UNITED STATESSECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
For the transition period from ______________ to _____________.
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.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
As of July 30, 2004, there were 168,307,665 shares of common stock outstanding.
CINCINNATI FINANCIAL CORPORATIONFORM 10-Q FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2004
TABLE OF CONTENTS
PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Cincinnati Financial Corporation and Subsidiaries
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, and are presented in conformity with accounting principles generally accepted in the United States of America (GAAP). All significant intercompany balances and transactions have been eliminated in consolidation.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The December 31, 2003, 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 June 30, 2004, condensed consolidated financial statements of the company 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 interim periods are not necessarily an indication of results to be expected for the remainder of the year. Per share amounts have been adjusted for the 5 percent stock dividend paid June 15, 2004, to shareholders of record on April 30, 2004.
Investments
Fixed maturities (bonds and notes) and equity securities (common and preferred stocks) have been classified as available for sale and are stated at fair values at June 30, 2004, and December 31, 2003.
At June 30, 2004, unrealized investment gains before taxes totaled $5.873 billion and unrealized investment losses in the investment portfolio amounted to $52 million. Total unrealized appreciation was primarily due to the company’s holdings in Fifth Third Bancorp (Nasdaq: FITB) and Alltel Corporation (NYSE:AT) common stock. The change in unrealized gains and losses on investments, net of taxes, described in the following table, are included in shareholders’ equity in accumulated other comprehensive income. The change in fixed maturities unrealized gains and losses for the second quarter and six months ended June 30, 2004, was due primarily to interest-rate driven market value fluctuations in the fixed maturity portfolio. The change in equity securities unrealized gains and losses for the second quarter and six months ended June 30, 2004, was due primarily to the decline in Fifth Third's market value, as well as the previously announced second-quarter 2004 sale of equity securities.
Realized gains and losses on investments are recognized in net income on a specific identification basis. See Investment Portfolio, Page 27, for additional discussion of the investment portfolio. 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 three-month and six-month periods ended June 30, 2004, the company recorded $1 million and $3 million in other-than-temporary impairment charges, compared with $17 million and $69 million in other-than-temporary impairment charges in the comparable prior-year periods (see Investments Results of Operations, Page 24, for discussion of the impairment charges).
Reinsurance
In the accompanying condensed consolidated 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, 2004, the company expanded its property catastrophe reinsurance program, adding another $100 million layer in excess of $400 million and retaining 5 percent of the losses in this layer. See Property Casualty Insurance Operations, Page 14, for discussion of the company’s strategy to support the financial strength ratings of its property casualty insurance operations.
Stock Options
The company has qualified and non-qualified stock option plans under which options are granted to associates at prices which 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 six months ended June 30, 2004 and 2003, respectively: dividend yield of 2.78 and 2.52 percent; expected volatility of 25.91 percent and 25.90 percent; risk-free interest rates of 4.30 percent and 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.
Pension Plan
The measurement date for the company’s pension plan is December 31. The following summarizes the components of net periodic pension costs:
As of June 30, 2004, no contributions had been made; however, the company continues to anticipate contributing $8 million in 2004, as stated in the 2003 Annual Report on Form 10-K.
Reclassifications
Certain prior-period amounts have been reclassified to conform with the current-period classifications.
Recent Accounting Pronouncements
In March 2004, the Financial Accounting Standards Board ratified the consensus reached by the Emerging Issues Task Force in Issue 03-1, “The Meaning of Other-Than-Temporary Impairments and Its Application to Certain Investments” (EITF 03-1). EITF 03-1 is effective for the company in the third quarter of 2004. EITF 03-1 provides guidance for
determining when an investment is impaired, whether impairment is other than temporary, and measurement of an impairment loss. An impairment loss should be recognized equal to the difference between the investment’s carrying value and its fair value when an impairment is other than temporary. Subsequent to an other-than-temporary impairment loss, a debt security should be accounted for in accordance with Statement of Position No. 03-3, “Accounting for Loans and Certain Debt Securities Acquired in a Transfer,” which allows the accretion of the discount between the carrying value and expected value of a security if the amount and timing of the recognition of that difference in cash is reasonably estimable. EITF 03-1 also indicates that although not presumptive, a pattern of selling investments prior to the forecasted recovery may call into question an investor’s intent to hold the security until it recovers in value.
The EITF 03-1 impairment model applies to all investment securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and to investment securities accounted for under the cost method to the extent an impairment indicator exists or the reporting entity has estimated the fair value of the investment security in connection with SFAS No. 107, “Disclosures about Fair Value of Financial Instruments.”
The final consensus on EITF 03-1 included additional disclosure requirements incremental to those included in the company’s 2003 Annual Report on Form 10-K.
The company is currently evaluating the impact of EITF 03-1 on its process for determining other-than-temporary impairment for the affected securities. More specifically, the company is analyzing whether subsequent to adoption of the standard, its portfolio management practices for certain securities classified as available for sale pursuant to SFAS No. 115 could be interpreted as a pattern of selling, thereby affecting its designated intent to hold such investments for the period necessary to allow for the forecasted recovery of fair value pursuant to the requirements of EITF 03-1. As a result of this analysis, the company potentially may record as realized capital losses the unrealized net capital losses associated with certain securities classified as available for sale.
Adoption of this standard may accelerate the timing of recognition of certain impairment losses or otherwise result in impairment losses being recognized when they previously may not have been and may result in the designation of certain investment securities as trading. It also may increase the volatility of net income due to:
Adoption of this standard is not expected to have a material impact on shareholders’ equity since fluctuations in fair value are already recorded in accumulated other comprehensive income.
Gross unrealized losses on available-for-sale securities were $52 million at June 30, 2004. The company is continuing to evaluate the impact of EITF 03-1 and is unable to estimate the impact of adoption in the third quarter of 2004. Any other-than-temporary impairment losses that may need to be recognized upon adoption will be dependent on market conditions and management’s intent and ability to hold any such impaired securities. The company’s current asset impairment policy is discussed in the 2003 Annual Report on Form 10-K, Page 19.
