Cincinnati Financial - 10-Q quarterly report FY

 

 

(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 o No

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):

o Yes þ No

As of October 24, 2008, there were 162,382,939 shares of common stock outstanding.

 

 

The condensed consolidated financial statements include the accounts of Cincinnati Financial Corporation and its consolidated subsidiaries, each of which is wholly owned. The statements 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 us to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Our actual results could differ from those estimates. The December 31, 2007, consolidated balance sheet amounts are derived from the audited financial statements but do not include all disclosures required by accounting principles generally accepted in the United States of America. These condensed consolidated financial statements should be read in conjunction with our consolidated financial statements included in our 2007 Annual Report on Form 10-K.

Our September 30, 2008, condensed consolidated financial statements are unaudited. Certain financial information that is included in annual financial statements prepared in accordance with GAAP is not required for interim reporting and has been condensed or omitted. We believe that we have made all adjustments, consisting only of normal recurring accruals that are necessary for fair presentation. The results of operations for interim periods do not necessarily indicate results to be expected for the full year.

In October 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) 157-3, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. FSP No. 157-3 provides key considerations when determining fair value for financial assets that are not active. In February 2008, the FASB issued FSP No. 157-2, Fair Value Measurement. FSP No. 157-2 and FSP No. 157-3 are amendments of Statement of Financial Accounting Standards (SFAS) No. 157, issued in September 2006. SFAS No. 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure about fair value measurements.

SFAS No. 157 was effective for fiscal years beginning after November 15, 2007. We partially adopted SFAS No. 157 in the first quarter of 2008. We elected to defer SFAS No. 157, Fair Value Measurements, for nonfinancial assets and nonfinancial liabilities until January 1, 2009, as permitted under FSP No. 157-2. We did not have a cumulative-effect adjustment to beginning retained earnings as a result of the adoption of SFAS No. 157.

In February 2007, the FASB issued SFAS No. 159, Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of SFAS No. 115. SFAS No. 159 permits an entity to choose to measure many financial instruments and certain other items at fair value (on an instrument-by-instrument basis) at specified election dates. The objective is to improve financial reporting by providing an entity with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. We have not elected to value any assets or liabilities (not otherwise measured at fair value) under SFAS No. 159. We continue to evaluate the impact of adopting SFAS No. 159 in the future.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities — an amendment of SFAS No. 133. SFAS No. 161 requires that objectives for using derivative instruments be disclosed in terms of underlying risk and accounting designation. SFAS No. 161 also requires cross-referencing within the footnotes to assist the users of financial statements in identifying significant information about derivative instruments. The effective date of SFAS No. 161 is the company’s fiscal year beginning January 1, 2009.

Fixed maturities (bonds and redeemable preferred stocks), equity securities (common and non-redeemable preferred stocks) and short-term investments have been classified as available for sale and are stated at fair values at September 30, 2008, and December 31, 2007.

At September 30, 2008, unrealized investment gains before taxes totaled $1.861 billion and unrealized investment losses in the investment portfolio amounted to $338 million. The unrealized gains were largely due to long-term gains from our common stock portfolio. Holdings that contributed 10 percent or more of the $1.861 billion in gains were: Exxon Mobil Corporation (NYSE:XOM), Fifth Third Bancorp (NASDAQ:FITB), PNC Financial Services Group, Inc. (NYSE:PNC) and The Procter & Gamble Company (NYSE:PG).

The change in unrealized gains and losses on investments, net of taxes, described in the following table, is included in other comprehensive income and shareholders’ equity. During the three and nine months ended September 30, 2008, we recognized $8 million and $13 million in realized investment losses related to current period changes in valuation of our hybrid securities. At September 30, 2008, we had $118 million of hybrid securities included in fixed maturities that now are accounted for under SFAS No. 155.

The change in fixed maturities unrealized gains and losses for the three and nine months ended September 30, 2008 and 2007, was largely due to fair value fluctuations in the fixed maturity portfolio, which were driven primarily by widening credit spreads. At September 30, 2008, 1,438 of the 2,156 securities we owned were trading below book value compared with 373 of the 2,053 securities we owned at year-end 2007. The 1,438 holdings trading below book value at September 30, 2008, represented 46.9 percent of fair value of invested assets and $338 million in unrealized losses. The increase largely was due to a greater number of fixed-maturity investments trading below book value. We deem the risk related to these securities to be relatively minor and at least partially offset by the earned income potential of these investments.

Equity securities unrealized gains declined for the three and nine months ended September 30, 2008, primarily because of equity security market value fluctuations and the realization of gains through the sale of 38 million shares of our holdings of Fifth Third common stock along with sales of other financial and non-financial common stock holdings. During the three and nine months ended September 30, 2008, we recognized $121 million and $400 million in other-than-temporary impairment charges.

Third-quarter impairment charges represented 1.2 percent of invested assets and included $47 million to write down preferred shares of Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. Impairments of equity securities accounted for more than 80 percent of total nine-month other-than-temporary impairment charges, reflecting the portfolio mix, the historic weighting in financial sector securities and the unprecedented decline in overall stock market values during 2008. Equity securities unrealized gains declined for the three and nine months ended September 30, 2007, primarily because of the sale of common stock holdings and declines in the market value of equity holdings. During the three and nine months ended September 30, 2007, we recognized $1 million and $2 million in other-than-temporary impairment charges.

Realized gains and losses on investments are recognized in net income on a specific identification basis. See our 2007 Annual Report on Form 10-K, Item 1, Investments Segment, Page 15, 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 2006, we began actively participating in a securities lending program under which certain fixed-maturity securities from our investment portfolio were loaned to other institutions for short periods of time. We required cash collateral in excess of the market value of the loaned securities. The collateral received was invested in accordance with our guidelines in high-quality, short-duration funds to generate additional investment income. The market value of the loaned securities was monitored on a daily basis and additional collateral was added or refunded as the market value of the loaned securities changed. The program was accounted for as a

secured borrowing; therefore, the collateral was recognized as an asset and was classified as securities lending collateral invested, with a corresponding liability for the obligation to return the collateral.

During the third quarter of 2008, we terminated the program. At September 30, 2008, we had no fixed maturities on loan compared with $760 million on loan at year-end 2007.

In conjunction with the termination of the program, we returned the offsetting collateral. We returned $64 million of cash in lieu of $45 million book value of Alt-A, residential collateralized mortgage obligations (CMOs), which were included in fixed maturities as of September 30, 2008. In the first nine months of 2008, these CMOs had fair value adjustments of $19 million. The CMOs were an investment made by one of the short-duration funds, which subsequently dissolved and distributed the assets to its investors. When we terminated the securities lending program, we chose to retain the CMOs rather than sell them at what we felt were distressed prices in an illiquid market.

Our statements of income include earned consolidated property casualty insurance premiums on assumed and ceded business:

Our statements of income include incurred consolidated property casualty insurance loss and loss expenses on assumed and ceded business:

Our statements of income include earned life insurance premiums on assumed and ceded business:

Our statements of income include life insurance contract holder benefits incurred on assumed and ceded business:

The following summarizes the components of net periodic costs for our qualified and supplemental pension plans:

In the third quarter, we changed the form of retirement benefit we offer associates to a 401(k) plan with company match from a qualified defined benefit pension plan. Effective June 30, 2008, we froze entry into the pension plan, and only participants 40 years of age or older on August 31, 2008, could elect to continue to participate. For participants remaining in the pension plan, the company will continue to contribute to fund

future benefit obligations. We contributed $10 million to the pension plan during the nine months ended September 30, 2008, and we currently anticipate contributing an additional $1 million during the fourth quarter. The fourth-quarter contribution amount may vary due to fluctuations in the capital markets.

For participants leaving the pension plan, benefit accruals were frozen effective August 31, 2008. The company plans to transfer $60 million of the pension plan’s accumulated benefit obligation to an intermediary spin-off plan to facilitate the partial curtailment and settlement for these participants. A curtailment charge of $3.0 million was included in results of operations for the third quarter of 2008.

