|• FORM 10-Q • EXHIBIT 31.A • EXHIBIT 31.B • EXHIBIT 32 • XBRL INSTANCE DOCUMENT • XBRL TAXONOMY EXTENSION SCHEMA • XBRL TAXONOMY EXTENSION CALCULATION LINKBASE • XBRL TAXONOMY EXTENSION LABEL LINKBASE • XBRL TAXONOMY EXTENSION PRESENTATION LINKBASE • XBRL TAXONOMY EXTENSION DEFINITION LINKBASE|
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the quarterly period ended June 30, 2012.
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the transition period from _____________________ to _____________________.
Commission file number 0-4604
CINCINNATI FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Registrant’s telephone number, including area code: (513) 870-2000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
þ Yes ¨ No
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
þ Yes ¨ No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company" in Rule 12b-2 of the Exchange Act.
þ Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):
¨ Yes þ No
As of July 23, 2012, there were 162,521,638 shares of common stock outstanding.
CINCINNATI FINANCIAL CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2012
TABLE OF CONTENTS
Part I – Financial Information
Item 1. Financial Statements (unaudited)
Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Balance Sheets
Accompanying notes are an integral part of these condensed consolidated financial statements.
Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Comprehensive Operations
Accompanying notes are an integral part of these condensed consolidated financial statements.
Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Shareholders’ Equity
Accompanying notes are an integral part of these condensed consolidated financial statements.
Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Cash Flows
Accompanying notes are an integral part of these condensed consolidated financial statements.
Notes to Condensed Consolidated Financial Statements (unaudited)
Note 1 — Accounting Policies
The condensed consolidated financial statements include the accounts of Cincinnati Financial Corporation and its consolidated subsidiaries, each of which is wholly owned. These statements are presented in conformity with accounting principles generally accepted in the United States of America (GAAP). All intercompany balances and transactions have been eliminated in consolidation.
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Our actual results could differ from those estimates. The December 31, 2011, condensed consolidated balance sheet amounts are derived from the audited financial statements but do not include all disclosures required by GAAP.
Our June 30, 2012, condensed consolidated financial statements are unaudited. Certain financial information that is included in annual financial statements prepared in accordance with GAAP is not required for interim reporting and has been condensed or omitted. We believe that we have made all adjustments, consisting only of normal recurring accruals, that are necessary for fair presentation. These condensed consolidated financial statements should be read in conjunction with our consolidated financial statements included in our 2011 Annual Report on Form 10-K. The results of operations for interim periods do not necessarily indicate results to be expected for the full year.
Adopted Accounting Updates
ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
In October 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. ASU 2010-26 modified the definitions of the type of costs incurred by insurance entities that can be capitalized in the successful acquisition of new and renewal contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. We retrospectively adopted ASU 2010-26 on January 1, 2012.
The following table illustrates the effect of adopting ASU 2010-26 in the condensed consolidated balance sheets:
The following table illustrates the effect of adopting ASU 2010-26 in the condensed consolidated statements of comprehensive operations:
ASU 2011-04, Fair Value Measurements, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS
In May 2011, the FASB issued ASU 2011-04, Fair Value Measurements, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (IFRS). The ASU converges fair value measurement and disclosures among U.S. GAAP and IFRS. ASU 2011-04 changes certain fair value measurement principles and expands disclosure requirements. The company adopted ASU 2011-04 during the first quarter of 2012, and it did not have a material impact on our company’s financial position, cash flows or results of operations.
ASU 2011-05, Presentation of Comprehensive Income
In December 2011, the FASB issued ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update 2011-05, Presentation of Comprehensive Income. ASU 2011-05 requires entities to present the total of comprehensive income, the components of net income and the components of other comprehensive income either in a single, continuous statement of comprehensive income or in two separate but consecutive statements. ASU 2011-12 defers the changes in ASU 2011-05 that relate to the presentation of reclassification adjustments. The deferral of those changes allows the FASB time to redeliberate whether to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income for all periods presented. The company adopted ASU 2011-12 and ASU 2011-05 during the first quarter of 2012, and it did not have a material impact on our company’s financial position, cash flows or results of operations.
Note 2 – Segment Information
We operate primarily in two industries, property casualty insurance and life insurance. We regularly review our reporting segments to make decisions about allocating resources and assessing performance:
We report as Other the non-investment operations of the parent company and its non-insurer subsidiary, CFC Investment Company. See our 2011 Annual Report on Form 10-K, Item 8, Note 18, Segment Information, Page 136, for a description of revenue, income or loss before income taxes and identifiable assets for each of the five segments.
Segment information is summarized in the following table:
Note 3 – Investments
The following table provides cost or amortized cost, gross unrealized gains, gross unrealized losses and fair value for our invested assets:
The net unrealized investment gains in our fixed-maturity portfolio are primarily the result of the current low interest rate environment that increased the fair value of our fixed-maturity portfolio. Included in corporate fixed maturities are $13 million of AAA rated commercial mortgage-backed securities. The three largest net unrealized investment gains in our common stock portfolio are from Exxon Mobil Corporation (NYSE:XOM), The Procter & Gamble Company (NYSE:PG) and Chevron Corporation (NYSE:CVX), which had a combined net gain position of $269 million. At June 30, 2012, we had $51 million fair value of hybrid securities included in fixed maturities that follow Accounting Standards Codification (ASC) 815-15-25, Accounting for Certain Hybrid Financial Instruments. The hybrid securities are carried at fair value, and the changes in fair value are included in realized investment gains and losses. At June 30, 2012, and December 31, 2011, there were no other-than-temporary impairments included within accumulated other comprehensive income (AOCI).
The table below provides fair values and unrealized losses by investment category and by the duration of the securities’ continuous unrealized loss position:
The following table provides realized investment gains and losses and the change in unrealized investment gains and losses and other items:
During the three and six months ended June 30, 2012 and 2011, there were no credit losses on fixed-maturity securities for which a portion of other-than-temporary impairment (OTTI) has been recognized in other comprehensive income.
During the quarter ended June 30, 2012, we other-than-temporarily impaired four securities. At June 30, 2012, 16 fixed-maturity investments with a total unrealized loss of $4 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity investments had fair values below 70 percent of amortized cost. Three equity investments with a total unrealized loss of less than $1 million had been in an unrealized loss position for 12 months or more as of June 30, 2012. Of that total, no equity investments were trading below 70 percent of cost.
At December 31, 2011, 20 fixed-maturity investments with a total unrealized loss of $5 million had been in an unrealized loss position for 12 months or more. Of that total, no fixed-maturity investments had fair values below 70 percent of amortized cost. Two equity investments with a total unrealized loss of less than $1 million had been in an unrealized loss position for 12 months or more as of December 31, 2011. Of that total, no equity investments were trading below 70 percent of cost.
Note 4 – Fair Value Measurements
Fair Value Hierarchy
In accordance with accounting guidance for fair value measurements and disclosures, we categorized our financial instruments, based on the priority of the observable and market-based data for the valuation technique used, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3). When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used. Our valuation techniques have not changed from those used at December 31, 2011, and ultimately management determines fair value.
Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:
We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. 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 a nationally recognized pricing vendor, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. The company obtains and reviews the pricing service’s valuation methodologies and related inputs and validates these prices by replicating a sample across each asset class using a discounted cash flow model. When a price is not available from these sources, as in the case of securities that are not publicly traded, we determine the fair value using various inputs including quotes from independent brokers. We have generally obtained and evaluated two non-binding quotes from brokers, our investment professionals determine our best estimate of fair value. The fair value of investments not priced by a pricing vendor is less than 1 percent of the fair value of our total investment portfolio. Reclassification of certain financial instruments may occur when input observability changes. All reclassifications are reported as transfers in or out of the Level 3 category as of the beginning of the quarter in which the reclassification occurred.
The technique used for the Level 2 fixed-maturity securities and taxable fixed maturities in separate accounts is the application of matrix pricing. The inputs used include relevant market information by asset class, trade activity of like securities, yield to maturity and economic events. All of the Level 2 fixed-maturity securities are priced by a nationally recognized pricing vendor.
The Level 2 preferred equities technique used is the application of matrix pricing. The inputs used, similar to those used by the pricing vendor for our fixed-maturity securities, include relevant market information, trade activity of like securities, yield to maturity, corporate action notices and economic events. All of the Level 2 preferred equities are priced by a nationally recognized pricing vendor.
Fair Value Disclosures for Assets
The following tables illustrate the fair value hierarchy for those assets measured at fair value on a recurring basis at June 30, 2012, and December 31, 2011. We do not have any material liabilities carried at fair value. There were no transfers between Level 1 and Level 2.
Each financial instrument that was deemed to have significant unobservable inputs when determining valuation is identified in the tables below by security type with a summary of changes in fair value as of June 30, 2012. Total Level 3 assets continue to be less than 1 percent of financial assets measured at fair value in the condensed consolidated balance sheets. Assets presented in the table below were valued based primarily on broker/dealer quotes for which there is a lack of transparency as to inputs used to develop the valuations. The quantitative detail of these unobservable inputs is neither provided nor reasonably available to us.
The following tables provide the change in Level 3 assets for the three months ended June 30:
The following tables provide the change in Level 3 assets for the six months ended June 30:
With the exception of the Level 3 reconciliation table, additional disclosure for the Level 3 category is not material.
Fair Value Disclosure for Assets and Liabilities Not Carried at Fair Value
The disclosures below are presented to provide timely information about the effects of current market conditions on financial instruments that are not reported at fair value in our condensed consolidated financial statements.
This table summarizes the amortized cost and principal amounts of our long-term debt:
The following table shows fair values of our note payable and long-term debt subject to fair value disclosure requirements:
Fair value of the note payable is determined based upon the outstanding balance at June 30, 2012, because it is short term and tied to a variable interest rate. The note payable was classified as Level 2 as a market does not exist.
The fair value of our long-term debt approximated $814 million at year-end 2011. Fair value was determined under the fair value measurements and disclosure accounting rules based on market pricing of similar debt instruments that are actively trading. We determine fair value for our debt the same way that corporate fixed-maturities are valued in our investment portfolio. Fair value can vary with macroeconomic conditions. Regardless of the fluctuations in fair value, the outstanding principal amount of our long-term debt is $793 million. None of the long-term debt is encumbered by rating triggers.
The following table shows the fair value of our life policy loans, included in other invested assets, subject to fair value disclosure requirements:
The fair value of life policy loans outstanding principal and interest approximated $43 million at December 31, 2011. Outstanding principal and interest for these life policy loans was $36 million and $37 million at June 30, 2012, and December 31, 2011, respectively. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates as non-performance risk is minimal; and (2) the loan repayment rate by which policyholders pay off their loan balances is in line with past experience.
The following table shows fair values of our deferred annuities and structured settlements, included in life policy and investment contract reserves, subject to fair value disclosure requirements:
The fair value for deferred annuities and structured settlements were $794 million and $208 million, respectively, at December 31, 2011. Recorded reserves for the deferred annuities and structured settlements were $1.039 billion and $1.025 billion at June 30, 2012, and December 31, 2011, respectively.
Fair values for deferred annuities are calculated based upon internally developed models because active, observable markets do not exist for those items. To determine the fair value, we make the following significant assumptions: (1) the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at June 30, 2012, to account for non-performance risk; (2) the rate of interest credited to policyholders is the portfolio net earned interest rate less a spread for expenses and profit; and (3) additional lapses occur when the credited interest rate is exceeded by an assumed competitor credited rate, which is a function of the risk-free rate of the economic scenario being modeled.
Determination of fair value for structured settlements assumes the discount rates used to calculate the present value of expected payments are the risk-free spot rates plus an A3 rated bond spread for financial issuers at June 30, 2012, to account for non-performance risk.
Note 5 – Property Casualty Loss and Loss Expenses
This table summarizes activity for our consolidated property casualty loss and loss expense reserves:
We use actuarial methods, models and judgment to estimate, as of a financial statement date, the property casualty loss and loss expense reserves required to pay for and settle all outstanding insured claims, including incurred but not reported (IBNR) claims, as of that date. The actuarial estimate is subject to review and adjustment by an inter-departmental committee that includes actuarial management and is familiar with relevant company and industry business, claims and underwriting trends, as well as general economic and legal trends, that could affect future loss and loss expense payments. The amount we will actually have to pay for claims can be highly uncertain. This uncertainty, together with the size of our reserves, makes the loss and loss expense reserves our most significant estimate. The reserve for loss and loss expenses in the condensed consolidated balance sheets also includes $59 million at June 30, 2012, and $56 million at June 30, 2011, for certain life and health loss and loss expense reserves.
During the second quarter of 2012, we experienced $85 million of favorable development on prior accident years. There was $5 million from favorable development of catastrophe losses compared with no favorable development of catastrophe losses at June 30, 2011. Overall favorable development for commercial lines reserves illustrated the potential for revisions inherent in estimating reserves, especially for long-tailed lines such as commercial casualty and workers’ compensation. We recognized favorable reserve development of $56 million for the commercial casualty line and favorable development of $12 million for the workers’ compensation line due to reduced uncertainty of prior accident year loss and loss adjustment expense for these lines.
During the first half of 2012, we experienced $201 million of favorable development on prior accident years. There was $27 million from favorable development of catastrophe losses compared with $1 million at June 30, 2011. We recognized favorable reserve development of $104 million for the commercial casualty line and favorable development of $28 million for the workers’ compensation line due to reduced uncertainty of prior accident year loss and loss adjustment expense for these lines.
Note 6 – Deferred Acquisition Costs
The expenses associated with issuing insurance policies – primarily commissions, premium taxes and underwriting costs – are deferred and amortized over the terms of the policies. We update our acquisition cost assumptions periodically to reflect actual experience, and we evaluate our deferred acquisition costs for recoverability. All acquisition costs reflect ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, which we adopted on January 1, 2012. The table below shows the deferred policy acquisition costs and asset reconciliation, including the amortized deferred policy acquisition costs.
There were no premium deficiencies recorded in the reported condensed consolidated statements of comprehensive income, as the sum of the anticipated loss and loss adjustment expenses, policyholder dividends and unamortized deferred acquisition expenses did not exceed the related unearned premiums and anticipated investment income.
Note 7 – Life Policy and Investment Contract Reserves
We establish the 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 as well as for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
We establish reserves for the company’s universal life, deferred annuity and structured settlement policies equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals. Some of our universal life policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance, based on expected no-lapse guarantee benefits and expected policy assessments.
Note 8 – Reinsurance
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. Primary components of our property and casualty reinsurance program include a property risk treaty, casualty per occurrence treaty and property catastrophe treaty.
Our condensed consolidated statements of comprehensive operations include earned consolidated property casualty insurance premiums on assumed and ceded business:
The decrease in ceded earned premiums for 2012 compared with 2011 is related to earned reinstatement premiums as a result of the increase in catastrophe losses in the second quarter of 2011.
Our condensed consolidated statements of comprehensive income include incurred consolidated property casualty insurance loss and loss expenses on assumed and ceded business:
The decrease in ceded loss and loss expenses for 2012 compared with 2011 is related to the higher catastrophe losses in the second quarter of 2011.
Our life insurance company purchases reinsurance for protection of a portion of the risk that is written. Primary components of our life reinsurance program include individual mortality coverage and aggregate catastrophe and accidental death coverage in excess of certain deductibles. Our condensed consolidated statements of comprehensive operations include earned life insurance premiums on ceded business:
Our condensed consolidated statements of comprehensive operations include life insurance contract holders’ benefits incurred on ceded business:
Note 9 – Net Income Per Common Share
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.
Here are calculations for basic and diluted earnings per share:
The current sources of dilution of our common shares are certain equity-based awards as discussed in our 2011 Annual Report on Form 10-K, Item 8, Note 17, Stock-Based Associate Compensation Plans, Page 134. The above table shows the number of anti-dilutive stock-based awards for the three and six months ended June 30, 2012 and 2011. We did not include these stock-based awards in the computation of net income per common share (diluted) because their exercise would have anti-dilutive effects. Due to the net loss in the second quarter of 2011, the assumed exercise of certain stock options and nonvested shares were excluded from the computation of diluted loss per share.
Note 10 – Employee Retirement Benefits
The following summarizes the components of net periodic costs for our qualified and supplemental pension plans:
See our 2011 Annual Report on Form 10-K, Item 8, Note 13, Employee Retirement Benefits, Page 130, for information on our retirement benefits. We made matching contributions of $3 million and $2 million to our 401(k) and Top Hat savings plans during the second quarter of 2012 and 2011 and contributions of $5 million and $4 million for the first halves of 2012 and 2011, respectively.
We made no contribution to the pension plan during the first half of 2012. We anticipate contributing $14 million in the third quarter of 2012 to our qualified pension plan as indicated in our 2011 Annual Report on Form 10-K.
Note 11 – Stock-Based Compensation Plans
We currently have four equity compensation plans that permit us to grant various types of equity awards. We currently grant incentive stock options, non-qualified stock options, service-based restricted stock units and performance-based restricted stock units, including some with market-based performance objectives, under our shareholder-approved plans to associates. We also have a Holiday Stock Plan that permits annual awards of one share of common stock to each full-time associate for each full calendar year of service up to a maximum of 10 shares. One of our equity compensation plans permits us to grant stock to our outside directors as a component of their annual compensation. For additional information about our equity compensation plans, see our 2011 Annual Report on Form 10-K, Item 8, Note 17, Stock-Based Associate Compensation Plans, Page 134.
A total of 17.3 million shares are authorized to be granted under the shareholder-approved plans. At June 30, 2012, 9.3 million shares were available for future issuance under the plans.
Stock-based awards were granted to associates during 2012 and are summarized in the tables below. Stock-based compensation cost after tax was $3 million for both the three months ended June 30, 2012 and 2011 and $5 million for both the six months ended June 30, 2012 and 2011, respectively. As of June 30, 2012, $27 million of unrecognized compensation costs related to non-vested awards is expected to be recognized over a weighted-average period of 2.2 years.
Here is a summary of option information:
Here is a summary of restricted stock unit information:
Note 12 – Income Taxes
As of June 30, 2012, and December 31, 2011, we had no liability for unrecognized tax benefits. Details about our liability for unrecognized tax benefits are found in our 2011 Annual Report on Form 10-K, Item 8, Note 11, Income Taxes, Pages 129 and 130.
The differences between the 35 percent statutory income tax rate and our effective income tax rate were as follows:
The change in our effective tax rate was primarily due to changes in pretax income from underwriting results and realized investment gains and losses.
Note 13 – Commitments and Contingent Liabilities
In the ordinary course of conducting business, the company and its subsidiaries are named as defendants in various legal proceedings. Most of these proceedings are claims litigation involving the company’s insurance subsidiaries in which the company is either defending or providing indemnity for third-party claims brought against insureds who are litigating first-party coverage claims. The company accounts for such activity through the establishment of unpaid loss and loss adjustment expense reserves. We believe that the ultimate liability, if any, with respect to such ordinary-course claims litigation, after consideration of provisions made for potential losses and costs of defense, is immaterial to our consolidated financial condition, results of operations and cash flows.
The company and its subsidiaries also are occasionally involved in other legal actions, some of which assert claims for substantial amounts. These actions include, among others, putative class actions seeking certification of a state or national class. Such putative class actions have alleged, for example, breach of an alleged duty to search national data bases to ascertain unreported deaths of insureds under life insurance policies. The company’s insurance subsidiaries also are occasionally parties to individual actions in which extra-contractual damages, punitive damages or penalties are sought, such as claims alleging bad faith in the handling of insurance claims or claims alleging discrimination by former associates.
On a quarterly basis, we review these outstanding matters. Under current accounting guidance, we establish accruals when it is probable that a loss has been incurred and we can reasonably estimate its potential exposure. The company accounts for such probable and estimable losses, if any, through the establishment of legal expense reserves. Based on our quarterly review, we believe that our accruals for probable and estimable losses are reasonable and that the amounts accrued do not have a material effect on our consolidated financial condition or results of operations. However, if any one or more of these matters results in a judgment against us or settlement for an amount that is significantly greater than the amount accrued, the resulting liability could have a material effect on the company’s consolidated results of operations or cash flows. Based on our quarterly review, for any other matter for which the risk of loss is more than remote we are unable to reasonably estimate the potential loss or establish a reasonable range of loss.
The following discussion highlights significant factors influencing the consolidated results of operations and financial position of Cincinnati Financial Corporation (CFC). It should be read in conjunction with the consolidated financial statements and related notes included in our 2011 Annual Report on Form 10-K. Unless otherwise noted, the industry data is prepared by A.M. Best Co., 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).
As discussed in Item 1, Note 1, Accounting Policies, Page 7, effective January 1, 2012, we adopted ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. We adjusted applicable financial statements. Related financial data shown in Management’s Discussion and Analysis of Financial Condition and Results of Operations also have been adjusted.
We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and dividends. Dollar amounts are rounded to millions; calculations of percent changes are based on dollar amounts rounded to the nearest million. Certain percentage changes are identified as not meaningful (nm).
Safe Harbor Statement
This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. Some of those risks and uncertainties are discussed in our 2011 Annual Report on Form 10-K, Item 1A, Risk Factors, Page 26.
Factors that could cause or contribute to such differences include, but are not limited to:
Further, the company’s insurance businesses are subject to the effects of changing social, economic and regulatory environments. Public and regulatory initiatives have included efforts to adversely influence and restrict premium rates, restrict the ability to cancel policies, impose underwriting standards and expand overall regulation. The company also is subject to public and regulatory initiatives that can affect the market value for its common stock, such as measures affecting corporate financial reporting and governance. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
Corporate Financial Highlights
Statements of Comprehensive Income and Per Share Data
Revenues rose for the second quarter and the first six months of 2012 compared with the same periods of 2011, primarily due to growth in earned premiums. Premium and investment revenue trends are discussed further in the respective sections of Results of Operations, Page 30.
Realized investment gains and losses are recognized on the sales of investments or as otherwise required by GAAP. We have substantial discretion in the timing of investment sales, and that timing generally is independent of the insurance underwriting process. GAAP also requires us to recognize in net income the gains or losses from certain changes in fair values of securities even though we continue to hold the securities.
Net income for the second quarter of 2012 compared with the 2011 second quarter increased $82 million, reflecting stronger property casualty underwriting income that rose $124 million after taxes. Lower catastrophe losses, mostly weather related, reduced net-of-taxes property casualty underwriting results by $93 million less than the second quarter of 2011, in addition to better underwriting results before catastrophes. After-tax investment income in our investment segment results for the second quarter of 2012 rose $1 million compared with the second quarter of 2011, while life insurance segment results on a pretax basis declined by $3 million. Second-quarter 2012 after-tax net realized investment gains and losses were $40 million lower than a year earlier.
For the six-month period ended June 30, 2012, net income increased compared with the same period of 2011, also primarily due to higher property casualty underwriting results that rose $149 million after taxes, including $62 million from lower catastrophe losses. After-tax investment income rose by $1 million while after-tax net realized investment gains and losses were $38 million lower. Life insurance segment results on a pretax basis were $3 million lower.
Performance by segment is discussed below in Results of Operations, beginning on Page 30. As discussed in our 2011 Annual Report on Form 10-K, Item 7, Factors Influencing Our Future Performance, Page 41, there are several reasons that our performance during 2012 may be below our long-term targets. In that annual report, as part of Results of Operations, we also discussed the full-year 2012 outlook for each reporting segment.
The board of directors is committed to rewarding shareholders directly through cash dividends and through share repurchase authorizations. Through 2011, the company had increased the indicated annual cash dividend rate for 51 consecutive years, a record we believe was matched by only nine other publicly traded companies. Cash dividends declared during the first six months of 2012 increased approximately 1 percent compared with the same period of 2011. Our board regularly evaluates relevant factors in share repurchase- and dividend-related decisions, and the 2011 dividend increase signaled confidence in our strong capital, liquidity and financial flexibility, as well as progress through our initiatives to improve earnings performance.
Balance Sheet Data and Performance Measures
Total assets increased 3 percent compared with year-end 2011, largely due to growth in invested assets that was driven by additional purchases of securities and to a lesser extent by higher market valuation. Shareholders’ equity rose 2 percent and book value per share was up 2 percent during the first six months of 2012. Our debt-to-total-capital ratio (capital is the sum of debt plus shareholders’ equity) decreased compared with year-end 2011. The value creation ratio, a non-GAAP measure defined below, was higher for the first six months of 2012 compared with 2011, primarily due to growth in unrealized investment gains and net income. The $0.63 increase in book value per share during the first six months of 2012 contributed 2.0 percentage points to the value creation ratio while dividends declared at $0.805 per share during the first six months of 2012 contributed 2.6 points. Value creation ratio trends and a reconciliation of the non-GAAP measure to comparable GAAP measures are shown in the tables below.
Progress Toward Long-Term Value Creation
Operating through The Cincinnati Insurance Company, Cincinnati Financial Corporation is one of the 25 largest property casualty insurers in the nation, based on 2011 direct written premium volume for approximately 2,000 U.S. stock and mutual insurer groups. We market our insurance products through a select group of independent insurance agencies in 39 states as discussed in our 2011 Annual Report on Form 10-K, Item 1, Our Business and Our Strategy, Page 3.
We maintain a long-term perspective that guides us in addressing immediate challenges or opportunities while focusing on the major decisions that best position our company for success through all market cycles. We believe that this forward-looking view has consistently benefited our policyholders, agents, shareholders and associates.
To measure our long-term progress in creating shareholder value, we have defined a value creation metric that we believe captures the contribution of our insurance operations, the success of our investment strategy and the importance we place on paying cash dividends to shareholders. This measure, our value creation ratio or VCR, is made up of two primary components: (1) our rate of growth in book value per share plus (2) the ratio of dividends declared per share to beginning book value per share. For the period 2010 through 2014, an annual value creation ratio averaging 12 percent to 15 percent is our primary performance target. Management believes this non-GAAP measure is a useful supplement to GAAP information.
When looking at our long-term objectives, we see three performance drivers:
Highlights of Our Strategy and Supporting Initiatives
Management has worked to identify a strategy that can lead to long-term success, with concurrence by the board of directors. Our strategy is intended to position us to compete successfully in the markets we have targeted while appropriately managing risk. Further description of our long-term, proven strategy can be found in our 2011 Annual Report on Form 10-K, Item 1, Our Business and Our Strategy, Page 3. We believe successful implementation of initiatives that support our strategy, summarized below, will help us better serve our agent customers and reduce variability in our financial results while we also grow earnings and book value over the long term, successfully navigating challenging economic, market or industry pricing cycles.
We discuss initiatives supporting each of these strategies below, along with metrics we use to assess our progress.
Improve Insurance Profitability
The main initiatives to improve our insurance profitability include:
During the second quarter of 2012, development for our second generation workers’ compensation predictive model was completed. Once further integration with our policy administration systems is complete, all of our commercial lines predictive models will operate on the same platform. Additional integration should enhance the ability of underwriters to target profitability and to discuss pricing impacts with agency personnel. The updated version of the workers’ compensation predictive modeling tool is expected to be deployed to our underwriters for new business and renewal policy processing during the third quarter.
In late 2011, we developed tools to improve pricing precision for small business policies written through our new product known as CinciPakTM. Plans to implement these tools for underwriters’ use include rolling them out to eight states by the end of 2012. During the first quarter we began to pilot CinciPak for a few dozen agencies in one state, as scheduled. Progress during the second quarter included introducing CinciPak in two additional states, and introduction in two more states is planned for the third quarter.
For our personal lines business, we will continue to enhance our pricing model attributes and expand our pricing points to add more precision during 2012. These enhancements should help us continue to be competitive on the most desirable business and to adapt more rapidly to changes in market conditions. During the first quarter, we completed a homeowner policy rate proposal based on our most recent modeled results. Rate changes based on the proposal will be filed in the majority of our states with effective dates in the fourth quarter of 2012. Progress during the second quarter included completion of a personal auto rate proposal based on recent modeled results. Rate changes based on this proposal will be filed in the majority of our states with effective dates in early 2013.
Continued development for additional coverages in our commercial lines policy administration system is expected to facilitate important internal process improvement initiatives. Progress during the second quarter included completion of requirements for these coverages and initiation of their development. Delivery of the first iteration to 10 states is expected by the end of 2012, followed by additional states in 2013. In addition, at the beginning of the third quarter of 2012, we launched the system, known as e-CLAS® CPP, in an additional state, the 35th in our 39-state operating territory for commercial lines.
For our personal lines business, we have also been developing business rules and parameters to allow future processing of some policies without intervention by an underwriter, for risks that meet qualifying underwriting criteria. The objective is to streamline processing for our agents and associates, permitting more time for risks that need additional service or attention while also reducing internal costs. During the first quarter, we expanded our pilot to automate renewal underwriting into three additional states, for a total of four states. Progress during the second quarter included expansion into two additional states for a total of six states. We also introduced automated processing of certain endorsements.
We measure the overall success of our strategy to improve insurance profitability primarily through our GAAP combined ratio for property casualty results, which we believe can be consistently within the range of 95 percent to 100 percent for any five-year period. We also compare our statutory combined ratio to the industry average to gauge our progress, as discussed in the Performance Drivers section above.
In addition, we expect these initiatives to contribute to our rank as the No. 1 or No. 2 carrier based on premium volume in agencies that have represented us for at least five years. In 2011, we again earned that rank in approximately 75 percent of the agencies that have represented Cincinnati Insurance for more than five years, based on 2010 premiums. We are working to increase the percentage of agencies where we achieve that rank.
Drive Premium Growth
Primary initiatives to drive premium growth include:
During the first quarter we placed two new personal lines field marketing representatives to provide service to additional agencies located in the Northeast and Mid-Atlantic areas, for a total of 10 in various parts of our personal lines operating territory.
For our excess and surplus lines operation, we have been approved as a non-admitted carrier and brokerage in Delaware and Rhode Island. During the first half of 2012, we expanded our field underwriting presence and now have 10 field underwriting territories. During the first half of 2012, we also introduced a new quick-issue offering for special event policies and began more broadly marketing our expertise in large accounts.
Expansion of our personal lines operation is planned for additional states where we currently offer commercial lines products but do not offer personal lines products. We entered the state of New York during the first quarter of 2012. We plan to expand to one additional state by the end of 2012 and another state in the first half of 2013.
We also continue to develop and coordinate targeted marketing, including cross-selling opportunities, through our Target Markets department. This area focuses on commercial product development, including identification and promotional support for promising classes of business. We offered nine target markets programs to our agencies by the end of 2011. During the first quarter of 2012, we completed one of the four additional target market programs we plan to launch by the end of the year, with plans to launch our second program early in the third quarter. In each of the first two quarters, we also rolled out additional coverage forms for our existing programs.
We seek to build a close, long-term relationship with each agency we appoint. We carefully evaluate the marketing reach of each new appointment to ensure the territory can support both current and new agencies. During April 2012, we staffed two new marketing territories for commercial lines. Our 127 commercial lines field marketing territories are staffed by marketing representatives averaging 19 years of industry experience and nearly 10 years as a Cincinnati Insurance field marketing representative. The team of field associates in each territory works together with headquarters support associates to form our agent-centered business model, providing local expertise, helping us better understand the accounts we underwrite and creating market advantages for our agents. We help our agents grow their business by attracting more clients in their communities through unique Cincinnati-style service, and generally have earned a 10 percent share of an agency’s business within 10 years of its appointment.
We measure the overall success of our strategy to drive premium growth primarily through changes in net written premiums, as discussed in the Performance Drivers section above. In addition to tracking our progress toward our year-end 2015 direct written premiums target, we believe we can grow faster than the industry average over any five-year period.
An important part of our long-term strategy is financial strength, which is described in our 2011 Annual Report on Form 10-K, Item 1, Our Business and Our Strategy, Financial Strength, Page 5. One aspect of our financial strength is prudent use of reinsurance to help manage financial performance variability due to catastrophe loss experience. A description of how we use reinsurance is included in our 2011 Annual Report on Form 10-K, Item 7, Liquidity and Capital Resources, 2012 Reinsurance Programs, Page 98.
Another aspect is our investment portfolios, which remain well-diversified as discussed in Item 3, Quantitative and Qualitative Disclosures about Market Risk, Page 51. We continue to maintain strong parent company liquidity and financial strength that increases our flexibility through all periods to maintain our cash dividend and to continue to invest in and expand our insurance operations. At June 30, 2012, we held $1.025 billion of our cash and invested assets at the parent company level, of which $872 million, or 85.1 percent, was invested in common stocks, and $23 million, or 2.3 percent, was cash or cash equivalents. Our debt-to-total-capital ratio at 14.8 percent remains well below our target limit of 20 percent. Another important indicator of financial strength is our ratio of property casualty net written premiums to statutory surplus, which was 0.9-to-1 for the 12 months ended June 30, 2012, up from 0.8-to-1 at year-end 2011.
Our financial strength ratings by independent ratings firms also are important. In addition to rating our parent company’s senior debt, four firms award insurer financial strength ratings to our property casualty insurance companies and three firms rate our life insurance company based on their quantitative and qualitative analyses. These ratings primarily assess an insurer’s ability to meet financial obligations to policyholders and do not necessarily address all of the matters that may be important to investors. Ratings may be subject to revision or withdrawal at any time by the rating agency, and each rating should be evaluated independently of any other rating.
As of July 25, 2012, our insurer financial strength ratings were:
All of our insurance subsidiaries continue to be highly rated.
On May 3, 2012, Fitch Ratings affirmed our ratings that it had assigned in September 2010, continuing its stable outlook. Fitch noted that ratings strengths include conservative capitalization, moderate holding company leverage and strong liquidity. Fitch noted our reserve adequacy and implementation of initiatives anticipated to improve underwriting results. Fitch said rating concerns include challenges from a competitive market and exposure to regional natural catastrophes and weather-related losses.
Results of Operations
The consolidated results of operations reflect the operating results of each of our five segments along with the parent company and other activities reported as “Other.” The five segments are:
We report as Other the non-investment operations of the parent company and its non-insurer subsidiary, CFC Investment Company. See Item 1, Note 12, Segment Information, Page 20, for discussion of the calculations of segment data. Results of operations for each of the five segments are discussed below.
Consolidated Property Casualty Insurance Results of Operations
Consolidated property casualty insurance results include premiums and expenses for our standard market insurance (commercial lines and personal lines segments) as well as our surplus lines operations.
Our consolidated property casualty insurance operations generated an underwriting loss of $77 million and $68 million for the three and six months ended June 30, 2012, compared with an underwriting loss of $267 million and $297 million for the three and six months ended June 30, 2011. The primary causes of the improved underwriting results were lower losses from natural catastrophes and improving trends in pricing relative to loss costs. We believe the favorable trends for loss experience before catastrophes are in part due to our initiatives to improve pricing precision and loss experience related to claims and to loss control practices. Details of property casualty insurance results are discussed below, including our commercial lines, personal lines and excess and surplus lines segments.
We measure and analyze property casualty underwriting results primarily by the combined ratio and its component ratios. The GAAP-basis combined ratio is the percentage of incurred losses plus all expenses per each earned premium dollar – the lower the ratio, the better the performance. An underwriting profit results when the combined ratio is below 100 percent. A combined ratio above 100 percent indicates that an insurance company’s losses and expenses exceeded premiums.
The combined ratio can be affected significantly by natural catastrophe losses and other large losses as discussed in detail below. The combined ratio can also be affected by updated estimates of loss and loss expense reserves established for claims that occurred in prior periods, referred to as prior accident years. Net favorable development on prior accident year reserves, including reserves for catastrophe losses, improved the combined ratio by 12.4 percentage points in the first six months of 2012, or 2.1 percentage
points more compared with 10.3 percentage points in the same period of 2011. On a before-catastrophe losses basis, net favorable development on prior accident year reserves for the first six months of 2012 was 0.5 percentage points more. Net favorable development for the first six months of 2012 is discussed in further detail in results of operations by property casualty insurance segment, Pages 34 through 44.
Our consolidated property casualty combined ratio for the second quarter improved 27.2 percentage points, and for the first six months of 2012 it improved 15.8 points, both compared with the same periods of 2011. In addition to catastrophe losses that were 22.0 and 7.9 percentage points lower, the loss and loss expenses ratio before catastrophe losses were 4.6 and 6.9 points lower, together accounting for most of the improvement.
The ratio for current accident year loss and loss expenses before catastrophe losses improved. The 68.8 percent ratio for the first six months of 2012 improved 6.4 percentage points compared with the 75.2 percent accident year 2011 ratio measured as of June 30, 2011, in part reflecting recent-year initiatives to improve pricing precision and loss experience related to claims and to loss control practices and improving market conditions. Lower new large losses incurred, shown on the table on Page 32, decreased the 2012 ratio by 2.0 percentage points and were partly responsible for the ratio’s improvement. The effect of the $38 million ceded in 2011 to reinstate coverage layers of our property catastrophe reinsurance treaty increased the 2011 ratio by 1.9 percentage points. We believe the remaining reduction of 2.5 percentage points is largely due to initiatives to improve pricing precision and loss experience related to claims and loss control practices, somewhat offset by normal loss cost inflation.
The underwriting expense ratio improved for the second quarter and first six months of 2012 compared with the same periods a year ago, primarily due to higher earned premiums.
The trends in net written premiums and earned premiums summarized in the table above largely reflect the effects of our premium growth strategies, better pricing and the unfavorable effect on 2011 premiums due to additional ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty. Reinsurance reinstatement premiums lowered net written and earned premiums by $38 million during the second quarter and first six months of 2011.
Consolidated property casualty net written premiums for the three and six months ended June 30, 2012, grew $135 million and $199 million compared with the same periods of 2011. Ceded premiums to reinstate coverage layers of our property catastrophe reinsurance treaty lowered net written and earned premiums by $38 million during the second quarter and first six months of 2011. On a percentage basis, 2011 reinsurance reinstatement premiums accounted for 6 percent and 3 percent of net written premium growth for the three and six months ended June 30, 2012, respectively. Each of our property casualty segments grew during the second quarter and first six months of 2012. Our premium growth initiatives from prior years continue to favorably affect current year growth, particularly as newer agency relationships mature over time. Improving insured exposure-level comparatives reflecting some improving areas of the economy also favorably affected premium growth. We discuss current initiatives in Highlights of Our Strategy and Supporting Initiatives, Page 26. The main drivers of trends for 2012 are discussed by segment on Pages 34, 39 and 43.
Consolidated property casualty agency new business written premiums for the three and six months ended June 30, 2012, increased $14 million and $20 million compared with the same periods of 2011. We continued to experience new business growth related to initiatives for geographic expansion into new and underserved areas. Agents appointed during 2011 or 2012 produced an increase in standard lines new business of $18 million for the first six months of 2012 compared with the same period in 2011. As we appoint new agencies that choose to move accounts to us, we report these accounts as new business. While this business is new to us, in many cases it is not new to the agent. We believe these seasoned accounts tend to be priced more accurately than business that may be less familiar to our agent upon obtaining it from a competing agent.
Other written premiums – primarily including premiums ceded to our reinsurers as part of our reinsurance program – contributed $40 million and $44 million to net written premium growth for the three and six months ended June 30, 2012, compared with the same periods of 2011. The $38 million unfavorable effect on 2011 premiums from additional ceded premiums to reinstate coverage layers of our
property catastrophe reinsurance treaty accounted for much of the contribution. In addition to lower total ceded written premiums, other written premiums also benefited from a more favorable adjustment, compared with the second quarter of last year, for estimated direct written premiums of policies in effect but not yet processed. The adjustment had an immaterial effect on earned premiums.
Catastrophe losses typically have a meaningful effect on property casualty results and can vary significantly from period to period. Losses from natural catastrophes contributed 17.8 and 14.6 percentage points to the combined ratio in the three and six months ended June 30, 2012, compared with 39.8 and 22.5 percentage points in the same periods of 2011. The following table shows catastrophe losses and loss expenses incurred, net of reinsurance, as well as the effect of loss development on prior period catastrophe events. One of the second-quarter 2012 catastrophe events had losses estimated at June 30, 2012, that exceeded our $75 million loss retention for our property catastrophe reinsurance treaty. Terms of the treaty include one automatic reinstatement by layer of reinsurance. The first layer provides recovery of 48.3 percent of per-event losses between $75 million and $100 million. Amounts recovered and reinstatement premiums related to the second quarter of 2012 were immaterial. We individually list catastrophe events for which our incurred losses reached or exceeded $5 million.
The following table includes data for losses incurred of $250,000 or more per claim, net of reinsurance.
Consolidated Property Casualty Insurance Losses by Size
We believe the inherent variability of aggregate loss experience for our portfolio of larger policies is greater than that of our portfolio of smaller policies, and we continue to monitor the variability in addition to general inflationary trends in loss costs. Our analysis continues to indicate no unexpected concentration of these large losses and case reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. The second-quarter 2012 property casualty total large losses incurred of $164 million, net of reinsurance, matched the $164 million quarterly average during 2011 and higher than the $141 million for the second quarter of 2011. The ratio for these large losses and case reserve increases was 0.7 percentage points higher compared with last year’s second quarter, with new losses up 0.9 points and case reserve development down 0.2 points. The second-quarter increase in losses added to the ratio for total large losses incurred for the first six months of 2012, which also included a first-quarter 2012 ratio that was 1.0 point lower than the first quarter of 2011. We believe results for the three-month and six-month periods largely reflected normal fluctuations in loss patterns and normal variability in large case reserves for claims above $250,000. Losses by size are discussed in further detail in results of operations by property casualty insurance segment, Pages 34 through 44.
Commercial Lines Insurance Results of Operations