Regulatory Proceedings
On June 28, 2004, Cincinnati Financial Corporation filed an application with the Securities and Exchange Commission formally requesting an exemption for the holding company under Section 3(b)(2) of the Investment Company Act, which permits the SEC to exempt entities primarily engaged in business other than that of investing, reinvesting, owning, holding or trading in securities. Cincinnati Financial Corporation alternatively has asked the SEC for relief pursuant to Section 6(c) of the Investment Company Act that would exempt it from all the provisions of the Act because doing so is necessary or appropriate in the public interest consistent with the protection of investors and consistent with the purposes intended by the Investment Company Act. The company simultaneously contacted the SEC’s Division of Investment Management to discuss the status of Cincinnati Financial Corporation under the Investment Company Act.
Management strongly believes that Cincinnati Financial Corporation is not an investment company because it is engaged primarily in the business of property casualty and life insurance through subsidiaries it owns, rather than the business of investing, reinvesting, owning, holding or trading in securities. As of the filing date of this Form 10-Q, the matter is being actively considered by the SEC staff. See Item 5, Other Information, Application to SEC Requesting Exemption from Investment Company Act of 1940, Page 34, for additional information regarding the application.
NOTE 2 — SEGMENT INFORMATION
The company is organized and operates primarily in two industries, property casualty insurance and life insurance. Company management regularly reviews four reportable segments — commercial lines property casualty insurance, personal lines property casualty insurance, life insurance and investment operations — to make decisions about allocating resources and assessing their performance. Included in the Other category are operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding investment activities) and other income of the insurance subsidiaries.
Revenues are primarily from unaffiliated customers. Revenue for the insurance segments is insurance premiums earned. Revenue for the investment operations segment consists of net investment income and realized investment gains and losses. Other revenue is primarily finance/lease income.
Income before income taxes for the commercial lines and personal lines insurance segments consists of underwriting profit (loss), which is defined as premiums earned minus loss and loss expenses incurred or policyholder benefits and underwriting expenses. Income before income taxes for the life insurance segment represents underwriting profit (loss),
which is defined as premiums earned plus separate account investment management fees less contract holder benefits incurred and expenses incurred plus investment interest credited to contract holders.
Income before income taxes for the investment operations segment consists of net investment income plus realized investment gains and losses, less interest credited to contract holders of the life insurance segment, for all fixed maturity and equity security investments, regardless of ownership. Losses before income taxes in the Other category are primarily due to interest expense from debt of the parent company and operating expenses of company headquarters.
Identifiable assets by segment are those assets used in the respective segment’s operations. Information regarding identifiable assets is not reported 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 investment assets, 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 2003 Annual Report on Form 10-K. Dollar amounts are rounded to millions; calculations of percent changes are based on whole dollar amounts. Per share amounts have been adjusted for the 5 percent stock dividend paid June 15, 2004, to shareholders of record on April 30, 2004.
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:
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
The consolidated results of operations reflect the operating results of each of the company’s four segments along with parent company and other non-insurance related activities. Per share amounts have been adjusted for the 5 percent stock dividend paid June 15, 2004, to shareholders of record on April 30, 2004. The four segments are:
Revenues for the three- and six-month periods increased due to growth in earned premiums and substantial realized investment gains in the second quarter of 2004. The company reported realized investment gains for the first six months of 2004, compared with realized investment losses in last year’s first six months. Net income rose due to the growth in revenues and higher pretax underwriting profits for the property casualty insurance operations.
Realized investment gains and losses – A significant factor in the growth rate for net income in any period can be realized investment gains and losses. Management believes it is important to carefully consider the impact of realized investment gains and losses on net income when evaluating the company’s operating segments: property casualty insurance and life insurance. Management believes the level of realized investment gains and losses for any particular period, while it may be material, may obscure the performance of ongoing underlying business operations in that period. While realized investment gains and losses are integral to the company’s insurance operations over the long term, the determination to recognize investment gains or losses in any period may be subject to management’s discretion and is independent of the insurance underwriting process. Moreover, under applicable accounting requirements, gains and losses can be recognized from certain changes in market values of securities without actual realization, such as changes in the valuation of embedded derivatives or other-than-temporary impairment charges.
In the second quarter of 2004, the after-tax impact of net realized investment gains was to increase net income by $36 million, or 21 cents per share, compared with net realized investment gains in last year’s second quarter that increased net income by $1 million, or 1 cent. For the first six months of 2004, the after-tax impact of net realized investment gains was to increase net income by $40 million, or 24 cents per share, compared with net realized investment losses that reduced net income by $39 million, or 23 cents per share, in the first six months of 2003. The company reported a net realized investment gain in the second quarter of 2004 primarily because of the previously disclosed sale of equity securities. In addition, other-than-temporary impairment charges declined. See Investments Results of Operations, Page 24, for additional information on net realized investment gains and losses.
Other considerations –Following the Ohio Supreme Court’s late 2003 decision to limit its 1999 Scott-Pontzer v. Liberty Mutual decision, during the first quarter of 2004, the company reviewed outstanding uninsured motorist/underinsured motorist (UM/UIM) claims for which litigation was pending. Those claims represented approximately $37 million in previously established case reserves. Over the three months ended March 31, 2004, the company filed motions for dismissal in various jurisdictions for specific claims and released $32 million in related case reserves in addition to the $38 million that was released in the fourth quarter of 2003. UM/UIM-related reserve changes had a minimal effect on second-quarter 2004 results and the company believes that UM/UIM-related reserve changes will be immaterial in coming quarters.
Management considers the reserve release to be unusual, and it should be taken into consideration when evaluating ongoing business operations. The reserve releases in the first quarter added $21 million, or 12 cents per share, to net income in the first six months of 2004. See the 2003 Annual Report on Form 10-K, Property Casualty Loss and Loss Expense Reserves, for additional information regarding UM/UIM reserves.
