Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building contains approximately 800,000 total square feet. The property, including land, is carried in our financial statements at $68 million as of December 31, 2007, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (1 percent).
We look beyond 2007, recognizing the challenges that will face us and with strategies in place to address those challenges. We remain committed to providing a stable market for our agents’ high quality business, underwriting this business carefully and producing steady value for our shareholders, as represented by the board of directors’ recent decision to increase our 2008 indicated annual cash dividend by 9.9 percent, which would mark the 48th consecutive year of increase in that measure. We believe we can achieve above-industry-average growth in written premiums and industry-leading profitability over the long term by building on our proven strategies: strong agency relationships, local underwriting, quality claims service, solid reserves and total return investing.
As the commercial markets have grown more competitive over the past several years, we have focused on leveraging our local relationships and the efforts of our agents and the teams that work with them. We believe that we are maintaining appropriate pricing discipline for both new and renewal business as we emphasize the importance of assessing account quality to our agencies and underwriters.
Commercial lines commission expense as a percent of earned premium was relatively stable in 2007 after declining by 1.0 percentage points in 2006. 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.
In 2006, we also reviewed each of our established workers’ compensation case reserves above $100,000 in light of current trends in medical cost inflation and estimated payout periods. The review led to an approximate $60 million increase in case reserves held for specific claims from accident years going back as many as 20 years and the identification of several new losses greater than $1 million. Since we had raised workers’ compensation IBNR reserves in 2005 to reflect trends in medical cost inflation and estimated payout periods, we were able to offset $44 million of the case reserve increases through IBNR reserve decreases.
Specialty packages net written premiums rose in 2007 and 2006. The rollout of our commercial lines policy processing system for Businessowners Policies, which are included in this business line, should help us meet changing agency needs and address pricing, technology and service innovations that other carriers have introduced for similar products in recent years.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 55
Realized investment gains and losses - We reported realized investment gains in all three years largely due to investment sales that were discretionary in timing and amount.
During the past three years, fixed maturity securities were divested as a result of calls or as outright sales executed to either improve yield prospects or in response to adverse credit concerns. Although we prefer to hold fixed-maturity investments until they mature, a decision to sell reflects our perception of a change in the underlying fundamentals of the security and preference to allocate those funds to investments that more
We do not utilize any special-purpose financing vehicles or have any undisclosed off-balance sheet arrangements (as that term is defined in applicable SEC rules) that are reasonably likely to have a current or future material effect on the company’s financial condition, results of operation, liquidity, capital expenditures or capital resources. Similarly, the company holds no fair-value contracts for which a lack of marketplace quotations would necessitate the use of fair-value techniques.
Interest on long-term debt - Our interest expense remained unchanged in 2007 at an annual rate of approximately $52 million. We generally have tried to minimize our reliance on debt financing and do not expect a material increase in interest expense from long-term debt in the near future.
The low point of each year’s range corresponds to approximately one standard error below each year’s mean reserve estimate, while the high point corresponds to approximately one standard error above each year’s mean reserve estimate. We discussed management’s reasons for basing reasonably likely reserve ranges on standard errors in Reserve Estimate Variability above.
Management’s best estimate of total loss reserves as of year-end 2007 was consistent with the corresponding actuarial best estimate. Management’s best estimate as of year-end 2006 was above the corresponding actuarial best estimate. Our inter-departmental committee, which includes our actuarial management team, chose a higher estimate for two reasons. First, we incurred three unusually large workers’ compensation claims in accident year 2006 that totaled $12 million. The historical reserving data used to derive the actuarial best estimate for this line of business did not fully reflect those three losses. Second, management recognized the potential for a higher level of loss expense inflation for the commercial casualty line than was reflected in the actuarial best estimate. Management chose the higher level because of a rise in loss expense inflation between 2004 and 2006.
December 31, 1997, had developed a $311 million redundancy over 10 years, net of reinsurance, which was reflected in income over the 10 years. The table shows favorable development in redundant reserves as a negative number. The effects on income in 2007, 2006 and 2005 of changes in estimates of the reserves for loss and loss expenses for all accident years are shown in the reconciliation below.
In evaluating the development of our estimated reserves for loss and loss expenses for the past 10 years, note that each amount includes the effects of all changes in amounts for prior periods. For example, payments or reserve adjustments related to losses settled in 2007 but incurred in 2001 are included in the cumulative deficiency or redundancy amount for 2001 and each subsequent year. In addition, this table presents calendar year data, not accident or policy year development data, which readers may be more accustomed to analyzing. Conditions and trends that affected development of the reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this data.
Lower risk profile after 2001 due to commercial lines underwriting initiatives
We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2007, in accordance with accounting principles generally accepted in the United States of America (GAAP).
The audit committee meets periodically with management, our independent registered public accounting firm and our internal auditors to discuss how each is handling responsibilities. The audit committee reports their findings to the board of directors. The audit committee recommends to the board the annual appointment of the independent registered public accounting firm. The audit committee reviews with this firm the scope of the audit assignment and the adequacy of internal controls and procedures. Deloitte & Touche LLP, our independent registered public accounting firm, audited the consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2007. Their report is on Page 82. Deloitte’s auditors met with our audit committee to discuss the results of their examination. They have the opportunity to present their opinions about the adequacy of internal controls and the quality of financial reporting without management present.
SFAS No. 160, Noncontrolling Interests In Consolidated Financial Statements - an amendment of Accounting Research Bulletin (ARB) No. 51 - In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests In Consolidated Financial Statements - an amendment of Accounting ARB No. 51. SFAS No. 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. The provisions of SFAS No. 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. Management currently is evaluating the effect SFAS No. 160 will have on our results of operations and financial position.
Declared cash dividends per share were $1.42, $1.34 and $1.21 for the years ended December 31, 2007, 2006 and 2005, respectively.
Cincinnati Financial Corporation - 2007 Annual Report on 10-K - Page 97
The IRS has begun the examination phase of its audit for our 2005 and 2006 tax years. It is reasonably possible that a change in the unrecognized tax benefits may occur once the examination phase has concluded. At this time, we can neither estimate the settlement date of, nor quantify an estimated range for any potential change to, the unrecognized tax benefits relating to these years.
Options outstanding and exercisable consisted of the following at December 31, 2007: