Cincinnati Financial
Annual Report 2001

Plain-text annual report

Cincinnati Financial Corporation 2001 Annual Report t H o m eA O n America’s M a i n S t r e e t s A B O U T T H E C O M PA N Y Cincinnati Financial Corporation is the nation’s 17th largest property casualty insurer, based on revenues. Its record of outperforming the industry in growth and profitability reflects a strong competitive position, continued market penetration in its operating territories and a business strategy that fully integrates the strengths of the independent agency system. Foremost among these strengths, independent agents have the local knowledge and relationships valued by policyholders and underwriters alike. To turn this strength into profitable business, Cincinnati supports agents with responsive claims service; flexibility and a willingness to be a market for most types of risks the typical local agent handles; a flat, no-branch structure; and a large field force with decision-making authority. Cincinnati Financial, formed in 1968, operates through six subsidiaries. The Cincinnati Insurance Company, founded in 1950, leads the property casualty group, which is rounded out by The Cincinnati Casualty Company and The Cincinnati Indemnity Company. The group markets a broad range of business and personal policies through its elite group of 959 local independent insurance agencies in 31 states. The Cincinnati Life Insurance Company markets life, disability income and long term care insurance and annuities, while CFC Investment Company complements the insurance subsidiaries with commercial leasing and financing services. CinFin Capital Management Company provides asset management services to institutions, corporations and individuals. The consistency, strength and stability that make Cincinnati the agents’ choice are the same hallmarks that bring value to shareholders. Cash dividends have increased steadily for 41 consecutive years. The Company’s investment portfolio, its primary source of profits, is distinguished by a focus on carefully selected equities that feature both a history of dividend increases and a potential for appreciation. A b o u t t h e c o v e r A t H o m e O n America’s M a i n S t r e e t s : F I E L D R E P R E S E N T A T I V E S Through local field representatives, The Cincinnati Insurance Companies are privileged to be thoroughly at home on America’s Main Streets. Almost a third of Cincinnati’s 3,299 associates live and work in field territories close to the agents, policyholders and claimants they serve. They are the claims, marketing, loss control and legal professionals, the engineers and auditors who meet the public every day. Most work out of their own homes or from agency offices, adding their personal touch to each service provided. Cincinnati’s representatives don’t just visit agent communities on business. They know the territory and respond effectively to its insurance needs because these are their communities – where their everyday lives contribute to making better homes for families and businesses. C O N T E N T S Financial Highlights . . . . . . . . . . . . . . .1 Overview of Insurance Operations . . 2 Letter to Shareholders . . . . . . . . . . . . 4 Overview of Investment Operations . .7 Main Street: Our Foundation and Our Future . . . . . . . . . . . . . . . 1 0 Selected Financial Information . . . . .18 Management Discussion . . . . . . . . . 20 Selected Quarterly Financial Data . . .33 Responsibility for Financial Statements . . . . . . . . . . . . . . . . . . 34 Independent Auditors’ Report . . . . . 34 Consolidated Financial Statements . . . . . . . . . . . . . . . . . . 35 Notes to Consolidated Financial Statements . . . . . . . . . . . 39 Subsidiary Officers and Directors . . 47 Shareholder Information and Price Range of Common Stock . . .48 Corporate Officers and Directors . . . 49 F I N A N C I A L H I G H L I G H T S Cincinnati Financial Corporation and Subsidiaries (dollars in millions except per share data) 2001 2000 Pro Forma* Change 00%00 I N C O M E S TAT E M E N T D ATA Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before income taxes . . . . . . . . . . . . . . . . Net operating income . . . . . . . . . . . . . . . . . . . . . Net capital losses . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net operating income per common share (diluted) Net income per common share (diluted) . . . . . . . Net income per common share (diluted). . . . . . Cash dividends declared . . . . . . . . . . . . . . . . . . . Average shares outstanding (diluted) . . . . . . . . . . $ 2,561 221 210 (17) 193 193 1.29 1.19 1.19 .84 162 $ $ 2,331 148* 146* (2) 144* 118 .90* .89* .73 .76 164 $ B A L A N C E S H E E T D ATA Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . Book value per share . . . . . . . . . . . . . . . . . . . . . $13,959 5,998 37.07 $13,287 5,995 37.26 9.9 49.8 44.1 (870.8) 34.4 63.3 43.3 33.7 63.0 10.5 (0.9) 5.1 — (0.5) R AT I O D ATA Statutory combined ratio** . . . . . . . . . . . . . . . . . Return on equity . . . . . . . . . . . . . . . . . . . . . . . . Return on equity including net unrealized gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103.6% 3.2% 109.9%* 2.5%* 5.7 28.0 2.5% 13.5%* (81.5) Revenues (dollars in millions) 1 6 5 , 2 1 3 3 , 2 8 2 1 , 2 4 5 0 , 2 2 4 9 , 1 97 98 99 00 01 Revenues rose 9.9% in 2001 on strong growth of insurance premiums and investment income. Net Operating and Net Income/ Dividends Paid Per Common Share (dollars) Net Operating Income Net Income Dividends Paid 7 7 . 1 9 4 . 1 2 5 . 1 2 5 . 1 1 4 . 6 1 1 . 1 9 2 . 1 9 1 . 1 0 9 . 0 9 8 . 0 0.53 0.60 0.66 0.74 0.82 97 98 99 01 00 Pro Forma* Net operating income for 2001 included $66 million from parent company investment operations; $30 million from life operations; $111 million from property casualty operations; and $3 million from non-insurance subsidiaries. * In 2000, the Company incurred a one-time charge (GAAP) for asset impairment of $39 million, before tax; $25 million, or 16 cents per share, net of tax. Pro forma results exclude the charge for comparison purposes only. Including the 2000 charge, income before income taxes was $109 million; net operating income was $120 million, or 74 cents per share (diluted); the statutory combined ratio was 111.6 percent; and return on equity was 2.1 percent and 13.0 percent including net unrealized gains and losses. ** As more fully discussed in the Management Discussion beginning on Page 20, 2001 statutory data for The Cincinnati Insurance Companies’ property casualty subsidiary reflects the Company’s adoption of Codification of Statutory Accounting Principles effective January 1, 2001. For comparison purposes, a $402 million one-time net written premium adjustment required to conform with Codification was excluded, and 2000 property casualty subsidiary statutory data was reclassified; as originally reported before reclassification, the 2000 combined ratio, excluding the one-time charge, was 110.7 percent for the full year. Book Value Per Common Share (dollars) 6 2 7. 3 7 0 7. 3 2 7 . 3 3 6 4 . 3 3 5 3 . 8 2 Note: All per share data adjusted for stock split in 1998. This report contains forward-looking statements that involve potential risks and uncertainties. Please see the Management Discussion, beginning on Page 20, for factors that could cause results to differ materially from those discussed. Back to table of contents 97 98 99 00 01 Unrealized gains in the investment portfolio contributed 68.6% of book value in 2001. 1 (cid:2) Property Casualty Premiums Statutory (dollars in millions) Net Written Premiums Net Earned Premiums 8 8 1 , 8 2 2 8 , 1 6 3 9 , 1 7 6 0 , 2 1 8 6 , 1 7 5 6 , 1 8 5 5 , 1 3 4 5 , 1 2 7 4 , 1 4 5 4 , 1 97 98 99 01 00 Pro Forma* Growth in established states fueled a $286 million increase in agency direct premiums. Ohio, with 24.2% of total direct volume, grew 10.4%. Other top states: Illinois, up 17.4%; Indiana, up 16.7%; Michigan, up 16.7%. Property Casualty Net Written Premium Growth Rate Statutory (percent) Cincinnati Insurance Companies Estimated Industry (A.M. Best) 1 . 3 1 8.5 9 . 1 1 4.4 01 00 Pro Forma* 4 . 6 2.9 97 8 . 5 1.8 98 9 7. 1.9 99 O V E RV I E W O F I N S U R A N C E O P E R AT I O N S P R O P E R T Y C A S U A L T Y I N S U R A N C E O P E R AT I O N S : G R O W T H Property casualty statutory net written premiums grew 13.1 percent for the year, accounting for 96 percent of the Company’s to help inspect and review risks. This ongoing effort enables Cincinnati to total in 2001. Commercial statutory net written identify accounts premiums rose 16.6 percent to $1.551 billion in that previously 2001, while statutory net written premiums for were underpriced personal lines of insurance rose 5.3 percent to and accept good $637 million. business that The primary source of premium growth in wholesale Premium Mix Percent of 2001 Consolidated Statutory Net Written Premiums Life 4% Personal Lines 28% Commercial Lines 68% 2001 was firmer pricing on new and renewal approaches simply leave behind. commercial business. While the Company’s philosophy does not support large, across-the- board price increases, it has been introducing new estimating tools and tapping local knowledge of the field force to identify and insure new or previously underestimated risk exposures. This allows Cincinnati to provide the full amount of coverage needed and collect an Growth of Cincinnati’s net written premiums consistently outpaces industry growth. Commercial premiums, 71% of property casualty volume, grew 16.6% in 2001. Personal premiums, 29% of the total, grew 5.3%. adequate premium. In 2001, new business written directly by Cincinnati agents reached $272 million, just short of the all-time high of Combined Loss and Expense Ratio Statutory, Post-Dividend (percent) Cincinnati Insurance Companies Estimated Industry (A.M. Best) $275 million recorded in 2000. 2001 results were particularly satisfying given the year’s priority on re-underwriting activities. The Company continues to enlist the 101.6 105.6 107.8 110.1 0 . 8 9 2 . 4 0 1 4 . 0 0 1 117.0 support of its agents to strengthen frontline underwriting, providing them with a field team 6 . 3 0 1 9 . 9 0 1 P R O P E R T Y C A S U A L T Y I N S U R A N C E O P E R AT I O N S : P R O F I TA B I L I T Y For 2001, the Company recorded a 103.6 percent statutory combined ratio, reflecting the impact of Midwest hailstorms and continued claims severity. This measure of profitability was, as expected, several points above the 101.3 percent the Company averaged in the second half of the 1990s. Cincinnati’s September 11 catastrophe losses were a relatively minor $9 million, with total catastrophe losses for the year at $64 million, net of reinsurance. For 2001, commercial lines generated a statutory loss and loss adjustment expense (LAE) ratio of 74.4 percent, including 1.9 points for catastrophes. Personal lines had a statutory loss 01 98 97 99 00 Pro Forma* Cincinnati’s 2001 ratio included 3.1 points for catastrophes versus 2.7 points in 2000. It compared favorably with the industry’s 2001 ratio of 117%, including 6 points for World Trade Center losses and 2.8 points for other catastrophes. The Cincinnati Insurance Companies (statutory, property casualty subsidiary) The Cincinnati Insurance Companies (statutory, including effects of Codification, property casualty subsidiary) Note: As more fully discussed in the Management Discussion beginning on Page 20, 2001 statutory data for The Cincinnati Insurance Companies’ property casualty subsidiary reflects the Company’s adoption of Codification effective January 1, 2001. For comparison purposes, a $402 million one-time net written premium adjustment required to conform with Codification was excluded, and 2000 statutory data was reclassified; as originally reported before reclassification, the 2000 combined ratio, excluding the one-time charge, was 110.7 percent for the full year. * In 2000, the Company incurred a one-time charge for asset impairment. Pro forma results exclude the charge for comparison purposes only. Including the 2000 charge, the statutory combined ratio for 2000 was 111.6 percent. 2 Back to table of contents (cid:2) Net Premium Income The Cincinnati Life Insurance Company (dollars in millions) and LAE ratio of 82.9 percent, with 5.8 points deposits written by Cincinnati Life to settle for catastrophes. Among the Company’s major Cincinnati’s property casualty claims increased 3 6 9 7 1 8 5 7 0 7 lines of insurance, workers’ compensation, to $27 million in 2001, compared with commercial auto and homeowners continued as $21 million in 2000. Instead of making a the most unprofitable. Cincinnati is responding lump-sum claim payment, structuring the with appropriate rate increases, tightened settlement as an annuity allows the Company underwriting guidelines, product refinements to earn investment income while paying the and new insurance-to-value initiatives. claim over time and providing steady income At the same time, the Company is continuing for claimants or beneficiaries. to leverage local knowledge and personal Life company expenses in 2001 increased contact to control losses. For example, claims 23.1 percent due to charges for automation, representatives are reporting to agencies, incentives and policy audits on certain lines of marketing representatives and underwriters business. As of December 31, 2001, assets reached any changes in risks that they observe while $1.761 billion, up 8.6 percent. Policyholder meeting with claimants and visiting properties surplus rose 5.2 percent to $552 million. to respond to claims. Field marketing With Cincinnati Life’s term insurance representatives are gathering with engineering, products, Cincinnati property casualty agents loss control and claims staff to pool knowledge are expanding their life insurance marketing and to support agents as they review renewal and sales opportunities while diversifying and 97 98 99 00 01 Cincinnati Life’s 2001 net premium income exceeded the 2000 total, which benefited from late processing of term applications submitted before the January 1, 2000 effective date of Triple X regulations. Life Policy Face Amounts in Force Excluding annuities, accident and health business (dollars in millions) 4 3 5 7, 2 5 2 5 , 3 2 0 0 9 7, 1 0 6 0 , 3 1 8 5 8 , 0 1 accounts. And loss control associates now are increasing their revenue stream. Term insurance 97 98 99 00 01 performing risk inspections at the request of in force rose 23 percent in 2001, contributing commercial underwriters. Cincinnati also to excellent cash flow for Cincinnati Life’s continues to maintain exceptional expense investment operations. To further the cross- control, even while paying appropriate selling opportunities with property casualty commissions for the agents who provide agencies, Cincinnati Life will introduce a new superior service to policyholders with one of and enhanced term product series in the first the lowest non-commission expense ratios in quarter of 2002. Face amounts of life insurance policies in force increased 17% from 2000 to 2001. Cincinnati Life’s policy count rose to 319,281 from 313,649. the industry. In 2001, Cincinnati’s ratio was 10.2 percent. * Cincinnati remains committed to the * * * * * agency-centered business model and philosophies L I F E I N S U R A N C E O P E R AT I O N S upon which the Company was founded. Local The Cincinnati Life Insurance Company’s net knowledge, local authority and local support written premiums in 2001 were $102 million. are at the core, ensuring that Cincinnati is at Annuity net written premiums increased to home on America’s Main Streets and helping $10 million in 2001, compared with $7 million the Company achieve the consistent growth in 2000. Structured settlement annuity and profitability that are its hallmark. Back to table of contents 3 (cid:2) TO O U R S H A R E H O L D E R S : 2 0 0 1 : H A R D Q U E S T I O N S F O R H A R D T I M E S • Do corporate accounting policies and standards adequately protect investors? When business historians talk about 2001, All of these are tough questions with they will highlight fallout from two dramatic far-reaching, long-range implications for our collapses, that of the twin towers in New York City on September 11 and that of giant energy trader Enron. These events raised serious questions about the physical and financial security of American citizens. • Can our government protect us from harm? nation and for our insurance industry. They deserve the urgent attention of political and business leaders. As citizens and as insurance professionals, we support a proactive approach to homeland security and serious consideration of proposals for a federally backed insurance facility to absorb the • Are adequate resources available to effect financial shock of an act of terror. recovery from huge disasters? At H o m e O n M a i n S t r e e t: C I N C I N N A T I A S S O C I A T E S When Chairman and CEO Jack Schiff, Jr. addressed a gathering of Company associates outside CFC Headquarters on a bright November afternoon, everyone’s thoughts were on another day and with others whose workplaces and homes would never be the same after September 11. Associates responded to the great sadness that swept over not just New York, Pennsylvania and Washington, D.C., but all of America’s Main Streets. They felt the same urge to act that they would feel if a next-door neighbor suffered a grievous loss. So while management worked to determine and fulfill insurance obligations arising out of September 11 events, associates contributed personally and raised funds to support heroic rescuers and their lifesaving companions. On November 21, Jack thanked associates for establishing a $55,000 fund to aid in the training of search and rescue dogs and their handlers. “The Company benefits from having staff and agents who value personal involvement and relationships,” Jack said. “In the Main Street markets we serve, people are more comfortable doing business with someone they know, someone who cares. That means someone who takes the extra time to customize their insurance program; someone who makes the extra effort to keep policies and coverages up to date; someone who knows that when they have a claim, their loss may be more than financial. From our file rooms and administrative areas to our underwriting and field departments, associates keep Cincinnati’s performance personal.” 4 Back to table of contents (cid:2) More immediately, the year’s high-profile share, on a comparable basis excluding that collapses were less dramatic in their direct year’s one-time charge of $25 million, or effects on the performance of Cincinnati 16 cents per share, for impaired technology Financial Corporation. As an insurer with a assets. Net operating income rose 44.1 percent Main Street focus and regional distribution to $210 million, or $1.29 per share, in outside of the largest population centers, 2001 versus $146 million, or 90 cents per your Company was not as exposed to such share, on the comparable basis in 2000. losses as some insurers. At $9 million – Revenues advanced 9.9 percent to a record mostly for assumed reinsurance – the $2.561 billion in 2001. Company’s losses from September 11 events This year’s higher earnings were driven were small compared with an April hailstorm by investment income, which continued to that caused $47 million of insured losses benefit from steadily increasing dividends for our policyholders, with an impact of on common stocks in the portfolio, and $19 million after reinsurance and taxes. by improved insurance underwriting, As for the second collapse, your Company which benefited from firmer pricing in the wrote no insurance or surety bonds for commercial insurance marketplace. Enron, once the nation’s seventh-largest From your Company’s perspective as a firm. Our investment portfolio held regional insurer with a Main Street focus, securities issued by Enron and Kmart, the changing price environment is the big another firm going through a high-profile story of 2001 and 2002. After 13 years of bankruptcy. Combined, these issues were soft prices in a buyer’s market, industry just $18 million – less than two-tenths of underwriting losses have been mounting and 1 percent – of the portfolio. After sales industry surplus declining. This pressure has and write downs, these holdings retained forced insurers, your Company included, $1 million of book value. to become more selective about the business The $11.571 billion investment portfolio written and more diligent in pricing it in comprises 82.9 percent of your Company’s line with the risk accepted. The turn to a assets, which reached an all-time high of seller’s marketplace was already in motion $13.959 billion at year-end 2001. Book prior to September 11, and some observers value, which also reflects the strength of think that turn could come faster and last our investment portfolio, was $37.07 at longer after the financial shocks associated year-end 2001, slightly below the year-ago with last year’s collapses. level of $37.26. Now here are some more tough questions, Net income rose 34.4 percent in 2001 to ones that we have to answer ourselves. $193 million, or $1.19 per share, after net • Can The Cincinnati Insurance Companies capital losses of $17 million. In 2000, net control loss severity and still maintain a stable income was $144 million, or 89 cents per market for the local independent agents we serve? Back to table of contents 5 (cid:2) Investment Income Less Expenses (dollars in millions) 0 1 4 1 2 4 7 8 3 8 6 3 9 4 3 • Can those agents continue to rely on ratio is 1.0, indicating a good margin for Cincinnati to be a market for 60 percent to growth. The industry’s written premiums are 70 percent of the risks encountered by a 1.2 times surplus, weakened from 0.9 times typical agency in our operating territory? surplus in 2000. Strong growth of earned • If our actions in this marketplace lead premiums softened 2001 loss severity, and to top-line growth of premium revenues, our capacity to write more good business can we turn this growth into bottom-line will be a factor in offsetting continued earnings? * 01 2 0 0 1 : H A R D W O R K E R S M E E T A H A R D E N I N G M A R K E T 97 00 *Excludes BOLI interest 99 98 Investment income has grown steadily, even as the Company repurchased its shares and reinvested called or redeemed bonds at lower prevailing interest rates. Assets (dollars in millions) 9 5 9 , 3 1 7 8 2 , 3 1 2 8 4 , 1 1 8 0 8 , 1 1 7 6 8 , 9 Over the years, Cincinnati has been tagged as a company that thrives in a strong market for insurance – a hard market in the industry’s vernacular. We think that’s true, and we’ll be all right. Many positives are on our side. First and foremost, we do know how to underwrite, and for us that’s an activity that happens both in the field and at headquarters. Over the past two years, we became more aggressive about cleaning up the book of business and in 2001 improved results for some lines, notably commercial 97 98 99 00 01 and personal auto. Agents, field representatives Total assets rose 5.1% to an all-time high at year-end 2001. Over the past five years, assets grew at a 8.0% compound rate. and underwriters are teaming up to gather facts and closely evaluate new and renewal risks. They aren’t afraid of the work that leads to sound risk selection, appropriate policy terms and conditions and accurate pricing for the risk exposure. They recognize that local knowledge and local decision- making are advantages we can leverage to stay a market for good accounts in most classes of business. Second, your Company has the financial strength to pick up the pace as opportunities arise. Our written premiums-to-surplus severity due to inflated costs and judgments. Your Company’s cash flow historically has been sufficient to fund claim payments and fuel investments – the key to bottom- line profits. We make accounting policies and reserving decisions with the intention of giving a conservative, true picture of your Company’s position. We feel strongly that our financial reporting should reflect not just the letter, but the spirit, of accounting policies and standards. When material bad news is on the horizon – such as the problems with the uninsured motorist line in 2000 – our strategy has been to deal with it openly and then move on. Faced with rising severity of losses, we opted to provide our constituents with more information, not less, shedding light on the issues and the solutions we pursued. Third, your Company has longstanding relationships with highly-rated reinsurers. Our capacity and willingness to retain more risk in 2002 will help mitigate the very large premium increases these reinsurers need to protect their own financial health. Both our catastrophe reinsurance program and the reinsurance working treaties we use to structure layers of coverage for large risks include terrorism coverage, with limitations. 6 Back to table of contents (cid:2) O V E R V I E W O F I N V E S T M E N T O P E R AT I O N S The momentum of premium coming into Cincinnati’s insurance companies drove the pace in the Investment Department. Cash flow available for investment during 2001 was superb – one of the best years ever without a debt offering. Portfolio managers invested $359 million of net new cash, allocating 77.5 percent of new money to fixed income investments and 22.5 percent to equities. Historically, on a cost basis, fixed income has been 65 percent and common stock 35 percent of the portfolio. As market values change over time, this allocation reverses, resulting in a portfolio that has approximately 75 percent of market value in equities. The Company’s total-return equity orientation is reflected in high unrealized gains as stocks are held to appreciate over the long term while they pay steadily increasing dividends. At December 31, 2001, the equity portfolio contained $6.321 billion of unrealized gains, 95.9 percent of this in the 10 largest of the Company’s 44 stock holdings. Annualized Investment Assets Market Value as of December 31 (dollars in millions) 11,571 66 388 8,107 11,316 69 377 8,149 Others Preferred Stock Common Stocks Taxable Bonds Tax-Exempt Bonds 10,325 10,194 58 442 7,013 66 404 7,107 8,797 47 530 5,469 Composition of Equity Investments As of December 31, 2001 (dollars in millions) 8,107 5,532 Banks, Trusts and Insurance Industrial, Miscellaneous Public Utilities 1,594 1,801 868 1,863 1,895 1,730 1,738 1,968 720 981 373 32 261 80 Preferred Stock Portfolio by Cost 388 36 271 81 Preferred Stock Portfolio by Market Value 213 Common Stock Portfolio by Cost Common Stock Portfolio by Market Value While the Company’s high percentage of common stock investments reduces the portfolio’s effective yield relative to other insurers, it also contributes to the long-term growth of surplus. 