Construction of a 690,000 total square foot underground garage and third office tower at our headquarters building began in early 2005. We estimate a completion date of July 2008 for the project. We believe this estimated $100 million expansion will accommodate our business needs for the foreseeable future. The construction project is on schedule and on budget. As of December 31, 2007, construction costs totaled $86 million, which is classified as land, building and equipment, net, for company use.
In 2007, The Cincinnati Life Insurance Company sold a four-story office building in Springdale, Ohio. The property was carried in the financial statements at $3 million as of December 31, 2006, and was classified as other invested assets. A capital gain of $2 million was realized on the sale of the property.
2007 - The company sold 3.8 million shares of its holding in Exxon Mobil Corporation common stock. The sale contributed $217 million (pretax) to realized investment gains and revenues and $141 million (after tax), or 81 cents per share, to net income. The company divested the majority of its real estate investment trust holdings. The sales contributed $73 million (pretax) to realized investment gains and revenues and $47 million (after tax), or 27 cents per share, to net income. The company sold 5.5 million shares of its holdings in Fifth Third Bancorp common stock. The sale contributed $64 million (pretax) to realized investment gains and revenues and $42 million (after tax), or 24 cents per share, to net income. The company sold all of its holdings in FirstMerit Corporation common stock. The sale contributed $59 million (pretax) to realized investment gains and revenues and $38 million (after tax), or 22 cents per share, to net income.
2006 - The company sold all of its holdings in Alltel Corporation common stock. The sale contributed $647 million (pretax) to realized investment gains and revenues and $412 million (after tax), or $2.35 per share, to net income.
2000 - The company recorded a one-time charge of $39 million, pretax, to write down previously capitalized costs related to the development of software to process property casualty policies. The company 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 - 2007 Annual Report on 10-K - Page 31
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 in accordance with accounting principles generally accepted in the United States of America (GAAP).
Among the factors that influence the consolidated results of operations and financial position of the company, we consider our relationships with independent insurance agents to be the most significant. We seek to be an indispensable partner in each agency’s success. To continue to achieve our performance targets, we must maintain these strong relationships, write a significant portion of each agency’s business and attract new agencies that share our business philosophy.
In 2007, we did not achieve some of our objectives for creating shareholder value. For the year, we wrote less new property casualty business than the prior year and market pricing trends led to slightly lower written premiums and put some pressure on our current accident year margins. Nonetheless, we continued to build our company for the long term. Agencies continued to successfully market our products to their better accounts. They gave us $325 million of new property casualty business and helped us maintain the persistency of renewals at more than 90 percent of our accounts. Our equity-focused investment strategy led to another year of record investment income even as declines in the market values of our financial sector common stocks led to lower invested assets and book value.
Over the years, we have been able to increase our share of our agencies’ business by making available insurance products that meet the needs of the individuals and businesses in their communities. In recent years, our agents had indicated their interest in having Cincinnati available as a market for commercial accounts that require the flexibility of excess and surplus lines coverage. Preparations that began in early 2007 to initiate excess and surplus lines operations concluded on schedule in December 2007. Our new subsidiary, The Cincinnati Specialty Underwriters Insurance Company, received an A (Excellent) rating from A.M. Best, an independent provider of insurer ratings. As noted in Item 1, Excess and Surplus Lines Operation Further Enhances Agency Relationships, Page 6, our new wholly owned brokerage CSU Producer Resources began marketing excess and surplus lines policies to selected agencies in five states in January 2008.
Below we review highlights of our financial results for the past three years and measures of the success of our efforts to create shareholder value. Detailed discussion of these topics appears in Results of Operations, Page 42, and Liquidity and Capital Resources, Page 60.
Underwriting profit or loss - The consolidated property casualty underwriting profit rose in 2007 because of lower catastrophe losses and a higher level of savings from favorable development on prior period reserves. In 2006, underwriting profit was below the prior year due to higher catastrophe losses and a lower level savings from favorable development of prior period reserves as well as higher underwriting expenses. These factors are discussed in more detail in the Results of Operations beginning on Page 42.
2006 - Raised net income by $434 million, or $2.48 per share. This amount reflected the sale of our Alltel Corporation common stock holding.
Cash dividends declared per share rose 6.0 percent and 11.2 percent in 2007 and 2006.
Invested assets and total assets declined in 2007, primarily due to lower market values of financial sector equity holdings. Invested assets and total assets rose in 2006 on new investments and appreciation in the equity portfolio.
Comprehensive income is net income plus the year-over-year difference in unrealized gains on investments. Comprehensive income moved in concert with the changes in unrealized investment gains over the three-year period. Unrealized investment gains declined in 2007 because of lower market values of our financial sector holdings, after rising in 2006. Unrealized gains were lower in 2005 primarily due to a decline in the market value of our Fifth Third investment.
Return on equity in 2007 declined slightly due to lower realized gains on investments after rising in 2006 due to higher realized gains on investments. Return on equity based on comprehensive income declined in 2007 because of lower comprehensive income due to lower unrealized investment gains. It rose in 2006 due to the increase in accumulated other comprehensive income.
We also measure a variety of non-financial metrics for our property casualty operations. For example, we monitor our rank within our reporting agency locations. In 2006, we ranked No. 1 or No. 2 by premium volume in 74.2 percent of the locations that have marketed our products for more than five years. Other measures include subdivision of territories and new agency appointments. We ended 2007 with 106 field territories, subdividing three new territories and merging one into the surrounding regions. As discussed in Item 1, Growing with Our Agencies, Page 9, we made 66 new agency appointments in 2007, 50 of which were new relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 38 in 2007.
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Agent satisfaction with our technology solutions is, and will continue to be, a requirement for maintaining our strong relationships with these agencies. In 2007, we made additional progress in implementing technology solutions that we believe should make it easier for agencies to do business with us. Among other 2007 milestones, we deployed our new commercial lines policy processing system to agencies in 10 states for use in processing new and renewal businessowners policies, bringing the year-end total to 17 states. We also deployed our personal lines policy processing system in four states, bringing the year-end total to 17 states, and continued to make important upgrades and enhancements.
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 - If current commercial lines pricing trends continue into 2008, our net written premiums could decline as much as 5 percent compared with the 1.9 percent decline in 2007.
Overall industry premiums are expected to decline 0.6 percent in 2008, which includes an estimated 5.0 percent decline for the reinsurance sector. Net written premiums for the commercial lines sector are expected to be down 2.3 percent in 2008 while the personal lines sector is expected to grow 1.4 percent. The projected industry average 2008 combined ratio is 98.6 percent.
