CINCINNATI FINANCIAL CORP annual report, FY2011

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Cincinnati Financial Corporation — 2011 Form 10-K

Reporting period: Fiscal year ended December 31, 2011; comparisons are primarily with 2010. This is an annual filing, not a standalone fourth-quarter report. The filing reports fourth-quarter net income of $134 million, following a second-quarter net loss of $49 million.

Business context

Cincinnati Financial is an Ohio-based insurance holding company whose principal business is property and casualty insurance distributed through independent agencies in 39 states. Its reporting segments are commercial lines, personal lines, excess and surplus lines, life insurance, and investments.

Financial and operating performance

  • Revenue and earnings: Total revenue was $3.803 billion, up 1% from $3.772 billion. Net income was $166 million, or $1.02 per diluted share, down 56% from $377 million, or $2.31 per diluted share. Pretax income fell to $176 million from $501 million.
  • Premiums: Earned premiums increased 4% to $3.194 billion. Property-casualty net written premiums rose 5% to $3.098 billion. By segment, earned premiums were $2.197 billion commercial (+2%), $762 million personal (+6%), $70 million excess and surplus (+43%), and $165 million life (+4%).
  • Underwriting and margins: Consolidated property-casualty underwriting loss widened to $276 million from $47 million. The GAAP combined ratio rose to 109.2% from 101.7% (above 100% indicates an underwriting loss); catastrophe losses and prior-year reserve development together added 4.0 points. Segment combined ratios were 104.7% commercial, 123.9% personal, and 92.2% excess and surplus. Life reported a $3 million segment loss.
  • Catastrophes and reserves: Net catastrophe losses were approximately $402 million, versus $148 million in 2010; management estimated gross catastrophe losses of $658 million. The May 20–27 storm system, including the Joplin tornado and Dayton-area hail, was the company’s largest catastrophe event to date. Favorable prior-year reserve development of $285 million benefited 2011 results, compared with $304 million in 2010.
  • Investments: Net investment income was $525 million, up 1%; realized investment gains, net, were $70 million versus $159 million. Other-than-temporary impairment charges were $57 million versus $36 million. Year-end invested assets were $11.801 billion, including $8.779 billion of fixed maturities and $2.956 billion of equity securities. The portfolio had $1.489 billion of pretax net unrealized gains.
  • Cash flow and liquidity: Consolidated operating cash flow was $247 million, down from $531 million, principally reflecting catastrophe-related claim payments and working-capital changes. Cash and cash equivalents ended the year at $438 million, up from $385 million. Parent-company cash and marketable securities totaled $1.051 billion.
  • Capital and debt: Shareholders’ equity was $5.055 billion, up less than 1%; book value per share was $31.16 versus $30.91. Debt principal totaled $894 million: $790 million long-term and $104 million short-term. Debt-to-total-capital increased to 15.0% from 14.3%, below the company’s 20% target ceiling.
  • Shareholder returns: Declared dividends were $1.605 per share, up from $1.59. The company repurchased 1.23 million shares for approximately $32 million. Its value creation ratio was 6.0%, below its stated 12%–15% annual-average target for 2010–2014.

Material changes versus 2010

  • Net income declined 56%, mainly because property-casualty underwriting results were $149 million lower after tax, including the effect of substantially higher catastrophe losses, and net realized investment gains were $58 million lower after tax.
  • The consolidated combined ratio worsened by 7.5 percentage points. Catastrophe losses were the primary driver; the company also incurred reinsurance reinstatement premiums.
  • Premium growth improved: property-casualty net written premiums rose 5%, versus 2% in 2010. Management attributed growth to pricing, new and renewal business, and improving insured exposures.
  • Investment income edged higher, but gains from investment sales were lower. The effective tax rate fell to 5.7% from 24.8%, primarily reflecting the mix of pretax income and tax-advantaged investment income.
  • Short-term borrowings increased by $55 million, primarily to support share repurchases. Long-term debt principal was unchanged.

Outlook, risks and unusual items

  • Outlook and targets: Management expected commercial pricing to continue firming during 2012 and assumed continued economic growth, while warning that 2012 value creation could fall below its long-term target. Long-term objectives include a property-casualty GAAP combined ratio of 95%–100% over any five-year period and $5 billion of annual direct written premiums across property-casualty and life by year-end 2015; 2011 direct written premiums were $3.534 billion.
  • 2012 business plans: Management planned roughly 130 new agency appointments, further use of predictive pricing analytics, and expansion of personal lines into three additional states. It expected personal-lines growth to exceed the industry projection but acknowledged that pricing must outpace loss trends to improve profitability. It also expected low interest rates to pressure investment income and did not plan to aggressively market annuities.
  • Key risks: Severe weather and catastrophe concentration, especially in the Midwest and Southeast; uncertain loss-reserve estimates; competitive pricing and rate-regulatory constraints; inflation and rising claim severity; low interest rates and investment-market declines; reinsurer credit and collection risk; agency-channel dependence; and technology, business-continuity and cybersecurity exposures.
  • Reinsurance and contingencies: At year-end, reinsurance receivables were $622 million, including $108 million associated with USAIG. The filing describes potential additional USAIG pool liability of up to $220 million if participants and supporting collateral failed. Florida regulatory subpoenas issued in 2007 remained outstanding but inactive. The company reported no material litigation apart from ordinary-course matters and no material off-balance-sheet arrangements.
  • Unusual accounting item: In the fourth quarter, the company refined its property-casualty loss-expense allocation method, shifting $23 million of adjusting and other expenses from commercial lines to personal lines; management said this had no effect on consolidated property-casualty results. A new insurance-acquisition-cost accounting standard was expected to reduce equity by about $20 million after tax on adoption, without a material historical or prospective effect on results of operations.
  • Audit and controls: Deloitte & Touche issued an unqualified opinion on the financial statements and internal control over financial reporting; management also concluded controls were effective at year-end.

Important facts for investors to verify

  • Whether catastrophe losses normalize and pricing improvements translate into better underwriting results, particularly in personal lines and homeowners.
  • How much future earnings depend on favorable prior-year reserve development, and whether current reserves remain adequate as claims mature.
  • The effect of reinsurance costs, recoveries, and the USAIG-related receivable and contingent exposure.
  • Whether investment income can hold up in a prolonged low-rate environment and how equity-market changes affect book value and capital.
  • Parent-company liquidity, insurance-subsidiary dividend limits, and the refinancing or renewal of credit lines due in 2012.
  • Progress toward the 2015 premium target and the five-year combined-ratio and value-creation objectives.