium growth in 2009 was largely a result of introducing new coverages, and also increased understanding by agencies representing The Cincinnati Insurance Companies of competitive advantages described in Excess and Surplus Lines Property Casualty Insurance Segment, Page 16. For most
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 70 of 2008, only general liability coverages were available. In late 2008, property and professional liability coverages were first offered, followed by excess liability in late 2009.
Other written premiums are primarily premiums that are ceded to reinsurers and that lower our net written premiums. Changes in ceded premium volume tend to follow a pattern similar to changes in the total of renewal and new business written premiums.
Competition for new business increased during 2010 as we observed more instances of business being written by standard market commercial lines insurers seeking additional growth opportunities. In many cases we saw policy terms and conditions being offered that were less restrictive than those we observed in the past for similar risks, without a corresponding premium for the broadened insurance coverage. As a result, we declined to write many of those new business and some renewal business opportunities, leading to a significantly slower rate of new business growth for 2010 at 9 percent compared with 129 percent in 2009.
Excess and Surplus Lines 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. Most of the incurred losses and loss expenses shown in the three-year highlights table above on Page 70 are for the respective current accident years, and reserve development on prior accident years is shown separately. Since less than 20 percent of our 2010 excess and surplus lines current accident year incurred losses and loss expenses represents net paid losses, a large majority represents reserves for our estimate of ultimate losses and loss expenses. These reserves develop over time, and we re-estimate previously reported reserves as we learn more about the development of the related claims. The table below illustrates that development. For example, the 75.6 percent accident year 2009 loss and loss expense ratio reported as of December 31, 2009, developed favorably by 2.1 percentage points to 73.5 percent due to settling claims for less than previously estimated, or due to updated reserve estimates for unpaid claims, as of December 31, 2010. Accident years 2009 and 2008 for the excess and surplus lines segment have both developed favorably, as indicated by the progression over time for the ratios in the table.
Catastrophe losses partially explain some of the accident year loss and loss expenses trend for years 2008 through 2010. Catastrophe losses added 1.2 percentage points for 2010, 0.2 for 2009 and 0.4 percentage points for 2008 to the respective excess and surplus lines accident year loss and loss expense ratios in the table above.
The 2010 increase of 8.4 percentage points in the current accident year loss and loss expense ratio before catastrophe losses was driven by higher large losses. New losses of $250,000 or more per claim totaled $12 million in 2010, compared with less than $1 million in 2009, and accounted for 23.5 percentage points of the ratio. No unexpected concentration of these losses was indicated from our analysis by risk category, geographic region, policy inception, agency or field marketing territory.
Our first excess and surplus lines policies were written in 2008 and reserves for estimated unpaid losses and loss expenses were $5 million as of December 31, 2008, for losses that occurred in 2008. As of December 31, 2010, an estimated $2 million remained unpaid for those same loss events that occurred in 2008. Due to the limited history of settled claims for our excess and surplus lines business it is difficult to draw meaningful inferences about claim settlement patterns or trends in loss and loss expense experience based on data in the table above.
Excess and surplus lines reserve development on prior accident years netted to a favorable amount in 2010, $1 million, resulting in a loss and loss expenses ratio effect similar to 2009. Development trends are further analyzed in Excess and Surplus Lines Insurance Segment Reserves, Page 89.
We believe the adequacy of loss and loss expenses reserves for our excess and surplus lines business is strong. We establish case reserves in a manner consistent with standard lines coverages, despite the more restrictive terms and conditions for excess and surplus lines policies.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 71 Excess and Surplus Lines Insurance Underwriting Expenses
Excess and surplus lines commission expense at 16.5 percent of earned premiums for 2010 is expected to remain near that level in the future.
Non-commission underwriting expenses declined in 2010 primarily due to the reduction of various start-up costs during 2008 and 2009 as our excess and surplus lines began operations in 2008. The primary category of expense reduction was development costs for our rating and policy administration system.
Excess and Surplus Lines Outlook
The general trends of 2010 for the excess and surplus lines markets are expected to continue in 2011, according to several industry reports. Competition is expected to remain strong, in part due to standard market insurance companies insuring businesses that previously were written by excess and surplus lines insurers. Soft market conditions for commercial lines business overall is the driver of this trend, and industry observers generally expect little change in the foreseeable future. The slowly recovering U.S. economy, another major factor in demand for insurance products, is also expected to contribute to modestly declining or relatively flat premium volume during 2011 for the excess and surplus lines industry.
Industry reports suggest that opportunities for managing profitability and growth exist through greater use of technology. Technology and data are also being used by excess and surplus lines insurance companies to identify new exposures in emerging businesses that need insurance protection or other value-added services.
Our strategy of providing superior service is expected to continue to grow our excess and surplus lines segment and achieve profitability despite challenging market conditions. We intend to continue carefully selecting and pricing risks, providing prompt delivery of insurance quotes and policies and outstanding claims and loss control service from local field representatives who also handle the standard lines business for their assigned agencies. These local representatives are supported by headquarters underwriters and claims managers who specialize in excess and surplus lines.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 72 Life Insurance Results Of Operations
Overview — Three-Year Highlights
Performance highlights for the life insurance segment include:
Life Insurance Premiums
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 2010 largely because of growth in our term and universal life insurance business. Earned premiums from term insurance grew $10 million, or 12 percent, and earned premiums from universal life insurance grew $7 million, or 25 percent.
Separate account investment management fee income contributed $1 million to total revenue in 2010, compared with less than $1 million contribution in 2009 and $2 million in 2008. These fees increased primarily because of the net realized capital gain and 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 31 life field marketing representatives work in partnership with our 117 property casualty field marketing representatives. Approximately 69 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 $39 million in 2010, compared with a net profit of $22 million in 2009 and a net loss of $19 million in 2008. The life insurance company portfolio had after-tax net realized investment gains of $2 million in 2010, compared with after-tax net realized investment losses of $13 million in 2009, which included $15 million in OTTI charges. Net realized investment losses were $58 million in 2008, including $66 million in OTTI charges. Realized investment gains and losses are discussed under Investment Results of Operations, Page 75.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 73 Life segment expenses consist principally of:
Life segment profitability depends largely on premium levels, the adequacy of product pricing, underwriting skill and operating efficiencies. Life segment results include only investment interest credited to contract holders (interest assumed in life insurance policy reserve calculations). The remaining investment income is reported in the investment segment results. The life investment portfolio is managed to earn target spreads between earned investment rates on general account assets and rates credited to policyholders. We consider the value of assets under management and investment income for the life investment portfolio as key performance indicators for the life insurance segment.
We seek to maintain a competitive advantage with respect to benefits paid and reserve increases by consistently achieving better than average claims experience due to skilled underwriting. Commissions paid by the life insurance operation are on par with industry averages.
During the past several years, we have invested in imaging and workflow technology and have significantly improved application processing. We have achieved process efficiencies while improving our service. 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
During 2010, the life insurance market continued to stabilize from the turmoil it experienced during the financial crisis. Of particular interest to us, 2010 saw decreased rate volatility for term insurance as the cost of reserve financing moderated, albeit at rates substantially higher than before the financial crisis. This higher cost of reserve financing has led a number of large term writers to replace their term portfolios with term-like universal life products. These companies have sacrificed a simple design and the high redundant reserve requirement with a much more complex design and a lower reserve requirement. We believe this offers us a competitive advantage, and we expect to see continued growth in our term business because of our commitment to offering our distribution the most straight-forward products possible, at a reliable and competitive rate.
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 2010, our property casualty agencies produced 69 percent and our life-only agencies 31 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 emphasize the cross-serving opportunities of our worksite products for our property casualty agencies' commercial accounts, and in 2010 we introduced a new worksite term product with a return of premium feature. Also in 2010, we introduced a second-to-die universal life product. We believe this product helps satisfy an important need that is heightened by an aging boomer population and a fluctuating federal estate tax situation.
We expect annuity sales to moderate somewhat in 2011 as we introduce a new product with a lower guaranteed rate of interest. Such a product affords us more protection during prolonged periods of low interest rates. New annuity suitability regulations also are a headwind on annuity sales due to the added burden on the agent and the resulting increased acquisition costs.
We made good progress in improving our operational technology in 2010. We remain on track to complete a major administration system consolidation project in 2011. Online illustrations were introduced and are already contributing to savings. Finally, we have other initiatives underway that will make it easier for our agents to do business with us, from flexible compensation arrangements to electronic applications. We fully expect all of these initiatives to contribute additional revenue and/or reduced expenses in 2012 and beyond.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 74 Investments Results Of Operations
Overview — Three-Year Highlights
Investment Results
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 Income
The primary drivers of investment income were:
In 2010, we continued to invest available cash flow in both fixed income and equity securities in a manner that we believe balances current income needs with longer-term invested assets growth goals.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 75 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 OTTI 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 given period. 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. At year-end 2010, the fixed maturities fair value was 106.3 percent of book value compared with 104.5 percent at year-end 2009.
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 $185 million for the year ended December 31, 2010, reflected:
The $13 million in net gains from fixed-maturity sales included a $1 million gain in short-term investments due to the final receipt from the Reserve Primary Fund that exceeded the impaired basis. The net gains also included $12 million in losses due to sales of all of the remaining holdings of collateralized mortgage obligations, which occurred during the first quarter of 2010.
The $440 million net realized investment gain in 2009, was primarily due to $624 million from sales of various equity holdings, including Pfizer Inc. (NYSE: PFE), Exxon Mobil Corporation (NYSE: XOM), The Procter & Gamble Company (NYSE: PG), Fifth Third Bancorp (NASDAQ: FITB), and Piedmont Natural Gas Company Inc. (NYSE: PNY). Realized losses of $162 million from the sale of several equity securities partially offset realized investment gains.
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.
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 2010 we recorded $10 million in fair value realized gains compared with $27 million in 2009 and a $38 million fair value decline for 2008. 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, Page 105, for details on the accounting for convertible security embedded options.
Other-than-temporary Impairment Charges
In 2010, we recorded $36 million in write-downs of 15 securities that we deemed had experienced an other-than-temporary decline in fair value compared with $131 million for 50 securities in 2009 and $510 million for 126 securities in 2008. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 44. The OTTI charges in 2010 were less than 1 percent of our investment portfolio at year-end compared with 1 percent for 2009 and 5 percent for 2008. OTTI charges also include unrealized losses of holdings that we intend to sell but have not yet completed a transaction.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 76
The decrease in OTTI charges for both 2010 and 2009 was largely due to the improvement in values as asset markets rebounded. The higher level of OTTI charges in 2008 was largely due to write-downs of holdings of
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 77 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.
Investments Outlook
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2011, 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 rating agency comments. We discuss our portfolio strategies in Item 1, Investments Segment, Page 19.
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 OTTI 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 44.
Other
Revenues in 2010 for our Other businesses nearly equaled 2009. Other includes non-investment operations of the parent company and its subsidiary, CFC Investment Company, and former subsidiary CinFin Capital Management Company. Losses before income taxes for Other were largely driven by interest expense from debt of the parent company.
Taxes
We had $124 million of income tax expense in 2010 compared with $150 million in 2009 and $111 million in 2008. The effective tax rate for 2010 was 24.8 percent compared with 25.7 percent in 2009 and 20.7 percent in 2008.
The change in our effective tax rate was primarily due to changes in pretax income from underwriting results, changes in investment income and the amount of realized investment gains and losses. Changes to tax-exempt interest and the dividend received deduction in the current year compared with prior years also contributed to the change.
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 21 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 120.
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 to meet the short- and long-term cash requirements of business obligations and growth needs. 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 78 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 81. Other uses of parent company cash include dividends to shareholders, common stock repurchases and general operating expenses described under Other Commitments, Page 81. As of December 31, 2010, the parent company had $1.042 billion in cash and marketable securities, providing strong liquidity to fund uses of cash.
The table below shows a summary, by the direct method, of the major sources and uses of liquidity by the parent company. Dividends received in 2010 from our insurance subsidiary returned to a level near the average of recent years. No dividends were received from our insurance subsidiary in 2009, in order to maintain strong statutory surplus and financial strength ratings. We expect sources of liquidity to increase in 2011 and beyond, primarily from improved profitability from our property casualty operations, funding a potentially larger dividend to the parent company. 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. Share repurchases are discretionary, depending on cash availability and capital management decisions.
Insurance Subsidiary Liquidity
Our insurance subsidiary's primary means of meeting liquidity requirements are collection of premiums, investment income, and sale proceeds from investments held at the subsidiary level. Property casualty insurance premiums generally are received before losses are paid under the policies purchased with those premiums. Our insurance subsidiary's expenditures are property casualty loss and loss expenses, commissions, salaries and other ongoing operating expenses. Over the past three years, cash receipts from property casualty along with investment income, have been more than sufficient to pay claims and operating expenses. Excess cash flow was partially used to pay dividends to the parent company. We are not aware of any known trends that would materially change historical cash flow results. We discuss the factors that affected insurance operations in Commercial Lines and Personal Lines Insurance Results of Operations, Page 54 and Page 64.
Additional Sources of Liquidity
Investment income is a primary source of liquidity for both the parent company and our insurance subsidiary operations. For both, cash in excess of operating requirements and dividends are invested in fixed-maturity and equity securities. Equity securities provide the potential for future increases in dividend income and for capital appreciation. In Item 1, Investments Segment, Page 19, 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 claim 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, $2.804 billion, or 35.4 percent, of our fixed-maturity portfolio will mature. At year-end 2010, total unrealized gains in the investment portfolio, before deferred income taxes, were $1.250 billion. Further,
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 79 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.
We had $790 million of long-term debt and $49 million in borrowings on our short-term lines of credit at year-end 2010. 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 118. None of the notes are encumbered by rating triggers:
The company's senior debt is rated investment grade by independent rating firms. On July 19, 2010, Standard & Poor's lowered counterparty credit rating for our senior debt from BBB+ to BBB. Three other rating agencies made no changes to our debt ratings in 2010. Our debt ratings from the other rating agencies are: a from A.M. Best, BBB+ from Fitch Ratings and A3 from Moody's Investors Service.
Short-Term Debt
At December 31, 2010, we had two lines of credit with commercial banks amounting to $225 million, with $49 million borrowed. There was no change in the amount of the $49 million short-term debt during 2010 or 2009. Access to these lines of credit requires compliance with various covenants, including maintaining a minimum consolidated net worth and not exceeding a 20 percent debt-to-capital ratio. As of December 31, 2010, we were well within compliance with all of the covenants under the credit agreements and believe we will remain in compliance.
