Cincinnati Financial Corporation also owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property. This four-story office building has approximately 124,000 square feet of available space. The property is carried in the financial statements at $6 million as of December 31, 2008, and is classified as an other invested asset. Unaffiliated tenants occupy approximately 8 percent. All unoccupied space is currently available for lease.
The Cincinnati Insurance Company owns an unoccupied building on 16 acres of land in Springfield Township, Ohio, approximately six miles from our headquarters. We plan to renovate the 48,000 square foot building to serve as a business continuity center. The property, including land, is carried on our financial statements at $6 million as of December 31, 2008, and is classified as land, building and equipment, net, for company use.
Realized investment gains and losses are integral to our financial results over the long term, but our substantial discretion in the timing of investment sales may cause this value to fluctuate substantially. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 66.
2008 - We changed the form of retirement benefit we offer certain associates to a 401(k) plan with company match from a qualified defined benefit pension plan. We incurred a pretax expense of $27 million to recognize a settlement loss associated with the partial termination of the qualified pension plan. The expense reduced net income by $17 million, or 11 cents per share, and raised the combined ratio by 0.8 percentage points.
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Through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on written premium volume for approximately 2,000 U.S. stock and mutual insurer groups. We market our insurance products through a select group of independent insurance agencies in 35 states as discussed in Item 1, Our Business and Our Strategy, Page 1.
Although 2008 was a difficult year 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 policyholders, agents, shareholders 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. Between 2010 and 2014, we expect the total of 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 to average 12 percent to 15 percent. With the current economic and market uncertainty, we believe this ratio is an appropriate way to measure our long-term progress in creating value.
Investment income growth has averaged 2.9 percent over the past five years. It grew in each year except 2008 when we experienced a dramatic reduction in dividend payouts by financial services companies held in our equity portfolio, a risk we addressed aggressively during 2008.
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Improve insurance profitability - Implementation of these operational initiatives is intended to support improved cash flow and profitable growth for the agencies that represent us and for our company. These initiatives primarily seek to strengthen our relationships with agents, allowing them to serve clients faster and manage expenses better. Others may streamline our internal processes so we can devote more resources to agent service.
Drive premium growth - Implementation of these operational initiatives is intended to expand our geographic footprint and diversify our premium sources to obtain profitable growth without significant infrastructure expense. Diversified growth also may reduce our catastrophe exposure risk.
In January and February of 2009, storms affecting our policyholders largely in the Midwest currently are estimated to have resulted in about $30 million of reported claims, which will be included in first-quarter pretax catastrophe losses. This estimate does not take into account development of these catastrophes, any further catastrophe activity that may occur in the remainder of the first quarter of 2009 or potential development from events in prior periods.
The weak economy is expected to continue to affect policyholders by deflating their business and personal insurable assets. Until the economy begins to recover, we also do not expect to see significant appreciation of our investments.
Lingering effects of soft insurance market pricing are expected to affect growth rates and earned premium levels into 2010, continuing to weaken loss ratios and hamper near-term profitability. Economic factors, including inflation, may increase our claims and settlement expenses related to medical care, litigation and construction.
Property casualty written premium growth may lag as our growth initiatives need more time to reach their full contribution.
Diversification of the investment portfolio over the past year included sales of selected positions to lock in gains, reduce concentrations and increase liquidity. Proceeds of sales are being reinvested in both fixed income and in equity securities with yields that we believe are likely to be more secure. This may slow the return to growth in investment income although we believe year-over-year comparisons may turn positive in the second half of the year. We expect to continue to make changes to the portfolio, as appropriate.
Our view of the value we can create over the next five years relies on two assumptions about the external environment. First, we’re anticipating some firming of commercial insurance pricing during 2009. Second, we believe that the economy and financial markets can resume a growth track by the end of 2010. If those assumptions prove to be inaccurate, we may not be able to achieve our performance targets even if we accomplish our strategic objectives.
We expect the independent insurance agency system to remain strong and viable, with continued agency consolidation, especially as agency margins come under more pressure due to soft pricing and the difficult economic environment. The soft commercial market that has extended into 2009 creates additional risk for agencies. We expect the soft market to continue, particularly in non-catastrophe event prone states and lines of business, absent a significant event or events.
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 70.
The value creation ratio discussed in the Executive Summary, Page 37, was a negative 23.5 percent in 2008, a negative 5.7 percent in 2007 and a positive 16.7 percent in 2006. In both 2008 and 2007, a decline in unrealized gains on our investment portfolio was the most significant factor in the decline in book value as discussed below. In 2008, net income also was significantly below the level of the prior two years.
Invested assets declined because of lower fair values for portfolio investments, largely due to economic factors. The downturn in the economy had a particularly adverse effect on our financial sector equity holdings, which made up a significant portion of the portfolio prior to mid-2008. By year-end 2008, the portfolio was substantially more diversified and generally better positioned to withstand short-term fluctuations. We discuss our investment strategy in Item 1, Investments Segment, Page 17, and results for the segment in Investments Results of Operations, Page 66.
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Net income declined in 2008 from the higher levels of the prior two years because of a three-year decline in realized investment gains, a first-ever decline in investment income and a lower aggregate contribution from our insurance segments. The pension plan settlement reduced 2008 net income by $17 million, or 11 cents per share. The transition from a defined benefit pension plan reduces company risk while providing flexible, company-sponsored 401(k) benefit to associates.
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 64. Income and gains from the life insurance investment portfolio are included in Investment segment results.
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 98. 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.
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 $4.040 billion at year-end 2008 compared with $3.925 billion at year-end 2007.
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 these claims. 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.
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For all other claims and events, we calculate IBNR reserves quarterly by first deriving an actuarially based estimate of the ultimate cost of total loss and loss expenses incurred. We then reduce the estimate by total loss and loss expense payments and total case reserves carried. We discuss below the development of actuarial-based estimates of the ultimate cost of total loss and loss expenses incurred.
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Emergence of loss and allocated loss expenses on an accident year basis. Historical paid loss, reported loss and paid allocated loss expense data for the business lines we analyze contain patterns that reflect how unpaid losses, unreported losses and unpaid allocated loss expenses as of a financial statement date will emerge in the future on an accident year basis. Unless our actuarial staff or management identifies reasons or factors that invalidate the extension of historical patterns into the future, these patterns can be used to make projections necessary for estimating IBNR reserves. Our actuaries significantly rely on this assumption in the application of all methods and models mentioned above.
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.
The table below provides standard errors and reserve ranges for lines of business that account for 90.6 percent of our 2008 loss and loss expense reserves as well as the potential effects on our net income, assuming a 35 percent federal tax rate. Standard errors and reserve ranges for assorted groupings of these lines of business cannot be computed by simply adding the standard errors and reserve ranges of the component lines of business, since such an approach would ignore the effects of product diversification. See Range of Reasonable Reserves, Page 74, for a 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.
Our fixed-maturity and equity investment portfolios are our largest assets. The company’s asset impairment committee continually monitors the holdings in these portfolios and all other assets for signs of other-than-temporary or permanent impairment. The committee monitors significant decreases in the fair value of invested assets, changes in legal factors or in the business climate, an accumulation of costs in excess of the amount originally expected to acquire or construct an asset, uncollectability of all receivable assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure to pay interest or dividends or signs indicating that the carrying amount may not be recoverable.
Our portfolio managers monitor their assigned portfolios. If a security is trading below book value, the portfolio managers undertake additional reviews. Such declines often occur in conjunction with events taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing organization. Management reviews quantitative measurements such as a declining trend in fair value, the extent of the fair value decline and the length of time the value of the security has been depressed, as well as qualitative measures such as pending events, credit ratings and issuer liquidity. We are even more proactive when these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and market conditions. We provide information about valuation of our invested assets in Item 8, Note 2 of the Consolidated Financial Statements, Page 104.
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 2008 in Item 7A, Application of Asset Impairment Policy, Page 87. An other-than-temporary decline in the fair value of a security is recognized in net income as realized investment losses.
We adopted the provisions of SFAS No. 157 on January 1, 2008. SFAS No. 157 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 SFAS No. 157, we considered various factors such as liquidity and volatility but primarily obtained pricing from various external services, including broker quotes.
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 of the Consolidated Financial Statements, Page 106.
Included in the Level 2 hierarchy are a small portfolio of collateralized mortgage obligations that represented less than 1 percent of the fair value of our investment portfolio at December 31, 2008. We obtained the CMOs as part of the termination of our securities lending program during 2008. The CMOs were an investment made by one of the short-duration funds, which subsequently dissolved and distributed the assets to its investors. When we terminated the securities lending program, we chose to retain the CMOs rather than sell them at what we felt were distressed prices in an illiquid market.
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. Management ultimately determined the pricing for each Level 3 security that we considered to be the best exit price valuation. As of December 31, 2008, total Level 3 assets were 1.6 percent of our investment portfolio measured at fair value, which was relatively stable throughout 2008. Broker quotes are obtained for thinly traded securities that subsequently fall within the Level 3 hierarchy. We obtained two non-binding quotes from brokers and used the more conservative price for fair value. At December 31, 2008, total fair value of assets priced by broker quotes for the SFAS No. 157 disclosure was $83 million and consisted mostly of taxable fixed maturities.
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Key assumptions used in developing the 2008 net pension obligation were a 6.00 percent discount rate and rates of compensation increases ranging from 4 percent to 6 percent. Key assumptions used in developing the 2008 net pension expense were a 6.25 percent discount rate, an 8 percent expected return on plan assets and rates of compensation increases ranging from 4 percent to 6 percent. See Note 13 for additional information on assumptions.
In 2008, the net pension expense was $47 million, including one-time charges of $27 million for settlement and $3 million for curtailment related to the modifications to the qualified pension plan. In 2009, we expect a net pension expense of $11 million.
The fair value of the plan assets was $52 million less than the accumulated benefit obligation at year end 2008 and $4 million greater than the accumulated benefit obligation at year-end 2007. The fair value of the plan assets was $88 million less than the projected plan benefit obligation at year-end 2008 and $60 million less at year-end 2007. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. In 2009, we expect to contribute approximately $33 million to our qualified 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 $75 million in 2008 contributed 2.5 percentage points to the property casualty combined ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would affect 2009 net income by $2 million (after tax), or 1 cent per share, and the combined ratio by approximately 0.1 percentage points.
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
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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 2009, the account holder would pay a surrender charge equal to 1 percent of the contract’s account value. The surrender charge falls to zero in 2010 and beyond.
At year-end 2008, net unamortized realized losses amounted to $12 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 $36 million before tax in the separate account portfolio, which had a book value of $521 million at year-end 2008.
Information about recent accounting pronouncements is provided in Item 8, Note 1 of the Consolidated Financial Statements, Page 98. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
Consolidated financial results primarily reflect the results of our four reporting segments. These segments are defined based on financial information we use to evaluate performance and to determine the allocation of assets.
We report as “Other” the non-investment operations of the parent company and its subsidiaries CFC Investment Company and CinFin Capital Management Company (excluding client investment activities), as well as other income of our standard market property casualty insurance operations. CinFin Capital Management will terminate all operations effective February 28, 2009. Beginning in 2008, we also include in Other the results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources.
We measure profit or loss for our commercial lines and personal lines property casualty and life insurance segments based upon underwriting results (profit or loss), which represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also frequently evaluate results for our consolidated property casualty insurance operations, which is the total of our commercial, personal and surplus insurance results. Underwriting results and segment pretax operating income are not substitutes for net income determined in accordance with GAAP.
The calculations of segment data are described in more detail in Item 8, Note 18 of the Consolidated Financial Statements, Page 119. The following sections review results of operations for each of the four segments. Commercial Lines Insurance Results of Operations begins on Page 51, Personal Lines Insurance Results of Operations begins on Page 59, Life Insurance Results of Operations begins on Page 64, and Investments Results of Operations begins on Page 66. We begin with an overview of our consolidated property casualty operations, which is the total of our commercial lines, personal lines and surplus lines results.
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Changes in written and earned premiums over the past three years reflected growing price competition partially offset by consistently high retention rates of renewal business. New business written directly by agencies rose in 2008 after declining in 2007. The resurgence in new business was largely due to the contribution of agencies appointed the past five years, the contribution of our surplus lines business and more competitive personal lines pricing. Other written premium is largely ceded reinsurance premiums.
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Combined ratio - Our commercial lines combined ratio rose to 97.0 percent in 2008 from very strong performances in 2007 and 2006. The 2008 ratio largely reflected higher current accident year losses before catastrophe losses. We continue to focus on sound underwriting fundamentals and obtaining adequate premiums per policy. We discuss factors affecting the combined ratio and reserve development by line of business below. Approximately $49 million, or 2.1 percentage points, of the rise in current accident year loss and loss expenses was due to refinements made to the allocation of IBNR reserves by accident year.
