Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building contains approximately 800,000 total square feet. The property, including land, is carried in our financial statements at $71 million as of December 31, 2006, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (1 percent).
Construction of a 690,000 total square foot underground garage and third office tower at our headquarters building began in early 2005. We estimate a completion date of September 2008 for the project. We believe this estimated $100 million expansion will accommodate our business needs for the foreseeable future. The construction project is on schedule and on budget. As of December 31, 2006, construction costs totaled $41 million, which is classified as land, building and equipment, net, for company use.
Cincinnati Financial Corporation owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property. This is a four-story office building containing approximately 124,000 square feet. The property is carried in the financial statements at $7 million as of December 31, 2006, and is classified as land, building and equipment, net, for company use. CFC and our subsidiaries occupy approximately 90 percent of the rentable square feet and unaffiliated tenants occupy approximately 10 percent.
The Cincinnati Life Insurance Company owns a four-story office building in Springdale, Ohio, approximately four miles from our headquarters. It contains approximately 102,000 rentable square feet. This property is carried in the financial statements at $3 million as of December 31, 2006, and is classified as other invested assets. At year-end 2006, two tenants occupied approximately 37 percent of the rentable square feet. The remaining space is available for lease. The property is available for sale.
In 2006, The Cincinnati Insurance Company purchased an unoccupied building on 16 acres of land in Springfield Township, Ohio, approximately six miles from our headquarters. We plan to renovate the 51,000 square foot building to serve as a data processing center and a disaster recovery center. The property, including land, is carried on our financial statements at $3 million as of December 31, 2006, and is classified as land, building and equipment, net, for company use.
2006 - The company sold its holdings in Alltel Corporation common stock. The sale contributed $647 million (pretax) to realized investment gains and revenues and $412 million (after tax), or $2.35 per share, to net income.
2000 - The company recorded a one-time charge of $39 million, pretax, to write down previously capitalized costs related to the development of software to process property casualty policies.
The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial position. Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Pages 28 and 29, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 78. We present per share data on a diluted basis unless otherwise noted and we have adjusted those amounts for all stock splits and dividends.
We achieve claims excellence, covering the spectrum from our response to reported claims to our approach to establishing reserves for not-yet-paid claims
We invest for long-term total return, using available cash flow to purchase equity securities after covering insurance liabilities by purchasing fixed-maturity securities
We believe consistently applying our long-term strategies rather than taking short-term actions will allow us to address these challenges. We seek to meet our agents’ needs, with an eye toward solutions and approaches that will give us an advantage for five, 10 or more years. As we appoint new agencies, we are looking to build relationships that will grow as successfully as those we have had for 40 or 50 years.
In 2006, we did not achieve some of our objectives for creating shareholder value. For the year, we reached record levels of new business and total property casualty insurance premiums in the face of growing competition. Business policyholders continued to respond favorably to their local independent agents’ presentation of the Cincinnati value proposition. In the second half of the year, agents and personal lines policyholders responded to new pricing for Cincinnati’s personal lines products with higher customer retention rates and rising new business. Further, our equity-focused investment strategy led to another year of record investment income and record book value.
However, other factors dampened our enthusiasm for those favorable results. Nine catastrophe events, primarily storms affecting our policyholders in the Midwest, led to a record level of catastrophe losses even as the industry experienced a lighter catastrophe year. Loss severity crept upward. And ongoing investment in our people and our infrastructure, including technology and systems to make it easier for agents to do business with our company, contributed to expenses rising more rapidly than premiums.
We look beyond 2006 with a measure of optimism. We remain committed to providing a stable market for our agents’ high quality business, underwriting this business carefully and producing steady value for our shareholders, as represented by the board of directors’ recent decision to increase our 2007 indicated annual
cash dividend by 6 percent, which would mark the 47th consecutive year of increase in that measure. We believe we can achieve above-industry-average growth in written premiums and industry-leading profitability over the long term by building on our proven strategies: strong agency relationships, local underwriting, quality claims service, solid reserves and total return investing.
Over our 56 year history, our growth largely has been driven by increasing our share of the business written by the agencies that market our products, growth of those agencies and, to a lesser extent, appointment of new agencies and our periodic entry into new states. During 2007, we expect to make more than 50 new agency appointments, including our initial appointments in two new states: New Mexico and Washington.
Over the years, we have been able to increase our share of our agencies’ business by making available insurance products that meet the needs of the individuals and businesses in their communities. In recent years, our agents have indicated their desire to have Cincinnati available as a market for commercial accounts that require the flexibility of excess and surplus lines coverage.
In 2007, we will take the initial steps necessary to incorporate a new excess and surplus subsidiary and determine its structure. During the year we will appoint a team to begin researching and developing the appropriate terms and conditions, rates and underwriting guidelines. We anticipate little, if any, premium contribution from excess and surplus lines in 2007.
Below we review highlights of our financial results for the past three years and measures of the success of our efforts to create shareholder value. Detailed discussion of these topics appears in Results of Operations, Page 40, and the Liquidity and Capital Resources, Page 59.
Revenues rose in 2006 and 2005. The growth in 2006 primarily reflected the sale of our Alltel common stock holdings. In both years, rising pretax investment income offset slowing consolidated property casualty earned premium growth.
Net income and net income per share reached record levels in 2006 and 2005. A number of factors contributed to net income:
The consolidated property casualty underwriting profit declined in 2006 due to higher catastrophe losses, increased loss severity and less savings from favorable development of prior period losses as well as higher underwriting expenses. Underwriting profitability was healthy in 2005. The factors behind these changes are discussed in the Results of Operations.
The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. Cash dividends declared per share rose 11.2 percent and 16.1 percent in 2006 and 2005.
Invested assets and total assets rose in 2006 on new investments and appreciation in the equity portfolio. Invested assets and total assets were flat in 2005 as strong cash flow for new investments was offset by lower unrealized investment gains.
Comprehensive income is net income plus the year-over-year difference in unrealized gains on investments. In 2006, comprehensive income rose because of higher unrealized gains in the investment portfolio. In 2005 and 2004, comprehensive income was lower because of reduced unrealized gains primarily due to a decline in the market value of our Fifth Third investment.
We also measure a variety of non-financial metrics for our property casualty operations. For example, we monitor our rank within our reporting agency locations. In 2005, we ranked No. 1 or No. 2 by premium volume in 75 percent of the locations that have marketed our products for more than five years. Other measures include subdivision of territories and new agency appointments. We ended 2006 with 102 field territories, subdividing three new territories and merging one into the surrounding regions. As discussed in Item 1, Growing with Our Agencies, Page 7, we made 55 new agency appointments in 2006, 42 of which were new relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 37 in 2006.
In 2007, we expect to make further progress in our efforts to improve service to and communication with our agencies through our expanding portfolio of software. In particular, we will continue to deploy our commercial lines and personal lines quoting and policy processing systems that allow our agencies and our field and headquarters associates to collaborate on new and renewal business more efficiently and give our agencies choice and control. We discuss our technology plans for 2007 in Item 1, Technology Solutions, Page 4.
Our combined ratio estimate for 2007 is 97 percent to 99 percent on either a GAAP or statutory basis compared with 94.3 percent on a GAAP basis in 2006. The year-over-year increase reflects four assumptions:
Catastrophe losses should contribute approximately 5.5 percentage points to the combined ratio. We think this is an appropriate estimate based on our reinsurance treaty retention and catastrophe loss experience in recent years.