Our $75 million unsecured line of credit with PNC Bank, N.A. was established more than five years ago and was renewed effective August 30, 2010, for a one-year term to expire on August 28, 2011. CFC Investment Company also is a borrower under this line of credit. PNC Bank is a subsidiary of The 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 also is a borrower under this line of credit. At year-end 2010, 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 Corporation (NYSE:BAC) and Northern Trust Corporation (NASDAQ:NTRS) also participate, each providing $25 million of capacity.
This 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 2010, 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 year-end 2010 debt rating are 5 basis points and 8 basis points, respectively.
Capital Resources
Capital resources represent our overall financial strength to support writing and growing our insurance businesses. At December 31, 2010, we had total shareholders' equity of $5.032 billion, an increase of $272 million, or 6 percent, from the prior year. Our total debt was $839 million, unchanged from a year ago. We seek to maintain a solid financial position and provide capital flexibility by keeping our ratio of debt to total capital moderate. We target a ratio below 20 percent. At year-end 2010, the ratio was 14.3 percent compared with 15.0 percent at year-end 2009. The decrease in the debt-to-total-capital ratio was due entirely to the increase in shareholders' equity at year-end 2010.
At the discretion of the board of directors, the company can return cash directly to shareholders:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 80
Consistent with our approach since mid-2008, we chose to preserve capital and repurchased a minimal amount of shares. Recent repurchases have been intended to partially offset the issuance of shares through equity compensation plans, primarily due to vesting of service-based restricted stock units of equity awards granted in the past. During the first half of 2008, we repurchased 3.8 million shares. In the past, repurchases have occurred when we believed that stock prices on the open market were favorable for such repurchases. Our corporate Code of Conduct restricts repurchases during certain time periods. The details of the repurchase authorizations and activity are described in Item 5, Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 31.
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.
Contractual Obligations
Our two 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 beginning on Pages 82 and Page 89, respectively. Other future contractual obligations include:
Other Commitments
As of December 31, 2010, we believe our most significant other commitments are:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 81 Liquidity and Capital Resources Outlook
A long-term perspective governs our liquidity and capital resources decisions, with the goal of benefiting our policyholders, agents, shareholders and associates over time. While our insurance results for 2010 and 2009 did not meet our combined ratio objective of being consistently below 100 percent, our improved capital position since 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, 2010, we had $385 million in cash and cash equivalents. That strong liquidity and our consistent cash flows gives us the flexibility to meet current obligations and commitments 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 loss payments within a short period of time. There could also be additional obligations for our insurance operations due to increasing severity or frequency of non-catastrophe 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 2011 Reinsurance Programs, Page 90. We also monitor the financial condition of our reinsurers because an insolvency could place in jeopardy a portion of our $572 million in outstanding reinsurance recoverables as of December 31, 2010.
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 2011, total dividends that our insurance subsidiary can pay to our parent company without regulatory approval are approximately $378 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.
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 $4.137 billion is lower than loss and loss expense reserves of $4.200 billion as of year-end 2010. The $63 million difference is due to life and health loss reserves, as discussed in Item 8, Note 5 of the Consolidated Financial Statements, Page 117.
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 do not include reinsurance receivables or ceded losses. As discussed in 2011 Reinsurance Programs, Page 90, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance unpaid receivables of $326 million at year-end 2010 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 $1.865 billion of net claim payments during 2010. At year-end 2010, net property casualty reserves reflected $2.076 billion in unpaid amounts on reported claims (case reserves), $877 million in loss expense reserves and $858 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 82 adequate in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 82.
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 5.0 years at year-end 2010. By contrast, the duration of our loss and loss expense reserves was approximately three and one-half 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 sold, 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 $3.571 billion to $3.952 billion at year-end 2010, with the company carrying net reserves of $3.811 billion. The likely range was $3.459 billion to $3.774 billion at year-end 2009, with the company carrying net reserves of $3.661 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 117.
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 43.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2010 and 2009. 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 2010 was consistent with the corresponding actuarial best estimate. Management's best estimate of total loss and loss expense reserves as of year-end 2009 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, 2010, 2009 and 2008, in Item 8, Note 5 of the Consolidated Financial Statements, Page 117. The reconciliation of our year-end 2009 reserve balance to net incurred losses one year later recognizes approximately $304 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 — 2010 Annual Report on 10-K — Page 83 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 2010 but incurred in 2004 are included in the cumulative deficiency or redundancy amount for 2004 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.
Development of Estimated Reserves for Loss and Loss Expenses
Asbestos and Environmental Reserves
We carried $134 million of net loss and loss expense reserves for asbestos and environmental claims as of year-end 2010, compared with $118 million for such claims as of year-end 2009. These amounts constitute 3.5 percent and 3.2 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 84 1990s, commercial lines grew as a percentage of our overall business and our exposure to asbestos and environmental claims grew accordingly. Over that period, we endorsed to or included in most policies an asbestos and environmental exclusion.
Additionally, since 2002, we have revised policy terms where permitted by state regulation to limit our exposure to mold claims prospectively and further reduce our exposure to other environmental claims generally. Finally, we have not engaged in any mergers or acquisitions through which such a liability could have been assumed. We continue to monitor our claims for evidence of material exposure to other mass tort classes such as silicosis, but we have found no such credible evidence to date.
Reserving data for asbestos and environmental claims has characteristics that limit the usefulness of the methods and models used to analyze loss and loss expense reserves for other claims. Specifically, asbestos and environmental loss and loss expenses for different accident years do not emerge independently of one another as loss development and Bornhuetter-Ferguson methods assume. In addition, asbestos and environmental loss and loss expense data available to date does not reflect a well-defined tail, greatly complicating the identification of an appropriate probabilistic trend family model.
Due to these considerations, our actuarial staff elected to use a paid survival ratio method to estimate reserves for incurred but not yet reported asbestos and environmental claims. Although highly uncertain, reserve estimates obtained via this method have developed in a reasonably stable fashion since 2004. Since our exposure to such claims is limited, we believe the paid survival ratio method is sufficient. Reserves for asbestos and environmental claims increased in 2010 as a result of changes in the identification of asbestos and environmental losses and is not related to new or additional asbestos and environmental exposures.
Commercial Lines Insurance Segment Reserves
For the business lines in the commercial lines insurance segment, the following table shows the components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves for the segment in total grew less than 1 percent from year-end 2009.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 85
Overall favorable development for commercial lines reserves of $269 million in 2010 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 $186 million for the commercial casualty line accounted for approximately 70 percent of the segment total in 2010, while favorable reserve development of $39 million for the workers' compensation line accounted for approximately 15 percent of the segment total in 2010. Drivers of significant reserve development are discussed below.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 86
An examination of factors contributing to the remaining $9 million of commercial lines favorable reserve development, not accounted for by the commercial casualty, commercial auto and workers' compensation lines, did not turn up any abnormal or unexpected variations. As noted in Critical Accounting Estimates, Key Assumptions - Loss Reserving, Page 43, 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 components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves for the segment in total were fairly stable, up approximately 1 percent from year-end 2009.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 87
Favorable development for personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. Several factors discussed in Commercial Lines Insurance Segment Reserves, Page 85, that contributed to commercial lines segment reserve development in 2010 also contributed to personal lines favorable reserve development, most notably the factors related to umbrella coverage in the other personal line of business.