As commercial lines markets have grown more competitive over the past several years, we have focused on leveraging our local relationships as well as the efforts of our agents and the teams that work with them. In this environment, we have been careful to maintain appropriate pricing discipline for both new and renewal
In 2008, we estimated that policyholders with a contractor-related ISO general liability code accounted for approximately 38 percent of our general liability premiums, which are included in the commercial casualty line of business, and that policyholders with a contractor-related NCCI workers’ compensation code accounted for approximately 47 percent of our workers’ compensation premiums. The contractor market has been one of the more adversely affected by the economic slowdown.
The decline in 2008 agency renewal written premiums was largely driven by the pricing and exposure declines while policy retention rates remained relatively steady. For renewal business, our headquarters underwriters talk regularly with agents. Our field teams are available to assist headquarters underwriters by conducting inspections and holding renewal review meetings with agency staff. These activities can help verify that a commercial account retains the characteristics that caused us to write the business initially. For renewal business, the typical pricing decline has moved into the mid-single-digits, although higher declines occur. In addition to pricing pressures, premiums confirmed by audits of policyholder sales and payrolls declined for 2008.
In 2007 and 2008, other written premiums lowered net written premiums more than 2006. Higher ceded reinsurance costs were the primary driver in both 2007 and 2008, including the reinsurance reinstatement premium incurred in 2008.
market conditions and softer pricing that began in 2005 and continued through 2008, as discussed above. In 2008, we saw a higher level of larger losses from director and officer liability coverages, as discussed below. The increase in larger losses in 2007 was primarily seen in general liability, commercial auto and workers’ compensation.
The rise in the loss and loss expense ratio reflected a growing contribution from new losses and case reserve increases greater than $250,000. In total, commercial lines new losses and reserve increases greater than $250,000 rose to 26.3 percent of earned premiums from 23.3 percent in 2007 and 21.3 percent in 2006. 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 increase was due to a number of factors, including a larger number of director and officer liability claims, changes in retention levels for our per risk reinsurance programs, changes in case reserving practices for our workers’ compensation business line, natural volatility and general inflationary trends in loss costs, which we continue to monitor. In 2006 and 2007, our retention for our property and casualty working treaties was $4 million. In 2008, we raised the casualty retention to $5 million.
Commercial lines commission expense as a percent of earned premium declined in 2008 from the relatively stable level of the prior two years. The change in the ratio reflected both the decline in earned premiums and a lower level of contingent commissions in 2008. Commission expenses include our profit-sharing, or contingent, commissions, which are calculated on the profitability of an agency’s aggregate property casualty book of Cincinnati business, taking into account longer-term profit and premium volume, with a percentage for prompt payment of premiums and other criteria, to reward the agency’s effort. These profit-based commissions generally fluctuate with our loss and loss expense ratio. Our 2008 contingent commission
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accrual reflected our estimate of the profit-sharing commissions to be paid to our agencies in early 2009, based largely on each agency’s performance in 2008.
In Item 1, Strategic Initiatives, Page 7, we discuss the initiatives we are implementing to achieve our corporate performance objectives. We discuss our overall outlook for our property casualty insurance operations in the Executive Summary, Page 37.
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.
Commercial casualty is our largest business line. The decline in commercial casualty net written premiums reflected the intensifying competition in the casualty market. In addition, premiums for this business line can reflect economic trends, including changes in underlying exposures.
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refinements to our IBNR reserve allocation, quarter-to-quarter reductions in actuarial reserve estimates, the introduction of an additional umbrella reserving model, sooner-than-expected moderation in the inflation trend of allocated loss expenses and unusual deviations from predictions of reserving methods and models. These factors are discussed in Commercial Lines Insurance Segment Reserves, Page 77. The level of new losses and case reserve increases greater than $250,000 was slightly lower than in 2007.
Commercial property is our second largest business line. The decline in commercial property net written premiums over the three-year period reflected pricing declines exacerbated by higher reinsurance premiums, including the premium reinstatement premium in 2008.
The calendar year loss and loss expense ratio deteriorated substantially in 2008 after improving in 2007, primarily due to fluctuations in catastrophe losses. New losses and case reserve increases greater than $250,000 added 3.4 percentage points to the 2008 ratio. Development on prior period reserves was relatively stable over the period.
The current accident year loss and loss expense ratio before catastrophe losses deteriorated over the three-year period. A portion of the increase was due to a higher loss expense allocation because of the level of catastrophe and weather-related losses. In addition, the refinement in the allocation of IBNR reserves by accident year artificially accentuated the difference between the 2007 and 2008 ratios by approximately 2 percentage points.
Workers’ compensation written premiums have been relatively flat over the past three years. Although we have seen rising policy counts, these gains have been offset by reductions in payroll levels due to the troubled economy as well as rate decreases and the use of credits in a majority of our territories. We have had initiatives in place to judiciously expand our workers’ compensation business in selected states that
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traditionally have been profitable markets for us and to enter states, such as Arizona and West Virginia, where we previously were not actively writing the line. We cannot offer workers’ compensation coverage in Ohio, our highest total property casualty premium volume state, because it is provided solely by the state instead of private insurers.
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 remained above our target levels over the three-year period. Management is actively pursuing programs to improve financial performance for this line. For example, in 2009, we are putting in place a predictive modeling program to improve our pricing accuracy, and we are accelerating our delivery of loss control services to help manage our workers’ compensation profitability.
In addition, 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.
Specialty packages net written premiums were relatively flat over the three-year period. Our commercial lines policy processing system for Businessowners Policies, which are included in this business line, is helping us meet changing agency needs and address pricing, technology and service innovations that other carriers have introduced for similar products in recent years.
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Director and officer liability coverage accounted for 58.9 percent of surety and executive risk premiums in 2008 compared with 62.3 percent in 2007 and 60.5 percent in 2006. We actively manage the potentially high risk of writing director and officer liability by:
Marketing primarily to nonprofit organizations, which accounted for approximately 80 percent of the director and officer liability policies we wrote in 2008.
Providing limits no higher than $15 million with facultative or treaty reinsurance in place in 2009 for losses greater than $6 million.
Machinery and equipment net written premiums rose in 2008 after a relatively flat 2007. Because of the relatively small size of this business line, the calendar year and accident year loss and loss expense ratios can fluctuate substantially.
