Cincinnati Financial - 10-Q quarterly report FY

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UNITED STATES

WASHINGTON, D.C. 20549

FORM 10-Q

Commission file number 0-4604

CINCINNATI FINANCIAL CORPORATION

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.x Yeso No

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).x Yeso No

     As of April 30, 2003, there were 160,729,799 shares of common stock outstanding.

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CINCINNATI FINANCIAL CORPORATION
FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2003

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Part I – Financial Information

Item 1. Financial Statements

Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Balance Sheets

Accompanying notes are an integral part of these condensed consolidated financial statements.
Cincinnati Financial Corporation
Form 10-Q for the Quarter Ended March 31, 2003

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Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Income

Accompanying notes are an integral part of these condensed consolidated financial statements
Cincinnati Financial Corporation
Form 10-Q for the Quarter Ended March 31, 2003

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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
Form 10-Q for the Quarter Ended March 31, 2003

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Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Cash Flows

Accompanying notes are an integral part of these condensed consolidated financial statements.
Cincinnati Financial Corporation
Form 10-Q for the Quarter Ended March 31, 2003

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

NOTE 1 — ACCOUNTING POLICIES
The condensed consolidated financial statements present the accounts of Cincinnati Financial Corporation and all of its subsidiaries, each of which is wholly owned, in conformity with accounting principles generally accepted in the United States of America. These principles require management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates. All significant inter-company investments and transactions have been eliminated in consolidation. The December 31, 2002, consolidated balance sheet amounts are derived from the audited financial statements but do not include all disclosures herein required by accounting principles generally accepted in the United States of America.

The preceding summary of financial information for Cincinnati Financial Corporation and consolidated subsidiaries is unaudited. The company believes that all adjustments (consisting only of normal recurring accruals) necessary for fair presentation have been made. The results of operations for this interim period are not necessarily an indication of results to be expected for the remainder of the year.

Investments
Fixed maturities and equity securities have been classified as available for sale and are carried at fair values at March 31, 2003, and December 31, 2002.

Unrealized Gains and Losses
The increases (decreases) in unrealized gains for fixed maturities and equity securities, net of income tax effects, are as follows:

Such amounts are included as additions to (deductions from) shareholders’ equity.

Other-Than-Temporary Impairments
Other-than-temporary declines in the fair value of investments are recognized in net income as realized investment losses at the time when facts and circumstances indicate such write-downs are warranted. In the first quarter ended March 31, 2003, the company recorded $53 million in other-than-temporary impairments compared with $6 million in last year’s first quarter.

Reinsurance
In the accompanying statements of income, premiums earned are net of ceded premiums and insurance losses and policyholder benefits are net of reinsurance recoveries, as follows:

Effective April 1, 2003, the company expanded its property catastrophe reinsurance program, adding another $100 million layer in excess of $300 million, and retaining 5 percent of the losses in this layer.

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Stock Options
The company has qualified and non-qualified stock option plans under which options are granted to employees at prices that are not less than market price at the date of grant and that are exercisable over 10-year periods. The company applies Accounting Principles Board (APB) Opinion 25 and related interpretations in accounting for these plans. Accordingly, no compensation cost has been recognized for the stock option plans.

Had compensation cost for the company’s stock option plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of Statement of Financial Accounting Standards (SFAS) No. 123 “Accounting for Stock-Based Compensation,” the company’s net income and earnings per share would have been reduced to the pro forma amounts indicated below:

In determining the pro forma amounts above, the fair value of each option was estimated on the date of grant using the binomial option-pricing model with the following weighted-average assumptions used for grants in the three months ended March 31, 2003 and 2002, respectively: dividend yield of 2.52 percent; expected volatility of 25.90 percent; risk-free interest rates of 4.26 percent; and expected lives of 10 years for all periods. Compensation expense in the pro forma disclosures is not indicative of future amounts as options vest over several years and additional grants generally are made each year. The company has adopted the disclosure provisions of SFAS No. 148 “Accounting for Stock-based Compensation — Transition and Disclosure” (issued in December 2002). The company will adopt a transition method when a consistent fair value recognition and measurement provision is determined by The Public Company Accounting Oversight Board and is required to be adopted.

New Accounting Standards
The FASB issued SFAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” in April 2003 to amend and clarify financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. Management does not expect this statement to have a significant effect on the company’s consolidated financial statements.

Reclassifications
Certain prior amounts have been reclassified to conform with the current-period classifications.

NOTE 2 — SEGMENT INFORMATION
The company is organized and operates primarily in two industries, property casualty insurance and life insurance, and has four reportable segments – commercial lines property casualty insurance, personal lines property casualty insurance, life insurance and investment operations. Company management regularly reviews these four segments to make decisions about allocating resources and to assess their performance. Included in the Other category are the parent company; non-investment operations of CFC Investment Company and CinFin Capital Management Company; and, non-premium income of the insurance subsidiaries.

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Revenue is primarily from unaffiliated customers. Insurance segments’ revenue is insurance premiums earned; investment operations’ revenue represents net investment income and realized investment gains and losses; and other revenue is primarily finance/lease income, asset management fees and other income of the insurance subsidiaries.

Income before income taxes for the insurance segments represents underwriting profit (loss), which is premiums earned minus losses and loss expenses incurred or policyholder benefits and other expenses. Income before income taxes for the investment operations represents net investment income plus realized investment gains and losses, less interest credited to contract holders. The investment operations segment incurred other-than-temporary impairment charges related to investments of $53 million in the first quarter of 2003 and $6 million in the first quarter of 2002. Losses before income taxes in the Other category of $10 million and $6 million recorded in the first quarter of 2003 and 2002, respectively, were primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.