888 917 887 983 1,042 97 98 99 00 01 Approximately $71.00 in investments supported each Cincinnati Financial common share at year- end 2001. Portfolio managers favor stocks with above-average market yields and convertible and investment-grade bonds with compelling risk- reward profiles. dividend income from these stocks is approximately $172 million, up $18 million from 2001 increases, as 26 of the 44 stocks in the portfolio raised their dividends. Our largest holding – Fifth Third Bancorp – raised its dividend twice during the year for a total annualized addition to income of $15 million. While the Company’s concentrated investment in a small group of high-quality, dividend-paying financial and value stocks is unconventional for an insurer, the strategy has proven successful. In a declining interest-rate environment, financial stocks have tended to maintain their value better than others. In 2001, the equity portfolio outperformed the S&P 500 Index for the fourth time in six years, with a 2001 rate of return of 0.7 percent versus the S&P 500’s 11.9 percent decline. C I N F I N C A P I TA L M A N A G E M E N T C O M PA N Y CinFin’s strategy mirrors that of the parent company – equity-based portfolios centering on best-in-class companies. In its third full year of operations, the Company’s asset management services subsidiary ended the year with $663 million under management, up 23.6 percent from the year-ago total. Back to table of contents 7 (cid:2) I N D E P E N D E N T R AT I N G S A.M. Best Company affirmed the A++ Superior rating of Cincinnati’s property casualty companies based on superior capitalization, strong regional franchise, modest financial leverage and excellent cash flow. Fewer than 3 percent of insurer groups qualify at this level. Best affirmed Cincinnati Life’s A+ Superior rating and awarded a new aa Very Strong debt rating to Cincinnati Financial’s senior debentures. Standard & Poor’s currently rates the corporate debentures A+ Strong and our insurance companies at AA- Very Strong, citing a strong market position afforded by an extremely loyal and productive agency force, a low-cost infrastructure, extremely strong capitalization and strong financial flexibility. While S&P lowered its ratings in January 2001 after our announcement of a $110 million reserve addition in the fourth quarter of 2000, Cincinnati retains top-tier S&P Security Circle ratings. Moody’s Investors Service maintained the A2 rating on the corporate debentures and the Aa3 rating of the property casualty companies, noting a strong regional agency franchise, large capital base and historic operating profitability. R A N K I N G S (published in 2001 and generally based on 2000 performance) For new risks with more than $50 million of total insured values, the Company is purchasing facultative reinsurance in excess of our retention. Our reinsurers are “grandfathering” in terrorism coverage until the policy’s anniversary or renewal. Risks with lower insured values have terrorism coverage under the working treaty. Named the leading commercial package insurer in survey results published by Crittenden’s Property Casualty Rates & Ratings newsletter (July 2001), Cincinnati writes approximately 80 percent to 85 percent of our commercial policies at annual premiums below $10,000. With reinsurance and terrorism coverage in place, we will have the flexibility to safely write the Main Street risks that are our primary appetite and to selectively write larger risks when our agents Fortune (April 16, 2001): Among the Fortune 1,000 U.S. industrial and their clients have special needs. and service corporations, Cincinnati Financial was the 17th largest Finally, we have built the infrastructure U.S. stock property casualty insurer based on revenues, placing sixth in to accept and service more good business. that industry category for 10-year total return to investors. Our talented associates and loyal agents are Forbes (April 16, 2001): Among the top 500, Cincinnati Financial primed to do what has to be done and to ranked 237th for assets and 352nd for market value. Compared with all do it better than ever. Staffing has increased companies appearing on any of the Forbes 500 lists for market value, 13 percent since the beginning of 2000, and sales, profits or assets, Cincinnati Financial scored 391st. training programs have greatly expanded for Best’s Review (July 2001): Cincinnati ranked 32nd among property both Company and agency staff. The casualty groups based on net premiums written. Among the top 200 Company is developing and introducing life health insurers, Cincinnati Life ranked 164th. technology to streamline back-office Business Insurance (August 20, 2001): Cincinnati was one of only functions. The year 2001 brought the debut eight companies named to both the property casualty and life health of CinciLink, an agency extranet that is the Ward’s 50 Benchmark Groups. Qualifying insurers have outstanding delivery platform for new and updated five-year scores for financial safety, consistency and performance. software including CinciPrint, which gives Cincinnati Insurance stood among just 10 companies named to the agents the convenience of retrieving and Ward’s 50 for 11 consecutive years. completing forms online. 8 Back to table of contents (cid:2) Imaging technology currently in use for compares favorably with a yield of 1.4 percent selected business will be applied in additional for the S&P 500 Index. The vote to continue areas during 2002, and agents in a pilot state the trend of increasing dividends reflects the will begin using an online personal policy Board’s confidence in our financial strength, processing system with functionality business strategy, associates and agents. supporting a direct-bill option. 2 0 0 2 : H O L D I N G H A R D T O T H E C O U R S E All of these considerations give us optimism for 2002. Barring unusual catastrophes, our target is to return by year-end to a statutory combined ratio of 101.3 percent, which was our average ratio from 1995 to 1999. Our will to underwrite and the improved pricing environment should help us build on the positive trends of 2001, when the ratio improved to 103.6 percent compared with 109.9 percent in 2000. Ultimately, we won’t be satisfied until we achieve breakeven underwriting that makes it possible for all investment income to flow to earnings. Cincinnati Financial returned more than $182 million to shareholders in 2001, including cash dividends and common stock repurchases of more than 1 million shares at an average price of $37.67. Over the past 10 years, cash dividends paid per share rose to 82 cents from 27 cents, adjusted for stock dividends and splits. That’s a 10.2 percent compound growth rate for the 10-year period. Further, the Board declared a The 2001 Mergent’s (formerly Moody’s) Handbook of Dividend Achievers ranked Cincinnati Financial 15th for the longest record of dividend growth, with 40 consecutive years (now 41) of annual cash dividend increases. And on December 31, 2001, Cincinnati Financial was an entrée on BusinessWeek’s “Menu of Investment Opportunities” as a stock with a high S&P Equity Ranking and low price-to-book value. While there are many schools of thought about investment valuation, steadily increasing dividends and stable book value are two historically attractive features of your Company. As we work to preserve and expand shareholder value, our plan is to build on strengths instead of shift directions. Our Main Street focus, hard-working people, selective and conservative approach and commitment to personal service and relationships are proven strategies through all kinds of business and economic cycles. 6 percent increase in the dividend during the John J. Schiff, Jr., CPCU first quarter of 2002, raising the indicated Chairman, President and Chief Executive Officer annual dividend to 89 cents per share. At February 6, 2002 2.3 percent, the current dividend yield Back to table of contents 9 (cid:2) M A I N S T R E E T: O U R F O U N D AT I O N A N D O U R F U T U R E In an insurance climate marked by change T H E M A R K E T P L A C E and uncertainty, The Cincinnati Insurance In 2001, insured property casualty losses Companies’ strong presence on America’s were estimated at nearly $285 billion, Main Streets is a competitive advantage. including an estimated $30 billion to For Cincinnati, Main Street is not so $45 billion in the aftermath of September 11. much a place as it is an approach, a commit- Even before the terrorist attacks, property ment to know and support the people we casualty insurers faced rising claims severity, serve. It is a personal way of doing business. adverse court decisions and mounting losses It is an emphasis on the local market. It due to more than a decade of insufficient relies on relationships, and it pays dividends. rates and overcapacity. Industry-wide, Main Street is both our foundation and excluding the 6-point impact of the World our future. We maintain our business the Trade Center losses, the combined ratio for way we built it, on America’s Main Streets, 2001 was estimated at 111.0 percent, up through an elite corps of agents. Independent from 110.1 percent in 2000. agencies representing Cincinnati, 959 in all, Such losses have created a market in place an average of almost 20 percent of which underwriting and pricing can and their business with the Company. These top must be re-evaluated. While some carriers producers are committed to a long-term are exiting product lines or enforcing large, relationship with Cincinnati. across-the-board price increases, Cincinnati During 2001, the Company took steps continues to do business the way we always to leverage our Main Street advantages through our large and experienced field staff. This has meant more attention to have: on the local level, focusing on each relationship separately. We work with agents case by case to recognize and accurately front-line underwriting, more involvement measure exposures, then price each risk in renewal discussions, more specialized adequately and appropriately for the local expertise in claims adjusting and more inspections. It has meant subdividing marketplace. Commercial lines pricing remains flexible to respond to each risk in territories to increase points of contact. It partnership with local agents who know has meant creating a deeper and more personal understanding of our business their markets and their business. For personal lines, we are seeking and obtaining regulatory from the ground up. And in doing all of approval for increases where warranted. This this, we remain confident that we can restore customized approach means less immediate consistently healthy profitability over the results but longer-term success. By making long term, despite the challenges our decisions that are risk-specific, we give our industry faces. Company the opportunity to retain not just business, but high-quality business. 10 Back to table of contents (cid:2) U N D E R W R I T I N G Cincinnati measures results for every Although Cincinnati outperformed the program in every line of business, reviewing industry during 2001, reporting a statutory trends and taking action where justified. combined ratio of 103.6 percent, we believe That process brought to the forefront the we can and we will do better. The path to need to seek regulatory approval for improved profitability begins with strong appropriate rate increases for the homeowner fundamentals, and it begins at home on line, which continues to experience increased America’s Main Streets. loss severity. It highlighted the need to more At H o m e O n M a i n S t r e e t: C L A I M S R E P R E S E N T A T I V E S Wendy Alberts takes The Cincinnati Insurance Companies’ credo – “we’re here to pay claims” – seriously. A claims representative in northeastern Ohio, Wendy calls upon policyholders during times of loss. She works to settle their claims quickly, compassionately and personally. “I meet people during a difficult time in their lives,” says Wendy, who also volunteers to care for hospice patients and participates in memorial services with their families. “My response to their claim may be the only time they interact with an insurance company. I want to meet them at a human level.” That means going the extra mile – not only in terms of personal interaction, but also in coordinating repairs that truly meet the needs of the claimant. An independent insurance agent who represented Cincinnati before becoming a claims representative, Wendy also considers it her responsibility to make certain that the claims process is equitable for the Company. “Part of my job is to make sure that the repair people and contractors who respond to our claims are charging fair prices for good quality work,” she says. “Cincinnati operates under the Golden Rule. We are to treat people the way we treat family. It’s a very personal, very honorable philosophy. It’s the reason agents respect us and policyholders trust us.” Back to table of contents 11 (cid:2) carefully manage blanket and replacement 2000, two additional field representatives property coverages and to limit the use of were assigned to established marketing credits and dividend-paying plans in territories, raising the total number of establishing workers’ compensation policy property casualty marketing territories to 76. pricing. It demonstrated the need to In 2002, the Company plans to split and continue to aggressively re-underwrite staff another six or more new territories. commercial auto policies to ensure that Policyholders, too, deserve intense, local, driver records are current. personal attention, and they get it from Personal lines account reviews determined agents, engineers, marketing representatives, that nearly 19 percent of our homeowner claims representatives and loss control property claims from 1996-2000 were specialists. On-site inspections, photographs, related to water damage. Going forward, building cost estimates, loss trend and risk rather than include that coverage as analyses increasingly are part of the process standard, we’ll give policyholders more used to insure to value, providing business choice of the coverage amount they need owners and homeowners with the coverage and the price they’ll pay for it. Water they need to repair or replace their property. damage exclusions and endorsements This attention to detail is part of the developed in 2001 will begin to take effect process in new business discussions and in over the next year in most states. renewals. Once a policy is on the books, an Disciplined underwriting means knowing entire team of people works to help the your book of business. Again, being at agent monitor the risk, regardless of home on America’s Main Streets is a whether loss activity occurs. Agents, field Cincinnati advantage. claims representatives and field marketing Agencies generally sell Cincinnati representatives review many account products to their neighbors and to renewals together. Where losses are reported, organizations they know and understand. we take an even closer look. The number of To ensure business remains agent-focused, in-depth risk reports increased more than Cincinnati’s property casualty field marketing 200 percent in 2001. These reports from representatives are assigned to specific claims representatives include on-site agencies, and their territories are divided inspections and detailed analyses to help according to activity levels. The number of underwriters at renewal time. Where agency relationships each field representative exposures have changed, all of this detail manages is kept to a minimum – 13 on allows for more accurate coverage amounts, average – allowing Cincinnati to provide the terms and conditions, as well as premiums. personal service each agency deserves. During 12 Back to table of contents (cid:2) C L A I M S dedicated storm teams aid them in handling Cincinnati is in the business of paying claims fairly and accurately. claims promptly, fairly and personally. During 2001: Our policy is to contact a claimant within • Nearly 500 claims representatives and trainees 24 hours of receiving notice from the participated in schools to enhance claims agent that a loss has occurred. Local claims handling techniques for workers’ compensation, representatives move quickly to assess losses physical damage, fire loss investigation, and estimate costs. Specialized training and settlement negotiation and other claims skills. At H o m e O n M a i n S t r e e t: P R O P E R T Y C A S U A L T Y M A R K E T I N G R E P R E S E N T A T I V E S People energize Mark Massaro. The agencies he visits, the policyholders he meets, the businesses he inspects, all generate enthusiasm and excitement. Not to mention the parents and kids he encounters through scouting. Mark, a Cincinnati sales and marketing representative in Minnesota, understands that to the agents and commercial policyholders in his territory, he is The Cincinnati Insurance Companies. “It’s a huge responsibility,” he says, “and a very rewarding job. The more I get to know the people in my community and their businesses, the better I can advise agents.” He doesn’t do it alone. Now more than ever, Mark and other marketing representatives count on gathering specific knowledge about each risk from the field team including claims, loss control, life, audit, sales and machinery and equipment representatives. “Being active in the community allows me to associate with a variety of dedicated people,” Mark says. “From them, I learn about local business interests as well as social, educational, economic and political issues. During 2001, this knowledge made me a more valuable sales and underwriting resource as I worked with agencies, the field team and headquarters underwriters to review new and renewal business opportunities.” Back to table of contents 13 (cid:2) • Midway through the year, we designated handle non-catastrophe claims in a timely staff in larger metropolitan areas as specialists and personal manner. who work to contain costs for large property Additionally, new resources are helping losses. verify, control and recoup costs. Re-pricing • More than 150 people specifically assigned of auto physical damage estimates helped to storm duty responded immediately to save an average of $80 each on repairs during areas affected by severe weather. Storm duty a 2001 pilot project in just a few territories. teams help free local claims representatives to At H o m e O n M a i n S t r e e t: L O S S C O N T R O L R E P R E S E N T A T I V E S As a former city safety director who now is a Cincinnati loss control consultant in Indiana, Scott Hendrix helps policyholders identify potential risks in their businesses. He provides training and education about policies and procedures that prevent losses. “I’m a safety resource to policyholders and a marketing tool for agents,” Scott says. During 2001, Cincinnati’s Commercial Lines Department turned to Scott for risk evaluations on southwestern Indiana accounts. “Proactive risk evaluations effectively open doors,” Scott says. “Besides providing underwriters with good information about the account, these evaluations place me on-site to lend a helping hand and keep businesses and their people accident and injury free. That adds even more depth to the policyholder relationship.” Scott’s work with United Way as a member of an allocation committee is another way he makes sure people in his community get a helping hand when they need it. “Cincinnati has a legacy of being hands-on,” he says. “By living and working in the communities we serve, we are better able to analyze local situations, control losses and make a difference.” 14 Back to table of contents (cid:2) And a special Recovery and Subrogation as we bring software applications online. Group in 2001 regained $40 million, nearly Other technology initiatives in development, an 11 percent increase over 2000, through test or pilot stages include imaging projects, sale of assets recovered or salvaged from online production and loss reports and losses and recapture of payments that were policy quoting and processing systems. the responsibility of a third party. L I F E I N S U R A N C E P R O D U C T S A N D S E R V I C E S The Cincinnati Life Insurance Company To better serve the independent agents for enhances local independent agents’ ability whom and by whom Cincinnati was founded, to deliver financial protection to their we committed resources to new tools and communities. At the same time, policyholders new products to protect their policyholders. benefit from the personal, local service New products included a Credit Union that is unique to the Cincinnati family of Blanket Bond and the Executive CEO insurance companies. policy. The latter meets the needs of Distributed primarily through agents individuals with higher-valued homes. Each representing Cincinnati’s property casualty policy comes with a building survey, giving group, Cincinnati Life helps those agents the homeowner the security of knowing increase their revenue streams with a full line replacement value is covered and giving of whole, term and universal life products, Cincinnati an accurate premium for fixed annuities, disability income and long that value. term care products. For the Company, Property valuation software introduced in Cincinnati Life offers the benefits of October 2001 and available on Cincinnati’s strengthening the relationship with agents agency extranet further helps determine and providing a steady cash flow to fuel replacement value of commercial buildings. investments and return. Life operations This software provides information on contributed $30 million to Cincinnati geographic values, construction costs and Financial Corporation’s $210 million in net other variables, working as a supplement to operating income for the year. on-site inspections to ensure that the policyholder buys adequate protection. Cincinnati continues to invest in and roll out tools to speed processing and cut costs at the local level and at headquarters. More than 500 agency representatives visit our agency extranet weekly to download software, print forms and check Company news or ratings. This number will grow significantly O U R C O M M U N I T I E S , O U R R E S P O N S I B I L I T I E S The Cincinnati Insurance Companies – like the people who work for the Company and represent our products – are committed to our communities. We demonstrate that commitment with the same local emphasis on all of our business practices. Back to table of contents 15 (cid:2) In the agent community, we support our commercial and personal lines schools. partners with outstanding service. Senior These sessions aid in everything from agency management travels to annual sales meetings accounting to selling skills. And many of in 28 cities to meet, greet and listen to these programs are held in cities around agents. We support the education and training the country, making it possible for agency of agents by offering producer schools, associates to stay close to home while earning agency management and executive liability necessary education credits. roundtables, life product seminars and At H o m e O n M a i n S t r e e t: L I F E M A R K E T I N G R E P R E S E N T A T I V E S “Team builder” best describes Norm Alms, whether he is recruiting fellow bicyclists for a charity tour or organizing agents to market a new insurance product. Norm calls on agencies throughout Wisconsin and the Upper Peninsula of Michigan to promote Cincinnati’s life insurance products, educate their staff and meet with policyholders. Serving this territory for 14 years, he’s created exceptional team spirit, trust and loyalty by making service to others his top priority. When Norm’s team traveled this summer to a cycling event to raise funds for diabetes research, he stayed in the hospital with an ill rider from his community until family could arrive. When agents needed support to sell Cincinnati’s Long Term Care Insurance, they also knew they could count on Norm to be there for them. He intensely studied that market and developed a seminar that he began leading this year for agencies and their clients. “Cincinnati’s life marketing representatives are out in the community every day,” Norm says, “and we often field questions on everything from financial goals and life insurance to property casualty insurance and claims. Agents and policyholders know that if I can’t answer a question, I’ll find a colleague who can. That creates respect, and in many cases, it creates new business.” 