We begin with an executive summary of our results of operations and outlook, as well as details on critical accounting policies and estimates. Periodically, we refer to estimated industry data so that we can give information on our performance versus the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best, a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory basis. When we provide our results on a comparable statutory basis, we label it as such; all other company data is presented on a GAAP basis.
Cincinnati Financial Corporation is the parent company of the nation’s 23rd largest property casualty insurer, based on statutory net written premium volume through the first six months of 2006, the most recent period for which this information is available. We primarily market commercial lines and personal lines property casualty insurance products through a select group of independent insurance agencies in 32 states. As we discussed in the business description in Item 1, we believe three characteristics distinguish our company and allow us to build shareholder value:
Finally, 2006 earnings reflected the adoption of stock option expensing and, as anticipated, savings from favorable development of prior period losses below the unusually high level in 2005.
Generally, excess and surplus lines insurance carriers provide insurance that is unavailable to businesses in the standard market due to market conditions or due to characteristics of the insured that are caused by nature, the insured’s history or the nature of their business.
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. Security sales led to realized investment gains in the past three years.
2006 - Raised net income by $434 million, or $2.48 per share. The sale of our Alltel common stock holding contributed $412 million, or $2.35 per share, of the gain.
2005 - Raised net income by $40 million, or 23 cents per share.
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. At year-end 2006, weighted average shares outstanding on a diluted basis had declined 2 million from year-end 2005.
Return on equity rose in 2006 due to higher realized gains on investments. Return on equity based on comprehensive income grew in 2006 due to the increase in accumulated other comprehensive income.
Our ratio of long-term debt to capital (long-term debt plus shareholders’ equity) declined in 2006 due to the increase in shareholders’ equity due to higher accumulated other comprehensive income.
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 Segments, Page 9 and Page 11. In each of the past three years, our overall written premium growth rate has exceeded that of the industry. Industry net written premiums were estimated to grow 2.6 percent in 2006 and 4.4 percent in 2004, but declined 0.2 percent in 2005. In the past three years, industry premium trends have been obscured by the reinsurance sector, where premiums were estimated to have risen 25.1 percent in 2006 after declining 28.2 percent in 2005.
The estimated industry average statutory combined ratios were 93.3 percent, 100.8 percent and 98.5 percent for 2006, 2005 and 2004, respectively. The 144.9 percent estimated reinsurance sector combined ratio obscured the industry combined ratio in 2005.
Agent satisfaction with our technology solutions is, and will continue to be, a requirement for maintaining our strong relationships with these agencies. In 2006, we made additional progress in implementing technology solutions that we believe should make it easier for agencies to do business with us. Among other milestones, we have deployed our new commercial lines policy processing system to agencies in seven states for use in processing new and renewal businessowners policies. We also deployed our personal lines policy processing system in six additional states and continued to make important upgrades and enhancements.
We use a variety of metrics to measure the success of our strategies:
Maintaining our strong relationships with our established agencies, writing a significant portion of each agency’s business and attracting new agencies - In 2007, we expect to continue to rank No. 1 or No. 2 by premium volume in approximately 75 percent or more of the locations that have marketed our products for more than five years. We expect to improve service to our agencies by subdividing or creating four field territories in 2007. We also expect to appoint another 50 agencies. We are working on plans to enter New Mexico and eastern Washington within the next year and will soon begin the process by preparing policy forms and rates to submit to the departments of insurance in those states.
Achieving above-industry-average growth in property casualty statutory net written premiums and maintaining industry-leading profitability by leveraging our regional franchise and proven agency-centered business strategy - We believe growth in our consolidated property casualty written premiums may be in the low single digits in 2007 compared with the 3.3 percent increase in 2006.
Legislative and regulatory developments in early 2007 added to the uncertainty that already existed for the insurance industry in Florida. In February 2007, we asked our agents that they not send us new business submissions. This request, which extends to all lines of insurance and other business areas, may result in lower 2007 premium growth. It does not affect policies in force, which we will continue to support and address at renewal, in line with our current underwriting guidelines and in compliance with Florida rules and regulations. We continue to assess the changing insurance environment in Florida and hope to resume writing policies in the state as the market stabilizes.
Overall industry premium growth is projected to be 0.1 percent in 2007, which includes an estimated 18.6 percent reinsurance sector growth rate. Net written premiums for the commercial lines industry are expected to be flat in 2007 while the personal lines sector is expected to grow 1.2 percent.
Savings from favorable reserve development in line with our historical norms. Savings from favorable development on prior period reserves averaged about 2 percentage points between 2000 and 2003. Between 2004 and 2006, the average rose to an unusually high level of approximately 5 percentage points.
Loss ratio deterioration as pricing becomes even more competitive and loss severity increases.
Higher other underwriting expenses as we continue to invest in people and technology. We believe the consolidated property casualty 2007 underwriting expense ratio could be approximately 31.5 percent.
Pursuing a total return investment strategy that generates both strong investment income growth and capital appreciation - In 2007, we are estimating pretax investment income growth to be in the range of 6.5 percent to 7.0 percent. This outlook is based on the higher 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 2006, our compound annual equity portfolio return was 16.1 percent, compared with a compound annual total return of 15.8 percent for the Index. Over the five years ended December 31, 2006, our compound annual equity portfolio return was 2.0 percent compared with a compound annual total return of 6.2 percent for the Index. Our equity portfolio underperformed the market for the five-year period because of the decline in the market value of our holdings of Fifth Third common stock between 2002 and 2005.
Increasing the total return to shareholders through a combination of higher earnings per share, growth in book value and increasing dividends - We do not announce annual targets for earnings per share or book value. Over the long term, we look for our earnings per share growth to outpace that of a peer group of national and regional property casualty insurance companies. Long-term book value growth should exceed that of our equity portfolio.
The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. In February 2007, the board increased the indicated annual dividend rate 6.0 percent, marking the 47th consecutive year of increases in our indicated dividend rate. We believe our record of dividend increases is matched by only 11 other publicly traded corporations.
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 49.4 percent was below the 71.4 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 - 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 approximately 11 percent.
In December 2006, we finalized our property casualty reinsurance program for 2007, updating it to maintain the balance between the cost of the program and the level of risk we retain. Under the new program, our 2007 reinsurance premiums are expected to be $22 million higher than in 2006.
Factors supporting our outlook for 2007 are discussed below in the Results of Operations for each of the four business segments.