Catastrophe loss ratio - We assume catastrophe losses could contribute approximately 4.5 percentage points to the full-year 2008 combined ratio. We are aware of the unpredictability of catastrophic events in any given year. Catastrophe losses have made an average contribution of 3.7 percentage points to our combined ratio in the past 10 years, ranging from 2007’s low of 0.8 points to 1998’s high of 6.1 points.
In January and February of 2008, storms affecting our policyholders in the Midwest resulted in at least $36 million of pretax catastrophe losses, which will be included in first-quarter 2008 results. This estimate does not take into account any catastrophe activity that may occur in the remainder of the first quarter of 2008 or potential development from events in prior periods.
Savings from favorable development on prior period reserves - To establish this combined ratio estimate, management made the assumption that prior period reserves would develop favorably and that the development would affect the ratio by 4 percentage points. The actual level of development on prior period reserves will be based on sound actuarial analysis.
Increasing the total return to shareholders through a combination of higher earnings per share, growth in book value, increasing dividends and share repurchase - 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, periodically authorizing stock dividends and splits and authorizing share repurchase. In February 2008, the board increased the indicated annual cash dividend rate 9.9 percent, marking the 48th consecutive year of increase in the dividend rate. We believe our record of dividend increases is matched by only 11 other publicly traded corporations. Between January 1 and February 22, 2008, we repurchased 1 million shares under the current board authorization.
The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 of the Consolidated Financial Statements, Page 87. In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company’s critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 36
For some lines of business that we write, a considerable and uncertain amount of time can elapse between the occurrence, reporting and payment of insured claims. The amount we will actually have to pay for such claims also can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. Gross loss and loss expense reserves were $3.925 billion, or 36.7 percent of total liabilities, at year-end 2007, compared with $3.860 billion, or 37.1 percent of total liabilities, at year-end 2006.
Our actuarial staff bases its estimates primarily on the indications of methods and models that analyze accident year data. Accident year is the year in which an insured claim, loss, or loss expense occurred. The specific methods and models that we have used for the past several years are:
such as homeowner and commercial property. For our mid-tail lines such as personal and commercial auto liability, all models and methods provide useful insights.
Emergence of loss and allocated loss expenses on an accident year basis. Historical paid loss, reported loss and paid allocated loss expense data for the business lines we analyze contain patterns that reflect how unpaid losses, unreported losses and unpaid allocated loss expenses as of a financial statement date will emerge in the future on an accident year basis. Unless our actuarial staff or management identifies reasons or factors that invalidate the extension of historical patterns into the future, these patterns can be
used to make projections necessary for estimating IBNR reserves. Our actuaries significantly rely on this assumption in the application of all methods and models mentioned above.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 39
The application of our impairment policy resulted in other-than-temporary impairment charges and realized investment losses that reduced our income before income taxes by $16 million in 2007 and $1 million in both 2006 and 2005.
Our portfolio managers 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 undertake additional reviews. Such declines often occur in conjunction with events taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing organization. Management reviews quantitative measurements such as a declining trend in 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 market conditions. We provide information regarding valuation of our invested assets in Item 8, Note 2 of the Consolidated Financial Statements, Page 93.
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Permanent impairment charges (write-offs) are defined as those for which management believes there is little potential for future recovery, for example, following the bankruptcy of the issuer. A permanent decline in the fair value of a security is written off at the time when facts and circumstances indicate such write-down is warranted, and is reflected in realized investment losses.
Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate would lower our 2008 net income before income taxes by $2 million. Likewise, a 0.5 percentage point decline in the expected return on plan assets would lower our 2008 income before income taxes by $1 million.
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 2008, the account holder would pay a surrender charge equal to 2 percent of the contract’s account value. The surrender charge will fall to 1 percent in 2009 and 0 percent in 2010 and beyond.
The consolidated results of operations reflect the operating results of each of our four segments along with the parent company and other non-insurance activities. The four segments are:
We measure profit or loss for our property casualty and life segments based upon underwriting results (profit or loss), which represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also frequently evaluate results for our consolidated property casualty insurance operations, which is the total of our commercial lines and personal lines insurance segments. Our consolidated property casualty insurance operations generated an unusually low percent of our total revenues in 2007 and 2006 due to sales of investment assets, which are included in the investments segment results. Underwriting results and segment pretax operating income are not substitutes for net income determined in accordance with GAAP.
The calculations of segment data are described in more detail in Item 8, Note 17 of the Consolidated Financial Statements, Page 96. The following sections review results of operations for each of the four segments. Commercial Lines Insurance Results of Operations begins on Page 44, Personal Lines Insurance Results of Operations begins on Page 51, Life Insurance Results of Operations begins on Page 56, and Investments Results of Operations begins on Page 57. We begin with an overview of our consolidated property casualty operations, which is the total of our commercial lines and personal lines segments.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 42
Changes in written and earned premiums over the past three years, reflecting growing price competition partially offset by consistently high retention rates. New business written directly by agencies was $325 million, $357 million and $314 million in 2007, 2006 and 2005, respectively. New business levels reflected market conditions for commercial and personal lines as well as the advantages of our agency relationship strategy.
Non-catastrophe weather-related losses - Approximately 1 percentage point of the increase in the 2007 accident year loss and loss expense ratio was due to higher losses from weather events not deemed to be catastrophes, including a few unusually large losses.
Catastrophe losses contributed 0.8 percentage points to the combined ratio in 2007, the lowest catastrophe loss ratio for our company since 1991. The ratio compared with 5.5 percentage points in 2006 and 4.1 percentage points in 2005. The following table shows catastrophe losses incurred, net of reinsurance, for the past three years as well as the effect of loss development on prior period catastrophe events. Our 2005 Hurricane Katrina and Rita losses included significant losses associated with commercial accounts with operations extending into states where we do not actively market, as well as losses under three assumed reinsurance treaties.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 43
The discussions of our property casualty insurance segments provide additional detail regarding these factors.
Premiums - As competition in our commercial markets continued to increase, our 2007 commercial lines written premiums declined slightly. Softer pricing offset the benefits of our strong agency relationships, healthy policy retention rates, accurate risk classification, and insurance-to-value initiatives. We continue to make deliberate decisions not to write or renew certain business. In this pricing environment we have been careful to maintain our underwriting discipline for both renewal and new business. We believe that our written premium growth rate compares satisfactorily with the average for the overall commercial lines industry, which was estimated to decline 1.5 percent in 2007, after rising 3.5 percent in 2006 and declining 0.4 percent in 2005. Earned premiums remained relatively steady over the period.
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 profitable growth over the longer term.
In 2006, strong new business activity, steady 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 showing the slowest rate of growth.