During the fourth quarter of 2008, pursuant to SFAS No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, we anticipate an expense of approximately $26 million in the consolidated statement of income to recognize a settlement loss associated with the partial termination of the qualified pension plan. Included in the charge is the anticipated contribution of approximately $24 million to complete funding of benefits that will be distributed in the fourth quarter to participants leaving the qualified pension plan.

The company began making matching contributions to our sponsored 401(k) plan during September 2008. The company contributed less then $1 million during the third quarter of 2008 to the 401(k) plan. Associates who are not accruing benefits under the pension plan are eligible to receive the company match of up to 6 percent of cash compensation.

We currently have four equity compensation plans that together permit us to grant incentive stock options, non-qualified stock options, restricted stock, restricted stock units, stock appreciation rights and other stock-based awards. The Cincinnati Financial Corporation 2006 Stock Compensation Plan also gives us the flexibility to make grants to associates of any type of stock-based awards, subject to performance-based criteria, to directly link compensation to performance. We currently grant incentive stock options, non-qualified stock options, service-based restricted stock units and performance-based restricted stock units under our plans. One of our equity compensation plans permits us to grant common stock to our outside directors as discussed in our 2008 Proxy Statement.

A total of 16,725,250 shares are authorized to be granted under the shareholder-approved plans. At September 30, 2008, 8,974,266 shares were available for future issuance under the plans. We currently issue new shares for option exercises.

Our pretax and after-tax share-based compensation costs are summarized below:

Stock options are granted to associates at an exercise price that is not less than fair market value on the date of grant and are exercisable over 10 year periods. The stock options generally vest ratably over a three-year period. In determining the share-based compensation amounts for 2008, the fair value of each option granted in 2008 was estimated on the date of grant using the binomial option-pricing model with the following weighted average assumptions used for grants in 2008:

As of September 30, 2008, there was $15 million of unrecognized compensation cost related to non-vested awards that we expect to recognize over a weighted-average period of two years.

Here is a summary of option information:

Service-based and performance-based restricted stock units are granted to associates at fair market value on the date of grant. Service-based restricted stock units vest as a unit three years after the date of grant, while performance-based restricted stock units vest on the first day of March after a three-calendar year performance period, if certain performance targets are attained. As of September 30, 2008, management assumed for accounting purposes that performance targets used for the restricted stock unit awards would not be met.

The fair value of the restricted stock unit awards was determined based on the fair value on the date of grant less the present value of the dividends that holders of restricted stock units will not receive on the shares underlying the restricted stock units during the vesting period.

Here is a summary of restricted stock unit information:

Legal issues are part of the normal course of business for all companies. As such, we have various litigation and claims against us in process and pending. Having analyzed those claims with our legal counsel, we believe the outcomes of normal insurance matters will not have a material effect on our consolidated financial position, results of operations or cash flows. We further believe that the outcomes of non-insurance matters will be covered by insurance coverage or will not have a material effect on our consolidated financial position, results of operations or cash flows.

On January 1, 2007, we adopted the provisions of FIN 48. As of December 31, 2007, we had gross unrecognized tax benefits (FIN 48 liability) of $14.2 million. Details about our FIN 48 liability are found in our 2007 Annual Report on Form 10-K, Item 8, Note 10 of the Consolidated Financial Statements, Page 98.

During 2008, our unrecognized tax benefits as a result of tax positions taken during prior years increased $2.8 million, our unrecognized tax benefits as a result of tax positions taken in the current year increased $1.6

million and our unrecognized tax benefits for settlements with taxing authorities decreased $2.8 million. Our total FIN 48 liability as of September 30, 2008, was $15.8 million. In May 2008, the IRS presented us with preliminary adjustments related to the valuation of our loss reserves for tax years 2005 and 2006. Upon evaluation of the IRS preliminary adjustments, management refined certain assumptions used to calculate the unrecognized tax benefits associated with this issue, resulting in a revised measurement of the unrecognized tax benefits for both current and prior years. During the three and nine months ended September 30, 2008, there have been no changes to any assumptions about the amount of our FIN 48 liability that may be settled with the IRS in the next 12 months related to tax years 2005 to 2006.