Our most significant estimates relate to our reserves for property casualty loss and loss expenses. We believe that the stability of our business makes our historical data the most important source for establishing adequate reserve levels. We base reserve estimates on company experience and information from internal analyses and obtain additional information from the appointed actuary. When reviewing reserves, we analyze historical data
Payment and reporting pattern changes attributable to the implementation of a new claims management system and to the use of a claims mediation process that promotes earlier liability settlement resolution
Reserves are established for the total of unpaid loss and loss expenses, including estimates for claims that have been reported, estimates for claims that have been incurred but not yet reported (IBNR) and estimates of loss expenses associated with processing and settling those claims. Reserves are determined for the various lines of business. Loss reserves are reduced by anticipated salvage and subrogation recoveries.
We establish case reserves for claims that have been reported within the parameters of coverage provided in the policy. Individual case reserves greater than $35,000 established by field claims representatives are reviewed by experienced headquarters claims supervisors while case reserves greater than $100,000 also are reviewed by headquarters claims managers. The estimates reflect the informed judgment and experience of our claims associates based on general insurance reserving practices and their experience with the company. Case reserves are reviewed on a 90-day cycle, or more frequently if specific circumstances require, based on events such as the status of ongoing negotiations.
The anticipated effect of inflation is implicitly considered when estimating reserves for loss and loss expenses. While anticipated cost increases due to inflation are considered in estimating ultimate claim costs, increases in average severity of claims are caused by a number of factors that vary by individual type of policy. Average severity projections are based on historical trends adjusted for anticipated changes in underwriting standards, policy provisions and general economic trends. We do not discount any of our property casualty loss and loss expense reserves.
In 2001, we began to establish higher initial case reserves on serious injury claims. The higher reserves reflect experience indicating the likelihood that juries would ignore significant liability issues in cases involving seriously injured claimants.
The internal actuaries provide a point estimate and a range to summarize their analysis. At year-end 2006 and 2005, IBNR reserves differed from the internal actuarial point estimate by less than 2 percent of our loss and loss expense reserve.
Historically, we have established adequate reserves that have fallen in the upper half of the appointed actuary’s range. This approach has resulted in recognition of reserve redundancies for the past 10 years, as we discuss in Development of Loss and Loss Expenses, Page 64. Modestly redundant reserves support our business strategy to retain high financial strength ratings and remain a market for agencies’ business in all market conditions.
The appointed actuary conducts a thorough evaluation of the adequacy of reserves as of the end of the third quarter of each year and conducts a supplemental review of full-year data at year-end.
The application of our impairment policy resulted in other-than-temporary impairment charges and write-offs of investments that reduced our income before income taxes by $1 million in both 2006 and 2005 and $6 million in 2004.
Our portfolio managers constantly monitor the status of their assigned portfolios for indications of potential problems that may be possible impairment issues. If a security is trading below book value, the portfolio managers even more closely scrutinize the security. Such declines often occur in conjunction with events taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing corporation. These specific criteria include quantitative measurements such as a declining trend in market value, the extent of the market value decline and the length of time the value of the security has been depressed, as well as qualitative measures such as pending events and issuer liquidity. Generally, these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and
When evaluating other-than-temporary impairments, the committee considers the company’s intent and ability to retain a security for a period adequate to recover a significant percentage of cost. Because of the company’s investment philosophy and strong capitalization, it can hold securities that have the potential to recover value until their scheduled redemption, when they might otherwise be deemed impaired. 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 entity operates.
Securities that have already been impaired are evaluated based on their adjusted book value and further written down, 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 2006 in Item 7A, Unrealized Investment Gains and Losses, Page 75. An other-than-temporary decline in the fair value of a security is recognized in net income as realized investment losses.
2006 net pension expense were a 5.50 percent discount rate, an 8 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent.
In 2006, the net pension expense was $19 million. In 2007, we expect a net pension expense of $21 million, primarily as a result of increased service costs, which are expected to more than offset a 0.25 percent reduction in the discount rate.
For property casualty policies, deferred acquisition costs are amortized over the terms of the policies. For life policies, acquisition costs are amortized into income either over the premium-paying period of the policies or the life of the policy, depending on the policy type.
Another significant estimate relates to our accrual for property casualty contingent (profit-sharing) commissions. We base the contingent commission accrual estimates on property casualty underwriting results and on supplemental information. Contingent commissions are paid to agencies using a formula that takes into account agency profitability and other factors, such as prompt monthly payment of amounts due to the company. Due to the complexity of the calculation and the variety of factors that can affect contingent commissions for an individual agency, the amount accrued can differ from the actual contingent commissions paid. The contingent commission accrual of $95 million in 2006 contributed 3.0 percentage points to the property casualty combined ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would affect 2007 net income by $3 million (after tax), or 2 cents per share, and the combined ratio by approximately 0.1 percentage points.
Separate account assets are carried at fair value. Separate account liabilities primarily represent the contract holders’ claims to the related assets and also are carried at the fair value of the assets. Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holders and, therefore, are not included in our Consolidated Statements of Income. However, each separate account contract includes a negotiated realized gain and loss sharing arrangement with the company. This share is transferred from the separate account to our general account 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.
For our most significant separate account, written in 1999, realized gains and losses are retained in the separate account and are deferred and amortized to the contract holder over a five-year period, subject to certain limitations. Upon termination or maturity of this separate account contract, any unamortized deferred gains and/or losses will revert to the general account. In the event this separate account holder were to exchange the contract for the policy of another carrier in 2007, the account holder would pay a surrender charge equal to 4 percent of the contract’s account value. Since year five, the surrender charge has decreased 2 percent each policy year and will fall to 0 percent in policy year 11.
At year-end 2006, net unamortized realized gains amounted to $2 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded, and charged to the general account. Potentially, losses could be material; however, unrealized losses in the separate account portfolio were less than $6 million at year-end 2006.
For the combined 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 readily available. We also use statutory accounting data and ratios as key performance indicators for our life insurance operations. We do not believe that inflation has had a material effect on consolidated results of operations, except to the extent that inflation may affect interest rates. We continue to monitor market trends in construction costs that could affect claim payments and headquarters construction costs.
The calculations of segment data are described in more detail in Item 8, Note 17 of the Consolidated Financial Statements, Page 102. The following sections review results of operations for each of the four segments. Commercial Lines Insurance Results of Operations begins on Page 42, Personal Lines Insurance Results of Operations begins on Page 49, Life Insurance Results of Operations begins on Page 54, and Investments Results of Operations begins on Page 56. We begin with an overview of our consolidated property casualty operations, which is the total of our commercial lines and personal lines segments.
In addition to the factors discussed in Commercial Lines and Personal Lines Insurance Results of Operations, Page 42 and Page 49, growth and profitability for the property casualty insurance operations were affected by:
New business written directly by agencies - New business written directly by agencies was $357 million, $314 million and $330 million in 2006, 2005 and 2004, respectively. New business levels reflected market conditions for commercial and personal lines as well as the advantages of our agency relationship strategy.
Savings from favorable development on prior period reserves reduced the combined ratio by 3.7 percentage points in 2006 compared with 5.2 and 6.7 percentage points in 2005 and 2004. The unusually high level of savings in 2004 partially reflected the release of uninsured motorist/underinsured motorist (UM/UIM) reserves following an Ohio Supreme Court decision in late 2003 to limit its 1999 Scott-Pontzer vs. Liberty Mutual decision.
The adoption of stock option expensing increased the 2006 combined ratio by 0.5 percentage points.
The discussions of property casualty insurance segments provide additional detail regarding these factors.
Combined ratio - Our commercial lines combined ratio rose to 91.3 percent in 2006 largely because of softer pricing, increasing loss severity, less savings from favorable development on prior period reserves and the adoption of stock option expensing. The combined ratio was very strong in 2005 and 2004. We continue to focus on sound underwriting fundamentals and seek to obtain adequate premiums per policy. A single large loss in 2005 increased the ratio in that year by 1.0 percentage point. We discuss large
Stable rates on some of the shorter-tail coverages within the policies.
We intend to remain a stable market for our agencies’ best business, and believe that our case-by-case approach gives us a clear advantage. Our independent agents, field marketing representatives and headquarters underwriters work together to select risks and respond appropriately to local pricing trends. Historically, they have proven capable of balancing risk and price to achieve growth over the longer term.
In 2006, strong new business activity, higher policy retention rates and higher premiums per policy led to net written premium growth in all of our commercial lines of business, with commercial auto rising slightly. In 2005, growth largely was driven by higher commercial casualty premiums with commercial auto premiums declining. Commercial auto is one of the first lines to experience pricing pressure because it often represents the largest portion of insurance costs for commercial policyholders. Commercial auto also is one of the larger, annually priced components of our three-year policies.
From 2004 through 2006, we experienced no growth in overall commercial lines policy counts as growth in accounts with premiums above $10,000 offset a decline in the number of smaller accounts. Agency emphasis and technology considerations were the primary reasons for the shift.
For new business, our field marketing associates and agents are working together to select risks and respond appropriately to local pricing trends. New commercial lines business was $324 million in 2006, up from $282 million in both 2005 and 2004.
We discuss growth by commercial lines of business on Page 47.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. We believe more competitive market conditions and softer pricing contributed to the rise in the loss and loss expense ratio excluding catastrophe losses between 2004 and 2006. In addition, 2005 results include a single large loss that was insufficiently covered through our facultative reinsurance programs, which increased 2005 loss and loss expenses by $22 million, net of reinsurance, or 1.0 percentage points. Savings from favorable loss reserve development moved lower over the three years, which we discuss by commercial lines of business on Page 47.
A refinement and subsequent release of a contingent commission over accrual from 2004 in the first three months of 2005 was responsible for 0.3 percentage points of the decline in 2005. The refinement reflected the use of final 2004 financial data to calculate the contingent commissions paid in 2005. Our 2006 contingent commission accrual reflected our estimate of the profit-sharing commissions that will be paid to our agencies in early 2007.
Policyholder dividend expense was 0.7 percent of earned premium in 2006 compared with 0.2 percent in 2005 and 0.5 percent in 2004. The increase in 2006 was a result of higher paid dividends and increased accrual for future dividends. The increased accrual reflects the improved profitability of workers’ compensation policies with respect to recent policy years.
Approximately 95 percent of our commercial lines premiums relate to accounts with coverages from more than one of our business lines. As a result, we believe that commercial lines is best measured and evaluated on a segment basis. However, we provide the line of business data to summarize growth and profitability trends separately for our business lines.
Another factor that helped produce savings through favorable development was the headquarters claims department initiative to establish higher initial case reserves on serious injury claims. The higher reserves reflect our experience indicating the likelihood that juries would ignore significant liability issues in cases involving seriously injured claimants as well as trends in medical cost inflation and life expectancies.
In large part because this business line also includes umbrella coverages, the accident year loss and loss expense ratio can fluctuate significantly on a year-over-year basis.
Commercial property is our second largest business line. Commercial property net written premiums rose in 2006 and 2005. The primary reason for the more rapid growth in 2006 was a $5 million ceded reinsurance reinstatement premium in 2005 to restore affected layers of our property catastrophe reinsurance program following Hurricane Katrina. This added 1.2 percentage points to the 2006 growth rate.
The commercial property loss and loss expense ratio excluding catastrophe losses improved in 2006 after rising in 2005 and remained within the range we consider appropriate. In each of the last three calendar years, activity in the reserves for prior period losses contributed to the changes in the loss and loss expense ratio.
2006 - Reserve strengthening raised the loss and loss expense ratio by 0.9 percentage points.
2005 - Reserve strengthening raised the loss and loss expense ratio by 3.5 percentage points.
2004 - Reserve strengthening raised the loss and loss expense ratio by 0.3 percentage points.
Commercial auto net written premiums rose slightly in 2006 after declining 2.2 percent in 2005. We are beginning to see the impact of the downward pressure on pricing on underwriting results. 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 is generally one of the larger components of the typical package.
As a result of our underwriting activities and moderating industrywide severity and frequency trends, the loss and loss expense ratio for commercial auto remained at an acceptable level in 2006 and 2005 despite increasing due to pricing pressures. The increase in the loss and loss expense ratio in 2006 also reflected a 2.9 percentage point rise in the ratio of $1 million plus losses to commercial auto earned premiums.
In each of the last three calendar years, favorable development on prior period losses, due to commercial lines re-underwriting efforts and favorable frequency and severity trends, contributed to the changes in the loss and loss expense ratio.
2006 - Favorable development lowered the loss and loss expense ratio by 4.6 percentage points.
2005 - Favorable development lowered the loss and loss expense ratio by 5.0 percentage points.
2004 - Favorable development lowered the loss and loss expense ratio by 10.5 percentage points, including 4.6 percentage points due to the release of UM/UIM reserves.
In 2006 and 2005, workers’ compensation written premiums rose more rapidly than our total commercial lines written premiums. Workers’ compensation premiums are benefiting from the healthy business economy and related payroll growth. Premiums also are benefiting from initiatives to modestly expand our workers’ compensation business in selected states. We cannot offer workers’ compensation coverage in Ohio, our highest volume state, because it is provided solely by the state instead of private insurers.
Specialty packages net written premiums rose in 2006 and 2005. The rollout we have begun of our commercial lines policy processing system should help us meet changing agency needs and address pricing, technology and service systems other carriers have introduced for similar products in recent years.
2004 - Reserve strengthening raised the loss and loss expense ratio by 3.7 percentage points.
2005 - Favorable development lowered the loss and loss expense ratio by 5.4 percentage points.
2004 - Favorable development lowered the loss and loss expense ratio by 9.3 percentage points.
2005 - Favorable development lowered the loss and loss expense ratio by 3.7 percentage points.