Premiums - Over the past three years, competition in our personal lines markets rose and we continued to adjust pricing in an effort to return to consistent profitability in our personal lines segment. Our written premiums declined on lower premiums per policy and higher reinsurance-related premiums as new business growth remained positive. Industry average written premium growth was estimated at 1.0 percent in 2008 after being flat in 2007 and rising 2.0 percent in 2006.
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the current accident year loss and loss expense ratio before catastrophe losses also rose substantially. Approximately $20 million, or 2.9 percentage points, of the rise in current accident year loss and loss expenses was due to refinements made to the allocation of IBNR reserves by accident year.
Our personal lines policyholder retention and new business levels have remained at higher levels following our July 2006 introduction of a limited program of policy credits for personal auto and homeowner pricing in most of the states in which our Diamond system is in use. The program provided credits for eligible new and renewal policyholders identified as above-average risks.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. The increase in the current accident year loss and loss expense ratio before catastrophe losses over the past three years was due to the pricing factors discussed above, normal loss cost inflation, refinements made to the allocation of IBNR reserves by accident year and higher non-catastrophe weather-related losses. Larger personal lines losses were a smaller percentage of earned premiums in 2008.
Catastrophe losses were highly volatile over the three-year period as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 49. Savings from prior period reserve development continued to trend favorably in 2008 as discussed in Personal Lines Insurance Segment Reserves, Page 79.
The effect on the loss and loss expense ratio from new losses and case reserve increases greater than $250,000 was lower in 2008 than it was in 2007. 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 increase in 2007 largely was due to general inflationary trends in loss costs, which we continue to monitor, as well as natural volatility.
Personal lines commission expense as a percent of earned premium declined in 2008 after rising slightly in 2007. The 2008 decline in the ratio reflected both the decline in earned premiums and a lower level of contingent commissions. Commission expenses include our profit-sharing, or contingent, commissions, which are calculated on the profitability of an agency’s aggregate property casualty book of Cincinnati business, taking into account longer-term profit and premium volume, with a percentage for prompt payment of premiums and other criteria, to reward the agency’s effort. These profit-based commissions generally fluctuate with our loss and loss expense ratio. Our 2008 contingent commission accrual reflected our estimate of the profit-sharing commissions to be paid to our agencies in early 2009 based largely on each agency’s performance in 2008.
Non-commission underwriting expenses were relatively stable over the three-year period. The modest increase in 2008 was due to the pension charge. Refinements in the allocation of expenses between our commercial lines and personal lines segments also contributed to minor variations in the non-commission underwriting expenses.
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Written and earned premium trends in 2008 and 2007 reflected improved new business levels offset by higher reinsurance premiums in both years. Reinsurance premiums, including a reinstatement premium of $8 million in 2008, were $33 million in 2008, $21 million in 2007 and $16 million in 2006. 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.
Other personal written premiums were essentially unchanged over the three-year period. The decline in the number of homeowner and personal auto policies over the past several years hindered growth in this business line since most of our other personal coverages are endorsed to homeowner or auto policies.
The calendar year loss and loss expense ratio for other personal deteriorated in 2008 after improving in 2007. Variations in catastrophe losses and favorable development on prior period reserves accounted for this result. Savings from favorable development on prior period reserves is high for this business line because personal umbrella losses, which are a major component of other personal losses, can fluctuate significantly.
Profitability - The life insurance segment frequently reports only a small profit or loss on a GAAP basis because most of its investment income is included in investment segment results. We include only investment income credited to contract holders (interest assumed in life insurance policy reserve calculations) in life insurance segment results. The segment reported a $4 million profit in 2008.
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.
Separate account investment management fee income contributed $2 million to total revenue in 2008, compared with a $4 million contribution in 2007 and $3 million in 2006. These fees declined primarily because of a net realized capital loss sharing agreement between the separate account and the general account.
Contract holders (policyholders) benefits incurred related to traditional life and interest-sensitive products accounted for 75.7 percent of 2008 total benefits and expenses compared with 71.9 percent in 2007 and 73.8 percent in 2006. Total benefits and expenses rose due to net death claims that increased but remained within our range of pricing expectations.
Operating expenses incurred, net of deferred acquisition costs, accounted for 24.3 percent of 2008 total benefits and expenses compared with 28.1 percent in 2007 and 26.2 percent in 2006. Operating expenses declined on an absolute and percentage basis principally because of the level of deferred acquisition costs associated with new term life insurance policies.
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
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The difficulties have been most acute for writers of variable and equity-indexed products. In addition to losing significant amounts of fee income, such writers must draw down on capital to establish additional reserves for product guarantees and they must pay a higher cost for hedging programs as the markets have declined and become more volatile. We have not entered the variable or equity-indexed market, so we are not subject to the severe costs associated with these products.
Companies writing competitively priced term life insurance also must deal with very conservative statutory reserves and the associated heavy capital requirements. Many term life writers have used capital market solutions to move redundant reserves off their balance sheets. The increased cost of these solutions has decreased their viability as a method for relieving reserve strain. Because of our financial strength, we have not had to employ these solutions, and their unavailability is not curtailing our ability to continue offering competitively priced term life insurance.
Some life companies are adopting new rules and/or requesting permitted practices from their domiciliary state that allow them to strengthen their statutory balance sheets by reducing their reserve and/or capital requirements. In view of our strong capital, we have elected not to follow such a course of action. Even in the current difficult business and economic environment, we believe that we are in a good position to grow at reasonable and profitable levels in 2009.
Realized investment gains and losses - We reported realized investment gains in all three years, largely due to investment sales that were discretionary in timing and amount. In 2008, those sales were offset by $510 million of other-than-temporary impairment charges for the writedown of 126 securities.
Interest income rose again in 2008. Purchases of new fixed maturity securities over the course of 2008 served to offset market value declines generally driven by macro factors. At year-end 2008, the fixed maturity portfolio was trading at 96.2 percent of book value compared with 101.1 percent at year-end 2007.
We are investing available cash flow in both fixed income and equity securities with yields that we believe are likely to be more secure. This may slow the return to growth in investment income although we believe year-over-year comparisons may turn positive in the second half of 2009.
Net realized investment gains and losses are made up of realized investment gains and losses on the sale of securities, changes in the valuation of embedded derivatives within certain convertible securities and other-than-temporary impairment charges. These three areas are discussed below.
Investment gains or losses are recognized upon the sales of investments or as otherwise required under GAAP. The timing of realized gains or losses from sales can have a material effect on results in any quarter. 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. Impairment charges are recorded for other-than-temporary declines in value if, in the asset impairment committee’s judgment, there is little expectation that the value may be recouped within a designated recovery period. Other-than-temporary impairment losses represent non-cash charges to income.
