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, 2007, and is classified as land, building and equipment, net, for company use. Our subsidiaries occupy approximately 90 percent of the rentable square feet and unaffiliated tenants occupy approximately 10 percent. In 2008, subsidiary operations in this building will relocate to the third officer tower at our headquarters location. Portions of this space will be available for lease during 2008.
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 51,000 square foot building to serve as a disaster recovery and backup data processing center at an estimated cost of $26 million. The property, including land, is carried on our financial statements at $3 million as of December 31, 2007, and is classified as land, building and equipment, net, for company use.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 30
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 lead them to award us a preferred position and a meaningful share of the business they write.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 32
Over our 57 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, appointment of new agencies and our periodic entry into new states. During 2008, we are targeting 65 new agency appointments.
Revenues in 2007 and 2006 were significantly higher than in 2005. Both years reflected significant net realized investment gains from sales of common stock holdings. In both years, rising pretax investment income offset the slowing growth rate of consolidated property casualty earned premiums.
Net income and net income per share declined slightly in 2007 from a record level in 2006. The most significant factors contributing to net income are:
Realized investment gains or losses - Realized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that will be recognized in any period. That discretion generally is independent of the insurance underwriting process. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. As discussed in Investments Segment Results of Operation, Page 57, security sales led to realized investment gains in the past three years:
2007 - Raised net income by $245 million, or $1.43 per share. This amount reflected the sale of 3.8 million shares of Exxon Mobil Corporation, the block sale of 5.5 million shares of Fifth Third Bancorp common stock, the sale of our FirstMerit Corporation common stock holdings and the disposition of the majority of our real estate investment trust holdings.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 33
Weighted average shares outstanding may fluctuate from period to period because we regularly repurchase shares under board authorizations and we issue shares when associates exercise stock options. Weighted average shares outstanding on a diluted basis declined 3 million in 2007 and 2 million in 2006.
Our ratio of long-term debt to capital (long-term debt plus shareholders’ equity) rose in 2007 after declining in 2006. The increase in 2007 was due to share repurchase and lower unrealized gains, which primarily reflected the lower market values of our financial sector equity holdings.
The trend in overall written premium growth reflected the competitive and market factors discussed in Item 1, Commercial Lines and Personal Lines Insurance Results of Operations, Page 44and Page 51. Our consolidated property casualty insurance underwriting profit rose in 2007 after declining in 2006, matching the trend in our combined ratio. (The combined ratio is the percentage of each premium dollar spent on claims plus all expenses - the lower the ratio, the better the performance.) 2007 performance was bolstered by lower catastrophe losses and higher savings from favorable development on prior period reserves.
In each of the past three years, our results have compared satisfactorily to estimated industry results. Industry net written premiums were estimated to decline 1.2 percent in 2007. In 2006, industry premiums were estimated to rise 3.9 percent after no change in 2005. In the past three years, industry premium trends have been obscured by the reinsurance sector, where premiums were estimated to have declined 8.5 percent in 2007, risen 28.1 percent in 2006 and declined 28.2 percent in 2005. The estimated industry average statutory combined ratios were 95.6 percent in 2007, 92.4 percent in 2006 as well as 101.2 percent in 2005 when the 144.9 percent estimated reinsurance sector combined ratio obscured the industry combined ratio.
Looking into 2008 and beyond, we will continue to measure the success of our strategies:
In 2008, 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 2008 in Item 1, Technology Solutions, Page 4.
Our combined ratio estimate for 2008 is 96 percent to 98 percent compared with 90.3 percent in 2007. The year-over-year increase reflects three assumptions:
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 35
Pursuing a total return investment strategy that generates both strong investment income growth and capital appreciation - In 2008, we estimate the growth rate of investment income may be below the 6.6 percent growth rate in 2007 as financial sector holdings in our portfolio evaluate their dividend levels. We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. This outlook considers the anticipated level of dividend income from equity holdings, the investment of insurance operations cash flow and the current portfolio attributes.
We do not establish annual capital appreciation targets. Over the long term, our target is to have the equity portfolio outperform the Standard & Poor’s 500 Index. In 2007, our compound annual equity portfolio return was a negative 16.3 percent, compared with a compound annual total return of 5.5 percent for the Index. Over the five years ended December 31, 2007, our compound annual equity portfolio return was flat compared with a compound annual total return of 12.8 percent for the Index. Our equity portfolio underperformed the market for the five-year period primarily because of the decline in the market value of our holdings of Fifth Third common stock between 2003 and 2007.
Over the long-term, we seek to increase earnings per share, book value and dividends at a rate that would allow long-term total return to our shareholders to exceed that of the Standard & Poor’s Composite 1500 Property Casualty Insurance Index. Over the past five years, our total return to shareholders of 34.0 percent was below the 62.3 percent return for that Index.
Maintaining financial strength by keeping the ratio of debt to capital below 15 percent and purchasing reinsurance to provide investment flexibility - Our debt-to-capital ratio rose to 12.7 percent in 2007 because of the decline in shareholders’ equity. Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2007. As a result, we believe our debt-to-capital ratio will remain below 13 percent.
In December 2007, we finalized our property casualty reinsurance program for 2008, updating it to maintain the balance between the cost of the program and the level of risk we retain. Under the new program, our 2008 reinsurance costs are expected to decline slightly due to higher retention levels and moderating rates for certain lines of business. We provide more detail on our reinsurance programs in 2008 Reinsurance Programs, Page 70.
Factors supporting our outlook for 2008 are discussed in the Results of Operations for each of the four business segments.
Case reserves of all sizes are subject to review on a 90-day cycle or more frequently, if new information regarding a loss becomes available. As part of the review process, we monitor industry trends, cost trends, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional loss exposures.
We also establish incurred but not reported (IBNR) reserves to provide for all unpaid loss and loss expenses not accounted for by case reserves. For other than asbestos and environmental claims, we calculate IBNR reserves quarterly by first deriving an actuarially based estimate of the ultimate cost of total loss and loss expenses incurred as of the financial statement date. We then reduce the estimate by total loss and loss expense payments and total case reserves carried as of the financial statement date.