Option expense – In the three months ended June 30, 2004 and 2003, reported net income per share on a diluted basis would have been reduced by 1 cent and 2 cents, respectively, if option expense, calculated using the binomial option-pricing model, had been included in operating expenses. In the six months ended June 30, 2004 and 2003, reported net income per share on a diluted basis would have been reduced by 3 cents, if option expense, calculated using the binomial option-pricing model, had been included in operating expenses.
Book value – Due to a lower level of unrealized gains in the investment portfolio; book value per share declined to $36.27 at June 30, 2004, from the record year-end 2003 level of $36.85.
Comprehensive income – Accumulated other comprehensive income, which includes the accumulated unrealized gains on investments and derivatives, declined by $207 million in the second quarter. Return on equity based on comprehensive income was a negative 3.3 percent, compared with a positive 55.2 percent last year, because of a decline in accumulated unrealized gains, compared with an increase in accumulated unrealized gains in last year’s second quarter.
Outlook
Over the long term, management’s objective is to achieve steady growth while performing as an industry profitability leader. At the beginning of the year, management had established specific performance targets for full-year 2004. With results for the first half of the year available, management has updated those targets based on its outlook for the insurance and investment markets and its progress in implementing operating strategies. Management now anticipates:
Factors supporting management’s outlook for 2004 are discussed in the results of operations for each of the four business segments.
Property Casualty Insurance Operations
Within the property casualty insurance market, the company offers both commercial and personal policies through a network of independent agencies. Highlights of the performance for the combined property casualty insurance operations included:
The discussion of the commercial lines and personal lines segments provides additional detail regarding these strategies and trends.
Commercial Lines Results of Operations
Performance highlights for the commercial lines segment included:
Earned premiums – The primary source of earned premium growth for the three- and six-month periods was higher pricing on new and renewal commercial business and continued solid new business growth. In the second quarter of 2004, commercial lines new business premiums written directly by agencies rose 5.9 percent to a record $75 million from $71 million a year earlier. In the first six months of 2004, commercial lines new business premiums written directly by agencies rose 14.4 percent to a record $142 million from $124 million a year earlier.
The company’s standard approach is to write three-year commercial policies, which the company considers to be a competitive advantage in the commercial lines market, as further discussed in Item 1 of the 2003 Annual Report on Form 10-K. However, management estimates that approximately 75 percent of second-quarter 2004 commercial premiums were subject to annual rating within the three-year policy or were written with a one-year policy term.
Profitability – Improvement in commercial lines profitability primarily has been driven by more adequate premiums per exposure. In addition, careful attention to underwriting has slowed the rate of growth in loss and loss expenses. The commercial lines combined ratio for the first six months of 2004 of 83.5 percent included the benefit of the UM/UIM reserve release, which reduced the ratio by 3.0 percentage points.
Commercial Lines Losses Incurred Analysis
Line of Business Analysis
In total, commercial multi-peril, workers compensation, commercial auto and other liability accounted for approximately 90 percent of total commercial lines earned premium. Approximately 95 percent of the company’s commercial lines premiums are written for accounts with coverages from more than one business line. The company believes that its commercial lines growth and profitability is best measured and evaluated on a segment basis.
Results for the business lines within the commercial lines segment have reflected the company’s emphasis on underwriting and obtaining adequate pricing for the covered risk. Other factors that have affected results for these lines included:
Commercial Lines Outlook
During 2004, the company anticipates commercial lines insurance market trends will reflect the pressure on pricing from the industry’s increasing surplus and improving profitability. During the second quarter, agent feedback indicated that renewal price increases were running in the low single digits, with pricing for property lines softening and modest pricing increases for casualty-driven lines holding steady, and management expects competition to accelerate during the remainder of the year. The company will continue to market its products to a broad range of business classes, price its products adequately and take a package approach.
For the full year, management anticipates commercial lines growth on a written premium basis of approximately 10 percent if market conditions remain stable. When compared with results for 2003, management also anticipates incremental improvement in its already strong combined ratio.
Personal Lines Results of Operations
Performance highlights for the personal lines segment include:
Earned premiums – The primary source of growth in the three- and six-month periods was higher rates for renewal personal lines business, additional premium derived from initiatives to ensure that policyholders purchase adequate coverage limits for the insured risk and to provide for specific charges for certain coverage extensions such as water damage. Policy count remained relatively flat compared with the year-earlier period. The company continues to renew approximately 90 percent of personal lines policies, indicating that current policyholders recognize the value that their agent and the company bring. Personal lines new business premiums written directly by agencies was $12 million in the second quarter of 2004, compared with $16 million in the second quarter of 2003, and $25 million for the first six months of 2004, compared with $31 million in the prior six-month period.
Management believes recent homeowner rate increases brought pricing in some markets to levels that may no longer be competitive, diminishing a differentiating factor for more price-sensitive consumers. The company’s independent agents are guiding management on potential refinements of the current rate structure, as needed. Further, the company believes that agencies are placing less new business with the company pending the introduction of the company’s new personal lines policy processing system in their state. Agencies that begin using the new personal lines policy processing system may not be placing new business with the company during the period when they are initially converting existing policyholders to the new system.
Combined ratio – The second-quarter and six-month combined ratios declined when compared with the year-earlier period as higher earned premium reduced the lower loss and loss expense ratio excluding catastrophe losses, offsetting higher underwriting expenses. Catastrophe losses were relatively unchanged year-over-year.
While generally seeking to leverage the relationships with the company’s independent agencies, efforts to improve personal lines profitability have focused on the personal auto and homeowner business lines as discussed below. The significant components of expenses for the personal lines segment were:
Personal Lines Losses Incurred Analysis
The personal auto and homeowner business lines together account for approximately 90 percent of the total personal lines earned premiums. The company’s intent is to write personal auto and homeowners coverages in personal lines packages. The company believes that the personal lines business is best measured and evaluated on a segment basis.