As appropriate, we buy, hold or sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives.
In 2008, we recorded $510 million in write-downs of 126 securities that we deemed had experienced an other-than-temporary decline in fair value versus $16 million in 2007 and $1 million in 2006. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 45. The other-than-temporary impairment charges in 2008 represented 5.7 percent of our total invested assets at year-end. Other-than-temporary impairment charges also include unrealized losses of holdings that we had identified for sale but not yet completed a transaction.
Other-than-temporary impairment charges from the investment portfolio by industry are summarized as follows:
Losses before income taxes for our Other business were largely driven by interest expense from debt of the parent company. In 2008, the loss also reflected expenses related to the surplus lines operation.
We had $111 million of income tax expense in 2008 compared with $337 million in 2007 and $399 million in 2006. The effective tax rate for 2008 was 20.7 percent compared with 28.3 percent in 2007 and 30.0 percent in 2006.
The parent company’s primary means of meeting liquidity requirements are dividends from our insurance subsidiary, investment income and after-tax 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 73. Other uses of parent company cash include general operating expenses described under Other Commitments, Page 73, as well as dividends to shareholders and common stock repurchases.
This table shows a summary of the major sources and uses of liquidity by the parent company:
In 2008, we repurchased 3.8 million shares, all in the first six months of the year. As economic and market conditions deteriorated, we choose to preserve capital rather than continue repurchase activity. In the past, repurchases have occurred when we believe that stock prices on the open market are favorable for such repurchases. Our corporate code of conduct restricts repurchases during certain time periods. At a minimum, we historically have repurchased to offset dilution from share-based compensation.
premiums, subsequent premiums are used to generate investment income until the policy benefits are paid or the policy term expires.
Further, financial resources of the parent company also could be made available to our insurance subsidiary, if circumstances required. This would include our ability to access the capital markets and short-term bank borrowings.
We provide details of our three long-term notes in Item 8, Note 8 of the Consolidated Financial Statements, Page 109. None of the notes are encumbered by rating triggers:
$28 million aggregate principal amount of 6.9% senior debentures due 2028.
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Moody’s Investors Service removed our ratings from review on September 25, 2008, lowering the senior debt rating of Cincinnati Financial Corporation to A3 from A2 with a stable outlook. Moody’s maintained a two-notch spread between the debt rating and insurance financial strength ratings due to significant financial flexibility and liquidity afforded by the holding company’s large investment portfolio representing over 100 percent of its outstanding debt.
At year-end 2008, we had two lines of credit with commercial banks amounting to $225 million with $49 million outstanding.
Our $75 million unsecured line of credit with PNC Bank, N.A. was established more than five years ago and was renewed effective June 30, 2008 for a one-year term to expire on June 30, 2009. The line has no financial covenants, and we currently believe we may be able to renew it under terms and conditions that are essentially unchanged. CFC Investment Company, a subsidiary of Cincinnati Financial Corporation, also is a borrower under this line of credit. At year-end 2008, there was $49 million outstanding on this line of credit at a rate of LIBOR plus 50 basis points. PNC Bank is a subsidiary of PNC Financial Services Group, Inc. (NYSE:PNC)
The second line of credit is an unsecured $150 million revolving line of credit administered by The Huntington National Bank. It was established in 2007 and will mature in 2012. The line contains customary financial covenants that we presently meet. It is to be used for general corporate purposes. We borrowed $20 million against the line in 2007, which was repaid during 2008.
The line of credit includes a swing line sub-facility for same-day borrowing in the amount of $35 million. The credit agreement provides alternative interest charges based on the type of borrowing and our debt rating. The interest rate charged for an advancement is adjusted LIBOR plus the applicable margin. Based on our debt ratings at year-end 2008, interest for Eurodollar rate advances is adjusted LIBOR plus 33 basis points, and for floating rate advances is adjusted LIBOR. Utilization and commitment fees based on Cincinnati Financial Corporation’s current debt rating are 5 basis points and 8 basis points, respectively. CFC Investment Company, a subsidiary of Cincinnati Financial Corporation, is a co-borrower under the agreement.
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Further, parent company liquidity could be constrained by State of Ohio regulatory requirements that restrict the dividends insurance subsidiaries can pay. During 2009, total dividends that our insurance subsidiary can pay to our parent company without regulatory approval are approximately $336 million.
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.
As of December 31, 2008, we believe our most significant other commitments are:
Qualified pension plan - In 2009, we currently estimate a voluntary cash contribution of $33 million to pension plan assets. Our results of operation would reflect an anticipated $11 million net pension expense and an estimated $8 million expense for company 401(k) contributions. Going forward, potential savings due to lower funding requirements for the pension plan are expected to be offset by the company 401(k) contributions. We chose to transition away from a defined benefit plan to reduce the company’s future market risk while offering associates an up-to-date, more flexible benefits program. We discuss the change to the pension plan and future contributions in Item 8, Note 13 to the Consolidated Financial Statements, Page 113.
Commissions - We expect commission payments to generally track with written premiums. We discuss commission trends in the Commercial Lines and Personal Lines Insurance Results of Operations, Page 51 and Page 59.
Technology - In addition to contractual obligations for hardware and software discussed below, we anticipate capitalizing approximately $50 million in spending for key technology initiatives in 2009. Technology projects are discussed in Item 1, Strategic Initiatives, Page 7. Capitalized development costs related to key technology initiatives totaled $38 million in 2008. These activities are conducted at our discretion, and we have no material contractual obligations for activities planned as part of these projects.
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Interest on long- and short-term debt - We expect total interest expense to be approximately $53 million in 2009. We discuss outstanding debt in Additional Sources of Liquidity, Page 71.
Operating property - We expect to invest a total of $9 million, including $7 million over the next two years to renovate an unoccupied building several miles from our headquarters for use as a business continuity center.
We direct our associates and agencies to settle claims and pay losses as quickly as is practical and made $1.955 billion in net claim payments during 2008. At year-end 2008, net property casualty reserves reflected $2.009 billion in unpaid amounts on reported claims (case reserves), $802 million in loss expense reserves and $687 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 to establish loss and loss expense reserves and our belief that reserves are adequate in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 41.
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 fixed-maturity portfolio was 5.4 years at year-end 2008. By contrast, the duration of our loss and loss expense reserves was 3.0 years, and the duration of all insurance operation liabilities was 3.3 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow from operations is sufficient to meet these obligations. In addition, investment holdings could be liquidated, if necessary, to meet higher than anticipated loss and loss expenses.
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.
Management’s best estimate of total loss reserves as of year-end 2008 was consistent with the corresponding actuarial best estimate. Management’s best estimate of total loss reserves as of year-end 2007 also was consistent with the corresponding actuarial best estimate.
Section B shows the cumulative net amount paid with respect to the previously recorded reserve as of the end of each succeeding year. For example, as of December 31, 2008, we had paid $1.429 billion of loss and loss expenses in calendar years 1999 through 2008 for losses that occurred in accident years 1998 and prior. An estimated $170 million of losses remained unpaid as of year-end 2009 (net re-estimated reserves of $1.599 billion from Section C less cumulative paid loss and loss expenses of $1.429 billion).
Section D, cumulative net redundancy, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 1998, had developed a $241 million redundancy over 10 years, net of reinsurance, which was reflected in income over the 10 years. The table shows favorable development in redundant reserves as a negative number. The reconciliation shows the effects on income in 2008, 2007 and 2006 of changes in estimates of the reserves for loss and loss expenses for all accident years.
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 held up reasonably well since 2004. Between 2006 and 2008, total asbestos and environmental reserves decreased 11.6 percent. Our exposure to such claims is limited; therefore, we do not believe that a more detailed reserve analysis would be an appropriate use of resources.
For the business lines in the commercial lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves. The rise in total gross reserves for our commercial business lines is partially due to normal loss cost inflation and exposure growth in our workers’ compensation business line, the higher level of catastrophe losses in 2008 and an increase in larger surety and executive risk losses, as discussed in Commercial Lines Insurance Results of Operations, Page 51.
Overall favorable development for commercial lines reserves of $274 million in 2008 illustrated the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty. Favorable reserve development for the commercial casualty line accounted for 94.2 percent of the segment total in 2008. Five factors, accounting for $182 million of favorable reserve development for the commercial casualty line of business as discussed below, were atypical.
approximately $43 million lower. The release in 2008 of $43 million of commercial casualty reserves on prior accident years added to the line’s favorable reserve development.
Introduction of additional umbrella reserving model - Our actuaries became increasingly dissatisfied in 2008 with the performance of the reserving model they had been using to estimate commercial umbrella loss reserves, which are a component of our commercial casualty reserves. As a result, they began using blended trends from two separate reserving models to estimate required commercial umbrella reserves as of year-end 2008. If the actuaries had estimated required commercial umbrella reserves as of year-end 2007 in a similar fashion, commercial casualty reserves at year-end 2007 would have been approximately $54 million lower. Accordingly, 2008 favorable reserve development for the commercial casualty line would have been reduced by a like amount.
Sooner-than-expected moderation in inflation trend of allocated loss expenses - For some of our commercial casualty coverages, the claims department’s early settlement resolution initiative caused calendar year payments for allocated loss expenses to inflate at a temporarily higher rate beginning in 2005. Based on data available in 2007, our actuaries expected the higher inflation rate to persist through the end of 2007. In 2008, they learned that the inflation rate had reverted to normal in 2007. If our actuaries had recognized this reversion when deriving year-end 2007 reserve estimates, commercial casualty reserves as of year-end 2007 would have been approximately $8 million lower.
Unusual deviations from predictions of reserving methods and models - At year-end 2007, our actuaries based loss reserve estimates for commercial multi-peril liability coverages, which are part of the commercial casualty line, on the indications of the reported loss development method and a selected paid loss probabilistic trend family model. In deriving the reported loss development estimate, the actuaries relied heavily on five-year averages to guide their parameter selections. The vast majority of these selections proved high in 2008, some significantly so. Our actuaries also identified a significant deviation in 2008 related to the use of the paid loss probabilistic trend family model. Consideration of premium growth, pricing changes and loss cost trends for commercial multi-peril liability coverages led them to use an index to capture exposure growth that paid loss data for immature accident years could fail to reflect. In 2008, it became apparent that the index was not needed. We believe that the implementation of tighter terms and conditions on general liability policies between 2002 and 2005 played a role in this deviation. If our actuaries had recognized these deviations when deriving year-end 2007 reserve estimates, commercial casualty reserves as of year-end 2007 would have been approximately $39 million lower.
Factors contributing to the remaining $76 million of commercial casualty favorable reserve development were not unusual or unexpected. 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.
For the business lines in the personal lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were down slightly from year-end 2007 due to the decline in premiums and exposures for this segment. However, gross reserves for the homeowner line of business rose slightly on a higher level of catastrophe losses in 2008, as we discussed in Personal Lines Insurance Results of Operations, Page 59.
Gross life policy reserves were $1.551 billion at year-end 2008, compared with $1.478 billion at year-end 2007. 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.
Primary components of the 2009 property and casualty reinsurance program include:
Property per risk treaty - The primary purpose of the property treaty is to provide capacity up to $25 million, adequate for the majority of the risks we write. It also includes protection for extra-contractual liability coverage losses. We retain the first $5 million of each loss, up from the $4 million retention in 2008. Losses between $5 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $34 million for 2009, compared with $37 million in 2008 and $35 million in 2007.
reinsured at 100 percent. The ceded premium is estimated at $40 million in 2009, compared with $43 million in 2008 and $50 million in 2007.
Casualty excess treaties - We purchase a casualty reinsurance treaty that provides an additional $25 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $50 million of protection for workers’ compensation, extra-contractual liability coverage and clash coverage losses, which would apply when a single occurrence involved multiple policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated at $2 million in 2009, unchanged from 2008.
We purchase a second casualty excess treaty, which provides an additional $20 million in casualty loss coverage. This treaty also provides catastrophic coverage for workers’ compensation and extra-contractual liability coverage losses. The ceded premium is estimated at less than $1 million for 2009, similar to the premium we paid in 2008.
Property catastrophe treaty - To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, we purchase property catastrophe reinsurance with a limit up to $500 million. For the 2009 treaty, ceded premiums are estimated at $48.6 million compared with $41.3 million in 2008 and $48 million in 2007. We retain the first $45 million of any loss and varying shares of losses up to $500 million:
18 percent of losses between $300 million and $400 million and
After reinsurance, our maximum exposure to a catastrophic event that caused $500 million in covered losses would be $118 million compared with $105 million in 2008. The largest catastrophe loss in our history was Hurricane Ike in September 2008, which was estimated to be $129 million before reinsurance. The treaty contains one reinstatement provision.