For these reasons, we may not achieve our objective of an industry-leading combined ratio in 2007. The projected industry average 2007 combined ratio is 96.8 percent.
Cincinnati Financial Corporation’s financial statements are prepared using GAAP. These principles require management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ materially from those estimates.
The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 to the Consolidated Financial Statements, Page 85. 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.
and estimate the effect of various loss factors. We believe that the following represent the primary risks to our ability to estimate loss reserves accurately:
Changes in medical inflation and mortality rates that affect workers’ compensation claims
Changes in claim cost trends, including the effects of general economic and tort cost inflation, not reflected in the historical data used to estimate loss reserves
Changes in reinsurance coverage, not reflected in reserving data, that affect the company’s net payments and net case reserves
Reporting pattern changes attributable to case reserving practices, particularly with respect to workers’ compensation claims
Absence of cost-effective methods for accurately assessing asbestos and environmental claim liabilities (see Property Casualty Insurance Reserves, Asbestos and Environmental Reserves, Page 66, for discussion of related reserve levels and trends)
In 2000, we began using a claims mediation process that promotes earlier liability settlement resolution. By 2004, we had introduced the program into several states, which has provided favorable results.
To review IBNR reserves on an annual basis, we use a variety of tools, including actuarial and statistical methods. These may include but are not limited to:
Supplemental statistical information is compiled and reviewed to aid in the application of actuarial methods and models. The supplemental data also is used to evaluate the reasonableness of estimates derived from the actuarial methods and models. This information includes:
We conduct our thorough evaluation of the adequacy of reserves as of the end of the third quarter of each year. As a result, the most significant refinements in reserves historically have been implemented in the fourth quarter. In 2006, we began conducting a detailed supplemental review as of the end of the fourth quarter of each year in parallel with the outside actuarial review. Less detailed, periodic reviews of reserve adequacy are made at the other quarter ends. A loss review committee, including internal actuaries and representatives from management of multiple operating departments, is responsible for the quarterly review process.
Fixed-maturity and equity investments are our largest assets. The company’s asset impairment committee continually monitors these investments and all other assets for signs of other-than-temporary and/or permanent impairment. The committee monitors significant decreases in the market value of the 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 other 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.
market conditions. We provide information regarding valuation of our invested assets in Item 8, Note 2 to the Consolidated Financial Statements, Page 90.
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 will be recouped in the foreseeable future. A security valued between 90 percent and 100 percent of book value will not be monitored separately by the committee. These assets generally are at this value because of interest rate-driven factors. A security valued below 90 percent of book value is reported to the asset impairment committee. A security valued below 70 percent of book value is defined as distressed.
Distressed securities receive additional scrutiny. Effective January 1, 2006, a security will be written down in the event of a declining market value for four consecutive quarters with quarter-end market value below 70 percent of book value, or when a security’s market value is 70 percent below book value for three consecutive quarters. A sudden and severe drop in market value that does not otherwise meet the above criteria is reviewed for possible immediate impairment.
Permanent impairment charges (write-offs) are defined as those for which management believes there is little potential for future recovery, for example, following the bankruptcy of the issuing corporation. A permanent decline in the fair value of a security is written off at the time when facts and circumstances indicate such write-down is warranted, and is reflected in realized investment losses.
We establish reserves for our universal life, deferred annuity and investment contracts equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals. Some of our universal life insurance policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance based on expected no-lapse guarantee benefits and expected policy assessments.
Key assumptions used in developing the 2006 net pension obligation were a 5.75 percent discount rate and rates of compensation increases ranging from 4 percent to 6 percent. Key assumptions used in developing the
Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate would lower our 2007 net income before income taxes by $2 million. Likewise, a 0.5 percentage point decline in the expected return on plan assets would lower our 2006 income before income taxes by $1 million.
Information regarding recent accounting pronouncements is provided in Item 8, Note 1 to the Consolidated Financial Statements, Page 85. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
We measure profit or loss for our property casualty and life 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 measure aspects of the performance of our commercial lines and personal lines segments on a combined property casualty insurance operations basis. Underwriting results and segment pretax operating income are not a substitute for net income determined in accordance with GAAP.
Catastrophe losses contributed 5.5, 4.1 and 5.1 percentage points to the combined ratio in 2006, 2005 and 2004, respectively. Catastrophe losses in 2006 included wind and hail losses in March, April and October, with incurred losses of $37 million, $37 million and $38 million, respectively. Of the almost 13,000 catastrophe claims reported through January 31, 2007, for all catastrophes in 2006, more than 95 percent are already closed. Our field claims representatives’ prompt responses and personal approach reflect positively on our agents, supporting their marketing efforts. The following table shows catastrophe losses incurred, net of reinsurance, for the past three years as well as the effect of loss development on prior period catastrophe events.
The Cincinnati Insurance Companies do not appoint agencies to actively market property casualty insurance in Louisiana, Mississippi or Texas. Our 2005 Hurricane Katrina and Rita losses included losses associated with commercial accounts written by agents in other states to cover locations and vehicles in multiple states, including Louisiana, Mississippi and Texas.
Hurricane Katrina losses also included $18 million of assumed losses. The Cincinnati Insurance Company participates in three assumed reinsurance treaties with two reinsurers that spread the risk of very high catastrophe losses among many insurers. The assumed losses from Hurricane Katrina included $16 million under a treaty with the Munich Re Group to assume 2 percent of property losses between $400 million and $1.2 billion from a single event. Munich Re has reserved its Hurricane Katrina losses above $1.2 billion. In 2006, we reduced our participation in the Munich Re assumed reinsurance treaty to 1 percent as discussed in Item 1A, Risk Factors, Page 20.
Premiums - Although competition in our commercial markets continued to increase, our written premium growth rate increased in 2006, reflecting our agency relationships, strong new business growth, healthy policy retention rates, more accurate risk classification, insurance-to-value initiatives, higher reinsurance treaty retentions and exposure growth due to the healthy economy. These more than offset our deliberate decisions not to write or renew certain business and the loss of some accounts due to competition. In the more competitive pricing environment we have been careful to maintain our underwriting discipline for both renewal and new business. We believe that our written premium growth rate continues to exceed the average for the overall commercial lines industry, which was estimated at 1.0 percent in 2006 after declining 0.4 percent in 2005. Earned premium growth remained relatively steady over the period.
losses and other factors affecting the combined ratio beginning on Page 44. We discuss the savings from favorable loss reserve development by commercial lines of business on Page 47.
Our commercial lines statutory combined ratio was 90.8 percent in 2006 compared with 87.1 percent in 2005 and 83.7 percent in 2004. By comparison, the estimated industry commercial lines combined ratio was 94.3 percent in 2006, 99.7 percent in 2005 and 102.5 percent in 2004. We believe our results are trending differently than the overall industry because the industry experienced unusually high catastrophe losses in 2004 and 2005 and unusually low catastrophe losses in 2006.
As competition in commercial markets has increased, we have focused on maintaining our pricing discipline for both renewal and new business. Our independent agents continued to report steady pressure on pricing during 2006 and communicated that winning new business and retaining renewals required more pricing flexibility and careful risk selection.
