Cincinnati Financial Annual Report 2005

Plain-text annual report

Cincinnati Financial C O R P O R A T I O N I Am the Face I Am the Face of Cincinnati of Cincinnati 2005 Annual Report Chairman’s Letter to Shareholders Page 2 Furnishing Protection with a Human Touch Page 12 2005 Annual Report on Form 10-K Page 25 About Your Company 1 Financial Highlights Cincinnati Financial Corporation, formed in 1968, offers property casualty insurance, its main business, through its subsidiaries. The Cincinnati Insurance Company, founded in 1950, leads the property casualty group known as The Cincinnati Insurance Companies. The Cincinnati Casualty Company and The Cincinnati Indemnity Company round out that group, known for its strong customer focus on a select group of independent insurance agencies that market its broad range of business and personal policies in 32 states. The Cincinnati Life Insurance Company primarily markets life insurance and annuities. CFC Investment Company offers commercial leasing and ﬁnancing services. CinFin Capital Management Company provides asset management services to institutions, corporations and high net worth individuals. Financial highlights provide a snapshot of your company’s ﬁnancial results and strength. 2 To Our Shareholders A letter from the chairman and chief executive officer discusses events of 2005, your company’s progress and issues that may affect it in 2006 and beyond. Consolidated Pretax Investment Income Less expenses (Dollars in millions) 2 9 4 5 6 4 6 2 5 5 4 4 1 2 4 2001 2002 2003 2004 2005 Property Casualty Combined Ratio Statutory (Percent) The Cincinnati Insurance Companies Estimated industry (A.M. Best) 115.7 107.3 100.2 98.1 102.0 . 6 3 0 1 . 6 9 9 . 0 5 9 . 4 9 8 . 0 9 8 2001* 2002* 2003 2004 2005 7 8 9 Condensed Balance Sheets and Income Statement Six-year Summary of Financial Information Financial Performance Overview 2005 results for property casualty insurance operations, including commercial lines and personal lines; life insurance operations; and investment operations. 12 The Face of Cincinnati You are invited to go behind the scenes and meet some of your company’s remarkable associates. They carry out the everyday details that help local independent agents serve policyholders. As they describe their work, you’ll see how associates integrate a genuine concern for people into every process and every transaction. 21 Corporate Directors and Officers 22 Deﬁnitions of Non-GAAP Information and Reconciliation to Comparable GAAP Measures 25 Annual Report on Form 10-K In the Annual Report on Form 10-K, a report required by the U.S. Securities and Exchange Commission of all publicly traded companies, we describe your company’s operations, its results and three-year trends, giving clear and thorough explanations with supporting data. Appendix Subsidiary Officers and Directors Inside Back Cover Shareholder Information, Common Stock Price and Dividend Data This report contains forward-looking statements that involve potential risks and uncertainties. Please see Management’s Discussion and Analysis in the Annual Report on Form 10-K, which begins on Page 25, for factors that could cause results to differ materially from those discussed. Financial Highlights Cincinnati Financial Corporation and Subsidiaries (In millions except per share data) Revenue Highlights Years ended December 31, 2004 2005 Change % Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment income, net of expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,164 526 3,767 $ 3,020 492 3,614 Income Statement Data Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net realized investment gains and losses, after tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income before realized investment gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Per Share Data (diluted) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net realized investment gains and losses, after tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income before realized investment gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Average shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ $ $ $ 602 40 562 3.40 0.23 3.17 1.21 34.88 177 $ $ $ $ $ 584 60 524 3.28 0.34 2.94 1.04 35.60 178 Balance Sheet Data Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 16,003 6,086 $ 16,107 6,249 Ratio Data Property casualty statutory combined ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on equity based on comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89.0% 9.8 1.6 89.4% 9.4 4.6 4.8 6.9 4.2 3.1 (33.9) 7.3 3.7 (32.4) 7.8 16.1 (2.0) (0.7) (0.6) (2.6) Revenues (Dollars in millions) 7 6 7 , 3 4 1 6 , 3 1 8 1 , 3 3 4 8 , 2 1 6 5 , 2 Net Income/ Dividends Paid Per common share (Dollars) Net income before realized investment gains and losses, before one-time items Net income before one-time items Dividends paid Book Value Per common share (Dollars) 0 4 3 . 7 1 . 3 8 2 . 3 4 9 . 2 6 1 . 2 1 0 . 2 7 6 . 1 2 3 . 1 7 1 . 1 7 0 . 1 0 1 . 5 3 0 6 . 5 3 8 8 . 4 3 2 6 . 3 3 3 4 . 1 3 0.74 0.80 0.89 1.02 1.16 2001 2002 2003 2004 2005 2001 2002 2003* 2004 2005 2001 2002 2003 2004 2005 Over the past ﬁve years, revenues rose at a compound annual rate of 10.1 percent, reﬂecting growth of total earned premiums and investment income. 2005 revenues grew 4.2 percent as market conditions slowed growth of property casualty earned premiums. Realized gains made a positive contribution in 2005 and 2004. 2005 net income and operating income reached record highs. Cash dividends paid to shareholders rose at an 11.6 percent compound annual rate over the past ﬁve years. The indicated annual dividend payout rose 9.8 percent in February 2006 as the board increased the quarterly cash dividend for the 46th consecutive year. Book value was 2 percent below the year-earlier level at year-end 2005. Strong cash ﬂow from operations was offset by lower unrealized gains in the investment portfolio. *The Deﬁnitions of Non-GAAP Information and Reconciliation to Comparable GAAP Measures on Page 22 deﬁnes and reconciles measures presented in this report that are not based on GAAP or statutory accounting principles. 1 To Our Shareholders: Property Casualty Net Earned Premiums (Dollars in millions) Personal lines Commercial lines 2,919 3,058 4 5 2 , 2 6 2 1 , 2 2,653 8 0 9 , 1 2,391 1 2 7 , 1 2,073 3 5 4 , 1 0 2 6 0 7 6 5 4 7 3 9 7 4 0 8 2001 2002 2003 2004 2005 Property casualty net earned premiums increased 4.8 percent in 2005. On the statutory basis that facilitates industry comparisons, net written premiums rose 2.6 percent, and the company continued its track record of outpacing industry growth, estimated at 0.7 percent. Consolidated Assets (Dollars in millions) 7 0 1 , 6 1 3 0 0 , 6 1 9 0 5 , 5 1 2 2 1 , 4 1 4 6 9 , 3 1 2001 2002 2003 2004 2005 Over the past ﬁve years, assets grew at a 3.8 percent compound annual rate, primarily because of 2.3 percent compound annual growth in invested assets. 2005 10-K For a detailed review of the company's 2006 outlook, please see the Executive Summary, 10-K Pages 31-35. 2 Your company set new records in statutory written premiums reached 2005, with net income up 3.1 percent to $3.076 billion, up 2.6 percent compared with $602 million and operating income up A.M. Best's estimate of 0.7 percent industry 7.3 percent to $562 million. This was the growth. Life insurance written premiums fourth consecutive year of higher property reached $205 million, up 6.6 percent. casualty underwriting proﬁts. Investment Statutory property casualty surplus, a key income set another record, continuing our measure of ﬁnancial strength, remained unbroken string of year-over-year increases exceptionally strong at $4.194 billion. in this measure. Dividends from our Fifth Third Bancorp common stock added $106 million to investment income, which in total contributed $526 million to earnings before taxes. The growth rate reached 6.9 percent, and we anticipate another good year in 2006, in the same 6.5 percent to 7.0 percent range. Lower unrealized gains in our investment portfolio in 2005, due primarily to a lower year-end market value of the Fifth Third stock, led to book value of $34.88 versus $35.60 at year-end 2004. Return on equity improved to 9.8 percent from 9.4 percent, while return on equity including comprehensive income declined to 1.6 percent from 4.6 percent, also reﬂecting year-end market values. The cumulative, steady efforts of our independent agents and our associates over the past several years once again showed results. Property casualty underwriting proﬁts rose 10.8 percent, contributing $330 million before taxes. The statutory combined ratio improved to 89.0 percent from 89.4 percent, with commercial lines continuing strong at 87.1 percent and personal lines improving more than 10 points to 94.3 percent. A.M. Best Co. estimates the industry's 2005 combined ratio at 102 percent. With increased competition in the current marketplace, our 2005 property casualty Issues and Perspectives Looking beyond 2005's very satisfactory numbers, certain trends suggest that 2006 will be a challenging year for our industry and for your company. We anticipate that our results may be tempered by our decisions to give up short-term gain in order to achieve long-term results. Brieﬂy, these are the issues and our perspective: • The property casualty insurance marketplace. Pricing on commercial lines business, the source of 71 percent of our premium revenues, is softening. It's increasingly difficult to take business away from the quality insurers that are our main competition in our agents' offices. After a few good years, there is plenty of capital and surplus to support growth, and every insurer wants to put it to work. And, while we focused on restoring personal lines proﬁtability in 2005, other carriers reﬁned their pricing models and began reducing their prices for good accounts. Even as we earned a full-year underwriting proﬁt on personal lines for the ﬁrst time since 1999, we began working on plans to resume personal lines growth. As a result, we are projecting that our 2006 written premiums will be ﬂat to slightly up, with modest growth in commercial lines offsetting a decline in personal lines. • Expenses. Your company is investing in our future. Infrastructure improvements include major automation projects that improve service to and communication with our agencies. We are incurring expenses for new project development as well as deployment and enhancement of systems in operation. Current earnings also are charged for the previously capitalized costs of developing the systems now in operation. We've also added staff to work on these projects and to service our growing business. And in 2006, we will begin expensing options as required, with a per-share earnings impact of about 2 cents per quarter. For both commercial lines and personal lines, lower 2006 earned premium growth could contribute to a higher expense ratio as we continue investing in our infrastructure. Overall, we expect to achieve a property casualty combined ratio in the range of 92 percent to 94 percent, which would be excellent but would not match our outstanding 89.2 percent GAAP ratio in 2005. • Catastrophes and reinsurance. After two years of multiple hurricanes and other catastrophe losses, most observers believe we are in a period with higher potential for severe weather. Our 2005 catastrophe losses were $127 million compared with $148 million in 2004 and $97 million in 2003, including ceded and assumed reinsurance. Considering this trend, along with our increased retention under 2006 reinsurance agreements, we believe catastrophe losses could contribute between 4.0 to 4.5 percentage points to our 2006 combined ratio, slightly above historic levels. We expect premium costs for all of our 2006 property casualty reinsurance agreements to be about $7 million less than 2005, without taking into account the reinstatement premiums we paid in 2005. However, reinsurance costs for some business lines are rising. Our savings primarily arose from the exceptional ﬁnancial strength that allowed us to increase our 2006 retentions, the deductible- like amounts that we would pay before our reinsurers would cover some or all of our excess losses. John J. Schiff, Jr., CPCU, chairman, president and chief executive officer • Reserve development. Insurers set aside loss reserves from current earnings for claims that are still in the settlement process or that have not yet been reported. Generally, as time goes on, we study those reserves and adjust them if claims are coming in lower or higher than anticipated, with a corresponding beneﬁt or charge to current earnings. In 2004 and 2005, underwriting income and combined ratios beneﬁted from higher-than-normal favorable development of reserves. While we anticipate a beneﬁt again in 2006, we expect it may improve our combined ratio 2 to 3 percentage points, compared with 5.7 points in 2005 and 6.7 points in 2004. Productivity Drives Opportunities While these trends could pressure your company's short-term performance, we nevertheless remain very conﬁdent about the future. We have seen soft market pricing before and know that our best approach is to price every account in line with the risk we assume, continuing to target a proﬁt in our overall insurance underwriting. We are patient, and we have proven capable of achieving industry-leading results, seeing opportunities in all market cycles. In May 2005, Independent Agent Magazine looked at the 19 “Tiffany class” U.S. publicly traded property casualty 2005 10-K For a detailed review of the company's property casualty business, please see Commercial Lines Insurance Results of Operations, 10-K Pages 41-47, and Personal Lines Insurance Results of Operations, 10-K Pages 47-52. 2005 10-K For a detailed review of the company's life insurance business, please see Life Insurance Results of Operations, 10-K Pages 52-54. 3 Property Casualty Statutory Surplus Ratio Net written premiums to surplus Estimated industry net written premiums to surplus (A.M. Best) 1.3 1.1 1 . 0 1 . 1 1.2 0 . 1 1.1 1.0 7 . 0 7 . 