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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 88 Excess and Surplus Lines Insurance Segment Reserves
For the excess and surplus lines insurance segment, the following table shows the components of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were up from year-end 2009 primarily due to the increase in premiums and exposures for this segment, as we discussed in Excess and Surplus Lines Insurance Results of Operations, Page 70. Favorable development during 2010 of $1 million for excess and surplus lines insurance segment reserves illustrates the potential for revisions inherent in estimating reserves. Factors affecting the modest favorable reserve development included the lack of a sufficiently long experience period on which to base reserve estimates.
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 income 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 $228 million at year-end 2010. As discussed in 2011 Reinsurance Programs, Page 90, we purchase reinsurance to mitigate our life insurance risk exposure. At year-end 2010, ceded death benefits represented approximately 47.2 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 $3.848 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy reserves and separate accounts for future policy benefits and claims of $2.692 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $3 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 $2.034 billion at year-end 2010, compared with $1.783 billion at year-end 2009. The increase was primarily due to reserves for deferred annuities. 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 89 2011 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 and monitor our exposure in certain coastal regions. An example of this would be our recent depopulation of homeowner policies in the southeastern coastal region. This area was identified as a major contributor to our catastrophe probable maximum loss estimates and has subsequently been greatly reduced. We also continually review aggregate exposures to huge disasters and purchase reinsurance protection to cover these exposures. 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.
To help determine appropriate reinsurance coverage for hurricane, earthquake, and tornado/hail exposures, we use the RMS and AIR models to estimate the probable maximum loss from a single event occurring in a one-year period. The models are proprietary in nature, and the vendors that provide them periodically update the models, sometimes resulting in significant changes to their estimate of probable maximum loss. As of the end of 2010, both models indicated a hurricane event represents our largest amount of exposure to losses. The table below summarizes estimated probabilities and the corresponding probable maximum loss from a single event occurring in a one-year period for that exposure, and indicates the effect of such losses on consolidated shareholders' equity as of December 31, 2010. Net losses are net of reinsurance and income taxes. The modeled losses according to RMS in the table are based on their RiskLink version 10.0 catastrophe model and utilize a near-term storm catalog methodology. The near-term storm catalog theory is a more conservative approach and places a higher weighting on the increased hurricane activity of the past several years, thus producing higher probable maximum loss projections than a longer term view. The modeled losses according to AIR in the table are based on their AIR Clasic/2 version 12 catastrophe model and utilize a long-term methodology. The AIR storm catalog includes decades of documented weather events used in simulations for probably maximum loss projections.
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 2011 property and casualty reinsurance program include:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 90
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 agreement. 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. For risks with property or casualty limits which are between $25 million and $27 million, we sometimes forego facultative reinsurance and retain an additional $2 million of loss exposure.
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, the property per risk treaty and the casualty per occurrence treaty, which provide coverage for commercial and personal risks. Our property catastrophe treaty provides terrorism 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 2010 was $369 million (20 percent of 2009 subject premiums), and we estimate it is $366 million (20 percent of 2010 subject premiums) in 2011.
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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 91 The Cincinnati Specialty Underwriters Insurance Company, which began issuing insurance policies in 2008, has separate property and casualty reinsurance treaties for 2011 through The Cincinnati Insurance Company. Primary components of the treaties include:
For property risks with limits exceeding $5 million or casualty risks with limits exceeding $6 million, underwriters place facultative reinsurance coverage on an individual certificate basis.
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 24. 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 — 2010 Annual Report on 10-K — Page 92
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 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 — 2010 Annual Report on 10-K — Page 93
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 19, 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 94 the area (water service, sewer service, etc.). Another risk related to tax-exempt bonds is regulatory risk or the potential for legislative changes that would negate the benefit of owning tax-exempt bonds. We monitor regulatory activity for situations that may negatively affect current holdings and our ongoing strategy for investing in these securities.
The final, less significant risk is our exposure to credit risk for a portion of the tax-exempt portfolio that has support from corporate entities. Examples are bonds insured by corporate bond insurers or bonds with interest payments made by a corporate entity through a municipal conduit/authority. Our decisions regarding these investments primarily consider the underlying municipal situation. The existence of third-party insurance is intended to reduce risk in the event of default. In circumstances in which the municipality is unable to meet its obligations, risk would be increased if the insuring entity were experiencing financial duress. Because of our diverse exposure and selection of higher-rated entities with strong financial profiles, we do not believe this is a material concern as we discuss in Item 1, Investments Segment, Page 19.
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 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 effective duration of the fixed maturity portfolio was 5.0 years at year-end 2010, compared with 5.3 years at year-end 2009. A 100 basis point movement in interest rates would result in an approximately 5.0 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.
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 $3.041 billion in fair value and accounted for approximately 60 percent of the unrealized appreciation of the entire portfolio at year-end 2010. See Item 1, Investments Segment, Page 19, for additional details on our holdings.
The primary risks related to preferred stocks are similar to those related to investment grade corporate bonds. Rising interest rates adversely affect market values due to the normal inverse relationship between interest rates and bond prices. 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 — 2010 Annual Report on 10-K — Page 95 Short-Term Investments
Our short-term investments historically consisted primarily of commercial paper, demand notes or bonds purchased within one year of maturity. In 2009, we made short-term investments primarily with funds to be used to make upcoming cash payments, such as taxes.
Application of Asset Impairment Policy
As discussed in Item 7, Critical Accounting Estimates, Asset Impairment, Page 44, 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 OTTI charges that reduced our income before income taxes by $36 million in 2010, $131 million in 2009 and $510 million in 2008. Impairments are discussed in Item 7, Investment Results of Operations, Page 75.
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 2010, 316 of the 2,671 securities we owned were trading below 100 percent of book value compared with 355 of the 2,505 securities we owned at year-end 2009 and 944 of the 2,233 securities we owned at year-end 2008.
The 316 holdings trading below book value at year-end 2010 represented 10.6 percent of invested assets and $49 million in unrealized losses.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 96
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 97 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, 2010, 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, 2010. Its report is on Page 100. 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.
Management’s Annual Report on Internal Control Over Financial Reporting
The management of Cincinnati Financial
Corporation and its subsidiaries is responsible for establishing and
maintaining adequate internal controls, designed to provide reasonable
assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance
with accounting principles generally accepted in the United States of
America (GAAP). The company’s internal control over financial reporting
includes those policies and procedures that:
All internal control systems, no matter how
well designed, have inherent limitations, including the possibility of
human error and the circumvention of overriding controls. Accordingly,
even effective internal control can provide only reasonable assurance
with respect to financial statement preparation and presentation.
Further, because of changes in conditions, the effectiveness of
internal control may vary over time.
The company’s management assessed the
effectiveness of the company’s internal control over financial
reporting as of December 31, 2010, 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, 2010. The assessment led management to conclude
that, as of December 31, 2010, 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, 2010. This report appears on
Page 100.
February 25, 2011
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 99 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, 2010 and 2009, and the related
consolidated statements of income, shareholders’ equity, and cash flows
for each of the three years in the period ended December 31, 2010. 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, 2010, 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 based on the assessed risk. Our audits also
included 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, 2010 and 2009,
and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 2010, 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, 2010, 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 — 2010 Annual Report on 10-K — Page 100 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
Accompanying notes are an integral part of these consolidated financial statements.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 101 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Accompanying notes are an integral part of these consolidated financial statements.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 102 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
Accompanying notes are an integral part of these consolidated financial statements.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 103 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Accompanying notes are an integral part of these consolidated financial statements.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 104 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 1,245 independent insurance
agencies with 1,544 reporting locations across 39 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
property and casualty 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 and its subsidiaries, each of which are
wholly owned, and are presented in conformity with accounting
principles generally accepted in the United States of America (GAAP).
