Cincinnati Financial - 10-Q quarterly report FY

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

As of July 31, 2003, there were 160,421,516 shares of common stock outstanding.

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CINCINNATI FINANCIAL CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 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 financial statements.

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Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Income

Accompanying notes are an integral part of these condensed financial statements.

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Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Shareholders’ Equity

Accompanying notes are an integral part of these condensed financial statements.

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Cincinnati Financial Corporation and Subsidiaries
Condensed Consolidated Statements of Cash Flows

Accompanying notes are an integral part of these condensed financial statements.

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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. The sum of the quarterly reported amounts may not equal year-to-date amounts as each is computed independently.

Investments
Fixed maturities and equity securities have been classified as available for sale and are carried at fair values at June 30, 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, that are included as additions to (deductions from) shareholders’ equity, are as follows:

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 six-month and three-month periods ended June 30, 2003, the company recorded $69 million and $17 million, respectively, in other-than-temporary impairment charges compared with $29 million and $25 million in the comparable prior-year periods (see Management’s Discussion and Analysis, Page 8, for discussion of the impairment charges).

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.

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.

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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 six months ended June 30, 2003 and 2002, respectively: dividend yield of 2.52 percent and 2.20 percent; expected volatility of 25.90 percent and 25.54 percent; risk-free interest rates of 4.26 percent and 5.54 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 Financial Accounting Standards Board (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 under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. Management does not expect this statement to have a significant effect on the company’s consolidated financial statements.

In May 2003, the FASB issued SFAS No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer of financial instruments classifies and measures in its statement of financial position certain instruments with characteristics of both liabilities and equity. SFAS No. 150 affects an issuer’s accounting for various types of financial instruments that are required to be accounted for as liabilities.

SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003. For all financial instruments entered into prior to May 31, 2003, SFAS 150 is effective at the beginning of the first interim period beginning after June 15, 2003, which for the company begins July 1, 2003. The company does not have any financial instruments outstanding to which the provisions of SFAS No. 150 apply; therefore, the adoption of FASB No. 150 is not expected to have any impact on the company’s consolidated financial statements.

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

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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.

Revenues are 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 revenues are 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 loss 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 six- and three-month periods of 2003 and 2002 included other-than-temporary impairment charges (see Management’s Discussion and Analysis, Page 8, for discussion of the charges). Losses before income taxes in the Other category in the six- and three-month periods 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 2002 Annual Report on Form 10-K. 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 Bancorp shares; political, regulatory, economic, re-valuation 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 affecting 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 — Financial Highlights

Management utilizes net income before realized investment gains and losses to evaluate underlying performance for a number of reasons. First, quarterly fluctuations in net realized investment gains and losses are unrelated to trends in the company’s insurance business. Second, among other items, net realized investment gains and losses can include gains related to the sale of investments made at management’s discretion. Third, net income before realized investment gains and losses is a measure commonly used by investors to evaluate insurance companies.

The 8.3 percent growth in revenues for the six months ended June 30, 2003, reflected:

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In addition to the higher revenues, the 28.1 percent increase in net income for the six months ended June 30, 2003, reflected slower growth of benefits and expenses, resulting in improvement in the consolidated property casualty combined ratio. For the period, the ratio was 96.8 percent, including 3.8 percentage points due to catastrophe losses, compared with 103.6 percent, including 5.4 percentage points due to catastrophes, for the comparable prior six-month period. The quarterly combined ratio has remained below 100 percent for four consecutive quarters, reflecting the support and cooperation of agents, firm prices and careful attention to underwriting. As a result of the improvement, the company reported a property casualty underwriting profit of $42 million in the first half of 2003 compared with an underwriting loss of $42 million in the year-earlier period.

Book value improved $1.92, or 5.5 percent, from year-end 2002, although it remained below the year-earlier level. The bond and equity market recovery during the second quarter of 2003 increased the unrealized gains in the company’s investment portfolio.

PROPERTY CASUALTY INSURANCE OPERATIONS

Within the property casualty insurance market, the company offers both commercial and personal policies through a network of independent agencies.

Commercial Lines

Commercial lines earned premiums rose 13.5 percent for the six months. The primary source of growth continued to be firm pricing on new and renewal commercial business, more than offsetting deliberate decisions not to write or renew certain policies. Beginning in the first quarter of 2003, the company resumed writing three-year package commercial policies at its normal pace because of their competitive advantages.

Based on annualized premiums written directly by agencies, commercial new business premiums for the first six months were $124 million, compared with $121 million in the first six months of 2002, as 9.0 percent growth in new business in the second quarter offset a modest decline in the first quarter.

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For the first six months of 2003, the commercial lines combined ratio improved by 7.3 percentage points. The continuing improvement in the combined ratio reflected rate increases as well as longer-term efforts to ensure adequate premium for the company’s exposure to each risk.

Line of Business Analysis
Commercial multi-peril, workers compensation, commercial auto and other liability account for more than 90 percent of total commercial lines earned premium. The following analyzes growth and profitability for these lines separately:

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Management monitors claim activity and appropriately modifies amounts added to loss 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/underinsured motorist losses (UM/UIM) incurred but not yet reported. The court rulings affected all auto insurers in the state. During the first six-months of 2003, the IBNR reserve was reduced by $8 million for reported claims, leaving the remaining reserve balance at $18 million. Management reviewed the level of the reserve in light of several recent Ohio Supreme Court cases related to the period of time covered by the original decision and the timing of related claim reporting. Management believes the present reserve is adequate based on that review and the level of claims activity during the first six months of 2003. The company 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

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 six months of 2003, the total ratio of large losses and case reserve increases greater than $250,000 declined to 15.7 percent of earned premium from 20.4 percent a year earlier due to earned premium growth.

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Personal Lines