0 2001 2002 2003 2004 2005 The company historically has maintained its ratio of net written premiums to statutory surplus below the industry average. The lower the ratio, the stronger a property casualty insurer's security for policyholders and its capacity to support business growth. In 2004, the company transferred equity securities to the property casualty subsidiary. The transfer accounted for most of the reduction in the ratio for 2005 and 2004. Life Statutory Capital and Surplus Ratio (Percent) Adjusted capital and surplus to liabilities Estimated industry adjusted capital and surplus to liabilities (A.M. Best) 3 . 2 5 7 . 9 3 2 . 9 3 2 . 0 4 3 . 7 3 insurers with the highest 2004 revenues. of business, commercial auto and Cincinnati Financial Corporation – No. 19 – commercial packages. On the personal lines stood at the top of the list for after-tax proﬁts side, our Diamond policy processing system per employee. is live, as of early 2006, in 10 states that You don't have to look far to ﬁnd the represent approximately 85 percent of total sources of this exceptional productivity. personal lines premium volume, and many Productivity Drives Progress Your company has made strides in agents are beginning to see the beneﬁts of easier renewal processing. updating its technology. We're now placing People Drive Productivity our forms libraries and state manuals online. The most important source of our Several business areas have eliminated waiting and duplication of effort by productivity truly is our people. Their effectiveness, above and beyond efficiency centralizing their ﬁles in online document or automation, leads to proﬁts. From our repositories, where they are simultaneously 14 investment portfolio managers available on demand to multiple viewers. responsible for our $12.657 billion of Life insurance and claims operations have securities, to our 100 ﬁeld marketing used this capability to streamline their representatives who manage agency processes and reduce turnaround time. relationships and $282 million of new Cincinnati and our vendor were recognized commercial lines business, associates across with a 2005 Best Practices Award from the the company are highly skilled and intensely Association for Information and Image alert to opportunities to contribute to your Management for enabling ﬁeld claims company's success. representatives to remotely capture, index In 2005, underwriters continued to pay and submit supplemental claim materials, particular attention to insurance-to-value and such as pictures and audio ﬁles, via an risk transfer when renewing policies. Field Internet connection. claims associates, led by Vice President Our commercial lines department began Charles “Bud” Stoneburner II, CPCU, as imaging its ﬁles in 2005. By year-end, half of early 2005, responded to more than 11.1 10.0 10.5 10.7 10.4 of its teams were using online underwriting 3,300 hurricane claims and more than 2001 2002 2003 2004 2005 renewals, with plans to include the other half due under the policy and doing so with a and policy ﬁles for new business and 200,000 claims in total, paying all that was The ratio of statutory adjusted capital and surplus to liabilities for Cincinnati Life remained at more than three times the estimated industry average in 2005, reﬂecting the ﬁnancial stability of Cincinnati Life. The higher the ratio, the stronger a life insurer's security for policyholders and its capacity to support business growth. 4 during 2006. Our commercial lines policy human touch. quoting system now is available in all of our states, for all major product lines. We launched a new, Web-based commercial policy processing system, e-CLAS™, late in 2005. The initial release produces Ohio Businessowners Package policies. We have plans to extend the system in 2006 to our agents in additional states and to start preparations for adding the next lines The Relationship Mindset Your company's professional claims representatives continue to be our best advertising program. Satisﬁed agents and policyholders often report that they could pay less for a policy from another carrier but refuse to give up the service of their local Cincinnati ﬁeld associates. Cincinnati associates connect with their the top two carriers in three-quarters. customers, coming forward to meet their The independent agencies we select are needs. That initiative extends to their recognized across our industry as strong 2005 10-K For a discussion of strategies to cultivate relationships with independent insurance agents, please see Our Business and Our Strategy, 10-K Pages 1-8. Details related to technology solutions are on 10-K Pages 4-5, and details related to insurer ﬁnancial strength ratings are on 10-K Pages 5-7. community. In 2005, associates organized sales organizations. This year, the relief for tsunami and Katrina survivors, in Independent Insurance Agents & Brokers addition to participating in regular activities of America gave one of our Minnesota such as blood drives, school partnerships and agents its most distinguished honor and fund drives for the arts and United Way. named 36 Cincinnati agencies among just En masse, they put work aside for a few 139 chosen nationally for its 2005 Best minutes, lining the streets in front of our headquarters offices to joyfully welcome a local battalion back safely from Iraq and to Practices Study Group. Another agency in North Carolina earned Rough Notes' Marketing Agency of the Year title. These somberly salute soldiers who had sacriﬁced agencies market the worth of their service, their lives. their insurance skill and local knowledge Deeply engaged with people, Cincinnati along with Cincinnati product and service associates have the right mindset to create advantages. What they offer is a step above the strong agency relationships cited by both the rest, positioning them to go on the A.M. Best and Fitch Ratings as they offense as value players rather than compete affirmed your company's ﬁnancial strength primarily on price. ratings in 2005. The A++ from A.M. Best We also go on the offense by continuously places your company among the top improving products and tools and reﬁning 1.6 percent of property casualty insurance our underwriting guidelines and rate groups. Moody's Investors Service and structures. During 2005, for example, we Standard & Poor's Ratings Services also introduced a new edition of our commercial award very strong ratings to your company. property form and our new Termsetter series Franchise Worth All of these superior ratings increase our franchise value, attracting good agents by giving them a sales point to emphasize with the many insurance buyers who are willing to pay a fair price for high quality protection. In 2005, we began appointing agencies to actively market in Delaware, our 32nd state of operations. New appointments pushed us past the 1,000 mark to 1,024 agency relationships operating in 1,253 locations. Leveraging the Cincinnati claims and ratings of life insurance products. In 2006, we are 2005 10-K working on improved worksite life products For a detailed review of investment operations, please see Investments Results of Operations, 10-K Pages 54-57. and enrollment software, as well as expanded eligibility and coverage updates for our Businessowners Package Policy. Your company's personal lines operations have moved into the proﬁtable range. In 2006, we are working to improve our high policy retention and attract desirable personal lines accounts by adjusting rates, increasing our loss-free credit and incorporating insurance scores into our pricing. advantages, each reporting agency location Steady Over Time produced $2.5 million of business, on Our intention remains to be a steady average, making us the top carrier within market participant, capable of writing most more than half of our agencies and one of types of accounts served by local agencies. 5 Consolidated Pretax Investment Income Less expenses (Dollars in millions) 2 9 4 5 6 4 6 2 5 5 4 4 1 2 4 2001 2002 2003 2004 2005 Consolidated pretax investment income rose 6.9 percent in 2005. Dividend increases announced during 2005 by companies whose common stocks are in the portfolio are expected to add $15 million to investment income in 2006. That steadiness is good for shareholders, too. Poor's 500 Index. For the ﬁve years ending In a study published in 2005, Aon Re Global December 31, 2005, our total return reached listed Cincinnati Financial as the ﬁrst runner- 40.9 percent versus 2.8 percent for the up among all commercial insurers for having S&P 500. Cincinnati Financial has the lowest earnings volatility over a two-year outperformed the S&P 500 in 13 of the period. Aon's premise is that less volatile past 16 years. earnings will, over time, lead to increased Over time, we seek to increase earnings shareholder value. It's a premise we share. per share, book value and dividends at a rate Over time, the effects of insurance pricing that would allow long-term total return to and economic cycles even out. At any point, our shareholders to exceed that of the we choose to look past the peaks and valleys, Standard & Poor’s Composite 1500 Property focusing on what it takes to assure growth Casualty Insurance Index. Our ﬁve-year total and proﬁts over the longer term. That's the return matched the Index return. basis for our total return investment program NASDAQ and Mergent, Inc., introduced a and our emphasis on common stocks, which new NASDAQ Dividend Achievers Index in make up 54.8 percent of our consolidated February 2006, naming Cincinnati Financial portfolio's market value. as a founding member. It is comprised of We like stocks with steadily increasing NASDAQ-listed companies that have dividends and potential for appreciation. increased annual regular dividend payments While our ﬁnancial stocks, including our for the last 10 or more consecutive years. largest holding in Fifth Third, are cyclical, In fact, your 2006 indicated annual they meet this longer-term investment objective. In late 2005, we began selling our dividend of $1.34 per share represents the 46th consecutive year of increase. core holding in Alltel Corporation common Your company's people are prepared to stock when its business model and outlook rise above any challenges that 2006 may for dividend increases changed. With that bring and to dedicate themselves to sale complete early in 2006, we are investing increasing shareholder value, over time. 2005 10-K For a detailed review of the company's ﬁnancial results and condition, please see Financial Statements and Supplementary the proceeds in line with our overall investment objectives. Respectfully, Since 1996, the board of directors also /S/ John J. Schiff, Jr. has authorized investment in our own shares, John J. Schiff, Jr., CPCU Data, 10-K Page 77, and Notes including the most recent authorization of Chairman, President and to Consolidated Financial Statements, 10-K Page 84. 10 million shares approved in August 2005. Chief Executive Officer Your company returned $267 million to March 10, 2006 shareholders during 2005, including $63 million through repurchases of our common stock and $204 million of cash dividends paid. Shareholders also received a 5 percent stock dividend in April. Total return to shareholders was 9.1 percent in 2005 versus 4.9 percent for the Standard & 6 Condensed Balance Sheets and Income Statements Cincinnati Financial Corporation and Subsidiaries (Dollars in millions) Assets At December 31, 2005 2004 Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premiums receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reinsurance receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liabilities Insurance reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Unearned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.125% senior notes due 2034 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.9% senior debentures due 2028 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.92% senior debentures due 2028 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders' Equity Common stock and paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income – unrealized gains on investments and derivatives . . . . . . . . . . Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities and shareholders' equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,702 119 1,116 681 1,385 _________ $ 16,003 _________ _________ $ 5,004 1,559 1,622 371 28 392 941 _________ 9,917 _________ 1,358 2,088 3,284 (644) _________ 6,086 _________ $ 16,003 _________ _________ $ 12,677 306 1,119 680 1,325 _________ $ 16,107 _________ _________ $ 4,743 1,539 1,834 371 420 – 951 _________ 9,858 _________ 988 2,057 3,787 (583) _________ 6,249 _________ $ 16,107 _________ _________ (Dollars in millions except per share data) Revenues 2005 Years ended December 31, 2004 2003 Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment income, net of expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Realized investment gains and losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Beneﬁts and Expenses Insurance losses and policyholder beneﬁts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total beneﬁts and expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,164 526 61 16 _________ 3,767 _________ 1,911 627 406 _________ 2,944 _________ Income Before Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 823 Provision for Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221 _________ $ 602 _________ _________ Per Common Share Net income – basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income – diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 3.44 3.40 $ 3,020 492 91 11 _________ 3,614 _________ 1,846 615 353 _________ 2,814 _________ 800 216 _________ $ 584 _________ _________ $ $ 3.30 3.28 $ 2,748 465 (41) 9 _________ 3,181 _________ 1,887 536 278 _________ 2,701 _________ 480 106 _________ $ 374 _________ _________ $ $ 2.11 2.10 7 Six-year Summary Financial Information Cincinnati Financial Corporation and Subsidiaries (Dollars in millions except per share data) Financial Highlights Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . One-time items* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income before one-time items* . . . . . . . . . . . . . . . . . . Net realized investment gains and losses, after tax . . . . . . Net income before net realized investment gains and losses, before one-time items* . . . . . . . . . . . . . . . . Comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . . . . Per Share Data (diluted) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . One-time items* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income before one-time items* . . . . . . . . . . . . . . . . . . Net realized investment gains and losses, after tax . . . . . . Net income before net realized investment gains and losses, before one-time items* . . . . . . . . . . . . . . . . Cash dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . Book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ratio Data Investment yield-to-cost (pretax) . . . . . . . . . . . . . . . . . . . . Debt-to-capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on equity (ROE) before one-time items* . . . . . . . . ROE based on comprehensive income before one-time items* . . . . . . . . . . . . . . . . . . . . . . . . . . Property Casualty Insurance Operations (Statutory) Written premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premiums (adjusted)* . . . . . . . . . . . . . . . . . . . . . . Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss expense ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Underwriting expense ratio . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (reported) . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (adjusted)* . . . . . . . . . . . . . . . . . . . . . . Policyholders' surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial Lines Property Casualty Insurance Operations (Statutory) Written premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premiums (adjusted)* . . . . . . . . . . . . . . . . . . . . . . Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss expense ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Underwriting expense ratio . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (reported) . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (adjusted)* . . . . . . . . . . . . . . . . . . . . . . $ 2,290 2,306 2,254 46.6% 11.0 29.5 87.1% 87.1% Personal Lines Property Casualty Insurance Operations (Statutory) Written premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premiums (adjusted)* . . . . . . . . . . . . . . . . . . . . . . Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loss expense ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Underwriting expense ratio . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (reported) . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (adjusted)* . . . . . . . . . . . . . . . . . . . . . . $ 786 791 804 56.7% 7.2 30.4 94.3% 94.3% Life Insurance Operations (Statutory) Written premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income before realized investment gains and losses . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross life insurance face amount in force . . . . . . . . . . . . . Admitted assets excluding separate account business . . . . Risk-based capital Total adjusted capital . . . . . . . . . . . . . . . . . . . . . . . . . . . Authorized control level risk-based capital . . . . . . . . . . 2005 2004 2003 2002 2001 2000 Years ended December 31, $ $ $ $ $ $ 602 – 602 40 562 99 3.40 – 3.40 0.23 3.17 1.21 34.88 7.0% 11.5 9.8 $ $ $ $ $ $ 584 – 584 60 524 287 3.28 – 3.28 0.34 2.94 1.04 35.60 7.2% 11.2 9.4 $ $ $ $ $ $ 374 15 359 (27) 386 815 2.10 0.09 2.01 (0.15) 2.16 0.90 35.10 $ $ $ $ $ $ 238 – 238 (62) 300 (232) 1.32 – 1.32 (0.35) 1.67 0.81 31.43 7.5% 8.9 6.0 7.9% 9.7 4.1 1.6 4.6 13.5 (4.0) $ 3,076 3,097 3,058 49.2% 10.0 29.8 89.0% 89.0% $ 4,194 $ 2,997 3,026 2,919 49.8% 10.3 29.3 89.4% 89.4% $ 4,191 $ 2,186 2,209 2,126 43.4% 10.9 29.4 83.7% 83.7% $ 811 817 793 66.7% 8.9 29.0 104.6% 104.6% $ 2,815 2,789 2,653 56.1% 11.6 26.5 94.2% 95.0% $ 2,783 $ 2,031 2,009 1,908 51.2% 12.7 27.0 90.9% 91.6% $ 784 780 745 68.8% 8.9 25.2 102.9% 103.9% $ 2,613 2,496 2,391 61.5% 11.4 25.5 98.4% 99.6% $ 2,340 $ 1,905 1,795 1,721 57.8% 12.5 25.0 95.3% 96.8% $ 708 701 670 71.0% 8.7 26.8 106.5% 106.8% $ 205 10 21 51,493 1,882 $ 193 26 28 44,921 1,713 $ 143 27 20 38,492 1,572 $ 220 20 17 32,486 1,477 $ $ $ $ $ $ 193 – 193 (17) 210 150 1.07 – 1.07 (0.10) 1.17 0.76 33.62 8.1% 9.2 3.2 2.5 $ 2,590 2,188 2,073 66.8% 10.1 22.6 99.5% 103.6% $ 2,533 $ 1,827 1,551 1,453 62.6% 11.8 22.3 96.7% 100.7% $ 763 637 620 76.7% 6.2 23.0 105.9% 110.4% $ 102 21 15 27,534 1,329 $ $ $ $ $ $ 118 (25) 143 (2) 145 744 0.67 (0.14) 0.81 (0.01) 0.82 0.69 33.80 8.4% 9.4 2.5 13.5 $ 1,881 1,936 1,828 71.1% 11.4 30.0 112.5% 109.9% $ 3,172 $ 1,275 1,326 1,232 71.1% 12.9 33.2 117.2% 114.4% $ 606 610 596 71.1% 8.1 31.4 110.6% 108.4% $ 140 28 30 23,525 1,201 * The Deﬁnitions of Non-GAAP Information and Reconciliation to Comparable GAAP Measures on Page 22 deﬁnes and reconciles measures presented in this report that are not based on GAAP or statutory accounting principles. 8 511 52 491 47 443 50 420 47 457 44 503 76 Financial Performance Overview Our local independent agents, ﬁeld and headquarters associates achieved excellent ﬁnancial results in 2005. They invested in efforts that strengthen our position going into 2006, a year that may prove challenging for our Premium Mix Percent of 2005 consolidated net earned premiums industry. Top-notch claims service, especially the response to this year's many weather catastrophes, ﬁrmed up policyholder loyalties. Active salesmanship produced more than Life 3% Personal lines 26% Commercial lines 71% $300 million of new business and many new policyholders. And our infrastructure expanded with signiﬁcant progress on technology and physical plant projects, helping assure our ability to achieve the company's objectives over the long term. All three of our insurance areas contributed to this year's strong underwriting results. Commercial lines, which provided 71 percent of total earned premiums, brought in $285 million of underwriting proﬁt. Personal lines, which provided 26 percent of total earned premiums, added $45 million in underwriting proﬁt. Life insurance, which provided 3 percent of total earned premiums, contributed 20 cents per share to operating earnings, up from 18 cents last year. Our investment operations contributed $526 million in pretax investment income, up 6.9 percent. The next two pages give a brief overview of 2005 ﬁnancial results for our insurance and investment operations. We encourage you to read the Management's Discussion and Analysis in our Annual Report on Form 10-K Page 31, for a detailed look at management's view of the results of operations and liquidity and capital resources. Property Casualty Insurance Operations We believe that our agent-centered strategy provides important advantages as we go head-to-head with other proﬁtable, ﬁnancially strong competitors in our regional markets. Across our commercial lines market areas, during 2005 we saw continued signs of the soft market, with fewer increases and more declines in renewal pricing, aside from any changes in an account's exposures. Account quality, class of business, size of account, location and the mix of carriers that compete in that local market all continue as factors in pricing levels. Commercial policyholders continue to respond favorably to our agents' presentation of the Cincinnati value proposition – customized coverage packages, personal claims service and high ﬁnancial strength ratings – all wrapped up in a convenient three-year commercial policy. 14.7 11.7 14.0 13.0 The Cincinnati Insurance Companies Estimated industry (A.M. Best) Property Casualty Net Written Premium Growth (Adjusted*) Statutory (Percent) The personal lines market remains competitive. We are further reﬁning our rates and premium credits. In Diamond states, we plan in July to introduce a limited program of rate segments that incorporate insurance scores into pricing of personal auto and homeowner policies. These changes better position our agents to sell the value of our homeowner auto package, superior claims service and ﬁnancial strength, which should help us resume growing in this business area. 2001* 2002* 2003* 2004* 2005* 2.3 8.5 8.5 0.7 4.7 9.6 *The Deﬁnitions of Non-GAAP Information and Reconciliation to Comparable GAAP Measures on Page 22 deﬁnes and reconciles measures presented in this report that are not based on GAAP or statutory accounting principles. 9 Other 2005 highlights of the property casualty operations included: • 2.6 percent increase in 2005 total property casualty net written premiums, ahead of the estimated industry average growth rate of 0.7 percent. • 89.2 percent GAAP Property Casualty Combined Ratio Statutory (Percent) The Cincinnati Insurance Companies Estimated industry (A.M. Best) 115.7 107.3 100.2 98.1 102.0 6 . 3 0 1 6 . 9 9 0 . 5 9 4 . 9 8 0 . 9 8 combined ratio (89.0 percent statutory) for full-year 2005. Improvement reﬂected lower catastrophe losses, continued strong commercial lines underwriting results and a return to personal lines underwriting proﬁtability. 2001* 2002* 2003* 2004 2005 • $127 million in full-year 2005 catastrophe losses, including ceded and assumed reinsurance. Catastrophe losses added 4.1 percentage points to the 2005 combined ratio. Full-year 2004 catastrophe losses of $148 million, on the same basis, added 5.1 percentage points to last year’s ratio. • A net increase of 40 reporting agency locations in 2005. We had 1,024 agency relationships with 1,253 reporting agency locations marketing our insurance products at year-end 2005, up from 986 agency relationships with 1,213 reporting agency locations at year-end 2004. Commercial Lines Insurance Highlights • 87.4 percent 2005 commercial lines GAAP combined ratio, marking the second consecutive year with a sub-90 percent combined ratio. • 4.7 percent rise in 2005 commercial lines net written premiums, with slower growth primarily due to a more competitive pricing environment. The growth rate of commercial lines written premium exceeded the 2.7 percent growth estimated on an industrywide basis. • $282 million in new commercial lines business written directly by agencies in 2005, unchanged from 2004. • WinCPP, our commercial lines rate quoting system, rolled out to all 32 states where our agents actively market our insurance products to businesses. • Ohio agents began using e-CLAS™, our Web-based commercial lines policy processing system, to issue Businessowners Package policies (BOPs) during 2005. With almost $1 million in BOP premiums on that processing system by year-end, we anticipate introducing it in 2006 to agents in several other states and beginning preparations to add product lines to enhance its utility. Personal Lines Insurance Highlights • 94.4 percent 2005 personal lines GAAP combined ratio, reﬂecting substantial progress in lowering our homeowner loss and loss expense ratio closer to breakeven. 2005 was the ﬁrst full year of proﬁtability for personal lines since 1999. • 3.0 percent decline in 2005 personal lines net written premiums, with 6.6 percent fourth-quarter decline. • $32 million in new personal lines business written directly by agencies in 2005, compared with $48 million last year. • Diamond, the company's personal lines policy processing system, in use at year-end in seven states. These states represented approximately 70 percent of total 2005 personal lines earned premium volume. In 2005, $417 million of personal lines' $786 million of written premium was issued through Diamond. • Diamond rollout to extend to six additional states in 2006. Georgia, Kentucky and Wisconsin agents began using Diamond in early 2006, with Minnesota, Missouri and Tennessee rollouts planned for later in the year. *The Deﬁnitions of Non-GAAP Information and Reconciliation to Comparable GAAP Measures on Page 22 deﬁnes and reconciles measures presented in this report that are not based on GAAP or statutory accounting principles. 10 Life Insurance Operations The Cincinnati Life Insurance Company contributed 2 cents more to our company's operating earnings this year, reﬂecting higher earned premium with stable expenses and mortality experience within pricing guidelines. Overall, the life operation continues to provide a consistent income stream for our agents and the company, helping to offset some of the inevitable ﬂuctuations in property casualty results. Cincinnati Life — Gross Life Policy Face Amounts In Force Excluding annuities, accident and health business (Dollars in millions) Other 2005 highlights of the life insurance operations included: • $205 million in 2005 total life insurance operations written premiums, up from 3 9 4 , 1 5 1 2 9 , 4 4 2 9 4 , 8 3 6 8 4 , 2 3 4 3 5 , 7 2 2001 2002 2003 2004 2005 Investment Operations We remain committed to our buy-and-hold equity investing strategy, which we believe is key to the company's long-term growth and stability. During the second half of 2005, we made moderate additions to our equity portfolio and anticipate making equity investments in 2006 that provide both income and the potential for capital appreciation over the years. Consolidated Investment Portfolio As of December 31, 2005 (Dollars in millions) Market (Fair) Value Book Value 12,657 7,590 (Dollars in millions) Book Value Taxable ﬁxed maturity Tax-exempt ﬁxed maturity Common equity Preferred equity Short-term Total $ 3,304 2,083 1,961 167 75 $ 7,590 Market (Fair) Value $ 3,359 2,117 6,936 170 75 $12,657 Other 2005 highlights of the investment operations included: • 6.9 percent increase in pretax net investment income. Interest income from ﬁxed- $193 million in 2004. Written premiums for life insurance operations for all periods include life insurance, annuity and accident and health premiums. Life insurance 2004 premiums included the sale of two general account bank- owned life insurance (BOLIs) policies totaling $10 million. • 14.6 percent rise in face amount of life policies in force to $51.493 billion at year-end 2005 from $44.921 billion at year-end 2004. Applications submitted in 2005 rose 2.0 percent, with a 6.3 percent gain in worksite applications. • 16.1 percent rise in 2005 term life insurance gross written premiums, beneﬁting from midyear introduction of a new series of term products. The Termsetter Plus series includes an optional return-of-premium feature. Response to the new portfolio has been favorable, with approximately 25 percent of applications requesting the return-of-premium feature. income investments contributed 53.3 percent of 2005 net investment income. Dividend increases from common stocks more than offset loss of income from sales or calls of convertible preferred securities in the past 12 months. Fifth Third, the company's largest equity holding, contributed 43.6 percent of total dividend income in 2005. • $15 million annually in additional investment income expected from dividend increases announced during 2005 by Fifth Third and another 35 of the 49 common stock holdings in the equity portfolio. • $4.194 billion in statutory surplus for the property casualty insurance group at year-end 2005, essentially unchanged from year-end 2004. The ratio of common stock to statutory surplus for the property casualty insurance group portfolio was 97.0 percent at year-end 2005, compared with 103.5 percent at year-end 2004. • 33.9 percent ratio of investment securities held at the holding-company level to total holding-company-only assets at year-end 2005, in line with management's below-40 percent target. • 1.5 million of our shares repurchased at a total cost of $63 million in 2005. 