Basket retention - CSU has purchased this coverage to limit our retention to $1 million in the event that the same occurrence results in both a property and a casualty loss.
For property or casualty risks with limits exceeding $5 million, underwriters place facultative reinsurance coverage on an individual certificate basis. The combined property and casualty treaty provides protection on
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a participating basis for extra contractual obligations, as well as exposure to losses in excess of policy limits. The limit is $5 million for both property and casualty.
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 our Item 1A, Risk Factors, Page 25. 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.
Further decline in overall stock market values negatively affecting the company’s equity portfolio and book value
Events, such as the credit crisis, followed by prolonged periods of economic instability, that lead to:
Personal lines pricing and loss trends that lead management to conclude that this segment could not attain sustainable profitability, which could prevent the capitalization of policy acquisition costs
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 their 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.
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The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2008, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment is 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, 2008. The assessment led management to conclude that, as of December 31, 2008, 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, 2008. This report appears on Page 93.
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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 financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
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, 2008 and 2007, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2008, 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, 2008, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
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Cincinnati Financial operates through our insurance group and three 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 in 35 states. The group provides quality customer service to our select group of 1,113 local insurance agencies with 1,387 reporting locations. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life insurance policies, disability income policies and annuities, and The Cincinnati Specialty Underwriters Insurance Company, which began offering excess and surplus lines insurance products in 2008.
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, 2008.
We grant qualified and non-qualified share-based compensation under authorized plans. Until 2007, all stock-based awards were in the form of stock options that had an exercise price equal to the market value of the underlying common stock on the date of grant. The options vest ratably over three years following the date of grant and are exercisable over 10 year periods.
The 2006 Stock Compensation Plan provides the compensation committee of the board of directors flexibility in the types of available stock-based awards including stock options, restricted stock, restricted stock units, stock appreciation rights and other stock-based awards. The 2006 Stock Compensation Plan also provides for the grant of performance-based awards.
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 Cincinnati Insurance Companies actively write standard market property casualty insurance policies in 35 states. Our 10 largest states generated 68.7 percent and 69.1 percent of total property casualty premiums in 2008 and 2007. Ohio, our largest state, accounted for 20.9 percent and 21.2 percent of total earned premiums in 2008 and 2007. Agencies in Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each contributed between 4 percent and 9 percent of premium volume in 2008. The largest single agency relationship accounted for approximately 1.3 percent of the company’s total agency direct earned premiums in 2008.
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, 2008, the contract holders account value exceeded the current fair value of the BOLI invested assets and cash by approximately $40 million. If the BOLI projected fair value is below the value we guaranteed, a liability would be established by a charge to the company’s earnings.
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.
Our portfolio investments are primarily in publicly traded fixed-maturity, equity and short-term investments, classified as available for sale at fair value in the consolidated financial statements. Fixed-maturity investments (taxable bonds, tax-exempt bonds, redeemable preferred stocks and collateralized mortgage obligations) and equity investments (common and non-redeemable preferred stocks) are classified as available for sale and recorded at fair value in the consolidated financial 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 intent is to hold fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values.
Included within our other invested assets are life policy loans, venture capital fund investments, private equity investments and investment 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. Our private equity investments within our invested assets are accounted for under the cost method. Investment real estate consists of one office building that is carried at cost less accumulated depreciation.
We include unrealized gains and losses on investments, net of taxes, in shareholders’ equity as accumulated other comprehensive income. Realized gains and losses on investments are recognized in net income on a specific identification basis.
We account for our investment portfolio at fair value and apply fair value measurements as defined by SFAS No. 157, “Fair Value Measurements,” to financial instruments. Fair value is applicable to SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” and SFAS No. 107, “Disclosures about Fair Value of Financial Instruments.”
We adopted the provisions of SFAS No. 157 on January 1, 2008. SFAS No. 157 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 SFAS No. 157, we considered various factors such as liquidity and volatility but primarily obtained pricing from various external services, including broker quotes. We primarily base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on prices from FT Interactive Data, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. When a price is not available from these sources, as in the case of securities that are not publicly traded, we determine the fair value using various inputs including quotes from independent brokers. The fair value of investments not priced by FT Interactive Data is less than 1 percent of the fair value of our total investment portfolio.
For the purpose of SFAS No. 107 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 and notes payable on the quoted market prices for such notes.
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SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements - an amendment of Accounting Research Bulletin (ARB) No. 51,” was issued in December 2007. SFAS No. 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. The provisions of SFAS No. 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. Management does not expect adoption of this statement to have a material impact on our results of operations and financial position.
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles.” SFAS No. 162 identifies sources of GAAP and provides a framework, or hierarchy, for principles to be used for non-governmental entities. This statement was effective on November 15, 2008, and did not have an impact on our results of operations and financial position.
At December 31, 2008, contractual maturity dates for fixed-maturity and short-term investments were:
At December 31, 2008, investments with book value of $80 million and fair value of $81 million were on deposit with various states in compliance with regulatory requirements.
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When evaluating for other-than-temporary impairments, our asset impairment committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost.
During 2008, we impaired 126 securities. As a result, 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, there were no fixed maturity investments trading below 70 percent of book value.
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Level 2 - Financial assets and liabilities for which values are based on quoted prices in markets that are not active or for which values are based on similar assets and liabilities that are actively traded. Also includes pricing models for which the inputs are corroborated by market data.
This table summarizes components of our deferred policy acquisition costs asset:
Because of changes in estimates of insured events in prior years, we reduced loss and loss expenses by $323 million, $244 million and $116 million in calendar years 2008, 2007 and 2006. These decreases are partly due to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for amounts less than expected. The reserve for loss and loss expenses in the consolidated balance sheets also includes $46 million, $42 million and $36 million at December 31, 2008, 2007 and 2006, respectively, for certain life and health losses.
This table summarizes the principal amounts of our long-term debt excluding unamortized discounts:
Declared cash dividends per share were $1.56, $1.42 and $1.34 for the years ended December 31, 2008, 2007 and 2006, respectively.
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 balance sheets at December 31 were as follows:
We believe it is more likely than not that our deferred tax assets will be realized. Significant factors we considered in determining the probability of realizing the deferred tax benefits include our historical operating results, the amount of our loss carryback potentials and the expectations of future earnings. The likelihood of realizing our deferred tax asset will be reviewed periodically; any adjustments required to the valuation allowance will be made in the period in which the developments they are based become known.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 111
On January 1, 2007, we adopted the provisions of FIN 48. As of December 31, 2008, we had gross unrecognized tax benefits (FIN 48 liability) of $2.1 million.