Personal Lines Outlook
Management is maintaining reasonable growth projections for the personal lines area as the company introduces Diamond, its new personal lines processing system, as discussed above. The Diamond training program for agency representatives was completed for Michigan and Indiana agencies in the second quarter. Agencies that complete the training immediately begin using the Diamond system to process all new and renewal personal lines policies. Groups of Ohio agencies began training in late June, and the roll-out is expected to be completed during 2004. In Michigan and Indiana during the second quarter, agents chose direct bill for 47 percent of the policies and headquarters policy printing for 73 percent of the policies. Agents in Alabama, Florida, Illinois, Kentucky, Georgia and Wisconsin will be trained on a state-by-state basis beginning in the fourth quarter of 2004 and running throughout 2005.
The new system will make it easier for agents to place personal auto, homeowners and other personal lines business with the company, while greatly increasing policy-issuance efficiency and providing direct-bill capabilities. Management will be better able to assess the potential effect of the new system on personal lines growth during the second half of 2004, when the system will be in use in Indiana, Michigan and Ohio, three of the largest personal lines states. It has been used by the company’s Kansas agencies since July 2002 and is undergoing a series of upgrades and modifications to accommodate each state’s rules and rates. The appointment of new agencies over the next several years also could contribute to personal lines growth.
In addition, management believes that it has in place strategies to improve the profitability of its homeowner line of business while maintaining or slightly improving personal auto profitability. While primarily focusing on longer-term targets for the homeowner line because of the existing base of three-year policies, management expects to see steady improvement in the overall personal lines loss and loss expense ratio excluding catastrophes in 2004 and beyond as the company continues to work through the renewal policy cycle.
Life Insurance Results of Operations
Performance highlights for the life insurance segment include:
Revenues – Earned premiums grew 17.4 percent and 16.8 percent in the second quarter and first six months of 2004, and life policy face amounts in force rose to $41.753 billion at June 30, 2004, from $38.492 billion at December 31, 2003. The company’s life insurance subsidiary reported statutory written life premium of $27 million for the second quarter of 2004, unchanged from last year’s second quarter. Statutory written life premium was $53 million for the first six months of 2004, compared with $51 million in last year’s period. New annuity sales were $23 million in this year’s second quarter, compared with $6 million last year and $31 million in the first six months of 2004 unchanged from the comparable prior period. Second-quarter and six-month results reflected a positive response to recently introduced enhancements to the life insurance company’s term life insurance product portfolio.
Profitability – The GAAP-based income reported by the life insurance segment was modest because its investment income is included in investment segment results, except investment income credited to contract holders (interest assumed in life insurance policy reserve calculations). At the same time, management recognizes that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life policies. For that reason, management also evaluates GAAP data including results for investment activities on life insurance-related assets for The Cincinnati Life Insurance Company subsidiary, which comprises the life insurance segment. Looking at this key performance indicator for Cincinnati Life, GAAP net income grew to $10 million in the second quarter of 2004, compared with $7 million a year earlier. For the six months, net income including net realized capital gains and losses rose to $19 million from $6 million for the comparable 2003 period.
Life Insurance Outlook
As the life insurance company seeks to increase penetration of the property casualty agencies, management’s objective is growth in premiums. Late in 2004, Cincinnati Life expects to add a disability income product to its worksite marketing portfolio and make electronic enrollment available for worksite marketing programs. Other 2004 technology initiatives include placing the life insurance sales system on CinciLink, the company’s agency extranet. This will bring agents the convenience of online form completion and submission, eliminating the expense of frequent software-update mailings.
Investments Results of Operations
The investment segment contributes investment income and realized investment gains and losses to results of operations.
Investment income – Pretax investment income reached a new record of $121 million in the second quarter of 2004, rising 5.6 percent over the second quarter of 2003. Growth in investment income continued to be driven by higher interest income due to increased cash flow invested in the fixed-income portfolio and increased dividend income from the common stock portfolio. Overall, dividends contributed 48.5 percent of pretax investment income in the second quarter of 2004, compared with 48.3 percent in the second quarter of 2003. Over the past 12 months, 32 of the 49 common stock holdings in the portfolio raised their indicated dividend payout. Those increases should add approximately $16 million to investment income on an annualized basis. Fifth Third, the company’s largest equity holding, contributed 40.3 percent of total dividend income in the second quarter of 2004.
Pretax investment income was $241 million for the first six months of 2004, rising 4.7 percent. Dividends contributed 48.7 percent of pretax investment income in the first six months of 2004, compared with 48.5 percent in the first six months of 2003. Fifth Third, the company’s largest equity holding, contributed 39.2 percent of total dividend income in the first six months of 2004.
Net realized investment gains and losses – The company recorded $55 million in pretax net realized investment gains in the second quarter of 2004, compared with $2 million in pretax net realized investment gains in the second quarter of 2003.
Investments Outlook
Management believes that it can achieve investment income growth above 4.5 percent in 2004 as a result of the anticipated growth in dividend income, the potential rise in interest rates, strong cash flow from insurance operations and the higher-than-normal allocation of new cash flow to fixed-income securities. While management does not forecast realized investment gains and losses, it believes that impairment charges in 2004 will be limited to securities marked to market because they have been identified for sale, or those where issuer-specific events cause sharp declines in market value with little or no warning.
The company’s asset impairment committee continues to monitor the investment portfolio. The company also is evaluating the impact of EITF 03-1 (see Note 1, Recent Accounting Pronouncements, Page 8) and is unable to estimate the impact of adoption in the third quarter of 2004. Any other-than-temporary impairment losses that may need to be recognized upon adoption will be dependent on market conditions and management’s intent and ability to hold any such impaired securities. The company’s current asset impairment policy is discussed in the 2003 Annual Report on Form 10-K, Page 19. The committee’s ongoing reviews help to minimize surprise events that may negatively impact the value of the company’s holdings.