11 I Am the Face I Am the Face of Cincinnati of Cincinnati “Our business is to protect people against calamitous misfortunes and catastrophes. It is our duty to furnish this protection – with a warm human interest in those we insure – and in the most progressive and efficient manner.” This preamble appeared from 1957 to 1963 in your Room to grow company’s annual reports. Efficiency was a high priority then, Meeting the needs of our independent insurance agencies as it is today. And we continue to get the job done, furnishing the protection expected by our agency customers and their clients. Just as important, we integrate into every process and every transaction a genuine concern for people. In these pages, you’ll meet some of the associates who carry out the everyday details related to “furnishing protection.” They are remarkable. Their words reveal strong ownership not has allowed us to grow more rapidly than the overall industry. But substantial potential remains in our 32 active states. In 26 states, our market share is less than 1 percent. To tap this potential, Cincinnati Market Share by State Based on 2004 Direct Written Premiums Above 5% 1% to 5% Less than 1% Inactive states only of their individual jobs, but also of our mission to support we have the continued success of our local independent agents, who we believe are best equipped to serve the policyholders in their communities. As a growing organization whose competitive edge has always been our ability to provide the human touch, how do we avoid becoming another large, impersonal organization of people in cubicles, not fully awake to the impact – for better or accelerated efforts to appoint new agency relationships. In 2005 and 2004, we added worse – of their actions? How do we create totally vested 91 new agency * * DE in 2005 Headquarters (no branches) associates willing to give of themselves in providing warm relationships. We anticipate making 50 appointments in 2006. human responses? 12 Growing relationships We select and reward professional independent agents who share our long-term focus – agents who do business person to person; offer broad, value-added services; maintain sound Cincinnati Market Share Within Reporting Agency Locations Based on 2004 Direct Written Premiums (Percent) Your company sees challenges in the coming year, as market conditions for our property casualty insurance business make it more difficult to grow and as our investments in people and systems continue. We believe we’re moving in the right direction and will move past those challenges stronger than ever. People are our major advantage. We are represented in the marketplace by top, professional independent agents. We have a culture that encourages associates to look within themselves to ﬁnd solutions, to increase and direct their efforts with certainty that individual contributions make a difference. 24.3 We hear those individuals, almost 4,000 strong, each saying, “I am the face of Cincinnati.” ■ 11.5 5.1 0.5 Less than 1 year up to 5 years up to 10 years 10 or more years Product growth Cincinnati is a regional carrier, serving local markets and working with our agents account by account. This approach balance sheets; and manage their agencies professionally. As agents learn about Cincinnati, they develop an appreciation for our approach and reward us with a steadily increasing share of their business. We rank No. 1 or No. 2, based on premium volume, in 74 percent of the reporting agency locations that we have served for more than ﬁve years. There is tremendous potential in the 196 reporting agency locations that have marketed our products for less than ﬁve years, even as we continue to grow with the 1,057 more established reporting locations. You’ll hear a consistent chorus of answers to these questions as you follow these associates through the process of getting business done to high standards: • They have – and use – considerable authority to ﬂexibly respond to each situation. They take individual responsibility for making, controlling, improving and completing our processes. • They have the right training to understand the big picture as well as the close-up. • Theirs is a team effort, empowering them to broadly deﬁne their roles and broadly assist customers, knowing they can draw on extensive experience and resources as needed. has made us the 25th largest property casualty insurer based on net premiums written. In selected product lines, it has made us an even more signiﬁcant player. We rank nationally among the top 20 carriers for commercial property, commercial auto and commercial casualty insurance. We Cincinnati’s Highest Volume Lines National Market Share and Rank based on 2004 Direct Written Premiums (Percent) 1.7 1.5 #15 #16 1.2 #18 y t l a u s a C l i a c r e m m o C l i a c r e m m o C o t u A y t r e p o r P l i a c r e m m o C 0.5 #24 l i r e P i t l u M s r e n w o e m o H 0.6 #29 ' s r e k r o W n o i t a s n e p m o C 0.3 #44 e t a v i r P o t u A r e g n e s s a P achieve those ranks even though our market share in those product lines is less than 2 percent, showing the potential that remains as we continue to meet agent needs. 13 Putting a Personal Stamp on ‘The Process’ Behind every Cincinnati commercial lines policy is a process involving underwriters, raters, typists and policy service specialists. But the last thing Cincinnati wants agents to worry about is “the process.” “We want the personal touch,” said Susi Reasch, team leader of the group serving Michigan agencies. “Our relationship with the agent is very important.” Supporting Reasch and the 10 other underwriters in her group are three typists, ﬁve raters, three policy service assistants and two Advanced Workstation Rating (AWR) operators – specialists who work on automated policy processing systems. Working closely with commercial lines are associates from other Cincinnati headquarters departments, including imaging and agency accounting. “We all work well together,” Reasch said. “We all understand the urgency of getting something done and getting it right the ﬁrst time.” On a typical morning, Don Gray, an underwriter on Reasch’s team, arrives at his desk to ﬁnd e-mails from agencies containing information he has requested to process pending renewals. He interacts with agency staff via telephone, too, on peak days making or receiving up to 40 calls. He’s prompt at responding to questions, even if it’s just to let the agency know he is researching the answer. “It’s just courtesy,” he said. He knows the agents and customer service 14 representatives in each agency by name, and the conversation is friendly as they exchange information. Underwriting – or risk selection and pricing – on new business is done in the ﬁeld by the marketing representative, but the headquarters underwriter helps set up the ﬁle. If Gray has questions about new business, he can contact the marketing representative or the agent. On renewal business, Gray, who has been an underwriter for more than ﬁve years, is responsible for underwriting the policy himself. He’ll examine the loss history and work with the agency to make sure the appropriate endorsements and exclusions are part of the policy. He also takes care of requests for endorsements on in-force policies. Building a Better Underwriter “It takes at least six months to train an underwriter,” said Susi Reasch, a commercial lines team leader. Because the agency relationship is the core Cincinnati value, underwriters are assigned to agencies rather than to underwriting specialties. It is each underwriter’s job to understand property, liability, auto, inland marine, crime, umbrella and workers’ compensation coverages. Underwriters begin training with structured classroom sessions in Cincinnati’s own Training Center. They study insurance coverage topics and various insurance operations beyond underwriting: claims, loss control, machinery and equipment, legal issues, product research and development, and regulatory matters, among others. Specialists from inside the company take turns teaching the topics. “We teach relationships and negotiation and how to do a good job with an agency,” Reasch said. Upon graduating, new underwriters spend several months observing and working under close supervision of a mentor. When they have mastered the necessary skills, the underwriters are assigned their own territories, usually smaller ones at ﬁrst. Managers are there to back up the new underwriters as they learn. And the learning doesn’t end after a territory is assigned. Over time, some underwriters develop expertise in speciﬁc areas. For example, Reasch is a crime and umbrella coverage specialist. Besides serving her own agencies, she has become a resource across the commercial lines department. Associates also have numerous opportunities for continuing education, both within the company and through industry professional organizations. Many underwriters continue to study throughout their careers, earning nationally recognized designations in personal or commercial insurance and insurance management, including the Chartered Property Casualty Underwriter designation. 15 Above: Underwriter Don Gray answers an agent’s question by reviewing a policy online. Left: Commercial North team members, Susi Reasch, Sheryl Thacker, Don Gray, Guynn Green and Scott Smith, manager. Policy service assistants, imaging associates, raters and typists speed the process, all serving as extra hands or extra eyes. The assistants deliver mail and faxes; imaging associates scan policies into electronic ﬁles for easy retrieval; raters research premium guidelines and typists or AWR operators ﬁnalize the policy. Underwriters like Gray and Reasch draw on a variety of reference materials, procedure guides and automated systems to help them evaluate renewal business. Underwriting managers and coverage area specialists – in areas such as crime and umbrella – also are available to help. By following established procedures, the commercial lines team can be sure to cover every important step. Despite “the process,” underwriters understand that ﬂexibility and service are key. When an agency has a request or issue, the underwriter is able to stop and take care of it. That ﬂexibility is what keeps Reasch enthused about her job after 28 years. “It’s not a factory,” she said, smiling. ■ Specialized Knowledge Provides Sales Advantage “Sales” is nowhere in Mike Swiadas’ title, yet he sells Cincinnati Insurance every day. The machinery and equipment specialist calls on his mechanical knowledge, national boiler inspection certiﬁcation and insurance know-how to protect policyholders from ﬁnancial loss due to equipment breakdown. “After 31 years in the business, I have a lot of information in my head,” he noted. That helps the agent sell the policy. Swiadas routinely accompanies agents, ﬁeld marketing and loss control representatives when they inspect businesses seeking Cincinnati’s “Thank you for the excellent description of your coverage! This really is helpful to us in the ﬁeld selling your product. I started to work with Cincinnati about eight months ago, and this type of response is why you are quickly becoming my favorite carrier.” Patrick Martell – Chittenden Insurance – Portsmouth, New Hampshire commercial coverage. The team inspections help everyone better understand risks. “It’s how we serve our clients,” Swiadas said. “We all work together.” Swiadas is certiﬁed by the National Board of Boiler and Pressure Vessel Inspectors. That means he has passed a rigorous exam and continuing education requirements. He also continues his informal education, responding to equipment breakdown claims and visiting agencies. Swiadas is an underwriter, too, with authority to underwrite machinery risks. “Cincinnati is a full-service insurance company,” explained Duane Cantrell, ﬁeld supervisor. “We want it to be easy to do business with us.” Underwriter Charles Harrison and Machinery & Equipment Specialist Mike Swiadas discuss boiler coverage. Cincinnati’s expertise in loss control and machinery and equipment creates a key competitive advantage. Agents don’t need a specialty carrier to cover boilers, turbines and other equipment; Cincinnati can cover them. ■ 16 A Relationship Built to Last a Lifetime When a client chooses a Cincinnati Life insurance policy, it’s the beginning of a relationship that can last 60 years or more. Trust is vital. “We understand we are helping a family or providing business continuity,” said Mark McPheron, life underwriting superintendent. McPheron and his staff go into action when they receive applications from independent agents. They check application information and study medical exams to make sure the applicant is a suitable candidate for life insurance. Technology innovations, including LifePro® and imaging software and an electronic workﬂow system, collect information in one convenient electronic ﬁle. Underwriters and policy issue specialists have easy access. After the policy is issued, the Life Policy Service team takes over. They handle transactions over the life of the policy, including address changes, beneﬁciary changes, loans, terminations or reinstatements, term expirations and beneﬁt changes. Service representatives work with policyholders or through an agent “once the policy has been released,” explained Amanda Bowers, lead customer service representative. When a policyholder dies, Ann Binzer’s life claims team “Thanks for your prompt attention. I’m not sure the insured will ever appreciate what it took for you to make this happen. I got a panicked call on Tuesday saying that the bank needed a copy of the life insurance policy in order to close. ‘That’s OK.’I told her. ‘The company overnighted the policies, can I bring them out now?’Having the policies that fast really made our agency, your staff and the company look great.” Jamie Purmort – Purmort & Martin Insurance Agency – Sarasota, Florida works to pay the claim. A processor gathers information from the beneﬁciary to verify coverage and issue the check. Currently, most claims are processed on paper, but in 2006, the department expects to join the Claims Management System. The goal is to have all claims ﬁles imaged to make them more easily accessible. Relatives often ﬁnd policies long after a death. But sometimes a call comes while grief is still fresh. The team is trained to handle it. “When a loved one dies, it’s a difficult time,” said Binzer, manager of the 16-member Life & Health Claims department. “We do what needs to be done to get the claim paid.” ■ Above: Marsha Houston and Amanda Bowers, lead customer service representatives. Right: Underwriter Mark McPheron with trainees Teresa Rose and Kristy Rumley and Stephanie Johnson, policy issue specialist. Far right: Ann Binzer, manager of Life & Health Claims. Communication, Consistency, Cooperation Pieter Kes works from an office in his home, like all of the 751 Cincinnati claims associates who work in the ﬁeld. This allows him the ﬂexibility to serve agency customers and policyholders around Birmingham, Alabama, promptly and on a schedule that meets their needs. The day after Hurricane Katrina hit the Gulf Coast and spread destruction northward into his area, Kes already was in action. He inspected eight properties that ﬁrst day, making sure they were secured. “By responding quickly, we can help people avoid further damage,” Kes said. “That helps policyholders, and it helps our company, too.” Cincinnati’s catastrophe response teams soon joined Kes, helping him maintain quality service not only on storm claims, but also on other claims. Catastrophe response teams closed 77 percent of the Katrina claims within eight weeks. Cincinnati’s automated Claims Management System eased the process. Because claims ﬁles now are electronic, emergency teams could easily check the status on claims and move them toward resolution. In addition to claims service, Kes also provides another set of eyes in his territory. If he sees something an agent or underwriter should know about – positive or negative – he ﬁles a risk report. For example, while working on a claim, he noticed vines growing across the entryway steps, creating a potential hazard – and a potential liability. Kes wrote a risk report that was shared with the agency and various Cincinnati 18 Above: Karen Gray, Bob Bernard and Birdie McCane each play a role in Diamond’s success. Right: Alabama underwriting team – Bill Rizzo, Pat Buchman, Tim Wright, Rob Treinen and Carrie McKitrick. associates. The agent alerted the property owner and the problem was ﬁxed. Pat Buchman routinely sees such reports. As a personal lines underwriter in Cincinnati’s headquarters, Buchman ﬂags items for review when an Alabama policy comes up for renewal. It’s his job to make sure risks are correctly identiﬁed and the appropriate premium charged. That diligence helps get policyholders the right coverage and helps agencies stay proﬁtable. “We like the involvement of the ﬁeld claims representatives,” said underwriting manager Tim Wright. In underwriting and issuing a renewal policy through the automated Diamond policy production system, the agent might not get to see details of a home’s condition. But the ﬁeld claims representative does, allowing the Cincinnati team to supply the agent with better information. Another place where Buchman and Wright add value is through detailed analysis of agency business. Every year, Buchman reviews his assigned agencies and works with them to improve the business they write. When he makes his agency visits, there are no surprises. The key, he said, is to “stick to the three C’s: communication, consistency and cooperation.” “It takes time to build that relationship up,” Wright said. Communication makes it easier for Cincinnati to be ﬂexible when an agent asks for an accommodation on a hard-to-write piece of business. With research and careful use of credits and deductibles, underwriters can accept business that may not precisely ﬁt the guidelines, but that still will be proﬁtable. “Our philosophy is to try to ﬁnd a way to write the business,” Wright said. ■ When Storms Hit, Cincinnati Claims Teams Shine Before low pressure systems formed in the tropics...before the 2005 hurricanes churned in the ocean...long before “Katrina” was a household word, David Rice and his Cincinnati ﬁeld claims associates were planning for the worst while hoping for the best. Every December, Rice, manager of Cincinnati’s catastrophe response teams, assembles a list of more than 400 volunteers for “on call” duty throughout the upcoming year. When a catastrophe such as a hurricane or tornado generates enough claims to strain local operations, Rice quickly sends help. Each team includes 10 claims representatives from across Cincinnati’s territories. Although storm duty can mean 12-hour days away from home for weeks, recruiting is not difficult. “People want to help,” Rice said. Field Claims officers David Rice and Bud Stoneburner. Below: Field Claims associates load a trailer with supplies needed to respond to catastrophe claims. “There’s a great deal of personal satisfaction going into a catastrophe situation and making things better.” Back at home, it’s business as usual. Associates cover for storm volunteers. If the claims volume requires an extended storm team presence, teams are rotated in and out until the local staff ﬁnds the caseload manageable. The Claims Management System makes it easy to reassign claims and for all parties to track activity electronically. Just as with normal claims operations, ﬁeld claims associates on catastrophe duty are committed to providing prompt, personal and fair service. “On storm duty, we do what we normally do,” Rice said. “We just do more, and we do it faster and under very unusual circumstances.” 19 Flexibility in the Field It’s an awesome responsibility, yet a point of great pride. “I am the face of Cincinnati to the agencies; the ﬁeld marketing representative is the person they turn to for complaints and for praise,” explained Glenn Wernke, ﬁeld director in a Cincinnati sales territory that serves 13 agencies around Indianapolis. Unlike marketing representatives from most other insurance companies, Wernke has the authority to decide about new business himself. He estimates 90 percent of his time is spent quoting and underwriting commercial lines business. After 20 years in insurance, “I have a pretty good idea of what’s a good risk and what’s a bad risk,” he said. Wernke visits his assigned agencies regularly, ready to look at new business and give approvals or request more information. “I try to quote the business right in their office, if possible,” he said. Cincinnati’s underwriting philosophy has always allowed the ﬁeld representative the ﬂexibility to look at an excellent risk in a good agency, even if it’s in a tough class of business. “That sets us apart from the rest,” Wernke said. “No other company gives that kind of ﬂexibility.” Wernke doesn’t work alone, however, and knows he can call on ﬁeld or headquarters team members for support, whether it’s discussing an underwriting issue with a commercial lines team member or working with the loss control department to answer an agency question. Cincinnati’s machinery and equipment and loss control representatives also are based in the local communities. Wernke added that agents appreciate having these experts on hand to perform inspections and recommend speciﬁc actions to improve the safety of a policyholder’s operations and the quality of the agent’s insurance account. The headquarters sales management team – all of whom have underwriting and ﬁeld marketing experience – also are available to pitch in. “Our primary role is to support Glenn in the ﬁeld,” said Bill Clevidence, Wernke’s headquarters manager. “We work with Glenn to help perpetuate the agencies he serves and help improve their ﬁnancial health.” Recent technology advances have allowed Wernke to submit quotes electronically, spending less time on paperwork and more time in his customers’ offices. While the technology is a nice beneﬁt, it’s not usually what keeps an agency in the Cincinnati family. “The agencies who have us wouldn’t give us up,” Wernke said. “We care. To them, the heart is more important than the tools.” ■ Left to right: Members of Cincinnati’s Indianapolis ﬁeld team: Allen Wilson, Tim McCord, Glenn Wernke, Tom Murray and Danny Nickleson. 20 Cincinnati Financial Corporation Directors and Officers Directors (as of March 10, 2006) William F. Bahl, CFA Chairman Bahl & Gaynor Investment Counsel, Inc. Director since 1995 (1)(3)(4)(5*) James E. Benoski Vice Chairman and Chief Insurance Officer Cincinnati Financial Corporation Director since 2000 (3)(4) Michael Brown President Cincinnati Bengals, Inc. Director since 1980 (3) Dirk J. Debbink President MSI General Corporation Director since 2004 (1) Kenneth C. Lichtendahl President and Chief Executive Officer Tradewinds Beverage Company Director since 1988 (1*)(2)(5) W. Rodney McMullen Vice Chairman The Kroger Co. Director since 2001(2*)(4) Gretchen W. Price Vice President – Finance & Accounting Global Operations Procter & Gamble Director since 2002 (1)(2) John J. Schiff, Jr., CPCU Chairman, President and Chief Executive Officer Cincinnati Financial Corporation Director since 1968 (3*)(4*) Thomas R. Schiff Chairman and Chief Executive Officer John J. & Thomas R. Schiff & Co., Inc. (insurance agency) Director since 1975 (4) John M. Shepherd Chairman and Chief Executive Officer The Shepherd Chemical Company Director since 2001 (3)(5) Douglas S. Skidmore President and Chief Executive Officer Skidmore Sales & Distributing Company, Inc. Director since 2004 (1) John F. Steele, Jr. Chairman and Chief Executive Officer Hilltop Basic Resources, Inc. Director since 2005 (1) Larry R. Webb, CPCU President Webb Insurance Agency, Inc. Director since 1979 (3) E. Anthony Woods Chairman Deaconess Associations, Inc. Director since 1998 (2)(4) * Committee Chair (1) Audit Committee (2) Compensation Committee; also Lawrence H. Rogers II, adviser (3) Executive Committee (4) Investment Committee; also Richard M. Burridge, CFA, adviser (5) Nominating Committee W.F. Bahl J.E. Benoski M. Brown D.J. Debbink K.C. Lichtendahl W.R. McMullen G.W. Price J.J. Schiff, Jr. Officers (as of March 10, 2006) John J. Schiff, Jr., CPCU Chairman, President and Chief Executive Officer James E. Benoski Vice Chairman and Chief Insurance Officer Kenneth W. Stecher Chief Financial Officer and Senior Vice President, Secretary, Treasurer Kenneth S. Miller, CLU, ChFC Chief Investment Officer and Senior Vice President, Assistant Secretary, Assistant Treasurer Eric N. Mathews, CPCU, AIAF Vice President, Assistant Secretary, Assistant Treasurer T.R. Schiff J.M. Shepherd D.S. Skidmore J.F. Steele, Jr. Directors Emeriti Vincent H. Beckman Robert J. Driehaus John E. Field, CPCU Jackson H. Randolph Lawrence H. Rogers II John Sawyer Robert C. Schiff Frank J. Schultheis David B. Sharrock Thomas J. Smart Alan R. Weiler, CPCU William H. Zimmer L.R. Webb E.A. Woods 21 Definitions of Non-GAAP Information and Reconciliation to Comparable GAAP Measures Cincinnati Financial Corporation prepares its public ﬁnancial statements in conformity with accounting principles generally accepted in the United States of America (GAAP). Statutory data is prepared in accordance with statutory accounting rules as deﬁned by the National Association of Insurance Commissioners’ (NAIC) Accounting Practices and Procedures Manual and, therefore, is not reconciled to GAAP data. Management uses certain non-GAAP and non-statutory ﬁnancial measures to evaluate its primary business areas – property casualty insurance, life insurance and investments – when analyzing both GAAP and certain non-GAAP measures may improve understanding of trends in the underlying business, helping avoid incorrect or misleading assumptions and conclusions about the success or failure of company strategies. Management adjustments to GAAP measures generally: apply to non-recurring events that are unrelated to business performance and distort short-term results; involve values that ﬂuctuate based on events outside of management’s control; or relate to accounting reﬁnements that affect comparability between periods, creating a need to analyze data on the same basis. • Net income before realized investment gains and losses: Net income before realized investment gains and losses (readers also may have seen this measure deﬁned as operating income) is calculated by excluding net realized investment gains and losses from net income. Management evaluates net income before realized investment gains and losses to measure the success of pricing, rate and underwriting strategies. While realized investment gains (or losses) are integral to the company’s insurance operations over the long term, the determination to realize investment gains or losses in any period may be subject to management’s discretion and is independent of the insurance underwriting process. Also, under applicable GAAP accounting requirements, gains and losses can be recognized from certain changes in market values of securities and embedded derivatives without actual realization. Management believes that the level of realized investment gains or losses for any particular period, while it may be material, may not fully indicate the performance of ongoing underlying business operations in that period. For these reasons, many investors and shareholders consider net income before realized investment gains and losses to be one of the more meaningful measures for evaluating insurance company performance. Equity analysts who report on the insurance industry and the company generally focus on this metric in their analyses. The company presents net income before realized investment gains and losses so that all investors have what management believes to be a useful supplement to GAAP information. • Statutory accounting rules: For public reporting, insurance companies prepare ﬁnancial statements in