16 Back to table of contents (cid:2) Beyond the frequent direct contact we In the insurance community, Cincinnati have with our agents, we support their Financial is a responsible citizen, working to businesses through subsidiaries such as protect the integrity of our industry. Our CFC Investment Company and CinFin philosophy on legislative and regulatory Capital Management. issues is consistent with our philosophy on CFC Investment Company helps local business practices: Keep decision-making independent agents, their clients and the as close as possible to the local level. general public develop their businesses That brings us to our namesake through equipment and vehicle loans and community – the Greater Cincinnati region. leases, as well as real estate loans. This Cincinnati-based associates have a tradition support helps agencies expand to better serve of supporting the arts, education and customers in their communities. other community-related activities in our CinFin Capital Management, the hometown. As a Company and personally, Company’s asset management services we commit to living and working every day subsidiary, is another service to our agencies. as part of a proud community. Headquarters CinFin invites agencies and their clients to associates give generously to organized fund benefit from an investment strategy that drives such as the Fine Arts Fund and mirrors that of the Company. Clients with United Way, volunteering for service activities assets under CinFin management – typically ranging from tutoring and mentoring agencies, pension plans, corporations, students to special events like blood and endowment funds and high net-worth food donations. individuals – receive the personal, Our mission is to grow profitably and customized attention for which The enhance the ability of local independent Cincinnati Insurance Companies are known. insurance agents to deliver quality financial We also serve agents and policyholders by protection to the people and businesses continuing education for Company associates. they serve. Whether field representatives or In 2001, more than 1,000 field and headquarters associates, we fulfill this headquarters associates participated in online mission agency by agency, community by courses to improve both technical and community. Cincinnati is at home on interpersonal skills. Additionally, 38 claims America’s Main Streets. representative trainees graduated in 2001. For the second year in a row, five classes of trainees graduated from our professional underwriting school. Back to table of contents 17 (cid:2) Years Ended December 31, 2000 1999 ____________________ ____________________ S E L E C T E D F I N A N C I A L I N F O R M AT I O N Cincinnati Financial Corporation and Subsidiaries (dollars in millions except per share data) I N C O M E S TAT E M E N T D ATA ( G A A P ) Net earned premiums...................................... Net investment income.................................. Revenues.......................................................... Net operating income........................................ Net capital (losses) gains .................................. Net income...................................................... Net operating income per common share: Basic................................................................ Diluted.......................................................... Net income per common share: Basic................................................................ Diluted.......................................................... Cash dividends per common share: Declared...................................................... Paid............................................................ B A L A N C E S H E E T D ATA ( G A A P ) Total assets...................................................... Long term debt.............................................. Shareholders’ equity.......................................... Book value per share...................................... R AT I O D ATA ( G A A P ) Loss ratio............................................................ LAE ratio........................................................ Expense ratio...................................................... Combined ratio .............................................. 2001 ____________________ $ 2,152 421 2,561 210 (17) 193 1.31 1.29 1.20 1.19 .84 .82 $ 1,907 415 2,331 120** (2) 118** .75** .74** .74** .73** .76 .74 $13,959 426 5,998 37.07 $13,287 449 5,995 37.26 66.6% 10.1 28.2 104.9% 71.1% 11.3 30.4** 112.8%** P R O P E R T Y C A S U A L T Y S U B S I D I A R Y S TAT U T O R Y D ATA * Net written premiums .................................... $ 2,188* Net earned premiums...................................... 2,067 Net investment income.................................. 223 Unearned premiums........................................ 1,033 Loss reserves...................................................... 1,886 Loss adjustment expense reserves.................... 466 Policyholders’ surplus.................................... 2,533 $ 1,936 1,828 223 507 1,730 452 3,172 $ 1,732 387 2,128 255 – 255 1.55 1.52 1.55 1.52 .68 .661⁄3 $11,808 456 5,421 33.46 61.6% 10.0 28.6 100.2% $ 1,681 1,658 208 455 1,513 419 2,852 Loss ratio............................................................ LAE ratio........................................................ Expense ratio .................................................. Combined ratio................................................ 66.8% 10.1 26.7* 103.6%* 71.1% 11.3 29.2** 111.6%** 61.6% 10.0 28.8 100.4% Note: The selected financial information above allows for a more complete analysis of results of operations and should not be considered a substitute for any GAAP measure of performance. The statutory basis data presented above for the year ended December 31, 2001 reflects the adoption of the Codification of Statutory Accounting Principles (Codification) on January 1, 2001, as required by the State of Ohio, as more fully discussed in the Management Discussion beginning on Page 20. Property casualty subsidiary statutory data for the year ended December 31, 2000 has been reclassified for comparative purposes; information was not readily available to reclassify earlier years’ statutory data presented above. 18 Back to table of contents 1998 ____________________ $ 1,613 368 2,054 199 43 242 1.19 1.16 1.45 1.41 .611⁄3 .592⁄3 $11,482 472 5,621 33.72 65.4% 9.3 29.6 104.3% $ 1,558 1,543 204 432 1,432 408 3,020 65.4% 9.3 29.5 104.2% (cid:2) Cincinnati Financial Corporation and Subsidiaries 1997 ____________________ 1996 ____________________ 1995 ____________________ 1994 ____________________ 1993 ____________________ 1992 ____________________ 1991 ____________________ $ 1,516 349 1,942 254 45 299 1.54 1.49 1.81 1.77 .542⁄3 .531⁄3 $ 9,867 58 4,717 28.35 58.3% 10.1% 30.0% 98.4% $ 1,472 1,454 199 418 1,374 403 2,473 58.3% 10.1% 29.6% 98.0% $ 1,423 327 1,809 193 31 224 1.15 1.11 1.34 1.31 .482⁄3 .472⁄3 $ 7,397 80 3,163 18.95 61.6% 13.8% 28.2% 103.6% $ 1,384 1,367 190 402 1,319 383 1,608 61.6% 13.8% 27.6% 103.0% $ 1,314 300 1,656 207 20 227 1.24 1.20 1.36 1.33 .422⁄3 .422⁄3 $ 6,439 80 2,658 15.80 57.6% 14.7% 27.8% 100.1% $ 1,296 1,263 180 385 1,274 307 1,269 57.6% 14.7% 26.9% 99.2% $ 1,219 263 1,513 189 12 201 1.13 1.09 1.21 1.18 .382⁄3 .371⁄3 $ 5,037 80 1,940 11.63 63.3% 9.8% 27.8% 100.9% $ 1,191 1,170 162 354 1,213 219 999 63.3% 9.8% 26.9% 100.0% $ 1,141 239 1,442 183*** 33 216*** 1.10*** 1.06*** 1.30*** 1.27*** .341⁄3 .331⁄3 $ 4,888 80 1,947 11.70 63.5% 8.7% 28.5% 100.7% $ 1,124 1,092 153 334 1,100 193 1,012 63.5% 8.7% 27.4% 99.6% $ 1,039 219 1,304 148 23 171 .90 .87 1.04 1.03 .31 .30 $ 4,357 80 1,714 10.37 63.8% 9.0% 29.9% 102.7% $ 1,015 992 142 302 961 177 934 63.8% 9.0% 29.0% 101.8% $ 948 193 1,161 141 5 146 .86 .86 .90 .89 .272⁄3 .272⁄3 $ 3,750 – 1,441 8.79 61.6% 9.2% 30.2% 101.0% $ 930 903 126 280 826 160 736 61.6% 9.2% 28.9% 99.7% ***2001 property casualty subsidiary statutory data excludes the effects of a $402 million one-time adjustment to recognize net written premiums on the basis of the policy contract term rather than the policy billing period as of January 1, 2001, as required to conform with Codification of Statutory Accounting Principles. ***2000 results include a one-time net charge for asset impairment of $39 million, before tax; $25 million, or 16 cents per share, net of tax. The charge affected the statutory expense ratio and combined ratio by 1.7 percentage points and the GAAP expense ratio and combined ratio by 2.1 percentage points. ***1993 earnings include a net credit for $14 million, or 8 cents per share, cumulative effect of a change in the method of accounting for income taxes to conform with SFAS No. 109 and a net charge of $9 million, or 5 cents per share, related to the effect of the 1993 increase in income tax rates on deferred taxes recorded for various prior year items. 19 Back to table of contents (cid:2) M A N A G E M E N T D I S C U S S I O N Cincinnati Financial Corporation and Subsidiaries I N T R O D U C T I O N 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 beginning on Page 35 and the 11-year summary of selected financial information on Pages 18 and 19. CFC had six subsidiaries at year-end 2001. The lead property casualty insurance subsidiary, The Cincinnati Insurance Company, markets a broad range of business and personal policies in 31 states through an elite corps of 959 independent insurance agencies. Other members of the property casualty group are The Cincinnati Casualty Company and The Cincinnati Indemnity Company, which provide the Company with flexibility in underwriting, pricing and billing. The Cincinnati Life Insurance Company markets life, long term care and disability income policies and annuities through property casualty agencies and independent life agencies. CFC Investment Company complements the insurance subsidiaries with commercial leasing, financing and real estate services. The Company’s sixth subsidiary, CinFin Capital Management Company, provides asset management services to institutions, corporations and individuals with $500,000 minimum accounts. The Company’s segments are defined based upon the components of the Company for which financial information is used internally to evaluate segment performance and determine the allocation of resources. Investment operations are CFC’s primary source of profits. A total-return strategy emphasizes investment in fixed-maturity securities, as well as equity securities that contribute to current earnings through dividend increases and add to net worth through long-term price appreciation. 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: unusually high levels of catastrophe losses due to changes in weather patterns or other causes; the frequency and severity of claims; environmental events or changes; changes in insurance regulations, legislation or court decisions that place the Company at a disadvantage in the marketplace; adverse outcomes from litigation or administrative proceedings; recession or other economic conditions resulting in lower demand for insurance products; sustained decline in overall stock market values negatively affecting the Company’s equity portfolio; delays in the development, implementation and benefits of technology enhancements; and decreased ability to generate growth in investment income. Further, the Company’s insurance businesses are subject to the effects of changing social, economic and regulatory environments. Public and regulatory initiatives have included efforts to adversely influence and restrict premium rates, restrict the ability to cancel policies, impose underwriting standards and expand overall regulation. The 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. INSURANCE REGULATORY OVERSIGHT The Company’s insurance subsidiaries, in common with other insurers based in the United States, are subject to extensive governmental regulation and supervision in the various states and jurisdictions in which they transact business. The laws and regulations of Ohio, the state of domicile of the Company’s insurance subsidiaries, have the most significant impact on their operations. For public reporting, insurance companies prepare financial statements in accordance with accounting principles generally accepted in the United States (GAAP). However, certain data also must be calculated according to statutory accounting rules, based on Statutory Accounting Principles, and must be reported to state insurance departments per the National Association of Insurance Commissioners (NAIC), the oversight organization for state insurance regulations. While not a substitute for any GAAP measure of performance, statutory data frequently is used by industry analysts and other recognized reporting sources to facilitate comparisons of the performance of insurance companies. When appropriate, the following discussion makes use of statutory data to analyze trends or to make comparisons to industry performance. Estimated industry data included below is taken from materials published by A.M. Best Company, a leading insurance industry analytical and rating agency, and presented on a statutory basis. Statutory data for the Company is labeled as such and all other data is prepared based on accounting principles generally accepted in the United States. NAIC adopted the Codification of Statutory Accounting Principles (Codification) in March 1998. Codification, which is intended to standardize regulatory accounting and reporting to state insurance departments, became effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. Ohio required adoption of Codification, with certain modifications, for the preparation of statutory-basis financial statements effective January 1, 2001. Codification is now incorporated into the NAIC 20 Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries Accounting Practices and Procedures Manual. The effects of the Company’s adoption of Codification are discussed below. The NAIC uses risk-based capital (RBC) formulas for both property casualty and life insurers, which serve as an early warning tool for the NAIC and the state regulators to identify companies that are undercapitalized and merit further regulatory action. The Company’s property casualty and life companies have more than sufficient capital to meet the RBC requirements. Effects of Codification of Statutory Accounting Practices The effect of adopting Codification is reported as a cumulative- effect type change in accounting principle for the Company’s insurance subsidiaries’ statutory financial statements as of January 1, 2001. This means that the January 1, 2001 balances of the Company’s insurance subsidiaries’ statements of admitted assets, liabilities and capital and surplus have been adjusted to the amounts that would have been reported had Codification been in effect since the subsidiaries began operations. Accordingly, the significant changes to statutory surplus were as follows: For the property casualty companies – deferred tax assets of $314 million, consisting primarily of taxes on the timing of loss reserves and unearned premiums; deferred tax liabilities of $701 million, comprised mainly of taxes on net unrealized gains; guaranty fund assessments and premium tax liabilities of $11 million; and earned- but-unbilled premium receivables of $6 million, with a resulting decrease in surplus of $392 million. For the life company – deferred tax liabilities of $62 million, comprised mainly of taxes on net unrealized gains, and a corresponding decrease in surplus. Additionally, prior to 2001, the Company’s property casualty insurance subsidiaries recognized written premiums as they were billed throughout the policy period, which was a previously acceptable method. Beginning on January 1, 2001, these companies began recognizing written premiums on an annualized basis at the effective date of the policy as required by Codification. This method of recognizing written premiums had no effect on statutory income or surplus because earned premiums were unaffected. To account for unbooked premium related to policies with effective dates prior to January 1, 2001, the Company recorded a written premium adjustment on January 1, 2001 of $402 million that will appear in 2001 statutory financial reports submitted to insurance regulatory authorities. Since this adjustment affected written premiums only and was one-time in nature, it has been excluded from comparisons of written premiums between 2001 and 2000 in this report. Written premiums presented throughout this report for 2000 have been reclassified to conform with the 2001 presentation based on contractual period; information was not readily available to reclassify earlier years’ statutory data. R E S U LT S O F O P E R AT I O N S THREE-YEAR HIGHLIGHTS 2001 Change 2000 Change % 1999 Change % % Pro Forma* $2,331 (dollars in millions except per share data) Revenue Net operating income Net capital losses Net income Net income $2,561 9.9 $ 210 44.1 (17)(870.8) 34.4 63.3 $ 193 $ 193 Per Share Data (diluted): Net operating income Net capital losses Net income Net income $ 1.29 43.3 (.10)(900.0) 33.7 63.0 $ 1.19 $ 1.19 9.5 $2,128 3.6 (2) (359.8) $ 146* (43.0) $ 255 – $ 144* (43.5) $ 255 (53.5) $ 255 $ 118 (.01) $ .90* (40.8) $ 1.52 – nm $ .89* (41.4) $ 1.52 (52.0) $ 1.52 $ .73 28.1 nm 5.4 5.4 31.0 nm 7.8 7.8 Note: The selected financial information presented above allows for a more complete analysis of results of operations and should not be considered as a substitute for any GAAP measures of performance. *In 2000, the Company incurred a one-time net charge for asset impairment of $39 million, before tax; $25 million, or 16 cents per share, net of tax. Pro forma amounts exclude the one-time charge for comparison purposes. Revenue growth in each of the past three years primarily reflected higher contributions from property casualty earned premiums and investment income. In 2001, the growth rate for property casualty earned premiums rose for the fourth consecutive year because of strong growth in the Company’s commercial insurance lines. Revenue from investment income rose 2.8 percent in 2001 on a comparable basis, below the 6.0 percent growth rate in 2000 and 5.1 percent growth in 1999, due to the lower interest rate environment. Growth rates are calculated excluding $5 million in interest earned in 2000 from a $303 million single-premium bank- owned life insurance (BOLI) policy booked at the end of 1999. Excluding a one-time charge for asset impairment in 2000, net operating income in 2001 rose 44.1 percent over 2000, primarily because of a decline in the underwriting loss in 2001. In 2000, higher losses and $72 million (after-tax) in additional reserves related to uninsured motorists coverage resulted in a 43.0 percent decline in net operating income compared with the prior year’s record level. In 1999, net operating earnings increased 28.1 percent principally due to lower catastrophe losses. The one-time charge of $25 million (after-tax) recorded in 2000 expensed impaired assets related to development of next-generation software to process property casualty policies. For comparison purposes all data discussed below excludes the charge, unless otherwise indicated. Back to table of contents 21 (cid:2) M A N A G E M E N T D I S C U S S I O N (continued) Cincinnati Financial Corporation and Subsidiaries The Company reported a net capital loss of $17 million in 2001 as detailed in Investment Operations. The net capital loss was $2 million in 2000 and less than $1 million in 1999. Book value was $37.07 at year-end 2001, below the record $37.26 at year-end 2000, but up from $33.46 at year-end 1999. The decrease in 2001 was primarily due to an increase in outstanding shares as convertible debenture conversions offset a modest $3 million increase in total shareholders’ equity. PROPERTY CASUALTY INSURANCE OPERATIONS Property Casualty Insurance Premiums Cincinnati leverages its strong relationships with independent insurance agents in 31 states to market property casualty insurance. In 2001, approximately 98 percent of the Company’s agency direct written premium volume was in the 26 states in which the Company has had a presence for more than five years. In 2001, the Company’s 959 independent insurance agencies generated an average of approximately $2.3 million each in agency direct written premiums; no single agency accounted for more than 1.3 percent of the Company’s total agency direct written premiums. Further, agencies in Ohio contributed 25 percent and Georgia, Illinois, Indiana, Michigan and Pennsylvania each contributed between 5 percent and 10 percent of premium volume in 2001. Factors that distinguish the Company in the insurance marketplace include: • Single-channel distribution strategy that emphasizes the value of independent agents and their knowledge of the local markets. • Local field staff that enhances service and accountability by providing 24/7 availability and local decision-making authority. The field marketing staff is responsible for the selection of new independent agents as well as underwriting and pricing of new commercial business. • Widely recognized, high-quality claims service via locally based field claims staff in conjunction with independent agents. To help ensure prompt claims service, the Company provides most agents with authority to pay claims immediately up to $2,500 and assigns claims representatives to agencies. In total, the Company pays an average of $5 million per business day in claims. • Innovative products and services that meet the needs of the Company’s independent agents and their customers, including the availability of three-year policy terms for many types of insurance coverage. In 2001, both new and updated policies were introduced to further meet the needs of agents and their customers, including the new Credit Union Blanket Bond and improved broadening endorsements for commercial general liability and business auto as well as updated dentist, printer and homeowner-auto packages. • Emphasis on improving customer service through the creation of smaller marketing territories, permitting local field marketing representatives to devote more time to each independent agent. During 2001, two additional field representatives were assigned to established marketing territories. Since the beginning of 1997, the Company has subdivided 10 territories in established states. During 2002, the Company plans to split and staff another six or more territories. Smaller territories allow marketing representatives to increase the level of service as well as expand the opportunities to ask for and earn new business. • Programs to support agency growth, including education programs for agents and staff, and financing for buildings and equipment. In 2001, the insurance subsidiaries augmented ongoing training programs with a number of special events, including seminars held around the country to encourage cross-selling by expanding awareness of the Company’s products among producing agents. CFC Investment Company offers convenient, competitive equipment and vehicle leases and loans for independent insurance agents, their commercial customers and other businesses and also provides commercial real estate loans to agents to help them operate and expand their businesses. By leveraging these characteristics, the Company has expanded property casualty total net written premiums more rapidly than the estimated industry growth rate in each of the past three years. The Company’s total net earned premiums grew 13.3 percent in 2001, 10.3 percent in 2000 and 7.4 percent in 1999. For 2001 only, GAAP net earned premiums were $6 million higher than statutory net earned premiums due to certain adjustments required by statutory Codification. Property Casualty Insurance Subsidiary Premiums (GAAP) (dollars in millions) 2000 Change 2001 Change 1999 Change % % % Commercial lines net earned premiums Personal lines net earned premiums Total net $1,453 17.9 $1,232 13.3 $1,088 6.7 620 4.0 596 4.6 570 8.9 earned premiums $2,073 13.3 $1,828 10.3 $1,658 7.4 The primary source of growth in 2001 was firmer pricing on new and renewal commercial business. Premium growth in states in which the Company has had a presence for more than five years was a healthy 13.9 percent in 2001, reflecting the continued opportunities available to Cincinnati. Expansion states, where the Company has operated for fewer than five years, also were a factor in overall growth, with agency direct premiums of $33 million in 2001 compared with $16 million in 2000. Over the past five years, the Company began marketing commercial lines insurance in North Dakota, Montana, upstate New York, Idaho and Utah, and began writing or expanding personal lines in states that were 22 Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries previously commercial-only territories: Maryland, Michigan, Minnesota, Montana, North Dakota and Pennsylvania. Commercial Lines Commercial lines premiums rose to 70.0 percent of total net earned premiums in 2001 from 67.4 percent in 2000 and 65.6 percent in 1999, reflecting the higher rate of growth in that segment as the market continued the strengthening that began in the second half of 1999 after years of intense price competition. Industry-wide growth in net written commercial insurance premiums was 10.0 percent in 2001 compared with 7.2 percent in 2000. The Company’s standard approach is to write three-year policies, an advantage in the commercial lines market. Exceptions often include business new to the agency or, in certain local competitive marketplaces, when a policy is aggressively priced. Within those multi-year packages, automobile, workers’ compensation, professional liability and most umbrella liability coverages remain subject to annual adjustment. Management estimates that approximately 70 percent of the commercial written premiums is subject to annual adjustment or re-pricing. Multi-year packages are offered at rates that may be slightly higher than single- year or annually-adjusted rates. By reducing annual administrative efforts, multi-year policies reduce the Company’s and agency’s expenses and the incentive for the policyholder to shop for a new policy every year. In 2001, new commercial lines business written directly by Cincinnati agents reached $220 million, just short of the all-time high of $230 million recorded in 2000. 