| CINCINNATI FINANCIAL CORP Item 1A Risk Factors Our business involves various risks and uncertainties that may affect achievement of our business objectives |
| Many of the risks could have ramifications across our integrated business activities |
| For example, while risks related to setting insurance rates and establishing and adjusting loss reserves are insurance activities, errors in these areas could have an impact on our investment activities |
| The following discussion should be viewed as a starting point for understanding the significant risks we face |
| It is not a definitive summary of their potential impact or of our strategies to manage and control the risks |
| The risks and uncertainties below are not the only ones we face |
| There are additional risks and uncertainties that we currently do not believe are material |
| There also may be risk and uncertainties of which we are not aware |
| If any risks or uncertainties discussed here develop into actual events, they could have a material adverse effect on our business, financial condition or results of operations |
| In that case, the market price of our common stock could decline materially |
| Readers should carefully consider this information together with the other information we have provided in this report and in other reports and materials we file periodically with the Securities and Exchange Commission as well as news releases and other information we disseminate publicly |
| We rely exclusively on independent insurance agents to distribute our products |
| These agents are not obligated to promote our products and can and do sell our competitors’ products |
| We must offer insurance products that meet the needs of these agencies and their clients |
| We need to maintain good relationships with the agencies that market our products |
| If we do not, these agencies may market our competitors’ products instead of ours, which may lead to us having a less desirable mix of business, which could affect our results of operations |
| Events or conditions that could diminish a competitive advantage that our independent agencies enjoy: • Downgrade of the financial strength ratings of our insurance subsidiaries |
| We believe our strong insurer financial strength ratings, in particular the A++ rating from AM Best of our property casualty insurance subsidiaries, are an important competitive advantage |
| Only 16 other insurance groups, or 1dtta7 percent of all insurance groups, qualify for the A++, AM Best’s highest rating |
| If our property casualty ratings were downgraded, our agents might find it more difficult to market our products or might choose to emphasize the products of other carriers, which could adversely affect our results of operations |
| • Concerns that doing business with us is difficult or perceptions that our level of service is no longer a distinguishing characteristic in the marketplace |
| If agents or policyholders believed that we were no longer providing the prompt, reliable personal service that has long been a distinguishing characteristic of our insurance operations, our results of operations could be adversely affected |
| • Delays in the development, implementation, performance and benefits of technology projects and enhancements or independent agent perceptions that our technology solutions are inadequate to match their needs |
| A reduction in the number of independent agencies marketing our products, the failure of these agencies to successfully market our products or the choice of these agencies to reduce their writings of our products could reduce our revenues and our results of operations if we were unable to replace them with agencies that produce adequate premiums |
| Further, policyholders may choose a competitor’s product rather than our own because of real or perceived differences in price, terms and conditions, coverage or service |
| If the quality of the independent agencies with which we do business were to decline, that also might cause policyholders to purchase their insurance through different agencies or channels |
| Increased comfort in Internet purchasing could further reduce independent agencies’ writings of personal lines products |
| Please see Item 1, Our Business and Our Strategy, Page 1, for a discussion of our relationships with independent insurance agents |
| Competition could adversely affect our ability to sell policies at rates we deem adequate |
| The insurance industry is highly competitive |
| Competition in our insurance business is based on many factors, including: • Competitiveness of premiums charged • Underwriting and pricing methodologies that allow insurers to identify and flexibly price risks • Underwriting discipline • Terms and conditions of insurance coverage • Rate at which products are brought to market 2005 10-K Page 21 _________________________________________________________________ [51]Table of Contents • Technological innovation • Ability to control expenses • Adequacy of financial strength ratings by independent ratings agencies such as AM Best • Quality of services provided to agents and policyholders If we were unable to compete effectively because of one or more of these factors, our premium writings could decline and our results of operations and financial condition could be materially adversely affected |
| Please see Item 7, Commercial Lines, Personal Lines and Life Insurance Results of Operations, Page 41, Page 47, and Page 52, for a discussion of our competitive position in the insurance marketplace |
| Managing technology initiatives and meeting new data security requirements are significant challenges |