2004 - Favorable development lowered the loss and loss expense ratio by 1.3 percentage points.
We intend to continue to market our products to a broad range of business classes, price our products adequately and take 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 regarding rates, the use of three-year commercial policies and other policy terms on a case-by-case basis, even in lines and classes of business that are under competitive pressure. New marketing territories created over the past several years and new agency appointments will contribute to commercial lines growth.
Personal lines new business premiums written directly by agencies increased 1.6 percent to $33 million in 2006 after declining 33.9 percent to $32 million in 2005 and 19.9 percent to $48 million in 2004.
In late 2004, price competition returned to the personal lines market as insurers leveraged the higher profitability and stronger financial positions that were the outcome of industrywide increases in homeowner rates and stricter enforcement of underwriting standards between 2000 and 2003.
We opted to delay certain rate changes to address the competitive situation until mid-2005 because we felt it was more important to fully commit our programming resources to completing necessary modifications and upgrades to our then-new Diamond policy processing system. During that time period, other carriers began making more aggressive use of segmented pricing models, offering lower rates for higher quality accounts.
During 2005 and 2006, we increased the system’s processing power and availability and offered additional functionality requested by agency staff. For example, we began offering convenient account billing to direct bill customers, invoicing for multiple policies at one time, and electronic funds transfer, which accommodates new monthly payment plans. We continue to respond to agency requests for enhancements as we prepare Diamond for additional states.
The policy credits contributed to increases in new business for both personal auto and homeowner for the first time in several years. The new credit structure also led to improved retention of current business. However, new business did not rise sufficiently to offset the lower prices that our current personal lines policyholders received at renewal with these policy credits. As a result, total net written premiums continued to decline in the second half of 2006. To build on the new business and retention trends of the second half of 2006, we will need to monitor the competitiveness of our personal auto and homeowner rates on an ongoing basis and make refinements as necessary.
Strategies to accelerate our personal lines growth are discussed in Personal Lines Outlook, Page 54. We discuss premium trends by personal lines of business on Page 53.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. The change in the loss and loss expense ratio excluding catastrophe losses between 2004 and 2006 largely was due to pricing and loss cost trends. Increased loss severity was seen primarily in higher new losses and case reserve increases greater than $250,000. In total, personal lines new losses and case reserve increases greater than $250,000 were 11.1 percent of annual earned premiums in 2006 compared with 8.2 percent in 2005 and 10.2 percent in 2004. Personal lines new losses and case reserve increases declined as a percent of earned premiums in 2005, in part because of higher rates per exposure. Our analysis indicated no unexpected concentration of these losses and case reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. In 2006, homeowner fires, which spiked in the third quarter, were the most frequent cause for new losses greater than $1 million. We believe loss severity generally is rising, but we cannot predict the magnitude of future increases.
Personal lines catastrophe losses, net of reinsurance and before taxes, contributed 5 percentage points more to the combined ratio in 2006 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.
Personal lines commission expense as a percent of earned premium rose by 0.7 percentage points in 2006 after declining by 0.9 percentage points in 2005. The 2006 change was primarily due to higher profit-sharing commissions resulting from accrual and allocation adjustments. Profit-sharing, or contingent, commissions are calculated on the profitability of an agency’s aggregate book of business, taking into account longer-term profit, with a percentage for prompt payment of premiums and other criteria, and reward the agencies’ efforts. These profit-based commissions generally fluctuate with our loss and loss expenses.
Non-commission underwriting expenses increased 1.2 percentage points in 2006 and 2.0 percentage points in 2005. We continue to invest in our associates and technology, which is contributing to an increase in non-commission underwriting expenses. Higher technology expense contributed 0.8 and 0.5 percentage points to the increase in 2006 and 2005. Higher staffing expense contributed 0.8 to the increase in 2006, with stock option expense accounting for 0.5 percentage points of that amount. Increases in those amounts in 2006 were offset partially by savings in taxes, licenses and fees. The increase in 2005 reflected an unfavorable deferred acquisition cost comparison of 1.0 percentage points due to premium declines.
The loss and loss expense ratio for the homeowner line excluding catastrophe losses rose in 2006 after improving in 2005. The increase in 2006 reflected a higher contribution from large losses. In each of the last three calendar years, activity in the reserves for prior period losses also contributed to the changes in the loss and loss expense ratio.
2006 - Reserve strengthening raised the loss and loss expense ratio by 1.5 percentage points.
2005 - Favorable development lowered the loss and loss expense ratio by 0.4 percentage points.
We continue to seek to improve homeowner results so that this line achieves profitability. Since we generally do not allocate non-commission expenses to individual business lines, to measure homeowner profitability, we now assume total commission and underwriting expenses would contribute approximately 33 percentage points to our homeowner combined ratio, up from a 32 percent assumption in prior years. Lower levels of premium growth affected our ability to attain our expense ratio target in 2006 and may continue to do so in the future.
Other personal written premiums were down slightly in 2006 after rising slightly in 2005. Lower retention and new business for homeowner and personal auto during 2005 and the first half of 2006 contributed to the decline, since most of our other personal coverages are endorsed to homeowner or auto policies.
2006 - Favorable development lowered the loss and loss expense ratio by 28.6 percentage points.
2005 - Favorable development lowered the loss and loss expense ratio by 28.7 percentage points.
We are pursuing a number of strategies in our personal lines business to achieve our long-term objectives for this segment:
New agencies - The availability of Diamond should help us increase the number of agencies that offer our personal lines products, which also should contribute to personal lines growth and geographic diversity. We currently market both homeowner and personal auto insurance products through 772 of our 1,289 reporting agency locations in 22 of the 32 states where we market commercial lines insurance. We market homeowner products through 22 locations in three additional states (Maryland, North Carolina and West Virginia).
Profitability - The life insurance segment reports a small GAAP loss because its investment income is included in investment segment results, except investment income credited to contract holders (interest assumed in life insurance policy reserve calculations). The segment operating profit declined in 2006 after improving in 2005 due to:
We offer term, whole life and universal life products, fixed annuities and disability income products.
Total statutory life insurance net written premiums were $161 million in 2006 compared with $205 million in 2005 and $193 million in 2004. Total statutory written premiums for life insurance operations for all periods include life insurance, annuity and accident and health premiums. The change primarily was due to:
Statutory written annuity premiums declined $58 million in 2006 and increased $18 million in 2005. Since late 2005, we have de-emphasized annuities because of an unfavorable interest rate environment.
Fee income from universal life products declined 14.9 percent to $23 million in 2006 and rose 2.7 percent in 2005 to $27 million. Separate account investment management fee income contributed $3 million, $4 million and $3 million to total revenues in 2006, 2005 and 2004.
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 and northeastern states.
Operating expenses incurred, net of deferred acquisition costs, accounted for 29.7 percent of 2006 total benefits and expenses, 34.0 percent of 2005 total benefits and expenses and 35.7 percent of 2004 total benefits and expenses. Stock option expense added $1 million, or 0.7 percentage points, to expenses in 2006.
We seek to maintain a competitive advantage with respect to benefits paid and reserve increases by consistently achieving better than average claims experience due to skilled underwriting. Commissions paid by the life insurance operation are on par with industry averages. During the past several years, we have invested
in imaging and workflow technology and have significantly improved application processing. We have achieved efficiencies while maintaining our service standards.
Marketplace and regulatory changes continued to affect the availability of cost-effective reinsurance for term life insurance. We are addressing this situation by retaining no more than a $500,000 exposure, ceding the balance using excess over retention mortality coverage and retaining the policy reserve.
Because of the conservative nature of statutory reserving principles, retaining the policy reserve requires a large commitment of capital and reduces statutory earnings. However, we believe the long-term profitability of term life insurance serves to enhance GAAP results. Although the exact timing and details are uncertain, the NAIC continues to make progress toward comprehensive reforms of statutory reserving principles, as we discuss in 2007 Reinsurance Programs, Page 69.
Realized investment gains and losses - We reported realized investment gains in 2006 and 2005 largely due to investment sales. The sale of our Alltel common stock holding contributed $647 million (pretax) of the 2006 gain.
Overall, common stock dividends contributed 42.4 percent of pretax investment income in 2006 compared with 43.7 percent in 2005 and 43.9 percent in 2004. Fifth Third, our largest equity holding, contributed
2004 - We sold $356 million in equity holdings as part of a program to support the financial strength ratings of our property casualty insurance operations. We selected holdings to sell primarily based on the belief of the investment committee and management that these securities would have a lower dividend growth rate over the next several years when compared with other holdings in the portfolio. We also considered the potential tax effect of any unrealized gains. Partial sales of holdings in which we held over $100 million in fair value at year-end 2003 contributed $311 million.
We sold fixed-maturity investments during the past three years as part of our portfolio management strategies. The majority of these were bonds disposed of due to rating or credit concerns, including several in the airline and auto-related industries. Although we prefer to hold fixed-maturity investments until they mature, a decision to sell reflects our perception of a change in the underlying fundamentals of the security and preference to allocate those funds to investments that more closely meet the 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.
The significant decline in other-than-temporary impairment in the past three years was due to prior impairments in the portfolio, disposition of certain securities in prior years and an improvement in the general financial climate.
Other-than-temporary impairment charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 14, are summarized below:
We believe investment income growth for 2007 could be in the range of 6.5 percent to 7.0 percent. This outlook is based on the higher anticipated level of dividend income from equity holdings, the investment of insurance operations cash flow and the current portfolio attributes. In 2007, we expect to allocate a higher proportion of cash available for investment to equity securities, taking into consideration insurance department regulations and ratings agency comments. We continue to identify companies with the potential for revenue, earnings and dividend growth, a strong management team and favorable outlook. These equities offer the potential for steadily increasing dividend income along with capital appreciation. Dividend increases within the last 12 months by Fifth Third and another 37 of the 50 common stock holdings in the equity portfolio should add $16 million to annualized investment income.
In 2006, other income of the insurance subsidiaries, parent company operations and non-investment operations of CFC Investment Company and CinFin Capital Management Company resulted in $14 million in revenues compared with $12 million in 2005 and $8 million in 2004. Losses before income taxes of $51 million in 2006 were primarily due to $51 million in interest expense from debt of the parent company. Losses before income taxes were $50 million and $37 million in 2005 and 2004, when interest expense was $52 million and $36 million, respectively.
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 calculations. Our non-insurance subsidiaries own no tax-advantaged fixed-maturity investments. For our insurance subsidiaries, the dividend received deduction exempts approximately 60 percent of dividends from qualified equities from federal tax calculations. The dividend received deduction exempts 70 percent of dividends from qualified equities for our non-insurance subsidiaries. Details regarding our effective tax rate are found in Item 8, Note 10 to the Consolidated Financial Statements, Page 95.
Our insurance subsidiary declared dividends to the parent company of $275 million in both 2006 and 2005 and $175 million in 2004. State of Ohio regulatory requirements restrict the dividends insurance subsidiaries can pay. During 2007, total dividends that our lead insurance subsidiary can pay to our parent company without regulatory approval are approximately $572 million.
Based on our outlook for commercial lines, personal lines and life insurance, we believe that cash flows from underwriting could decline again in 2007. A lower level of cash flow available for investment could lead to lower investment income and reduced potential for capital gains.
Investment income is a primary source of liquidity for both the parent company and insurance subsidiary. The transfer of equity holdings to our insurance subsidiary from the parent company in 2004 increased the amount of investment income generated at the subsidiary level but had no effect on consolidated investment income. As we discuss under Investments Results of Operations, Page 56, investment income rose in each of the past three years, and we expect investment income could grow 6.5 percent to 7.0 percent in 2007.
We generally have substantial discretion in the timing of investment sales and, therefore, the resulting gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process. In 2007, we expect to continue to limit the disposition of investments to those that no longer meet our investment parameters or those that reach maturity or are called by the issuer. The sale of equity investments that no longer meet our investment criteria can provide cash for investment in common stocks that we perceive to have greater potential for dividend growth and capital appreciation.
At year-end 2006, our debt-to-capital ratio was 11.0 percent. 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 approximately 11 percent.
We provide details of our three long-term notes in Item 8, Note 7 of the Consolidated Financial Statements, Page 93. None of the notes are encumbered by rating triggers.
On April 28, 2006, A.M. Best affirmed its senior debt ratings and issuer credit rating (ICR) of aa- of Cincinnati Financial Corporation. On September 15, 2006, Fitch Ratings affirmed its AA- issuer default rating and A+ senior debt ratings of Cincinnati Financial Corporation. Moody’s maintains our senior debt ratings at A2-. On July 25, 2006, Standard & Poor’s Ratings Services affirmed its A (Strong) counterparty credit rating on Cincinnati Financial Corporation.
At December 31, 2006, we had two lines of credit totaling $125 million with $49 million outstanding. One line of credit for $75 million was established more than five years ago and has no financial covenants. The second line of credit is an unsecured $50 million line of credit from Fifth Third Bank established in 2005 and renewed annually. It is available for general corporate purposes and contains customary financial covenants. During 2006, CFC Investment Company, our commercial leasing and financing subsidiary, replaced $49 million of intercompany debt with $49 million in borrowings against our $75 million line of credit to improve cash flow for the parent company. This line of credit matures on February 28, 2007, and we expect to renew it under terms and conditions that are essentially unchanged.
During 2006, we entered into an interest-rate swap as an economic cash flow hedge of variable interest payments for certain variable-rate debt obligations ($49 million notional amount). Under this interest-rate swap contract, we have agreed to pay a fixed rate of interest for a three-year period. The contract is intended to be a hedge against changes in the amount of future cash flows associated with the related interest payments. The interest-rate swap contract is reflected at fair value in our balance sheet. SFAS No. 133 “Accounting for Derivative Financial Instruments and Hedging Activities,” as amended, requires changes in the fair value of the
company’s derivative financial instruments to be recognized periodically as realized gains or losses on the consolidated statement of income or as a component of accumulated other comprehensive income in shareholders’ equity, respectively. We recorded a $324,000 investment loss in 2006 due to the decline in the fair value of the interest-rate swap.
Our estimate of material commitments for interest on long-term debt was approximately 21.8 percent and our estimate of material commitments for long-term debt was 13.8 percent of the estimated contractual obligations at year-end 2006.
Our interest expense remained unchanged in 2006 at an annual rate of approximately $52 million. We generally have tried to minimize our reliance on debt financing and do not expect a material increase in interest expense from long-term debt in the near future.
Our estimate of material commitments for obligations due under annuities written by our life insurance subsidiary was approximately 3.4 percent of the estimated contractual obligations at year-end 2006.
The historic pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The effective duration of our fixed-maturity portfolio was 5.1 years at year-end 2006. By contrast, the duration of our loss and loss expense reserves was 2.9 years and the duration of all liabilities was 2.6 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow from operations is sufficient to meet these obligations. In addition, our investment strategy has led to substantial unrealized gains from holdings in equity securities. These equity holdings could be liquidated to meet higher than anticipated loss and loss expenses.
We believe that our insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen circumstances such as catastrophe losses, reinsurer insolvencies, changes in the timing of claims payments, increases in claims severity, reserve deficiencies or inadequate premium rates. We believe catastrophic events are the most likely cause of an unexpected rise in claims severity or frequency.
As discussed above, commissions and non-commission underwriting expenses paid rose in each the past two years, reflecting the operating expense trends we discuss in the Commercial Lines and Personal Lines Insurance Results of Operations, Page 42 and Page 49. Commission payments also include contingent, or profit-sharing, commissions, which are paid to agencies using a formula that takes into account agency profitability and other factors. Commission payments generally track with written premiums. Contingent commission payments in 2007 will be influenced by the decline in profitability we experienced in 2006.
In addition to contractual obligations for hardware and software, we anticipate investing approximately $35 million in key technology initiatives in 2007, of which approximately $14 million will be capitalized. Technology projects for 2007 include continued spending on our personal lines policy processing system and investment in the development and rollout of our commercial lines policy processing system that we discuss in Item 1, Technology Solutions, Page 4. Capitalized development costs related to key technology initiatives totaled $15 million in 2006. These activities are conducted at our discretion and we have no material contractual obligations for activities planned as part of these projects.
Effective in 2008, the Pension Protection Act of 2006 changes the manner in which pension funding is determined. We currently are assessing the impact of this Act but do not except it to have a material effect on our results of operations or financial position. We anticipate contributing $10 million to the plan in 2007.
Dividends to shareholders - Over the past 10 years, the company has paid an average of 38 percent of net income as dividends, with the remaining 62 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.
In February 2007, the board of directors authorized a 6.0 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.42 per share. In 2006, 2005 and 2004, we paid cash dividends of $228 million and $204 million and $177 million.
Common stock repurchase - 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. Common stock repurchases for treasury have continued at a steady pace over the last several years and occur when we believe that stock prices on the open market are favorable for such repurchases. At a minimum, we would expect the repurchase to offset dilution from share-based compensation. In 2006, 2005 and 2004, we used $120 million, $63 million and $66 million for share repurchase.
The details of the repurchase activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 26. Between February 1999 and year-end 2006, we have repurchased 17.4 million shares at a total cost to the company of $661 million. We do not adjust the number of shares repurchased and average price per repurchased share for stock dividends.
The appointed actuary’s range for adequate statutory reserves, net of reinsurance, was $3.194 billion to $3.440 billion for 2006; $2.921 billion to $3.153 billion for 2005; and $2.794 billion to $3.032 billion for 2004. The assumptions used to establish the recommended ranges were consistent with the actuary’s practices. Historically, we have established reserves in the upper half of the actuary’s range, as discussed in Critical Accounting Estimates, Property Casualty Loss and Loss Expense Reserves, Page 35.
In 2006, we reviewed each of our established workers’ compensation case reserves above $100,000 in light of current trends in medical cost inflation and estimated payout periods. The review led to the allocation of additional amounts to case reserves held for specific claims from accident years going back as many as 20 years. Our intent is to bring workers’ compensation case reserve adequacy more in line with our other business lines although our success may be affected by additional medical cost inflation and longer life spans.
The table on Page 65 shows the development of the estimated reserves for loss and loss expenses the past 10 years.
Section A shows our total property casualty loss and loss expense reserves recorded at the balance sheet date for each of the indicated calendar years on a gross and net basis. Those reserves represent the estimated amount of unpaid loss and loss expenses for claims arising in the indicated calendar year and all prior accident years at the balance sheet date, including losses that have been incurred but not yet reported to the company.
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, 2006, we had paid $1.175 billion of loss and loss expenses in calendar years 1997 through 2006, for losses that occurred in accident years 1996 and prior. An estimated $148 million of losses remained unpaid as of year-end 2006 (net re-estimated reserves of $1.323 billion from Section C less cumulative paid loss and loss expenses of $1.175 billion).
Section D, cumulative net redundancy, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 1996, had developed a $379 million redundancy over 10 years, net of reinsurance, which was reflected in income over the 10 years. The table shows redundant reserves as a negative number. The effects on income in 2006, 2005 and 2004 of changes in estimates of the reserves for loss and loss expenses for all accident years are shown in the reconciliation below.
Loss and loss expenses incurred for all asbestos and environmental claims were $12 million, or 0.6 percent of total loss and loss expenses in 2006, compared with $12 million, or 0.7 percent in 2005 and $42 million, or 2.4 percent, in 2004.
The overall favorable development recorded in the commercial lines reserves illustrates the potential for revisions inherent in estimating reserves, especially in long-tail lines such as commercial casualty. With the exception of the UM/UIM reserve releases and other significant changes in assumptions discussed above, commercial lines reserve development over the past three years was consistent with:
The initiative, begun in 2001, to establish higher initial case reserves on liability claims in the period in which the claim is reported
A single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event could present us with a liquidity and financial risk. In an effort to control such losses, we forego marketing property casualty insurance in specific geographic areas, monitor our exposure in certain coastal regions, review aggregate exposures to huge disasters and purchase reinsurance. We use the Risk Management Solutions (RMS) and Applied Insurance Research (AIR) models to evaluate exposures in determining appropriate reinsurance coverage programs. In conjunction with these activities, we also continue to evaluate information provided by our reinsurance broker. These various sources explore and analyze credible scientific evidence, including the impact of global climate change, which may affect our exposure under insurance policies.