For our renewal business, our headquarters underwriters talk regularly with agents. Our field teams are available to assist the headquarters underwriters by holding renewal review meetings with agency staff to verify that each commercial account retains the characteristics that caused us to write the business initially. For quality risks, our commercial underwriters are offering policyholders the convenience of policy extensions of one and two additional years. Policy extensions provide:
Retention of the terms and conditions that policyholders originally selected, backed by our superior claims service and our A++ rating from A.M. Best Co.
Staying abreast of evolving market conditions is a critical function, accomplished in both an informal and a formal manner. Informally, our field marketing representatives and underwriters are in constant receipt of market intelligence from the agencies with which they work. Formally, our commercial lines product management group and field marketing associates complete periodic market surveys to obtain competitive intelligence. This market information helps identify the top competitors by line of business or specialty program and also identifies our market strengths and weaknesses. The analysis encompasses pricing, breadth of coverage and underwriting/eligibility issues.
In addition to reviewing our competitive position, our product management group and our underwriting audit group review compliance with our underwriting standards as well as the pricing adequacy of our commercial insurance programs and coverages. Further, our research and development department analyzes opportunities and develops new products, new coverage options and improvements to existing insurance products.
Over the past three years, we have continued to focus on seeking and maintaining adequate premium per exposure as well as pursuing non-pricing means of enhancing longer-term profitability. These have included identifying the exposures we have for each risk and making sure we offer appropriate coverages, terms and conditions and limits of insurance. We continue to adhere to our underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions, where necessary. In addition, we continue to leverage our strong local presence. Our field marketing representatives meet with local agencies to reaffirm agreements on the extent of frontline renewal underwriting they will perform. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. Field claims representatives prepare full risk reports on any account reporting a loss above $100,000 or on any risk of concern. These actions have helped to mitigate rising loss severity.
Re-underwriting our commercial lines book of business in the early 2000s has had a positive impact on loss cost trends such as frequency of loss, resulting in significant savings from favorable reserve development. The favorable development in 2005 and 2004 also was due to a headquarters claims department initiative, begun in 2001, to establish higher initial case reserves on severe injury claims. The higher reserves reflect our experience that juries often ignore significant liability issues in cases involving seriously injured claimants as well as trends in medical cost inflation and life expectancies. These higher initial amounts produce case reserves that reflect our full exposure more accurately. But some claims settle before reaching a jury and some juries make awards that are less than the “worst-case” scenario.
Another factor in the rise in the loss and loss expense ratio excluding catastrophe losses in 2006 was increasing loss severity, reflected primarily by an increase in 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 21.3 percent of annual earned premiums in 2006 from 16.8 percent in 2005 and 14.9 percent in 2004. Those amounts included an increase in new losses greater than $1 million. 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 loss severity generally is rising, but we cannot predict the magnitude of future increases. Severe injury was frequently the cause for new losses greater than $1 million. We continue to analyze factors that could be contributing to a rise in severe injuries.
Commercial lines catastrophe losses have been relatively stable as a percentage of net earned premiums over the past three years.
Commercial lines commission expense as a percent of earned premium declined by 1.0 and 0.4 percentage points in 2006 and 2005, respectively, primarily due to lower profit-sharing commissions on lower overall underwriting profits. Profit-sharing, or contingent, commissions are calculated on the profitability of an agency’s aggregate book of business, taking into account longer-term profit, with a percentage for prompt payment of premiums and other criteria, and reward the agencies’ efforts. These profit-based commissions generally fluctuate with our loss and loss expenses.
Non-commission underwriting expenses rose to 11.1 percent of earned premiums in 2006 from 10.1 percent in 2005 and 9.4 percent in 2004. We continue to invest in our associates and technology, which is contributing to an increase in other underwriting expenses. Higher technology expense contributed 0.3 and 0.1 percentage points to the increase in 2006 and 2005. Higher staffing expense contributed 0.9 percentage points to the increase in 2006, with stock option expense accounting for 0.5 percentage points of that amount.
Commercial casualty is our largest business line. Commercial casualty net written premium growth slowed in 2006, but remained above the overall growth rate for commercial lines. While casualty pricing continues to become more competitive, new business is strong. We also are seeing a boost from the healthy business economy over the past several years as well as related exposure growth.
The commercial casualty loss and loss expense ratio rose in 2006 after improving in 2005, but remained within the range we consider appropriate. In each of the last three calendar years, activity in the reserves for prior period losses has been the primary reason for the fluctuations in the loss and loss expense ratio.
2006 - Favorable development lowered the loss and loss expense ratio by 12.0 percentage points.
2005 - Favorable development lowered the loss and loss expense ratio by 22.5 percentage points.
Over the three years, flat commercial umbrella loss costs helped produce savings through favorable development on prior period reserves. Factors that contributed to the flat loss cost trend included commercial lines re-underwriting efforts, Ohio judicial decisions regarding underinsured/uninsured motorist claims and a claims mediation process that promoted earlier liability settlement resolution, which also contributed to lower loss cost trends for our other general liability coverages. Once these commercial lines and claims initiatives are fully implemented, loss cost trends could be expected to return to normal levels.
In addition, the large loss discussed on Page 42 added 5.0 percentage points to the 2005 ratio.
We pay a lower commission rate on workers’ compensation business, which means this line has a higher loss and loss expense breakeven point than our other commercial business lines.
The workers’ compensation loss and loss expense ratio rose in 2005 after remaining steady for several years and remained above our target levels in 2006. The 2005 rise largely was due to a higher level of reserve strengthening for older accident years. The ratio remained above our target level in 2006 because of modest reserve strengthening and seven new losses greater than $1 million, primarily in the second half of the year. The seven losses in 2006 totaled $18 million and added 4.9 percentage points to the workers’ compensation loss and loss expense ratio. There was only one similarly sized loss, for $1.6 million, in 2005 and none in 2004.
Our philosophy is to establish case reserves when we learn of a loss to reflect our best estimate of ultimate payouts. The higher initial reserves established in 2006 for newly reported claims demonstrate our commitment to applying our claims reserving philosophy to this business line.
In 2006, we also reviewed each of our established workers’ compensation case reserves above $100,000 in light of current trends in medical cost inflation and estimated payout periods. The review led to the allocation of approximately $60 million to case reserves held for specific claims from accident years going back as much as 20 years. Reductions to IBNR reserves offset approximately $44 million of those reserve increases. We had raised workers’ compensation IBNR reserves in 2005, in light of the trends identified in the workers’ compensation market. However, small shifts in medical cost inflation and payout periods could have a significant effect on our potential future liability compared with our current projections.
2006 - Reserve strengthening raised the loss and loss expense ratio by 2.6 percentage points, as discussed above.
2004 - Reserve strengthening raised the loss and loss expense ratio by 4.9 percentage points, which also was due to medical cost inflation.
The loss and loss expense ratio excluding catastrophe losses improved in 2006 after rising in 2005, but remained within the range we consider appropriate. In each of the last three calendar years, activity in the reserves for prior period losses contributed to the fluctuations in the loss and loss expense ratio.
2005 - Reserve strengthening raised the loss and loss expense ratio by 10.9 percentage points.
Surety and executive risk net written premiums rose in 2006 and were unchanged in 2005. Healthy economic activity drove the 2006 growth.
The loss and loss expense ratio rose in 2006 and 2005; however, surety and executive risk losses can fluctuate significantly, and we do not believe that the increases indicate any new trend or risk.
Director and officer liability coverage accounted for 59.0 percent of surety and executive risk premiums in 2006 compared with 61.7 percent in 2005 and 65.7 percent in 2004. Our director and officer liability policies are offered primarily to nonprofit organizations, reducing the risk associated with this line of business. As of December 31, 2006, two of our in-force director and officer liability policies covered Fortune 500 companies, 36 covered publicly traded companies (excluding banks and savings and loans) and 57 covered banks and savings and loans with more than $500 million in assets.
2006 - Reserve strengthening raised the loss and loss expense ratio by 21.1 percentage points due to case reserves additions for director and officer liability claims.
The loss and loss expense ratio rose in 2006; however, machinery and equipment losses can fluctuate significantly, and we do not believe that the increase indicates any new trend or risk.
2006 - Reserve strengthening raised the loss and loss expense ratio by 0.8 percentage points.
Combined ratio - After improving substantially in 2005, the combined ratio increased in 2006 due to higher catastrophe losses, less savings from favorable development on prior period reserves, an increase in loss severity and higher expenses. Lower earned premiums exacerbated the year-over-year comparisons. Our personal lines statutory combined ratio was 103.6 percent in 2006 compared with 94.3 percent in 2005 and 104.6 percent in 2004. By comparison, the estimated industry personal lines combined ratio was 92.0 percent in 2006, 97.6 percent in 2005 and 94.9 percent in 2004. We believe our results are trending differently than the overall industry because of the competitive and pricing factors discussed below.
When price competition emerged in 2004, we were in the early stages of a program to improve profitability for our homeowner line by raising rates and making changes to our policy terms and conditions. We raised our personal lines rates in some territories too high to allow our agents to market the benefits of a Cincinnati policy, leading to declines in our policy retention rates and lower new business levels between 2002 and 2005.
When some important system modifications were completed in mid-2005, we began filing rate and credit changes to better position our products in the market, but written premiums, new business and retention rates continued to decline.
During the 2003 to 2005 period, we also were introducing Diamond in our higher volume states, which may have contributed to lower growth rates. The focus required by our agencies to convert to our newer technology and make the necessary adaptations to their work flows may have diverted their resources from new business efforts. Diamond gives agencies additional choices to consider for their business operations and for policyholders. Agents are growing more familiar with the new options and work flow, and many now are seeing benefits from efficiencies as they renew business through the system.
In mid-2006, we introduced a limited program of policy credits to incorporate insurance scores into homeowner and personal auto pricing. These were intended to improve our ability to compete for our agents’ highest quality personal lines accounts, increasing the opportunity for our agents to market the advantages of our personal lines products and services to their clients.
Savings from favorable loss reserve development moved lower over the three years, which we discuss by personal lines of business on Page 53.
We prefer to write personal lines coverage on an account basis that includes both auto and homeowner coverages as well as coverages from the other personal business line. As a result, we believe that personal lines is best measured and evaluated on a segment basis. However, we provide the line of business data to summarize growth and profitability trends separately for the three business lines.
The accident year loss data provides current estimates of incurred loss and loss expenses for the past three accident years. Accident year data classifies losses according to the year in which the corresponding loss event occurred, regardless of when the losses are actually reported, booked or paid.
Written and earned premiums for the personal auto line declined in 2006 and 2005. As noted above, the decline primarily was due to price competition in some states and territories, which resulted in lower policy renewal retention and significantly lower new business levels through mid-2006. We continue to monitor and modify selected rates and credits to address our competitive position.
The loss and loss expense ratio for personal auto has remained satisfactory. For selected agencies, we use re-underwriting programs to review and to strengthen underwriting standards, such as requiring motor vehicle reports for insured drivers. We work with agencies to develop strategies to increase the company’s penetration of the agency’s personal lines business. The rise in the ratio in 2006 was due to price reductions.
2006 - Reserve strengthening raised the loss and loss expense ratio by 0.6 percentage points.
The growth rate of written and earned premiums for the homeowner line slowed over the three-year period. As discussed above, until mid-2006, the benefit of rate increases in 2004 and 2005 was being increasingly offset by lower policy renewal retention rates and significantly lower new business levels. Earned premiums rose more rapidly because of the benefit of higher written premium growth in earlier periods.
We began a strategic shift in 2004 to a more conventional one-year homeowner policy term from our traditional three-year policy term. We are transitioning to one-year policies in conjunction with the state-by-state deployment of Diamond, our personal lines policy processing system. One-year policies allow us to modify rates, terms and conditions more promptly in response to market changes. At year-end 2006, approximately 85 percent of all homeowner policies had been converted to a one-year term, up from approximately 56 percent at year-end 2005. We are continuing to renew homeowner policies for three-year terms in five states that currently account for less than 1 percent of total personal lines premiums.
2004 - Favorable development lowered the loss and loss expense ratio by 2.7 percentage points.
We also assume catastrophe losses as a percent of homeowner earned premium would be in the range of 17 percent. Over the past three years, catastrophe losses have averaged 22.2 percent of homeowner earned premiums. We did not change our catastrophe loss assumption because the geographic concentration of these losses has been unusual in the past three years.
We had hoped that by 2007 the full benefit of our pricing and underwriting actions would be reflected in homeowner results and this line would be approaching breakeven. Pricing changes enacted in mid-2006, however, have slowed our progress toward overall homeowner profitability.
The loss and loss expense ratio for other personal rose in 2006 due to higher personal umbrella and dwelling fire losses in the second quarter. Personal umbrella losses can fluctuate significantly, and we do not believe that the increase indicated any new trend or risk. In each of the last three calendar years, activity in the reserves for prior period losses also contributed to the changes in the loss and loss expense ratio.
2004 - Favorable development lowered the loss and loss expense ratio by 18.9 percentage points.
Competitive rates -In mid-2006, we introduced insurance scores into our program of policy credits for homeowner and personal auto pricing. That action led to the increased new business for both personal auto and homeowners in the second half of 2006. It also led to improved retention of current business. While these pricing refinements have reduced premiums per policy, we believe they present an opportunity to attract our agents’ more quality conscious clientele.
Policy characteristics - In keeping with industry practices, most of our homeowner products no longer automatically provide guaranteed full replacement cost coverage in our basic policies. We add specific charges for some optional coverages previously included at no charge, such as limited replacement cost and water damage coverages. Policyholders who need the water damage protection now can select the amount of coverage that meets their needs. However, these changes and our transition to one-year homeowner policies have diminished some of the factors that distinguished our products.
Diamond introduction -The Diamond system is in use by agencies writing approximately 90 percent of personal lines premium volume. We believe the system ultimately will make it easier for agents to place personal auto, homeowner and other personal lines business with us, while greatly increasing policy-issuance and policy-renewal efficiencies and providing direct-bill capabilities. Agents using Diamond chose direct bill for 47 percent and headquarters printing for 81 percent of policy transactions in 2006.
During 2007, we hope to add personal lines for 30 to 35 agency locations in the 13 states in which Diamond is in use that currently market only our commercial lines products. During 2007, our field teams and personal lines associates are contacting these agencies to re-introduce them to our personal lines product line and technology. Expanding into these agencies would provide additional sources of premiums and help geographically diversify our personal lines portfolio.