| While technology can streamline many business processes and ultimately reduce the cost of operations, technology initiatives present short-term cost and implementation risks |
| In addition, we may have inaccurate expense projections, implementation schedules or expectations regarding the efficacy of the end product |
| These issues could escalate over time |
| Data security is subject to increasing regulation |
| We face rising costs and competing time constraints in meeting compliance requirements of new and proposed regulations |
| Computer viruses, hackers and other external hazards could expose our data systems to security breaches |
| These increased risks and expanding regulatory requirements could expose us to data loss, damages and significant increases in compliance costs |
| Please see Item 1, Technology Solutions, Page 4, for a discussion of our technology initiatives |
| The effects of emerging or latent claim and coverage issues on our business are uncertain |
| As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to insurance claims and coverage may emerge |
| These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims |
| In some instances, these changes may not become apparent until some time after we have issued the insurance policies that could be affected by the changes |
| As a result, the full extent of liability under our insurance contracts may not be known for many years after a policy is issued |
| The effects of such unforeseeable emerging and latent claim and coverage issues could adversely affect our results of operations |
| Please see Item 7, Property Casualty and Life Insurance Reserves, Page 61 and Page 67, for a discussion of our reserving practices |
| Our loss reserves, our largest liability, are based on estimates and could be inadequate to cover our actual losses |
| Our financial statements are prepared using GAAP These principles require us to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes |
| Actual results could differ materially from those estimates |
| For a discussion of the significant accounting policies we use to prepare our financial statements and the material implications of uncertainties associated with the methods, assumptions and estimates underlying our critical accounting policies, please refer to Item 7, Property Casualty Insurance Loss And Loss Expense Reserves, Page 35, and Item 8, Note 1 to the Consolidated Financial Statements, Page 84 |
| Our most critical accounting estimate is of loss reserves |
| The loss reserves we establish in our financial statements represent an estimate of amounts needed to pay and administer claims arising from insured events that have occurred, including events that have not yet been reported to us |
| Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability |
| Accordingly, our loss reserves for past periods could prove to be inadequate to cover our actual losses and related expenses |
| Any changes in these estimates are reflected in our results of operations during the period in which the changes are made |
| An increase in our loss reserves would decrease earnings, while a decrease in our loss reserves would increase earnings |
| The estimation process for unpaid loss and loss expense obligations involves uncertainty by its very nature |
| We continually review the estimates and adjust the reserve as facts regarding individual claims develop, additional losses are reported and new information becomes known |
| Adjustments due to loss development for prior years are reflected in the calendar year in which they are identified |
| 2005 10-K Page 22 _________________________________________________________________ [52]Table of Contents Unforeseen losses, the type and magnitude of which we cannot predict, may emerge in the future |
| These additional losses could arise from changes in the legal environment, catastrophic events, increases in loss severity or frequency, or other causes |
| Such future losses could be substantial |
| We could experience an unusually high level of losses due to catastrophic or terrorism events or risk concentrations |
| Our financial condition, cash flow and results of operations depend on our ability to underwrite and set rates accurately for a full spectrum of risks |
| We establish our pricing based on assumptions regarding the level of losses that will occur within classes of business, geographic regions and other criteria |
| A number of factors could cause our assumptions regarding future losses to be inaccurate |
| In the normal course of our business, we provide coverage for exposures for which estimates of losses are highly uncertain, in particular catastrophic and terrorism events |
| Catastrophes can be caused by a number of events, including hurricanes, tornadoes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires |
| Due to the nature of these events, we are unable to predict precisely the frequency or potential cost of catastrophe occurrences |
| The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event |
| We have catastrophe exposure to: • Hurricanes in the gulf and southeastern coastal regions |
| • Earthquakes in the New Madrid fault zone, which lies within the central Mississippi valley, extending from northeast Arkansas through southeast Missouri, western Tennessee and western Kentucky to southern Illinois, southern Indiana and parts of Ohio |
| • Tornado, wind and hail in the Midwest, Southeast, mid-Atlantic and Western regions |
| We have identified terrorism exposure to general commercial risks in the metropolitan Chicago area as well as small co-op utilities, small shopping malls and small colleges throughout our 32 active states |