We calculate IBNR reserves for asbestos and environmental claims by deriving an actuarially based estimate of total unpaid loss and loss expenses as of the financial statement date. We then reduce the estimate by total case reserves as of the financial statement date. We discuss the reserve analysis that applies to claims other than asbestos and environmental claims below. We discuss the reserve analysis that applies to asbestos and environmental reserves in Asbestos and Environmental Reserves,
Our actuarial staff uses diagnostics provided by stochastic reserving software to evaluate the appropriateness of the models and methods listed above. The software’s diagnostics have indicated that the appropriateness of these models and methods for estimating IBNR reserves for our lines of business tends to depend on a line’s tail. Tail refers to the time interval between a typical claim’s occurrence and its settlement. For our long tail lines such as workers’ compensation and commercial casualty, models from the probabilistic trend family tend to provide superior fits and to validate well compared with models underlying the loss development and Bornhuetter-Ferguson methods. The loss development and Bornhuetter-Ferguson methods, particularly the reported loss variations, tend to produce the more appropriate IBNR reserve estimates for our short-tail lines
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 37
These trends and measures also support the estimation of ultimate accident year loss ratios needed for applying the Bornhuetter-Ferguson methods and for assessing the reasonability of all IBNR reserve estimates computed. Our actuarial staff reviews these trends and measures quarterly and updates them as necessary.
Our actuarial staff makes a number of key assumptions when using their methods and models to derive IBNR reserve estimates. Appropriate reliance on these key assumptions essentially entails determinations regarding the likelihood that statistically significant patterns in historical data will extend into the future. The four most significant of the key assumptions used by our actuarial staff and approved by management are:
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 38
Calendar year inflation. For long-tail and mid-tail business lines, calendar year inflation trends for future paid losses and paid allocated loss expenses will not vary significantly from a stable, long-term average. Our actuaries base reserve estimates derived from probabilistic trend family models on this assumption.
The table below provides standard errors and reserve ranges for lines of business that account for 91.6 percent of our 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 below 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 will fall, one or more lines’ actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
If actual unpaid loss and loss expenses fall within these ranges, our cash flow and fixed maturity investments should provide sufficient liquidity to make the subsequent payments. To date, our cash flow has covered our loss and loss expense payments, and we have never had to sell investments to make these payments. If this were to become necessary, however, our fixed maturity investments should provide us with ample liquidity. At year-end 2007, fixed maturity investments exceeded total insurance reserves (including life policy reserves) by more than $400 million.
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 market 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.
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 95 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. All securities valued below 95 percent of book value are reported to the asset impairment committee for evaluation.
When evaluating for other-than-temporary impairments, the committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost. Because of the company’s strong capitalization, management may not impair certain securities even though they are trading below cost. The company can make that determination based on its ability to hold until their scheduled redemption securities that have the potential to recover value. In addition to evaluating the security’s current valuation, the impairment committee reviews objective evidence that indicates the potential for a recovery in value. Information is evaluated regarding the security, such as financial performance, near-term prospects and the financial condition of the region and industry in which the issuer operates.
Securities that have previously been impaired are evaluated based on their adjusted book value and written down further, if deemed appropriate. The decision to sell or write down a security with impairment indications reflects, at least in part, management’s opinion that the security no longer meets the company’s investment objectives. We provide detailed information about securities trading in a continuous loss position at year-end 2007 in Item 7A, Unrealized Investment Gains and Losses, Page 77. An other-than-temporary decline in the fair value of a security is recognized in net income as realized investment losses.
In 2007, the net pension expense was $21 million. In 2008, we expect a net pension expense of $19 million, primarily as a result of reduced service costs due to a 0.5 percentage point increase in the discount rate.
We establish a deferred asset for costs that vary with, and are primarily related to, acquiring property casualty and life insurance business. These costs are principally agent commissions, premium taxes and certain underwriting costs, which are deferred and amortized into income as premiums are earned. Deferred acquisition costs track with the change in premiums. Underlying assumptions are updated periodically to reflect actual experience. Changes in the amounts or timing of estimated future profits could result in adjustments to the accumulated amortization of these costs.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 41
Information regarding recent accounting pronouncements is provided in Item 8, Note 1 of the Consolidated Financial Statements, Page 87. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
For our consolidated property casualty insurance operations as well as the commercial lines and personal lines segments, statutory accounting data and ratios are key performance indicators that we use to assess business trends and to make comparisons to industry results, since GAAP-based industry data generally is not as readily available. We also use statutory accounting data and ratios as key performance indicators for our life insurance operations.
In addition to the factors discussed in Commercial Lines and Personal Lines Insurance Results of Operations, Page 44 and Page 51, growth and profitability for our consolidated property casualty insurance operations were affected by:
Savings from favorable development on prior period reserves improved the combined ratio by 7.7 percentage points in 2007 compared with 3.7 and 5.2 percentage points in 2006 and 2005. These amounts include development on prior period catastrophe loss reserves as discussed below.
The adoption of stock option expensing added approximately 0.5 percentage points to the 2007 and 2006 combined ratios.
Combined ratio - Our commercial lines combined ratio was a strong 89.2 percent in 2007. This was better than the 91.3 percent reported in 2006 but higher than the 87.4 percent reported in 2005. The 2007 ratio reflected higher current accident year losses excluding catastrophe losses and higher underwriting expenses. These were more than offset by lower catastrophe losses and higher savings from favorable development on prior period reserves. We continue to focus on sound underwriting fundamentals and seek to obtain adequate premiums per policy. We discuss factors affecting the combined ratio and savings from favorable reserve development by commercial line of business below.
Our commercial lines statutory combined ratio was 89.2 percent in 2007 compared with 90.8 percent in 2006 and 87.1 percent in 2005. By comparison, the estimated industry commercial lines combined ratio was 94.0 percent in 2007, 91.2 percent in 2006 and 99.7 percent in 2005. We believe our results trended differently than the overall industry in part because the industry experienced unusually high catastrophe losses in 2005 and unusually low catastrophe losses in 2006.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 44
For new business, our field associates are in our agents’ offices helping to judge the quality of each account, emphasizing the Cincinnati value proposition, calling on prospects with those agents, carefully evaluating risk exposure and working up their best quotes. At year-end 2007, our field marketing representatives reported pricing down about 15 percent to 20 percent on average to write the same piece of new quality business we would have quoted in 2006, the second consecutive year of significant declines in our new business pricing. We believe this reflects the importance carriers are placing on protecting their renewal portfolios.