We adopted SFAS No. 157 in the first quarter of 2008. Our investment portfolio is subject to SFAS No. 157 disclosure requirements for interim reporting. Our year-end 2008 reporting will include disclosure for the investment portfolio as well as the fair value measurement framework for all SFAS No. 107 disclosures.

In accordance with SFAS No. 157, we categorized our financial instruments, based on the priority of the observable and market-based data for each valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices with readily available independent data in active markets for identical asses or liabilities (Level 1) and the lowest priority to unobservable market inputs (Level 3).

When various inputs for measurement fall within different levels of the fair value hierarchy, the lowest observable input that has a significant impact on fair value measurement is used.

Financial instruments are categorized based upon the following characteristics or inputs to the valuation techniques:

We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. Reclassification of certain financial instruments may occur when input observability changes. As noted below in the Level 3 disclosure table, reclassifications are reported as transfers in/out of the Level 3 category as of the beginning of the quarter in which the reclassification occurred.

The following table illustrates the fair value hierarchy for those assets measured at fair value on a recurring basis as of September 30, 2008. We do not have any material liabilities carried at fair value.

Each financial instrument deemed to have significant unobservable inputs when determining valuation is identified in the table below by security type with a summary of changes in fair value for the three months ended September 30, 2008.

Level 3 taxable fixed-maturity securities decreased primarily because of sales and impairments. Preferred stocks also decreased primarily due to impairment charges of $10 million. In addition, we may transfer securities in and out of levels following quarterly reviews that determine the appropriate current use of observable or unobservable inputs.

Below is a summary of changes in fair value for the nine months ended September 30, 2008.

Unrealized gains or losses on Level 3 securities were included in accumulated other comprehensive income and were not included in net realized investment gains or losses for the three and nine months ended September 30, 2008.

We operate primarily in two industries, property casualty insurance and life insurance. We regularly review four different reporting segments to make decisions about allocating resources and assessing performance:

We report as “Other” the non-investment operations of the parent company and its subsidiaries CFC Investment Company and CinFin Capital Management Company (excluding client investment activities), as well as other income of our insurance subsidiary. Beginning in the first quarter of 2008, we also are including results of The Cincinnati Specialty Underwriters and CSU Producer Resources Inc. in Other. See our 2007 Annual Report on Form 10-K, Item 8, Note 17, Segment Information, Insurance Company Page 105, for a description of revenue, income or loss before income taxes and identifiable assets for each segment.

Segment information is summarized in the following table:

Identifiable assets:

Investment asset sale — In early October 2008, we sold 9 million shares, or 31.7 percent, of the company’s Fifth Third common stock holding as of September 30, 2008. The October sales generated total proceeds of $120 million, which will be reduced by capital gains taxes of approximately $40 million. The sale was executed pursuant to Rule 144 under the Securities Act of 1933, as amended. The net after-tax gain of approximately $75 million, or about 46 cents per share, will be included in net income for the three-months and full-year ending December 31, 2008. After the transaction, Cincinnati Financial and its subsidiaries own 20 million shares of Fifth Third’s common stock, or approximately 3.5 percent of the bank’s total common shares outstanding as of October 21, 2008.

The following discussion highlights significant factors influencing the consolidated results of operations and financial position of Cincinnati Financial Corporation (CFC). It should be read in conjunction with the consolidated financial statements and related notes included in our 2007 Annual Report on Form 10-K. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory basis. When we provide our results on a comparable statutory basis, we label it as such; all other company data is presented in accordance with accounting principles generally accepted in the United States of America (GAAP).

We present per share data on a diluted basis unless otherwise noted, adjusting those amounts for all stock splits and dividends. Dollar amounts are rounded to millions; calculations of percent changes are based on whole dollar amounts or dollar amounts rounded to the nearest thousand. Certain percentage changes are identified as not meaningful (nm).

This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. Some of those risks and uncertainties are discussed in our 2007 Annual Report on Form 10-K, Item 1A, Risk Factors, Page 21. Although we often review and update our forward-looking statements when events warrant, we caution our readers that we undertake no obligation to do so.

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.