We identify several other factors that may affect the personal lines combined ratio in 2007 and beyond. Personal lines underwriters continue to focus on insurance-to-value initiatives to verify that policyholders are buying the correct level of coverage for the value of the insured risk, and we are carefully maintaining underwriting standards. However, if premiums decline more than we expect, the personal lines expense ratio may be higher than the 2006 level, because some of our costs are relatively fixed, such as our planned investments in technology. We discuss our overall outlook for the property casualty insurance operations in Measuring Our Success in 2007 and Beyond, Page 34.
Higher mortality expenses compared with the year-earlier periods principally due to growth in life insurance in force. Mortality experience remained within pricing guidelines.
Adoption of stock option expensing, which added approximately $1 million to 2006 other operating expenses.
At the same time, we recognize that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life products. For that reason, we also evaluate GAAP data, including all investment activities on life insurance-related assets, which grew 32.6 percent in 2006 to $63 million and 23.8 percent in 2005 to $47 million. The life insurance company portfolio had pretax realized investment gains of $45 million in 2006 compared with $17 million in 2005 and $9 million in 2004.
Statutory written premiums for term and other life insurance products rose 12.7 percent to $127 million for 2006 and declined 4.2 percent to $113 million for 2005.
In 2006, our life insurance segment experienced a 0.3 percent rise in life applications submitted and a 10.6 percent increase in gross face amounts issued, primarily due to continued strong sales of term insurance marketed through the company’s property casualty agency force.
Over the past several years, we have worked to maintain a portfolio of straightforward and up-to-date products, primarily under the LifeHorizons banner. Our product development efforts emphasize death benefit protection and guarantees.
Contract holders benefits incurred related to traditional life and interest-sensitive products accounted for 70.3 percent of 2006 total benefits and expenses, 66.0 percent of 2005 total benefits and expenses and 64.3 percent of 2004 total benefits and expenses.
As the life insurance company seeks to improve penetration of our property casualty agencies, our objective is to increase premiums and contain expenses. Term insurance is our largest life insurance product line. We continue to introduce new term products with features our agents indicate are important. In addition, we introduced new universal life products including cash value accumulation products for adults and children.
In the future, we expect that assets under management, capital appreciation and investment income, which are reported in investment segment results, will continue to be integral to our evaluation of the success of the life insurance operations. While life insurance segment profit may continue to fluctuate near break-even, when we also consider life insurance investment activities, we continue to believe the life insurance operations will continue to provide a steady income stream to help offset the fluctuations of the property casualty insurance business.
Investment income - Pretax investment income reached a new record in 2006, rising 8.4 percent from the prior record in 2005. Growth in investment income over the past two years has been driven by strong cash flow for new investments, higher interest income from the growing fixed-maturity portfolio and increased dividend income from the common stock portfolio.
Growth in investment income reflected new investments, higher interest income from the growing fixed-maturity portfolio and increased dividend income from the common stock portfolio. The advantages of strong cash flow in the past three years for new investments have been somewhat offset by the challenge of investing in a low interest rate environment. In 2006, proceeds from the sale of the Alltel holding that were later used to make the applicable tax payments during the year were invested in short-term instruments that generated approximately $5 million in interest income.
43.8 percent of total dividend income in 2006. We discuss our Fifth Third investment in Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 75. In 2006, 38 of the 50 common stock holdings in the portfolio raised their indicated annual dividend payout, as did 36 of 49 in 2005 and 33 of 51 in 2004.
2006 - We sold the remainder of our Alltel common stock holdings. We discuss this sale in Item 1, Investments Segment, Page 14, and Item 8, Note 2 to the Consolidated Financial Statements, Page 90.
2005 - We had gains from the sale of equity holdings that no longer met our investment parameters or were obtained from convertible securities whose underlying common stock was never intended to be a long-term holding. Included in 2005 were gains from the initial sales of a portion of our Alltel holding.
Realized gains in the past three years also have included gains from the sale of previously impaired securities.
In 2006, we recorded $7 million in fair value increases compared with $7 million in fair value declines in 2005 and $10 million in fair value increases in 2004. These changes in fair value are due to the application of SFAS No. 133, which requires measurement of the fluctuations in the value of the embedded derivative features in selected convertible securities. The changes in fair values are recognized in net income in the period they occur. See the discussion of Derivative Financial Instruments and Hedging Activities in Item 8, Note 1 to the Consolidated Financial Statements, Page 85, for details on the accounting for convertible security embedded options.
We believe impairments in 2007 should be limited to securities that have been identified for sale or that have experienced a sharp decline in fair value with little or no warning because of issuer-specific events. All securities in the portfolio were trading at or above 70 percent of book value at December 31, 2006. Our asset impairment committee continues to monitor the investment portfolio. The current asset impairment policy is in Critical Accounting Estimates, Asset Impairment, Page 37.
Income tax expense was $399 million in 2006 compared with $221 million in 2005 and $216 million in 2004. The effective tax rate for 2006 was 30.0 percent compared with 26.8 percent in 2005 and 27.0 percent in 2004. The sale of our Alltel common stock holdings in the first three months of 2006, which generated a $647 million pretax gain, was the primary reason for the change in effective tax rate for the year. Growth in the tax-exempt municipal bond portfolio, higher investment income from dividends and lower operating earnings also contributed to the change in the effective tax rate for 2006.
The parent company’s primary means of meeting liquidity requirements are dividends from our insurance subsidiary and income from investments held at the parent-company level supported by our capital resources. At year-end 2006, we had shareholders’ equity of $6.808 billion and total debt of $840 million. Our ability to access the capital markets and short-term bank borrowing provide other potential sources of liquidity. One way we seek to maintain financial strength is by keeping our ratio of debt to capital below 15 percent. Our parent company’s cash requirements include dividends to shareholders, interest payments on our long-term debt, common stock repurchases and general operating expenses.
Our insurance subsidiary’s primary sources of liquidity are collection of premiums and investment income. Its cash needs primarily consist of paying property casualty and life insurance loss and loss expenses as well as ongoing operating expenses and payments of dividends to the parent company. Although we have never sold investments to pay claims, the sale of investments would provide an additional source of liquidity, if required. After satisfying operating cash requirements, cash flows are invested in fixed-maturity and equity securities, leading to the potential for increases in future investment income and unrealized appreciation.
After paying claims and operating expenses, cash flows from underwriting declined in 2006 from the level of 2005 and 2004. We discuss our future obligations for claims payments in Contractual Obligations, Page 61, and our future obligations for underwriting expenses in Commissions and Other Underwriting Expenses, Page 62. Insurance subsidiary operating cash flow remained stable over the three years, however, due to rising investment income.
Sales of fixed-maturity investments - We prefer to hold fixed-maturity securities until maturity. Any decision to sell or to reduce a holding reflects our perception of a change in the underlying fundamentals of the security and our preference to allocate those funds to investments that more closely meet our established parameters for long-term stability and growth.
Call or maturity of fixed-maturity investments - Calls and maturities of fixed-maturity investments are a function of the yield curve. The pace of calls of fixed maturities continued to decline in 2006 as interest rates generally shifted upward.
Sales of equity securities investments - The decision to divest an equity position is generally reached after careful analysis regarding the direction the company is headed and how well it meets our investment parameters. In 2006, we completed the sale of our Alltel common stock holdings and made other sales of all or part of smaller holdings.