Other
Operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding investment activities) and other income of the insurance subsidiaries contributed $3 million in revenues in the second quarters of 2004 and 2003. Losses before income taxes of $9 million, compared with $10 million, were primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.
Taxes
Income from operations resulted in current tax expense of $10 million for the second quarter of 2004. This tax expense was offset by a $16 million capital loss carryforward, which resulted in a net current tax credit of $6 million for the second quarter of 2004 compared with a net current tax expense of $27 million in the second quarter of 2003. The deferred tax asset of $32 million that the company had been carrying for 2002 capital losses now has been reduced to $16 million due to this utilization.
The company’s total income tax expense was $59 million in the second quarter of 2004, compared with $23 million in the second quarter of 2003. The effective tax rate was 27.4 percent, compared with 21.5 percent for the same period last year, because of higher underwriting profits and the higher level of capital gains, which are taxed at a 35 percent rate, compared with capital losses in the first six months of 2003.
Income tax expense was $114 million in the first six months of 2004 compared with $31 million in the first six months of 2003. The effective tax rate for the first six months of 2004 was 27.4 percent compared with 18.1 percent for the same period last year.
The company pursues a strategy of investing some portion of cash flow in tax-advantaged fixed maturities and equity securities to minimize its overall tax liability and maximize after-tax earnings. See Note 10 to the Consolidated Financial Statements in the 2003 Annual Report on Form 10-K for detail regarding the company’s effective income tax rate. Management now anticipates that the effective annual tax rate will be in the 25 percent to 28 percent range compared with its earlier estimate of 21 percent to 24 percent range. The increase reflects the company’s strong profitability and achievement of its performance objectives of an underwriting profit, growth in investment income and realized investment gains.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow
The company’s property casualty and life insurance operations generated positive cash flows from underwriting of $327 million in the first six months of 2004, compared with $226 million a year earlier. This strong underwriting cash flow, defined as premiums collected less losses, loss expenses, commissions and other underwriting expenses paid, primarily was due to growth of insurance premiums. In addition, investment income from the insurance operations generated cash flows of $170 million, compared with $161 million a year earlier.
The insurance subsidiaries invested $799 million and $640 million in fixed-income and equity securities in the first six months of 2004 and 2003, respectively. Those purchases were offset by sales of fixed-income securities totaling $19 million and $69 million, and by calls and maturities of fixed-income securities totaling $288 million and $184 million in the first six months of 2004 and 2003, respectively. Sales, calls or maturities of equity and equity-linked securities totaled $404 million and $84 million in the same periods. During the second quarter of 2004, the company sold $356 million in equity holdings and $30 million in equity-linked holdings. A portion of the proceeds were reinvested in fixed income and convertible securities. These figures do not include the transfer of $153 million in equity holdings to the parent company in exchange for fixed-income securities. See Property Casualty Insurance Operations, Page 15, for discussion of the company’s strategy to support the financial strength ratings of its property casualty insurance operations.
In the first six months of 2004 and 2003, the company’s property casualty insurance subsidiary paid ordinary dividends of $75 million and $50 million, respectively, to the parent company.
As a result of investment income from its investments and dividends and borrowings from its property casualty insurance subsidiary, the parent company met its cash requirements for general operating expenses, interest payments on its long-and short-term debt, dividends to shareholders and common stock repurchases. In addition, the company paid $94 million in principal on one of its short-term credit lines pending discussions with its bankers regarding the application filed June 28 to clarify the company’s status under the Investment Company Act (see Item 5, Other Information, Application to SEC Requesting Exemption from Investment Company Act of 1940, Page 34, for additional information on the application). Subsequent to the end of the quarter the company paid-off the remaining $34 million balance on that line of credit. The company is working to re-establish a short-term line of credit on essentially the same terms. While the company currently does not know whether or not such a line will be established, it would access any short-term line of credit that may be established as needed to fund parent-company activities.
Investing activities for the parent company generated $40 million of cash flow in the first six months of 2004 after using $2 million in the comparable prior period.
Dividends
Cincinnati Financial has increased the indicated annual cash dividend rate to shareholders for 44 consecutive years and, periodically, the board of directors authorizes stock dividends or splits. In January 2004, the board of directors authorized a 10.0 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.10. At the same time, the board also authorized a 5 percent stock dividend payable June 15, 2004, to shareholders of record April 30, 2004. This is the 28th stock dividend or split declared over the past 47 years.
Common Stock Repurchase
In the second quarter of 2004, the company repurchased 25 thousand shares at an average price of $40.99, below the level of recent periods due to the timing of company-imposed trading blackouts. Common stock repurchases for treasury have continued at a steady pace over the last several years and occur whenever management believes that stock prices on the
open market are favorable for such repurchases. At a minimum, the company would expect to offset dilution of option exercises. At June 30, 2004, 5 million shares remained authorized for repurchase. See Part II, Item 2, Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities, Page 33, for additional information regarding the stock repurchase activity.
The holding company’s unresolved status under the Investment Company Act (see Item 5, Other Information, Application to SEC Requesting Exemption from Investment Company Act of 1940, Page 34, for additional details) is expected to preclude the company from accessing the capital markets until the SEC has acted on the company’s application for an exemption from the Act. However, management continues to believe that cash provided by its insurance operations are adequate to meet anticipated short-term and long-term obligations and will continue to be the primary source of funds for the company.
Management anticipates its insurance subsidiaries may pay additional ordinary dividends to the parent company in the remainder of 2004. During the remainder of 2004, the subsidiaries can pay up to $203 million in additional ordinary dividends to the parent company before needing approval from the Ohio Department of Insurance.
The company will determine the timeline for developing additional space at its headquarters location during the remainder of this year. The construction of additional office space at its headquarters location is not expected to begin until 2006, although the company now anticipates beginning work on a parking garage in early 2005.