| Additionally, our life insurance subsidiary could be adversely affected in the event of an epidemic such as the avian flu, particularly if the epidemic affects a broad range of the population beyond just the very young or the very old |
| Our results of operations would be adversely affected if the level of losses we experienced over a period of time exceeded our actuarially determined expectations |
| In addition, our financial condition would be adversely affected if we were required to sell securities prior to maturity or at unfavorable prices to pay an unusually high level of loss and loss expenses |
| Securities pricing might be even less favorable if a number of insurance companies needed to sell securities during a short period of time because of unusually high losses from catastrophic events |
| Our geographic concentration ties our performance to business, economic and regulatory conditions in certain states |
| We market our property casualty insurance product in 32 states, but our business is concentrated in the Midwest and Southeast |
| We also have exposure in states where we do not actively market insurance when clients of our independent agencies have business or properties in multiple states |
| The Cincinnati Insurance Company also participates in three assumed reinsurance treaties with two reinsurers that spread the risk of very high catastrophe losses among many insurers |
| In 2006, we have exposure to assumed losses of 1 percent of property losses between dlra400 million and dlra1dtta2 billion from a single event under an assumed reinsurance treaty for Munich Re Group |
| In the event of a severe catastrophic event or terrorist attack elsewhere in the world, our insurance losses may be immaterial |
| However, the companies in which we invest might be severely affected, which could affect our financial condition and results of operations |
| Our ability to obtain or collect on our reinsurance protection could affect our business, financial condition and results of operations |
| We buy property casualty and life reinsurance coverage to mitigate the liquidity risk of an unexpected rise in claims severity or frequency from catastrophic events or a single large loss |
| The availability, amount and cost of reinsurance depend on market conditions and may vary significantly |
| If we are unable to obtain reinsurance on acceptable terms and in appropriate amounts, our business and financial condition may be adversely affected |
| 2005 10-K Page 23 _________________________________________________________________ [53]Table of Contents In addition, we are subject to credit risk with respect to our reinsurers |
| Although we purchase reinsurance to manage our risks and exposures to losses, this reinsurance does not discharge our direct obligations under the policies we write |
| We would remain liable to our policyholders even if we were unable to recover what we believe we are entitled to receive under our reinsurance contracts |
| Reinsurers might refuse or fail to pay losses that we cede to them, or they might delay payment |
| For long-term cases, the creditworthiness of our reinsurers may change before we can recover amounts to which we are entitled |
| A reinsurer’s insolvency, inability or unwillingness to make payments under the terms of its reinsurance agreement with our insurance subsidiaries could have a material adverse effect on our financial position and results of operations |
| Prior to 2003, we participated in USAIG, a joint underwriting association of individual insurance companies that collectively function as a worldwide insurance market for all types of aviation and aerospace accounts |
| At year-end 2005, 36dtta9 percent, or dlra251 million, of our total reinsurance receivables were related to USAIG, primarily for September 11, 2001, events |
| Although more than 99 percent of the reinsurance recoverables associated with USAIG are backed by securities on deposit, if we are unable to collect these receivables, our financial position and results of operations could be materially affected |
| We no longer participate in new business generated by USAIG and its members |
| Please see Item 7, 2006 Reinsurance Programs, Page 68, for a discussion of our reinsurance treaties |
| Our ability to realize our investment objectives could affect our financial condition or our results of operation |
| We invest premiums received from policyholders and other available cash to generate investment income and capital appreciation, maintaining sufficient liquidity to pay covered claims and operating expenses, service our debt obligations and pay dividends |
| At year-end 2005, our investment portfolio was dlra12dtta657 billion, or 79dtta1 percent of our total assets |
| In 2005, our investment operations contributed 15dtta6 percent of our revenue and 65dtta1 percent of our total income before income taxes |
| Investment income is an important component of our revenues and net income |
| The ability to achieve our investment objectives is affected by factors that are beyond our control, such as inflation, economic growth, interest rates, world political conditions, terrorism attacks or threats and other widespread unpredictable events |
| These events may adversely affect the economy generally and could cause our investment income or the value of securities we own to decrease |
| A significant decline in our investment income could have an adverse effect on our net income, and thereby on our shareholders’ equity and our policyholders’ surplus |
| For more detailed discussion of risks associated with our investments; please refer to Item 7A, Qualitative and Quantitative Disclosures About Market Risk, Page 70 |