As a long-term investor, we historically have followed a buy-and-hold investing strategy. This policy has generated a significant amount of unrealized appreciation on equity investments. Unrealized appreciation, before deferred income taxes, was $5.244 billion and $5.067 billion at year-end 2006 and 2005, respectively. On an after-tax basis, it constituted 49.6 percent of total shareholders’ equity at year-end 2006.
Our parent company and insurance subsidiary have contractual obligations and other commitments. In addition, one of our primary uses of cash is to enhance shareholder return.
At December 31, 2006, we estimated our future contractual obligations as follows:
Our estimate of material commitments for short-term debt was 1.0 percent of material commitments at year-end 2006. On February 28, 2007, we plan to renew our $49 million outstanding note payable drawn on our $75 million in line of credit.
The completion of our new office building and parking garage to be situated at our headquarters located in Fairfield is expected to require approximately $62 million over the next two years. The construction project is on schedule and on budget. As of December 31, 2006, construction costs totaled $41 million. We expect construction to be completed by September 2008.
Our estimate of material commitments for net property casualty claims payments was approximately 58.1 percent of the estimated contractual obligations at year-end 2006.
We direct our associates to settle claims and pay losses as quickly as practical and made $1.763 billion in net claim payments during 2006. At year-end 2006, we had net property casualty reserves of $3.356 billion, reflecting $1.843 billion in unpaid amounts on reported claims (case reserves), $771 million in loss expense reserves and $742 million in estimates of IBNR claims. 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 the adequacy of our property casualty and life insurance loss and loss expense reserves in Property Casualty Insurance Reserves, Page 63.
Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover for losses under one of our reinsurance agreements depends on the financial viability of the reinsurer.
We expect to spend approximately $5 million in 2007 to begin renovation of a newly purchased building that will serve as our data processing and disaster recovery center.
After fulfilling operating requirements, cash flows from underwriting, investment and other corporate activities are invested in fixed maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. See Item 1, Investments Segment, Page 14, for a discussion of our investment strategy, portfolio allocation and quality. From the second quarter of 2004 until year-end 2005, virtually all of our available cash flow was used to purchase fixed-maturity investments to reduce our property casualty subsidiary’s ratio of common stock to statutory surplus. In 2006, equity purchases returned to a more significant level.
In 2007 we anticipate a resumption of active equity investing while also continuing to be cognizant of rating agency and regulatory guidelines. See Item 1, Investments Segment, Page 14, for a discussion of our investment strategy, portfolio allocation and quality.
At year-end 2006, the total reserve balance, net of reinsurance, was $3.356 billion, compared with $3.111 billion at year-end 2005 and $2.977 billion at year-end 2004. We provide a reconciliation of the property casualty reserve balances with the loss and loss expense liability on the balance sheet in Item 8, Note 4 to the Consolidated Financial Statements, Page 92. The reserves reflected in the consolidated financial statements are management’s best estimate.
In addition to our conclusions regarding adequate reserve levels, other factors that have affected reserve levels over the past three years included:
Higher loss adjustment expense due to a claims mediation process that promotes earlier liability settlement resolution
As we discuss in Commercial Lines Insurance Segment Reserves, Page 66, re-underwriting the commercial lines book of business beginning in 2000, including decisions to non-renew certain policyholders due to risk levels and to increase rates to better reflect exposure levels, has resulted in improved profitability. We believe the program has led to a lower risk profile for the overall commercial lines segment, contributing to favorable loss reserve trends.
In 2003 and 2004, $70 million in reserves were released following the November 2003 Ohio Supreme Court’s decision limiting its 1999 Scott-Pontzer v. Liberty Mutual decision. The reserve releases were primarily made in the commercial auto and commercial casualty business lines. Following the fourth-quarter 2003 reserve review, reserve levels were modified to reflect management’s assessment that mold claims behaved similar to asbestos and environmental claims, and reserves for these claims should be estimated using similar methods. These changes have been seen predominately in the commercial casualty business line. We expect that mold exclusions added to our commercial policies beginning in 2003 will mitigate this issue after 2006.
Further, beginning in 2003, reserve levels reflected the need to establish higher expense reserves because of the rise in litigation costs due to larger and more complex claims. These changes have been seen predominately in the commercial casualty business line. Beginning in 2002, our conclusions regarding reserve levels for all business lines reflected refinement of the manner in which the value of future salvage and subrogation for claims already incurred were estimated.
We reconcile the beginning and ending balances of our reserve for loss and loss expenses at December 31, 2006, 2005 and 2004, in Item 8, Note 4 to the Consolidated Financial Statements, Page 92. The reconciliation of our year-end 2005 reserve balance to net incurred losses one year later recognizes approximately $116 million in redundant reserves.
In evaluating the development of our estimated reserves for loss and loss expenses for the past 10 years, note that each amount includes the effects of all changes in amounts for prior periods. For example, payments or reserve adjustments related to losses settled in 2006 but incurred in 2000 are included in the cumulative deficiency or redundancy amount for 2000 and each subsequent year. In addition, this table presents calendar year data, not accident or policy year development data, which readers may be more accustomed to analyzing. Conditions and trends that have affected development of the reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this data.
We believe that our asbestos and environmental reserves, including mold reserves, are adequate at this time and that these coverage areas are immaterial to our financial position due to the types of accounts we have insured in the past.
Net reserves for all asbestos and environmental claims were $131 million in 2006 compared with $130 million in 2005 and $128 million in 2004. Net reserves for all asbestos and environmental claims were 3.9 percent, 4.2 percent and 4.3 percent of total reserves in 2006, 2005 and 2004, respectively.
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 our growth. The increase also reflected higher loss expense reserves due to a claims mediation process that promoted earlier liability settlement resolution and increased loss expenses due to higher legal fees. In addition, commercial casualty, workers’ compensation and surety and executive risk gross reserves rose because of the increase in large losses as we discussed in Commercial Lines Insurance Results of Operations, Page 42. Reserve practices discussed above also contributed.
The initiative, begun in 2000 and expanded to other states in 2004, to use a claims mediation process that promotes earlier liability settlement resolution
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 2005 due to the decline in premiums in this business line. Homeowner gross reserves reflected the increase in large losses as we discussed in Personal Lines Insurance Results of Operations, Page 49.
The overall favorable development recorded in the personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. Personal lines reserve development over the past three years was consistent with:
Differences in the timing of actual settlements compared with the payout patterns assumed in the accident year IBNR reductions
Gross life policy reserves were $1.409 billion at year-end 2006, compared with $1.343 billion at year-end 2005. 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.
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 is used when there is a single occurrence involving multiple policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated to be $2 million in 2007 and is comparable with the premium paid in 2006.
We purchase another 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 to be $1 million for 2007, comparable with the premium paid in 2006.
Our maximum exposure to a 2007 catastrophic event that resulted in $500 million in losses would be $103 million compared with $68 million in 2006. The largest catastrophe loss in our history was $87 million before reinsurance.
Responding to the challenges presented by terrorism has become a very important issue for the insurance industry over the last five years. Terrorism coverage at various levels has been secured in all of our reinsurance agreements. The broadest coverage for this peril is found in the property and casualty working treaties, which provide coverage for commercial and personal risks. In addition, our property catastrophe treaty provides coverage for personal risks and the majority of our reinsurers provide limited coverage for commercial risks with total insured values of $10 million or less.
The NAIC has asked for comments on proposals to modify statutory accounting procedures to reduce the negative effect on statutory life insurance income. We expect the NAIC proposals will be adopted. If they are not, we believe we will be able to structure a reinsurance program to provide the life insurance company with the ability to continue to grow in the term life insurance marketplace while appropriately managing risk, at a cost that allows us to achieve our life insurance company profit targets.
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 20. 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, the company’s insurance businesses are subject to the effects of changing social, economic and regulatory environments. Public and regulatory initiatives have included efforts to adversely influence and restrict premium rates, restrict the ability to cancel policies, impose underwriting standards and expand overall regulation. The company also is subject to public and regulatory initiatives that can affect the market value for its common stock, such as recent measures affecting corporate financial reporting and governance. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2006, in accordance with accounting principles generally accepted in the United States of America (GAAP).
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 on 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.
To the Shareholders and Board of Directors of Cincinnati Financial Corporation:
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, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, 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, management’s assessment that the company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, the company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We underwrite insurance through four companies that market through local independent insurance agents. Our products include a broad range of business and personal policies, as well as life and disability income insurance and annuities. We also provide finance/leasing products and asset management services through our CFC Investment Company and CinFin Capital Management Company subsidiaries.
Our consolidated financial statements include the accounts of the parent company and our wholly owned subsidiaries. We present our statements in accordance with accounting principles generally accepted in the United States of America (GAAP). In consolidating our accounts, we have eliminated significant intercompany balances and transactions.
The Cincinnati Insurance Companies actively market property casualty insurance policies in 32 states. Our 10 largest states generated 70.0 percent and 69.7 percent of total property casualty premiums in 2006 and 2005. Ohio, our largest state, accounted for 22.0 percent and 22.5 percent of total earned premiums in 2006 and 2005. Agencies in Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each contributed between 4 percent and 10 percent of premium volume in 2006. No single agency relationship accounted for more than 1.2 percent of the company’s total agency direct earned premiums in 2006.
Certain workers’ compensation policies include the possibility of an insured earning a return of a portion of their premium, called a policyholder dividend. The dividend is generally calculated by determining the profitability of a policy year along with the associated premium. We reserve for all probable future policyholder dividend payments.
For universal life long-duration contracts we maintain a liability equal to the policyholder account value. There is no provision for adverse deviation. Some of our universal life policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance, based on expected no-lapse guarantee benefits and expected policy assessments.
Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holder and we do not include them in the Consolidated Statements of Income. Revenues and expenses related to separate accounts consist of contractual fees and mortality, surrender and expense risk charges. Also, each separate account BOLI includes a negotiated gain and loss sharing arrangement with the company. A percentage of each separate account’s realized gain and loss representing contract fees and assessments accrues to us and is transferred from the separate account to our general account and is recognized as revenue or expense.
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 and redeemable preferred stocks) and equity investments (common and non-redeemable preferred stocks) are classified as available for sale and recorded at fair value in the consolidated financial statements. Short-term investments are classified as available for sale and recorded at amortized cost, which approximates 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, we intend to hold fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values.
We estimate fair value for liabilities under investment-type insurance contracts (annuities) using discounted cash flow calculations. We base the calculations on interest rates offered on contracts of similar nature and maturity. We base fair value for long-term senior notes and notes payable on the quoted market prices for such notes.
In 2006, CFC Investment Company, our commercial leasing and financing subsidiary, replaced $49 million of intercompany debt with borrowings against one of our short-term lines of credit to improve cash flow for the parent company. During the third quarter, we entered into an interest-rate swap to manage the variability of interest payments for certain variable-rate debt obligations ($49 million notional amount). Under this interest-rate swap contract, we have agreed to pay a fixed rate of interest for a three-year period. The contract is intended to be a hedge against changes in the amount of future cash flows associated with the related interest
payments for our short-term line of credit. The interest-rate swap contract is reflected at fair value in our consolidated balance sheet.
SFAS No. 133, as amended, requires changes in the fair value of the company’s derivative financial instruments to be recognized periodically as realized gains or losses on the consolidated statement of income or as a component of accumulated other comprehensive income in shareholders’ equity, respectively. We recognized a $324,000 pretax realized investment loss due to the decline in the fair value of the interest rate swap prior to qualifying for hedge accounting treatment.
In October, we completed the necessary requirements for the interest-rate swap to qualify for hedge accounting treatment under SFAS No. 133. We expect that the interest-rate swap will be a highly effective hedge and that future changes in the fair value of the interest-rate swap will be recorded as a component of accumulated other comprehensive income. We do not expect any significant amounts to be reclassified into earnings in the next 12 months. The fair value of the company’s interest rate swap was $430,000 at December 31, 2006.
We maintain the right and ability to redeem the fixed-maturity securities loaned on short notice and continue to earn interest on the securities. We maintain effective control over the securities that we have loaned, which are classified as invested assets on our consolidated balance sheets. Interest income on collateral, net of fees, was $697,000 for the twelve months ended December 31, 2006. At December 31, 2006, we had no securities on loan and held no collateral. We recalled our securities on loan prior to year end for statutory reporting reasons. We have continued the securities lending program in 2007.
Our CFC Investment Company subsidiary provides auto and equipment direct financing (leases and loans) to commercial and individual clients. We generally transfer ownership of the property to the client as the terms of the leases expire. Our lease contracts contain bargain purchase options. We record income over the financing term using the interest method.
We calculate deferred income tax liabilities and assets using tax rates in effect for the time when temporary differences in book and taxable income are estimated to reverse. We recognize deferred income taxes for numerous temporary differences between our taxable income and book-basis income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains on investments and differences in the recognition of deferred acquisition costs and insurance reserves. We charge deferred income taxes associated with unrealized appreciation (except the amounts related to the effect of income tax rate
In September 2006, FASB issued SFAS No. 157, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We currently are evaluating the timing and impact of adopting SFAS No. 157 on our financial position.
In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108 to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that we quantify misstatements based on their impact on each of our financial statements and related disclosures. SAB 108 is effective as of December 31, 2006, allowing a one-time transitional cumulative effect adjustment to retained earnings as of January 1, 2006, for errors that were not previously deemed material, but are material under the guidance in SAB No. 108.The impact of adopting SAB No. 108 did not result in a material effect on our results of operations and financial position.
Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109
In July 2006, FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. FIN 48 is an interpretation of SFAS No. 109, Accounting for Income Taxes. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 as of January 1, 2007, as required. In the first quarter of 2007, we will record a cumulative effect adjustment of a change in accounting principle as prescribed by FIN 48. We do not expect FIN 48 to have a material effect on our results or operations or financial position.
SOP 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts
We have reclassified certain prior-year amounts to conform with current-year classifications.
At December 31, 2006, contractual maturity dates for fixed-maturity and short-term investments were:
At December 31, 2006, investments with book value of $64 million and fair value of $66 million were on deposit with various states in compliance with regulatory requirements.
At December 31, 2006, 482 fixed-maturity investments with a total unrealized loss of $53 million and three equity securities with a total unrealized loss of $1 million had been in that position for 12 months or more. All were trading between 70 percent to less than 100 percent of book value.
We sold 12,700,164 shares of our holdings of Alltel Corporation common stock in January 2006 and 475,000 shares in December 2005. The sale contributed $647 million and $27 million to our 2006 and 2005 pretax realized gains. The sale contributed $412 million and $15 million to net income in 2006 and 2005, respectively.
At both December 31, 2006 and 2005, the fair value associated with the annuities shown above was approximately $563 million.
We had two lines of credit with commercial banks amounting to $125 million with an outstanding balance of $49 million at year-end 2006. We had no compensating balance requirement on short-term debt for either 2006 or 2005. We had two lines of credit with commercial banks amounting to $125 million with no outstanding balance at year-end 2005. Interest rates charged on such borrowings ranged from 5.90 percent to 6.03 percent during 2006.
The fair value of our senior debt approximated $850 million at year-end 2006 and $870 million at year-end 2005. None of the notes are encumbered by rating triggers.
As of December 31, 2006, 11.6 million shares of common stock were available for future stock option grants.
Filed tax returns for calendar years 2000 through 2005 are currently open with the Internal Revenue Service. As of December 31, 2005, federal income taxes had not been provided for on our life insurance subsidiary’s Policyholder Surplus Account (PSA), which totaled $14 million as of December 31, 2005 and 2004. The American Jobs Creation Act of 2004 suspended for a two-year period beginning January 1, 2005, the tax liability of a stock life insurance company on distributions made from the PSA. In July 2006, the company’s life insurance subsidiary declared and paid a $14 million dividend, eliminating its PSA balance as of December 31, 2006.
Basic earnings per share are computed based on the weighted average number of shares outstanding. Diluted earnings per share are computed based on the weighted average number of common and dilutive potential common shares outstanding. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2006.
The only current source of dilution of our common shares is outstanding stock options to purchase shares of common stock. The above table shows the number of anti-dilutive options shares at year-end 2006, 2005 and 2004. We did not include these options in the computation of net income per common share (diluted) because their exercise would have an anti-dilutive effect.
We sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension plan covering substantially all employees. We do not contribute to the 401(k) plan but we do pay all operating expenses. Benefits for the defined benefit pension plan are based on years of credited service and compensation level. Contributions are based on the frozen entry age actuarial cost method. We also maintain a supplemental retirement plan (SERP) with liabilities of approximately $5 million to $9 million at year-end 2006 and 2005. The SERP is included in the obligation and expense amounts. Our pension expense is composed of several components that are determined using the projected unit credit actuarial cost method and are based on certain actuarial assumptions.
Key assumptions used in developing the 2006 net pension expense were a 5.50 percent discount rate, an 8 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent. The 8 percent return on plan assets assumption is based partially on the fact that substantially all of the investments held by the pension plan are common stocks that pay annual dividends. We believe this rate is representative of the expected long-term rate of return on these assets. These assumptions were consistent with the prior year, except that the discount rate was reduced by 0.25 percentage points due to market interest rate conditions.
At December 31, 2005 there were no amounts recognized in accumulated other comprehensive income for the plans. A reconciliation follows of the funded status at the end of the measurement period to the amounts recognized in the statement of financial position at December 31, 2006:
The projected benefit obligation and fair value of plan assets for pension plans with a projected benefit obligation in excess of plan assets at December 31 follows:
The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for pension plans with an accumulated benefit obligation in excess of plan assets at December 31 follows:
Here is a summary of the weighted-average assumptions we use to determine our net expense for the plan:
We expect to contribute approximately $10 million to our pension plan in 2007 with a target allocation of 90 percent equity securities and 10 percent fixed maturities and cash.
We expect to make the following benefit payments, which reflect expected future service:
The incremental effect of applying SFAS No. 158 on individual line items in the statement of financial position at December 31, 2006, follows:
Statutory net income and capital and surplus 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:
Statutory capital and surplus for our insurance subsidiary, The Cincinnati Insurance Company, includes capital and surplus of its three insurance subsidiaries.
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $7 million, $6 million and $11 million on premium volume of approximately $40 million, $41 million and $76 million for 2006, 2005 and 2004, respectively.
Following its SEC filing, the holding company transferred investment securities to our subsidiary, The Cincinnati Insurance Company, in August 2004, lowering the holding company’s ratio of investment securities to holding-company-only assets below 40 percent. We have maintained that ratio below the 40 percent level since the time of the transfer.
Because the ratio is below 40 percent, we believe the SEC staff is not actively considering the application.
We strongly believe the holding company is, and has been, outside the intended scope of the Investment Company Act because the company is, and has been, primarily engaged in the business of property casualty and life insurance through its subsidiaries. As a registered investment company, the holding company would not be permitted to operate its business as it currently operates, nor would a registered investment company be permitted to have many of the relationships that the holding company has with its affiliated companies.
To increase certainty that regulation under the Investment Company Act would not apply to the company in the future, our operations are limited by the constraint that investment securities held at the holding company level should remain below the 40 percent threshold described above. Efforts to stay below the threshold could result in:
and capital appreciation, contributing to long-term growth in book value. Constraining our ability to pursue this strategy and invest in equity securities could hamper book value growth over the long term.
Maintenance of a greater portion of our portfolio of equity securities at our insurance subsidiary. As a result of the transfer of assets to ensure compliance with the 40 percent threshold, the holding company now is more reliant on that subsidiary for cash to fund parent-company obligations, including shareholder dividends and interest on long-term debt.
Although we intend to manage assets to stay below the 40 percent threshold, events beyond our control, including significant appreciation in the value of certain investment securities, could result in the holding company exceeding the 40 percent threshold. While we believe that even in such circumstances the company would not be an investment company because it is primarily engaged in the business of insurance through its subsidiaries, the SEC, among others, could disagree with this position.
As a result of adopting SFAS No. 123(R) on January 1, 2006, our income before income taxes for the year ended December 31, 2006, was reduced by $17 million. Our net income for the year ended December 31, 2006, was reduced by $14 million. If we had continued to account for stock-based compensation under APB Opinion No. 25, there would have been no effect on net income. The weighted-average grant-date fair value of options granted during 2006 and 2005 was $10.09 and $12.49, respectively. The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004, was $22 million, $9 million and $6 million, respectively. The total intrinsic value of options vested during the years ended December 31, 2006, 2005 and 2004, was $10 million, $12 million and $11 million. (Intrinsic value is the market price less the exercise price.)
compensation cost for all stock options granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R)
Results for prior periods have not been retrospectively adjusted for SFAS No. 123(R). As of December 31, 2006, we had $14 million of unrecognized total compensation cost related to non-vested stock options. That cost will be recognized over a weighted-average period of 1.7 years. SFAS No. 123(R) also requires us to classify certain tax benefits related to share-based compensation deductions as cash from financing activities. As of December 31, 2006, these tax benefits totaled $2 million.
2005 - Dividend yield of 2.66 percent; expected volatility of 25.61 percent; risk-free interest rate of 4.62 percent; and expected lives of 10 years.
2004 - Dividend yield of 2.40 percent; expected volatility of 25.65 percent; risk-free interest rate of 4.37 percent; and expected lives of 10 years.
Options outstanding and exercisable consisted of the following at December 31, 2006:
Income before income taxes for the investment operations segment is net investment income plus realized investment gains and losses for all fixed-maturity and equity security 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 fixed-maturity and equity security investment assets, regardless of ownership, in the investment operations segment.