UNITED STATESSECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark one)
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 p No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).þ Yes p No
As of October 31, 2003, there were 160,427,727 shares of common stock outstanding.
TABLE OF CONTENTS
CINCINNATI FINANCIAL CORPORATIONFORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2003
Part I – Financial Information
Item 1. Financial Statements
Cincinnati Financial Corporation and SubsidiariesCondensed Consolidated Balance Sheets
Accompanying notes are an integral part of these condensed financial statements.
Cincinnati Financial Corporation and SubsidiariesCondensed Consolidated Statements of Income
Cincinnati Financial Corporation and SubsidiariesCondensed Consolidated Statements of Shareholders’ Equity
Cincinnati Financial Corporation and SubsidiariesCondensed Consolidated Statements of Cash Flows
Notes to Condensed Consolidated Financial Statements (unaudited)
NOTE 1 — ACCOUNTING POLICIESThe 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 condensed consolidated financial statements of Cincinnati Financial Corporation and its consolidated subsidiaries are 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.
InvestmentsFixed maturities and equity securities have been classified as available for sale and are carried at fair values at September 30, 2003, and December 31, 2002.
Unrealized Gains and LossesThe 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 ImpairmentsOther-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 nine-month and three-month periods ended September 30, 2003, the company recorded $77 million and $8 million, respectively, in other-than-temporary impairment charges compared with $38 million and $8 million in the comparable prior-year periods (see Management’s Discussion and Analysis, Page 10, for discussion of the impairment charges).
ReinsuranceIn 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 OptionsThe 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 nine months ended September 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 provisions are determined by The Public Company Accounting Oversight Board and is required to be adopted.
New Accounting StandardsThe 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. This statement did not have any 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 did not have any impact on the company’s consolidated financial statements.
FASB Interpretation 46 “Consolidation of Variable Interest Entities” was issued in January 2003 and is effective at various dates for various requirements. This interpretation addresses consolidation of variable interest entities (formerly known as special purpose entities). Management believes that this interpretation will have no significant effect on the company’s consolidation financial statements.
ReclassificationsCertain prior-period amounts have been reclassified to conform with the current-period classifications.
NOTE 2 — SEGMENT INFORMATIONThe 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 nine- and three-month periods of 2003 and 2002 included other-than-temporary impairment charges (see Management’s Discussion and Analysis, Page 10, for discussion of the charges). Losses before income taxes in the Other category in the nine- 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.
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 STATEMENTThe 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.
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, 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 10.4 percent growth in revenues for the nine months ended September 30, 2003, reflected:
In addition to the higher revenues, the 34.3 percent increase in net income for the nine months ended September 30, 2003, reflected recovery of $23 million pretax in the third quarter of 2003 resulting from a settlement negotiated with a vendor. The recovery added $15 million, or 9 cents per share, to after tax net income. The negotiated settlement related to the $39 million one-time, pretax charge incurred in the third quarter of 2000 to write off previously capitalized software development costs.
In addition, improved non-catastrophe underwriting led to slower growth of benefits and expenses and a decline in the consolidated property casualty combined ratio. The quarterly combined ratio has remained at or below 100 percent for five consecutive quarters, reflecting the support and cooperation of agents, firm prices and careful attention to underwriting. For the nine-month period, the ratio was 96.7 percent compared with 101.4 percent for the comparable 2002 nine-month period. Included in the 2003 nine-month combined ratio were:
As a result of the factors stated above, the company reported a property casualty underwriting profit of $65 million in the first nine months of 2003 compared with an underwriting loss of $25 million in the year-earlier period.
Book value improved $1.29, or 3.7 percent, from year-end 2002. The continued bond market recovery during 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 12.4 percent for the nine 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 commercial package policies at its normal pace because of their competitive advantages.
The company’s standard approach is to write three-year policies, a competitive advantage in the commercial lines market. Though the company issues policies for a three-year term, policies are renewable annually at the discretion of the policyholder and are cancelable by the policyholder at any time. While writing three-year policies would appear to restrict opportunities to quickly adjust pricing, annual adjustments are in fact made within multi-year packages to automobile, workers compensation, professional liability and most umbrella liability coverages. Within a multi-year term package, these coverages are adjusted or repriced at the policy’s annual anniversary. The repricing affects the next policy year going forward, not the past policy year. These annual pricing changes could incorporate rate changes approved by state insurance regulatory authorities between the date the policy was written and its annual anniversary, as well as changes in risk exposures and premium credits or debits relating to loss experience, competition and other underwriting judgment factors. Management estimates that 75 percent of 2002 commercial premium was subject to annual adjustment or repricing.