For renewal business, our headquarters underwriters talk regularly with agents. Our field teams are available to assist the 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 quality risks, our commercial underwriters are offering policyholders the convenience of policy extensions of one and two additional years.
In these conditions, we have needed to use credits more frequently to retain renewals of quality business - the larger the account, the higher the credits, with variations by geographic region and class of business. At year-end 2007, rate declines of 4 percent to 6 percent seemed typical for our renewal business.
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 conduct periodic surveys to obtain competitive intelligence. This market information helps identify the top competitors by line of business or specialty program and also identifies our market strengths and weaknesses. The analysis encompasses pricing, breadth of coverage and underwriting/eligibility issues.
In 2007, competition in our markets continued to intensify, and we view this as the most significant factor in the 1.2 percent decline in commercial lines written premiums. Our largest four commercial lines of business reported lower written premiums, led by commercial auto, which is one of the first lines to experience pricing pressure because it often represents the largest portion of insurance costs for many commercial policyholders. In this environment, we will continue to work with our agents to identify quality risks, lower prices to keep our
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 45
best accounts and help our agencies protect their accounts from competition. Agency emphasis on larger accounts, convenience and technology considerations were the primary reasons for a slight decline in the number of our smallest policies.
Other factors contributing to the year-over-year premium differences include the economic slowdown in many regions and higher reinsurance premiums. For commercial accounts, we typically calculate general liability premiums based on sales or payroll volume while we calculate workers’ compensation premiums based on payroll volume. A change in sales or payroll volume generally indicates a change in a business’s exposure to risk.
Economic factors, such as the housing market slowdown, can cause demand for our policyholders’ business services to rise or fall. Changes in demand may cause our policyholders’ sales and payroll volumes to fluctuate. Those fluctuations can have a modest effect on our premium trends. Policyholders that experience sales or payroll volume changes due to economic factors may be purchasers of other types of insurance, such as commercial auto or commercial property, in addition to general liability and workers’ compensation. Premium levels for these other types of policies generally are not linked directly to sales or payroll volumes. In 2007, we estimated that policyholders with a contractor-related ISO general liability code accounted for approximately 43 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 46 percent of our workers’ compensation premiums.
We describe the significant cost components for the commercial lines segment below.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. The trend in the loss and loss expense ratio excluding catastrophe losses over the past three years reflected competitive market conditions and softer pricing that began in 2005 and continued through 2007, as discussed above. This resulted in a steady increase in the accident year loss and loss expense ratio excluding catastrophe losses to 65.2 percent in 2007 from 61.4 percent in 2006 and 60.3 percent in 2005.
Savings from favorable development on prior period reserves reduced the ratio by 8.4, 4.1 and 5.6 percentage points in 2007, 2006 and 2005, respectively. Particularly for our longer-tail lines, our ultimate loss ratio estimates continue to show the benefits of re-classification and re-pricing initiatives undertaken early in this decade. During the same period, we also made changes to our policy terms, conditions and coverages, to help manage limits or exposures. Further, we also continue to see positive payment and reporting pattern changes, attributable to the implementation of a claims management system and to the use of a claims mediation process that promotes earlier liability settlement resolution.
The rise in the loss and loss expense ratio included a higher 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 23.3 percent of earned premium from 21.3 percent in 2006 and 16.8 percent in 2005. 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 was due to a number of factors, including changes in retention levels for our per risk reinsurance programs, case reserve practices for our workers’ compensation business line, natural volatility and general inflationary trends in loss costs, which we continue to monitor. A single large loss in 2005 was insufficiently covered through our facultative reinsurance programs, which increased that year’s loss and loss expenses by $22 million, net of reinsurance, or 1.0 percentage points.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 46
Commercial lines catastrophe losses added just 0.7 percentage points to the loss and loss expense ratio in 2007, down from the significantly higher levels of the prior two years.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 47
The commercial casualty loss and loss expense ratio improved slightly in 2007 after rising in 2006 and remains within the range we consider appropriate. In each of the last three calendar years, the level of favorable development on prior period reserves has been the primary reason for the fluctuations in the loss and loss expense ratio. Factors contributing to the level of favorable development are discussed in Commercial Lines Insurance Segment Reserves, Page 67. In addition to the level of favorable development, the ratio was affected by the substantial rise in 2007 and 2006 of the level of $1 million plus general liability losses compared with the level in 2005. These large losses contributed 6.9 percentage points to the loss and loss expense ratio in 2007, 5.9 percentage points in 2006 and 2.4 percentage points in 2005.
Pricing and normal loss cost inflation accounted for a portion of the deterioration in the accident year loss ratio over the three-year period. In addition, the commercial casualty business line includes some of our longest tail exposures, making initial estimates of accident year loss and loss expenses incurred more uncertain, as we discuss in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 37.
The commercial property loss and loss expense ratio excluding catastrophe losses deteriorated in 2007 after improving in 2006. The rise in 2007 reflected the growing impact of softer pricing on our commercial property business line. The improvement in the ratio in 2006 largely was due to the large loss discussed above that added 5.0 percentage points to the 2005 ratio.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 48
The commercial auto loss and loss expense ratio remained within the range we consider appropriate despite the increasing pricing pressures. New losses greater than $1 million contributed 16.5 percentage points to the loss and loss expense ratio in 2007, 11.5 percentage points in 2006 and 8.5 percentage points in 2005. We believe the higher number of commercial auto losses greater than $1 million was due to natural volatility and general inflationary trends in loss costs.
Pricing and normal loss cost inflation were the primary drivers of the deterioration in the accident year loss ratio over the past three years. In each calendar year, the loss and loss expense ratio reflected an increase in the accident-year loss and loss expense ratio that was moderated by favorable development on prior period reserves, a benefit of past re-underwriting efforts, Ohio judicial decisions regarding underinsured/uninsured motorist claims and a favorable frequency trend.
In 2007, workers’ compensation written premiums were essentially unchanged after rising significantly in 2006. Workers’ compensation premiums partially reflect the general business economy and related payroll levels. Premiums also benefited from initiatives to modestly expand our workers’ compensation business in selected states. 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.
In 2005, the workers’ compensation loss and loss expense ratio rose to 90.9 percent after remaining steady for several years. The 2005 rise largely was due to reserve strengthening on incurred but not yet reported claims for older accident years to reflect higher trends in medical cost inflation and longer estimated payout periods than originally projected. Since we pay a lower commission rate on workers’ compensation business, this line has a higher loss and loss expense breakeven point than our other commercial business lines. Nonetheless, the ratio remained above our target level over the three-year period.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 49
Pricing and normal loss cost inflation contributed to the increase in the accident year loss and loss expense ratio in 2007. 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. Favorable development on prior period reserves moderated the effect of the increase in the 2007 accident year loss and loss expense ratio on the corresponding calendar year ratio.
The loss and loss expense ratio excluding catastrophe losses and the accident year loss and loss expense ratio remained within the ranges we consider appropriate.
Surety and executive risk net written premiums rose in 2007 and 2006. Healthy economic activity in some regions drove the 2006 growth.
Director and officer liability coverage accounted for 62.3 percent of surety and executive risk premiums in 2007 compared with 60.5 percent in 2006 and 57.1 percent in 2005. Our director and officer liability policies are offered primarily to nonprofit organizations, reducing the risk associated with this line of business. Nonprofit organizations accounted for approximately 80 percent of the director and officer liability policies we wrote in 2007. We manage our loss exposure to director and officer liability coverages by writing on claims-made coverage forms, providing limits up to $10 million and purchasing reinsurance.
In addition, our independent agencies market our director and officer liability policies to some clients that are for-profit organizations. At year-end 2007, our in-force director and officer liability policies provided coverage to 30 non-financial publicly traded companies, including two Fortune 1000 companies. We also provided this coverage to approximately 500 banks, savings and loans and other financial institutions. The majority of these financial institution policyholders are smaller community banks, and we believe they have no unusual exposure to credit-market concerns, including subprime mortgages. Only 12 of our bank and savings and loan policyholders have assets greater than $2 billion, including one Fortune 500 company; only 23 have assets between $1 billion and $2 billion; and 52 have assets between $500 million and $1 billion.
Personal lines new business premiums written directly by agencies increased 16.9 percent to $38 million in 2007 and 1.6 percent to $33 million in 2006 after declining 33.9 percent to $32 million in 2005.
Combined ratio - The combined ratio improved 9.7 percentage points in 2007 after rising 9.2 percentage points in 2006. The year-over-year differences largely were due to fluctuations in the level of catastrophe losses and the steady rise in the current accident year loss and loss expense ratio excluding catastrophe losses. Year-over-year comparisons would have been stronger if earned premiums had not declined.
Our personal lines statutory combined ratio was 94.1 percent in 2007, 103.6 percent in 2006 and 94.3 percent in 2005. By comparison, the estimated industry personal lines combined ratio was 97.0 percent in 2007, 92.3 percent in 2006 and 97.6 percent in 2005. We believe our results are trending differently than the overall industry because of the competitive and pricing factors discussed below. In addition, the industry experienced unusually high catastrophe losses in 2005 and unusually low catastrophe losses in 2006.
Premium trends by personal line of business and strategies to achieve growth in our personal lines segment are discussed below.
We describe the significant cost components for the personal lines segment below.
Personal lines catastrophe losses, net of reinsurance and before taxes, contributed 10 percentage points less to the combined ratio in 2007 primarily because of the lower level of catastrophe activity during the year. In 2006, catastrophe losses, net of reinsurance and before taxes, contributed 5 percentage points more to the combined ratio than in 2005 because of an increase of $35 million in incurred catastrophe losses and lower earned premium. The majority of these losses related to wind and hail from storms in Indiana and Ohio.
Non-commission underwriting expenses moderated slightly in 2007 after a significant rise in 2006. We continue to invest in our associates and technology, which contributed to an increase in non-commission underwriting expenses in 2006. In that year, higher technology expense contributed 0.8 percentage points and higher staffing expense contributed 0.8 points, with stock option expense accounting for 0.5 percentage points of that amount. Increases in those amounts were offset partially by savings in taxes, licenses and fees. Reallocation of expenses between our commercial lines and personal lines segments as we refined our data also contributed to the 2007 improvement.
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 the personal lines segment 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 each line.
The corresponding 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 event occurs, regardless of when the losses are actually reported, recorded or paid.
Written and earned premium trends reflected improved new business levels in 2007 that were not sufficient; however, to replace premiums lost due to price reductions, normal attrition and higher reinsurance premiums. Policy credits adopted in mid-2006 improved our competitive position, while lowering rates for eligible new and renewal policyholders. The new policy credits 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. Higher 2007 reinsurance premiums contributed 2.7 percentage points to the decline in written premiums.
catastrophe losses is assumed. Rate changes we made to keep our retention rate and new business at acceptable levels, along with higher reinsurance costs, have interrupted our progress toward consistent breakeven performance for the homeowner business line. Changes in catastrophe loss levels were the primary reason for the fluctuations in the accident year loss ratio over the past three years.
Two other factors also contribute to our ability to achieve satisfactory homeowner results:
Non-commission expenses - Since we generally do not allocate non-commission expenses to individual business lines, to measure homeowner profitability, we use a personal lines segment commission and underwriting expense ratio of approximately 33 percentage points to determine an estimated homeowner combined ratio. Lower levels of premium growth affected our expense ratio in 2007 and may affect our ability to attain our personal lines segment expense ratio target in the future.
Catastrophe losses - To measure our progress toward homeowner profitability, we use a normalized catastrophe loss ratio (as a percent of homeowner earned premium) in the range of 17 percent. Between 2005 and 2007, catastrophe losses averaged 14.5 percent of homeowner earned premiums. We have not changed our catastrophe loss assumption because unusually low catastrophe losses in 2007 artificially lowered the average and because the geographic concentration of losses in 2005 and 2006 was unusual.
Diamond -The Diamond system is in use by agencies writing approximately 97.5 percent of personal lines premium volume. The system makes 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. In 2008, we expect to implement upgrades that will further improve user satisfaction.