Identifiable assets by segment are those assets used in the respective segment’s operations. Information regarding identifiable assets is not reported separately for two reportable segments – commercial lines and personal lines of property casualty insurance – because these amounts are not used by company management for analysis of those segments. All fixed-maturity and equity security investments, regardless of ownership, are included in the investment operations segment.

Segment information is summarized in the following table.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

INTRODUCTION

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 the company’s Form 10-K for 2002. Dollar amounts are rounded to millions, calculations of percent changes are based on whole dollar amounts.

SAFE HARBOR STATEMENT
The following discussion contains certain forward-looking statements that involve potential risks and uncertainties. The company’s future results could differ materially from those discussed. Factors that could cause or contribute to such differences include, but are not limited to: unusually high levels of catastrophe losses due to changes in weather patterns or other natural or man-made causes; increased frequency and/or severity of claims; environmental events or changes; insurance regulatory actions, legislation or court decisions that increase expenses or place the company at a disadvantage in the marketplace; adverse outcomes from litigation or administrative proceedings; recession or other economic conditions resulting in lower demand for insurance products; sustained decline in overall stock market values negatively affecting the company’s equity portfolio, in particular a sustained decline in market value of Fifth Third shares; political, regulatory, economic, revaluation or interest-rate events that lead to a significant decline in the market value of a particular security or sector and impairment of assets; delays in the development, implementation and benefits of technology enhancements; and decreased ability to generate growth in investment income.

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 recent measures impacting corporate financial reporting and governance. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.

Readers are cautioned that the company undertakes no obligation to review or update the forward-looking statements included in this material.

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RESULTS OF OPERATIONS
Overview

Highlights of the company’s first-quarter performance included:

PROPERTY CASUALTY INSURANCE OPERATIONS

Overview
Within the property casualty insurance market, the company offers both commercial and personal policies through a network of independent agencies. Highlights of first-quarter property casualty insurance operations include:

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Commercial lines earned premiums rose 13.1 percent for the quarter. Net written premiums rose 10.9 percent. The primary source of growth continued to be firmer pricing on new and renewal commercial business, more than offsetting deliberate decisions to not write or renew certain business. Growth also has reflected the focus on improving customer service through the creation of smaller marketing territories, permitting local field marketing representatives to devote more time to each independent agency. During the first quarter, the company split and staffed one additional territory, bringing the total number of property casualty field territories to 84. During 2003, the company is targeting a total of six additional territories for expansion. Beginning in the first quarter 2003, the company has resumed writing three-year policies at its normal pace because of their competitive advantages.

Based on annualized premiums written directly by agencies, first-quarter commercial new business premiums were $53 million compared with $56 million in the first quarter of 2002. The growth of new business continued to be affected by the company’s decision to selectively reduce workers compensation as well as construction-related writings. On the basis of annualized premiums written directly, new workers compensation premiums declined 31.1 percent in the first quarter.

The losses and loss expenses ratio for the first quarter improved by 4.7 percentage points due to programs the company has implemented to increase profitability. The improvement in the commercial lines combined ratio was offset by a 1.3 percentage-point rise in the expense ratios, primarily due to higher commissions paid to agencies, particularly contingent commissions on profitable business. Management continues to expect overall expenses to remain relatively steady although the commission expense ratio is expected to rise as workers compensation, which has a low commission rate, becomes a smaller percentage of total premiums.

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LINE OF BUSINESS ANALYSIS

The following discussion details results for the four largest of the company’s commercial property casualty business lines. In total, commercial multi-peril, workers compensation, commercial auto and other liability accounted for more than 90 percent of total commercial lines earned premium in the first quarters of 2003 and 2002.

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Management monitors claim activity and appropriately modifies amounts added to losses and loss expense reserves via incurred but not yet reported (IBNR) additions on an ongoing basis. Following two Ohio Supreme Court decisions, in 2000 the company established a $110 million IBNR reserve, net of reinsurance, for past uninsured motorist/under-insured motorist losses (UM/UIM) incurred but not yet reported. The court rulings affected all auto insurers in the state. During the first quarter of 2003, the IBNR reserve was reduced by $4 million for reported claims. Recent decisions on two additional Ohio Supreme Court cases related to the period of time covered by the original decision and the timing of related claim reporting are expected to negatively affect the level of UM/UIM-related claims. During the second quarter, management will re-evaluate the adequacy of the reserve, which stood at $22 million at March 31, 2003. Management also continues to monitor cases pending before the Supreme Court in Ohio that could alter the outlook for future UM/UIM developments either positively or negatively.

COMMERCIAL LINES LOSSES INCURRED ANALYSIS (GAAP)

The company evaluates the trends in losses and case reserve increases greater than $250,000 to track frequency and severity of larger losses. In the first quarter of 2003, case reserve increases greater than $250,000 declined to 4.8 percent of earned premium from 8.1 percent a year earlier. Management believes this may be a preliminary indication that it is setting initial case reserves on reported claims more in line with higher loss costs.

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Personal Lines

Personal lines earned premiums rose 11.4 percent in the first quarter. Statutory net written premiums grew 9.6 percent. The sources of growth in the first quarter were rate increases on new and renewal personal lines business and additional premium derived from insurance-to-value initiatives and specific charges for certain coverage extensions such as water damage. The personal lines combined ratio improved by 4.2 percentage points over the year-earlier period. Catastrophe loss recoveries contributed a positive 1.3 percentage points to this year’s first-quarter combined ratio compared with a negative 6.0 percentage points from catastrophe losses in the first quarter of 2002.

LINE OF BUSINESS ANALYSIS

The personal auto and homeowner business lines together accounted for almost 90 percent of total personal lines earned premiums in the first quarters of 2003 and 2002. The following analyzes growth and profitability for these lines separately:

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PERSONAL LINES LOSSES INCURRED ANALYSIS (GAAP)