Future liquidity could be affected by catastrophe losses in excess of the company’s catastrophe reinsurance treaties, which now provide coverage for gross losses up to $500 million. The company has no significant exposure to assumed reinsurance, which accounted for no more than 2.4 percent of earned premiums in each of the last three years and is expected to remain at or near this level in 2004. See Item 5, Other Information, Application to SEC Requesting Exemption from Investment Company Act of 1940, Page 34, for information regarding potential liquidity concerns if the SEC were not to grant the request for an exemptive order. In addition, the company’s liquidity could be impacted if it is unable to reestablish a short-term line of credit.
Assets
At June 30, 2004, the investment portfolio made up 77.8 percent of total assets, which increased to $15.530 billion from $15.509 billion at December 31, 2003. The remainder consisted primarily of other invested assets (0.2 percent), premium receivables (7.4 percent), reinsurance receivables (4.2 percent), deferred acquisition costs (2.6 percent) and separate accounts (3.0 percent). These percentages have remained relatively constant over the last few years.
Investment Portfolio
The market value of the company’s investments securities was $12.082 billion at June 30, 2004.
Insurance regulatory and statutory requirements designed to protect policyholders from investment risk influence the company’s investment decisions on an individual insurance company basis. Cash generated from insurance operations is invested almost entirely in five classes of assets evaluated for yield and risk prior to purchase. During the second quarter ended June 30, 2004, the company temporarily changed the allocation of new property casualty portfolio investments to help reduce the ratio of common stock to statutory surplus below 100 percent, a level maintained in the property casualty portfolio throughout the 1990s. By year-end 2004, management believes the company will return to its historic investment pattern, allocating 65 percent to 75 percent of cash flow to fixed-income securities. See Property Casualty Insurance Operations, Page 15, for discussion of the company’s strategy to support the financial strength ratings of its property casualty insurance operations.
Liabilities and Shareholders’ Equity
At June 30, 2004, insurance reserves were 49.0 percent of total liabilities, which increased to $9.427 billion from $9.305 billion at December 31, 2003. The remainder consisted primarily of unearned premiums (16.4 percent), deferred income tax (19.7 percent) and long- and short-term debt (5.4 percent). These percentages have remained relatively constant over a number of years.
The company had two lines of credit totaling $250 million, with the outstanding balances on the lines totaling $92 million at June 30, 2004, compared with $183 million at year-end 2003. Prior to the announcement on June 28 of the application for exemptive relief from the Investment Company Act, the company paid down one of its short-term credit lines and paid it off at the beginning of the third quarter. The company is working to reestablish that short-term line of credit on essentially the same terms. While the company currently does not know whether or not the line will be re-established, it would access any short-term line of credit that may be established as needed to fund parent-company activities.
Other Matters
Significant Accounting Policies
The 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 six months ended June 30, 2004, 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, 2003, which are discussed in Note 1 to the Consolidated Financial Statements in the company’s 2003 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 2003 Annual Report on Form 10-K, management reviewed the estimates and assumptions used to develop reported amounts related to the most significant policies. Management discussed the development and selection of those accounting estimates with the audit committee of the board of directors.
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 2003 Annual Report on Form 10-K.
Fixed-Income Securities
By allocating approximately two-thirds of invested cash flows to the fixed-income portfolio over the longer term, the company believes it enhances portfolio stability and diversity. Compared with common stocks, fixed-income investments generally are less volatile and provide a more consistent income stream. Overall credit risk is reduced by diversifying the fixed-income portfolio among approximately 1,300 securities.
Interest Rate Risk
Because of the company’s strong surplus, long-term investment horizon and its ability to hold most fixed-income investments until maturity, management believes the company is well positioned for a rise in interest rates. A higher rate environment would provide the opportunity to invest cash flow in higher-yielding securities, while reducing the likelihood of calls of the higher-yielding U.S. agency paper purchased over the past year. While higher interest rates would be expected to continue to increase the number of fixed-income holdings trading below 100 percent of book value, management believes lower fixed-income security values due solely to interest rate changes would not signal a decline in credit quality.
The company is using a dynamic financial planning model developed during 2002 to further incorporate analytical tools in assessing market risks. Management believes the model is 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.
While interest rates were on a declining trend, the company monitored duration to the call date as a measure of its interest rate sensitivity. If rates rise, as is widely anticipated, the company will continue to measure duration to maturity, as this may become the more conservative measure. The table below summarizes the company’s interest rate risk and shows the effect of hypothetical changes in interest rates on the market value of the fixed-income portfolio under both duration scenarios:
In the dynamic financial planning model, the selected interest rate change of 100 basis points represents management’s views of a shift in rates that is quite possible over a one-year period. The rates modeled 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 changes in rates 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 Equity-Linked Securities
Management believes the company’s equity investment style – centered on companies that pay and increase dividends to shareholders – is an appropriate long-term strategy. While the company’s long-term financial position would be affected by prolonged changes in the market valuation of its investments, management believes the company’s strong surplus position and cash flow provide it with a cushion against short-term fluctuations in valuation. The continued payment of cash dividends by the issuers of the common equities held by the company also should provide a floor to their valuation.
The company’s investments are heavily weighted toward the financials sector, which represented 69.8 percent of the total market value of the common stock portfolio at June 30, 2004. Financials sector investments typically underperform the overall market during periods when interest rates are expected to rise. Management historically has seen these types of short-term fluctuations in market value of its holdings as potential buying opportunities but is cognizant that a prolonged downturn in this sector would create the greatest long-term negative effect on the portfolio.
While past performance cannot guarantee future returns, over the longer term, the performance of the company’s equity portfolio has exceeded that of the broader market, achieving a compound annual return of 3.6 percent for the five years ended June 30, 2004, compared with a compound annual decline of 2.2 percent for the Standard & Poor’s 500 Index, a common benchmark of market performance. In the second quarter of 2004, the equity portfolio underperformed the market, declining 0.6 percent, compared with the Standard & Poor’s 500’s total return of 1.7 percent.
