The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial position. Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Pages 30 and 31, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 80. We present per share data on a diluted basis unless otherwise noted, and we have adjusted those amounts for all stock splits and stock dividends.
Through The Cincinnati Insurance Company and its local independent agent representatives, Cincinnati Financial Corporation has become one of the 25 largest property casualty insurer groups in the nation, based on premium volume for the approximate 2,000 U.S. stock and mutual insurer groups. We primarily market standard market property casualty insurance products through a select group of independent insurance agencies in 34 states. As we discussed in the business description in Item 1, we believe three key characteristics distinguish our company and allow us to build shareholder value:
Maintaining our strong relationships with our established agencies, writing a significant portion of each agency’s business and attracting new agencies - In 2008, we expect to continue to rank No. 1 or No. 2 by premium volume in approximately 75 percent or more of the locations that have marketed our products for more than five years, not taking into account any contribution from our excess and surplus lines business. We expect to improve service to our agencies by subdividing one or two field territories in 2008. We also expect to appoint another 65 agencies.
Current accident year loss ratio excluding catastrophe losses - We believe the market trends that contributed to an increase in this ratio in 2007 are continuing and may put the ratio under further pressure in 2008.
Economic factors, including Inflation, may increase our claims and settlement expenses related to medical care, litigation and construction. We could see higher than anticipated loss costs related to workers’ compensation and lines of business that provide protection against bodily injury claims. Similarly, higher legal expenses could raise the loss expenses we incur to defend our policyholders and settle complex or disputed claims. We would factor any such higher losses and loss expenses into our pricing and reserve
calculations, potentially increasing reserves and adjusting rates. Our ability to meet performance targets would depend on our ability to offset the increased losses and loss expenses by promptly effecting rate adjustments or finding other savings and efficiencies, and on our agents’ ability to market at the increased rate.
Claims having atypical emergence patterns. Characteristics of certain subsets of claims, such as high frequency, high severity, or mass tort claims, have the potential to distort patterns contained in historical paid loss, reported loss and paid allocated loss expense data. When testing indicates this to be the case for a particular subset of claims, our actuaries segregate these claims from the data and analyze them separately. Subsets of claims that could fall into this category include hurricane claims, individual large claims and asbestos and environmental claims.
Key assumptions used in developing the 2007 net pension obligation were a 6.25 percent discount rate and rates of compensation increases ranging from 4 percent to 6 percent. Key assumptions used in developing the 2007 net pension expense were a 5.75 percent discount rate, an 8 percent expected return on plan assets and rates of compensation increases ranging from 4 percent to 6 percent.
The fair value of the plan assets exceeded the accumulated benefit obligation by $9 million at year-end 2007 and $8 million at year-end 2006. The fair value of the plan assets was less than the projected plan benefit obligation by $54 million at year-end 2007 and $58 million at year-end 2006. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan.
Another significant estimate relates to our accrual for property casualty contingent (profit-sharing) commissions. We base the contingent commission accrual estimates on property casualty underwriting results and on supplemental information. Contingent commissions are paid to agencies using a formula that takes into account agency profitability, premium volume and other factors, such as prompt monthly payment of amounts due to the company. Due to the complexity of the calculation and the variety of factors that can affect contingent commissions for an individual agency, the amount accrued can differ from the actual contingent commissions paid. The contingent commission accrual of $102 million in 2007 contributed 3.3 percentage points to the property casualty combined ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would affect 2008 net income by $3 million (after tax), or 2 cents per share, and the combined ratio by approximately 0.2 percentage points.
At year-end 2007, net unamortized realized gains amounted to $1 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded, and charged to the general account. Potentially, losses could be material; however, unrealized losses in the separate account portfolio were less than $6 million at year-end 2007.
Lower catastrophe losses were the primary factor in the decline in the accident year loss ratio over the three-year period.
The loss and loss expense ratio and reserve development fluctuated significantly over the three years. We do not believe the changes indicate any new trend or risk.
Because of the relatively small size of this business line, the calendar year and accident year loss and loss expense ratio fluctuates. In 2006, a single unusually large loss was responsible for the higher ratio.
Even though 2007 was a profitable year as a result of low catastrophe activity, the combined ratio excluding catastrophes has risen in each of the past three years and remains above our targeted range. We continue to address pricing, scale, growth and other issues to help restore the financial health of this strategic business segment. In 2006, higher catastrophe losses also contributed to a higher combined ratio.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 58
The increase in other-than-temporary impairment in 2007 from the negligible level of the prior two years was due to market value declines for 20 securities. Those declines reflected general credit concerns that began in the subprime mortgage market and spread to other areas in the homebuilding and related industries over the course of 2007. While we do not directly own mortgages or mortgage backed securities in our investment portfolio, we do own investments in industries directly affected by this credit environment.
The primary reason for the change in the effective tax rate was the level and timing of realized gains as discussed in Investments Results of Operations, Page 57. In 2007, we had pretax realized gains of $382 million compared with pretax gains of $684 million in 2006 and $61 million in 2005. Growth in the tax-exempt municipal bond portfolio, higher investment income from dividends and changes in operating earnings over the periods also contributed to the change in the effective tax rate for 2007.
We believe that our insurance operations maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen circumstances such as catastrophe losses, reinsurer insolvencies, changes in the timing of claims payments, increases in claims severity, reserve deficiencies or inadequate premium rates. We believe catastrophic events are the most likely cause of an unexpected rise in claims severity or frequency.
We generally have substantial discretion in the timing of investment sales and, therefore, the resulting gains or losses to be recognized in any period. That discretion generally is independent of the insurance underwriting process. In 2008, we expect to continue to limit the disposition of investments to those that no longer meet our investment parameters or those that reach maturity or are called by the issuer. The sale of equity investments that no longer meet our investment criteria can provide cash for investment in common stocks that we perceive to have greater potential for dividend growth and capital appreciation.
Qualified pension plan - We anticipate a cash contribution of $10 million to pension plan assets in 2008. Our results of operation will reflect an anticipated $19 million expense related to an increase in accrued pension benefits.
After fulfilling operating requirements, we invest cash flows from underwriting, investment and other corporate activities in fixed maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. See Item 1, Investments Segment, Page 15, for a discussion of our investment strategy, portfolio allocation and quality.
The table below shows the development of the estimated reserves for loss and loss expenses the past 10 years.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 85
SFAS No. 157, Fair Value Measurements - In September 2006, FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures of fair value measurements. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. Management currently is evaluating the effect SFAS No. 157 will have on our results of operations and financial position in 2008.
At both December 31, 2007 and 2006, the fair value associated with the annuities shown above was approximately $564 million and $563 million, respectively.
The change in unrealized gains and losses on investments, pension obligations and derivatives included:
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 101
The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to options granted under our stock option plans prior to our adoption of SFAS No. 123(R) on January 1, 2006. For purposes of this pro forma disclosure, the fair value of each option was estimated on the date of grant using the binomial option-pricing model. In 2005, the weighted-average assumptions used for grants were a dividend yield of 2.66 percent; expected volatility of 25.61 percent; risk-free interest rate of 4.62 percent; and expected lives of 10 years.
This table includes unaudited quarterly financial information for the years ended December 31, 2007 and 2006: