Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building has approximately 1,508,200 total square feet of available space. In 2008, we completed construction of a 425,400 square foot third office tower and 276,800 square foot underground garage. We expect this expansion to accommodate our business needs for the foreseeable future. The property, including land, is carried in our financial statements at $159 million as of December 31, 2008, 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 (less than 1 percent).
Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2008.
2000 - We 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. We earned $5 million in interest in the first quarter from a $303 million single-premium bank-owned life insurance (BOLI) policy booked at the end of 1999 that was segregated as a separate account effective April 1, 2000. Investment income and realized investment gains and losses from separate accounts generally accrue directly to the contract holder and, therefore, are not included in the company’s consolidated financials.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 34
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When looking at our longer-term objectives, we see three performance drivers:
Premium growth - We believe over any five-year period our agency relationships and initiatives can lead to a property casualty written premium growth rate that exceeds the industry average. The compound annual growth rate of our net written premiums was 1.3 percent over the past five years, equal to the estimated growth rate for a broad group of standard market property casualty insurance companies.
Combined ratio - We believe our underwriting philosophy and initiatives can generate a GAAP combined ratio over any five-year period that is consistently below 100 percent. Our GAAP combined ratio has averaged 92.8 percent over the past five years. Our combined ratio was below 100 percent in each year during the period, except 2008 when we experienced a record level of catastrophe losses as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 49. Our statutory combined ratio averaged 92.6 percent over the same period compared with an estimated 98.5 percent for the same industry group.
Over the five years ended December 31, 2008, our compound annual equity portfolio return was a negative 9.0 percent compared with a compound annual total return of a negative 2.1 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 previously large holdings in the financial services sector. In 2008, our compound annual equity portfolio return was a negative 31.5 percent, compared with a negative 36.9 percent for the Index.
The board of directors is committed to rewarding shareholders directly through cash dividends and through share repurchase authorization. The board also has periodically declared stock dividends and splits. Through
2008, the company has increased the indicated annual cash dividend rate for 48 consecutive years, a record we believe is matched by only 11 other publicly traded companies. While seeing merit in continuing that record, in February 2009, our board indicated its first priority was assuring continued financial strength for the company and that its intention was to consider the potential for a 49th year of increase over the course of 2009. We discuss our financial position in more detail in Liquidity and Capital Resources, Page 70.
Management has worked with the board of directors to identify the strategies that can lead to long-term success. Our strategies are intended to position us to compete successfully in the markets we have targeted while minimizing risk. We believe successful implementation of the initiatives that support our strategies will help us better serve our agent customers, reduce volatility in our financial results and weather difficult economic, market or pricing cycles.
Preserve capital - Implementation of these initiatives is intended to preserve our capital and liquidity so that we can successfully grow our insurance business. A strong capital position provides the capacity to support premium growth and provides the liquidity to sustain our investment in the people and infrastructure needed to implement our other strategic initiatives.
We discuss each of these strategies, along with the metrics we use to assess their progress, in Item 1, Strategic Initiatives, Page 7,
We will incur the cost of continued investment in our business, including technology, new states and process initiatives to create long-term value. In addition, we will not see the full advantage of many of our investments in technology until 2010 and beyond.
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We discuss in our Item 1A, Risk Factors, Page 25, many potential risks to our business and our ability to achieve our qualitative and quantitative objectives. These are real risks, but their probability of occurring may not be high. We also believe that our risk management programs generally can mitigate their potential effects, in the event they do occur.
We have formal risk management programs overseen by a senior officer and supported by a team of representatives from business areas. The team reports to our chairman, our president and chief executive officer and our board of directors, as appropriate, on detailed and summary risk assessments, risk metrics and risk plans. Our use of operational audits, strategic plans and departmental business plans, as well as our culture of open communications and our fundamental respect for our code of conduct, continue to help us manage risks on an ongoing basis.
Cash dividends declared per share rose 9.9 percent in 2008, 6.0 percent in 2007 and 11.2 percent in 2006.
Our ratio of debt to total capital (debt plus shareholders’ equity) rose over the three years due to the effect on shareholders’ equity of the declining value of our invested assets. Long-term debt was unchanged over the period.
Weighted average shares outstanding may fluctuate from period to period because we repurchase shares under board authorizations and we issue shares when associates exercise stock options. Weighted average shares outstanding on a diluted basis declined 9 million in 2008, 3 million in 2007 and 2 million in 2006.
As discussed in Investments Results of Operation, Page 66, security sales led to realized investment gains in all three years, although 2008 gains were tempered by $510 million in other-than-temporary impairment charges. 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 are 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 for securities with embedded derivatives without actual realization of those gains and losses.
The trend in overall written premium growth reflected the competitive and market factors discussed in Item 1, Commercial Lines and Personal Lines Property Casualty Insurance Segment, Page 11 and Page 14.
In 2008, our property casualty insurance operations reported an underwriting loss after achieving record profitability in 2007. Underwriting profitability can be measured by the combined ratio. (The combined ratio is the percentage of each earned premium dollar spent on claims plus all expenses - the lower the ratio, the better the performance.) In 2008 and 2007, higher savings from favorable development on prior period reserves helped offset other loss and loss expenses. Catastrophe losses fluctuated dramatically over the three-year period, making an unusually high contribution of 6.8 percentage points to the combined ratio in 2008 after an unusually low 0.8 points in 2007. The pension plan settlement increased the 2008 combined ratio by 0.8 percentage points.
Our new surplus lines operation contributed $14 million to net written premiums and $5 million to earned premiums, but had an immaterial effect on net income. The business achieved its first-year strategic plan objectives.
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For asbestos and environmental claims, we calculate IBNR reserves by deriving an actuarially based estimate of total unpaid loss and loss expenses. We then reduce the estimate by total case reserves. We discuss the reserve analysis that applies to asbestos and environmental reserves in Asbestos and Environmental Reserves, Page 76.
Management believes that the standard error of a reserve estimate, a measure of the estimate’s variability, provides the most appropriate measure of the estimate’s sensitivity. The reserves we establish depend on the models we use and the related parameters we estimate in the course of conducting reserve analyses.
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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 2008, consolidated fixed maturity investments exceeded total insurance reserves (including life policy reserves) by more than $190 million.
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The application of our impairment policy resulted in other-than-temporary impairment charges that reduced our income before income taxes by $510 million in 2008, $16 million in 2007 and $1 million in 2006. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, there is little expectation that the value may be recouped within a designated recovery period. Other than-temporary impairment losses represent non-cash charges to income.
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 financial strength, management may not impair certain securities even when they are trading below cost.
For fixed-maturity investments, we can make that determination based on our ability to hold until their scheduled redemption securities that are meeting their debt obligations and have the potential to recover value. For equity investments, we can make that determination based on a thorough assessment of the potential for recovery over a longer-term horizon. 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.