Currently participating on our property and casualty per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation and its subsidiaries, all of which have A.M. Best insurer financial strength ratings of A (Excellent) or A+ (Superior). Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and European markets.
Primary components of the 2007 property and casualty reinsurance program include:
Property catastrophe treaty - To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, we purchase property catastrophe reinsurance, with a limit up to $500 million. For the 2007 treaty, ceded premiums are estimated to be $49 million, up from $38 million in 2006, and $29 million, excluding the reinstatement premium, in 2005. The premium increase for 2007 primarily was due to the difficult market conditions brought on in part by the record catastrophe losses experienced by reinsurance companies in recent years. Our retention on this program remains at $45 million and we will retain:
Individual risks with insured values in excess of $25 million, as identified in the policy, are handled through a different reinsurance mechanism. We reinsure property coverage for individual risks with insured values between $25 million and $50 million under an automatic facultative treaty. For risks with property values exceeding $50 million, we negotiate the purchase of facultative coverage on an individual certificate basis. For casualty coverage on individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis.
Reinsurance protection for our life insurance business is covered under separate treaties with many of the same reinsurers that write the property casualty working treaties. In 2005, we modified our reinsurance protection for our term life insurance business due to changes in the marketplace that affected the cost and availability of reinsurance for term life insurance. We are retaining no more than a $500,000 exposure, ceding the balance using excess over retention mortality coverage, and retaining the policy reserve. Retaining the policy reserve has no direct impact on GAAP results. However, because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of our capital. We also have catastrophe reinsurance coverage on our life insurance operations
that reimburses us up to $20 million for covered net losses in excess of $5 million. The treaty contains a reinstatement provision, provided the covered losses were not due to terrorism, and contains protection for extra-contractual liability coverage losses. For term life insurance business written prior to 2005, we retain 10 percent to 25 percent of each term policy, not to exceed $500,000, ceding the balance or mortality risk and policy reserve.
Add assessments for guaranty funds, other insurance related assessments or mandatory reinsurance arrangements; or that impair our ability to recover such assessments through future surcharges or other rate changes
Recession or other economic conditions or regulatory, accounting or tax changes resulting in lower demand for insurance products
Events that lead to a significant decline in the value of a particular security and impairment of the asset
Prolonged low interest rate environment or other factors that limit the company’s ability to generate growth in investment income or interest-rate fluctuations that result in declining values of fixed-maturity investments
Events, such as an avian flu epidemic, natural catastrophe, terrorism or construction delays, that could hamper our ability to assemble our workforce at our headquarters location
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, 2006. Their report is on Page 80. Deloitte’s auditors met with our audit committee to discuss the results of their examination. They have the opportunity to present their opinions about the adequacy of internal controls and the quality of financial reporting without management present.
The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2006, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment is based on the criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and was designed to provide reasonable assurance that the company maintained effective internal control over financial reporting as of December 31, 2006. The assessment led management to conclude that, as of December 31, 2006, the company’s internal control over financial reporting was effective based on those criteria.
The company’s independent registered public accounting firm has issued an attestation report on our internal control over financial reporting as of December 31, 2006, and the company’s management assessment of our internal control over financial reporting. This report appears below.
We have audited the consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the company) as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the Index at Item 15(c). We also have audited management’s assessment, included in the Management’s Annual Report on Internal Control Over Financial Reporting report, that the company maintained effective internal control over financial reporting as of December 31, 2006, based on the 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 statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedules, an opinion on management’s assessment, and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audits.
As discussed in Note 1 to the Consolidated Financial Statements, the company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share Based Payment, on January 1, 2006, and the recognition and related disclosure provisions of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension Plans and Other Postretirement Benefit Plans on December 31, 2006.
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, 2006, including the 5 percent stock dividend paid April 26, 2005.
We grant qualified and non-qualified stock options (share-based compensation) under our plans. These stock options are granted to associates at an exercise price that is not less than market price at the date of grant and are exercisable over 10 year periods. Prior to January 1, 2006, we accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, as permitted by the Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. No stock-based employee compensation cost was recognized in the Statement of Income for the years ended December 31, 2005 and 2004, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), Share Based Payment, using the modified-prospective-transition method. We have elected to use the alternative method for determining the beginning balance of the additional paid-in capital pool, as described in FASB Staff Position 123(R)-3. See Note 16, Page 100, for more information regarding our share-based compensation.
We establish reserves to cover the expected cost of claims - or losses - and our expenses related to investigating, processing and resolving claims. Although determining the appropriate amount of reserves including reserves for catastrophe losses is inherently uncertain, we base our decisions on past experience and current facts. Reserves are based on claims reported prior to the end of the year and estimates of unreported claims. We take into account the fact that we may recover some of our costs through salvage and subrogation. We regularly review and update reserves using the most current information available. Any resulting adjustments are reflected in current year insurance losses and policyholder benefits.
We offer several types of life and health insurance and we account for each according to the duration of the contract. Short-duration contracts are written to cover claims that arise during a short, fixed term of coverage. We generally have the right to change the amount of premium charged or cancel the coverage at the end of each contract term. Group life insurance is an example. We record premiums for short-duration contracts similarly to property casualty contracts.
Long-duration contracts are written to provide coverage for an extended period of time. Traditional long-duration contracts require policyholders to pay scheduled gross premiums, generally not less frequently than annually, over the term of the coverage. Premiums for these contracts are recognized as revenue when due. Whole life insurance is an example. Some traditional long-duration contracts have premium payment periods shorter than the period over which coverage is provided. For these contracts the excess of premium over the amount required to pay expenses and benefits is recognized over the term of the coverage rather than over the premium payment period. Ten-pay whole life insurance is an example.
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 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. We estimate loss amounts recoverable from our reinsurers based on the reinsurance policy terms. Historically, our claims with reinsurers have been paid. We do not have an allowance for uncollectible reinsurance.
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.
We primarily base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on data provided by an outside resource that supplies global securities pricing. When a price is not available from these sources, as the case of securities that are not publicly traded, we determine the fair value using quotes from independent brokers. The fair value of investments priced by independent brokers is less than 1 percent of the fair value of our total investment portfolio.
Some of our investments contain embedded options. These investments include convertible debt and convertible preferred stock. We calculate fair value and account for the embedded options separately. The changes in fair values of embedded derivates are recognized in net income in the period they occur.
In 2006, we began actively participating in a securities lending program under which certain fixed-maturity securities from our investment portfolio are loaned to other institutions for short periods of time. We require collateral in excess of the market value of the loaned securities. The collateral is invested in accordance with our guidelines in high-quality, short-duration instruments to generate additional investment income. The market value of the loaned securities is monitored on a daily basis and additional collateral is added or refunded as the market value of the loaned securities changes. The securities lending collateral is recognized as an asset, and classified as securities lending collateral, with a corresponding liability for the obligation to return the collateral.
We capitalize and amortize lease or loan origination costs over the life of the financing using the interest method. These costs may include, but are not limited to: finder fees, broker fees, filing fees and the cost of credit reports.
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 recorded in 2006, 2005 and 2004 was $38 million, $33 million and $30 million, respectively. 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.
changes) to shareholders’ equity in accumulated other comprehensive income. We charge deferred taxes associated with other differences to income.
SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS Nos. 133 and 140
In February 2006, Financial Accounting Standards Board (FASB) issued SFAS No. 155. This accounting standard permits fair value re-measurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year beginning after September 15, 2006.
SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of SFAS Nos. 87, 88, 106, and 132(R)
In September 2006, FASB issued SFAS No. 158, which requires that we recognize the over-funded or under-funded status of our defined benefit plans as an asset or liability. SFAS No. 158 is effective as of December 31, 2006, with changes in the funded status recognized through accumulated other comprehensive income in the year in which they occur.
SAB No. 108, Considering the Effects of Prior Year Misstatements when Qualifying Misstatements in Current Year Financial Statements
In October 2005, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 05-1, which provides accounting guidance for deferred policy acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. Internal replacement contracts are those that are substantially changed from the replaced contract and are accounted for as an extinguishment of the replaced contract. Nonintegrated contract features are accounted for as separately issued contracts. Modifications resulting from the election of a feature or coverage within a contract or from an integrated contract feature generally do not result in an internal replacement contract subject to SOP 05-1 provided certain conditions are met. The provisions of SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. We do not expect this statement to have a material impact on our results of operations or financial position.
This table summarizes activity in the reserve for loss and loss expenses:
Because of changes in estimates of insured events in prior years, we decreased the provision for loss and loss expenses by $116 million, $160 million and $196 million in calendar years 2006, 2005 and 2004. These decreases are partly due to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for amounts less than expected.
The company’s subsidiary, CFC Investment Company, entered into an interest-rate swap agreement during 2006, which expires in three years, to hedge future cash flows (thereby obtaining a fixed interest rate of 5.985 percent) related to certain variable rate debt obligations. This swap is reflected at fair value in the consolidated balance sheets and the unrealized loss, net of tax, at December 31, 2006, of $69,000 is a component of shareholders’ equity in accumulated other comprehensive income. The company does not expect any significant amounts to be reclassified into earnings as a result of interest rate changes in the next 12 months.
Our statements of income include earned property casualty premiums on assumed and ceded business:
Here is a summary of the major components of our net deferred tax liability:
Key assumptions used in developing the 2006 net pension obligation were a 5.75 percent discount rate and rates of compensation increases ranging from 4 percent to 6 percent. To determine the discount rate, the plan’s particular liability characteristics - the amounts, timing and interest sensitivity of expected benefit payments - were evaluated and then matched to a yield curve based on actual high-quality corporate bonds across a full maturity spectrum. Once the plan’s projected cash flows matched the yield curve, a present value was developed, which was then calibrated to a single-equivalent discount rate. That discount rate, when applied to a single sum, would generate the necessary cash flows to pay benefits when due. It was increased by 0.25 percentage points in 2006 due to market interest rates conditions. We based the rates of compensation increase on the company’s historical data, which led us to lower the range from the 5 percent to 7 percent used in previous years.
We evaluate our pension plan assumptions annually and update them as necessary. The discount rate assumptions for our benefit obligation track with Moody’s Aa bond yield, and yearly adjustments reflect any
changes to those bond yields. Compensation increase assumptions reflect historical calendar year compensation increases.
Here are the components of our net periodic benefit cost at December 31:
The estimated costs that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next year are as follows:
Legal issues are part of the normal course of business for all companies. As such, we have various litigation and claims against us in process and pending. Having analyzed those claims with our legal counsel, we believe the outcomes of normal insurance matters will not have a material effect on our consolidated financial position, results of operations or cash flows. We further believe that the outcomes of non-insurance matters will be covered by insurance coverage or will not have a material effect on our consolidated financial position, results of operations or cash flows.
In June 2004 we discovered some uncertainty regarding the status of the Cincinnati Financial Corporation holding (parent) company under the Investment Company Act of 1940. Several tests and enumerated exemptions determine whether a company meets the definition of an investment company under the Investment Company Act. In particular, one test states that a company may be an investment company if it owns investment securities with a value greater than 40 percent of its total assets (excluding assets of its subsidiaries), a level which the holding company exceeded between 1991 and August 2004.
A need to dispose of otherwise desirable investment securities, possibly under undesirable conditions. Such dispositions could result in a lower return on investment because of market value fluctuations. Dispositions also could result in loss of investment income that we may be unable to replace in a timely fashion. If we were unable to manage the timing of the dispositions, we also might realize unnecessary capital gains, which would increase our annual tax payment.
compensation cost for all non-vested stock options granted prior to January 1, 2006, that vested during 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and
In determining the share-based compensation amounts for 2006, the fair value of each option granted in 2006 was estimated on the date of grant using the binomial option-pricing model with the following weighted average assumptions used for grants in 2006: dividend yield of 3.22 percent; expected volatility ranging from 20.25 to 27.12 percent; risk-free interest rates ranging from 4.5 to 4.61 percent; and expected lives of five to seven years.
The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to options granted under our stock option plans prior to our adoption of SFAS No. 123(R) on January 1, 2006. For purposes of this pro forma disclosure, the fair value of each option was estimated on the date of grant using the binomial option-pricing model with the following weighted-average assumptions used for grants in:
Cash received from the exercise of options was $27 million, $11 million and $10 million for the years ended December 31, 2006, 2005 and 2004, respectively. The tax benefit realized on options exercised was $3 million for the year ended December 31, 2006, and less than $1 million for the years ended December 31, 2005 and 2004.
The weighted-average remaining contractual life for exercisable awards as of December 31, 2006, was 4.24 years. As of December 31, 2006, 11.6 million shares of common stock were available for future stock option grants. We currently issue new shares for option exercises.
This table includes unaudited quarterly financial information for the years ended December 31, 2006 and 2005:
First-quarter and full-year 2006 - The company sold its holdings in Alltel Corporation common stock in the first quarter of 2006. The sale contributed $647 million to revenues and $412 million, or $2.35 per share, to net income.