accordance with GAAP. However, insurers also must calculate certain data according to statutory accounting rules as deﬁned in the NAIC’s Accounting Practices and Procedures Manual, which may be, and has been, modiﬁed by various state insurance departments. Statutory data is 22 publicly available, and various organizations use it to calculate aggregate industry data, study industry trends and compare insurance companies. • Written premium: Under statutory accounting rules, property casualty written premium is the amount recorded for policies issued and recognized on an annualized basis at the effective date of the policy. Management analyzes trends in written premium to assess business efforts. Earned premium, used in both statutory and GAAP accounting, is calculated ratably over the policy term. The difference between written and earned premium is unearned premium. • Written premium adjustment – statutory basis only: In 2002, the company reﬁned its estimation process for matching property casualty written premiums to policy effective dates, which added $117 million to 2002 written premiums. To better assess ongoing business trends, management may exclude this adjustment when analyzing trends in written premiums and statutory ratios that make use of written premiums. • Codiﬁcation: Adoption of Codiﬁcation of Statutory Accounting Principles was required for Ohio-based insurance companies effective January 1, 2001. The adoption of Codiﬁcation changed the manner in which the company recognized statutory property casualty written premiums. As a result, 2001 statutory written premiums included $402 million to account for unbooked premiums related to policies with effective dates prior to January 1, 2001. To better assess ongoing business trends, management excludes this $402 million when analyzing written premiums and statutory ratios that make use of written premiums. • Life insurance gross written premiums: In analyzing the life insurance company’s gross written premiums, management excludes ﬁve larger, single-pay life insurance policies (bank-owned life insurance or BOLIs) written in 2004, 2002, 2000 and 1999 to focus on the trend in premiums written through the independent agency distribution channel. • One-time charges or adjustments: Management analyzes earnings and proﬁtability excluding the impact of one-time items. * In 2003, as the result of a settlement negotiated with a vendor, pretax results included the recovery of $23 million of the $39 million one-time, pretax charge incurred in 2000. * In 2000, the company recorded a one-time charge of $39 million, pre-tax, to write down previously capitalized costs related to the development of software to process property casualty policies. * In 2000, the company earned $5 million in interest in the ﬁrst quarter from a $303 million single-premium BOLI policy that was booked at the end of 1999 and segregated as a separate account effective April 1, 2000. Investment income and realized investment gains and losses from separate accounts generally accrue directly to the contract holder and, therefore, are not included in the company’s consolidated ﬁnancials. Reconciliation of Consolidated Financial Data Cincinnati Financial Corporation and Subsidiaries (Dollars in millions except per share data) Income Statement Data Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . One-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income before one-time items . . . . . . . . . . . . . . . . . Net realized investment gains and losses . . . . . . . . . . . . . . Net income before realized investment gains and losses, before one-time items . . . . . . . . . . . . . . . . . Per Share Data (diluted) Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . One-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income before one-time items . . . . . . . . . . . . . . . . . . . Net realized investment gains and losses . . . . . . . . . . . . . . Net income before realized investment gains and losses, before one-time items . . . . . . . . . . . . . . . . . Return on Average Equity Return on average equity . . . . . . . . . . . . . . . . . . . . . . . . . . One-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on average equity before one-time items . . . . . . . . Return on Average Equity Based on Comprehensive Income ROE based on comprehensive income . . . . . . . . . . . . . . . One-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ROE based on comprehensive income before one-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment Income 2005 2004 2003 2002 2001 2000 Years ended December 31, $ __________ 602 – 602 40 $ __________ 584 – 584 60 $ __________ 374 15 359 (27) $ __________ 238 – 238 (62) 193 – 193 (17) __________ __________ __________ __________ __________ __________ $ __________ __________ $ 118 (25) 143 (2) $ __________ __________ 562 $ __________ __________ 524 $ __________ __________ 386 $ __________ __________ 300 $ __________ __________ __________ __________ 210 145 $ $ __________ 3.40 – 3.40 0.23 $ __________ 3.28 – 3.28 0.34 __________ __________ $ __________ 2.10 0.09 2.01 (0.15) __________ $ __________ 1.32 – 1.32 (0.35) __________ 1.07 – 1.07 (0.10) $ __________ __________ $ 0.67 (0.14) 0.81 (0.01) __________ __________ $ __________ __________ 3.17 $ __________ __________ 2.94 $ __________ __________ 2.16 $ __________ __________ 1.67 $ __________ __________ __________ __________ 1.17 0.82 $ 9.8% – __________ 9.8% __________ __________ 9.4% – __________ 9.4% __________ __________ 6.3% (0.3) __________ 6.0% __________ __________ 4.1% – __________ 4.1% __________ __________ 2.1% 0.4 __________ __________ 2.5% __________ __________ __________ __________ 3.2% – 3.2% 1.6% – __________ 4.6% – __________ 13.8% (0.3) __________ (4.0)% – __________ 13.1% 0.4 __________ __________ 2.5% – 1.6% __________ __________ 4.6% __________ __________ 13.5% __________ __________ (4.0)% __________ __________ 13.5% __________ __________ __________ __________ 2.5% Investment income, net of expenses . . . . . . . . . . . . . . . . . Bank-owned life insurance (BOLI) . . . . . . . . . . . . . . . . . . Investment income, net of expenses, before BOLI . . . . . . $ __________ $ __________ __________ 526 – 526 $ __________ $ __________ __________ 492 – 492 $ __________ $ __________ __________ 465 – 465 $ __________ $ __________ __________ 445 – 445 Reconciliation of Property Casualty Insurance Data (Statutory)(1) $ $ __________ __________ $ __________ __________ __________ __________ 415 (5) 410 421 – 421 $ Cincinnati Insurance Property Casualty Group (Dollars in millions) Premiums(1) Written premiums (adjusted) . . . . . . . . . . . . . . . . . . . . . . . Codiﬁcation(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premiums adjustment(2) . . . . . . . . . . . . . . . . . . . . Written premiums (reported)(2) . . . . . . . . . . . . . . . . . . . . . Unearned premiums change . . . . . . . . . . . . . . . . . . . . . . . . Earned premiums (GAAP) . . . . . . . . . . . . . . . . . . . . . . . . . Year-over-year Growth Rate(1) Written premiums (adjusted)(2) . . . . . . . . . . . . . . . . . . . . . Written premiums (reported)(2) . . . . . . . . . . . . . . . . . . . . . Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Combined Ratio(1) 2005 2004 2003 2002 2001 2000 Years ended December 31, $ 3,097 – (21) __________ 3,076 (18) __________ $ 3,058 __________ __________ $ 3,026 – (29) __________ 2,997 (78) __________ $ 2,919 __________ __________ $ 2,789 – 26 __________ 2,815 (162) __________ $ 2,653 __________ __________ $ 2,496 – 117 __________ 2,613 (222) __________ $ 2,391 __________ __________ __________ __________ $ 2,188 402 – 2,590 (517) __________ __________ $ 2,073 __________ __________ __________ __________ $ 1,936 (55) – 1,881 (53) $ 1,828 2.3% 2.6 4.8 8.5% 6.5 10.0 11.7% 7.7 10.9 14.0% 0.9 15.4 13.0% 37.7 13.3 15.2% 11.9 10.3 Combined ratio (reported) . . . . . . . . . . . . . . . . . . . . . . . . . Codiﬁcation(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premium adjustment . . . . . . . . . . . . . . . . . . . . . . One-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (adjusted) . . . . . . . . . . . . . . . . . . . . . . . . . Catastrophe losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio excluding catastrophe losses (adjusted) . . __________ 89.0% – nm – 89.0 (4.1) __________ 84.9% __________ __________ __________ 89.4% – nm – 89.4 (5.1) __________ 84.3% __________ __________ __________ 94.2% – nm 0.8 95.0 (3.6) __________ 91.4% __________ __________ __________ 98.4% – 1.2 – 99.6 (3.6) __________ 96.0% __________ __________ __________ __________ 112.5% (0.9) – (1.7) 109.9 (2.7) __________ __________ 107.2% __________ __________ __________ __________ 99.5% 4.1 – – 103.6 (3.1) 100.5% Dollar amounts shown are rounded to millions; certain amounts may not add due to rounding. Ratios are calculated based on whole dollar amounts. nm - not meaningful 1 Statutory data prepared in accordance with statutory accounting rules as deﬁned by the National Association of Insurance Commissioners and ﬁled with the appropriate regulatory bodies. 2 Prior to 2001, property casualty written premiums were recognized as they were billed throughout the policy period. Effective January 1, 2001, written premiums have been recognized on an annualized basis at the effective date of the policy. Written premiums for 2000 were reclassiﬁed to conform with the 2001 presentation; information was not readily available to reclassify earlier year statutory data. The growth rates in written premiums between 1999 and 2000 are overstated because 1999 premiums were calculated on a billed basis. 23 Reconciliation of Commercial Lines Property Casualty Insurance Data (Statutory)(1) Cincinnati Insurance Property Casualty Group (Dollars in millions) Premiums(1) Written premiums (adjusted) . . . . . . . . . . . . . . . . . . . . . . . Codiﬁcation(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premiums adjustment(2) . . . . . . . . . . . . . . . . . . . . . . Written premiums (reported)(2) . . . . . . . . . . . . . . . . . . . . . Unearned premiums change . . . . . . . . . . . . . . . . . . . . . . . . Earned premiums (GAAP) . . . . . . . . . . . . . . . . . . . . . . . . . Year-over-year Growth Rate(1) Written premiums (adjusted)(2) . . . . . . . . . . . . . . . . . . . . . Written premiums (reported)(2) . . . . . . . . . . . . . . . . . . . . . Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Combined Ratio(1) 2005 2004 2003 2002 2001 2000 Years ended December 31, $ 2,306 – (16) __________ 2,290 (36) __________ $ 2,254 __________ __________ $ 2,209 – (23) __________ 2,186 (60) __________ $ 2,126 __________ __________ $ 2,009 – 22 __________ 2,031 (123) __________ $ 1,908 __________ __________ $ 1,795 – 110 __________ 1,905 (184) __________ $ 1,721 __________ __________ __________ __________ $ 1,551 276 – 1,827 (374) __________ __________ $ 1,453 __________ __________ __________ __________ $ 1,326 (51) – 1,275 (43) $ 1,232 4.4% 4.7 6.0 10.0% 7.6 11.4 11.9% 6.6 10.8 15.8% 4.2 18.6 16.9% 43.3 17.9 20.5% 15.9 13.2 Combined ratio (reported) . . . . . . . . . . . . . . . . . . . . . . . . . Codiﬁcation(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premium adjustment . . . . . . . . . . . . . . . . . . . . . . One-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (adjusted) . . . . . . . . . . . . . . . . . . . . . . . . . Catastrophe losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio excluding catastrophe losses (adjusted) . . __________ 87.1% – nm – 87.1 (3.4) __________ 83.7% __________ __________ __________ 83.7% – nm – 83.7 (3.4) __________ 80.3% __________ __________ __________ 90.9% – nm 0.7 91.6 (2.2) __________ 89.4% __________ __________ __________ 95.3% – 1.5 – 96.8 (2.3) __________ 94.5% __________ __________ Reconciliation of Personal Lines Property Casualty Insurance Data (Statutory)(1) __________ __________ 117.2% (1.2) – (1.6) 114.4 (1.5) __________ __________ 112.9% __________ __________ __________ __________ 96.7% 4.0 – – 100.7 (1.9) 98.8% Cincinnati Insurance Property Casualty Group (Dollars in millions) Premiums(1) Written premiums (adjusted) . . . . . . . . . . . . . . . . . . . . . . . Codiﬁcation(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premiums adjustment(2) . . . . . . . . . . . . . . . . . . . . Written premiums (reported)(2) . . . . . . . . . . . . . . . . . . . . . Unearned premiums change . . . . . . . . . . . . . . . . . . . . . . . . Earned premiums (GAAP) . . . . . . . . . . . . . . . . . . . . . . . . . Year-over-year Growth Rate(1) 2005 2004 2003 2002 2001 2000 Years ended December 31, $ $ $ $ $ $ __________ __________ __________ __________ __________ __________ 817 – (6) 811 (18) 793 780 – 4 784 (39) 745 701 – 7 708 (38) 670 637 126 – 763 (143) 620 610 (4) – 606 (10) 596 __________ $ __________ __________ __________ $ __________ __________ __________ $ __________ __________ __________ $ __________ __________ __________ __________ $ __________ __________ __________ __________ $ 791 – (5) 786 18 804 Written premiums (adjusted)(2) . . . . . . . . . . . . . . . . . . . . . Written premiums (reported)(2) . . . . . . . . . . . . . . . . . . . . . Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3.2)% (3.0) 1.4 4.7% 3.4 6.4 12.0% 10.8 11.2 9.8% (7.2) 8.1 4.6% 26.1 4.0 5.0% 4.3 4.6 Combined Ratio(1) Combined ratio (reported) . . . . . . . . . . . . . . . . . . . . . . . . . Codiﬁcation(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Written premium adjustment . . . . . . . . . . . . . . . . . . . . . . One-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio (adjusted) . . . . . . . . . . . . . . . . . . . . . . . . . Catastrophe losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Combined ratio excluding catastrophe losses (adjusted) . . . __________ 94.3% – nm – 94.3 (6.3) __________ 88.0 % __________ __________ 104.6% – nm – __________ 104.6 (9.7) __________ 94.9% __________ __________ 102.9% – nm 1.0 __________ 103.9 (7.3) __________ 96.6% __________ __________ 106.5% – 0.3 – __________ 106.8 (7.1) __________ 99.7% __________ __________ __________ __________ 110.6% (0.2) – (2.0) 108.4 (5.4) __________ __________ 103.0% __________ __________ __________ __________ 105.9% 4.6 – – 110.5 (5.8) 104.7% Reconciliation of Life Insurance Company Data (Statutory)(1) The Cincinnati Life Insurance Company (Dollars in millions) 2005 2004 2003 2002 2001 2000 Years ended December 31, Gross written premiums (reported) . . . . . . . . . . . . . . . . . . . . Bank-owned life insurance (BOLI) adjustment . . . . . . . . . . . Gross written premiums (adjusted) . . . . . . . . . . . . . . . . . . . . $ __________ $ __________ __________ 249 – 249 $ __________ $ __________ __________ 230 (10) 220 $ __________ $ __________ __________ 173 – 173 $ __________ $ __________ __________ 244 (34) 210 $ $ __________ __________ $ __________ __________ __________ __________ 157 (20) 137 122 – 122 $ Dollar amounts shown are rounded to millions; certain amounts may not add due to rounding. Ratios are calculated based on whole dollar amounts. nm - Not meaningful 1 Statutory data prepared in accordance with statutory accounting rules as deﬁned by the National Association of Insurance Commissioners and ﬁled with the appropriate regulatory bodies. 