New agencies - The availability of Diamond should help us increase the number of agencies that offer our personal lines products. During 2007, some agency locations that previously marketed only our commercial lines products added our personal lines products. Expanding into these agencies should provide additional sources of premiums and help geographically diversify our personal lines portfolio.
Further, in 2008, we expect to deploy Diamond to agencies in eight additional states. We already market personal lines products in Maryland, Montana, New Hampshire, North Carolina and Vermont, and we expect agencies in these states to respond favorably to its advantages. We also expect to deploy Diamond to agencies in Arizona, South Carolina and Utah, where we currently market only commercial lines products.
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. Including investment income and realized gains on investments, GAAP net income for the life insurance segment grew 3.8 percent in 2007 to $65 million, 32.6 percent in 2006 to $63 million and 23.8 percent in 2005 to $47 million. The life insurance company portfolio had after tax realized investment gains of $26 million in 2007 compared with $29 million in 2006 and $11 million in 2005.
Statutory written premiums for term and other life insurance products rose 10.5 percent to $141 million for 2007 and 12.7 percent to $127 million for 2006. In 2006, we began emphasizing products that
generate a higher average premium per policy through enhanced features and higher face amounts while reducing expenses.
Statutory written annuity premiums declined $8 million in 2007 and $58 million in 2006. Since late 2005, we have de-emphasized annuities because of an unfavorable interest rate environment.
Fee income from universal life products increased 35.1 percent in 2007 to $31 million after declining 14.9 percent to $23 million in 2006. Our new universal life product with secondary guarantees contributed to the increase in fee income in 2007. Separate account investment management fee income contributed $4 million, $3 million and $4 million to total revenues in 2007, 2006 and 2005.
Our overall objective is to increase premiums and contain expenses as the life insurance company seeks to improve penetration of our property casualty agencies. Term insurance is our largest life insurance product line. We continue to introduce new term products with features our agents and their clients indicate are important. We also continue to improve our worksite portfolio to help in our cross-selling initiatives.
Investment income - Pretax investment income reached a new record again in 2007, rising 6.6 percent from the prior record in 2006. Growth in investment income over the past two years has been driven by
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 57
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 of investment income reflected new investments, higher interest income from the growing fixed-maturity portfolio and increased cash 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.
Pretax realized investment gains in the past three years largely were due to the sale of equity holdings. We discuss these sales in Item 1, Investments Segment, Page 15. As appropriate, we buy, hold or sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives.
We sold 3.8 million shares of ExxonMobil common stock, contributing $217 million to realized investment gains
We divested the majority of our real estate investment trust holdings, contributing $72 million to realized investment gains
We sold 5.5 million shares of Fifth Third common stock in a block sale, contributing $64 million to realized investment gains
We sold all of our FirstMerit common stock holdings, contributing $59 million to realized investment gains
2006 - We sold the remainder of our Alltel common stock holdings, contributing $647 million to realized investment gains.
closely meet our established parameters for long-term stability and growth. Our opinion that a security fundamentally no longer meets our investment parameters may reflect a loss of confidence in the issuer’s management, a change in underlying risk factors (such as political risk, regulatory risk, sector risk or credit risk), or a strategic shift in business strategy that is not consistent with our long-term outlook.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 59
We believe a continuation of the current credit environment, if exacerbated by recessionary economic conditions, could lead to further declines in portfolio values and a resulting increase in other-than-temporary impairment charges in 2008. All but three securities in the portfolio were trading at or above 70 percent of book value at year-end 2007. Our asset impairment committee continues to monitor the investment portfolio. The current asset impairment policy is described in Critical Accounting Estimates, Asset Impairment, Page 40.
Income tax expense was $337 million in 2007 compared with $399 million in 2006 and $221 million in 2005. The effective tax rate for 2007 was 28.3 percent compared with 30.0 percent in 2006 and 26.8 percent in 2005.
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 2007, we had shareholders’ equity of $5.929 billion and total debt of $860 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
Our property casualty and life insurance operations provide liquidity because premiums generally are received before losses are paid under the policies purchased with those premiums. After satisfying our cash requirements, we invest excess cash flows, increasing future investment income.
This table shows a summary of operating cash flow of the insurance subsidiary (direct method):
Based on our outlook for commercial lines, personal lines and life insurance, we believe that cash flows from underwriting could continue to decline in 2008. A lower level of cash flow available for investment could lead to lower investment income and reduced potential for future capital gains.
Sales of fixed-maturity investments - The majority of our fixed-maturity securities are held until maturity. Any decision to sell or reduce a holding is executed either to improve long term total return prospects or in response to adverse credit concerns.
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, including U.S. Agency paper, began to rise in 2007 as interest rates shifted lower in the second half of the year.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 61
Sales of equity securities investments - The decision to divest an equity position generally is reached after careful analysis of the direction the company is headed and its ability to meet our investment parameters.
In 2007 and 2006, we sold a portion of our ExxonMobil common stock holding, completed the sale of our Alltel and FirstMerit common stock holdings and made other sales of all or part of smaller holdings, including divesting the majority of our REIT holdings. We sold a portion of our Fifth Third position in 2007 to fund an accelerated share repurchase program.
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. Total unrealized appreciation in the investment portfolio, before deferred income taxes, declined to $3.339 billion from $5.244 billion at year-end 2007 and 2006, respectively, because of market value declines of our equity holdings. On an after-tax basis, it constituted 36.6 percent of total shareholders’ equity at year-end 2007.
We provide details of our three long-term notes in Item 8, Note 7 of the Consolidated Financial Statements, Page 96. None of the notes are encumbered by rating triggers.
At year-end 2007, we had two lines of credit with commercial banks amounting to $225 million with an outstanding balance of $69 million. One line of credit for $75 million was established more than five years ago and has no financial covenants. This line of credit matures on June 30, 2008, and we expect to renew it under terms and conditions that are essentially unchanged.
The second line of credit is an unsecured $150 million line of credit from Huntington Bancshares established in 2007 that will mature in 2012. It is available for general corporate purposes and contains customary financial covenants.