Primarily because of the heightened competition, new commercial lines business written directly by agencies declined 11.5 percent to $287 million in 2007 after rising 14.9 percent to a record $324 million in 2006.
We discuss growth by commercial line of business below. 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, seeking to ensure that we identified relevant exposures and offered appropriate coverages, terms and conditions and limits of insurance. We continue to adhere to our underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions, where necessary. In addition, we continue to leverage our strong local presence. Our field marketing representatives meet with local agencies to reaffirm agreements on the extent of frontline renewal underwriting agents will perform. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. Field claims representatives prepare full risk reports on any account reporting a loss above $100,000 or on any risk of concern.
Non-commission underwriting expenses rose to 11.9 percent of earned premiums in 2007 from 11.1 percent in 2006 and 10.1 percent in 2005. In 2007, slower earned premium growth led to an unfavorable deferred acquisition expense comparison. Further, our excess and surplus lines start-up activities contributed slightly to higher staffing and technology expenses. Reallocation of expenses between our commercial lines and personal lines segments as we refined our data also contributed to the increase in non-commission underwriting expenses. In 2006, higher technology and staffing expenses contributed 1.2 percentage points to the increase, with stock option expense accounting for 0.5 percentage points of that amount. These increases were offset partially by savings in taxes, licenses and fees.
Policyholder dividend expense was 0.6 percent of earned premium in 2007 compared with 0.7 percent in 2006 and 0.2 percent in 2005.
Approximately 95 percent of our commercial lines premiums relate to accounts with coverages from more than one of our business lines. As a result, we believe that the commercial lines segment is best measured and evaluated on a segment basis. However, we provide line of business data to summarize growth and profitability trends separately for each line. The accompanying accident year loss data provides current estimates of incurred loss and loss expenses and corresponding ratios over the most recent three accident years. Accident year data classifies losses according to the year in which the corresponding loss event occurs, regardless of when the losses are actually reported, recorded or paid.
Commercial casualty is our largest business line. Commercial casualty net written premiums declined slightly in 2007 as competition intensified in the casualty market. In addition, premiums for this business line can reflect economic trends, including changes in underlying exposures.
Commercial property is our second largest business line. Commercial property net written premiums declined slightly in 2007 in part due to higher reinsurance premiums. The 2006 growth rate benefited by 1.2 percentage points due to the effect of a $5 million reinsurance reinstatement premium included in 2005 premiums.
The decline in commercial auto 2007 written premiums 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 is generally one of the larger components of the typical package.
Due to the lengthy payout period of workers’ compensation claims, small shifts in medical cost inflation and payout periods could have a significant effect on our potential future liability compared with our current projections.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 50
Machinery and equipment net written premiums rose slightly in 2007, building on an 8.7 percent increase in 2006. Marketing by machinery and equipment and field marketing representatives contributed to the growth. Conditions in the machinery and equipment insurance marketplace are similar to those of commercial lines overall.
Industrywide commercial lines written premiums are expected to decline approximately 2.3 percent in 2008 with the industry combined ratio estimated at 97.5 percent. As discussed in Item 1, Commercial Lines Insurance Marketplace, Page 12, over the past several years, agents have reported that renewal and new business pricing have come under steadily increasing pressure, reinforcing the need for more flexibility and careful risk selection. We anticipate that commercial lines pricing trends observed in 2007 will persist into 2008.
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, policy term extensions and other policy conditions on a case-by-case basis, even in lines and classes of business that are under competitive pressure. We also expect new marketing territories created over the past several years and new agency appointments will make a growing contribution to commercial lines premiums and underwriting profit in 2008.
We believe our approach should allow us to continue to underwrite commercial lines business profitably in 2008 although we anticipate another year of both lower premiums and a higher commercial lines combined ratio, as ongoing soft market conditions lead to lower premium per exposure. In addition, we do not believe favorable reserve development will continue to contribute to underwriting profits to the extent seen over the past four years. Further, underwriting expenses are rising. We discuss our overall outlook for our property casualty insurance operations in Measuring Our Success in 2008 and Beyond, Page 35.
Premiums - As competition in our personal lines markets rose and we continued to work to generate consistent profitability in our personal lines segment, our written premiums declined in both 2007 and 2006, largely due to pricing that led to lower premiums per policy. Industry average written premiums were estimated to be flat in 2007, after rising 2.0 percent in 2006 and 3.7 percent in 2005.
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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 of stricter enforcement of underwriting standards. Through 2006, our growth and profitability were stymied by delays in implementing rate changes needed to respond to the market and delays in deploying new technology initiatives. During this time, other carriers began using segmented pricing models more aggressively, allowing them to develop more accurate prices for each risk.
Policyholder retention and new business levels have remained at higher levels following our July 2006 introduction of a limited program of policy credits for personal auto and homeowner pricing in most of the states in which our Diamond system is in use. These credits incorporate insurance scores and are intended to improve our ability to compete for our agents’ highest quality personal lines accounts, increasing the opportunity for our agents to market the advantages of our personal lines products and services to their clients. These changes resulted in credits for eligible new and renewal policyholders identified as above-average risks.
We also have deployed our technology solution, Diamond, to 17 states, which represent 97.5 percent of personal lines premiums. We continue to respond to agency requests for enhancements as we prepare Diamond for additional states.
At year-end 2007, new business premiums had risen for six consecutive quarters after declining for the 14 prior quarters. However, the increased new business did not fully offset the impact of lost business and lower rates on above-average quality renewal business. The number of in-force homeowner and personal auto policies has declined since 2003.
Loss and loss expenses include both net paid losses and reserve changes for unpaid losses as well as the associated loss expenses. The trend in the loss and loss expense ratio excluding catastrophe losses over the past three years largely was due to the pricing factors discussed above. This resulted in a steady increase in the accident year loss and loss expense ratio excluding catastrophe losses to 64.2 percent in 2007 from
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 52
61.9 percent in 2006 and 61.5 percent in 2005. Savings from favorable development on prior period reserves reduced the loss and loss expense ratio by 5.7, 2.4 and 4.3 percentage points in 2007, 2006 and 2005, respectively. We discuss the contribution of changes in prior period reserves by personal line of business below.
The rise in the loss and loss expense ratio included a higher contribution from new losses and case reserve increases greater than $250,000. In total, personal lines new losses and reserve increases greater than $250,000 rose to 12.8 percent of earned premium from 11.0 percent in 2006 and 8.2 percent in 2005. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. We believe the increase largely was due to general inflationary trends in loss costs, which we continue to monitor, as well as natural volatility. We also continue to analyze factors that could contribute to a rise in large losses.
Personal lines commission expense as a percent of earned premium rose by 0.4 and 0.7 percentage points in 2007 and 2006. The increases were primarily due to higher profit-sharing commissions resulting from accrual and allocation adjustments. Commission expenses include our profit-sharing, or contingent, commissions, which are calculated on the profitability of an agency’s aggregate property casualty book of Cincinnati business, taking into account longer-term profit and premium volume, with a percentage for prompt payment of premiums and other criteria, and reward the agency’s effort. These profit-based commissions generally fluctuate with our loss and loss expense ratio. Our 2007 contingent commission accrual reflected our estimate of the profit-sharing commissions to be paid to our agencies in early 2008 based largely on each agency’s performance in 2007.
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The decline in written and earned premiums over the past three years largely was due to policy credits adopted in mid-2006 that improved our position in the market by lowering premiums for eligible new and renewal policyholders. The new policy credits have had a positive effect on policyholder retention and new business activity. New business, however, has not yet returned to 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.
The personal auto loss and loss expense ratio excluding catastrophe losses deteriorated in 2007 after several years of stability. The higher ratio in 2007 largely reflected current pricing and normal loss cost trends. In recent years, we have seen generally higher costs for liability claims, including severe injuries, and we are seeking rate increases for liability coverages that would partially offset price decreases we are seeking for physical damage coverages. Pricing decreases and normal loss cost inflation also are the primary drivers in the rise in the accident year loss and loss expense ratio over the past three years.
The homeowner loss and loss expense ratio excluding catastrophes improved in 2007 after deteriorating in 2006. Although the full benefit of pricing and underwriting actions taken between 2004 and 2006 is reflected in homeowner results, this line has not yet achieved breakeven performance if a normalized level of
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Other personal written premiums were essentially unchanged between 2005 and 2007. The decline in the number of homeowner and personal auto policies over the past several years hindered growth in this business line since most of our other personal coverages are endorsed to homeowner or auto policies.
The loss and loss expense ratio for other personal improved in 2007 after deteriorating in 2006. Personal umbrella losses, which are a major component of other personal losses, can fluctuate significantly, and we do not believe that the changes indicated any new trend.
Industry analysts currently anticipate industrywide personal lines written premiums may rise approximately 1.4 percent in 2008 with the combined ratio estimated at 99.5 percent. While the improvement in our new business levels and policy retention rates over the past 18 months are positive indications for our personal lines business, we believe our growth rate will be below that of the industry as we continue to address our pricing structure. We are aware that our personal lines pricing and loss activity are at levels that could put pressure on our future consolidated property casualty insurance combined ratio, if those trends continue.
We plan to take steps in our personal lines insurance operations to enhance our response to the changing marketplace. These strategies should help us achieve our long-term objectives for this segment:
Competitive rates - In mid-2006, we introduced insurance scores into our rating program for homeowner and personal auto pricing. In 2007 we began offering a discount on homeowner policies in some states when an auto policy is also purchased. Previously, we discounted only the auto policy when a policyholder had both policies. Rollout of this credit will continue in additional states in 2008. While these pricing refinements reduced premiums for many policies we write, we believe they present an opportunity to attract our agents’ more quality-conscious clientele. We are working to build on this success with the introduction of more sophisticated rating during 2008.
Value-added products - We introduced three new personal lines products in 2007, supporting our agents’ ability to create packages with marketable differences: Replacement Cost Coverage for a Total Loss - Auto; Personal Auto Plus Endorsement; and Identify Theft Expense Coverage and Advocacy Services. Another new product will begin rolling out in the second half of 2008: Mechanical Breakdown Coverage adds protection for major home systems to the homeowner policy.
We identify several other factors that may affect the personal lines combined ratio in 2008 and beyond. Personal lines underwriters continue to focus on insurance-to-value initiatives to verify that policyholders are buying the correct level of coverage for the value of the insured risk, and we are carefully maintaining underwriting standards. If earned premiums decline more than we expect, the personal lines expense ratio may be higher than the 2007 level because some of our costs are relatively fixed, such as our planned investments in technology. We discuss our overall outlook for our property casualty insurance operations in Measuring Our Success in 2008 and Beyond, Page 35.
Revenues - Driven by higher term life insurance premiums, revenue growth has accelerated over the past three years. Gross in-force policy face amounts increased to $61.875 billion at year-end 2007 from $56.971 billion at year-end 2006 and $51.493 billion at year-end 2005.
Profitability - The life insurance segment frequently 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 reported a nominal operating profit in 2007.
Total statutory life insurance net written premiums were $167 million in 2007 compared with $161 million in 2006 and $205 million in 2005. 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:
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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 29 life field marketing representatives work in partnership with our 106 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.
Contract holders (policyholders) benefits incurred related to traditional life and interest-sensitive products accounted for 71.9 of 2007 total benefits and expenses, 73.8 percent of 2006 total benefits and expenses and 71.3 percent of 2005 total benefits and expenses.
Operating expenses incurred, net of deferred acquisition costs, accounted for 28.1 percent of 2007 total benefits and expenses, 29.7 percent of 2006 total benefits and expenses and 34.0 percent of 2005 total benefits and expenses. Operating expenses rose on an absolute and percentage basis principally because of changes in the amortization of universal life deferred acquisition costs.
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 process efficiencies while improving our service.
The life insurance business is considered mature. In our experience, it is not mature within the property casualty distribution system where cross-sell opportunities abound - both to personal lines and commercial lines clients. In particular, there are approximately 41 million under- and uninsured employees of small business in the United States, making the cross-selling of voluntary, worksite products a huge opportunity for Cincinnati Life’s worksite marketing and sales strategies.
In 2008 we plan to redesign all our term insurance products. In addition to redesigning our worksite term insurance, we will be updating all of the other products in our worksite life insurance portfolio. These improvements support opportunities to cross-sell life insurance products to clients of the independent agencies that sell Cincinnati’s property casualty insurance policies.
Overall, common stock dividends contributed 44.6 percent of pretax investment income compared with 42.4 percent in 2006 and 43.7 percent in 2005. Fifth Third, our largest equity holding, contributed 41.3 percent of total dividend income in 2007. We discuss our Fifth Third investment in Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 73. In 2007, 35 of the 42 common stock holdings in the portfolio raised their indicated annual dividend payout, as did 38 of the 50 in 2006 and 36 of 49 in 2005.
In 2007, we recorded $11 million in fair value declines compared with $7 million in fair value increases in 2006 and $7 million in fair value declines in 2005. In 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 and 2005, 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 87, for details on the accounting for convertible security embedded options.
In 2007, we recorded $16 million in write-downs of investments that we deemed had experienced an other-than-temporary decline in market value versus $1 million in both 2006 and 2005. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 40. The other-than-temporary impairment charges represented less than 0.1 percent of our total invested assets at year-end 2007. Other-than-temporary impairment charges also include unrealized losses of holdings that we have identified for sale but not yet completed a transaction.
Other-than-temporary impairment charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 15, are summarized below:
We believe investment income growth may slow in 2008 as managements of our financial sector holdings evaluate their dividend levels. Our buy-and-hold equity investing strategy has been key to the long-term growth
of our assets and shareholders’ equity. Our common stock investments generally are securities with annual dividend yields that meet or exceed that of the overall market and have the potential for future dividend increases. Other criteria we evaluate include increasing sales and earnings, proven management and a favorable outlook. Over the years, these equities have generally offered a steadily increasing flow of dividend income along with the potential for capital appreciation.
We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth. In 2008, we expect to continue to allocate a proportion of cash available for investment to equity securities, taking into consideration insurance department regulations and ratings agency comments.
In 2007, other income of the insurance subsidiaries, parent company operations and non-investment operations of CFC Investment Company and CinFin Capital Management Company resulted in $15 million in revenues compared with $14 million in 2006 and $12 million in 2005. Losses before income taxes of $46 million in 2007 were primarily due to $49 million in interest expense from debt of the parent company. Losses before income taxes were $51 million and $50 million in 2006 and 2005, when interest expense was $51 million and $52 million, respectively. An immaterial level of expenses for CSU Producer Resources was included in 2007.
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. The dividend received deduction exempts 70 percent of dividends from qualified equities for our non-insurance companies. Details regarding our effective tax rate are found in Item 8, Note 10 of the Consolidated Financial Statements, Page 98.
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ongoing operating expenses and payments of dividends to the parent company. Although we have never sold investments to pay claims, the sale of investments would provide an additional source of liquidity, if required. After satisfying operating cash requirements, cash flows are invested in fixed-maturity and equity securities, leading to the potential for increases in future investment income and unrealized appreciation.
Our insurance subsidiary declared dividends to the parent company of $420 million in 2007 and $275 million in both 2006 and 2005. State of Ohio regulatory requirements restrict the dividends insurance subsidiaries can pay. During 2008, total dividends that our insurance subsidiary can pay to our parent company without regulatory approval are approximately $658 million.
Historically, 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. While first-year life insurance expenses normally exceed the premiums, subsequent premiums are used to generate investment income until the time the policy benefits are paid.
After payment of claims and operating expenses, cash flows from underwriting declined in 2007 and 2006, tracking with the changes in underwriting income discussed in Commercial Lines and Personal Lines Insurance Results of Operations, Pages 44 and 51. We discuss our future obligations for claims payments in Contractual Obligations, Page 63, and our future obligations for underwriting expenses in Other Commitments, Page 64. Insurance subsidiary operating cash flow remained relatively stable over the three years, however, due to rising investment income.
Investment income is a primary source of liquidity for both the parent company and insurance subsidiary. As we discuss under Investments Results of Operations, Page 57, investment income rose in each of the past three years. We anticipate slower growth in investment income in 2008 as our financial sector holdings evaluate their dividend levels. We continue to focus on portfolio strategies to balance near-term income generation and long-term book value growth.
Realized gains also can provide liquidity, although we follow a buy-and-hold investment philosophy seeking to compound cash flows over the long-term. When we dispose of investments, we generally reinvest the gains in new investment securities. Disposition of investments may occur for a number of reasons:
At year-end 2007, our debt-to-capital ratio was 12.7 percent. Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2008. As a result, we believe that changes in our debt-to-capital ratio will be a function of the contribution of unrealized investment gains or losses to shareholders’ equity. We estimate that changes in that measure would not be sufficient to increase the debt-to-capital ratio above our target cap of 15 percent.
We had $791 million of long-term debt and $69 million in borrowings on our short-term lines of credit at year-end 2007. We generally have minimized our reliance on debt financing although we may utilize lines of credit to fund short-term cash needs.
Four independent credit rating organizations affirmed Cincinnati Financial Corporation’s debt ratings in 2007, maintaining stable outlooks on the ratings. On May 21, 2007, A.M. Best affirmed its aa- senior debt ratings and issuer credit rating. On July 26, 2007, Standard & Poor’s Ratings Services affirmed its A counterparty credit rating. On September 18, 2007, Moody’s Investors Service affirmed its A2 senior debt rating. On October 8, 2007, Fitch Ratings affirmed its AA- issuer default rating and A+ senior debt ratings.
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At December 31, 2007, we estimated our future contractual obligations as follows:
Gross property casualty loss and loss expense payments - Our estimate of gross property casualty loss and loss expense payments of $3.925 billion is lower than loss and loss expense reserves of $3.967 billion as of year-end 2007. The $42 million difference is due to life and health losses, as discussed in Item 8, Note 4 of the Consolidated Financial Statements, Page 95.
Our estimates of gross property casualty loss and loss expense payments also do not include reinsurance receivables or ceded losses. As discussed in 2008 Reinsurance Programs, Page 70, we purchase reinsurance to mitigate our property casualty risk exposure. Ceded property casualty reinsurance receivables of $528 million at year-end 2007 offset 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 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 4.84 years at year-end 2007. By contrast, the duration of our loss and loss expense reserves was 3.21 years, and the duration of all liabilities was 2.86 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, if necessary, to meet higher than anticipated loss and loss expenses.
Gross life policyholder obligations - Our estimates of life, annuity and disability policyholder obligations reflect future estimated cash payments to be made to policyholders for future policy benefits, policyholders’ account balances and separate account liabilities. These estimates include death and disability claims, policy surrenders, policy maturities, annuity payments, minimum guarantees on separate account products, commissions and premium taxes offset by expected future deposits and premiums on in-force contracts.
Our estimates of gross life, annuity and disability obligations do not reflect net recoveries from reinsurance agreements. Ceded life reinsurance receivables were $208 million at year-end 2007. As discussed in 2008 Reinsurance Programs, Page 70, we purchase reinsurance to mitigate our life insurance risk exposure. At year-end 2007, ceded death benefits represented approximately 53.3 percent of our total policy face amounts in force.
Factors contributing to our estimation of other future contractual obligations include:
Short-term debt - We plan to renew our $69 million outstanding note payable drawn on our lines of credit.
Headquarters building expansion - The construction project is on schedule and on budget. We expect construction to be completed by July 2008.
Commissions - As discussed above, commissions 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 44 and Page 51. Commission payments generally track with written premiums.
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 is the largest component of our operating expenses and is expected to rise again in 2008, reflecting the 1.7 percent average annual growth in our associate base over the past three years. Our associate base has grown as we focus on enhancing service to our agencies and staffing additional field territories. In 2008, we also anticipate an additional $9 million of expenses related to associate benefit plan modifications. Our benefit plans help us retain experienced associates, attract new talent and provide a measure of security and stability to associates and their families.
In addition to contractual obligations for hardware and software, we anticipate capitalizing $8 million in spending for key technology initiatives in 2008. Technology projects for 2008 are discussed in Item 1, Technology Solutions, Page 4. Capitalized development costs related to key technology initiatives totaled $6 million in 2007. These activities are conducted at our discretion, and we have no material contractual obligations for activities planned as part of these projects.
Disaster recovery and backup data processing center - We expect to spend approximately $26 million in 2008 and 2009 to begin renovation of a newly purchased building that will serve as our disaster recovery and backup data processing center.
In February 2008, the board of directors authorized a 9.9 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.56 per share. In 2007, 2006 and 2005, we paid cash dividends of $240 million, $228 million and $204 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 were a record in 2007, building from the steady pace of the last several years. Repurchases occur when we believe that stock prices on the open market are favorable for such repurchases. Our corporate code of conduct restricts repurchases during certain time
Repurchase activity in 2007 included open market purchases, two private transactions (at market prices) and an ASR agreement under which 4 million shares were purchased at an average price of $39.20. In conjunction with the authorization for the ASR, the board increased its repurchase authorization to an additional 13 million shares.
The details of the repurchase authorizations and activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 27. Between February 1999 and year-end 2007, we have repurchased 24.9 million shares at a total cost to the company of $967 million. We do not adjust the number of shares repurchased and average price per repurchased share for stock dividends.
We carried $123 million of net loss and loss expense reserves for asbestos and environmental claims as of year-end 2007, compared with $131 million for such claims as of year-end 2006. These amounts constitute 3.6 percent and 3.9 percent of total loss and loss expense reserves as of these year-end dates.
Due to these considerations, our actuarial staff elected to use a paid survival ratio method to estimate reserves for incurred but not yet reported asbestos and environmental claims. Although highly uncertain, reserve estimates obtained via this method have held up reasonably well since 2004. Between 2005 and 2007, total asbestos and environmental reserves decreased 1.3 percent. Our exposure to such claims is limited, therefore, we do not believe that a more detailed reserve analysis would be an appropriate use of resources.
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The following table shows net reserve changes at year-end 2007, 2006 and 2005 by commercial line of business and accident year:
The initiative, begun in 2001 and expanded to other states in 2004, to use a claims mediation process that promotes earlier liability settlement resolution
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Gross life policy reserves were $1.478 billion at year-end 2007, compared with $1.409 billion at year-end 2006. We establish reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
A single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event could present us with a liquidity 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 to a once-in-a-100 year and a once-in-a-250 year event to help determine 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.
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions regarding the appropriate level of risk retention are affected by various factors, including changes in our underwriting practices, capacity to retain risks and reinsurance market conditions. 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 covered under any reinsurance agreement depends on the financial viability of the reinsurer.
Casualty per occurrence treaty - The casualty treaty provides capacity up to $25 million. Similar to the property treaty, it provides sufficient capacity to cover the vast majority of casualty accounts we insure and also includes protection for extra-contractual liability coverage losses. We retain the first $5 million of each loss. Losses between $5 million and $25 million are reinsured at 100 percent. The ceded premium is estimated at $45 million in 2008, compared with $50 million in 2007 and $44.8 million in 2006.
Casualty excess treaties - We purchase a casualty reinsurance treaty that provides an additional $25 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $50 million of protection for workers’ compensation, extra-contractual liability coverage and clash coverage losses, which would apply when a single occurrence involved multiple policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated at $1.8 million in 2008, the same premium we paid in 2007.
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 2008 treaty, ceded premiums are estimated at $43 million compared with $48 million in 2007 and $38 million in 2006. Our retention on this program remains at $45 million and we also retain:
19 percent of losses between $300 million and $400 million and
After reinsurance, our maximum exposure to a catastrophic event that caused $500 million in covered losses would be $105 million compared with $103 million in 2007. The largest catastrophe loss in our history was $87 million before reinsurance. The treaty contains one reinstatement provision.
Individual risks with insured values in excess of $25 million, as identified in the policy, are handled through a different reinsurance mechanism. We typically reinsure property coverage for individual risks with insured values between $25 million and $60 million under an automatic facultative treaty. For risks with property values exceeding $60 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.
Terrorism coverage at various levels has been secured in all of our reinsurance agreements. The broadest coverage for this peril is found in the property and casualty working treaties, which provide coverage for commercial and personal risks. 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.
The company’s newly formed excess and surplus lines subsidiary has purchased a property and casualty reinsurance treaty for 2008 through Swiss Reinsurance America Corporation. Primary components of the treaty include:
For property or casualty risks with limits exceeding $5 million, underwriters place facultative reinsurance coverage on an individual certificate basis. The combined property and casualty treaty provides protection on a participating basis for extra contractual obligations, as well as exposure to losses in excess of policy limits. The limit is $5 million for both property and casualty.
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
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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 $40 million for covered net losses in excess of $10 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 of mortality risk and policy reserve.
Factors that could cause or contribute to such differences include, but are not limited to:
Sustained decline in overall stock market values negatively affecting the company’s equity portfolio and book value; in particular a sustained decline in the market value of Fifth Third shares, a significant equity holding
Events, such as the subprime mortgage lending crisis, that lead to a significant decline in the value of a particular security or group of securities, such as our financial sector holdings, and impairment of the asset(s)
Increased competition that could result in a significant reduction in the company’s premium growth rate
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Events, such as an epidemic, natural catastrophe, terrorism or construction delays, that could hamper our ability to assemble our workforce at our headquarters location
All internal control systems, no matter how well designed, have inherent limitations, including the possibility of human error and the circumvention of overriding controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation and presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time. The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2007, 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, 2007. The assessment led management to conclude that, as of December 31, 2007, 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, 2007. This report appears below.
As discussed in Note 1 of the Consolidated Financial Statements, the company adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 123(R), Share Based Payment, on January 1, 2006; the recognition and related disclosure provisions of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension Plans and Other Postretirement Benefit Plans, on December 31, 2006; the provisions of SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS No. 133 and 140, on January 1, 2007; and the provisions of Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an Interpretation of SFAS No. 109, on January 1, 2007.
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Cincinnati Financial operates through our insurance group and three complementary subsidiary companies: The Cincinnati Insurance Company leads our standard market property casualty insurance group that also includes subsidiaries The Cincinnati Casualty Company and The Cincinnati Indemnity Company. This group markets a broad range of standard market business, homeowner and auto policies in 34 states. The group provides quality customer service to our select group of 1,092 local insurance agencies with 1,327 reporting locations. Other subsidiaries of The Cincinnati Insurance Company include The Cincinnati Life Insurance Company, which markets life insurance policies, disability income policies and annuities, and The Cincinnati Specialty Underwriters Insurance Company, which began offering excess and surplus lines insurance products in 2008.
We grant qualified and non-qualified share-based compensation under authorized plans. Until 2007, all stock-based awards were in the form of stock options that had an exercise price equal to the market value of the underlying common stock on the date of grant, vested in equal amounts over the three years following the date of grant and were exercisable over 10 year periods.
In 2007, the committee approved a mix of stock options and restricted stock units for stock-based awards. Service-based stock options awarded had similar terms but generally were awarded for fewer shares compared with previous years to accommodate new awards of restricted stock units while keeping the overall cost of stock-based compensation in line with previous years.
The Cincinnati Insurance Companies actively market property casualty insurance policies in 34 states. Our 10 largest states generated 69.1 percent and 70.0 percent of total property casualty premiums in 2007 and 2006. Ohio, our largest state, accounted for 21.2 percent and 22.0 percent of total earned premiums in 2007 and 2006. Agencies in Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each contributed between 4 percent and 9 percent of premium volume in 2007. The largest single agency relationship accounted for approximately 1.2 percent of the company’s total agency direct earned premiums in 2007.
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 and disability income insurance are examples. 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.
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Universal life contracts are long-duration contracts for which contractual provisions are not fixed, unlike whole life insurance. Universal life contracts allow policyholders to vary the amount of premium, within limits, without our consent. However we may vary the mortality and expense charges, within limits, and the interest crediting rate used to accumulate policy values. We do not record universal life premiums as revenue. Instead we recognize as revenue the mortality charges, administration charges and surrender charges when received. Some of our universal life contracts assess administration charges in the early years of the contract that are compensation for services we will provide in the later years of the contract.
Our portfolio investments are primarily in publicly traded fixed-maturity, equity and short-term investments, classified as available for sale at fair value in the consolidated financial statements. Fixed-maturity investments (taxable bonds, tax-exempt bonds and redeemable preferred stocks) and equity investments (common and non-redeemable preferred stocks) are classified as available for sale and recorded at fair value in the consolidated financial statements. The number of fixed-maturity securities trading below 100 percent of book value can be expected to fluctuate as interest rates rise or fall. Because of our strong surplus and long-term investment horizon, our intent is to hold fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values.
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 committee considers the company’s intent and ability to retain a security for a period adequate to recover its cost.
We primarily base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on prices from FT Interactive Data, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. When a price is not available from these sources, as the case of securities that are not publicly traded, we determine the fair value using cash flow projection models or 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.
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). Under the interest-rate swap contract, CFC-I agreed to pay a fixed rate of interest of 5.66 percent for a three-year period ending 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, 2007 and 2006, the fair value of the interest rate swap was $1.2 million and $430,000, respectively. We do not expect any significant reclassification into consolidated net income for the year ending December 31, 2008.
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 cash collateral in excess of the market value of the loaned securities. The collateral received 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. As this program is accounted for as a secured borrowing, the collateral is recognized as an asset, and classified as securities lending collateral invested, with a corresponding liability for the obligation to return the collateral.
Our CFC Investment Company subsidiary provides auto and equipment direct financing (leases and loans) to commercial and individual clients. We generally transfer ownership of the property to the client as the terms of the leases expire. Our lease contracts contain bargain purchase options. We record income over the financing term using the effective interest method.
We calculate deferred income tax liabilities and assets using tax rates in effect for the time when temporary differences in book and taxable income are estimated to reverse. We recognize deferred income taxes for numerous temporary differences between our taxable income and book-basis income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains on investments and differences in the recognition of deferred acquisition costs and insurance reserves. We charge deferred income taxes associated with unrealized appreciation (except the amounts related to the effect of income tax rate changes) to shareholders’ equity in accumulated other comprehensive income. We charge deferred taxes associated with other differences to income.
FIN No. 48, Accounting For Uncertainty in Income Taxes, an interpretation of SFAS No. 109 - In July 2006, the FASB issued FIN 48. We adopted the provisions of FIN 48 on January 1, 2007.
As a result, we recorded a charge of approximately $300,000 to the January 1, 2007, retained earnings. As of the adoption date, we had a gross unrecognized tax benefit of $24.8 million. See Note 10, Income Taxes, Page 98, for additional information.
On January 1, 2007, we adopted SFAS No. 155, which allows us to account for the entire hybrid financial instrument at fair value, with changes in the fair value recognized in realized investment gains and losses rather than unrealized investment gains and losses. We elected the fair value option for hybrid financial instruments to simplify our reporting, to address cost-benefit considerations and to have a consistent and reliable fair value. The transition adjustment was comprised of $12 million of gross realized investment gains and $4 million of gross realized investment losses, before tax. Our transition adjustment increased retained earnings by $5 million, reducing accumulated other comprehensive income by the same amount.
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, the FASB issued SFAS No. 158, “Employers Accounting for Defined Benefit and Other Retirement Plans - an amendment of FASB Statements No. 87, 88, 106 and 132(R).” SFAS No. 158 requires employers to recognize the overfunded or underfunded status of defined benefit pension and other postretirement benefit plans as an asset or liability in its statement of financial position, measured as the difference between the fair value of plan assets and the projected benefit obligation as of the end of our fiscal year-end. In addition, SFAS No. 158 requires employers to recognize changes in the funded status of defined benefit pension and other postretirement plans in the year in which the changes occur through other accumulated comprehensive income. The company adopted SFAS No. 158 effective December 31, 2006. The adoption of SFAS No. 158 resulted in an increase in liabilities of $32 million on an after-tax basis with a corresponding reduction in accumulated other comprehensive income and shareholders’ equity. SFAS No. 158 did not change the amount of net periodic benefit expense recognized in an entity’s results of operations.
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At year-end 2007, our Fifth Third Bancorp common stock holding, with fair value of $1.691 billion and a cost of $185 million, was our only investment for which the fair value exceeded 10 percent of shareholders’ equity. At year-end 2006, our Fifth Third common stock holding, with fair value of $2.979 billion and a cost of $283 million, and our Exxon Mobil Corporation common stock holding, with a fair value of $687 million and a cost of $133 million, exceeded 10 percent of shareholders’ equity.
When evaluating for other-than temporary impairments, our asset impairment committee considers the company’s intent and ability to retain a security for a period adequate to remain its cost.
Because of changes in estimates of insured events in prior years, we decreased the provision for loss and loss expenses by $244 million, $116 million and $160 million in calendar years 2007, 2006 and 2005. These decreases are partly due to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for amounts less than expected. The reserve for loss and loss expenses in the consolidated balance sheets also includes $42 million, $36 million and $32 million at December 31, 2007, 2006 and 2005, respectively, for certain life and health losses.
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The fair value of our senior debt approximated $802 million at year-end 2007 and $850 million at year-end 2006. None of the notes are encumbered by rating triggers.
Our insurance subsidiary declared dividends to the parent company of $420 million in 2007 and $275 million in both 2006 and 2005. 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 2008, the total dividends that our lead insurance subsidiary may pay to our parent company without regulatory approval will be approximately $658 million.
Our statements of income include earned property casualty insurance premiums on assumed and ceded business:
Deferred tax assets and liabilities reflect temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amount recognized for tax purposes. The significant components of deferred tax assets and liabilities included in the balance sheet at December 31 were as follows:
The provision for federal income taxes is based upon filing a consolidated income tax return for the company and subsidiaries. As of December 31, 2007, we had no operating or capital loss carry forwards.
We adopted the provisions of FIN 48 on January 1, 2007. As a result of the adoption, we recorded a charge of approximately $300,000 to retained earnings. As of the adoption date, we had a gross unrecognized tax benefit (FIN 48 liability) of $25 million.
We reconcile the unrecognized tax benefit between January 1, 2007, and December 31, 2007, as follows:
The FIN 48 liability is carried in other liabilities in the condensed consolidated balance sheets as of December 31, 2007. Included in the FIN 48 liability is an immaterial amount 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 condensed consolidated statements of income. The accrued interest liability was $2.5 million and $1.8 million as of January 1, 2007, and December 31, 2007, respectively. The consolidated statements of income for the current year reflected net Internal Revenue Service interest income of $1.5 million from a reduction in the accrued interest liability and interest received on refund claims.
The IRS has concluded the examination phase of its audit of our 2002 through 2004 tax years. In November 2007, we met with IRS appeals personnel in an attempt to settle the unresolved issues related to those tax years. As a result of the appeals process, we reached a preliminary agreement with the IRS settling those unresolved issues. Until an IRS administrative review for the appeals settlement has been performed, the issues for which preliminary agreement have been reached cannot be considered effectively settled under FIN 48. However, as a result of the preliminary agreement, the FIN 48 liability associated with the 2002 to 2004 tax years have been adjusted and certain assumptions made for our FIN 48 liability associated with the tax years 2005 through 2007 tax years have been adjusted. We anticipate that the 2002 through 2004 tax years will be effectively settled in the next 12 months, resulting in a settlement of the FIN 48 liability of approximately $2 million, primarily related to the valuation of our loss reserves.
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. Of the state jurisdictions, Illinois has concluded an audit of tax years 2004 and 2005 resulting in an immaterial change to tax. No other audits are currently under way, nor is the company aware of any pending audits.
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, 2007.
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We sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension plan covering substantially all employees. We do not contribute to the 401(k) plan but we do pay all operating expenses. Benefits for the defined benefit pension plan are based on years of credited service and compensation level. Contributions are based on the frozen entry age actuarial cost method. We also maintain a supplemental retirement plan (SERP) with liabilities of approximately $6 million and $5 million at year-end 2007 and 2006. The SERP is included in the obligation and expense amounts. 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.
Key assumptions used in developing the 2007 net pension obligation were a 6.25 percent discount rate and rates of compensation increases ranging from 4 percent to 6 percent. To determine the discount rate, the plan’s particular liability characteristics - the amounts, timing and interest sensitivity of expected benefit payments - were evaluated and then matched to a yield curve based on actual high-quality corporate bonds across a full maturity spectrum. Once the plan’s projected cash flows matched the yield curve, a present value was developed, which was then calibrated to a single-equivalent discount rate. That discount rate, when applied to a single sum, would generate the necessary cash flows to pay benefits when due. We increased the rate by 0.5 percentage points in 2007 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.
Key assumptions used in developing the 2007 net pension expense were a 5.75 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 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 0.25 percentage points due to market interest rate conditions.
Benefit obligation activity using an actuarial measurement date at December 31 follows:
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A reconciliation follows of the funded status at the end of the measurement period to the amounts recognized in the balance sheet at December 31, 2007:
The weighted-average assumptions used to determine benefit obligations at December 31 follows:
We evaluate our pension plan assumptions annually and update them as necessary. The discount rate assumptions for our benefit obligation track with Moody’s Aa bond yield and yearly adjustments reflect any changes to those bond yields. Compensation increase assumptions reflect historical calendar year compensation increases.
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.
Compensation cost for all non-vested stock options that have nonsubstantive vesting requirements, such as those to associates who are eligible for retirement.
Results for prior periods have not been retrospectively adjusted for SFAS No. 123(R). As of December 31, 2007, we had $13 million of unrecognized total compensation cost related to non-vested stock options. That cost will be recognized over a weighted-average period of 1.7 years. SFAS No. 123(R) also requires us to classify certain tax benefits related to share-based compensation deductions as cash from financing activities. For the year ended December 31, 2007, these tax benefits totaled $2 million.
In determining the share-based compensation amounts for 2007, the fair value of each option granted in 2007 was estimated on the date of grant using the binomial option-pricing model with the following weighted average assumptions used for grants in 2007: dividend yield of 3.33 percent; expected volatility ranging from 18.29 percent to 24.14 percent; risk-free interest rates ranging from 4.80 percent to 4.81 percent; and expected lives of five to seven years.
The weighted-average remaining contractual life for exercisable awards as of December 31, 2007, was 4.20 years. As of December 31, 2007, 10.6 million shares of common stock were available for future stock option grants. We currently issue new shares for option exercises.
In January 2007, the compensation committee granted service-based and performance-based restricted stock units. The service-based restricted stock units vest at the end of a three-year vesting period. The performance based restricted stock units granted in 2007 will vest on March 1, 2010, if certain performance targets are attained. As of December 31, 2007, management assumed for accounting purposes that performance targets used for the 2007 awards would be met, which resulted in the inclusion of costs for these awards in share-based compensation for 2007.
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 do not receive on the restricted stock units during the vesting period.
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Income before income taxes for the insurance segments is defined as underwriting income or loss.
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Over the course of 2007, we sold 3.8 million shares of Exxon Mobil Corporation, 5.5 million shares of Fifth Third Bancorp common stock, all of our FirstMerit Corporation common stock holdings and disposed of the majority of our real estate investment trust holdings.
In the first quarter of 2006, we sold our Alltel Corporation common stock holding.
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