All significant intercompany balances and transactions have been
eliminated in consolidation.
The preparation of financial statements in
conformity with GAAP requires us to make estimates and assumptions that
affect amounts reported in the financial statements and accompanying
notes. Our actual results could differ from those estimates.
In the first quarter of 2010, we changed our
presentation of earned premiums in our consolidated statements of
income. We have summarized property casualty and life earned premiums
to a single caption, “Earned premiums.” See Note 10, Reinsurance, Page 119, for further detail on property casualty and life earned premiums.
In the second quarter of 2010, we changed our
presentation of long-term debt in our consolidated balance sheets. We
have summarized the long-term debt to a single caption, “Long-term
debt.” See Note 8, Senior Debt, Page 118, for further detail on
interest rates, year of issue and maturity of our long-term debt.
In the fourth quarter of 2010, we revised our
reportable segments to establish a separate reportable segment for
excess and surplus lines. This segment includes results of The
Cincinnati Specialty Underwriters Insurance Company and CSU Producer
Resources. Historically, the excess and surplus lines results were
reflected in Other. We began offering excess and surplus lines
insurance products in 2008. Separating excess and surplus lines into a
reportable segment allows readers to view this business in a manner
similar to how it is managed internally when making operating
decisions. Prior period data included in this annual report has been
recasted to represent this new segment.
In the fourth quarter of 2010, we changed our
presentation of other income in our consolidated statements of income.
We have allocated the portion that primarily represents premium
installment fees into a separate single caption, “Fee revenues.” Also,
the remaining amount from the historic single caption, “Other income,”
is presented as “Other revenues.”
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, 2010.
Stock-Based Compensation
We grant qualified and non-qualified
stock-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 2010, the committee approved a mix
of stock options and restricted stock units for stock-based awards. See
Note 17, Stock-Based Associate Compensation Plans, Page 125, for
further details.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 105 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 121 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. 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
analyze our acquisition cost assumptions periodically to reflect actual
experience and we test 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 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 2010,
2009 and 2008.
Certain property casualty policies are not
booked before the effective date. An actuarial estimate is made to
determine the amount of unbooked written premiums. The majority of the
estimate is unearned and does not have a material impact on earned
premium.
We establish reserves to cover the expected
cost of claims, or losses, and our expenses related to investigating,
processing and resolving claims. Although determining the appropriate
amount of reserves is inherently uncertain, we base our decisions on
past experience and current facts. Reserves are based on claims
reported prior to the end of the year and estimates of unreported
claims. We take into account the fact that we may recover some of our
costs through salvage and subrogation. We regularly review and update
reserves using the most current information available. Any resulting
adjustments are reflected in current year insurance losses and
policyholder benefits.
The consolidated property casualty companies
actively write property casualty insurance through independent agencies
in 39 states. Our 10 largest states generated 67.1 percent and 68.1
percent of total earned premiums in 2010 and 2009. Ohio, our largest
state, accounted for 20.5 percent and 21.0 percent of total earned
premiums in 2010 and 2009. Georgia, Illinois, Indiana, Michigan, North
Carolina, Pennsylvania and Virginia each accounted for between 4
percent and 9 percent of total earned premiums in 2010. Our largest
single agency relationship accounted for approximately 1.2 percent of
the company's total earned premiums in 2010.
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. We incur policyholder dividends as
underwriting, acquisition and insurance expenses.
Contingent Commission Accrual
We base the contingent commission accrual
estimate on property casualty underwriting results. 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. The contingent
commission accrual of $77 million in 2010 contributed 2.6 percentage
points to the property casualty combined ratio. Contingent commission
accruals for 2009 and 2008 were $81 million and $75 million,
respectively.
Life and Health Insurance
We offer several types of life insurance and
disability income 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 106 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.
Universal life contracts are long-duration
contracts for which contractual provisions are not fixed, unlike whole
life insurance. Universal life contracts allow policyholders to vary
the amount of premium, within limits, without our consent. However, we
may vary the mortality and expense charges, within limits, and the
interest crediting rate used to accumulate policy values. We do not
record universal life premiums as revenue. Instead we recognize as
revenue the mortality charges, administration charges and surrender
charges when received. Some of our universal life contracts assess
administration charges in the early years of the contract that are
compensation for services we will provide in the later years of the
contract. These administration charges are deferred and are recognized
over the period when we provide those future services.
For universal life long-duration contracts, we
maintain a liability equal to the policyholder account value. There is
no provision for adverse deviation. Some of our universal life policies
contain no-lapse guarantee provisions. For these policies, we establish
a reserve in addition to the account balance, based on expected
no-lapse guarantee benefits and expected policy assessments.
When we issue a universal life long-duration
contract, we capitalize acquisition costs. We then charge these
capitalized costs to expenses over the term of coverage of the
contract. When we charge deferred policy acquisition costs to expenses,
we use assumptions based on our best estimates of long-term experience.
We review and modify these assumptions on a regular basis.
Separate Accounts
We issue life contracts with guaranteed
minimum returns, referred to as bank-owned life insurance contracts
(BOLIs). We legally segregate and record as separate accounts the
assets and liabilities for some of our BOLIs, based on the specific
contract provisions. We guarantee minimum investment returns, account
values and death benefits for our separate account BOLIs. Our other
BOLIs are general account products.
We carry the assets of separate account BOLIs
at fair value. The liabilities on separate account BOLIs primarily are
the contract holders’ claims to the related assets and are carried at
an amount equal to the contract holders’ account value. At December 31,
2010, the current fair value of the BOLI invested assets and cash
exceeded the current fair value of the contract holders’ account value
by approximately $15 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 capital gain and loss sharing arrangement with the company.
A percentage of each separate account’s realized capital 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 107 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.
Both 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 and
redeemable preferred stocks) and equity investments (common and
non-redeemable preferred stocks) are classified as available for sale
and recorded at fair value in the consolidated financial statements.
The number of fixed-maturity securities trading below 100 percent of
book value can be expected to fluctuate as interest rates rise or fall.
Because of our strong surplus and long-term investment horizon, our
general intent is to hold fixed-maturity investments until maturity,
regardless of short-term fluctuations in fair values.
On April 1, 2009, we adopted a subsection of
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 subsection 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 (AOCI).
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, 2010
and 2009, are not measured on the same basis as December 31, 2008 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
$40 million of life policy loans, $28 million of venture capital fund
investments and $5 million of investments in real estate. Life policy
loans are carried at the receivable value, which approximates fair
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 AOCI. 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 108 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 rely upon observable market data whenever
possible. 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. See Note 3, Fair Value Measurements, Page 114,
for further details.
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 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
AOCI 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. Finance receivables are
reviewed for impairment on a quarterly basis. Impairment of our finance
receivables are considered insignificant to our consolidated financial
condition, results of operations and cash flows.
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 land at cost, and 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 39½ years) using straight-line and accelerated methods.
Depreciation expense was $40 million in 2010, $48 million in 2009, and
$35 million in 2008. 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
2010, 2009 or 2008.