We direct our associates and agencies to settle claims and pay losses as quickly as practical and made $1.791 billion in net claim payments during 2007. At year-end 2007, net property casualty reserves reflected $1.901 billion in unpaid amounts on reported claims (case reserves), $808 million in loss expense reserves and $688 million in estimates of incurred but not yet reported 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 loss and loss expense reserves in Critical Accounting Estimates, Property Casualty Insurance Loss and Loss Expense Reserves, Page 37.
These estimated cash outflows are undiscounted with respect to interest. As a result, the sum of the cash outflows shown for all years of $3.782 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy reserves and separate accounts for future policy benefits and claims of $2.037 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $10 million of separate accounts liabilities.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 63
Contingent commissions - Contingent, or profit-sharing, commissions are paid to agencies using a formula that takes into account agency profitability and other factors. We estimate 2008 contingent commission payments of approximately $102 million.
Computer hardware and software - We expect to need approximately $10 million over the next five years for current material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discuss below the non-contractual expenses we anticipate for computer hardware and software in 2008.
In addition to our contractual obligations, we have other operational commitments.
Dividends to shareholders - Over the past 10 years, the company has paid an average of 37 percent of net income as dividends, with the remaining 63 percent available to reinvest for future growth and for share repurchases. The ability of the company to continue paying cash dividends is subject to factors the board of directors may deem relevant.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 64
periods. At a minimum, we would expect repurchases to offset dilution from share-based compensation. In 2007, 2006 and 2005, we used $306 million, $118 million and $63 million for share repurchase.
The company established a reasonably likely range for net loss and loss expense reserves of $3.132 billion to $3.427 billion at year-end 2007, carrying net reserves of $3.397 billion. The likely range was $3.097 billion to $3.380 billion at year-end 2006, with the company carrying net reserves of $3.356 billion. Our loss and loss expense reserves are not discounted, but we have reduced the reserves by an estimate of the amount of salvage and subrogation payments we expect to recover. We provide a reconciliation of the property casualty reserves with the loss and loss expense reserve as shown on the balance sheet in Item 8, Note 4 of the Consolidated Financial Statements, Page 95.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2007 and 2006. However, actual unpaid loss and loss expenses could nonetheless fall outside of the indicated ranges.
We reconcile the beginning and ending balances of our reserves for loss and loss expenses at December 31, 2007, 2006 and 2005, in Item 8, Note 4 of the Consolidated Financial Statements, Page 95. The reconciliation of our year-end 2006 reserve balance to net incurred losses one year later recognizes approximately $244 million of redundant reserves.
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, 2007, we had paid $1.295 billion of loss and loss expenses in calendar years 1998 through 2007 for losses that occurred in accident years 1997 and prior. An estimated $171 million of losses remained unpaid as of year-end 2007 (net re-estimated reserves of $1.466 billion from Section C less cumulative paid loss and loss expenses of $1.295 billion).
Section C shows the re-estimated amount of the previously reported reserves based on experience as of the end of each succeeding year. The estimate is increased or decreased as we learn more about the frequency and severity of claims.
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
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 65
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 66
We believe our exposure to asbestos and environmental claims is limited, largely because our reinsurance retention was $500,000 or below prior to 1987. We also predominantly were a personal lines company in the 1960s and 1970s when asbestos and pollution exclusions were not widely used. During the 1980s and early 1990s, commercial lines grew as a percentage of our overall business and our exposure to asbestos and environmental claims grew accordingly. Over that period, we endorsed to or included in most policies an asbestos and environmental exclusion.
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 commercial casualty and workers’ compensation business lines. The increase also reflected higher loss expense reserves due to a claims mediation process that promoted earlier liability settlement resolution and to increased legal fees. In addition, commercial casualty gross reserves rose because of the increase in large losses as we discussed in Commercial Lines Insurance Results of Operations, Page 44.
The overall favorable development recorded for the commercial lines reserves illustrates the potential for revisions inherent in estimating reserves, especially for long-tail lines such as commercial casualty. Commercial lines reserve development over the past three years was consistent with:
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 68
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 2006 due to the decline in premiums and exposures for this segment. Homeowner gross reserves also reflected a lower level of catastrophe losses in 2007 as we discussed in Personal Lines Insurance Results of Operations, Page 51.
The following table shows net reserve changes at year-end 2007, 2006 and 2005 by personal line of business and accident year:
The overall favorable development recorded for 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:
Changes in case reserves based on new information for specific claims or classes of claims
Primary components of the 2008 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 $4 million of each loss. Losses between $4 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $38 million for 2008, compared with $35 million in 2007 and $29.5 million in 2006.
We have modified our casualty per occurrence treaty for one Fortune 1000 policyholder. Three executive risk policies are written for this insured and the $5 million casualty retention would apply separately to each policy for a total retention of $15 million. This aggregation would be applicable only if all three policies were triggered under the same occurrence.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 70
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 2008, the same premium we paid in 2007.
Property per risk treaty - The property treaty provides limits up to $5 million, which provides adequate capacity for the risk profile we expect to write in 2008. We retain the first $1 million of any policy loss. Losses between $1 million and $5 million are reinsured at 100 percent.
Casualty per occurrence treaty - The casualty treaty provides limits up to $5 million, which provides adequate capacity for the risk profile we expect to write in 2008. We retain the first $1 million of any policy loss. Losses between $1 million and $5 million are reinsured at 100 percent.
Property catastrophe treaty - As a subsidiary of The Cincinnati Insurance Company, CSU has been added as a named insured under our property catastrophe treaty. All terms and conditions of this treaty apply to policies underwritten by CSU.
The NAIC has asked for industry 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 21. 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.
Concerns that doing business with the company is too difficult or
Securities laws that could limit the manner and timing of our investment transactions
Delays or inadequacies in the development, implementation, performance and benefits of technology projects and enhancements
Actions of insurance departments, state attorneys general or other regulatory agencies that:
Restrict our ability to exit or reduce writings of unprofitable coverages or lines of business
Unforeseen departure of certain executive officers or other key employees due to retirement, health or other causes that could interrupt progress toward important strategic goals or diminish the effectiveness of certain longstanding relationships with insurance agents and others.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 80
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 81
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the company) as of December 31, 2007 and 2006, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2007. Our audits also included the financial statement schedules listed in the Index at Item 15(c). We also have audited the company’s internal control over financial reporting as of December 31, 2007, based on criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The company’s management is responsible for these financial statements and financial schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Annual Report on Internal Control Over Financial Reporting report. Our responsibility is to express an opinion on these financial statements and financial statement schedules and an opinion on the company’s internal control over financial reporting based on our audits.