Based on annualized premiums written directly by agencies, commercial new business premiums for the first nine months were $197 million, compared with a record $189 million in the first nine months of 2002, as 9.0 percent second quarter growth and 6.2 percent third quarter growth in new business offset a modest decline in the first quarter.
For the first nine months of 2003, the commercial lines combined ratio improved by 5.8 percentage points, reflecting rate increases as well as longer-term efforts to ensure adequate premium for the company’s exposure to each risk. The combined ratio in the first nine months of 2003 included 2.0 percentage points due to catastrophe losses compared with 2.7 percentage points in the first nine months of 2002. The expense ratio for the first nine months of 2003 reflected a 1.0 percentage point benefit from the recovery offset by an increase in the contribution of contingent commissions to 2.5 percentage points from 0.9 percentage points in 2002.
Line of Business AnalysisCommercial 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:
Management monitors claim activity and appropriately modifies amounts added to loss and loss expenses reserves via incurred but not yet reported (IBNR) additions on an ongoing basis.
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 nine months of 2003, the total ratio of large losses and case reserve increases greater than $250,000 declined to 16.9 percent of earned premium from 19.5 percent a year earlier, as the amount of losses in these categories remained relatively stable and earned premium grew.
Personal Lines
Personal lines earned premiums rose 11.5 percent in the first nine months of 2003. The sources of growth in the first nine months of 2003 were rate increases on renewal personal lines business and additional homeowner premium derived from insurance-to-value initiatives and specific charges for certain coverage extensions such as water damage. New business written directly by agents in the first nine months of 2003 was $16 million versus $19 million for the same period in 2002. The personal lines combined ratio improved 1.9 percentage points over the year-earlier period. Catastrophe losses contributed 11.2 percentage points to the combined ratio compared with 6.6 percentage points in the first nine months of 2003. The combined ratio for the third quarters of 2003 and 2002 reflected the seasonal variation in the loss ratio due to weather-related losses.
Line of Business AnalysisThe personal auto and homeowner business lines together accounted for approximately 90 percent of total personal lines earned premiums. The following analyzes growth and profitability for these lines separately:
Personal Lines Losses Incurred Analysis
LIFE INSURANCE OPERATIONS
Results for the life insurance segment exclude the impact of investment income on assets under the management of the life insurance company reported in the investment operations segment. Income before income taxes and realized investment gains and losses in the nine month period ended September 30, 2003, rose to $1 million compared with a loss of $9 million in the comparable 2002 period. At September 30, 2003, invested assets under management of the life insurance company were 18.4 percent above the year earlier level.
For the nine months, net earned premiums rose 8.4 percent and new submitted ordinary life applications rose 6.2 percent. That increase reflects a positive response to the company’s products and services. In 2004, the company will expand its portfolio with a new long-term guaranteed universal life insurance product and an improvement to its existing term life insurance product.
INVESTMENT OPERATIONS
Investment IncomeConsolidated pretax investment income rose 4.8 percent for the nine months and 3.3 percent for the third quarter, benefiting from dividend increases announced over the last year by companies in the equity portfolio. As of September 30, 2003, 22 of the 48 equity holdings in the portfolio have announced dividend increases that would add $13 million on an annualized basis to investment income including $9 million from Fifth Third Bancorp.
Realized Investment Gains and LossesRealized investment losses, before federal taxes, for the first nine months of 2003 were $44 million, or 0.4 percent of total invested assets at September 30, 2003, compared with last year’s $34 million, or 0.3 percent of total invested assets at September 30, 2002. In the third quarter, the company recorded realized investment gains of $15 million compared with realized investment losses of $16 million in last year’s third quarter.
Continuing weakness in the economy during the first half of 2003 led to a higher level of realized investment losses in that period due to the increase in write-downs of securities that management deemed had experienced other-than-temporary declines in market value. Also included in other-than-temporary impairments are unrealized losses of holdings that the company has identified for sale but not yet completed a transaction. Of the $77 million in other-than-temporary write-downs in the first nine months of 2003, $69 million occurred in the first six months of 2003. For the nine-month period, the majority of the write-downs related to 29 high-yield corporate bonds written down $36 million and 10 convertible securities written down $26 million. Third-quarter 2003 write downs primarily were due to five high-yield corporate airline bonds written down by $4 million and one equity security identified for sale written down by $3 million.