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 financial statement income and taxable income are
expected to reverse. We recognize deferred income taxes for numerous
temporary differences between our taxable income and financial
statement 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 AOCI. We charge deferred taxes associated with
other differences to income.
See Note 11, Income Taxes, Page 120, for
further detail on our uncertain tax positions. Although no Internal
Revenue Service (IRS) penalties currently are accrued, if incurred,
they would be recognized as a component of income tax expense. Accrued
IRS interest expense is recognized as other operating expense in the
consolidated statements of income.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 109 Subsequent Events
There were no subsequent events requiring adjustment to the financial statements or disclosure.
Pending Accounting Standards
Adopted Accounting Standards
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 110 2. Investments
The following table analyzes investment
income, realized investment gains and losses and the change in
unrealized investment gains and losses:
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, 2010, investments with book value of $81 million and fair value of $85 million were on deposit with various states in compliance with regulatory requirements.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 111 The following table analyzes cost or amortized cost, gross unrealized gains, gross unrealized losses and fair value for our invested assets, along with the amount of cumulative non-credit OTTI losses transferred to AOCI in accordance with ASC 320-10-65, Recognition and Presentation of Other-Than-Temporary Impairments, for securities that also had a credit impairment:
The unrealized investment gains at December 31, 2010, were largely due to a net gain position in our fixed income portfolio of $495 million and a net gain position in our common stock portfolio of $729 million. The two primary contributors to the net gain position were The Procter & Gamble Company (NYSE:PG) and Exxon Mobil Corporation (NYSE:XOM) common stocks, which had a combined net gain position of $237 million. At December 31, 2010, we had $69 million fair value of hybrid securities included in fixed maturities that follow ASC 815-15-25, Accounting for Certain Hybrid Financial Instruments. The hybrid securities are carried at fair value, and the changes in fair value are included in realized investment gains and losses.
The table below provides fair values and unrealized losses by investment category and by the duration of the securities' continuous unrealized loss position:
Net realized gains were $159 million for the year ended December 31, 2010 compared with net realized gains of $336 million and $138 million in 2009 and 2008, respectively. The net realized investment gains
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 112 for the year ended December 31, 2010 were largely due to the sale of Verisk (NYSE: VRSK), contributing $128 million.
Other-than-temporary Impairment Charges
The following table provides the amount of OTTI charges:
For the year ended December 31, 2010 and 2009,
there were no credit losses on fixed-maturity securities for which a
portion of OTTI has been recognized in other comprehensive income.
During 2010, we impaired 15 securities. At
December 31, 2010, 17 fixed-maturity investments with a total
unrealized loss of $4 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. Three equity investments
with a total unrealized loss of $1 million had been in an unrealized
loss position for 12 months or more as of December 31, 2010. Of that
total, no equity investments were trading below 70 percent of book
value.
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.
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 ASC
320 effective April 1, 2009, our invested asset impairment policy for
fixed-maturity securities 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 AOCI. ASC 320
does not allow retrospective application of the new OTTI model. Our
consolidated statements of income for the year ended December 31, 2010
and 2009, are not measured on the same basis as December 31, 2008, 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.
For each of our equity securities in an
unrealized loss position at December 31, 2010, 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. 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 113 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). 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.
Our valuation techniques have not changed since December 31, 2009, and
ultimately management determines fair value.
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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 114 The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis for the years ended December 31, 2010 and 2009. We do not have any material liabilities carried at fair value. There were also no significant transfers between Level 1 and Level 2.
Each financial instrument that was deemed to
have significant unobservable inputs when determining valuation is
identified in the table below by security type with a summary of
changes in fair value for the year ended December 31, 2010 and 2009. As
of December 31, 2010 and 2009, total Level 3 assets were less than 1
percent of financial assets measured at fair value. At December 31,
2010, total fair value of assets priced with broker quotes and other
non-observable market inputs for the fair value measurements and
disclosures was $31 million.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 115 The following tables explain changes to Level 3 securities during 2010 and 2009:
For the year ended December 31, 2010, one
Level 3 corporate fixed-maturity security was purchased for $5 million
and two corporate fixed-maturity securities were sold for approximately
$1 million. There were also two corporate fixed-maturity securities
that matured during the period for approximately $7 million. As a
result of these purchases, sales, issuances and settlements, corporate
fixed-maturity securities decreased $3 million.
4. Deferred Acquisition Costs
The expenses associated with issuing insurance
policies – primarily commissions, premium taxes and underwriting costs
– are deferred and amortized over the terms of the policies. We update
our acquisition cost assumptions periodically to reflect actual
experience, and we evaluate our deferred acquisition costs for
recoverability. The table below shows the deferred policy acquisition
costs and asset reconciliation, including the amortized deferred policy
acquisition costs.
There were no premium deficiencies recorded in the reported consolidated statements of income, as the sum of the anticipated loss and loss adjustment expenses, policyholder dividends, maintenance expenses and underwriting expenses did not exceed the related unearned premiums and anticipated investment income.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 116 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. The amount we will
actually have to pay for claims can be highly uncertain. This
uncertainty, together with the size of our reserves, makes the loss and
loss expense reserves our most significant estimate.
Because of changes in estimates of insured events in prior years, we
decreased the provision for prior accident years’ loss and loss
expenses by $304 million, $188 million and $323 million in calendar
years 2010, 2009 and 2008. 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 $63 million at December 31, 2010, and $46 million for both
2009 and 2008, for certain life and health loss reserves.
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.
Reserves for deferred annuities and other
investment contracts were $930 million and $736 million at December 31,
2010, and December 31, 2009, respectively. Fair value for these
deferred annuities and investment contracts was $933 million and $737
million at December 31, 2010, and December 31, 2009, 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, 2010, to account for non-performance risk; (2) the
rate of interest credited to
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 117 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 $46 million, compared with book
value of $40 million reported in the consolidated balance sheets at
December 31, 2010. 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, 2010 and 2009, 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 2010 and at year-end 2009. The $75 million line of credit
expires August of 2011. 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 2010 or 2009. The interest
rate charged on our borrowings was a fixed 2.58 percent during 2010.
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
$783 million at year-end 2010 compared with $740 million at year-end
2009. Fair value for 2010 and 2009 was determined under ASC 820 based
on market pricing of these or similar debt instruments that are
actively trading. Fair value can vary with macroeconomic concerns.
Regardless of the fluctuations in fair value, the outstanding principal
amount of our long-term debt remained unchanged from year-end 2009.
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 $220 million in 2010, $50 million in 2009 and
$160 million in 2008. State regulatory requirements restrict the
dividends insurance subsidiaries can pay. Generally, the most our
insurance subsidiary 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 2011, the total that our
lead subsidiary may pay in dividends is approximately $378 million.
As of December 31, 2010, 6 million shares of common stock were available for future equity award grants.
Declared cash dividends per share were $1.59,
$1.57 and $1.56 for the years ended December 31, 2010, 2009 and 2008,
respectively.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 118 Accumulated Other Comprehensive Income
The change in AOCI includes changes in unrealized gains and losses on investments and pension obligations as follows:
10. Reinsurance
Our consolidated statements of income include
earned consolidated property casualty insurance premiums on assumed and
ceded business:
For the year ended December 31, 2010, a reserve reduction occurred in our USAIG pool. Therefore, direct and ceded incurred loss and loss expenses were reduced by $33 million, so there was no effect on net incurred loss and loss expenses.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 119 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, 2010, we had no operating or
capital loss carry forwards.