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, 2007 and 2006, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, 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, 2007, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 83
The three complementary subsidiaries are CSU Producer Resources Inc. which offers insurance brokerage services to our independent agencies so their clients can access our excess and surplus lines insurance products; CFC Investment Company, which offers commercial leasing and financing services to our agents, their clients and other customers; and CinFin Capital Management Company, which provides asset management services to institutions, corporations and individuals.
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 options. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2007.
The 2006 Stock Compensation Plan, approved in 2006 by shareholders, provides the compensation committee of the board of directors flexibility in the types of available stock-based awards including stock options along with restricted stock, restricted stock units, stock appreciation rights and other stock-based awards. The 2006 Stock Compensation Plan also allowed the grant of performance-based awards.
Prior to January 1, 2006, we accounted for our stock option plans using the recognition and measurement provisions pursuant to Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations (APB 25), as permitted by the Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (SFAS No. 123). No stock-based employee compensation cost was recognized in the Statements of Income for the year ended December 31, 2005.
Effective January 1, 2006, we adopted the fair value recognition provisions of the SFAS No. 123(R), “Share-Based Payment,” using the modified-prospective-transition method. We elected to use the alternative method for determining the beginning balance of the additional paid-in capital pool, as described in the Financial Accounting Standards Board (FASB) Staff Position 123(R)-3. Refer to Note 16, Stock-based Associate Compensation Plans, Page 102 for more information regarding our share-based compensation.
We sponsor a defined benefit pension plan covering substantially all employees. Our pension expense is based on certain acturial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 87
Property casualty policy written premiums are deferred and recorded as earned premiums on a pro rata basis over the terms of the policies. We record as unearned premium the portion of written premiums that apply to unexpired policy terms. The expenses associated with issuing insurance policies - primarily commissions, premium taxes and underwriting costs - are deferred and amortized over the terms of policies. We update our acquisition cost assumptions periodically to reflect actual experience and we evaluate our deferred acquisition cost for recoverability.
We establish a liability for traditional long-duration contracts as we receive premiums. The amount of this liability is the present value of future expenses and benefits less the present value of future net premiums. Net premium is the portion of gross premium required to provide for all expenses and benefits. We estimate future expenses and benefits and net premium using assumptions for expected expenses, mortality, morbidity, withdrawal rates and investment income. We include a provision for adverse deviation, meaning we allow for some uncertainty in making our assumptions. We establish our assumptions when the contract is issued and we generally maintain those assumptions for the life of the contract. We use both our own experience and industry experience, adjusted for historical trends, in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumption for expected expenses. We base our assumption for expected investment income on our own experience, adjusted for current economic conditions.
These administration charges are deferred and are recognized over the period when we provide those future services.
We reduce risk and uncertainty by buying property casualty and life reinsurance. Reinsurance contracts do not relieve us from our duty to policyholders, but rather help protect our financial strength to perform that duty all of our reinsurer contracts transfer the economic risk of loss. All of our reinsurance contracts transfer the economic risk of loss.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 89
Investment income consists mainly of interest and dividends. We record interest on an accrual basis and record dividends at the ex-dividend date. We amortize premiums and discounts on fixed-maturity securities using the effective interest method over the expected life of the security.
We account for derivative financial instruments as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 137, “Deferral of the Effective Date of FASB Statement No. 133” and SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities” (collectively referred to as SFAS No. 133).
We maintain the right and ability to redeem the securities loaned on short notice and continue to earn interest on the collateral securities. Although the securities loaned have been pledged and effectively secure the cash collateral we receive, we maintain effective control over our securities, which we continue to classify as invested assets on our consolidated balance sheets. At year-end 2007, we had $745 million in securities on loan and $760 million of collateral. At year-end 2006, we had no securities on loan and held no collateral because we recalled our securities on loan prior to year-end. Interest income on collateral, net of fees, was $1.5 million in 2007 and $697,000 in 2006.
A portion of the securities lending collateral invested was placed in asset-backed commercial paper (ABCP) programs during 2007 by our lending agent. Due to the ABCP market disruption, maturities on two of our investments were extended beyond their original stated maturity dates. Only one of these investments remains outstanding. That ABCP had an amortized cost of $73 million at February 22, 2008, compared with $74 million at year-end 2007. The ABCP manager is continuing to work with investors to allow for an orderly liquidation of the fund. Excluding this remaining ABCP investment, all investments within our securities lending program now are in overnight securities.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 90
We record building and equipment at cost less accumulated depreciation. Certain equipment held under capital leases also is classified as property and equipment with the related lease obligations recorded as liabilities. Our depreciation is based on estimated useful lives (ranging from three years to 391/2 years) using straight-line and accelerated methods. Depreciation expense was $38 million in both 2007 and 2006 and $33 million in 2005. We monitor land, building and equipment for potential impairments. Potential impairments may include a significant decrease in the market values of the assets, considerable cost overruns on projects or a change in legal factors or business climate, or other factors that indicate that the carrying amount may not be recoverable.
We capitalize costs for internally developed computer software during the application development stage. These costs generally consist of external consulting, payroll and payroll-related costs.
SFAS No. 159, Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of FASB Statement No. 115 - In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115.” SFAS No. 159, which is effective for fiscal years beginning after November 15, 2007, permits an entity to choose to measure many financial instruments and certain other items at fair value (on an instrument-by-instrument basis) at specified election dates. The objective is to improve financial reporting by providing an entity with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. We have not yet determined whether we will elect the fair value option for certain financial assets or liabilities; and therefore, we do not know the impact, if any, SFAS No. 159 may have on our results of operations and financial position in 2008.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 91
SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS Nos. 133 and 140 - In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140.” SFAS No. 155 amends SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” and resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interest in Securitized Financial Assets.”
SFAS No. 155: (a) permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; (c) establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (d) clarifies that concentrations of credit risk in the form of subordination is not embedded derivatives; and (e) eliminates restrictions on a qualifying special-purpose entity’s ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. SFAS No. 155 was effective for all financial instruments acquired or issued in a fiscal year that begins after September 15, 2006.