2001 growth was excellent given the priority placed on underwriting activities during this period. Personal Lines During 2001, the personal insurance market grew less rapidly than the commercial insurance market due to continuing competition. Industry-wide growth in net written personal lines premiums was estimated at 7.0 percent, up from 3.7 percent in 2000. Cincinnati’s personal lines net earned premium growth rate was 4.0 percent in 2001 compared with 4.6 percent in 2000 and 8.9 percent in 1999. Growth in 2001 reflected a 14 percent increase in personal lines new business to $52 million. The Company introduced a new homeowner policy for higher valued homes and an updated personal auto program. Emphasis on writing homeowner coverage limits at full replacement value also began to contribute to total personal lines premium growth. These factors should contribute to premium growth in 2002 and beyond, as well. The Company has received regulatory approvals for homeowner rate increases averaging approximately 10 percent. In the fourth quarter of 2001, increases took effect in several states, including Ohio and Illinois. Further, rate increases will take effect in four major states in the first quarter of 2002 and in several additional states in the second quarter. As a result, management estimates an increase in homeowner premium of 7 percent to 8 percent in 2002 as new business is written and existing one- and three-year policies begin to renew. The personal lines automation project, launched at the end of 2000, now is testing key components and preparing for release to agencies in a pilot state in mid-2002. Sequential roll-out to other states will follow, extending over several years. The objectives are to create next-generation software for personal lines products; to build a single-entry data processing system to streamline policy issue; to speed up processing time to improve cash flow; and to offer direct billing, a feature frequently requested by agents. The automation program is expected to contribute to personal lines growth in future years. The total amount invested in development of this new software through December 31, 2001 was $8 million. Property Casualty Insurance Profitability The discussion of profitability is based on GAAP data, except for the following statutory analysis of results versus industry performance and the accident year analysis of loss data. The Company recorded a statutory net underwriting loss of $108 million in 2001, compared with underwriting losses of $210 million in 2000 and $13 million in 1999. In 2001, the Company’s statutory combined ratio was 103.6 percent. This measure of profitability was above the 101.3 percent (statutory basis) the Company averaged in the second half of the 1990s and which the Company has stated is its target for future performance. However, the 2001 ratio was considerably better than the industry’s estimated 117 percent combined ratio, which included approximately 6 points for World Trade Center losses. Cincinnati’s September 11 losses were a relatively minor $9 million, adding only 0.4 percentage points to the Company’s statutory combined ratio. The 2000 statutory combined ratio for Cincinnati was 109.9 percent, including 6 points for a $110 million reserve addition and excluding a one-time charge for asset impairment. The $110 million pre-tax addition to reserves, net of reinsurance, was an estimate of past uninsured and underinsured motorist (UM/UIM) losses incurred but not yet reported (IBNR) resulting from two Ohio Supreme Court decisions. Even including the reserve addition, the Company’s statutory combined ratio was below the estimated industry ratio of 110.1 percent. In 1999, Cincinnati’s statutory combined ratio was 100.4 percent comparing favorably with the estimated industry average of 107.8 percent. On a GAAP basis, the Company’s combined ratio was 104.9 percent in 2001, 112.8 percent in 2000 (110.7 percent excluding the asset impairment charge or 104.7 excluding both the asset impairment charge and the reserve addition) and 100.2 percent in 1999, a trend similar to that seen in the statutory data. The following contributed to the Company’s underwriting results: Loss and LAE Trends Excluding catastrophe losses, the total loss and loss adjustment expense (LAE) ratio in 2001 was 6.1 percentage points less than the level recorded in 2000 (essentially unchanged from 2000 when the reserve addition is excluded) and 4.2 percentage points higher than 1999. The total loss and LAE ratio for both 2001 and 2000 Back to table of contents 23 (cid:2) M A N A G E M E N T D I S C U S S I O N (continued) Cincinnati Financial Corporation and Subsidiaries was primarily affected by the increase in severity of losses of all sizes when compared with 1999, the first year the Company collected data on losses and reserve adjustments by size categories. Property Casualty Subsidiary Losses Incurred Analysis (GAAP) Over the three-year period, the following changes occurred in the loss patterns: (dollars in millions) Losses $1 million or more Losses $250 thousand to $1 million Development and reserve increases of $250 thousand or more Other losses Total losses incurred excluding catastrophe losses Catastrophe losses Total losses As a Percent of Net Earned Premiums: Losses $1 million or more Losses $250 thousand to $1 million Development and reserve increases of $250 thousand or more Other losses Loss ratio excluding catastrophe losses Catastrophe loss ratio Total loss ratio 2001 $ 71 143 122 981 $1,317 64 $1,381 2000 $ 58 118 1999 $ 36 89 114 961 90 770 $1,251 50 $1,301 $ 985 37 $1,022 3.4% 6.9 5.9 47.3 63.5% 3.1 66.6% 3.2% 6.5 6.2 52.5 68.4% 2.7 71.1% 2.2% 5.4 5.4 46.4 59.4% 2.2 61.6% • Losses $1 million or more – The average size of new losses of $1 million or more, net of reinsurance, declined over the three-year period. Rising overall severity and frequency was the primary factor in the increased contribution of losses of this size over the past three years. While total large losses rose $13 million, or 22.1 percent in 2001 compared with 2000, claim count rose by 30.0 percent. Between 2000 and 1999, total large losses increased by $22 million, or 62.7 percent, while claim count rose by 66.7 percent. With the number of in-force policies increasing over the three-year period, the Company would have expected some increase in the number of large losses. However, the rate at which total large losses increased over the period was greater than the growth in the overall business, which management believes was due to escalating legal costs, medical costs and jury verdicts along with inflated perceived values caused by announcements of sensational “celebrity” pay contracts. • Losses $250,000 to $1 million – New losses in this range over the past three years were driven by factors similar to those affecting losses of $1 million or more. These losses, in total, increased by 21.5 percent in 2001, while claim count rose by 19.4 percent. In 2000, these losses in total rose 32.0 percent with a 33.3 percent rise in frequency. • Development and reserve increases of $250,000 or more – In 2001, as the Company adapted to the changing environment and began establishing larger initial reserves to more accurately reflect severity trends, the number of claims requiring case reserve adjustments declined. For losses requiring reserve adjustments, however, the average increase in 2001 was 17.5 percent, a rate exceeding that of the growth in the overall business and reflecting the rising overall severity. • Other losses – This category includes adverse development and reserve increases less than $250,000 and IBNR. Following its initial rise of 24.7 percent in 2000, due to rising severity, the total of all other losses and case reserve adjustments rose 2.1 percent in 2001, stabilizing at 47.3 percent of net earned premiums. As these trends developed, management concluded that the most effective means of returning the Company’s loss ratio to its historic levels will be through pricing and rate increases, which the Company has been implementing. In addition, in 2001, the Company continued efforts to leverage its strong local presence in field territories. Insurance-to-value initiatives are designed to ensure the policyholders pay for coverage amounts appropriate for exposures. Field marketing representatives have been meeting with every agency to reaffirm agreements on the extent of frontline renewal underwriting to be performed by local agents. Claims representatives have been conducting on-site inspections and preparing full risk reports on every account reporting a loss above $100,000 and on accounts of concern. These and other actions are expected to contribute to further improvement in loss results and lead to improved profitability. Loss Trends by Business Line The loss and LAE ratio for commercial lines was 74.1 percent in 2001, compared with 84.0 percent in 2000 (75.7 percent when the reserve addition is excluded) and 72.9 percent in 1999. Catastrophe losses contributed 1.9 percent, 1.5 percent and 2.3 percent to the commercial loss and LAE ratio in 2001, 2000 and 1999, respectively. The loss and LAE ratio for personal lines was 82.9 percent in 2001, compared with 79.2 percent for 2000 (77.9 percent when the reserve addition is excluded) and 69.1 percent in 1999. Catastrophe losses contributed 5.8 percent, 5.3 percent and 2.1 percent to the personal lines’ loss and LAE ratio in 2001, 2000 and 1999, respectively. 24 Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries Property Casualty Subsidiary Accident Year Loss Analysis Results by accident year, excluding catastrophe losses, for selected business lines are as follows as of December 31, 2001: 2001 1999 2000 1998 154 185 166 $1,658 $1,543 142 182 150 $1,828 179 208 180 $2,067 221 252 191 Statutory Net Earned Premiums (dollars in millions) All lines Commercial auto Workers’ compensation Homeowner Statutory Accident Year Losses and LAE (dollars in millions) All lines $1,580 175 Commercial auto 184 161 Workers’ compensation 208 Homeowner 120 160 Statutory Accident Year Loss and LAE Ratios (percent) All lines Commercial auto Workers’ compensation Homeowner $1,494 185 195 153 113.4 87.1 72.3 103.1 93.9 85.2 76.4% 81.7% 75.9% 78.1% 83.3 82.6 83.7 106.9 74.1 86.8 $1,259 $1,206 152 135 131 Within commercial lines, the commercial auto and workers’ compensation lines were the most significant contributors to the higher losses in accident years 2001 and 2000 when compared with 1999. Based on the Company’s historic trends for reserve accuracy and its intent to reflect higher severity in its initial reserve activity, management believes that the improvement in 2001 accident year loss ratios, basically resulting from higher premiums, indicates that the Company’s strategies are reducing the impact of greater losses in these business lines. The most significant cause of the higher loss and LAE ratio between 2001 and 1999 in personal lines was weakening profitability in the homeowner line, an industry-wide trend. In 2000, the Company began a personal auto re-underwriting program that reviewed and strengthened underwriting standards, requiring motor vehicle reports for many insured drivers and commitments that some agencies will provide the Company with specific premium volume increases. That program helped mitigate the higher losses in 2001 and 2000. In 2001, the Company expanded the re-underwriting program to include homeowner coverages, emphasizing homeowner coverage limits at full replacement value. In addition, account reviews determined that water damage was a significant cause of homeowner property claims. Going forward, rather than including that coverage as standard, policyholders will be given the opportunity to select water damage coverage as a policy addition, in coverage amounts needed. New water damage exclusions and endorsements will begin to take effect over the next year in several states. Homeowner rate increases averaging 10 percent are scheduled to go into effect in the coming year for new and renewal policies. Insurance to value, rate increases, specific charges for water coverages and agency-by-agency reviews should help improve results in the homeowner line over the next several years. Catastrophe Losses The contribution to the loss ratio of catastrophe losses at 3.1 percentage points in 2001, 2.7 points in 2000, and 2.2 points in 1999 approximated the Company’s historic range. 2001 catastrophe losses totaled $64 million, net of reinsurance and before taxes, including $9 million for losses related to events of September 11, 2001. Reported direct losses accounted for only $300,000 of that total, with the remainder arising from the Company’s participation in an aircraft insurance pool and other reinsurance agreements. Due to the nature of catastrophic events, management is unable to predict accurately the frequency or potential cost of such occurrences in the future. However, in an effort to control such catastrophe losses, the Company does not market property casualty insurance in California, does not write flood insurance, reviews exposure to huge disasters and continues to reduce coverage in certain coastal regions. Property Casualty Subsidiary Profitability Ratios (GAAP) Commercial loss and LAE ratio including catastrophe losses Personal loss and LAE ratio including catastrophe losses Loss ratio excluding catastrophe losses LAE ratio Loss and LAE ratio excluding catastrophe losses Catastrophe loss and LAE ratio Loss and LAE ratio Expense ratio excluding policyholder dividends Policyholder dividend ratio Combined ratio Combined ratio 2001 2000 Pro Forma* 1999 74.1% 84.0% 72.9% 82.9% 79.2% 69.1% 63.5% 10.1 73.6% 3.1 76.7% 27.4 .8 104.9% 104.9% 68.4% 11.3 79.7% 2.7 82.4% 27.3* 1.0 110.7%* 112.8% 59.4% 10.0 69.4% 2.2 71.6% 28.2 .4 100.2% 100.2% *In 2000, the Company incurred a one-time net charge for asset impairment of $39 million. Including the charge, the expense ratio was 29.4% and the combined ratio was 112.8%. Pro forma results exclude the charge for comparison purposes. Expense Ratio The expense ratio, excluding the one-time charge to expense software development assets in 2000, remained relatively stable over the past three years, as the Company maintained its level of investment in staff and costs associated with upgrading technology and facilities. Policyholder Dividend Ratio Policyholder dividends as a percent of net earned premiums declined by 0.2 percentage points in 2001 after increasing Back to table of contents 25 (cid:2) M A N A G E M E N T D I S C U S S I O N (continued) Cincinnati Financial Corporation and Subsidiaries 0.6 percentage points in 2000 over 1999 due to growth in workers’ compensation premiums, particularly in Wisconsin, where these policies are structured to include policyholder dividends. The improvement in 2001 reflected the Company’s decision to move many workers’ compensation policies to The Cincinnati Casualty Company, a subsidiary company that writes non-participating workers’ compensation policies. As a result of this decision, the policyholder dividend ratio should further decline in 2002. LIFE AND ACCIDENT HEALTH OPERATIONS (GAAP) 1999 Change (dollars in millions) 2001 Change 2000 Change % % % Gross written premiums* Net written premiums* Earned premiums Other income Investment income Total revenues Total expenses Net operating income Net capital losses Net income Total assets Shareholder’s equity *Statutory basis $ 122 (10.7) $ 137 (66.5) $ 409 317.1 102 (14.2) 1.7 81 33.6 3 1.3 80 – 158 6.6 120 119 (70.1) 80 6.2 2 (32.1) 12.5 79 9.9 158 5.3 112 398 331.1 6.6 75 na 3 7.7 70 8.8 144 4.8 107 30 (8.1) (4) (136.0) 26 (15.4) 8.6 5.2 1,761 552 32 14.9 (2) 40.0 20.3 31 12.0 1,621 13.3 525 28 19.1 (3) (19.0) 19.1 26 19.6 1,447 463 (11.8) The Company’s life insurance subsidiary had statutory net written premiums of $102 million in 2001. In 2000, net written premiums were $119 million, including a single $20 million BOLI policy and a separate account. In 1999, net written premiums were $398 million, including a $303 million BOLI premium. Excluding BOLI premiums, net written premiums rose 3.0 percent in 2001, compared with increases of 3.8 percent in 2000 and 3.6 percent in 1999. Written premiums have been restated to exclude annuity deposits not involving life contingencies, which are not recognized as written premium under statutory rules. In 2001, net operating income was down 8.1 percent from the prior year primarily due to higher expenses related to charges for automation and policy audits and incentives. In 2000 and 1999, net operating income rose 14.9 percent and 19.1 percent, respectively, due to growth in investment income, favorable mortality experience, expense control and continued growth. The life insurance subsidiary contributed 14 percent of CFC’s operating income in 2001 compared with 27 percent in 2000 and 11 percent in 1999. An important part of Cincinnati Life’s strategic mission is to round out accounts while improving persistency for the Company. Term and worksite insurance products are well suited to cross- serving by the Company’s property casualty agency force, 90 percent of which now do business with Cincinnati Life. Agents find that offering worksite marketing to employees of their small commercial accounts provides a benefit to the employees at low cost to the employer. To further the cross-selling opportunities with property casualty agencies, new and enhanced term products will be introduced in early 2002. FEDERAL INCOME TAXES Investment operations are the Company’s primary source of profits. The Company pursues a strategy of investing in tax- advantaged fixed maturities and equity securities to minimize its overall tax liability and maximize after-tax earnings. Reflecting that strategy, the Company’s income tax expense (benefit) was $28 million, $(9) million and $67 million for 2001, 2000 and 1999, respectively, while the effective tax rate was 12.7 percent, (8.9) percent, and 20.8 percent for the same periods. The statutory net underwriting losses in each of the past three years served to further reduce the Company’s tax expense. The differences in income tax expense and the effective tax rate during the period were primarily the Company’s tax-exempt interest and dividends received exclusion. The 1999 tax rate was consistent with historical experience, and management anticipates that the effective tax rate will approximate that level if the Company achieves its performance objectives. I N V E S T M E N T O P E R AT I O N S The market value of the Company’s investments was $11.571 billion and $11.316 billion at year-end 2001 and 2000, respectively. These investments made up 82.9 percent of the Company’s $13.959 billion assets at year-end 2001 compared with 85.2 percent at year-end 2000. The Company’s primary investment strategy is to maintain liquidity to meet both immediate and long-range insurance obligations through the purchase and maintenance of medium-risk fixed-maturity bonds and equity securities. The Company’s investment decisions on an individual insurance company basis are influenced by insurance regulatory and statutory requirements designed to protect policyholders from investment risk. Cash generated from insurance operations is invested almost entirely in corporate, municipal, public utility and other fixed-maturity or equity securities. Such securities are evaluated prior to purchase based on yield and risk. Investments are primarily publicly-traded securities, classified as available-for-sale in the accompanying financial statements. Changes in the fair value of these securities are reported in other comprehensive income, net of tax. The Company invests in convertible bonds and convertible preferred stocks. The Company believes the conversion features enhance the overall value of the security when purchased. Management does not believe that investments in convertible securities (market value of $442 million at December 31, 2001) pose any significant risk to the Company or its portfolio due to the 26 Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries relatively high quality of the securities. Consequently, management intends to continue to invest in convertible securities in the future. Information regarding the composition of investments, together with maturity data regarding investments in fixed maturity obligations, is included in the Notes to Consolidated Financial Statements. INVESTMENT INCOME Pre-tax investment income reached a new record of $421 million in 2001; however, reflecting the lower interest rate environment, the growth rate for investment income slowed to 2.8 percent, compared with 6.0 percent in 2000, excluding interest income recorded from the BOLI policy, and 5.1 percent in 1999. The growth was primarily the result of investing the cash flows from operating activities and dividend increases from equity securities in the investment portfolio. In 2001, 26 of the 44 common stocks in the Company’s investment portfolio increased dividends during the year, adding more than $18 million to gross investment earnings on an annualized basis. Investment income was affected over the past three years by decreased cash available for the investment portfolio due to the repurchase of the Company’s common stock and the reinvestment of called or redeemed bonds at lower interest rates. NET CAPITAL LOSSES The Company reported a net capital loss of $17 million in 2001 following net capital losses of $2 million in 2000 and less than $1 million in 1999. Included in the 2001 loss were asset impairments of $47 million related to non-investment grade corporate bonds, recognized because management viewed the declines as “other than temporary.” (See Asset Impairment discussion in Significant Accounting Policies on Page 32 for factors considered by management.) During 2001 the corporate bond market experienced the highest default rates since 1990-1991. The Company is taking an aggressive approach, selling or writing down issues for management believes it may not be able to recoup lost value. In addition, the Company adopted SFAS No. 133 “Accounting for Derivative Financial Instruments and Hedging Activities” on January 1, 2001. Convertible securities (both fixed maturities and preferred stocks) have been divided between the host contract and the derivative financial instrument according to SFAS No. 133 for valuation purposes. The host contract continues to be accounted for as an available-for-sale security and the conversion feature has been marked to market and the related change in value recorded as net capital gains (losses). Prior to the adoption of SFAS No. 133, these changes in value affected only the Company’s balance sheet. The impact in 2001 was a $9 million net capital gain, before tax. Net capital gains (losses) in prior years were not affected by SFAS No. 133. MARKET RISK Market risk is the risk that the Company’s portfolio may incur losses due to changes in price for equity securities and changes in interest rates and credit ratings for fixed-maturity securities. Actively managing market risk is integral to the Company’s operations. The Company may change the character of future investments purchased or sold or alter the existing asset portfolios to manage exposure to market risk within defined tolerance ranges. The Company administers and oversees the investment risk management process primarily through the Investment Committee of the Board of Directors, which provides executive oversight of investment activities. The Company has specific guidelines and policies that define the overall framework for managing market and other investment risks, including the accountabilities and controls over these activities. These guidelines are applied daily by investment portfolio managers. Exposure to Changes in Price for Equity Securities Equity price risk is the risk that the Company will incur economic losses due to adverse changes in a particular equity investment or group of equity investments. At year-end 2001 and 2000, investments totaling approximately $8.495 billion and $8.526 billion ($2.174 billion and $2.068 billion at cost) of the Company’s $11.571 billion and $11.316 billion investment portfolio related to equity securities. The equity emphasis is on common stocks with an annual dividend yield of approximately 1.5 percent to 3 percent and with annual dividend increases. The Company’s portfolio of equity investments had an average dividend yield-to-cost of 9.4 percent at December 31, 2001. Management’s strategy in equity investments includes identifying, for the core of the investment portfolio, approximately 10 to 15 companies, in which the Company can accumulate 5 percent to 10 percent of their common stock. While the Company’s financial position would be impacted by changes in the market valuation of these investments, in 2001, the Company’s equity portfolio outperformed the Standard & Poor’s (S&P) 500 Index, a common measure of market performance, gaining 0.7 percent vs. a decline of 11.9 percent for the Index. Over the past five years, the portfolio performed similarly, with an average annual return of 20.2 percent compared with a 10.7 percent rate for the S&P 500 Index. While past performance cannot guarantee future returns, management believes the Company’s investment style – focused on companies that pay and increase dividends to shareholders – offers some protection in down markets. A prolonged downturn in the stocks of financial institutions would make future comparisons with the S&P 500 Index more difficult. At December 31, 2001, the Company held six individual equity investments that accounted for approximately 90 percent of the after-tax net unrealized appreciation of the entire investment portfolio. The Company’s largest equity holding is Fifth Third Bancorp (Nasdaq:FITB) common stock, of which the Company held 72.8 million shares at a cost of $283 million at December 31, 2001. The market value of the Company’s Fifth Third Bancorp position was $4.464 billion at year-end 2001, or 53 percent of its total equity portfolio. The after-tax unrealized gain represented by the Company’s Fifth Third Bancorp position was Back to table of contents 27 (cid:2) M A N A G E M E N T D I S C U S S I O N (continued) Cincinnati Financial Corporation and Subsidiaries $2.717 billion, or 66 percent of the Company’s total after-tax unrealized gains at year-end 2001. The Fifth Third Bancorp position represented $16.80 of the Company’s total book value of $37.07 per share at year-end 2001. If Fifth Third Bancorp’s common stock were to decline by 20 percent from its closing price of $61.33 at year-end 2001, the impact on CFC would be an $893 million reduction in assets and a $580 million reduction in after-tax unrealized gains. This would reduce shareholders’ equity by 10 percent and book value by $3.59 per share. Exposure to Changes in Interest Rates and Credit Ratings for Fixed-Maturity Securities Interest rate risk is the risk that the Company will incur economic losses due to adverse changes in interest rates. This risk arises from the Company’s exposure to interest rates through investing activities. The Company invests substantial funds in interest-sensitive assets and also has certain interest-sensitive liabilities. Credit rating risk is the risk that the Company will incur economic losses due to credit downgrades by Moody’s Investors Service and/or Standard & Poor’s. At year-end 2001 and 2000, investments totaling approximately $3.010 billion and $2.721 billion ($3.012 billion and $2.803 billion at amortized cost) of the Company’s $11.571 billion and $11.316 billion investment portfolio related to fixed-maturity securities. Interest rate risk is lessened through the maturity structure of the fixed-income portfolio. At December 31, 2001, the Company’s portfolio of fixed-maturity securities had a weighted average yield- to-cost of 7.8 percent, a weighted average maturity of 9.8 years and a weighted average modified duration of 6.1 years. For the insurance companies’ purposes, strong emphasis has been placed on purchasing current income-producing securities and maintaining such securities as long as they continue to meet the Company’s yield and risk criteria. By maintaining a well diversified, fixed-income portfolio, the Company attempts to mitigate overall credit risk. No individual fixed-income issuer’s securities account for more than 1.7 percent of the fixed-income portfolio. Historically, municipal bonds have been attractive due to their tax-exempt status. Essential service (e.g., schools, sewer, water, etc.) bonds issued by municipalities are prevalent in this area. The Company maintains a diversified portfolio of municipal bonds. While no single municipal issuer accounts for more than 1 percent of the tax-exempt bond portfolio, concentrations within individual states can be high. Holdings in the top five states account for 63 percent of the municipal portfolio. Because of alternative minimum tax matters, the Company uses a blend of tax-exempt and taxable fixed-maturity securities. Tax-exempt bonds comprised 9 percent of invested assets as of December 31, 2001, unchanged from year-end 2000. At year-end 2001 and 2000, approximately $1.240 billion and $1.079 billion ($1.208 billion and $1.067 billion at amortized cost) of the investment portfolio was related to corporate bonds rated as investment grade. Bonds with a Moody’s rating at or above Baa are considered investment grade. A majority of the bonds not rated by Moody’s are investment grade for statutory purposes and are related to small, tax-exempt bond issues. The breakdown of the Company’s fixed-income portfolio based on Moody’s ratings is as follows: Moody’s Rating Aaa, Aa, A Baa Ba B Caa Ca, C Not rated Total Market Value (dollars in millions) $ 966 788 399 308 67 7 475 $3,010 ______________ Percent of Total 32.1% 26.2 13.3 10.2 2.2 0.2 15.8 100.0% _________________ At year-end 2001 and 2000, approximately $652 million and $585 million ($718 million and $706 million at amortized cost) of the investment portfolio were corporate bonds rated as non- investment grade. Such investments tend to have higher yields and are inherently more risky and illiquid since the risk of default by the issuer, as exhibited by rating, is higher. Historically, they have benefited the Company’s results of operations and in general are less sensitive to interest rate fluctuations. Many have been upgraded to investment grade while owned. In 2001, however, the Company recorded losses in its non-investment grade bond portfolio due to deteriorating economic conditions and tightening credit standards. The Company continues to closely monitor this class of investments. While interest rates for U.S. treasuries traded at or close to their lowest level of the past 20 years, the corporate bond market saw a greater deviation in 2001. Companies with pristine balance sheets and no perceived risk of accounting irregularities followed the treasury market with the lowering of yields. Any company with known or perceived credit or liquidity concerns saw its borrowing cost (interest rate) increase dramatically. The Company currently is developing financial planning models to further incorporate other analytical tools in assessing market risks. Management believes the new models will improve the Company’s ability to measure the impact on bond values of changes in interest rates. Understanding the impact of interest rate changes should allow for a better matching of the Company’s assets and liabilities. 28 Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries O U T L O O K Management is targeting continued growth in excess of the industry average. In 2002, industry analysts are projecting 10.4 percent net written premium growth for the property casualty insurance market. The Company’s further objectives are to return to historic profitability levels in its insurance segments and to maintain above industry-average investment income growth. PROPERTY CASUALTY INSURANCE OPERATIONS Factors that contribute to the positive outlook for total premium growth include the growing strength of the commercial insurance marketplace, the Company’s strong competitive position and its reputation among independent insurance agencies and management’s belief that the Company can achieve additional market penetration in states in which it currently operates. Management has concluded, however, that the higher-than- historic levels of severity, an industry-wide phenomenon, is a permanent shift; and that underwriting and pricing must be adjusted appropriately. The re-underwriting efforts begun in 2000 and 2001 have begun to address that issue. In this context, over the course of 2002, management anticipates improvement in the statutory combined ratio from the 103.6 percent reported for 2001. Management has targeted a return to its five-year (1995-99) average statutory and GAAP combined ratio of 101.3 percent, including policyholder dividends. Assuming a normal level of catastrophes, management believes it could reach that level by the end of 2002. Industry analysts are projecting a 107.5 percent statutory combined ratio for the property casualty insurance industry in 2002. To obtain reinsurance coverage in 2002, the Company is paying rates substantially higher than in 2001. Management anticipates the impact of the higher reinsurance rates on 2002 earnings per share will be approximately 12 cents, after tax. INVESTMENT OPERATIONS Management believes that with the resumption of a favorable pricing environment and continued growth in new business, strong cash flow from insurance operations should contribute to continued above industry-average investment income growth. With market sentiment indicating an economic recovery in 2002, the Company’s value-driven focus on income-generating securities of growing businesses should help it reach its goal. Continued weakness in the economy, however, could keep many non-investment grade securities under pressure. Similar to many financial institutions, the Company has and will continue to tighten its standards to adjust for credit risk. Currently, CFC sees convertible securities and investment-grade fixed maturities offering the best risk-adjusted returns. CFC will continue to invest in common stocks of companies with good management teams that have growth in earnings, revenues and dividends. LIQUIDITY AND CAPITAL RESOURCES CASH FLOW (dollars in millions) Net cash provided by operating activities Net cash used in investing $ 540 $ 697 $ 370 2001 1999 2000 activities Net cash used in financing activities Net increase (decrease) in cash Cash at beginning of year Cash at end of year Supplemental: Interest paid Income taxes paid (359) (148) $ 33 60 $ 93 $ 41 9 (513) (136) $(279) 339 $ 60 $ 40 33 (205) (211) $ 281 58 $ 339 $ 32 55 Cash flow from operations was sufficient to meet operating needs in 2001, 2000 and 1999, with short-term borrowings utilized for financing activities. Management expects operating cash flow will continue to be CFC’s primary source of funds because no substantial changes are anticipated in the Company’s mix of business. In 2001, cash flow from operations rose $170 million over 2000, primarily because of growth in insurance operations and the improved operating results. The higher level of premiums in 2001 resulted in a $140 million increase in unearned premiums. While reinsurance receivables rose in 2001 by $300 million primarily due to a $286 million receivable from the Company’s participation in a United States Aircraft Insurance Group (USAIG) insurance pool, this was mostly offset by a $315 million increase in the related loss and loss expense reserves. The primary reason for the decline in cash flow from operations between 2000 and 1999 was the 1999 year-end sale of the BOLI policy, which added $303 million to 1999 results, combined with larger underwriting losses in 2000. Management is aware that future liquidity could be impacted by disasters that are in excess of catastrophe treaties, which provide coverage for gross losses up to $200 million. The Company has no significant exposure to assumed reinsurance, which accounted for no more than 2.3 percent of net premiums in each of the last three years and is expected to remain at this level. In 2002, however, the change in the Company’s ceded reinsurance agreements will result in higher ceded premiums and higher retention by the Company, which will increase incurred losses. The higher level of available cash in 2001 was used primarily for investing activities. Net cash used in investing activities declined by $154 million in 2001, after rising by $308 million in 2000 as the $303 million from the sale of the BOLI policy in 1999 was invested primarily in fixed-maturity securities. During 2000 and 1999, a large number of the Company’s fixed-maturity investments Back to table of contents 29 (cid:2) M A N A G E M E N T D I S C U S S I O N (continued) Cincinnati Financial Corporation and Subsidiaries were called by the issuers. The overall decline in interest rates in 2001 substantially reduced the number of bond calls. The net effect of this transaction was to fix the interest cost on the short-term loan. Net cash used in financing activities rose $12 million in 2001 The Company has no off-balance sheet arrangements. after declining by $75 million in 2000. The modest increase in 2001 primarily reflected the higher level of dividends paid during the year and a $39 million decrease in short-term borrowing due to a lower level of stock repurchase. The decline in 2000 was primarily due to the $150 million reduction in cash used to purchase treasury shares from the unusually high level in 1999. Over the three-year period, the increase in notes payable declined steadily due to the reduced level of borrowing for treasury share purchases. LIABILITIES At December 31, 2001, total long- and short-term debt was 4.4 percent and insurance reserves were 25.8 percent of total assets, with remaining liabilities consisting of unearned premiums, deferred income taxes, declared but unpaid dividends and other liabilities. Debt At December 31, 2001, and December 31, 2000, long-term debt consisted of $426 million and $449 million, respectively, of convertible and senior debentures, neither of which is encumbered by rating triggers. Notes payable, primarily short-term debt through two bank lines of credit, used to enhance liquidity and provide working capital, increased to $183 million in 2001 from $170 million in 2000 and $118 million in 1999. Management has used short- term debt for purchase of treasury shares and other purposes. At December 31, 2001, the Company had $92 million of available borrowing capacity on its $175 million and $100 million lines of credit. There are two financial covenants for the Company’s $175 million line of credit. First, consolidated net worth on the last day of each fiscal quarter shall not be less than $5.0 billion or $4.5 billion if such reduction in consolidated net worth is due solely to unrealized losses in the Company’s portfolio of debt and equity investments; at year-end 2001, the Company’s consolidated net worth was $6.0 billion. Second, the Company’s consolidated ratio of indebtedness for borrowed money to net worth, at any time during each fiscal quarter, shall not exceed the ratio of 0.25-to- 1.00; as of year-end 2001, the ratio of indebtedness to net worth was 0.10-to-1.00. The Company’s $100 million line of credit has no financial covenants. During the second quarter of 2001, CFC Investment Company entered into an interest rate swap as a cash hedge of variable interest payments for certain variable-rate debt obligations ($31 million notional amount). Under this interest rate swap contract, the Company agreed to pay a fixed rate of interest for a seven-year period. The contract is considered to be a hedge against changes in the amount of future cash flows associated with the related interest payments. Accordingly, the related unrealized gain or loss on this contract is a component of comprehensive income. The interest swap contract is reflected at fair value in the Company’s balance sheet. The unrealized loss at December 31, 2001 was insignificant. Ratings Insurers are rated on their financial strength and claims-paying ability to provide consumers with comparative information in the insurance industry. Among other factors, the ratings focus on items such as results of operations, capital resources and minimum policyholders’ surplus requirements as well as qualitative analysis. In 2001, Standard & Poor’s changed their rating of the Company’s senior debentures to A+ Strong from AA- Very Strong and their ratings of the Company’s insurance subsidiaries to AA- Very Strong from AA+ Very Strong. Their decision reflected their outlook for the overall insurance industry, and, within that context, the Company. Other leading rating firms have maintained their ratings of the Company; A. M. Best, the leading insurance company rating firm, awards CFC’s property casualty companies the A++ Superior rating, assigned to less than 3 percent of insurer groups. A.M. Best awards Cincinnati Life the A+ Superior rating. Moody’s has maintained an A2 rating on the corporate debentures and an Aa3 ratings of the property casualty companies. The Company believes its financial position is strong; however, the rating agencies could decide to lower its ratings in the future. The following table summarizes the Company’s current debt and financial strength ratings: A.M Best S&P Moody’s Cincinnati Financial Corporation Convertible Senior Debentures Senior Debentures The Cincinnati Insurance Companies Property Casualty Group (and each subsidiary) Cincinnati Life aa aa A++ A+ A+ A+ A2 A2 AA- AA- Aa3 — DIVIDENDS CFC has increased cash dividends to shareholders for 41 consecutive years and, periodically, the Board of Directors authorizes stock dividends or splits. In February 2002, the Board of Directors authorized a 6 percent increase in the regular quarterly dividend to an indicated annual rate of 89 cents. In February 2001, the Board authorized a 10.5 percent increase; and in February 2000, an 11.8 percent increase. Over the past 10 years, the Company has paid an average of 35 percent to 40 percent of net income as dividends, with the remaining 60 percent to 65 percent reinvested for future growth. The ability of the Company to continue paying cash dividends is subject to factors as the Board of Directors may deem relevant. Since 1992, the Company’s Board also has authorized four stock splits or stock dividends: a three-for-one stock split in 1998; a 5 percent stock dividend in 1996; a 5 percent stock dividend in 30 Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries 1995; and, a three-for-one stock split in 1992. After the stock split in 1998, a shareholder who purchased one Cincinnati Insurance share before 1957 would own 1,947 CFC shares if all shares from accrued stock dividends and splits were held and cash dividends not reinvested. COMMON STOCK REPURCHASE The CFC Board of Directors believes that stock repurchases can help fulfill the Company’s commitment to enhancing shareholder value. Consequently, the Company’s Board of Directors has authorized the repurchase of outstanding shares. At December 31, 2001, 7.9 million shares remained authorized for repurchase at any time in the future. The Company has purchased 1.2 million shares at a cost of $46 million, 2.1 million shares at a cost of $66 million and 6.1 million shares at a cost of $217 million during the years ended December 31, 2001, 2000 and 1999, respectively. Shares repurchased total 13.0 million at a total cost to the Company of $423 million, since the inception of the share repurchase program in 1996. SHAREHOLDERS’ EQUITY At year-end 2001, total shareholders’ equity was 43.0 percent of total assets. (dollars in millions) Common stock, paid-in capital less treasury stock Retained earnings Accumulated other comprehensive income Total shareholders’ equity 2001 2000 1999 $ 207 1,678 4,113 $5,998 $ 219 1,620 4,156 $5,995 $ 267 1,624 3,530 $5,421 As a long-term investor, the Company has followed a buy-and- hold strategy for more than 40 years. A significant amount of unrealized appreciation on equity investments has been generated as a result of this policy. Unrealized appreciation on equity investments, before deferred income taxes, was $6.321 billion and $6.458 billion at year-end 2001 and 2000, respectively. It constituted 54.6 percent of the total investment portfolio; 74.4 percent of the equity investment portfolio; and, after deferred income taxes, 68.5 percent of total shareholders’ equity at year-end 2001. The unrealized appreciation is primarily due to the Company’s holdings in Fifth Third Bancorp and Alltel Corporation (NYSE:AT) common stock. O T H E R I T E M S REINSURANCE The Company has finalized new property casualty catastrophe reinsurance treaty and new property and casualty working reinsurance treaties with reinsurers that have written the Company’s treaties for more than 10 years. Under the new programs, 2002 ceded premiums are estimated to be $86 million, compared with $68 million in 2001 and $47 million in 2000. The Company received no ceding commissions in 1999 or 2000, nor will it receive any in 2002. The Company received $9 million in ceding commissions in 2001. Under the new property catastrophe reinsurance treaty, the Company will retain the first $25 million of losses, 40 percent of losses from $25 million to $45 million and 5 percent of losses from $45 million to $200 million. The Company has the financial ability to absorb catastrophe losses at that level, and the revised reinsurance agreement is a means of balancing reinsurance costs and risks. Previously, the Company retained the first $25 million of property catastrophe losses and 5 percent of losses from $25 million up to $200 million. Under the new 2002 property working treaty, the Company retains 100 percent of the first $2 million in losses and 20 percent of the next $3 million up to $5 million. Losses in excess of $5 million are covered at 100 percent up to $25 million. In 2001 and 2000, the Company retained 100 percent of the first $2 million in losses, and losses in excess of $2 million were covered at 100 percent up to $25 million. Under the new 2002 casualty working treaty, the Company retains 100 percent of the first $2 million in losses and 40 percent of the next $2 million, up to $4 million. Losses in excess of $4 million are covered at 100 percent up to $25 million. In 2001 and 2000, the Company retained 100 percent of the first $2 million in losses and 20 percent of the next $2 million up to $4 million. Losses in excess of $4 million were covered at 100 percent up to $25 million. The Company’s reinsurance programs will include terrorism coverages with certain limitations. On commercial risks over $50 million in exposures, however, the Company will need to purchase separate coverage or assume the risk of the loss. Risks already insured by the Company are grandfathered in with terrorism coverage. USAIG POOL PARTICIPATION CFC, through The Cincinnati Insurance Company, participates 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. Member participation is renewed annually and each member’s share of premiums, losses, expenses and profits is in proportion to their contracted participation level. Each member company of USAIG must adhere to financial rating, statutory surplus and security agreement requirements. The member companies are required to fund a trust account at a depository bank to meet 100 percent of their respective net liabilities. USAIG has a reinsurance program for its members. Companies participating in the USAIG reinsurance program are all rated A or higher by A.M. Best. Reinsurance recoverables on behalf of unauthorized reinsurers participating in the pool are backed by Letters of Credit and trust funds from these reinsurers. The pool has two governing committees to which each member company may appoint a representative. The General Policy Committee meets periodically to review, among other things, reinsurance credit exposure, trends in the reinsurance marketplace Back to table of contents 31 (cid:2) M A N A G E M E N T D I S C U S S I O N (continued) Cincinnati Financial Corporation and Subsidiaries and to evaluate exceptions to the approved reinsurer list that may arise. The Advisory Council, which includes all member companies, meets annually. The managers of USAIG issue policies in the name of one or more of the member companies. All business written in The Cincinnati Insurance Company name is treated in the Company’s accounts as direct premium and losses and is then ceded to USAIG. For the years ended December 31, 2001, 2000 and 1999, direct business earned and then ceded was $57 million, $39 million and $27 million, while direct losses and LAE incurred and then ceded were $314 million, $7 million and $14 million, respectively. The Company then assumed its contracted share of the pool’s operating results. CFC’s participation share for policy years 2001, 2000 and 1999 was 10 percent, resulting in USAIG- related underwriting losses of $3 million, $2 million and $2 million for the years ending December 31, 2001, 2000 and 1999, respectively. The 2001 underwriting loss included $4 million related to the events of September 11, 2001, and the American Airlines flight 587 accident in Queens, New York in November 2001. Since The Cincinnati Insurance Company was named as the designated insurer for American Airlines policy year 2000 business, the gross losses and recoverables resulting from all American Airlines accidents were recorded on its 2001 financial statements. Management expects to recover 100 percent of the reinsurance recoverables associated with these accidents. SIGNIFICANT ACCOUNTING POLICIES Property Casualty Insurance Loss Reserves As discussed in the Notes to the Consolidated Financial Statements, management establishes the Company’s liabilities for insurance reserves, including adjustments of estimates, based upon Company experience and information from internal analysis. Though uncertainty always exists as to the adequacy of established reserves, management believes this uncertainty is mitigated by the historic stability of the Company’s book of business. Such reserves are related to various lines of business and will be paid out over future periods. Reserves for environmental claims have been reviewed, and the Company believes these reserves are adequate at this time. Environmental exposures are minimal as a result of the types of risks the Company has insured in the past. Historically, most of the Company’s commercial accounts were written with post-date coverages that afford clean-up costs and Superfund responses. The Company monitors trends in the industry, relevant court cases, current legislative activity and other current events in an effort to ascertain new or additional exposures to loss. For example, the $110 million IBNR reserve, net of reinsurance, established in 2000 for past uninsured and underinsured motorist losses incurred but not yet reported, was the result of two Ohio Supreme Court decisions. The court rulings affected all auto insurers in the state, and Cincinnati acted conservatively to clear the way for long-term performance improvements benefiting shareholders and policyholders. Prior to the establishment of the reserve, the Company incurred losses in 2000 and 1999 of $28 million and $12 million, respectively, related to these uninsured motorist claims. In 2001, the Company identified $54 million of case reserves for these exposures, leaving $56 million of IBNR. Management believes that the remaining reserves are adequate for losses incurred, but