Unrecognized Tax Benefits
As a result of positions taken in our federal
tax returns 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.
In December 2010, we reached agreement with
the IRS settling all issues related to the 2007 and 2008 tax years. As
a result of this IRS agreement, there is no liability for unrecognized
tax benefits as of December 31, 2010. Tax year 2009 has not been
audited by the IRS and remains open for examination.
In addition to our IRS filings, we file income tax returns with immaterial amounts in various state jurisdictions.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 120 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, 2010.
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 125. The above table
shows the number of anti-dilutive stock-based awards at year-end 2010,
2009 and 2008. 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. In addition, we froze entry into the pension plan
for new associates as of June 30, 2008. Only participants 40 years of
age or older as of August 31, 2008, could elect to continue to
participate. For participants who left the pension plan, benefit
accruals were frozen as of August 31, 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 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.
Matching contributions to our sponsored 401(k)
plan, which we began making during 2008, totaled $8 million, $7 million
and $3 million during the years 2010, 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.
We also maintain a supplemental executive
retirement plan (SERP) with liabilities of approximately $6 million at
year-end 2010 and $5 million at year-end 2009, which are included in
the obligation and expense amounts. 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 SERP participants who chose to leave the
defined benefit pension plan, SERP benefit accruals were frozen as of
December 31, 2008. During 2009, the frozen accrued SERP 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 began 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 — 2010 Annual Report on 10-K — Page 121 Defined Benefit Pension Plan Assumptions
Key assumptions used in developing the 2010
net pension obligation were a 5.85 percent discount rate for the
qualified plan and a 5.55 percent discount rate for our SERP and rates
of compensation increases ranging from 3.50 percent to 5.50 percent. To
determine the discount rate for each plan, a hypothetical diversified
portfolio of actual domestic Aa rated bonds were chosen to provide
payments approximately matching the plan’s expected benefit payments. A
single interest rate for each plan was determined based on the
anticipated yield of the constructed portfolio. We decreased the rate
by 0.25 percentage points for the qualified plan and by 0.55 percentage
points for the SERP due to market interest rate conditions at year-end
2010. Compensation increase assumptions reflect anticipated rates of
inflation, real return on wage growth and merit and promotional
increases.
Key assumptions used in developing the 2010
net pension expense were a 6.10 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
increased by 0.10 percentage points due to market interest rate
conditions at the beginning of the year. We based the rates of
compensation increase on the company’s historical data.
We evaluate our pension plan assumptions
annually and update them as necessary. The discount rate assumptions
for our benefit obligation generally track with high grade corporate
bond yields and yearly adjustments reflect any changes to those bond
yields. We believe the expected return on plan assets is
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 122 representative of the expected long-term rate
of return on these assets. Our compensation increase assumptions
reflect anticipated rates of inflation, real return on wage growth and
merit and promotional increases.
Here is a summary of the weighted-average assumptions we use to determine our net expense for the plan:
The total recognized in net periodic benefit
cost and other comprehensive income was $9 million, $25 million and $62
million for the years ended December 31, 2010, 2009 and 2008,
respectively. The estimated costs to be amortized from AOCI into net
periodic benefit cost over the next year for our plans are a $3 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.
Excluding cash, during 2010 we allocated
approximately 70 percent of the pension portfolio to highly observable
domestic equity investments, which reflect the long-term time horizon
of pension obligations. The remainder of the portfolio is allocated
approximately 16 percent to domestic fixed-maturity investments and
approximately 12 percent to taxable municipal bonds. The remaining 2
percent is allocated to preferred equities. At December 31, 2010, we
had $9 million of cash on hand, with carrying value approximating fair
value. Our shift to fixed maturities during the year was to increase
the duration of the portfolio, diversify the types of credit risk and
to better match our liability risks which is consistent with our
strategy. Our corporate and municipal 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 valued on quoted market prices at December
31, 2010 and 2009. Investments in securities that are not actively
traded are valued based on pricing models for which the inputs have
been corroborated by market data at December 31, 2010 and 2009.
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 114 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 123 The following table illustrates the fair value
hierarchy for those assets measured at fair value on a recurring basis
for period ended December 31, 2010 and 2009. The pension plan does not
have any assets categorized as Level 3. There have been no transfers
between Level 1 and Level 2 for the period ended December 31, 2010 and
2009.
Our pension plan assets included 642,113
shares of the company’s common stock, which had a fair value of $20
million and $17 million at December 31, 2010 and 2009, respectively.
The defined benefit pension plan did not purchase or sell any shares of
our common stock during 2010 and 2009. The company paid $1 million in
cash dividends on our common stock to the pension plan in both 2010 and
2009.
On February 1, 2011, we contributed $35
million to our qualified plan. We also expect to pay $2 million to the
SERP during 2011. 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 are determined in accordance with SAP prescribed or permitted by insurance regulatory authorities for five legal entities, our insurance subsidiary and its four insurance subsidiaries. Statutory capital and surplus for our insurance subsidiary, The Cincinnati Insurance Company, includes capital and surplus of its four insurance subsidiaries. The statutory net income and statutory surplus are presented below:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 124
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 $6 million on premium volume
of approximately $36 million, $36 million and $38 million for 2010,
2009 and 2008, 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. From time to time, the company also becomes aware of incidents
that could result in liability, with or without litigation or
regulatory action, for example, data processing errors by third-party
vendors servicing certain of our employee benefit plans.
On a quarterly basis, we review these
outstanding matters. Under current accounting guidance, we establish
accruals when it is probable that a loss has been incurred and we can
reasonably estimate its potential exposure. The company accounts for
such probable and estimable losses, if any, through the establishment
of legal expense reserves. Based on our quarterly review, we believe
that our accruals for probable and estimable losses are reasonable and
that the amounts accrued do not have a material effect on our
consolidated financial condition or results of operations. However, if
any one or more of these matters results in a judgment against us or
settlement for an amount that is significantly greater than the amount
accrued, the resulting liability could have a material effect on the
company’s consolidated results of operations or cash flows. Based on
our quarterly review, for any other matter for which the risk of loss
is more than remote we are unable to reasonably estimate the potential
loss or establish a reasonable range of loss.
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, including some with market-based performance
objectives, under our shareholder-approved plans. We also have a
Holiday Stock Plan that permits annual awards of one share of common
stock to each full-time associate for each full calendar 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.
Stock-based compensation cost after tax was $8
million, $7 million and $11 million for the years ended December 31,
2010, 2009 and 2008, respectively. Options exercised during the year
ended December 31, 2010 and 2009, had intrinsic value less than $1
million. The total intrinsic value of options exercised during the year
ended December 31, 2008, was $1 million. (Intrinsic value is the market
price less the exercise price.) Options vested during the year ended
December 31, 2010, had total intrinsic value of $1 million. Options
vested during the years ended 2009 and 2008 had intrinsic value less
than $1 million.
As of December 31, 2010, 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 1.8 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
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 125 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:
During 2010, we granted stock-based awards to
associates and issued our common stock to eligible associates under our
Holiday Bonus Plan. No stock based awards were granted to associates
during 2009. The following weighted average assumptions were used for
option grants issued during 2010 and 2008 in determining fair value:
Cash received from the exercise of options was less than $1 million for the years ended December 31, 2010 and 2009 and $4 million for the year ended December 31, 2008. We did not realize a tax benefit on options exercised for the years ended December 31, 2010, 2009 and 2008.
