The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial condition. Our Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Pages 34 and 35, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 91. We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and stock dividends.
For weather events designated as catastrophes, we calculate IBNR reserves directly as a result of an estimated IBNR claim count and an estimated average claim amount for each event. Our claims department management coordinates the assessment of these events and prepares the related IBNR reserve estimates. Such an assessment involves a comprehensive analysis of the nature of the storm, of policyholder exposures within the affected geographic area and of available claims intelligence. Depending on the nature of the event, available claims intelligence could include surveys of field claims associates within the affected geographic area, feedback from a catastrophe claims team sent into the area, as well as data on claims reported as of the financial statement date. We generally use the catastrophe definition provided by Property Claims Service, a division of Insurance Services Office. PCS defines a catastrophe as an event that causes countrywide damage of $25 million or more in insured property losses and affects a significant number of policyholders and insureds.
All securities valued below 100 percent of book value are reported to the asset impairment committee for evaluation. A security valued between 95 percent and 100 percent of book value is not monitored separately by the committee. These assets generally are at this value because of interest rate-driven factors.
As discussed in Item 8, Note 13 of the Consolidated Financial Statements, Page 113, we modified our qualified defined benefit pension during 2008, terminating participation in the plan for certain participants in a transition to a sponsored 401(k) with company matching of associate contributions. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates and expected return on plan assets, which are updated each year. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions.
Premiums - Pricing in our industry continues to be very competitive, and the poor economy is driving exposures lower. While our net written premium growth rate lagged that of the overall commercial lines industry, we feel our current pace for new and renewal business is consistent with our agents’ practice of selecting and retaining accounts with manageable risk characteristics that support the lower prevailing prices. We believe our pace reflects the advantages we achieve through our field focus, which provides us with quality intelligence on local market conditions. Commercial lines industry net written premiums were estimated to decline 3.8 percent in 2008 and 0.3 percent in 2007, after rising 3.5 percent in 2006. Our earned premiums declined in 2008 after rising slightly in 2007.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 52
The number of in-force homeowner and personal auto policies has declined steadily, but the year-over-year rate of decline slowed to 2.3 percent as of year-end 2008 compared with 3.1 percent at year-end 2007. Additional pricing and credit changes were implemented in early 2009, with introductions in additional states planned for subsequent months. This round of changes further improves pricing for the best accounts, which should help us retain and attract even more of our agents’ preferred business.
Liquidity and capital resources represent the overall financial strength of our company and our ability to generate cash flows to meet the short- and long-term cash requirements of business obligations and growth needs. We seek to maintain prudent levels of liquidity and financial strength for the protection of our policyholders, creditors and shareholders. We manage liquidity at two levels. The first is the liquidity of the parent company. The second is the liquidity of our insurance subsidiary. The management of liquidity at both levels is essential because each has different funding needs and sources and each is subject to certain regulatory guidelines and requirements.
Profit-sharing commissions - Profit-sharing, or contingent, commissions are paid to agencies using a formula that takes into account agency profitability and other factors. We estimate 2009 contingent commission payments of approximately $75 million. We discuss commission expense trends in Commercial Lines and Personal Lines Results of Operations, Page 51 and Page 59.
Computer hardware and software - We expect to need approximately $21 million over the next three years for current material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discussed above the non-contractual expenses we anticipate for computer hardware and software in 2009.
Casualty per occurrence treaty - The casualty treaty provides capacity up to $25 million. Similar to the property treaty, it provides sufficient capacity to cover the vast majority of casualty accounts we insure and also includes protection for extra-contractual liability coverage losses. We retain the first $6 million of each loss, up from the $5 million retention in 2008. Losses between $6 million and $25 million are
Cincinnati Life, our life insurance business, 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 up to $50 million for covered net losses in excess of $10 million. The treaty contains a reinstatement provision, provided the covered losses are not due to terrorism, and contains protection for extra-contractual liability coverage losses. For term life insurance business written prior to 2005, we retain 10 percent to 25 percent of each term policy, not to exceed $500,000, ceding the balance of mortality risk and policy reserve.
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2008, in accordance with accounting principles generally accepted in the United States of America (GAAP).
The hedging definitions included in SFAS No. 133 guide our recognition of the changes in the fair value of derivative financial instruments as realized gains or losses in the consolidated statements of income or as a component of accumulated other comprehensive income in shareholder’s equity in the period for which they occur.
SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities - an amendment of SFAS No. 133,” was issued in March 2008. SFAS No. 161 requires that disclosure of objectives for using derivative instruments include discussion of underlying risk and accounting designation. SFAS No. 161 also requires cross-referencing within the footnotes to assist the users of financial statements in identifying significant information about derivative instruments. The effective date of SFAS No. 161 is the company’s fiscal year beginning January 1, 2009. We do not expect adoption of this statement to have any impact on our results of operations and financial position.
In October 2008, FASB issued FASB Staff Position (FSP) 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” FSP No. 157-3 provides key considerations when determining fair value for financial assets that are not active. In February 2008, the FASB issued FSP No. 157-2, “Fair Value Measurement.” FSP No. 157-2 and FSP No. 157-3 are amendments of SFAS No. 157, issued in September 2006. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure about fair value measurements. SFAS No. 157 was effective for fiscal years beginning after November 15, 2007. We partially adopted SFAS No. 157 in the first quarter of 2008. We elected to defer SFAS No. 157 for nonfinancial assets and nonfinancial liabilities until January 1, 2009, as permitted under FSP No. 157-2. We did not have a cumulative-effect adjustment to beginning retained earnings as a result of the adoption of SFAS No. 157.
At year-end 2008, no investment accounted for more than 10 percent of shareholders’ equity. At year-end 2007, our Fifth Third Bancorp common stock holding, with fair value of $1.691 billion and a cost of $185 million, was our only investment for which the fair value exceeded 10 percent of shareholders’ equity. We sold 55.4 million shares of our holdings of Fifth Third common stock in 2008, 5.5 million shares in 2007, and the remaining 12 million shares sold in January 2009.
The following table illustrates the fair value hierarchy for those assets measured at fair value on a recurring basis as of December 31, 2008. We do not have any material liabilities carried at fair value.
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Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 109
Our statements of income include earned consolidated property casualty insurance premiums on assumed and ceded business:
Our statements of income include incurred consolidated property casualty insurance loss and loss expenses on assumed and ceded business:
The provision for federal income taxes is based upon filing a consolidated income tax return for the company and subsidiaries. As of December 31, 2008, we had no operating or capital loss carry forwards.
Compensation cost for all stock options granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R)