not yet reported. Insurance loss reserves are affected directly by management’s reserving philosophy. The Company’s claims management team has an average of 23 years of experience in the industry and 20 years of experience with the Company. The Company’s outside actuary provides management with an opinion regarding the acceptable range for adequate reserves based on generally accepted actuarial guidelines. Historically, the Company has established adequate reserves, falling in the upper half of the actuary’s recommended range. However, if the Company were slow to recognize and respond to unusual claim and loss patterns, such as those caused by the risk factors cited in the Company’s safe harbor statement, it could lead to a rise in IBNR due to the expectation of higher losses. Higher IBNR would lead to a higher loss and LAE ratio; each percentage point increase in the loss and LAE ratio would reduce operating income by $21 million, pre-tax (based on 2001 net earned premiums). Adjustments to prior years could be material. Life Insurance Policy Reserves Policy reserves for traditional life insurance policies are based on anticipated rates of mortality derived primarily from industry experience data, anticipated withdrawal rates based principally on Company experience and estimated future interest earnings. Management uses standard mortality rates for its policies and conservative withdrawal rates. Estimates of future earnings are based on long-term interest rates that range from 3 percent to 7 percent. Payments received for investment, limited pay and universal life- type contracts are recognized as income only to the extent of the current cost of insurance and policy administration, with the remainder recognized as liabilities and included in life policies reserves. Interest rates on approximately $471 million of such reserves are periodically adjusted based upon market conditions. Assuming a 1 percent increase or decrease in each of the assumed rates, the effect on these policy reserves would range from an increase of $5 million to a decrease of $5 million, respectively. Asset Impairment The Company’s Asset Impairment Committee continually monitors investments and other assets that have fair values that are less than carrying amounts for signs of other-than-temporary impairment. Factors such as the amount and timing of declines in fair values, the significance of the declines, the length of time (six to nine months) of the declines, duration of fixed-maturity securities, and interest payment defaults, among others, are considered when determining investment impairment. Invested assets and property and equipment are monitored for signs of impairment such as 32 Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries significant decreases in market value of assets, changes in legal factors or in the business climate, an accumulation of costs in excess of the amount originally expected to acquire or construct an asset, or other such factors indicating that the carrying amount may not be recoverable. Fixed maturities (bonds and notes) and equity securities (common and preferred stocks) are classified as available-for-sale and recorded at fair value in the financial statements. Unrealized gains and losses on investments held as available for sale, net of taxes, are included in shareholders’ equity as accumulated other comprehensive income. Other-than-temporary declines in the fair value of investments are recognized in earnings when facts and circumstances indicate such write-downs are warranted. During the years ended December 31, 2001, 2000 and 1999, the Company had realized losses amounting to $105 million, $118 million and $70 million, which compared with realized gains of $80 million, $116 million and $69 million, respectively. At December 31, 2001, there were unrealized losses in the investment portfolio amounting to approximately $83 million and unrealized gains of $4.190 billion, net of tax. Given current market conditions, the Company could record additional other- than-temporary impairments during 2002. RECENT ACCOUNTING PRONOUNCEMENTS See Note 1 of the Notes to the Consolidated Financial Statements for a description of recently issued accounting pronouncements. The impact of adopting new accounting pronouncements will not materially affect the Company’s financial condition or results of operations. RELATED-PARTY TRANSACTIONS Related-party transactions are covered in detail in the Company’s Proxy Statement dated March 8, 2002. The related- party transactions consist primarily of commissions paid to agents of the Company who also are directors of the Company or its subsidiaries. In total, these commissions represented less than 4 percent of the commissions paid by the Company’s insurance subsidiaries in 2001. S E L E C T E D QUA RT E R LY F I N A N C I A L D ATA (Unaudited) Cincinnati Financial Corporation and Subsidiaries (dollars in millions except per share data) Financial data for each quarter in the two years ended December 31: Quarter Revenues ........................................................ Income before income taxes .............................. Net income........................................................ Net income per common share (basic) .............. Net income per common share (diluted) .......... Quarter Revenues............................................................ Income before income taxes .............................. Net income........................................................ Net income per common share (basic) .............. Net income per common share (diluted) .......... ___________________ 1st $ 618 97 72 .45 .44 ___________________ 1st $ 571 104 79 .49 .48 ___________________ 2nd $ 645 51 49 .30 .30 ___________________ 2nd $ 579 97 75 .46 .45 ___________________ 2001 3rd $ 644 34 36 .22 .22 2000 3rd $ 600 ___________________ (9)* 6* .03* .03* ___________________ 4th $ $ 654 39 36 .23 .22 ___________________ 4th $ 581 (83) (41) (.26) (.26) Note: The sum of the quarterly reported amounts may not equal the full year as each is computed independently. *Third-quarter and full-year 2000 results include a one-time net charge for asset impairment of $39 million, before tax; $25 million, or 16 cents per share, net of tax. ____________________ Full Year $2,561 221 193 1.20 1.19 ____________________ Full Year $2,331 109* 118* .74* .73* 33 Back to table of contents (cid:2) R E S P O N S I B I L I T Y F O R F I N A N C I A L S TAT E M E N T S Cincinnati Financial Corporation and Subsidiaries The accompanying financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2001 were prepared by management in conformity with accounting principles generally accepted in the United States of America. The management of the Company is responsible for the integrity and objectivity of the financial statements, which are presented on an accrual basis of accounting and include amounts based upon management’s best estimates and judgment. Other financial information in the Annual Report is consistent with that in the financial statements. The accounting plan and related system of internal controls are designed to assure that the books and records reflect the transactions of the Company in accordance with established policies and procedures as implemented by qualified personnel. The Board of Directors has established an Audit Committee composed of outside directors who are believed to be free from any relationships that could interfere with the exercise of independent judgment as Audit Committee members. The Audit Committee meets periodically with management, the independent auditors and the internal auditor to make inquiries as to the manner in which the responsibilities of each are being discharged and reports thereon to the Board of Directors. In addition, the Audit Committee recommends to the Board of Directors the annual appointment of the independent auditors with whom the Audit Committee reviews the scope of the audit assignment, adequacy of internal controls and internal audit procedures. Deloitte & Touche LLP, independent auditors, have audited the financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2001, and their report is included herein. The auditors meet with members of the Audit Committee of the Board of Directors to discuss the results of their examination and are afforded the opportunity to present their opinions in the absence of management personnel with respect to the adequacy of internal controls and the quality of financial reporting of the Company. I N D E P E N D E N T AU D I TO R S ’ R E P O RT To the Shareholders and Board of Directors of Cincinnati Financial Corporation: We have audited the consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries as of December 31, 2001 and 2000 and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Cincinnati Financial Corporation and subsidiaries at December 31, 2001 and 2000 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. Cincinnati, Ohio February 6, 2002 34 Back to table of contents (cid:2) C O N S O L I D AT E D B A L A N C E S H E E T S Cincinnati Financial Corporation and Subsidiaries (dollars in millions except per share data) A S S E T S Investments Fixed maturities, at fair value (amortized cost: 2001–$3,012; 2000–$2,803)............................................................................ Equity securities, at fair value (cost: 2001–$2,174; 2000–$2,068)............................................................................ Other invested assets ...................................................................... Cash.................................................................................................. Investment income receivable............................................................ Finance receivable .............................................................................. Premiums receivable .......................................................................... Reinsurance receivable ........................................................................ Prepaid reinsurance premium.............................................................. Deferred policy acquisition costs.......................................................... Property and equipment, net, for Company use (accumulated depreciation: 2001-$135; 2000-$124).................... Other assets .......................................................................................... Separate accounts................................................................................ Total assets.............................................................................. L I A B I L I T I E S Insurance reserves Losses and loss expenses................................................................ Life policy reserves........................................................................ Unearned premium............................................................................ Other liabilities .......................................................................... Deferred income tax.......................................................................... Notes payable.................................................................................... 6.9% senior debenture due 2028............................................................ 5.5% convertible senior debenture due 2002........................................ Separate accounts................................................................................ Total liabilities.......................................................................... S H A R E H O L D E R S ’ E Q U I T Y Common stock, par value–$2 per share; authorized 200 million shares; issued: 2001–175 million shares; 2000–173 million shares .......... Paid-in capital.................................................................................... Retained earnings .............................................................................. Accumulated other comprehensive income–unrealized gains on investments and derivatives........................................................ Less treasury stock at cost (2001–13 million shares; 2000–12 million shares).................................................................. Total shareholders’ equity.......................................................... Total liabilities and shareholders’ equity.................................. Accompanying notes are an integral part of this statement. Back to table of contents December 31, 2001 _____________ 2000 _____________ $ 3,010 $ 2,721 8,495 66 93 93 27 732 515 28 286 125 99 390 _____________ $13,959 _____________ _____________ $ 2,932 674 1,062 293 2,001 183 420 6 390 _____________ 7,961 _____________ 350 284 1,678 4,113 _____________ 6,425 (427) _____________ 5,998 _____________ $13,959 _____________ _____________ 8,526 69 60 86 31 652 215 15 259 122 173 358 _____________ $13,287 _____________ _____________ $ 2,473 605 922 257 2,058 170 420 29 358 _____________ 7,292 _____________ 346 254 1,620 4,156 _____________ 6,376 (381) _____________ 5,995 _____________ $13,287 _____________ _____________ 35 (cid:2) C O N S O L I D AT E D S TAT E M E N T S O F I N C O M E Cincinnati Financial Corporation and Subsidiaries (dollars in millions except per share data) R E V E N U E S Net earned premiums Property casualty........................................................ Life.............................................................................. Accident health........................................................ Net earned premiums............................................ Net investment income...................................................... Realized losses on investments...................................... Other income.............................................................. Total revenues.......................................................... B E N E F I T S A N D E X P E N S E S Insurance losses and policyholder benefits .................... Commissions................................................................ Other operating expenses.................................................... Taxes, licenses and fees...................................................... Increase in deferred policy acquisition costs.................. Interest expense.................................................................. Other expenses ............................................................ Asset impairment–software written off.......................... Total benefits and expenses.................................... I N C O M E B E F O R E I N C O M E TA X E S .............................. P R O V I S I O N ( B E N E F I T ) F O R I N C O M E TA X E S Current............................................................................ Deferred...................................................................... Total provision (benefit) for income taxes.............. N E T I N C O M E ...................................................................... P E R C O M M O N S H A R E Net income (basic).......................................................... Net income (diluted).................................................... 2001 ___________ $2,071 77 4 ___________ 2,152 421 (25) 13 ___________ 2,561 ___________ 1,663 392 184 72 (27) 39 17 – ___________ 2,340 ___________ 221 ___________ 62 (34) ___________ 28 ___________ $ 193 ___________ ___________ $ 1.20 ___________ ___________ $ 1.19 ___________ ___________ Years Ended December 31, 2000 ___________ 1999 ___________ $1,827 77 3 ___________ 1,907 415 (2) 11 ___________ 2,331 ___________ 1,581 351 172 56 (33) 37 19 39 ___________ 2,222 ___________ 109 ___________ (11) 2 ___________ (9) ___________ $ 118 ___________ ___________ $ .74 ___________ ___________ $ .73 ___________ ___________ $1,657 66 9 ___________ 1,732 387 (1) 10 ___________ 2,128 ___________ 1,254 316 152 60 (17) 33 8 – ___________ 1,806 ___________ 322 ___________ 77 (10) ___________ 67 ___________ $ 255 ___________ ___________ $ 1.55 ___________ ___________ $ 1.52 ___________ ___________ Accompanying notes are an integral part of this statement. 36 Back to table of contents (cid:2) C O N S O L I D AT E D S TAT E M E N T S O F S H A R E H O L D E R S ’ E QU I T Y Cincinnati Financial Corporation and Subsidiaries (dollars in millions) Balance, December 31, 1998 .... Common Stock $ 341 _________________ Treasury Stock $ (97) _________________ Paid-In Capital $ 218 _________________ Retained Earnings $1,481 _________________ Accumulated Other Comprehensive Income $3,678 _________________ Total Shareholders’ Equity $5,621 _________________ Net income................................ Change in accumulated other .......................................................................... comprehensive income, net.. Comprehensive income.............. Dividends declared .................... Purchase/issuance of treasury shares...................... Stock options exercised.............. Conversion of debentures.......... Balance, December 31, 1999...... Net income .............................. Change in accumulated other comprehensive income, net.. Comprehensive income.............. Dividends declared .................... Purchase/issuance of treasury shares .................... Stock options exercised.............. Conversion of debentures.......... Balance, December 31, 2000...... Net income .............................. Change in accumulated other comprehensive income, net.. Comprehensive income ............ Dividends declared .................... Purchase/issuance of treasury shares .................... Stock options exercised.............. Conversion of debentures.......... Balance, December 31, 2001...... 1 2 344 _________________ (217) _________________ (314) 6 13 237 _________________ 1 1 346 _________________ (67) _________________ (381) 10 7 254 _________________ 1 3 $ 350 _________________ _________________ _________________ (46) _________________ $ (427) _________________ _________________ 10 20 $ 284 _________________ _________________ _________________ 255 (112) (148) _________________ _________________ 1,624 3,530 118 (122) 626 _________________ _________________ 1,620 4,156 193 (135) (43) _________________ $1,678 _________________ _________________ _________________ $4,113 _________________ _________________ 255 _________________ (148) 107 (112) (217) 7 15 5,421 _________________ 118 _________________ 626 744 (122) (67) 11 8 5,995 _________________ 193 _________________ (43) 150 (135) (46) 11 23 $5,998 _________________ _________________ _________________ Accompanying notes are an integral part of this statement. Back to table of contents 37 (cid:2) C O N S O L I D AT E D S TAT E M E N T S O F C A S H F L OW S Cincinnati Financial Corporation and Subsidiaries (dollars in millions) Cash flows from operating activities: Net income ................................................................................ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization........................................ Realized loss on investments.............................................. Asset impairment-software written off.............................. Interest credited to contract holders.................................. Changes in: Investment income receivable.................................... Premiums and reinsurance receivable.......................... Deferred policy acquisition costs................................ Other assets .................................................................... Loss and loss expense reserves ...................................... Life policy reserves...................................................... Unearned premiums.................................................... Other liabilities............................................................ Current income tax .................................................... Deferred income tax .................................................... Net cash provided by operating activities.................... (7) (399) (27) 37 459 44 140 22 43 (34) 540 2001 ______________ $ 193 25 25 – 19 Years Ended December 31, 2000 ______________ $ 118 18 2 39 24 1999 ______________ $ 255 16 1 – 20 ______________ ______________ ______________ ______________ ______________ ______________ Cash flows from investing activities: Sale of fixed maturities investments........................................ Call or maturity of fixed maturities investments...................... Sale of equity securities investments ........................................ Collection of finance receivables............................................ Purchase of fixed maturities investments.................................. Purchase of equity securities investments.................................. Investment in property and equipment.................................... Investment in finance receivables............................................ Investment in other invested assets.......................................... Net cash used in investing activities.......................... 35 218 223 16 (531) (295) (15) (12) 2 (359) ______________ ______________ ______________ ______________ ______________ ______________ Cash flows from financing activities: Payment of cash dividends to shareholders .............................. Purchase/issuance of treasury shares...................................... Increase in notes payable.......................................................... Proceeds from stock options exercised .................................... Contract holder funds deposited ............................................ Contract holder funds withdrawn .......................................... Net cash used in provided by financing activities........ Net increase (decrease) in cash...................................................... Cash at beginning of year................................................................ Cash at end of year...................................................................... Supplemental disclosures of cash flow information: Interest paid............................................................................ Income taxes paid.................................................................. Conversion of 5.5% senior debentures to common stock ...... Conversion of fixed maturity to equity security investments.. (132) (44) 13 9 24 (18) (148) 33 60 $ 93 ______________ ______________ ______________ ______________ ______________ (119) (67) 52 11 19 (32) (136) (279) 339 $ 60 ______________ ______________ ______________ ______________ ______________ (110) (217) 118 7 19 (28) (211) 281 58 $ 339 ______________ ______________ ______________ ______________ ______________ $ 41 9 24 51 $ 40 33 7 12 $ 32 55 15 83 Supplemental disclosure of noncash activity - During 2000, the Company established a separate account. This resulted in a noncash transfer to the separate account of the following: $301 from investments, $308 from life policy reserves, $11 from cash, $8 from accounts receivable/payable securities, $5 from investment income receivable and $1 from other liabilities. Accompanying notes are an integral part of this statement. 38 Back to table of contents (11) (153) (33) (72) 319 42 85 53 (63) 2 370 4 302 294 15 (796) (272) (44) (13) (3) (513) (3) (65) (17) 2 99 316 47 15 21 (10) 697 62 316 197 16 (423) (246) (102) (17) (8) (205) (cid:2) N OT E S TO C O N S O L I D AT E D F I N A N C I A L S TAT E M E N T S Cincinnati Financial Corporation and Subsidiaries All dollar amounts in millions, except share data, unless otherwise stated. 1 . S U M M A R Y O F S I G N I F I C A N T A C C O U N T I N G P O L I C I E S Nature of Operations – Cincinnati Financial Corporation (Company), through four insurance subsidiaries, sells insurance, primarily in the Midwest and Southeast regions of the United States of America through a network of local independent agents. Insurance products include fire, automobile, casualty, bonds and all related forms of property casualty insurance as well as life insurance, long term care, disability income policies and annuities. Basis of Presentation – The consolidated financial statements include the accounts of the Company and subsidiaries, each of which is wholly owned, and are presented in conformity with accounting principles generally accepted in the United States of America. All significant inter-company 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. Property Casualty Insurance – Expenses incurred in the issuance of policies are deferred and amortized over the terms of the policies. Anticipated investment income is not considered in determining if a premium deficiency related to insurance contracts exists. Policy premiums are deferred and earned on a pro rata basis over the terms of the policies. The portion of written premiums applicable to the unexpired terms of the policies is recorded as unearned premiums. Losses and loss expense reserves are based on claims reported prior to the end of the year and estimates of unreported claims, based upon facts in each claim and the Company’s experience with similar claims. The establishment of appropriate reserves, including reserves for catastrophes, is an inherently uncertain process. Reserve estimates are regularly reviewed and updated, using the most current information available. Any resulting adjustments are reflected in current operations. Life Insurance – Premiums for traditional life insurance and certain life contingent annuities are recognized as secure when due. Policy acquisition costs are deferred and amortized over the premium-paying period of the policies. Life policy reserves are based on anticipated rates of mortality derived primarily from industry experience data, anticipated withdrawal rates based principally on Company experience and estimated future interest earnings using initial interest rates ranging from 3 percent to 7 percent. Payments received for investment, limited pay and universal life-type contracts are recognized as income only to the extent of the current cost of insurance and policy administration, with the remainder recognized as liabilities and included in life policies reserves. Interest rates on approximately $471 and $414 of such reserves at December 31, 2001 and 2000, respectively, are periodically adjusted based upon market conditions. Accident Health Insurance – Expenses incurred in the issuance of policies are deferred and amortized over a five-year period. Policy premium income, unearned premiums and reserves for unpaid losses are accounted for in substantially the same manner as property casualty insurance discussed above. Reinsurance – In the normal course of business, the Company seeks to reduce losses that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance companies and reinsurers. Reinsurance contracts do not relieve the Company from any obligation to policyholders. Although the Company historically has not experienced uncollectible reinsurance, failure of reinsurers to honor their obligations could result in losses to the Company. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. The Company also assumes some reinsurance from other insurance companies, reinsurers and involuntary state pools. Such assumed reinsurance activity is recorded principally on the basis of reports received from the ceding companies. Investments – Fixed maturities (bonds and notes) and equity securities (common and preferred stocks), including embedded derivatives, are classified as available for sale and are stated at fair values. The Company now accounts for the fair value of embedded derivatives separately in its consolidated balance sheets. Unrealized gains and losses on investments, net of income taxes associated therewith, are included in shareholders’ equity in accumulated other comprehensive income. Realized gains and losses on sales of investments are recognized in net income on a specific identification basis. Investment income consists primarily of interest and dividends. Interest is recognized on an accrual basis, and dividends are recorded at the ex-dividend date. Derivative Financial Instruments and Hedging Activities – The Company invests in certain financial instruments that contain embedded options, such as convertible debt and convertible preferred stock. The Company also entered into an interest rate swap agreement as a cash flow hedge during 2001 in order to fix an interest rate related to certain of its variable rate debt obligations ($31 notional amount). Upon adoption of Statement of Financial Accounting Standards (SFAS) No. 133 “Accounting for Derivative Financial Instruments and Hedging Activities,” as amended, on January 1, 2001, changes in the fair value of the Company’s derivative financial instruments and its interest rate swap agreement began to be either recognized periodically in income or shareholders’ equity (as a component of accumulated other comprehensive income). Neither the adoption of SFAS No. 133 nor any subsequent changes in fair values of these instruments have had a significant impact on the accompanying consolidated financial statements. 39 Back to table of contents (cid:2) N OT E S TO C O N S O L I D AT E D F I N A N C I A L S TAT E M E N T S (continued) Cincinnati Financial Corporation and Subsidiaries Property and Equipment – Property and equipment is at cost less accumulated depreciation. The Company provides depreciation based on estimated useful lives using straight-line and accelerated methods. Depreciation expense recorded in 2001, 2000 and 1999 was $25, $20 and $18, respectively. The Company reviews property and equipment for impairment whenever events or changes in circumstances, such as significant decreases in market values of assets, changes in legal factors or in the business climate, an accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset, or other such factors indicate that the carrying amount may not be recoverable. The Company capitalizes costs related to computer software developed for internal use during the application development stage of software development projects. These costs generally consist of certain external, payroll and payroll-related costs. During 2000, the Company wrote off $39 of previously capitalized costs related to the development of next-generation software to process property casualty policies. Federal Income Taxes – Deferred income tax liabilities and assets are computed using the tax rates in effect for the time when temporary differences in book and taxable income are estimated to reverse. Deferred income taxes are recognized for numerous temporary differences between the Company’s taxable income and book-basis income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains on investments and differences in the recognition of deferred acquisition costs and insurance reserves. Deferred income taxes associated with unrealized appreciation (except the amounts related to the effect of income tax rate changes) are charged to shareholders’ equity in accumulated other comprehensive income, and deferred taxes associated with other differences are charged to income. Separate Accounts – The Company issues variable life contracts with guaranteed minimum returns, the assets and liabilities of which are legally segregated and recorded as assets and liabilities of the separate accounts. Minimum investment returns and account values are guaranteed by the Company and also include death benefits to beneficiaries of the contract holders. The assets of the separate accounts are carried at fair value. Separate account liabilities primarily represent the contract holders’ claims to the related assets and are carried at the fair value of the assets. In the event that the asset value of contract holders’ accounts is projected below the value guaranteed by the Company, a liability is established through a charge to the Company’s earnings. Investment income and realized capital gains and losses of the separate accounts generally accrue directly to the contract holders and, therefore, are not included in the Company’s Consolidated Statements of Income. Revenues and expenses for the Company related to the separate accounts consist of contractual fees, percentages of net realized capital gains and losses, and mortality, surrender and expense risk charges. Earnings Per Share – Net income per common share is based on the weighted average number of common shares outstanding during each of the respective years. The calculation of net income per common share (diluted) assumes the conversion of convertible senior debentures and the exercise of stock options. Fair Value Disclosures – Fair values for investments in fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) are based on quoted market prices, where available. For such securities not actively traded, fair values are estimated by discounting expected future cash flows using a current market rate applicable to the yield, credit quality and maturity of the investments. Fair values for equity securities are based on quoted market prices. The fair values for liabilities under investment-type insurance contracts (annuities) are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued. Fair values for short-term notes payable are estimated using interest rates currently available to the Company. Fair values for long-term debentures are based on the quoted market prices for such debentures. New Accounting Pronouncements – On June 29, 2001, SFAS No. 141 “Business Combinations” was approved by the Financial Accounting Standards Board (FASB). The Company’s adoption of SFAS No. 141 on July 1, 2001 had no effect on its consolidated financial statements. On June 29, 2001, SFAS No. 142 “Goodwill and Other Intangible Assets” was approved by the FASB. SFAS No. 142 changes the accounting for goodwill from an amortization method to an impairment-only approach. Amortization of goodwill, including goodwill recorded in past business combinations, will cease upon adoption of this statement. The Company is required to implement SFAS No. 142 on January 1, 2002. The Company does not expect that SFAS No. 142 will have a material effect on its consolidated financial statements. In August 2001, the FASB issued SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of. It supersedes SFAS No. 121 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” while retaining the fundamental provisions of Statement No. 121 for (a) recognition and measurement of the impairment of long-lived assets to be held and used and (b) measurement of long-lived assets to be disposed of by sale. It also supersedes the accounting and reporting provisions of Accounting Principles Board Opinion No. 30 “Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of Business, and Extraordinary, Unsual and Infrequently Occurring Events and Transactions.” 40 Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries The Company does not expect these standards will have a material effect on its consolidated financial statements. Reclassifications – Certain prior year amounts have been reclassified to conform with current-year classifications. 2 . I N V E S T M E N T S Investment income summarized by investment category: Interest on fixed maturities...... Dividends on equity securities Other investment income........ Total .................................... Less investment expenses.......... Net investment income.......... Years Ended December 31, 2000 ___________ 1999 ___________ 2001 ___________ ___________ $ 226 193 7 426 5 $ 421 ___________ ___________ ___________ ___________ $ 222 186 11 419 4 $ 415 ___________ ___________ ___________ ___________ $ 219 165 8 392 5 $ 387 ___________ ___________ ___________ Realized (losses) gains on investments summarized by investment category: Fixed maturities: Gross realized gains................ Gross realized losses.............. Equity securities: Gross realized gains................ Gross realized losses.............. Embedded derivatives .......... Realized losses on investments........................ Change in unrealized (losses) gains on investments summarized by investment category: Fixed maturities ...................... Equity securities...................... Change in unrealized (losses) gains on investments.......... $ 6 (73) 65 (32) 9 ___________ $ 8 (76) 108 (42) – ___________ $ 11 (49) 58 (21) – ___________ $ (25) ___________ ___________ $ (2) ___________ ___________ $ (1) ___________ ___________ $ 79 (145) ___________ $ (66) ___________ ___________ $ (7) 969 ___________ $ 962 ___________ ___________ $(204) (23) ___________ $(227) ___________ ___________ Contractual maturity dates for investments in fixed maturity securities as of December 31, 2001: Amortized Cost ___________________ Fair Value ___________________ % of Fair Value ___________________ Maturity dates occurring: One year or less.......................... $ 168 After one year through five years 720 After five years through ten years 975 After ten years ............................ 1,149 Total........................................ $3,012 ____________ ______________ ______________ $ 169 721 958 1,162 $3,010 ____________ ______________ ______________ 5.6 24.0 31.8 38.6 100.0 __________ ___________ ___________ Actual maturities may differ from contractual maturities when there exists a right to call or prepay obligations with or without call or prepayment penalties. At December 31, 2001, investments with a cost of $63 and fair value of $64 were on deposit with various states in compliance with certain regulatory requirements. Analysis of cost or amortized cost, gross unrealized gains, gross unrealized losses and fair value as of December 31: 2001 Fixed maturities: States, municipalities and political subdivisions .......... Convertibles and bonds with warrants attached Public utilities ........ United States government and government agencies and authorities ............ All other corporate bonds .................... .................................................. Total .................. Equity securities ........ 2000 Fixed maturities: States, municipalities and political subdivisions .......... Convertibles and bonds with warrants attached Public utilities ........ United States government and government agencies and authorities ............ All other corporate bonds .................... Total .................. Cost or Gross Amortized Unrealized Unrealized Gains Losses Gross Cost ______________ ______________ ______________ Fair Value ______________ $1,013 $ 37 $ 8 $1,042 69 115 4 1,811 ______________ $3,012 ______________ ______________ $2,174 ______________ ______________ 6 3 1 57 4 3 – 91 71 115 5 1,777 ______________ $ 104 ______________ ______________ $6,342 ______________ ______________ ______________ ______________ $ 106 ______________ ______________ $ 21 ______________ ______________ $3,010 ______________ ______________ $8,495 ______________ ______________ $ 947 $ 38 $ 2 $ 983 77 81 7 1 3 – 10 1 68 83 – 7 ______________ 1,691 $2,803 ______________ ______________ ______________ 40 $ 82 ______________ ______________ ______________ 151 $ 164 ______________ ______________ ______________ 1,580 $2,721 ______________ ______________ Equity securities ........ $2,068 ______________ ______________ $6,518 ______________ ______________ $ 60 ______________ ______________ $8,526 ______________ ______________ The fair value of the conversion features embedded in convertible securities amounted to $9 at December 31, 2001. Investments in companies that exceed 10 percent of the Company’s shareholders’ equity include the following as of December 31: Fifth Third Bancorp common stock...... Alltel Corporation common stock...... _________________________________________ 2001 _________________________________________ 2000 Cost ___________________ Fair Value ___________________ Cost ___________________ Fair Value ___________________ $ 283 $4,464 $ 269 $4,330 $ 119 $ 813 $ 119 $ 823 41 Back to table of contents (cid:2) N OT E S TO C O N S O L I D AT E D F I N A N C I A L S TAT E M E N T S (continued) Cincinnati Financial Corporation and Subsidiaries 3 . D E F E R R E D A C Q U I S I T I O N C O S T S Acquisition costs incurred and capitalized during 2001, 2000 and 1999 amounted to $481, $438 and $382, respectively. Amortization of deferred acquisition costs was $454, $405 and $365 for 2001, 2000 and 1999, respectively. 4 . PROPERTY CASUALTY LOSSES AND LOSS EXPENSES Activity in the reserve for losses and loss expenses is summarized as follows: Balance at January 1.................. Less reinsurance receivable.... Net balance at January 1 .......... Incurred related to: Current year.......................... Prior years ............................ Total incurred .......................... Paid related to: Current year.......................... Prior years ............................ Total paid.................................. Net balance at December 31...... Plus reinsurance receivable...... Balance at December 31........ _____________ _____________ Years Ended December 31, 1999 2000 $1,978 $2,093 138 161 1,840 1,932 2001 $2,401 219 2,182 _____________ _____________ _____________ _____________ _____________ _____________ _____________ 1,653 (62) 1,591 _____________ _____________ 1,528 (20) 1,508 _____________ _____________ 1,304 (116) 1,188 _____________ _____________ _____________ _____________ 724 697 1,421 2,352 513 $2,865 _____________ _____________ _____________ _____________ _____________ 667 591 1,258 2,182 219 $2,401 _____________ _____________ _____________ _____________ _____________ 574 522 1,096 1,932 161 $2,093 _____________ _____________ _____________ As a result of changes in estimates of insured events in prior years, the provision for losses and loss expenses decreased by $62, $20 and $116 in 2001, 2000 and 1999. These decreases are due in part to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for less than expected. The reserve for losses and loss expenses in the accompanying balance sheets also includes $67 and $72 at December 31, 2001 and 2000, respectively, for certain life health losses and loss checks payable. 5 . L I F E P O L I C Y R E S E R V E S Life policy reserves have been calculated using the account value basis for universal life and annuity policies and primarily the Basic Table (select) mortality basis for ordinary/traditional, industrial and other policies. Following is a summary of such reserves as of December 31: Ordinary/traditional life ........................................ Universal life .......................................................... Annuities .............................................................. Industrial .............................................................. Other.................................................................... Total .................................................................... 42 __________ 2001 $184 272 199 15 4 $674 __________ __________ __________ __________ 2000 $171 251 163 15 5 $605 __________ __________ __________ At December 31, 2001 and 2000, the fair value associated with the annuities shown above approximated $213 and $179, respectively. 6 . N O T E S PAYA B L E The Company and subsidiaries had no compensating balance requirement on debt for either 2001 or 2000. The Company had two lines of credit with commercial banks amounting to $275 in 2001 (expiring in 2002) and $225 in 2000, of which $183 and $170 were in use at December 31, 2001 and 2000. Interest rates charged on such borrowings ranged from 2.32 percent to 7.40 percent during 2001, which resulted in an average interest rate of 5.27 percent. At December 31, 2001, the fair value of the notes payable approximated the carrying value and the weighted average interest rate approximated 4.34 percent. The Company entered an interest rate swap agreement during 2001, which expires in 7 years, to hedge future cash flows (thereby obtaining a fixed interest rate) related to certain variable rate debt obligations ($31 notional amount). This swap is reflected at fair value in the accompanying balance sheet and the unrealized loss at December 31, 2001, which is insignificant, is a component of comprehensive income. The Company does not expect any significant amounts to be reclassified into earnings as a result of interest rate changes in the next 12 months. 7 . S E N I O R D E B E N T U R E S The Company issued $420 of senior debentures due in 2028 in 1998. The convertible senior debentures due in 2002 are convertible by the debenture holders into shares of common stock at a conversion price of $14.88 per share (67.23 shares for each one thousand dollars principal). At December 31, 2001 and 2000, the fair value of the debentures approximated $415 and $450, respectively. 8 . S H A R E H O L D E R S ’ E Q U I T Y A N D D I V I D E N D R E S T R I C T I O N S The insurance subsidiaries paid cash dividends to the Company of approximately $100, $100 and $175 in 2001, 2000 and 1999, respectively. Dividends paid to the Company by insurance subsidiaries are restricted by regulatory requirements of the insurance subsidiaries’ domiciliary state. Generally, 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 approval of the insurance department of the subsidiaries’ domiciliary state. During 2002, the total dividends that may be paid to the Company without regulatory approval are approximately $257. One million shares of common stock were available for future stock option grants, as of December 31, 2001. The Company’s Board of Directors has authorized the repurchase of outstanding shares. At December 31, 2001, 7.9 million shares remain authorized for repurchase at any time in the future. The Company has purchased 13.0 million shares at a cost of $423 million between the inception of the share repurchase program in 1996 and December 31, 2001. Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries Declared cash dividends per share were $.84, $.76 and $.68 as The provision for federal income taxes is based upon a of December 31, 2001, 2000 and 1999, respectively. Accumulated other comprehensive income – The change consolidated income tax return for the Company and subsidiaries. The differences between the statutory federal rates and the in unrealized gains on investments and derivatives included: Company’s effective federal income tax rates are as follows: Unrealized holding (losses) gains on securities and derivatives arising during the period.................................. Reclassification adjustment: Net realized loss on investments .......... Income taxes on above .............................. Change in unrealized (losses) gains 2001 ___________ 2000 ___________ 1999 ___________ $(100) $ 960 $(228) 34 23 ___________ 2 (336) ___________ 1 79 ___________ Tax at statutory rate............................ Increase (decrease) resulting from: Tax-exempt municipal bonds ........ Dividend exclusion........................ Other ............................................ Effective rate...................................... _____________ 2001 35.0% _____________ 2000 35.0% _____________ 1999 35.0% (7.9) (16.0) 1.6 12.7% _____________ _____________ _____________ (15.1) (30.4) 1.6 (8.9)% 20.8% (5.1) (9.2) .1 _____________ _____________ _____________ _____________ _____________ _____________ $ 626 on securities and derivatives, net.......... Income taxes relate to each component above ratably. $ (43) ___________ ___________ ___________ ___________ $(148) ___________ ___________ 9 . R E I N S U R A N C E Property casualty premium income in the accompanying statements of income includes approximately $38, $34 and $37 of earned premiums on assumed business and is net of approximately $155, $108 and $96 of earned premiums on ceded business for 2001, 2000 and 1999, respectively. Written premiums consist of the following: Direct........................................ Assumed .................................. Ceded ...................................... Net ........................................ _____________ _____________ Years Ended December 31, 1999 2000 $1,764 $1,987 37 36 (94) (99) $1,707 $1,924 2001 $2,315 41 (168) $2,188 _____________ _____________ _____________ _____________ _____________ _____________ _____________ _____________ _____________ _____________ Insurance losses and policyholder benefits in the accompanying statements of income are net of approximately $422, $109 and $63 of reinsurance recoveries for 2001, 2000 and 1999, respectively. 1 0 . F E D E R A L I N C O M E TA X E S Significant components of the Company’s net deferred tax liability are as follows as of December 31: 2001 ______________ 2000 ______________ Deferred tax liabilities: Unrealized gains on investments and derivatives .................................................. Deferred acquisition costs ............................ Other.............................................................. Total.............................................................. Deferred tax assets: Losses and loss expense reserves.................... Unearned premiums.................................... Life policy reserves........................................ Tax credit carryforward ................................ Other.............................................................. Total.............................................................. Net deferred tax liability.................................... $2,208 100 26 2,334 ______________ ______________ 187 83 20 9 34 333 $2,001 ______________ ______________ ______________ ______________ $2,232 82 28 2,342 ______________ ______________ 178 64 19 10 13 284 $2,058 ______________ ______________ ______________ ______________ No provision has been made (at December 31, 2001, 2000 and 1999) for federal income taxes on approximately $14 of the life insurance subsidiary’s retained earnings, since such taxes will become payable only to the extent that such retained earnings are distributed as dividends or exceed limitations prescribed by tax laws. The Company does not contemplate any such dividend. 1 1 . N E T I N C O M E P E R C O M M O N S H A R E Basic earnings per share is computed based on the weighted average number of shares outstanding. Diluted earnings per share is computed based on the weighted average number of common and dilutive potential common shares outstanding. For the Company, dilutive potential common shares consist of outstanding stock options and shares issuable under its 5.5 percent convertible senior debentures (debentures). The computations of basic and diluted earnings per share are as follows: Years Ended December 31, 2000 1999 ___________ ___________ 2001 ___________ Numerator: Net income (basic) .................. Effect of debentures.................. Net income (diluted) ................ Denominator (in millions): Weighted average common $ 193 1 $ 194 ___________ ___________ ___________ $ 118 1 $ 119 ___________ ___________ ___________ $ 255 1 $ 256 ___________ ___________ ___________ shares outstanding................ 161 Effect of: Debentures .......................... Stock options ........................ Adjusted weighted average shares .................................... Earnings per share: Basic........................................ Diluted.................................... 1 – ___________ 162 ___________ ___________ $1.20 ___________ ___________ $1.19 ___________ ___________ 161 2 1 ___________ 164 ___________ ___________ $ .74 ___________ ___________ $ .73 ___________ ___________ 165 2 2 ___________ 169 ___________ ___________ $1.55 ___________ ___________ $1.52 ___________ ___________ Options to purchase 1 million shares of common stock were outstanding during 2001, 2000 and 1999, respectively, but were not included in the computation of net income per common share (diluted) because the options’ exercise prices were greater than the average market price of the common shares. 