The weighted-average remaining
contractual life for exercisable awards as of December 31, 2010, was
3.5 years. A total of 16.9 million shares are authorized to be granted
under the shareholder-approved plans. At December 31, 2010, 6.0 million
shares were available for future issuance under the plans. During 2009,
our shareholders approved the Directors’ Stock Plan of 2009, which
authorizes 300,000 shares to be granted to our directors. During 2010
we granted 31,310 shares of common stock to our directors for 2009
board service fees. We currently issue new shares or use treasury
shares for stock-based compensation award issues or exercises.
Restricted Stock Units
Service 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.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 126 If certain performance conditions 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 conditions for the outstanding groups of performance
restricted stock units and recognizes related compensation costs in
accordance with ASC 718, Compensation, Stock Compensation.
We have market-based awards for which we
recognize compensation costs in accordance with ASC 718. These awards
vest according to the level of total shareholder return achieved
compared to a peer group over a three-year period. These awards are
valued using a Monte-Carlo valuation on the date of grant, which uses a
risk-neutral framework to model future stock price movements based upon
the risk-free rate of return, the volatility of each peer and the
correlations of each peer being modeled. Compensation cost is
recognized regardless of whether the market-based performance objective
has been satisfied, resulting in shares not being issued. We make
assumptions to develop the Monte-Carlo model as follows:
18. Segment Information
We operate primarily in two industries, property casualty insurance and life insurance. We regularly review our reporting segments to make decisions about allocating resources and assessing performance:
As discussed in Note 1, we revised our
reportable segments during the fourth quarter of 2010 to establish a
separate reportable segment for excess and surplus lines. This will
allow readers to view this business in a manner similar to how it is
managed internally when making operating decisions. This new segment
includes results of The Cincinnati Specialty Underwriters Insurance
Company and CSU Producer Resources. Historically, the excess and
surplus lines results were reflected in Other. Prior period data
included in this annual report has been adjusted to represent this new
segment.
We report as Other the non-investment operations of the parent company and its non-insurer subsidiary, CFC Investment Company. Also included in 2009 and 2008 results for this segment are the operations of a former subsidiary, CinFin Capital Management.
Revenues come primarily from unaffiliated customers:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 127
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, personal or excess and surplus 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 — 2010 Annual Report on 10-K — Page 128 This table summarizes segment information:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 129 19. Quarterly Supplementary Data (Unaudited)
This table includes unaudited quarterly financial information for the years ended December 31, 2010 and 2009:
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 130
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, 2010. 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, 2010, 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 99 and 100.
None
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 131 Part III
Our Proxy Statement will be filed with the SEC in preparation for the 2010 Annual Meeting of Shareholders no later than March 31, 2011. 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 — 2010 Annual Report on 10-K — Page 132
The “Compensation of Named Executive Officers and Directors,” section of our Proxy Statement for our Annual Meeting of Shareholders to be held April 30, 2011, which includes the “Report of the Compensation Committee,” “Compensation Committee Interlocks and Insider Participation,” and the “Compensation Discussion and Analysis,” is incorporated herein by reference.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 133
The following sections of our Proxy Statement for our Annual Meeting of Shareholders to be held April 30, 2011, are incorporated by reference: “Governance of Your Company — Director Independence” and “Governance of Your Company — Certain Relationships and Transactions.”
The “Audit-Related Matters,” section of our Proxy Statement for our Annual Meeting of Shareholders to be held April 30, 2011, which includes the “Proposal 2—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 — 2010 Annual Report on 10-K — Page 134 SCHEDULE I
Cincinnati Financial Corporation and Subsidiaries
Summary of Investments — Other than Investments in Related Parties
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 135 SCHEDULE I (CONTINUED)
Cincinnati Financial Corporation and Subsidiaries
Summary of Investments — Other than Investments in Related Parties
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 136 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 105.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 137 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 105.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 138 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 105. Note to Schedule II:
We have changed our presentation related to equity in net income of subsidiaries. We have reclassified dividends from subsidiaries in the condensed statements of income to be included within a single line, “Increase in equity of subsidiaries.” We have changed presentation in the condensed statements of cash flows to show separately “Dividends from subsidiaries” and “Increase in equity of subsidiaries” within cash flows from operating activities. We also have condensed various lines for presentation purposes. Prior year amounts have been reclassified to conform to current year presentation.
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 139 SCHEDULE III
Cincinnati Financial Corporation and Subsidiaries
Supplementary Insurance Information
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 140 SCHEDULE III (CONTINUED)
Cincinnati Financial Corporation and Subsidiaries
Supplementary Insurance Information
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 141 SCHEDULE IV
Cincinnati Financial Corporation and Subsidiaries
Reinsurance
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 142 SCHEDULE V
Cincinnati Financial Corporation and Subsidiaries
Valuation and Qualifying Accounts
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 143 SCHEDULE VI
Cincinnati Financial Corporation and Subsidiaries
Supplementary Information Concerning Property Casualty Insurance Operations
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 144 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 — 2010 Annual Report on 10-K — Page 145 INDEX OF EXHIBITS
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 146
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 147
Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 148 EXHIBIT 23
Consent of Independent Registered Public Accounting Firm
We consent to the incorporation by reference
in Registration Statement No. 333-85953 (on Form S-8), No. 333-24815
(on Form S-8), No. 333-24817 (on Form S-8), No. 333-49981 (on Form
S-8), No. 333-103509 (on Form S-8), No. 333-103511 (on Form S-8), No.
333-121429 (on Form S-4), No. 333-123471 (on Form S-4), No. 333-126714
(on Form S-8), as amended, and No. 333-155373 (on Form S-3), of
Cincinnati Financial Corporation of our report dated February 25, 2011,
relating to the consolidated financial statements and financial
statement schedules of Cincinnati Financial Corporation and
subsidiaries and the effectiveness of internal control over financial
reporting (which report expresses an unqualified opinion and includes
an explanatory paragraph relating to the company’s change in method of
accounting for the recognition and presentation of other-than-temporary
impairments in 2009), appearing in this Annual Report on Form 10-K of
Cincinnati Financial Corporation for the year ended December 31, 2010.
/S/ Deloitte & Touche LLP
Cincinnati, Ohio
February 25, 2011 Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 149 EXHIBIT 31A
Certification Pursuant to Section 302
of The Sarbanes Oxley Act of 2002 I, Kenneth W. Stecher, certify that:
Date: February 25, 2011
/S/ Kenneth W. Stecher Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 150 EXHIBIT 31B
Certification Pursuant to Section 302 of The Sarbanes Oxley Act of 2002 I, Steven J. Johnston, certify that:
Date: February 25, 2011
/S/ Steven J. Johnston Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 151 EXHIBIT 32
Certification Pursuant to Section 906 of The Sarbanes Oxley Act of 2002 The certification set forth below is being submitted in connection with this report on Form 10-K for the purpose of complying with Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and Section 1350 of Chapter 63 of Title 18 of the United States Code. Kenneth W. Stecher, the chief executive officer, and Steven J. Johnston, the chief financial officer, of Cincinnati Financial Corporation each certifies that, to the best of his knowledge:
Date: February 25, 2011 /S/ Kenneth W. Stecher /S/ Steven J. Johnston Cincinnati Financial Corporation — 2010 Annual Report on 10-K — Page 152
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 © 2011, Cincinnati Financial Corporation Investor Contacts |
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