Other-than-temporary impairment charges are distinct from the ordinary fluctuations seen in the value of a security when considered in the context of overall economic and market conditions. Securities considered to have a temporary decline would be expected to recover their fair value, which may be at maturity. Under the same accounting treatment as fair value gains, temporary declines (changes in the fair value of these securities) are reflected in shareholders’ equity on our balance sheet in accumulated other comprehensive income, net of tax, and have no impact on reported net income.
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The SFAS No. 157 exit price notion requires our valuation also to consider what a marketplace participant would pay to buy an asset or receive to assume a liability. Therefore, while we can consider pricing data from outside services, we ultimately determine whether the data or inputs used by these outside services are observable or unobservable.
In accordance with SFAS No. 157, we have categorized our financial instruments, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). If the inputs used to measure the financial instruments fall within different levels of the hierarchy, the categorization is based on the lowest level that is significant to the fair value measurement of the instrument.
Over 98 percent of our $8.8 billion invested assets measured at fair value are classified as Level 1 or Level 2. Financial assets that fall within Level 1 and Level 2 are priced according to observable data from identical or similar securities that have traded in the marketplace. Also within Level 2 are securities that are valued by outside services or brokers where we have evaluated the pricing methodology and determined that the inputs are observable.
All $30 million of the CMOs in our portfolio are collateralized by Alt-A mortgages that originated between 2004 and 2006. We owned investment grade CMOs with a fair value and book value of $27 million and $39 million, respectively, at December 31, 2008. Of the $27 million investment-grade CMOs, $21 million were rated AAA by Standard & Poor’s. We also owned non-investment grade CMOs that had a fair value and book value of $3 million and $4 million, respectively. We do not intend to make additional investments in this asset category.
Financial assets that fall within the Level 3 hierarchy are valued based upon unobservable market inputs, normally because they are not actively traded on a public market. Level 3 taxable fixed maturities securities include certain private placements, small issues, general corporate bonds and medium-term notes. Level 3 tax-exempt fixed maturities securities include various thinly traded municipal bonds. Level 3 common equities include private equity securities. Level 3 preferred equities include private and thinly traded preferred securities.
Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate would lower our 2009 net income before income taxes by $1 million. Likewise, a 0.5 percentage point decline in the expected return on plan assets would lower our 2009 income before income taxes by $1 million.
and is recognized as revenue or expense. In the event that the asset value of contract holders’ accounts is projected below the value guaranteed by the company, a liability is established through a charge to our earnings.
In addition to the factors discussed in Commercial Lines and Personal Lines Insurance Results of Operations, Page 51 and Page 59, growth and profitability for our consolidated property casualty insurance operations were affected by a number of common factors.
Our combined ratio before catastrophe losses and savings from favorable prior period reserve development rose substantially in 2008 due to lower pricing prompted by soft market conditions and also due to normal loss cost inflation, a higher level of larger commercial lines losses and the pension plan settlement cost. The pension plan settlement increased the 2008 combined ratio by 0.8 percentage points. Our 2007 combined ratio before catastrophe losses and savings from favorable prior period reserve development rose largely due to the effects of lower pricing, normal loss cost inflation and a higher level of larger commercial lines losses.
Catastrophe losses contributed 6.8 percentage points to the combined ratio in 2008, the highest catastrophe loss ratio for our company since 1991. In 2007, catastrophe losses added just 0.8 percentage points, the lowest ratio over the same period. 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 reserves.
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The three-year rise in total underwriting expenses largely was due to the rise in non-commission underwriting expenses, reflecting our continued investment in the people and systems necessary for our future growth. The change in our pension plan added 0.8 percentage points to the overall combined ratio, including a 0.5 percentage point addition to the non-commission expense ratio.
Our commercial lines statutory combined ratio was 96.6 percent in 2008 compared with 89.2 percent in 2007 and 90.8 percent in 2006. By comparison, the estimated industry commercial lines combined ratio was 106.5 percent in 2008, 95.1 percent in 2007 and 91.2 percent in 2006. Industry commercial lines estimates include the mortgage and financial guaranty insurers, which saw a surge in claims following the historically high level of mortgage defaults in 2008.
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business as we emphasize the importance of assessing account quality to our agencies and underwriters. We continue to make case-by-case decisions not to write or renew certain business. We continue to use rate credits to retain renewals of quality business and earn new business. Our experience remains that the larger the account, the higher the credits, with variations by geographic region and class of business. Agency emphasis on larger accounts, convenience and technology considerations were the primary reasons for a slight decline in the number of our smaller policies.
Over the past three years, we continued to focus on seeking and maintaining adequate premium per exposure as well as pursuing non-pricing means of enhancing longer-term profitability. Non-pricing means have included deliberate reviews of each risk, 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. 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 agents will perform. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. To assist underwriters, field claims representatives prepare full reports on risks of concern.
Both renewal and new business reflected the effects of the economic slowdown in many regions, as exposures declined and policyholders became increasingly focused on reducing expenses. 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 demand for a business’s goods or services, as well as a change in its exposure to risk. Policyholders who 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.
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 sales prospects with those agents, carefully evaluating risk exposure and working up their best quotes. In 2008, new business premium growth largely was driven by agencies appointed in the past five years with relatively stable contributions from the remaining agencies. At year-end 2008, our field marketing representatives reported pricing down about 5 percent to 10 percent on average to write the same piece of quality new business we would have quoted in 2007, the third consecutive year of significant declines in our new business pricing. Pricing on new business remains competitive as many carriers appear to be managing the soft market by working aggressively to protect their renewal portfolios.
For our larger business lines, the trend in the current accident year loss and loss expense ratio before catastrophe losses over the past three years reflected normal loss cost inflation as well as competitive
Catastrophe losses were highly volatile over the three year period as discussed in Consolidated Property Casualty Insurance Results of Operations, Page 49. Savings from prior period reserve development continued to trend favorably in 2008 as discussed in Commercial Lines Insurance Segment Reserves, Page 77.
In both 2007 and 2008, non-commission expenses rose on flat or declining earned premiums, which also led to unfavorable deferred acquisition expense comparisons. Further, in 2008, the salary cost contribution rose by approximately 0.8 percentage points and the change in our pension plan contributed 0.5 percentage points to the ratio. In 2007, our surplus lines start-up activities contributed slightly to higher staffing and technology expenses. Surplus lines expenses were included in Other in 2008. Refinements in the allocation of expenses between our commercial lines and personal lines segments also contributed to minor variations in the non-commission underwriting expenses.
Industrywide commercial lines written premiums are expected to decline approximately 1.4 percent in 2009 with the industry combined ratio estimated at 105.1 percent. As discussed in Item 1, Commercial Lines Insurance Marketplace, Page 13, over the past several years, renewal and new business pricing has come under steadily increasing pressure, reinforcing the need for more flexibility and careful risk selection. We expect commercial lines price declines to slow in 2009.
We intend to continue marketing our products to a broad range of business classes, pricing our products appropriately and taking a package approach. We intend to maintain our underwriting selectivity and carefully manage our rate levels as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions about rates, the use of three-year commercial policies and other policy conditions on a case-by-case basis, even in lines and classes of business that are under competitive pressure. Nonetheless, we expect commercial lines profitability to remain under pressure in 2009.
The calendar year loss and loss expense ratio improved in 2008 and 2007, largely because of higher savings from favorable development on prior period reserves. Factors contributing to the higher savings included
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 55
The decline in commercial auto written premiums over the three-year period reflected the downward pressure exerted by the market on the pricing of commercial accounts. Commercial auto is one of the business lines that we renew and price annually, so market trends may be reflected here more quickly than in other lines. Commercial auto also experiences pricing pressure because it often represents the largest portion of insurance costs for many commercial policyholders.
Pricing and normal loss cost inflation were the primary drivers of the deterioration in the accident year loss and loss expense ratio before catastrophe losses over the past three years.
The calendar year loss and loss expense ratio reflected the volatility in catastrophe losses over the three-year period. In addition, the current accident year loss and loss expense ratio before catastrophe losses has risen over the period because of pricing reductions and normal loss cost inflation.
Surety and executive risk net written premiums rose over the three-year period as we enhanced our marketing of these products.
Limiting the number of for-profit policies. At year-end 2008, 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. Based on new policy data or information from the most recent policy renewal, 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 49 have assets between $500 million and $1 billion.
The calendar year and current accident year loss and loss expense ratios rose substantially in 2008, driven by additional director and officer new losses and case reserve increases greater than $250,000. During 2008, 38 of the new director and officer losses and case reserve increases added approximately $43 million to loss and loss expenses compared with 20 adding about $9 million in 2007 and 16 adding about $16 million in 2006. The higher level in 2008 was largely due to six new losses and five case reserve increases greater than $1 million on claims made in 2007. Eight of these 11 items were related to lending practices at financial institutions. To address the potential risk of this portion of our surety and executive risk business line moving forward, we are working with our agents to limit the number of new director and officer policies for financial institutions. At renewal, we are carefully re-underwriting each account based on credit rating and other metrics.
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Combined ratio - The combined ratio rose substantially in 2008 after improving in 2007. The year-over-year differences were partially due to dramatic fluctuations in the level of catastrophe losses. In 2008,
Our personal lines statutory combined ratio was 111.6 percent in 2008, 94.1 percent in 2007 and 103.6 percent in 2006. By comparison, the estimated industry personal lines combined ratio was 103.3 percent in 2008, 96.1 percent in 2007 and 92.3 percent in 2006. Our concentration of business in areas hard-hit by catastrophe events contributed to recent results that differed from the overall industry.
The rate of decline in our personal lines agency renewal written premiums further slowed in 2008, as the benefits of additional tiers to our pricing structure were seen in many states. These tiers are intended to improve our ability to compete for our agents’ highest quality personal lines accounts, increasing opportunities for our agents to market the advantages of our personal lines products and services to their clients.
Our personal lines new business written by our agencies rose for the third consecutive year in 2008 as the number of agency locations writing our personal lines rose by over 130, or 14.0 percent, in 2008. We set the stage to improve our geographic diversification by opening Arizona and Utah to personal lines. We also expanded our activity in Maryland and North Carolina by introducing personal auto and appointing additional locations from our existing agency network. However, the increased new business did not fully offset the impact of lost business and lower rates on above-average quality renewal business.
In 2007 and 2008, other written premiums lowered net written premiums more than 2006. Higher ceded reinsurance costs were the primary driver in both years, including the reinsurance reinstatement premium incurred in 2008.
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Industry analysts currently anticipate industrywide personal lines written premiums may rise approximately 2.5 percent in 2009, with the combined ratio estimated at 97.6 percent. While the improvement in our new business levels and policy retention rates over the past several years are positive indications for our personal lines business, we expect our growth rate to be below that of the industry as we continue to address our pricing. In Item 1, Strategic Initiatives, Page 7, we discuss the initiatives we are implementing to address the unsatisfactory performance of our personal lines segment, in particular the homeowner line of business.
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We describe steps that will enhance our response to the changing marketplace. We are aware that our personal lines pricing and loss activity are at levels that could put achievement of our corporate financial objectives at risk if those trends continue. We discuss our overall outlook for our property casualty insurance operations in the Executive Summary, Page 37.
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 line of business data to summarize growth and profitability trends separately for each line. The accident year loss data provides current estimates of incurred loss and loss expenses and corresponding ratios over the most recent three accident years. Accident year data classifies losses according to the year in which the corresponding loss events occur, regardless of when the losses are actually reported, recorded or paid.
The decline in written and earned premiums slowed over the past three years as we continued to modify pricing, improving retention and attracting new policyholders. New business activity is nearing a level that would allow us to replace premiums lost due to price reductions and normal attrition. We continue to monitor and modify selected rates and credits to address our competitive position.
Pricing decreases and normal loss cost inflation also were primary drivers in the rise in the accident year loss and loss expense ratio before catastrophe losses over the past three years. In addition, the 2008 accident year loss and loss expense ratio rose by approximately 4 percentage points because of the refinements made to our IBNR reserve allocation by accident year.
The calendar year loss and loss expense ratio over the past three years fluctuated with catastrophe losses. Catastrophe losses have been above our expected range in recent years, averaging 24.7 percent of homeowner earned premium from 2006 to 2008, compared with a five-year average of 20.9 percent.
The current accident year loss and loss expense ratio before catastrophe losses rose significantly in 2008, in part because of the decline in earned premiums, which largely reflected rate changes we made to keep our retention rate and new business at acceptable levels. Non-catastrophe weather-related losses contributed about 5 percentage points to the 2008 ratio. In addition, the refinements made to our IBNR reserve allocation by accident year and a lower estimate of salvage and subrogation reserves raised the ratio by about 2 percentage points.
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Revenues - Driven by higher term life insurance premiums, earned premiums have grown over the past three years although separate account management fees have fluctuated, primarily reflecting a net realized capital loss sharing agreement between the separate account and the general account. Life insurance premiums have driven the increase in gross in-force policy face amounts to $65.888 billion at year-end 2008 from $61.875 billion at year-end 2007 and $56.971 billion at year-end 2006.
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Earned premiums increased slightly in 2008 largely because of growth in our term insurance business. Total statutory life insurance net written premiums rose in 2008 to $185 million, compared with $167 million and $161 million in 2007 and 2006. Total statutory written premiums for life insurance operations for all periods include life insurance, annuity and accident and health premiums. The increase in total statutory life insurance written premiums primarily was due to sales of term life insurance and annuity products.
Earned premiums for universal life products declined because fee income decreased 21 percent in 2008, principally reflecting an increase in our liability for unearned front-end loads, an actuarial adjustment.
Over the past several years, we have worked to maintain a portfolio of simple, yet competitive products, primarily under the LifeHorizons banner. Our product development efforts emphasize death benefit protection and guarantees. Distribution expansion within our property casualty insurance agencies remains a high priority. In the past several years, we have added life field marketing representatives for the western, southeastern and northeastern states. Our 30 life field marketing representatives work in partnership with our more than 100 property casualty field marketing representatives. Approximately 71 percent of our term and other life insurance product premiums were generated through our property casualty insurance agency relationships.
efficiencies have played a significant role in cost containment and in our ability to increase total premiums and policy count over the past 10 years with minimal headcount additions.
The life insurance industry faced a difficult year as broad and deep dislocations in the financial markets led to investment losses. While our investments also suffered, Cincinnati Life finished 2008 with very strong statutory capital and surplus and risk based capital ratios.
Investment income - Pretax investment income declined 11.6 percent in 2008, primarily because of dividend reductions by common and preferred holdings, including reductions during the year on positions subsequently sold or reduced. Investment income rose 6.6 percent to a record high in 2007 on strong cash flow for new investments, higher interest income from the healthy fixed-maturity portfolio and increased dividend income from the common stock portfolio.
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Dividend income declined 30.5 percent in 2008 after rising in 2007 and 2006. Because our equity portfolio was heavily concentrated in the financial sector at the beginning of 2008, we experienced dividend reductions by many common and preferred holdings, including reductions during the year on positions subsequently sold or reduced.
Pretax realized investment gains in the past three years largely were due to the sale of equity holdings. In 2008, most of the gain was due to sales of holdings of common and preferred stocks of financial services issuers, reflecting our historical weighting in financial sector securities. The majority of these holdings were sold following reductions or elimination of their cash dividends to shareholders. Because of our low cost basis, we were able to record gains on many of these sales despite the decline in overall stock market values during 2008. Realized gains were lower in 2007, although we chose to take gains from partial sales of selected holdings and to sell other holdings because of general credit concerns that began in the subprime mortgage market and spread to other areas in the homebuilding and related industries over the course of 2007. The gain in 2006 largely was due to the sale of our entire Alltel common stock holding.
We have a small portfolio of convertible preferred stocks and bonds, which have an embedded derivative component under GAAP accounting rules. In 2008 and 2007, we recorded $38 million and $11 million in fair value declines compared with $7 million in fair value increases in 2006. In 2008 and 2007, these changes in fair value were due to the application of SFAS No. 155, which allows us to account for the entire hybrid financial instrument at fair value, with changes recognized in realized investment gains and losses. In 2006, these changes in fair value were due to the application of SFAS No. 133, which required 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 of the Consolidated Financial Statements, Page 98, for details on the accounting for convertible security embedded options.
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Other-than-temporary impairment charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 17, are summarized below:
The increase in other-than-temporary impairment charges in 2008 was largely due to writedowns of holdings of bonds and common and preferred stocks of financial services issuers, reflecting our historical weighting in this sector and the decline in overall stock market values during 2008. Impairment charges rose slightly in 2007 on the initial concerns regarding the real estate market. While we own only $30 million of
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mortgage-backed securities in our investment portfolio, we do own investments in industries directly affected by this credit environment.
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2009, we expect to continue to allocate a portion of cash available for investment to equity securities, taking into consideration corporate liquidity and income requirements, as well as insurance department regulations and ratings agency comments. We discuss our portfolio strategies in Item 1, Investments Segment, Page 17.
We believe a continuation of the current credit environment, if exacerbated by recessionary economic conditions, could lead to further declines in portfolio values and additional other-than-temporary impairment charges. All but 83 securities of the 2,223 securities in the portfolio were trading at or above 70 percent of book value at year-end 2008. Our asset impairment committee continues to monitor the investment portfolio. The current asset impairment policy is described in Critical Accounting Estimates, Asset Impairment, Page 45.
The primary reason for the change in the effective tax rate was the level and timing of realized gains as discussed in Investments Results of Operations, Page 66. In 2008, we had pretax realized gains of $138 million compared with pretax gains of $382 million in 2007 and $684 million in 2006. Growth in the tax-exempt municipal bond portfolio, lower investment income from dividends and changes in operating earnings over the periods also contributed to the change in the effective tax rate for 2008.
We pursue a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. For our insurance subsidiaries, approximately 85 percent of income from tax-advantaged fixed-maturity investments is exempt from federal tax. Our non-insurance companies own no tax-advantaged fixed-maturity investments. For our insurance subsidiaries, the dividend received deduction, after the dividend proration of the 1986 Tax Reform Act, exempts approximately 60 percent of dividends from qualified equities from federal tax. For our non-insurance subsidiaries, the dividend received deduction exempts 70 percent of dividends from qualified equities. Details about our effective tax rate are found in Item 8, Note 11 of the Consolidated Financial Statements, Page 111.
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Dividends to shareholders - Over the past 10 years, the company has paid an average of 38.5 percent of net income as dividends. Dividends paid over the period have averaged 2.9 percent of beginning shareholders’ equity. The ability of the company to continue paying cash dividends is subject to factors the board of directors may deem relevant.
Common stock repurchase - Generally, our board believes that stock repurchases can help fulfill our commitment to enhancing shareholder value. Consequently, the board has authorized the repurchase of outstanding shares, giving management discretion to purchase shares at reasonable prices in light of circumstances at the time of purchase, pursuant to SEC regulations.
The details of the repurchase authorizations and activity are described in Item 5, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 32. Between February 1999 and year-end 2008, we have repurchased 28.7 million shares at a total cost to the company of $1.105 billion. We do not adjust the number of shares repurchased and average price per repurchased share for stock dividends.
Our insurance subsidiary’s primary means of meeting liquidity requirements are investment income and after-tax sale proceeds from investments held at the subsidiary level and collection of insurance premiums. Property casualty insurance premiums generally are received before losses are paid under the policies purchased with those premiums. While first-year life insurance expenses normally exceed first-year
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Our insurance subsidiary’s primary contractual obligations are property casualty loss and loss expenses and life policyholder obligations as well as certain ongoing operating expenses as shown under Contractual Obligations, Page 73. Other uses of insurance subsidiary cash include payments of dividends to the parent company and other operating expenses as discussed under Other Commitments, Page 73.
Over the past three years, cash receipts from property casualty and life insurance premiums, along with investment income, have been more than sufficient to pay claims, operating expenses and dividends to the parent company. We discuss the factors that affected insurance operations in Commercial Lines and Personal Lines Insurance Results of Operations, Page 51 and Page 59.
Investing is a primary source of liquidity for both the parent company and insurance subsidiary. At both the parent company and insurance subsidiary, cash in excess of operating requirements is invested in fixed-maturity and equity securities. Equity securities provide the potential for future increases in dividend income and for appreciation. In Item 1, Investments Segment, Page 17, we discuss our investment strategy, portfolio allocation and quality.
Income from our investments is the most important investment contribution to cash flow. After-tax proceeds of call or maturities also can provide liquidity. Although we have never sold investments to make claims payments, the sale of investments could provide an additional source of liquidity at either the parent company or insurance subsidiary level, if required, although we follow a buy-and-hold investment philosophy seeking to compound cash flows over the long-term. At year-end 2008, total unrealized gains in the investment portfolio, before deferred income taxes, were $588 million, down from $3.339 billion at year-end 2007, because of investment sales and market value declines of our equity holdings.
One way we seek to maintain a solid financial position and provide capital flexibility is by keeping our ratio of debt to total capital low. We now are targeting a ratio below 20 percent. At year-end 2008, the ratio was 16.7 percent compared with 12.7 percent at year-end 2007. The change was due entirely to the lower level of shareholders’ equity at year-end 2008. Based on our present capital requirements, we do not believe we will need to materially increase debt levels during 2009. As a result, we believe that changes in our debt-to-capital ratio will again be a function of changes in shareholders’ equity.
We had $791 million of long-term debt and $49 million in borrowings on our short-term lines of credit at year-end 2008. We generally have minimized our reliance on debt financing although we may use lines of credit to fund short-term cash needs.
$392 million aggregate principal amount of 6.92% senior debentures due 2028.
On December 22, 2008, A.M. Best removed our ratings from under review with negative implications, raised the outlook to stable and lowered Cincinnati Financial Corporation’s issuer credit rating and senior debt ratings to a from aa-; the issuer credit ratings of our standard market property casualty insurance group and member companies to aa from aa+; and the issuer credit ratings of our life insurance subsidiary to a+ from aa-.
On February 13, 2009, Fitch Ratings affirmed the ratings it had assigned on July 17, 2008, when it lowered the issuer default rating of Cincinnati Financial Corporation to A from AA- and its senior debt ratings to A- from A+, with a negative outlook.
Standard & Poor’s Ratings Services removed our counterparty credit ratings from credit watch on June 30, 2008, lowering Cincinnati Financial Corporation to BBB+ and our standard market property casualty insurance companies and our life insurance subsidiary to A+ with a negative outlook.
A long-term perspective governs all of our major decisions, with the goal of benefiting our policyholders, agents, shareholders and associates over time. Exacerbating the effect of our weaker insurance results, the ongoing instability of the financial markets in 2008 highlighted the value of building a cushion of financial strength over a period of years. In responding to current economic pressures, we are confident in the steps we have taken to protect our capital. We also are confident in our strategies to return our insurance operations to growth and profitability.
Our consistent cash flows and prudent cash balances continue to create exceptional liquidity. We enter 2009 with slightly more than $1 billion in cash and cash equivalents on hand, in part due to an unusual level of investment sales and bond calls in the second half of 2008, as well as unusual challenges in making new investments due to economic and market conditions. That high cash level gives us the flexibility to meet current obligations while building value by prudently investing where we see potential for both current income and long-term return.
In any year, we consider the most likely source of pressure on liquidity would be an unusually high level of catastrophe losses in a short period of time. This could create additional obligations for our insurance operations by increasing the severity or frequency of claims. To address the risk of unusual insurance loss obligations including catastrophe events, we maintain property casualty reinsurance contracts with highly rated reinsurers, as discussed under 2009 Reinsurance Programs, Page 81. We also monitor the financial condition of our reinsurers because an insolvency could place in jeopardy a portion of our $759 million in outstanding reinsurance recoverables as of December 31, 2008.
We pay obligations to customers, suppliers and associates in the normal course of our business operations. Some are contractual obligations that define the amount, circumstances and/or timing of payments. We have other commitments for business expenditures, however, the amount, circumstances and/or timing of our other commitments are not dictated by contractual arrangements.
Other operating expenses - Many of our operating expenses are not contractual obligations but reflect the ongoing expenses of our business. Non-commission operating expenses paid rose in the past two years.
Staffing - Staffing expenses are the largest component of our operating expenses. We expect a minimal increase in staffing expenses in 2009. Recent growth in our associate base has been largely limited to positions supporting enhanced service and technology to our agencies and staffing additional field territories.
As of December 31, 2008, we estimate our future contractual obligations as follows:
Our most significant contractual obligations are discussed in conjunction with related insurance reserves in Gross Property Casualty Loss and Loss Expense Payments and Gross Life Insurance Policyholder Obligations on Page 74 and Page 80, respectively. Other future contractual obligations include:
Our estimate of future gross property casualty loss and loss expense payments of $4.040 billion is lower than loss and loss expense reserves of $4.086 billion as of year-end 2008. The $46 million difference is due to life and health loss reserves, as discussed in Item 8, Note 5 of the Consolidated Financial Statements, Page 108.
Our estimates of gross property casualty loss and loss expense payments also do not include reinsurance receivables or ceded losses. As discussed in 2009 Reinsurance Programs, Page 81, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance receivables of $542 million at year-end 2008 are an offset to our gross property casualty loss and loss expense obligations. 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.
The company established a reasonably likely range for net loss and loss expense reserves of $3.256 billion to $3.592 billion at year-end 2008, with the company carrying net reserves of $3.498 billion. The likely range was $3.132 billion to $3.427 billion at year-end 2007, with the company carrying net reserves of $3.397 billion. Our loss and loss expense reserves are not discounted for the time-value of money, 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 5 of the Consolidated Financial Statements, Page 108.
The ranges reflect our assessment of the most likely unpaid loss and loss expenses at year-end 2008 and 2007. 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, 2008, 2007 and 2006, in Item 8, Note 5 of the Consolidated Financial Statements, Page 108. The reconciliation of our year-end 2007 reserve balance to net incurred losses one year later recognizes approximately $323 million of redundant reserves.
The table on the following page shows the development of estimated reserves for loss and loss expenses the past 10 years.
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 2008 but incurred in 2002 are included in the cumulative deficiency or redundancy amount for 2002 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 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.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 75
We carried $114 million of net loss and loss expense reserves for asbestos and environmental claims as of year-end 2008, compared with $123 million for such claims as of year-end 2007. These amounts constitute 2.8 percent and 3.1 percent of total loss and loss expense reserves as of these year-end dates.
Reserving data for asbestos and environmental claims has characteristics that limit the usefulness of the methods and models used to analyze loss and loss expense reserves for other claims. Specifically, asbestos and environmental loss and loss expenses for different accident years do not emerge independently of one another as loss development and Bornhuetter-Ferguson methods assume. In addition, asbestos and
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 76
environmental loss and loss expense data available to date does not reflect a well-defined tail, greatly complicating the identification of an appropriate probabilistic trend family model.
The following table shows net reserve changes at year-end 2008, 2007 and 2006 by commercial line of business and accident year:
Refinements in IBNR reserve allocation - Systems limitations prior to 2006 restricted the detail in which our actuaries could allocate IBNR reserves by accident year. The implementation of new systems at the end of 2005 eliminated those limitations. By the end of 2008, our actuaries had refined their IBNR reserve allocation by accident year to take advantage of the new systems’ flexibility and to more precisely reflect the findings of their quarterly reserve analyses. The new allocation placed a total for all lines of $69 million more reserves in the latest accident year, accident year 2008, than the old allocation would have. Of that $69 million, approximately $49 million was related to commercial lines of business. Accordingly, commercial lines favorable reserve development increased by a like amount for all of calendar year 2008. Commercial casualty’s share of the favorable reserve development was approximately $36 million.
Quarter-to-quarter reductions in actuarial reserve estimates - Our actuaries perform a detailed reserve analysis in the fourth quarter of each year, based on data available through the end of the preceding third quarter to estimate reserves the company should carry at the end of the year. Once fourth quarter data becomes available, they update their analysis to reflect the actual data. The actuaries use the updated analysis to estimate the range of reasonable reserves shown in Range of Reasonable Reserves, Page 74, as well as to guide reserving decisions in the first half of the following year. The updated analysis for 2007 reflected reserve estimates that were $66 million lower than the analysis conducted during the fourth quarter, including updated reserve estimates for commercial casualty that were
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 78
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 79
The following table shows net reserve changes at year-end 2008, 2007 and 2006 by personal line of business and accident year:
Favorable development for personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. As discussed in Commercial Lines Insurance Segment Reserves, Page 77, several atypical factors contributed to commercial lines favorable reserve development in 2008, two of which also contributed to personal lines favorable reserve development. First, during 2008, we refined our allocation of IBNR reserves by accident year. The new allocation placed approximately $20 million more reserves in the latest accident year, accident year 2008, than would have occurred using the prior allocation method. Accordingly, favorable reserve development increased by the same amount for calendar year 2008. Also during 2008, we began using blended trends from two separate reserving models to estimate required personal umbrella reserves as of year-end 2008. This added approximately $14 million of savings from development on prior accident years to the other personal business line.
Our estimates of gross life, annuity and disability obligations do not reflect net recoveries from reinsurance agreements. Ceded life reinsurance receivables were $206 million at year-end 2008. As discussed in 2009 Reinsurance Programs, Page 81, we purchase reinsurance to mitigate or life insurance risk exposure. At year-end 2008, ceded death benefits represented approximately 51.2 percent of our total policy face amounts in force.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 80
These estimated cash outflows are undiscounted with respect to interest. As a result, the sum of the cash outflows for all years of $3.513 billion (total of life insurance obligations) exceeds the liabilities recorded in life policy reserves and separate accounts for future policy benefits and claims of $2.144 billion (total of life insurance policy reserves and separate account policy reserves). Separate account policy reserves make up all but $1 million of separate accounts liabilities.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 81
Terrorism coverage at various levels has been secured in most 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. Our property catastrophe treaty provides coverage for personal risks, and the majority of its reinsurers provide limited coverage for commercial risks with total insured values of $10 million or less. For insured values between $10 million and $25 million, there also may be coverage in the property working treaty.
CSU, the company’s newly formed surplus lines subsidiary, has purchased a property and casualty reinsurance treaty for 2009 through Swiss Reinsurance America Corporation. Primary components of the treaty include:
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 2009. 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 2009. We retain the first $1 million of any policy loss. Losses between $1 million and $5 million are reinsured at 100 percent.
The NAIC recently rejected a package of industry proposals to relax certain statutory reserve and capital requirements. Due to our strong capital position, we do not intend to seek permission from the Ohio Department of Insurance to use these proposals as permitted practices. We continue to monitor the marketplace for attractive alternatives to finance the redundant statutory reserve strain associated with our term life insurance products.
Significant or prolonged decline in the value of a particular security or group of securities and impairment of the asset(s)
Further deterioration in the banking sector or with banks with which we have relationships
Changing consumer buying habits and consolidation of independent insurance agencies that could alter our competitive advantages
Ability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased, financial strength of reinsurers and the potential for non-payment or delay in payment by reinsurers
Events or conditions that could weaken or harm the company’s relationships with its independent agencies and hamper opportunities to add new agencies, resulting in limitations on the company’s opportunities for growth, such as:
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 83
Perceptions that the company’s level of service, particularly claims service, is no longer a distinguishing characteristic in the marketplace
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 84
Deloitte & Touche LLP, our independent registered public accounting firm, audited the consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2008. Their report is on Page 93. Deloitte’s auditors met with our audit committee to discuss the results of their examination. They have the opportunity to discuss the adequacy of internal controls and the quality of financial reporting without management present.
To the Shareholders and Board of Directors of Cincinnati Financial Corporation
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 93
Cincinnati Financial Corporation - Annual Report on 10-K - Page 94
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. CinFin Capital Management will cease operations effective February 28, 2009.
In accordance with GAAP, we have made estimates and assumptions that affect the amounts we report and discuss in the consolidated financial statements and accompanying notes. Actual results could differ from our estimates.
In 2008, the committee approved a mix of stock options and restricted stock units for stock-based awards. Stock options granted had similar terms but generally were awarded for fewer shares compared with previous years to accommodate new awards of service based and performance-based restricted stock units, while keeping the overall estimated cost of stock-based compensation in line with previous years.
Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (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 17, Stock-based Associate Compensation Plans, Page 117 for more information regarding our share-based compensation.
We sponsor a defined benefit pension plan that was modified during 2008. We froze entry into the pension plan and only participants 40 years of age or older could elect to remain in the plan. Our pension expense is based on certain actuarial assumptions and also is composed of several components that are determined using the projected unit credit actuarial cost method. Refer to Note 13, Employee Retirement Benefits, Page 113 for more information regarding our defined benefit pension plan.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 98
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 the policies. We update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate our deferred acquisition cost for recoverability.
When we issue a traditional long-duration contract, we capitalize acquisition costs. Acquisition costs are costs which vary with, and are primarily related to, the production of new business. We then charge these deferred policy acquisition costs to expenses over the premium paying period of the contract and we use the same assumptions that we use when we establish the liability for the contract. We update our acquisition cost assumptions periodically to reflect actual experience and we evaluate our deferred acquisition cost for recoverability.
When we issue a universal life long-duration contract we capitalize acquisition costs. We then charge these capitalized costs to expenses over the term of coverage of the contract. When we charge deferred policy acquisition costs to expenses, we use assumptions based on our best estimates of long-term experience. We review and modify these assumptions on a regular basis.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 100
Facts and circumstances sometimes warrant investment write-downs. We record such other-than-temporary declines as realized investment losses. When evaluating for other-than-temporary impairments, the asset impairment committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost.
In 2006, CFC Investment Company (CFC-I) replaced $49 million of intercompany debt owed to CFC with a short-term line of credit issued by PNC Bank. CFC-I entered into an interest-rate swap contract to hedge against fluctuations of interest payments for certain variable-rate debt obligations ($49 million notional amount) that expires August 29, 2009. In October 2006, we completed necessary requirements for the interest-rate swap to qualify for hedge accounting treatment under the provisions of SFAS No. 133. At December 31, 2008 and 2007, the fair value of the interest rate swap was $1.3 million and $1.2 million, respectively. We do not expect any significant reclassification into consolidated net income for the year ending December 31, 2009.
In 2007, we participated in a securities lending program under which certain fixed-maturity securities from our investment portfolio were loaned to other institutions for short periods of time. We required cash collateral in excess of the market value of the loaned securities. During the third quarter of 2008, we terminated the program.
We capitalize and amortize lease or loan origination costs over the life of the financing using the effective interest method. These costs may include, but are not limited to: finder fees, broker fees, filing fees and the cost of credit reports. We account for these leases and loans as direct financing-type leases.
Our CinFin Capital Management subsidiary generated revenue from management fees. We set those fees based on the market value of assets under management, and we recorded our revenue as it was earned. CinFin Capital Management will cease operations effective February 28, 2009.
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 $35 million in 2008 and $38 million in both 2007 and 2006. 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. There were no recorded land, building and equipment impairments for 2006 through 2008.
There are no amounts in our FIN 48 liability that would change the effective tax rate if recognized. Although no penalties currently are accrued, if incurred, they would be recognized as a component of income tax expense. Accrued interest expense is recognized as other operating expense in the consolidated statements of income.
SFAS No. 163, “Accounting for Financial Guarantee Insurance Contracts - an interpretation of FASB Statement No. 60,” was issued in May 2008. SFAS No. 163 applies to financial guarantee insurance and reinsurance contracts issued by enterprises that are similar to financial guarantee insurance such as mortgage guaranty insurance and credit insurance on trade receivables. The effective date is for financial statements issued for fiscal years beginning after December 15, 2008. The company does not have financial guarantee insurance products and we do not expect adoption of this statement to have any impact on our results of operations and financial position.
In February 2007, the FASB issued SFAS No. 159, “Fair Value Option for Financial Assets and Financial Liabilities - including an amendment of SFAS No. 115.” SFAS No. 159 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 elected to value any assets or liabilities not otherwise measured at fair value under SFAS No. 159. We continue to evaluate the impact of making that election in the future.
In January 2009, the FASB issued FSP No. EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20.” The FSP removes the exclusive reliance upon market participant assumptions about future cash flows when evaluating impairment of securities within its scope. The FSP requires companies to follow impairment guidance in SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” FSP No. EITF 99-20-1 is effective for interim and annual reporting periods ending after December 15, 2008. The adoption of the FSP did not have a material impact on our results of operations and financial position.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 103
At December 31, 2007, 184 fixed-maturity investments with a total unrealized loss of $20 million had been in an unrealized loss position for 12 months or more. Of that total, 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.
During the third quarter of 2008, we terminated a securities lending program that we initiated in 2006. As a result, no securities were on loan at year-end 2008 compared with $745 million at year-end 2007. In conjunction with the program termination, we chose to retain a small portfolio of collateralized mortgage obligations rather than sell them at what we felt were distressed prices in an illiquid market. The CMOs were an investment made by one of the short-duration funds, which subsequently dissolved and distributed the assets to its investors.
We adopted SFAS No. 157 in the first quarter of 2008. Our investment portfolio is subject to SFAS No. 157 disclosure requirements for interim and year-end reporting.
In accordance with SFAS No. 157, we categorized our financial instruments, based on the priority of the observable and market-based data for each valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3).
When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used.
Quotes from brokers or other external sources where it cannot be determined that market participants would in fact transact for the asset or liability at the quoted price;
We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. Reclassification of certain financial instruments may occur when input observability changes. As noted below in the Level 3 disclosure table, reclassifications are reported as transfers in/out of the Level 3 category as of the beginning of the quarter in which the reclassification occurred.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 106
Each financial instrument deemed to have significant unobservable inputs when determining valuation is identified in the table below by security type with a summary of changes in fair value for the year ended December 31, 2008.
Included within earnings for the Level 3 securities for the year ended December 31, 2008, was approximately $19 million of impairment charges. Of the $19 million, approximately $16 million was for impairment of preferred equities.
Unrealized gains or losses on Level 3 securities were included in accumulated other comprehensive income and were not included in net realized investment gains or losses for the year ended December 31, 2008. We transferred approximately $26 million out of Level 3 taxable fixed maturity securities and $19 million into Level 3 taxable fixed maturity securities throughout the year. We also transferred approximately $16 million out of Level 3 preferred equity securities and $7 million into Level 3 preferred equity securities throughout the year.
We provide an updated definition of fair value under SFAS No. 157 in Note 1, Summary of Significant Accounting Policies, Page 98. At December 31, 2008, fair value for annuities and investment contracts was approximately $460 million, using the updated definition. At December 31, 2007, fair value for annuities and investment contracts was approximately $564 million.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 108
At December 31, 2008 and 2007, we had two lines of credit with commercial banks with an aggregate borrowing capacity of $225 million. Our note payable balance was $49 million at year-end 2008, down from $69 million at year-end 2007. We had no compensating balance requirements on short-term debt for either 2008 or 2007. Interest rates charged on borrowings ranged from 2.99 percent to 6.11 percent during 2008.
In 2006, our subsidiary, CFC Investment Company, entered into an interest-rate swap agreement that expires August 29, 2009. The purpose of the interest-rate swap contract was to hedge against fluctuations of interest payments for certain variable-rate debt obligations ($49 million notional amount). 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 $640,000 at year-end 2008 compared with $594,000 at year-end 2007. Management does not expect any significant amounts to be reclassified into earnings as a result of interest rate changes in the next 12 months.
The fair value of our senior debt approximated $595 million at year-end 2008 compared with $802 million at year-end 2007. Fair value for 2008 was determined under SFAS No. 157 based on market pricing of these or similar debt instruments that are actively trading. Fair value can vary with macro economic concerns. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt remained unchanged from year-end 2007. None of the notes are encumbered by rating triggers.
Our insurance subsidiary declared dividends to the parent company of $160 million in 2008, $420 million in 2007 and $275 million in 2006. State regulatory requirements restrict the dividends insurance subsidiaries can pay. Generally, the most our insurance subsidiaries can pay without prior regulatory approval is the greater of 10 percent of policyholder surplus or 100 percent of statutory net income for the prior calendar year. Dividends exceeding these limitations may be paid only with approval of the insurance department of the domiciliary state. During 2009, the total dividends that our lead insurance subsidiary may pay to our parent company without regulatory approval will be approximately $336 million.