The company holds 72.8 million shares of Fifth Third common stock at a cost of $283 million. The market value of the company’s Fifth Third position was $3.914 billion at June 30, 2004, or 51.9 percent of the company’s total common equity portfolio, compared with $4.301 billion, or 52.7 percent, at year-end 2003. The after-tax unrealized gain represented by the company’s Fifth Third position was $2.360 billion, or 62.5 percent of the company’s total after-tax unrealized gains at June 30, 2004, compared with $2.612 billion, or 63.8 percent at year-end 2003. The Fifth Third position represented $14.03 of the company’s total book value of $36.27 per share at June 30, 2004, compared with $15.50 at year-end 2003. Every $1.00 change in the market price of Fifth Third’s common stock has approximately a 28 cent impact on book value per share. A 20 percent ($10.76) change in the market price of Fifth Third’s common stock, which was $53.78 at June 30, 2004, would result in a $783 million change in assets and a $509 million change in after-tax unrealized gains. This would affect shareholders’ equity by 8.3 percent and book value by $3.03 per share.
Fifth Third Bancorp announced on April 7, 2004, that the Federal Reserve Bank of Cleveland and the Ohio Department of Commerce, Division of Financial Institutions, terminated a Written Agreement entered into with Fifth Third Bancorp and Fifth Third Bank in late March 2003. That agreement outlined a series of steps to address and strengthen Fifth Third’s risk management processes and internal controls. Fifth Third noted that the steps taken in conjunction with the agreement have made its organization stronger. 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 a proven management team and a favorable outlook.
Potential Impairments
The following table summarizes the portfolio at June 30, 2004, and December 31, 2003:
At June 30, 2004, unrealized investment gains before taxes totaled $5.873 billion and unrealized investment losses in the investment portfolio amounted to $52 million. The unrealized appreciation was primarily due to the company’s holdings in Fifth Third (Nasdaq: FITB) and Alltel Corporation (NYSE:AT) common stock.
The continuing increase in the number of securities trading below 100 percent of book value since December 31, 2003, primarily reflected the changing interest rate environment and its impact on bond prices. That increase offset recent improvements in the credit quality of the bond portfolio, as rated by Standard & Poor’s and Moody’s. That increase also was offset by revised book values due to impairment charges recognized during 2003 and 2002. During the first six months of 2004, six 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 June 30, the six securities trading below 70 percent of book value had been at that level for six months or less and represented just $19 million in book value and gross unrealized losses of $8 million. All six are either backed by a single airline, or secured by its equipment.
The following table details the portfolio’s gross unrealized gains and losses as of June 30, 2004:
Management deems the risk related to securities trading between 70 percent and 100 percent of book value to be relatively minor and at least partially offset by the earned income potential of these investments. At June 30, 2004, 315 securities were trading between 70 percent and 100 percent of book value up from 116 at year-end 2003. The securities trading between 70 percent and 100 percent of book value at June 30, 2004, represented 11.6 percent of invested assets and $44 million in unrealized losses.
Of the total 321 holdings trading below book value at June 30, 2004, 301 were trading at or above 90 percent of book value, primarily because of the recent rise in interest rates. The market value of these 301 securities was $1.379 billion at June 30, 2004, and they accounted for less than $36 million in unrealized losses.
The remaining 20 securities, which accounted for the remaining $16 million in unrealized losses, are being monitored for credit- and industry-related risk factors. Of these securities, nine are airline-related.
Reflecting the company’s long-term investment philosophy, of the 1,114 securities trading at or above book value, 651, or 58.4 percent, have shown unrealized gains for more than 24 months.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures
The effectiveness of the design and operation of disclosure controls and procedures was evaluated under the supervision and with the participation of management, including the chief executive officer and chief financial officer. Based on that evaluation, the chief executive officer and chief financial officer concluded that the company’s disclosure controls and procedures were effective as of the end of the second quarter and provided reasonable assurance that the information required to be disclosed by the company in its periodic reports is accumulated and communicated to management as appropriate to allow timely decisions regarding disclosure and is recorded, processed, summarized and reported within the time periods required by law. The company’s management, including the chief executive officer and chief financial officer, does not expect that its disclosure controls and procedures will prevent or detect all error and all fraud. Such controls and procedures controls can only provide reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met.
(b) Changes in Internal Control over Financial Reporting
The chief executive officer and chief financial officer also have concluded that there were no significant changes in the second quarter of 2004 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
There has been no material change in the status of previously reported proceedings. The company’s subsidiaries are involved in various lawsuits arising in the ordinary course of business. While the ultimate outcome of such matters cannot be predicted with certainty, in the opinion of management, no such matter is likely to have a material adverse effect on the company’s consolidated financial position.
ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
The company’s board of directors has authorized the repurchase of outstanding shares. The company has repurchased 15.9 million shares at a cost of $532 million between the inception of the program in 1996 and June 30, 2004. At June 30, 2004, 5 million shares remain authorized for repurchase at any time in the future.
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
As reported in the company’s Form 10-Q for the three months ended March 31, 2004, the registrant held its Annual Meeting of Shareholders on April 24, 2004, for which the board of directors solicited proxies. All nominees named in the Registrant’s Proxy Statement were elected.
Shareholders ratified the selection of Deloitte & Touche LLP as the company’s independent audit firm for 2004.