SOP 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchange of Insurance Contracts - In September 2005, the Accounting Standards Executive Committee issued Statement of Position 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts.” This statement provides guidance on accounting for deferred acquisition costs on an internal replacement, which is defined broadly as a modification in product benefits, features, rights, or coverages that occurs by the exchange of an existing contract for a new contract, or by amendment, endorsement, or rider to an existing contract, or by the election of a benefit, feature, right, or coverage within an existing contract. An internal replacement that is determined to result in a replacement contract that is substantially unchanged from the replaced contract should be accounted for as a continuation of the replaced contract. Contract modifications resulting in a replacement contract that is substantially changed from the replaced contract should be accounted for as an extinguishment of the replaced contract and any unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from the replaced contract should not be deferred in connection with the replacement contract. The provisions of SOP 05-1 were effective for internal replacements beginning January 1, 2007. The initial adoption of SOP 05-1 did not have a material impact on our results of operations or financial position.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 92
At December 31, 2007, contractual maturity dates for fixed-maturity and short-term investments were:
At December 31, 2007, investments with book value of $52 million and fair value of $53 million were on deposit with various states in compliance with regulatory requirements.
We sold 5.5 million shares of our holdings of Fifth Third common stock in 2007. The sale contributed $64 million to our 2007 pretax realized gains and $42 million to net income. We sold 3.8 million shares of our holdings of ExxonMobil common stock in 2007. The sale contributed $217 million to our 2007 pretax realized gains and $141 million to net income.
We sold 12.7 million shares of our holdings of Alltel Corporation common stock in 2006. The sale contributed $647 million to our 2006 pretax realized gains and $412 million to net income.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 94
At December 31, 2007, 184 fixed-maturity investments with a total unrealized loss of $20 million had been in an unrealized position for 12 months or more. Three securities were trading below 70 percent of book value with a total unrealized loss of $6 million. The remainder were trading between 70 percent to less than 100 percent of book value.
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 an unrealized position for 12 months or more. All were trading between 70 percent to less than 100 percent of book value.
We use actuarial methods, models, and judgment to estimate, as of a financial statement date, the property casualty loss and loss expense reserves required to pay for and settle all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date. The actuarial estimate is subject to review and adjustment by an inter-departmental committee that includes actuarial management and is familiar with relevant company and industry business, claims, and underwriting trends, as well as general economic and legal trends, that could effect future loss and loss expense payments.
At December 31, 2007, we had two lines of credit with commercial banks amounting to $225 million with an outstanding balance of $69 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. The company had no compensating balance requirement on short-term debt for either 2007 or 2006. Interest rates charged on borrowings ranged from 5.4 percent to 8.3 percent during 2007.
The company’s subsidiary, CFC Investment Company, entered into an interest-rate swap agreement during 2006, which expires August 29, 2009. The purpose of the interest-rate swap contract is to hedge against fluctuations of interest payments for certain variable-rate debt obligations ($49 million notional amount). Under the interest-rate swap contract, CFC-I agreed to pay a fixed rate of interest of 5.66 percent. This swap is reflected at fair value in the consolidated balance sheets as a component of shareholders’ equity in accumulated other comprehensive income. The unrealized loss, net of tax, was $594,000 at year-end 2007 compared with $69,000 at year-end 2006. Management does not expect any significant amounts to be reclassified into earnings as a result of interest rate changes in the next 12 months.
As of December 31, 2007, 10.6 million shares of common stock were available for future stock option grants.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 96
Our statements of income include incurred property casualty insurance loss and loss expenses on assumed and ceded business:
Our statements of income include earned life insurance premiums on assumed and ceded business:
Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS No. 109
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 98
The only current sources of dilution of our common shares are outstanding stock options to purchase shares of common stock and non-vested shares. The above table shows the number of anti-dilutive options shares at year-end 2007, 2006 and 2005. 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.
The accumulated benefit obligation was $206 million and $204 million at December 31, 2007 and 2006, respectively. The fair value of our stock comprised $25 million (12 percent of total plan assets) at December 31, 2007, and $29 million (14 percent of total plan assets) at December 31, 2006.
We expect to contribute approximately $10 million to our pension plan in 2008 with a target allocation of 90 percent equity securities and 10 percent fixed maturities and cash.
The estimated costs to be amortized from accumulated other comprehensive income into net periodic benefit cost over the next year are as follows:
deferred income taxes are valued and established using a different basis.
We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $7 million, $7 million and $6 million on premium volume of approximately $37 million, $40 million and $41 million for 2007, 2006 and 2005, respectively.
The adoption of SFAS No. 123(R) on January 1, 2006, reduced our income before income taxes by $14 million and $17 million in the years ended December 31, 2007 and 2006, and reduced our net income by $11 million and $14 million in the years ended December 31, 2007 and 2006.
The weighted-average grant-date fair value of options granted during 2007 and 2006 was $9.43 and $10.09 per share, respectively. The total intrinsic value of options exercised during the years ended December 31, 2007, 2006 and 2005, was $8 million, $22 million and $9 million, respectively. In total, options vested during the year ended December 31, 2007, had no intrinsic value. The total intrinsic value of options vested during the years ended December 31, 2006 and 2005, was $10 million and $12 million. (Intrinsic value is the market price less the exercise price.)
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 102
Compensation cost for all non-vested stock options granted prior to January 1, 2006, that vested during 2007, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 103
Cash received from the exercise of options was $19 million, $27 million and $11 million for the years ended December 31, 2007, 2006 and 2005, respectively. The tax benefit realized on options exercised was $2 million for the year ended December 31, 2007, $3 million for the year ended December 31, 2006, and $1 million for the year ended December 31, 2005.
We report as “Other” the non-investment operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding client investment activities), as well as other income of our insurance subsidiary. In 2007, an immaterial level of expenses from The Cincinnati Specialty Underwriters Insurance Company was included in the commercial lines property casualty insurance segment while an immaterial level of expenses for CSU Producer Resources was included in Other.
Our investment operations’ revenues are pretax net investment income plus realized investment gains and losses.