As of December 31, 2008, 7.3 million shares of common stock were available for future equity award grants.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 110
Our statements of income include life insurance contract holder benefits incurred on assumed and ceded business:
The differences between the 35 percent statutory income tax rate and our effective income tax rate were as follows:
Although we have not been notified by the IRS of the date of our next audit, it is reasonable to expect that it will begin the audit of tax years 2007 and 2008 in the next 12 months. As a result, it is reasonably possible that a change in the unrecognized tax benefits may occur once the examination phase of this next audit has concluded. At this time, we can neither estimate the settlement date of, nor quantify an estimated range for any potential change to, the unrecognized tax benefits relating to these years.
In addition to our Internal Revenue Service filings, we file income tax returns in various state jurisdictions. Material amounts of income tax are paid to Ohio, Illinois and Florida. Although no state audits are currently under way nor are we aware of any pending audits, tax years 2005 and forward remain open for examination.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 112
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, 2008.
The current sources of dilution of our common shares are certain equity-based awards as discussed in Note 17 Stock-Based Associated Compensation Plans, Page 117. The above table shows the number of anti-dilutive options shares at year-end 2008, 2007 and 2006. 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 also maintain a supplemental executive retirement plan (SERP) with liabilities of approximately $6 million at both year-end 2008 and 2007. The SERP is included in the obligation and expense amounts in the tables below. The company also makes available to a select group of associates the Cincinnati Financial Corporation Top Hat Savings Plan, a non-qualified deferred compensation plan.
For any participant who left the pension plan, benefit accruals were frozen effective August 31, 2008. We transferred $60 million of the pension plan’s accumulated benefit obligation to an intermediary spin-off plan to facilitate the partial curtailment and settlement for these participants. For SERP participants who chose to leave the defined benefit pension plan, benefit accruals were frozen in the SERP as of December 31, 2008. During 2009, the frozen accrued benefit for those participants, collectively amounting to approximately $1 million, will transfer to the Top Hat Savings Plan. Beginning in 2009, for these associates, the company has begun matching deferrals to the Top Hat Savings Plan up to the first 6 percent of an associate’s compensation that exceeds the compensation limit specified by the Internal Revenue Code of 1986, as amended.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 113
Key assumptions used in developing the 2008 net pension expense were a 6.25 percent discount rate, an 8 percent expected return on plan assets and rates of compensation increases ranging from 4 percent to 6 percent. The 8 percent return on plan assets assumption was used for both the qualified plan and the intermediary spin-off plan that was created on September 1, 2008, and is based partially on the fact that substantially all of the investments held by the pension plan are common stocks that pay 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 increased by 0.50 percentage points due to market interest rate conditions. Due to the plan changes described above, we re-measured the net pension expense at September 1, 2008, using a 6.75 percent discount rate.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 114
A reconciliation follows of the funded status for our qualified and SERP plans at the end of the measurement period to the amounts recognized in the balance sheet at December 31, 2008:
Here are the components of our net periodic benefit cost for our qualified and SERP pension plans at December 31:
Our pension plan assets included 642,113 shares of the company’s common stock, which had a fair value of $19 million and $25 million at December 31, 2008 and 2007, respectively. The defined benefit pension plan did not purchase or sell any shares of our common stock during 2008 and 2007. The company paid $1 million in cash dividends on our common stock to the pension plan in both 2008 and 2007.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 115
Insurance companies use statutory accounting practices (SAP) as prescribed by regulatory authorities. The three primary differences between SAP and GAAP are:
On a quarterly basis, we review the outstanding lawsuits seeking such recourse. Based on our year-end review, we believe we have valid defenses to each. As a result, we believe the ultimate liability, if any, with respect to these lawsuits, after consideration of provisions made for estimated losses, will be immaterial to our consolidated financial position.
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 116
We currently have four equity compensation plans that together permit us to grant various types of equity awards. The Cincinnati Financial Corporation 2006 Stock Compensation Plan gives us the flexibility to make grants to associates of any type of stock-based awards, subject to performance-based criteria, to directly link compensation to performance. We currently grant incentive stock options, non-qualified stock options, service-based restricted stock units and performance-based restricted stock units under our plans. We also have a Holiday Stock Plan that permits annual awards of one share of common stock to each full time associate for each year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant common stock to our outside directors.
Compensation cost for all non-vested stock options and performance-based restricted stock units that have non-substantive vesting requirements, such as those to associates who are eligible for retirement.
The total intrinsic value of options exercised during the years ended December 31, 2008, 2007 and 2006, was $1 million, $8 million and $22 million, respectively. (Intrinsic value is the market price less the exercise price.) Options vested during the years ended December 31, 2008 and 2007, had no intrinsic value. The intrinsic value of options vested during the year ended December 31, 2006 was $10 million.
As of December 31, 2008, we had $22 million of unrecognized total compensation cost related to non-vested stock options and restricted stock unit awards. That cost will be recognized over a weighted-average period of 2.2 years.
Dividend yield is determined by dividing the per share dividend by the stock price on the date of grant.
The following weighted average assumptions were used for grants in determining fair value of share-based compensation:
Cincinnati Financial Corporation - 2008 Annual Report on 10-K - Page 117
The weighted-average remaining contractual life for exercisable awards as of December 31, 2008, was 3.9 years. As of December 31, 2008, 7.3 million shares of common stock were available for future equity award grants. We currently issue new shares for option exercises.
Service-based and performance-based restricted stock units are granted to associates at fair market value on the date of grant. Service-based restricted stock units vest as a unit three years after the date of grant.
As of December 31, 2008, management assumed that performance targets used for restricted stock unit awards granted during November 2008 would be met and we recognized related compensation cost. Management concluded that the company would not meet performance targets for all other restricted stock unit awards and did not recognize related compensation costs except for certain awards to retirement eligible associates. For the 2007 performance-based restricted stock awards, we recognize compensation cost during the performance period for retirement-eligible associates. We recognize that cost regardless of whether the performance criteria has been met. The fair value of the restricted stock unit awards was determined based on the fair value on the date of grant less the present value of the dividends that holders of restricted stock units will not receive on the shares underlying the restricted stock units during the vesting period.
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We operate primarily in two industries, property casualty insurance and life insurance. We regularly review four different reporting segments to make decisions about allocating resources and assessing performance:
We report as “Other” the non-investment operations of the parent company and its subsidiaries CFC Investment Company and CinFin Capital Management Company (excluding client investment activities), as well as other income of our standard market property casualty insurance operations and consolidated eliminations. Beginning in 2008, we also are including results of The Cincinnati Specialty Underwriters Insurance Company and CSU Producer Resources in Other. 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.
For the life insurance segment, we calculate underwriting income or loss by recording premiums earned and separate account investment management fees, minus contract holder benefits and expenses incurred, plus investment interest credited to contract holders.
Loss before income taxes for the Other category is primarily due to interest expense from debt of the parent company, operating expenses of our headquarters and, for 2008, loss and loss expenses and underwriting expenses from The Cincinnati Specialty Underwriters Insurance Company.
This table includes unaudited quarterly financial information for the years ended December 31, 2008 and 2007:
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