43 Back to table of contents (cid:2) N OT E S TO C O N S O L I D AT E D F I N A N C I A L S TAT E M E N T S (continued) Cincinnati Financial Corporation and Subsidiaries 1 2 . P E N S I O N P L A N The Company and subsidiaries sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension plan covering substantially all employees. Benefits for the defined benefit plan are based on years of credited service and compensation level. Contributions to the plan are based on the frozen entry age actuarial cost method. Pension expense is composed of several components that are determined using the projected unit credit actuarial cost method and based on certain actuarial assumptions. The following table sets forth summarized information on the Company’s defined benefit pension plan: Years Ended December 31, 2000 2001 ___________ ___________ Change in benefit obligation: Benefit obligation at beginning of year........ Service cost ................................................ Interest cost.................................................... Actuarial loss (gain).................................... Benefits paid .............................................. Benefit obligation at end of year.................. Change in plan assets: Fair value of plan assets at beginning of year........................................................ Actual return on plan assets........................ Benefits paid .............................................. Fair value of plan assets at end of year ........ Funded status: Funded status at end of year........................ Unrecognized net actuarial gain.................. Unrecognized net transitional asset.............. Unrecognized prior service cost.................. Prepaid (accrued) pension cost .................. $ 88 6 7 8 (3) $106 __________ __________ __________ $ 76 5 6 6 (5) $ 88 __________ __________ __________ $160 (10) (3) $147 __________ __________ 00-0 $148 17 (5) $160 __________ __________ 00-0 $ 41 (43) (2) 9 $ 5 __________ __________ __________ $ 72 (76) (2) 9 $ 3 __________ __________ __________ The fair value of the Company’s stock comprised $22 and $23 of the plan’s assets at December 31, 2001 and 2000, respectively. The following summarizes the assumptions for the plan: Discount rate............................................ Expected return on plan assets .................. Rate of compensation increase .................. ______________ Years Ended December 31, 2000 7.25% 8.00 5–7 2001 7.00% 8.00 5-7 ______________ The components of the net periodic benefit cost are as follows: ___________ ___________ ___________ Years Ended December 31, 2000 $ 5 6 (11) (3) $ (3) 1999 $ 5 5 (9) (1) – 2001 $ 6 7 (12) (3) $ (2) _________ _________ _________ _________ _________ _________ _________ _________ _________ Service cost .................................. Interest cost.................................. Expected return on plan assets .... Amortization of actuarial gain...... Net pension expense .................... 44 1 3 . S TAT U T O R Y A C C O U N T I N G I N F O R M AT I O N Accounting principles generally accepted in the United States of America differ in certain respects from statutory insurance accounting practices prescribed or permitted for insurance companies by regulatory authorities. The National Association of Insurance Commissioners adopted the Codification of Statutory Accounting Principles (the Codification). The Codification, which is intended to standardize regulatory accounting and reporting to state insurance departments, became effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. Ohio, the domiciliary state of the Company’s insurance subsidiaries, required adoption of the Codification with certain modifications for the preparation of statutory financial statements effective January 1, 2001. The following table reconciles consolidated net income for the years ended December 31, and shareholders’ equity at December 31, as reported herein in conformity with GAAP, with total statutory net income and capital and surplus of the Company’s insurance subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by insurance regulatory authorities: Balance per GAAP .................................... Deferred policy acquisition costs................ Deferred income taxes ................................ Income from derivatives............................ Parent company and undistributed net income of certain subsidiaries ................ Other........................................................ Balance per statutory accounting practices Balances by major business type: Property casualty insurance........................ Life insurance .............................................. Balance per GAAP.......................................... Deferred policy acquisition costs.................... Deferred income taxes .................................. Parent company and undistributed net income of certain subsidiaries...................... Reserves and non-admitted assets ................ Other .............................................................. Balance per statutory accounting practices.... Balances by major business type: Property casualty insurance............................ Life insurance................................................ __________ Net Income 2000 $118 (33) 5 – __________ 2001 $193 (27) (30) (5) __________ 1999 $255 (17) – (49) 22 $104 __________ __________ __________ $ 89 15 $104 __________ __________ __________ (39) 14 $ 65 __________ __________ __________ $ 35 30 $ 65 __________ __________ __________ (53) 46 $231 __________ __________ __________ $210 21 $231 __________ __________ __________ ______________ Shareholders’ Equity 2000 2001 $5,995 $5,998 (259) (286) 687 140 ______________ (3,127) (141) (51) $2,533 ______________ ______________ ______________ (3,078) (110) (63) $3,172 ______________ ______________ ______________ $2,153 380 $2,533 ______________ ______________ ______________ $2,761 411 $3,172 ______________ ______________ ______________ Back to table of contents (cid:2) Cincinnati Financial Corporation and Subsidiaries Adopting the Codification reduced statutory capital and surplus as of January 1, 2001 by $392 for the property casualty insurance subsidiaries and $62 for the life insurance subsidiary. 1 4 . T R A N S A C T I O N S W I T H A F F I L I AT E D PA R T I E S The Company paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $14, $14 and $13 on premium volume of approximately $95, $87 and $83 for 2001, 2000 and 1999, respectively. 1 5 . C O N T I N G E N C I E S Various litigation and claims against the Company and its subsidiaries are in process and pending and principally result from normal insurance activities. Based upon a review of open matters with legal counsel, management believes that the outcomes of such matters will not have a material effect upon the Company’s consolidated financial position or results of operations. 1 6 . S T O C K O P T I O N S The Company has primarily qualified stock option plans under which options are granted to employees of the Company at prices which are not less than market price at the date of grant and which are exercisable over ten-year periods. The Company applies 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 SFAS No. 123, the Company’s net income and earnings per share would have been reduced to the pro forma amounts indicated below: Net income Net income per common share (basic) Net income per common share (diluted) As reported Pro forma As reported Pro forma As reported Pro forma ___________ Years Ended December 31, 1999 2000 $ 255 $ 118 246 108 2001 $ 193 182 ___________ ___________ $1.20 1.14 $1.19 1.13 $ .74 .67 $ .73 .66 $1.55 1.49 $1.52 1.47 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 2001, 2000 and 1999, respectively: dividend yield of 2.20 percent, 2.11 percent and 2.36 percent; expected volatility of 25.54 percent, 24.92 percent and 22.89 percent; risk-free interest rates of 5.54 percent, 5.30 percent and 6.81 percent; and expected lives of 10 years for all years. Compensation expense in the pro forma disclosures is not indicative of future amounts as options vest over several years and additional grants are generally made each year. A summary of options information follows: Years Ended December 31, 2001 Outstanding at beginning of year Granted Exercised Forfeited/revoked Outstanding at end of year _____________________ Shares 6,153,218 1,132,200 (558,039) (123,550) 6,603,829 ____________________ ____________________ ____________________ Options exercisable at end of year Weighted-average fair value of options granted during the year 4,327,005 2000 Outstanding at beginning of year Granted Exercised Forfeited/revoked Outstanding at end of year 5,460,140 1,294,600 (520,679) (80,843) 6,153,218 ____________________ ____________________ ____________________ Options exercisable at end of year Weighted-average fair value of options granted during the year 3,694,725 1999 Outstanding at beginning of year Granted Exercised Forfeited/revoked Outstanding at end of year 4,940,591 1,011,800 (414,703) (77,548) 5,460,140 ____________________ ____________________ ____________________ Options exercisable at end of year Weighted-average fair value of options granted during the year 3,224,461 ___________________________________ Weighted-Average Exercise Price $29.05 36.41 16.30 33.82 31.30 $13.31 $27.57 31.08 18.48 29.57 29.05 $10.56 $25.11 35.46 16.55 32.89 27.57 $14.40 Back to table of contents 45 (cid:2) N OT E S TO C O N S O L I D AT E D F I N A N C I A L S TAT E M E N T S (continued) Cincinnati Financial Corporation and Subsidiaries Options outstanding and exercisable consisted of the following at December 31, 2001: $0$$0$0000000000000000000000000000000__000000000000000000000 00000000000000000_000_000 Options Outstanding Options Exercisable Number _________________________ Weighted-Average Remaining Contractual Life ______________________________________ Weighted-Average Exercise Price ____________________________________ Number __________________________ Weighted-Average Exercise Price ____________________________________ 195,295 433,509 1,064,123 1,052,939 741,736 2,223,367 892,860 6,603,829 1.07 yrs 3.57 yrs 4.62 yrs 8.85 yrs 7.05 yrs 8.09 yrs 6.59 yrs 6.83 yrs $13.43 18.93 21.26 29.60 33.62 35.50 42.78 $31.30 195,295 433,509 1,064,123 372,268 501,916 972,811 787,083 4,327,005 $13.43 18.93 21.26 29.41 33.63 34.44 43.07 $29.74 _________________________ ______________________ ______________________ _________________________ ______________________ _________________________ _________________________ ______________________ ______________________ ______________________ ______________________ _________________________ _________________________ ______________________ ______________________ Range of Exercise Prices _______________________________ $12.14 to 15.79 $15.95 to 20.47 $20.50 to 23.00 $26.41 to 29.72 $32.06 to 33.75 $33.88 to 39.88 $40.16 to 45.37 1 7 . S E G M E N T I N F O R M AT I O N The Company is organized and operates principally in two industries and has four reportable segments – commercial lines property casualty insurance, personal lines property casualty insurance, life insurance and investment operations. The accounting policies of the segments are the same as those described in the basis of presentation. Revenue is primarily from unaffiliated customers. Identifiable assets by segment are those assets, including investment securities, used in the Company’s operations in each industry. Corporate and other identifiable assets are principally cash and marketable securities. Segment information, which Company management regularly reviews to make decisions about allocating resources to the segments and assessing their performance, is summarized in the following table. Information regarding income before income taxes and identifiable assets is not available for two reportable segments – commercial lines and personal lines of property casualty insurance. ________________ Years Ended December 31, 2000 $ 1,231 596 80 413 11 $ 2,331 ________________ ________________ ________________ $ (225)* 1 379 (46) 109* ________________ $ ________________ ________________ ________________ 1999 $ 1,088 569 75 386 10 $ 2,128 ________________ ________________ ________________ $ 3 (1) 356 (36) $ 322 ________________ ________________ ________________ $ 6,488 1,619 5,180 $13,287 ________________ ________________ ________________ $ 5,800 1,442 4,566 $11,808 ________________ ________________ ________________ Revenues: Commercial lines insurance.................................................................. Personal lines insurance ........................................................................ Life insurance............................................................................................ Investment operations .......................................................................... Corporate and other ................................................................................ Total revenues.................................................................................. Income before income taxes: Property casualty insurance .................................................................. Life insurance............................................................................................ Investment operations .......................................................................... Corporate and other ................................................................................ Total income before income taxes .................................................... Identifiable assets: Property casualty insurance.................................................................... Life insurance............................................................................................ Corporate and other .............................................................................. Total identifiable assets .................................................................... ________________ 2001 $ 1,451 620 81 396 13 $ 2,561 ________________ ________________ ________________ $ (92) (1) 358 (44) $ 221 ________________ ________________ ________________ $ 6,954 1,752 5,253 $13,959 ________________ ________________ ________________ *2000 results include a one-time net charge for asset impairment of $39 million, before tax. 46 Back to table of contents (cid:2) S U B S I D I A RY O F F I C E R S A N D D I R E C TO R S As of December 31, 2001, Listed Alphabetically CFC Investment Company (CFC-I) The Cincinnati Casualty Company (CCC) The Cincinnati Insurance Company (CIC) The Cincinnati Indemnity Company (CID) The Cincinnati Life Insurance Company (CLIC) CinFin Capital Management (CCM) E X E C U T I V E O F F I C E R S James E. Benoski CIC, CID, CCC Vice Chairman, Senior Vice President-Claims and Chief Insurance Officer CLIC Senior Vice President-Claims and Chief Insurance Officer CIC, CID, CCC, CLIC, CFC-I Director James G. Miller CIC, CID, CCC, CLIC Senior Vice President- Investments and Chief Investment Officer CCM President CFC-I Senior Vice President; Treasurer CIC, CID, CLIC, CFC-I, CCM Director Kenneth S. Miller, CLU, ChFC CFC-I President and Chief Operating Officer; Director CIC, CID, CCC, CLIC Senior Vice President- Investments CCM Executive Vice President; Director Urban G. Neville CIC, CID, CCC, CLIC, CFC-I Senior Vice President- Strategic Planning CCC, CFC-I, CCM Director Larry R. Plum, CPCU CCC President CIC, CID Senior Vice President-Personal Lines CIC, CID, CCC, CLIC Director David H. Popplewell, FALU, LLIF J. Michael Dempsey, CLU CLIC Vice President-Marketing Todd H. Pendery, FLMI CLIC Vice President-Corporate Accounting Mark R. DesJardins, CPCU, AIM, AIC, ARP Thomas J. Scheid CIC, CID, CCC Vice President-Education & Training CIC, CID, CCC, CLIC Vice President-Staff Underwriting Dean W. Dicke CIC, CID, CCC Senior Vice President-Field Claims CCC Director Donald J. Doyle, Jr., AIM CIC, CID, CCC, CLIC Vice President- Information Technology Harold L. Eggers, CLU, FLMI, FALU, HIA CLIC Vice President-Life Policy Issue Frederick A. Ferris CIC, CID, CCC Vice President-Commercial Lines John E. Field, CPCU CIC, CID Director Bruce S. Fisher, CPCU, AIC CIC, CID, CCC Vice President-Claims Craig W. Forrester, CLU CIC, CID, CCC, CLIC Vice President- Information Technology Stephen C. Frechtling, FSA, MAAA, CLU, FLMI CLIC Vice President-Actuarial Robert C. Schiff CIC, CID, CCC, CLIC Director Thomas R. Schiff CIC, CID, CCC, CLIC Director Gregory D. Schmidt, CPCU, ARP, CSF, ARC CIC, CID, CCC, CLIC Vice President-Staff Underwriting Don E. Schricker CIC, CID, CCC Vice President-Personal Lines Frank J. Schultheis CIC, CID Director Norman R. Settle CIC, CID, CCC Senior Vice President-Administrative Services/Machinery & Equipment Specialties/ Loss Control Joan O. Shevchik, CLU, CPCU CCC, CIC, CID Vice President- Corporate Communications J. B. Shockey, CPCU, CIC, CLU CIC, CID, CCC Vice President-Sales & Marketing Cheryl L. Frey David W. Sloan CLIC President and Chief Operating Officer; Director CIC, CID, CCC Vice President-Meetings & Travel CFC-I Vice President-Leasing J. F. Scherer CIC, CID, CCC, CLIC Senior Vice President- Sales & Marketing Director of all subsidiaries John J. Schiff, Jr., CPCU CIC, CID Chairman, President and Chief Executive Officer CCC Chairman and Chief Executive Officer CLIC Chief Executive Officer CCM Chairman Director of all subsidiaries Kenneth W. Stecher CIC, CID, CCC, CLIC, CFC-I Senior Vice President- Corporate Accounting and Chief Financial Officer; Secretary CLIC, CCM Treasurer Director of all subsidiaries Timothy L. Timmel CIC, CID, CCC, CLIC, CFC-I Senior Vice President- Operations Director of all subsidiaries S E N I O R O F F I C E R S A N D D I R E C T O R S Michael R. Abrams CCM Vice President Donald R. Adick, FLMI CLIC Senior Vice President-Life Marketing Administration Dawn M. Alcorn CIC, CID, CCC Vice President-Administrative Services Brad E. Behringer CLIC Vice President-Life Underwriting Richard W. Cumming, FSA, ChFC, CLU CIC, CID, CCC, CLIC Senior Vice President- Chief Actuary CLIC Director Michael J. Gagnon CIC, CID, CCC Vice President-Claims Kevin E. Guilfoyle Steven A. Soloria, CFA CCM Secretary Henry W. Stein, Jr. CFC-I Senior Vice President-Leasing CIC, CID, CCC Vice President-Commercial Lines David L. Helmers, CPCU, API, ARe, AIM CIC, CID, CCC Vice President-Personal Lines Duane I. Swanson, CIC CIC, CID, CCC Vice President-Sales & Marketing Martin F. Hollenbeck, CFA CCM Vice President Thomas A. Joseph, CPCU CIC, CID, CCC Senior Vice President- Commercial Lines CCC Director Thomas H. Kelly CIC, CID, CCC Vice President-Bond & Executive Risk Christopher O. Kendall, CPCU, AAM, AIM, ARe, ARM, ARP CIC, CID, CCC Vice President-Commercial Lines Bob R. Kerns CIC, CID, CCC, CLIC Senior Vice President- Staff Underwriting CCC Director Eric N. Mathews, AIAF CIC, CID, CCC Senior Vice President-Corporate Accounting; Treasurer Richard P. Matson Jody L. Wainscott CIC, CID, CCC Vice President-Staff Underwriting Larry R. Webb, CPCU CIC, CID, CCM Director Alan R. Weiler, CPCU CIC, CID, CCM Director Mark S. Wietmarschen CIC, CID, CCC Vice President-Commercial Lines Gregory J. Ziegler CIC, CID, CCC, CLIC, CFC-I Vice President-Personnel Mark J. Huller CIC, CID, CCC, CLIC Senior Counsel Eugene M. Gelfand CIC, CID, CCC, CLIC Counsel G. Gregory Lewis CIC, CID, CCC, CLIC Counsel Lisa A. Love CIC, CID, CCC, CFC-I, CLIC Vice President-Purchasing CIC, CID, CCC, CLIC Counsel Daniel T. McCurdy CIC, CID, CCC Senior Vice President-Bond & Executive Risk CCC Director Glenn D. Nicholson, LLIF CLIC Senior Vice President and Senior Marketing Officer Marc A. O’Dowd, CPA, CPCU CIC, CID, CCC, CLIC Internal Audit Officer C I C D I R E C T O R S E M E R I T I Vincent H. Beckman Robert J. Driehaus Richard L. Hildbold, CPCU William H. Zimmer Back to table of contents 47 (cid:2) S H A R E H O L D E R I N F O R M AT I O N Cincinnati Financial Corporation had approximately 11,325 direct shareholders of record as of December 31, 2001. Many of our independent agent representatives and most of the 3,299 associates of our subsidiaries own stock in their Company. Registered owners hold 31 percent of Cincinnati Financial Corporation’s outstanding shares. A N N U A L M E E T I N G The Annual Meeting of Shareholders of Cincinnati Financial Corporation will take place at 9:30 a.m. on Saturday, April 6, 2002, at the Cincinnati Art Museum in Eden Park, Cincinnati, Ohio. I N T E R I M C O M M U N I C AT I O N S During 2002, Cincinnati Financial Corporation Management is tentatively scheduled to report interim results as follows: First Quarter Ending March 31 – April 25 Second Quarter Ending June 30 – July 25 Third Quarter Ending September 30 – October 24 Information regarding final interim release dates and the conference call Webcast is available approximately two weeks following the end of each quarter on our Web site, www.cinfin.com, or by calling (513) 870-2639 or by e-mail to investor_inquiries@cinfin.com. S H A R E H O L D E R S E R V I C E Please direct inquiries about stock transfer, dividend reinvestment, dividend direct deposit, lost certificates, change of address and elimination of duplicate mailings to Kenneth W. Stecher, Chief Financial Officer, Cincinnati Financial Corporation, P. O. Box 145496, Cincinnati, Ohio 45250-5496, (513) 870-2639 or e-mail to investor_inquiries@cinfin.com. F O R M 1 0 - K Shareholders may request a copy of Form 10-K for 2001. Cincinnati Financial Corporation files the Annual Report on Form 10-K with the Securities and Exchange Commission. You may access this document through a link to the SEC’s EDGAR database from the Investors/Financial Reports section of our Web site, www.cinfin.com. P R I C E R A N G E O F C O M M O N S TO C K Shares are traded on the Nasdaq National Market and the closing sale price is quoted under the symbol CINF on the National Market List of Nasdaq (National Association of Securities Dealers Automated Quotation System). Tables below show the price range reported for each quarter based on intra-day high and low prices. 00000000000000000000000$000,000 2001 00000000000000000000000$000,000 2000 Quarter High ............................................ $41.25 Low .............................................. 34.75 .19 Dividends paid.............................. 1st 00,0_00 00,0_00 2nd $42.92 34.00 .21 00,0_00 3rd $42.20 34.36 .21 00,0_00 4th $42.93 36.33 .21 00,0_00 1st $37.98 26.19 .17 00,0_00 2nd $43.31 31.00 .19 00,0_00 3rd $40.63 31.44 .19 00,0_00 4th $40.38 32.56 .19 48 Back to table of contents (cid:2) C I N C I N N AT I F I N A N C I A L C O R P O R AT I O N O F F I C E R S A N D D I R E C TO R S William F. Bahl, CFA James E. Benoski Michael Brown John E. Field, CPCU Kenneth C. Lichtendahl W. Rodney McMullen James G. Miller John J. Schiff, Jr., CPCU Robert C. Schiff Thomas R. Schiff Frank J. Schultheis John M. Shepherd DIRECTORS EMERITI: Vincent H. Beckman Robert J. Driehaus Jackson H. Randolph Lawrence H. Rogers II John Sawyer David B. Sharrock Thomas J. Smart Charles I. Westheimer William H. Zimmer Larry R. Webb, CPCU Alan R. Weiler, CPCU E. Anthony Woods OFFICERS AS OF DECEMBER 31, 2001 John J. Schiff, Jr., CPCU Chairman, President and Chief Executive Officer James G. Miller Senior Vice President and Chief Investment Officer, Assistant Secretary, Assistant Treasurer Kenneth W. Stecher Senior Vice President and Chief Financial Officer, Secretary, Treasurer Kenneth S. Miller, CLU, ChFC Vice President, Assistant Secretary, Assistant Treasurer Eric N. Mathews, AIAF Assistant Secretary, Assistant Treasurer DIRECTORS AS OF DECEMBER 31, 2001 William F. Bahl, CFA (1)(2)(4) President Bahl & Gaynor, Inc. (investment advisors) Director since 1995 James E. Benoski Vice Chairman, Senior Vice President and Chief Insurance Officer The Cincinnati Insurance Company Director since 2000 Michael Brown (2)(3)(5) President and General Manager Cincinnati Bengals, Inc. Director since 1980 John E. Field, CPCU (3) Chairman Wallace & Turner, Inc. (insurance agency) Director since 1995 Kenneth C. Lichtendahl (1)(2) President and Chief Executive Officer Tradewinds Beverage Company Director since 1988 W. Rodney McMullen (4) Executive Vice President The Kroger Co. Director since 2001 James G. Miller (4) Senior Vice President and Chief Investment Officer Cincinnati Financial Corporation Director since 1996 John J. Schiff, Jr., CPCU (3)(4)(5) Chairman, President and Chief Executive Officer Cincinnati Financial Corporation Director since 1968 Robert C. Schiff Chairman Schiff, Kreidler-Shell, Inc. (insurance agency) Director since 1968 Thomas R. Schiff (4) Chairman and Chief Executive Officer John J. & Thomas R. Schiff & Co., Inc. (insurance agency) Director since 1975 Frank J. Schultheis (3) President Schultheis Insurance Agency, Inc. Director since 1995 John M. Shepherd (1) Chairman and Chief Executive Officer The Shepherd Chemical Company Director since 2001 Larry R. Webb, CPCU President Webb Insurance Agency, Inc. Director since 1979 Alan R. Weiler, CPCU (3)(5) Chairman Archer-Meek-Weiler Agency, Inc. (insurance agency) Director since 1992 E. Anthony Woods (1) President and Chief Executive Officer Deaconess Associations, Inc. (health care) Director since 1998 (1) Audit Committee (2) Compensation Committee; also Lawrence H. Rogers II, advisor (3) Executive Committee (4) Investment Committee; also Richard M. Burridge, CFA, advisor (5) Nominating Committee Back to table of contents (cid:2) Cincinnati Financial Corporation The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company CFC Investment Company CinFin Capital Management Company P. O. Box 145496 Cincinnati, Ohio 45250-5496 (513) 870-2000 www.cinfin.com 

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