Below is the unrecognized tax benefit for December 31, 2008, and December 31, 2007:
The FIN 48 liability is carried in other liabilities in the consolidated balance sheets as of December 31, 2008. There are no amounts in our FIN 48 liability that would change the effective tax rate if recognized. Although no penalties currently are accrued, if incurred, they would be recognized as a component of income tax expense. Accrued interest expense is recognized as other operating expense in the consolidated statements of income. The accrued interest liability was $1.8 million as of December 31, 2007 with an accrued interest receivable of $800,000 at December 31, 2008. The consolidated statements of income for the current year reflect an immaterial amount of net IRS interest expense compared to net interest income of $1.5 million in 2007 from a reduction in the accrued interest liability and interest received on refund claims.
In May 2008, the IRS concluded the examination phase of its audit of our 2005 and 2006 tax years and presented us with adjustments primarily related to the valuation of our loss reserves. In October 2008, we reached agreement with the IRS settling all issues related to the 2005 and 2006 tax years. As a result of the IRS agreement for tax years 2005 and 2006, management refined certain assumptions used to calculate the unrecognized tax benefits associated with loss reserves, resulting in a revised measurement of the unrecognized tax benefits for both the current and prior year.
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 contribution to the 401(k) plan from the defined benefit pension plan. Effective June 30, 2008, we froze entry into the pension plan for new associates. Only participants 40 years of age or older could elect to continue to participate. For participants remaining in the pension plan, we will 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.
Pursuant to SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” we recognized expense of $3 million 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 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.
We began making matching contributions to our sponsored 401(k) plan during 2008, contributing $3 million during the year. 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.
Key assumptions used in developing the 2008 net pension obligation were a 6.00 percent discount rate and rates of compensation increases ranging from 4 percent to 6 percent. To determine the discount rate, the plan’s particular liability characteristics - the amounts, timing and interest sensitivity of expected benefit payments - were evaluated and then matched to a yield curve based on actual high-quality corporate bonds across a full maturity spectrum. Once the plan’s projected cash flows matched the yield curve, a present value was developed, which was then calibrated to a single-equivalent discount rate. That discount rate, when applied to a single sum, would generate the necessary cash flows to pay benefits when due. We decreased the rate by 0.25 percentage points in 2008 due to market interest rate conditions. We based the rates of compensation increase on the company’s historical data. Due to the curtailment, we re-measured the net pension obligation of our qualified plan on September 1, 2008, using a 6.75 percent discount rate.
The accumulated benefit obligation was $170 million and $206 million at December 31, 2008 and 2007, respectively.
The weighted-average assumptions used to determine benefit obligations for our qualified and SERP plans at December 31 follows:
We evaluate our pension plan assumptions annually and update them as necessary. The discount rate assumptions for our benefit obligation track with high grade corporate bond yield and yearly adjustments reflect any changes to those bond yields. Compensation increase assumptions reflect historical calendar year compensation increases.
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. Reflecting the long-term time horizon of pension obligations, we currently allocate 80 percent to 85 percent of the pension portfolio to equity investments, which are priced from highly observable and actively traded markets. The remainder of the portfolio is allocated to fixed-maturity investments and cash.
In 2009, we expect to contribute approximately $33 million to our qualified plan. We expect to make the following benefit payments for our qualified and SERP plans, which reflect expected future service:
The estimated costs to be amortized from accumulated other comprehensive income into net periodic benefit cost over the next year for our plans are a $1 million actuarial gain and a $1 million prior service cost.
Statutory net income and capital and surplus as determined in accordance with SAP prescribed or permitted by insurance regulatory authorities for four legal entities, our insurance subsidiary and its three insurance subsidiaries, are as follows:
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $6 million, $7 million and $7 million on premium volume of approximately $38 million, $37 million and $40 million for 2008, 2007 and 2006, respectively.
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 state 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. The company’s insurance subsidiaries also are occasionally parties to individual actions in which extra-contractual damages, punitive damage, or penalties are sought, such as claims alleging bad faith in the handling of insurance claims.
Nonetheless, given the potential for large awards in certain of these actions and the inherent unpredictability of litigation, an adverse outcome could have a material adverse effect on the company’s consolidated results of operations or cash flows in particular quarterly or annual periods.
Compensation cost for all non-vested stock options granted prior to January 1, 2006, that vested subsequent to that date, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and
Stock options are granted to associates at an exercise price that is equal to the fair market value as reported on the NASDAQ Global Select Market for the grant date and are exercisable over 10 year periods. The stock options generally vest ratably over a three-year period. In determining the share-based compensation amounts for 2008, 2007 and 2006, the fair value of each option granted in those years was estimated on the date of grant using the binomial option-pricing model. We make assumptions in four areas to develop the binomial option-pricing model:
Expected volatility is based on our stock price over a historical period which approximates the expected term.
Cash received from the exercise of options was $4 million, $19 million and $27 million for the years ended December 31, 2008, 2007 and 2006, respectively. SFAS No. 123(R) also requires us to classify certain tax benefits related to share-based compensation deductions as cash from financing activities. We did not realize a tax benefit on options exercised for the year ended December 31, 2008. We realized a $2 million tax benefit on options exercised for the year ended December 31, 2007, and a $3 million benefit for the year ended December 31, 2006.
If certain performance targets are attained, performance-based restricted stock units vest on the first day of March after a three-calendar year performance period. Quarterly, management reviews and determines the likelihood that the company will achieve the performance targets for the outstanding groups of service-based restricted stock units.
Here is a summary of restricted stock unit information for 2008:
Other revenues are primarily finance/lease income and, for 2008, earned premiums from The Cincinnati Specialty Underwriters Insurance Company.
Income before income taxes for the investment operations segment is net investment income plus realized investment gains and losses for investments of the entire company, minus investment interest credited to contract holders of the life insurance segment.
Identifiable assets are used by each segment in its operations. We do not separately report the identifiable assets for the commercial or personal lines segments because we do not use that measure to analyze the segments. We include all investment assets, regardless of ownership, in the investment operations segment.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 120
The sum of the quarterly reported per share amounts may not equal the full year as each is computed independently.
Revenues include realized investment gains and losses, which are integral to our financial results over the long term may cause this value to fluctuate substantially because we have substantial discretion in the timing of investment sales. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. We discuss realized investment gains for the past three years in Item 7, Investments Results of Operations, Page 66.