| Our investment performance also could suffer because of the types of investments, industry groups and/or individual securities in which we choose to invest |
| Market value changes related to these choices could cause a material change in our financial condition or results of operations |
| One of our investments, Fifth Third, accounted for 26dtta3 percent of our shareholders’ equity at year-end 2005 and dividends earned from our Fifth Third investment were 20dtta2 percent of our investment income in 2005 |
| If Fifth Third’s common stock price were to further decline significantly, our financial condition could be materially affected |
| If Fifth Third were to decrease or discontinue its dividend, our results of operation could be materially affected |
| Because we currently own more than 10 percent of Fifth Third’s outstanding shares, we are limited in the amount of Fifth Third stock we could sell in any given period |
| This limitation could lead us to hold a sizeable position in Fifth Third even if it would no longer meet our investment parameters |
| This could result in a variety of adverse consequences depending on the reason we had concluded Fifth Third no longer met our investment parameters |
| For example, if Fifth Third were to stop paying dividends on its common stock, we would not be able to reinvest quickly in other income-earning investments, which would have a material affect on our results of operations |
| Please see Item 1, Investments Segment, Page 15, and Item 7, Investments Results of Operations, Page 54, and Liquidity and Capital Resources, Page 57, for discussion of our investment activities |
| 2005 10-K Page 24 _________________________________________________________________ [54]Table of Contents Our status as an insurance holding company with no direct operations could affect our ability to pay dividends in the future |
| Cincinnati Financial Corporation is a holding company that transacts substantially all of its business through its subsidiaries |
| Our primary assets are the stock in our operating subsidiaries and our investments |
| Consequently, our cash flow to pay cash dividends and interest on our long-term debt depends on dividends we receive from our operating subsidiaries and income earned on investments held at the parent-company level |
| Dividends paid to us by our insurance subsidiary are restricted by the insurance laws of Ohio, our domiciliary state |
| These laws establish minimum solvency and liquidity thresholds and limits |
| Currently, the maximum dividend that may be paid without prior regulatory approval is limited to the greater of 10 percent of statutory surplus or 100 percent of statutory net income for the prior calendar year, up to the amount of statutory unassigned surplus as of the end of the prior calendar year |
| Dividends exceeding these limitations may be paid only with prior approval of the Ohio Department of Insurance |
| Consequently, at times, we might not be able to receive dividends from our insurance subsidiary or we might not receive dividends in the amounts necessary to meet our debt obligations or to pay dividends on our common stock |
| This could affect our financial position |
| Please see Item 1, Regulation, Page 18, and Item 8, Note 8 to the Consolidated Financial Statements, Page 91, for discussion of insurance holding company dividend regulations |
| We could make investment decisions or experience market value fluctuations that trigger restrictions applicable to the parent company under the Investment Company Act of 1940 |
| Compared to other insurance holding companies, we hold a significant level of investment assets at the parent company level |
| If these investment assets grow to account for more than 40 percent of parent company’s total assets, excluding assets of our subsidiaries, we might become subject to regulation under the Investment Company Act of 1940 |
| Our operations are limited by the constraint that investment securities held at the holding company level should remain below the 40 percent threshold described above |
| Efforts to stay below the threshold could result in: • Disposal of otherwise desirable investment securities, possibly under undesirable conditions |
| Such dispositions could result in a lower return on investment, loss of investment income, and if we were unable to manage the timing of the dispositions, we also might realize unnecessary capital gains, which would increase our annual tax payment |
| • Limited opportunities to purchase equity securities that hold the potential for market value appreciation, which could hamper book value growth over the long term |
| • Maintenance of a greater portion of our portfolio of equity securities at the insurance subsidiary, which would cause the parent to be more reliant on its subsidiaries for cash to fund parent-company obligations, including shareholder dividends and interest on long-term debt |
| If the parent company’s investment assets were to exceed the 40 percent ratio to total assets, excluding investment in its subsidiaries, and if it were determined that the holding company was an unregistered investment company, the holding company might be unable to enforce contracts with third parties, and third parties could seek rescission of transactions with the holding company undertaken during the period that it was an unregistered investment company, subject to equitable considerations set forth in the Investment Company Act |
| In addition, the holding company could become subject to monetary penalties or injunctive relief, or both, in an action brought by the SEC Please see Item 8, Note 15 to the Consolidated Financial Statements, Page 96, for discussion of the Investment Company Act of 1940 |