Federal Income TaxesThe effective rate for income taxes increased to 20.9 percent in the first nine months of 2003 from 15.2 percent in the comparable prior period primarily due to the $65 million property casualty underwriting profit in 2003 compared with a $25 million underwriting loss in 2002.
Liquidity and Capital ResourcesCash Flow
Compared with last year, the $206 million increase in net cash flow from operations for the first nine months of 2003 was due to the strong performance of the company’s property casualty insurance operations. The strong operating cash flow permitted the company to invest a net $443 million in invested assets in the first nine months of 2003. More than 78 percent of the new investments were made in fixed-income investments, focusing on high quality with intermediate maturities. Net cash used in financing activities rose due to $49 million in stock repurchases during the first nine months of 2003 compared with $36 million last year as well as a $9 million rise in cash dividends to shareholders offset by a reduction in annuity sales.
AssetsThe market value of the company’s invested assets was $11.774 billion at September 30, 2003, compared with $11.257 billion at year-end 2002. Invested assets made up 78.7 percent of the company’s $14.958 billion in assets at September 30, 2003, compared with 79.7 percent of the company’s $14.122 billion in assets at year-end 2002. Information regarding the company’s investment strategy and portfolio composition is available in the 2002 Annual Report on Form 10-K.
DebtThe company has two lines of credit totaling $250 million, with the outstanding balances on the lines totaling $183 million at September 30, 2003, unchanged from year-end 2002.
DividendsIn February 2003, the board of directors authorized a 12.4 percent increase in the regular quarterly cash dividend to an indicated annual payout of $1.00. On May 23 and August 15, the board of directors declared 25-cent per share regular quarterly dividends payable July 15, 2003 and October 15, 2003, to shareholders of record on June 25, 2003 and September 24, 2003, respectively.
Common Stock RepurchaseThe Cincinnati Financial board believes that stock repurchases can help fulfill the company’s commitment to enhancing shareholder value. Consequently, the company’s board has authorized the repurchase of outstanding shares.
At September 30, 2003, 5.4 million shares remained authorized for repurchase at any time in the future. The company repurchased approximately 1.4 million shares of common stock during the first nine months of 2003 at a cost of $49 million. Shares repurchases totaled approximately 15.7 million, at a total cost to the company of $518 million since the inception of share repurchases in 1996.
OutlookManagement believes the outlook for the company’s results of operations, liquidity and capital resources is positive in 2003 and beyond for a number of reasons:
Other Matters
Significant Accounting PoliciesThe company does not utilize any special-purpose financing vehicles or have any undisclosed off-balance sheet arrangements. Similarly, the company holds no fair-value contracts for which a lack of marketplace quotations would necessitate the use of fair-value techniques.
During the nine months ended September 30, 2003, the company did not change any significant accounting policies from those utilized in the preparation of the consolidated financial statements as of and for the year ended December 31, 2002, which are discussed in Note 1 to the Consolidated Financial Statements in the company’s 2002 Annual Report on Form 10-K and updated in Note 1 to the Condensed Consolidated Financial Statements beginning on Page 7.
In conjunction with those discussions, in the Management’s Discussion and Analysis contained in the 2002 Annual Report on Form 10-K, management reviews the estimates and assumptions used to develop reported amounts related to the most significant policies. Management discusses the development and selection of those accounting estimates with the audit committee of the board of directors.
New Accounting StandardsSee Notes to Condensed Consolidated Financial Statements for a discussion of new accounting standards.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk is the potential for a decrease in value resulting from broad yet uncontrollable forces such as inflation, economic growth, interest rates, world political conditions or other widespread unpredictable events. It is comprised of many individual risks that, when combined, create a macroeconomic impact. The company’s view of potential risks and its sensitivity to such risks is discussed in the 2002 Annual Report on Form 10-K.
Fixed-Income SecuritiesThe company is using financial planning models developed during 2002 to further incorporate analytical tools in assessing market risks. Management believes the models are improving the company’s ability to measure the impact on bond values resulting from changes in interest rates. Improved measurement of the impact of interest-rate changes should allow for improved matching of the company’s assets and liabilities.
Hypothetically, an increase in interest rates (market yields to maturity) of 100 basis points at September 30, 2003, would decrease the fair value of the fixed-income portfolio by $187 million to $3.575 billion from $3.762 billion. The interest-rate change selected represents management’s views of a shift in rates that is quite possible over a one-year period. The rates selected should not be considered a prediction of future events, as interest rates may be much more volatile in the future. The analysis is not intended to provide a precise forecast of the effect of rate changes on the company’s results or financial condition, nor does it take into account any actions that might be taken to reduce exposure to such risks.