ITEM 5. OTHER INFORMATION
Application to SEC Requesting Exemption from Investment Company Act of 1940
As a result of a review made in June 2004 in connection with a contemplated senior notes offering, the company determined there was some uncertainty regarding the status of the Cincinnati Financial Corporation holding company under the Investment Company Act of 1940. On June 28, 2004, Cincinnati Financial Corporation filed an application with the Securities and Exchange Commission formally requesting an exemption for the holding company under Section 3(b)(2) of the Investment Company Act, which permits the SEC to exempt entities primarily engaged in business other than that of investing, reinvesting, owning, holding or trading in securities. Cincinnati Financial Corporation alternatively has asked the SEC for relief pursuant to Section 6(c) of the Investment Company Act that would exempt it from all the provisions of the Act because doing so is necessary or appropriate in the public interest consistent with the protection of investors and consistent with the purposes intended by the Investment Company Act. The company simultaneously contacted the SEC’s Division of Investment Management to discuss the status of Cincinnati Financial Corporation under the Investment Company Act.
Management strongly believes that Cincinnati Financial Corporation is not an investment company because it is engaged primarily in the business of property casualty and life insurance through subsidiaries it owns, rather than the business of investing, reinvesting, owning, holding or trading in securities. As a result, Cincinnati Financial Corporation believes the holding company is outside the intended scope of the Investment Company Act and therefore should not be subject to the provisions of the Investment Company Act.
In the 1930s and 1940s, the U.S. Congress enacted a series of laws regulating publicly traded companies, including the Investment Company Act. The Investment Company Act is designed primarily to regulate “investment companies,” which generally includes mutual funds of the type sponsored by the Fidelity and Vanguard organizations (to pick two prominent examples), closed-end investment companies that are traded on the public stock markets, and certain non-managed pooled investment vehicles such as unit investment trusts. An investment company is required to register with the SEC as such, register its shares under the Securities Act of 1933, and is subject to a number of restrictions, regulations and limitations under the Investment Company Act.
There are several tests and enumerated exemptions to determine whether a company must register as an investment company under the Investment Company Act, along with defined processes for requesting exemptions. One such test, which is set forth in Section 3(a)(1)(C) of the Investment Company Act, states that a company is an investment company if it owns investment securities valued at more than 40 percent of its total assets (without including assets of its subsidiaries). At December 31, 2003, the investment assets held by Cincinnati Financial Corporation at the parent holding company were above the 40 percent level, as has been the case since 1991. As of December 31, 2003, as reflected on Schedule II in the Annual Report on Form 10-K, Cincinnati Financial Corporation reported $8.256 billion in total assets of which $4.833 billion, or approximately 58.5 percent, represented investment securities.
The company is committed to preserving its financial flexibility, maintaining its financial strength and protecting the value of its insurance operations over the long term. Management does not believe that the question of holding-company status under the Investment Company Act, or the process to resolve it, directly affects the company’s insurance company operations.
Management and the board are working with outside advisors to assess options that could reduce the Cincinnati Financial Corporation holding company’s ratio (as defined above) below 40 percent in the short term, while the SEC considers the application for an exemption from the Investment Company Act. Management has expressed some ideas to the Ohio Department of Insurance, but has not yet made a formal filing with the Department.
At this time, the company does not know if the SEC will grant the request for an exemptive order or, if the company is able to obtain such an order, how long the process will take. If the SEC takes the view that the holding company has been, and continues to be, operating as an unregistered investment company, Cincinnati Financial Corporation could be subject to remedial actions, should an action be brought by the SEC. Further, if Cincinnati Financial Corporation were to voluntarily elect to register as an investment company under the Investment Company Act, it could be subject to extensive, restrictive and potentially adverse regulation relating to, among other things, operating methods, management, capital structure, dividends and transactions with affiliates. If the SEC determines that the company is an unregistered investment company, Cincinnati Financial Corporation may be unable to enforce contracts with third parties, and third parties could seek to obtain rescission of transactions with Cincinnati Financial Corporation undertaken during the period it was established that the holding company was an unregistered investment company, subject to equitable considerations set forth in the Investment Company Act. As a result, it could be determined that holders of Cincinnati Financial Corporation’s $420 million aggregate principal amount of 6.90% Senior Debentures due 2028 have a right to rescind such indebtedness, thereby requiring Cincinnati Financial Corporation to immediately repay such amounts. Cincinnati Financial Corporation may be unable to refinance such obligation on acceptable terms as a result of its potential status under the Investment Company Act. However, Cincinnati Financial Corporation currently has available sufficient assets to fund such repayment and believes that its assets are adequate to meet its short- and long-term obligations.
If Cincinnati Financial Corporation’s holding company were to voluntarily elect to register as a closed-end investment company under the Investment Company Act, a number of significant requirements would be imposed upon it. These would include, but not be limited to, a requirement that at least 40 percent of Cincinnati Financial Corporation’s board of directors not be “interested persons” of Cincinnati Financial Corporation as defined in the Investment Company Act and that those directors be granted certain special rights with respect to the approval of certain kinds of transactions (particularly those that pose a possibility of giving rise to conflicts of interest); restrictions on incurring indebtedness and broad prohibitions on affiliate transactions. While Cincinnati Financial Corporation could apply for individual exemptions from these restrictions, there is no guarantee that such exemptions would be granted, or granted on terms that Cincinnati Financial Corporation would deem practical. Additionally, Cincinnati Financial Corporation would be required to report its financial results in a different form than currently used. The different form would have the effect of turning Cincinnati Financial Corporation’s Statement of Operations “upside down” by requiring that Cincinnati Financial Corporation report its investment income and the results of its investment activities, instead of its insurance operations, as its primary sources of revenue. Cincinnati Financial believes that there may be other remedies if the SEC determines the company is an unregistered investment company, but these alternatives would require substantial changes in the company’s long-standing operating philosophies and practices.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
(b) One current Report on Form 8-K was filed with the SEC since April 1, 2004.
The following Reports on Form 8-K were furnished to the SEC since April 1, 2004. The information furnished in these reports shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, or otherwise subject to the liabilities of that Section, nor shall such information be deemed incorporated by reference in any filing under the Securities Act of 1933, as amended.
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 second-quarter 2004 financial results on Form 8-K on July 22, 2004.
Date: August 9, 2004