Equity and Convertible SecuritiesIn the first nine months of 2003, the company’s equity portfolio underperformed the Standard & Poor’s 500 Index, a common benchmark of market performance, generating a total return of 1.5 percent versus 14.7 percent for the Index. The primary reasons for difference were the 5.1 percent decline in the market value of Fifth Third Bancorp (Nasdaq: FITB), the company’s largest equity holding, and a decline in the market value of the company’s healthcare-related holdings, which make up 8.3 percent of the equity portfolio market value.
Fifth Third’s value in early 2003 was affected by uncertainty surrounding a regulatory review announced in late 2002. Some of the uncertainty was removed when Fifth Third entered into an agreement with the Federal Reserve Bank and the Ohio Department of Commerce in late March 2003. In the agreement, Fifth Third outlined the series of steps its management has been taking to strengthen identified areas. At that time, Fifth Third noted that management is extremely serious about risk management and internal controls and that the company is taking the necessary steps to strengthen procedures to fully cooperate with the regulatory agencies. Fifth Third said that these efforts, many of which have already
begun, will result in Fifth Third emerging from this process as an even stronger company. Fifth Third continues to report results that meet Cincinnati Financial’s investing criteria of increasing sales, earnings and dividends. In addition, Cincinnati Financial management believes Fifth Third has proven management and a favorable outlook.
At September 30, 2003, the company held 48 individual equity investments, 14 of which each approach at least $100 million in market value. This group accounted for approximately 94 percent of the after-tax net unrealized appreciation of the investment portfolio. The company held 72.8 million shares of Fifth Third at a cost of $283 million at September 30, 2003. The market value of that position was $4.042 billion, or 53.5 percent of Cincinnati Financial’s total equity portfolio, with the after-tax unrealized gain represented by the position at $2.443 billion, or 65.6 percent of the company’s total after-tax unrealized gains. The Fifth Third holding represented $15.23 of the company’s total book value of $35.94 per share at September 30, 2003. Every $1.00 change in the market price of Fifth Third’s common stock has approximately a 29-cent impact on Cincinnati Financial’s book value per share. A 20 percent change in the market price of Fifth Third’s common stock, which was $55.54 at September 30, 2003, would result in a $809 million change in assets and a $526 million change in after-tax unrealized gains. This would affect shareholders’ equity by 9.1 percent and book value by $3.22 per share.
Management believes the company’s investment style – focused on companies that pay and increase dividends to shareholders – offers some protection in down markets. While past performance cannot guarantee future returns, in 2002, the company’s equity portfolio lost 7.3 percent versus a decline of 22.1 percent for the Standard & Poor’s 500 Index.
Potential ImpairmentsThe following table summarizes the portfolio at September 30, 2003, and December 31, 2002:
The reduction in the number of securities trading below 100 percent of book value reflects the recent emphasis on increasing the credit quality of the bond portfolio, as rated by Standard & Poor’s and Moody’s, as well as impairment charges made over the past nine months. During the first nine months of 2003, 47 securities were written down as other-than-temporarily impaired.
Management monitors securities trading below 70 percent of book value for potential other-than-temporary impairment. At September 30, 2003, three securities were trading below 70 percent of book value compared with 59 at December 31, 2002.
Management deems the risk related to securities trading at 70 percent to less than 100 percent of book value to be relatively minor and at least partially offset by the earned income potential of these investments. Other-than-temporary impairment of all securities trading in this range would have resulted in $47 million in additional realized investment losses, before taxes, at September 30, 2003. At year-end 2002, the securities trading in this range represented the potential
for $80 million in additional realized investment losses, before tax. In the first nine months of 2003, securities trading at 70 percent to less than 100 percent of book value, which represented 6.1 percent of invested assets, generated $28 million, or 8.1 percent, of gross investment income.
The following table details the portfolio’s gross unrealized gains and losses as of September 30, 2003:
At September 30, 2003, three of the company’s 220 high-yield corporate bonds were trading below 70 percent of book value and had a market value of $5 million, or less than 0.1 percent of total invested assets, and a book value of $7 million. The three issues have traded below 70 percent of book value for six months or less. At September 30, 2003, no securities in the company’s portfolio had traded below 70 percent of book value for more than six months.
For the 155 securities trading at 70 percent to less than 100 percent of book value, only 42 securities representing $14 million in unrealized losses had been trading in that range for more than 12 months, 17 securities representing $6 million in unrealized losses had been trading in that range for more than six to 12 months and 96 securities representing $24 million in unrealized losses had been trading in that range for six months or less.
Of the total 158 holdings trading below book value at September 30, 2003, eight were common stocks and 22 were convertible securities representing total unrealized losses of $19 million. Financial services-related securities accounted for $6 million, or 34.3 percent, of the unrealized losses. At September 30, 2003, financial services-related securities in the equity portfolio had a market value of $5.278 billion. The other $13 million in unrealized losses primarily were diversified among industrial, healthcare, energy, consumer staple, consumer discretionary and telecommunication securities.
Reflecting the company’s long-term investment philosophy, of the 1,249 securities trading at or above book value, 576, or 46.1 percent, have shown unrealized gains for more than 24 months.
Potential Impairment OutlookIn management’s judgment, the three securities trading below 70 percent of book value at September 30, 2003, that were not written down, do have the potential to recover based on analysis of economic-, industry- or company-specific factors. When applied to the evaluation of holdings trading at 70 percent to less than 100 percent of book value, the company’s investment philosophy considers the corporation’s strong capitalization, which allows it to retain equity securities that have the potential to recover value and to hold bonds until their scheduled redemption. Details of the company’s asset impairment policy are available in the 2002 Annual Report on Form 10-K.
Based on current information, in the fourth quarter the company anticipates other-than-temporary impairments will be under $5 million, absent new developments affecting individual companies or industries in the portfolio.
Item 4. Controls and Procedures
The company carried out an evaluation, under the supervision and with the participation of management, including the chief executive officer and chief financial officer, of the effectiveness of the design and operation of disclosure controls and procedures. Based on that evaluation of these disclosure controls and procedures, the chief executive officer and chief financial officer concluded that Cincinnati Financial Corporation’s disclosure controls and procedures were effective as of the end of the third quarter.
The chief executive officer and chief financial officer also have concluded that there were no significant changes in the third quarter of 2003 to the company’s internal controls or in other factors that have materially affected, or are reasonably likely to materially affect, the company’s internal control over financial reporting.
Part II – Other Information
Item 1. Legal Proceedings
The Cincinnati Insurance Company is a defendant in Rochlin et al v. The Cincinnati Insurance Company, a purported class action lawsuit filed in December 2000 in the U.S. District Court for Southern Indiana on behalf of certain female employees in three departments of the company alleging employment-related gender discrimination in promotions and pay. The complaint seeks unspecified monetary damages and injunctive relief. In July 2003 the court decertified the Title VII class, but left in place conditional certification of the collective action filed under the Equal Pay Act. The company denies the allegations of the suit and is vigorously defending this action.
The company is involved in no other material litigation other than routine litigation incident to the nature of its insurance business.
Item 2. Changes in Securities
There have been no material changes in securities during the third quarter.
Item 3. Defaults upon Senior Securities
The company has not defaulted on any interest or principal payment, and no arrearage in the payment of dividends has occurred.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders in the third quarter ended September 30, 2003.
Item 5. Other Information
The company’s chief executive officer and chief financial officer have furnished to the SEC the certification with respect to this Form 10-Q that is required by Section 906 of the Sarbanes-Oxley Act of 2002.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:Exhibit 11—Statement Recomputation of Per Share Earnings.Item 31—302 CertificationsItem 32—906 Certification
(b) The company furnished the following Reports on Form 8-K during the quarter ended September 30, 2003:July 14, 2003—Item 9. Regulation FD Disclosure (Disclosure of Results of Operations and Financial Condition). On July 14, 2003, Cincinnati Financial Corporation announced preliminary results for its second quarter ended June 30, 2003. The news release was furnished as an exhibit.July 29, 2003—Item 9. Regulation FD Disclosure (Disclosure of Results of Operations and Financial Condition). On July 29, 2003, Cincinnati Financial Corporation announced its financial results for its second quarter ended June 30, 2003. The news release was furnished as an exhibit.September 25, 2003—Item 9. Regulation FD Disclosure. On September 25, 2003, Cincinnati Financial Corporation commented on its long-term outlook, recent storm activity and preliminary results for its third quarter ended September 30, 2003. The news release was furnished as an exhibit.September 29, 2003—Item 9. Regulation FD Disclosure. On September 25, 2003, Cincinnati Financial Corporation held an investor headquarters visit. Presentations used at the visit are furnished as exhibits to the filing.
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. The company furnished a news release announcing the third-quarter 2003 financial results on Form 8-K on October 28, 2003.
CINCINNATI FINANCIAL CORPORATION
Date: November 13, 2003