2 Prior to 2001, property casualty written premiums were recognized as they were billed throughout the policy period. Effective January 1, 2001, written premiums have been recognized on an annualized basis at the effective date of the policy. Written premiums for 2000 were reclassiﬁed to conform with the 2001 presentation; information was not readily available to reclassify earlier year statutory data. The growth rates in written premiums between 1999 and 2000 are overstated because 1999 premiums were calculated on a billed basis. 24 Cincinnati Financial A T I O N O R O R C P 2005 Annual Report on Form 10-K Table of Contents Part I Item 1 Item 1A Item 1B Item 2 Item 3 Item 4 Part II Item 5 Item 6 Item 7 Item 7A Item 8 10-K Page Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . . . . . . . 26 Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities . . . . . . . . . . . . . . . . . . . . . . . 27 Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . 70 Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Includes: Responsibility for Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Management's Annual Report on Internal Control Over Financial Reporting . . . . 78 Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . 79 Item 9 Changes in and Disagreements with Accountants on Accounting Item 9A Item 9B Part III Item 10 Item 11 Item 12 Item 13 Item 14 Part IV Item 15 and Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Directors and Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . 100 Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 Security Ownership of Certain Beneﬁcial Owners and Management and Related Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Exhibits and Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Item 1. Business Part I CINCINNATI FINANCIAL CORPORATION – INTRODUCTION We are an Ohio corporation formed in 1968. Through our subsidiaries, we have been in business since 1950, marketing commercial, personal and life insurance through independent insurance agencies to businesses and individuals. Our headquarters is in Fairfield, Ohio. At year-end 2005, we had 3,983 associates, with approximately 2,800 headquarters associates providing support to approximately 1,150 field associates. Cincinnati Financial Corporation (CFC) owns 100 percent of three subsidiaries: The Cincinnati Insurance Company, CFC Investment Company and CinFin Capital Management Company. The Cincinnati Insurance Company owns 100 percent of our three smaller insurance subsidiaries: The Cincinnati Casualty Company, The Cincinnati Indemnity Company and The Cincinnati Life Insurance Company. The Cincinnati Insurance Company, founded in 1950, leads the property casualty group known as The Cincinnati Insurance Companies. The Cincinnati Casualty Company and The Cincinnati Indemnity Company round out the property casualty insurance group, providing flexibility in pricing and underwriting while ceding substantially all of their business to The Cincinnati Insurance Company. The Cincinnati Life Insurance Company primarily markets life insurance and annuities. CFC Investment Company complements the insurance subsidiaries with leasing and financing services. CinFin Capital Management Company provides asset management services to institutions, corporations and high net worth individuals. Our filings with the Securities and Exchange Commission (SEC) are available, free of charge, on our Web site, www.cinfin.com, as soon as possible after they have been filed with the SEC. These filings include our annual reports on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. In the following pages we reference various Web sites. These Web sites, including our own, are not incorporated by reference in this Annual Report on Form 10-K. Periodically, we refer to estimated industry data so that we can give information about our performance versus the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory basis. When we provide our results on a comparable statutory basis, we label it as such; all other company data is presented in accordance with accounting principles generally accepted in the United States of America (GAAP) . OUR BUSINESS AND OUR STRATEGY INTRODUCTION Our company was founded more than 50 years ago by independent agents to support the ability of local independent property casualty insurance agents to deliver quality financial protection to people and businesses in their communities. Today, we operate much the same way, actively marketing commercial insurance policies in 32 states through a select group of independent insurance agencies. We actively market all of our personal lines insurance policies in 22 of those states. We seek to become the life insurance carrier of choice for the agencies that market our property casualty insurance products and offer other financial services to help agents and their clients – the policyholders. Our company distinguishes itself in three ways: • We cultivate relationships with the independent insurance agents who market our policies and we make our decisions at the local level • We achieve claims excellence, covering the spectrum from our response to reported claims to our approach to establishing reserves for not-yet-paid claims • We invest for long-term total return, using available cash flow to purchase equity securities after covering insurance liabilities by purchasing fixed-maturity securities CULTIVATING RELATIONSHIPS WITH INDEPENDENT INSURANCE AGENTS The U.S. property casualty insurance industry is a highly competitive marketplace with approximately 3,100 stock and mutual companies operating independently or in groups. No single company or group dominates across all product lines and states. Insurance companies (carriers) can market a broad array of products nationally or: • • choose to sell a limited product line or only one type of insurance (monoline carrier) target a certain segment of the market (for example, personal insurance) 2005 10-K Page 1 focus on one or more states or regions (regional carrier) • Property casualty insurers generally market their products through one or more distribution channels: • • independent agents, who represent multiple carriers, captive agents, who represent one carrier exclusively, or • direct marketing through the mail or Internet Some carriers use more than one channel. For the most part, we compete with insurance companies that market through independent insurance agents. Independent Agency Distribution System We are committed to the independent agency distribution system, offering a broad array of commercial, personal and life insurance products through this channel. We recognize that locally based independent agencies have relationships in their communities that can lead to policyholder satisfaction, loyalty and profitable business. Our field associates provide service and accountability to the agencies, living in the communities they serve and working from offices in their homes, providing 24/7 availability to our agents. At year-end 2005, our 1,024 agency relationships had 1,253 reporting agency locations marketing our insurance products. An increasing number of agencies have multiple, separately identifiable locations, reflecting their growth and consolidation of ownership within the independent agency marketplace. We believe “reporting agency locations,” a new measure for our company, accurately describes our agents’ scope of business and our presence within our 32 active states. At year-end 2004, we had 986 agency relationships with 1,213 reporting agency locations. At year-end 2003, we had 957 agency relationships with 1,185 reporting agency locations. In addition to providing data on reporting agency locations, we continue to give agency relationships metrics, such as our penetration within each agency relationship. Property Casualty Agency Earned Premiums by State In our 10 highest volume states, 853 reporting agency locations wrote 71.1 percent of our 2005 total property casualty agency earned premium volume. Agency earned premiums are premiums before reinsurance. (Dollars in millions) Year ended December 31, 2005 Ohio Illinois Indiana Pennsylvania Michigan Georgia Virginia North Carolina Wisconsin Kentucky All other states Total Year ended December 31, 2004 Ohio Illinois Indiana Pennsylvania Michigan Georgia Virginia Wisconsin North Carolina Kentucky All other states Total Earned premium Percent of total Change % Reporting agency locations Avg premium per location $ $ $ $ 737 299 238 192 173 141 134 130 125 102 923 3,194 722 294 235 177 175 129 127 118 117 97 849 3,040 23.1 % 9.4 7.4 6.0 5.4 4.4 4.2 4.1 3.9 3.2 28.9 100.0 % 23.7 % 9.7 7.7 5.8 5.8 4.2 4.2 3.9 3.9 3.2 27.9 100.0 % 2.2 1.7 0.9 8.0 (1.2) 9.5 4.8 10.7 6.4 5.0 8.9 5.1 7.1 7.7 5.5 14.8 12.2 10.1 12.8 10.4 15.8 10.3 14.9 10.8 224 $ 112 99 63 88 59 53 68 49 38 400 1,253 224 $ 113 96 63 83 56 51 49 66 35 377 1,213 3.3 2.7 2.4 3.0 2.0 2.4 2.5 1.9 2.6 2.7 2.3 2.5 3.2 2.6 2.5 2.8 2.1 2.3 2.5 2.4 1.8 2.8 2.2 2.5 In 2004, the most recent period for which data is available, Cincinnati Insurance was the No. 1 or No. 2 carrier in 74 percent of the reporting agency locations that have represented us for more than five years. The independent agencies that we choose to market our products share our philosophies. They do business person to person; offer broad, value-added services; maintain sound balance sheets and manage their agencies professionally. On average, we have a 17.3 percent share of the property casualty insurance in our 2005 10-K Page 2 reporting agency locations. Our share is 24.3 percent in reporting agency locations that have represented us for more than 10 years; 11.5 percent in agencies that have represented us for five to 10 years; 5.1 percent in agencies that have represented us for one to five years; and less than 1 percent in agencies that have represented us for less than one year. Over the next decade, industry analysts predict successful agencies will have opportunities to increase their size on average almost three-fold. Agencies are expected to continue to pursue consolidation opportunities, buying or merging with other agencies to create stronger organizations and expand service. In addition to the growing networks of agency locations owned by banks and brokers, other agencies are addressing the consolidation by forming voluntary associations. These associations, or “clusters,” share back office and other functions to enhance economies, while maintaining their individual ownership structures. No single agency relationship accounted for more than 1.1 percent of our total agency earned premiums in 2005. Some of our agency relationships are with individual offices of bank- or broker-owned organizations. Our relationships are with each office separately, however, no bank- or broker-owned organization, in aggregate, accounted for more than 2.0 percent of our total agency earned premiums in 2005. Strengthening Our Agency Relationships We follow a number of strategies to strengthen our relationships with the independent property casualty insurance agencies that represent us: Risk-specific Underwriting We seek to be a consistent, predictable and reasonable carrier that agencies can rely on to serve their clients. Our field and headquarters underwriters make risk-specific decisions about both new business and renewals. On a case-by-case basis, we select risks we can cover on acceptable terms and at adequate prices rather than underwriting solely by geographic location or business class. For new commercial lines business, this case-by-case underwriting and pricing is coordinated by the local field marketing representatives. Our agents and our field marketing, loss control, bond and machinery and equipment representatives know the people and businesses in their communities and can make informed decisions about each risk. These field marketing representatives also are responsible for selecting new independent agencies, coordinating field teams of specialized company representatives and promoting all of the company's products within the agencies they serve. Commercial lines policy renewals are managed by headquarters underwriters who are assigned to specific agencies and consult with local field staff, as needed. We apply our risk-specific underwriting philosophy to personal lines new and renewal business in a different process. Each agency brings us personal lines business from within the geographic territory that it serves using its knowledge of the risks in those communities. New and renewal business activities are supported by headquarters associates assigned to individual agencies. Competitive Insurance Products We are committed to offering the products and services local agents need to serve their clients – the policyholders. Our commercial lines products are structured to allow flexible combinations of coverages in a single package with a single expiration date. Our intent is to write personal auto and homeowners coverages in personal lines packages that may also include personal umbrella and other coverages. The package approach brings policyholders convenience, discounts and a reduced risk of coverage gaps or disputes. At the same time, it increases account retention and saves time and expense for the agency and our company. Our commercial lines packages are typically offered on a three-year policy term for most insurance coverages, a key competitive advantage. Although we offer three-year policy terms, premiums for some coverages within those policies are adjustable at anniversary for the subsequent annual period, and policies may be cancelled at any time at the discretion of the policyholder. Contract terms often provide that rates for property, general liability, inland marine and crime coverages, as well as policy terms and conditions, are fixed for the term of the policy. The general liability exposure basis may be audited annually. Commercial auto, workers compensation, professional liability and most umbrella liability coverages within multi-year packages are rated at each of the policy's annual anniversaries for the next one-year period. The annual pricing could incorporate rate changes approved by state insurance regulatory authorities between the date the policy was written and its annual anniversary date, as well as changes in risk exposures and premium credits or debits relating to loss experience, competition and other underwriting judgment factors. We estimate that approximately 75 percent of 2005 commercial premiums were subject to annual rating or were written on a one-year policy term. In our experience, multi-year packages are somewhat less price sensitive for the quality-conscious insurance buyers who we believe are typical clients of our independent agents. Customized insurance programs on a three-year term complement the long-term relationships these policyholders typically have with their agents and with the company. By reducing annual administrative efforts, multi-year policies lower expenses for our company and for our agents. The commitment we make to policyholders encourages long-term relationships and reduces their need to annually re-evaluate their insurance carrier or agency. We believe that the 2005 10-K Page 3 advantages of three-year policies in terms of policyholder convenience, account retention and reduced administrative costs outweigh the potential disadvantage of these policies, even in periods of rising rates. Technology Solutions We seek to continuously improve service to and communication with our agencies through an expanding portfolio of software: • Web-based quoting and policy processing systems that allow our agencies and our field and headquarters associates to collaborate more efficiently on new and renewal business and that give our agencies choice and control • Systems that automate our internal processes so our associates can spend more time serving agents and policyholders Agencies access our quoting and policy processing systems via CinciLink®, our secure agency-only Web site. CinciLink also provides other content that makes it easier to do business with us, such as online policy loss information, software updates, online courses on the company’s products and services and electronic coverage forms libraries. We also are giving independent agents enhanced access to Cincinnati’s systems and client data quickly and easily through their agency systems. We recognize the investment agencies have made in agency management systems. In 2005, we gave agents access to CinciLink directly from their agency systems by leveraging industry leading integration products, TransactNOW® and Transformation Station®. In 2006, we plan to advance our usage of these products. For commercial lines, we will enable upload of select client data from the leading agency systems to our new commercial lines pricing and policy systems. For personal lines, agencies will be able to access Diamond billing information and policy detail directly from their agency systems. Three commercial lines and one personal lines system form the core of our quoting and policy processing systems: • WinCPP® is an online commercial lines rate quoting system for businessowners, commercial package, commercial auto and workers compensation policies. WinCPP is available in all 32 states and used by all of our reporting agency locations. During 2006, we will add data sharing capabilities with agency systems and roll out quoting for small specialty programs for metalworkers, professional artisan contractors and garage owners. (A businessowners policy combines property, liability and business interruption coverages for small businesses.) • e-CLAS™ is a commercial lines policy processing system. e-CLAS will make it easier and more efficient for our agencies to issue and administer our commercial lines policies. In 2005, we introduced e-CLAS to all of our agencies in Ohio to process new and renewal businessowners policies. Our primary long-term technology objectives are to: ○ complete development of e-CLAS for all of our commercial lines of business and ○ roll out the system to agencies in all of the states in which we do business During 2006, we expect to roll out businessowners policy processing to four additional states and provide dentists package policy processing in all five e-CLAS states. We also will begin developing commercial auto and commercial package policy processing capabilities. • CinciBond™ is an automated system to process license and permit surety bonds. CinciBond enables agents to issue and print bonds at their offices. CinciBond was delivered to all Ohio agencies and initial groups of Indiana and Illinois agencies in 2005. During 2006, we will continue to deploy CinciBond in Indiana and Illinois. • Diamond is a real-time personal lines policy processing system, supporting all six of our personal lines of business and allowing once and done processing. After its introduction in Kansas in 2002, we began full deployment of Diamond in 2004. At year-end, Diamond was in use in agencies representing approximately 70 percent of our 2005 personal lines premium volume, including those in Alabama, Florida, Kansas, Illinois, Indiana, Michigan and Ohio. In 2005, $417 million of our $786 million of personal lines written premium was issued through Diamond. During 2005, we improved the system’s stability and speed and made additional enhancements requested by our agencies. Training for agents in six states that represent another 21.5 percent of our premium volume is scheduled for 2006. Agents in Georgia, Kentucky and Wisconsin began using Diamond in early 2006 with Minnesota, Missouri and Tennessee roll-outs planned for later in the year. Two systems that automate our internal processes so our associates can spend more time serving agents and policyholders are accessed through CFCNet®, our secure intranet: • CMS™ is a claims file management system. CMS, initially deployed in late 2003, allows simultaneous access to claim files by headquarters and field claims associates. Field and headquarters claims associates use CMS to process all reported claims in a virtual claim file. We continue to refine the system 2005 10-K Page 4 to add capabilities to make our associates more effective. Agent access to selected information is planned for 2006. • i-View™ is a commercial lines policy imaging and workflow system. This system’s online policy viewing capability should speed the delivery and booking of policies as well as help expedite the claims process. We began rolling out i-View in 2004 and it was in use by approximately 50 percent of commercial lines underwriting teams at year-end 2005. Enhancements and infrastructure updates were completed in late 2005. Roll-out to the remaining teams began in January 2006 and we expect it will be completed during 2006. Life Insurance Offerings Diversify Revenues and Earnings We support the independent agencies affiliated with our property casualty operations in their programs to sell life insurance. The products offered by our life insurance subsidiary round out and protect accounts and improve account persistency. At the same time, the life operation looks to increase diversification of revenue and profitability sources for both the agency and our company. Our property casualty agencies make up the main distribution system for our life insurance products. We also develop life business from other independent life insurance agencies. We are careful to solicit business from these other agencies in a manner that does not conflict with or compete with the marketing and sales efforts of our property casualty agencies. We emphasize up-to-date products, responsive underwriting and high quality service as well as competitive commissions. Superior Financial Strength Ratings In addition to the ratings of our parent company senior debt, our property casualty and life operations are awarded insurer financial strength ratings. Insurer financial strength ratings assess an insurer’s ability to meet its financial obligations to policyholders and do not necessarily address matters that may be important to shareholders. As of March 3, 2006, our financial strength ratings were: Financial Strength Ratings: A. M. Best Co. Fitch Ratings Moody's Investors Services Standard & Poor's Ratings Services Property Casualty Statutory Ratings: Risk-Based Capital (RBC) Authorized control level risk-based capital Property casualty statutory surplus Property casualty written premium-surplus ratio Life Statutory Ratings: Risk-Based Capital (RBC) Authorized control level risk-based capital Life statutory surplus Life statutory risk-based adjusted surplus-liabilities ratio Parent Company Senior Debt Property Casualty Insurance Subsidiaries Life Insurance Subsidiary aa- A+ A2 A A++ AA Aa3 AA- A+ AA - AA- $ 4,254 635 4,194 0.7 x $ 511 52 451 37.3 % We believe that our superior insurer financial strength ratings are clear, competitive advantages in the segment of the insurance marketplace that our agents serve. Our financial strength supports the consistent, predictable performance that our policyholders, agents, associates and shareholders have always expected and received, and it must be able to withstand significant challenges. The most important way we seek to ensure that we remain consistent and predictable is to align agents’ interests with those of the company, giving agents outstanding service and compensation to earn their best business. • A.M. Best – In June 2005, A.M. Best affirmed its top A++ (Superior) financial strength ratings and stable outlook for our property casualty subsidiaries. Less than 2 percent of the 1,064 insurer groups A.M. Best reviews annually qualify for the A++ rating. A.M. Best cited our superior risk-based capitalization, successful business position developed through building a network of independent agents, very strong financial flexibility and liquidity, excellent interest coverage measures and modest financial leverage. A.M. Best said its ratings take into account our high common stock leverage, elevated investment concentration and somewhat geographically concentrated market profile. A.M. Best stated that it expects the property casualty group’s overall operating results and 2005 10-K Page 5 capitalization will remain strong in the near term due to our focused underwriting strategy, strong agency relations and consistently sound loss reserving practices. Also in June 2005, A.M. Best affirmed its A+ (Superior) rating for The Cincinnati Life Insurance Company. A.M. Best cited our life insurance subsidiary’s strategic position within Cincinnati Financial Corporation, our continuing focus on growth with a broad portfolio of life insurance products, expanding geographical presence, emphasis on full-time life insurance specialists, consistently positive statutory operating performance and adequate level of capitalization to manage our risks. A.M. Best said its rating considered the life subsidiary’s significant exposure to common stocks, lower operating profitability due to losses from accident and health business and the effect on surplus of acquisition costs related to writing increased amounts of new business. • Fitch Ratings – In August 2005, Fitch affirmed its AA (Very Strong) insurer financial strength ratings and stable outlook for our property casualty subsidiaries and life insurance subsidiary. Fitch cited the strong financial condition of our operating subsidiaries, excellent financial flexibility, successful total return investment strategy and competitive advantage derived from long-term relationships with independent agents who distribute our products. Fitch said its ratings consider the property casualty group’s significant investment concentration in a small number of common stocks, geographic concentration that contributes to sizable catastrophe exposure and regulatory concentration and underperforming homeowner line of business. Fitch stated that it expects that financial leverage will remain at or near its current level over the intermediate term. • Moody’s Investors Service – Following our announcement of third-quarter 2005 results, Moody’s commented that the company’s strong balance sheet and conservative financial and operating leverage metrics continue to support the property casualty subsidiaries’ Aa3 ratings. Moody’s said that its ratings took into account the increased volatility risk to capital and surplus presented by our equity exposure, along with its potential liabilities. Moody’s noted that the company was on track to achieve growth and profitability targets in line with Moody’s expectations for the current ratings. Moody’s said it expects the company will maintain our commercial pricing discipline along with our commitment to agency relationships, an integral filter in the underwriting process. Further, Moody’s expects full deployment of our policy processing system will simplify the process to introduce rate and product changes within our personal lines market. • Standard & Poor’s Ratings Services – In October 2005, Standard & Poor’s issued a corporate ratings report with the rationale for its AA- (Very Strong) ratings of the property casualty subsidiaries and its negative outlook. Standard & Poor’s based the ratings, affirmed in September 2004, on the group’s strong competitive position afforded by its extremely loyal and productive independent agency force, high business persistency, extremely strong capitalization and high degree of financial flexibility. Standard & Poor’s said its outlook took into account the company’s underperformance in our homeowner business; very aggressive investment strategies; slow, deliberate response to changing markets, and volatility related to geographic concentration. Standard & Poor’s stated that it expects that the company should continue to perform well in its largest business segment, commercial lines, while lagging peers in personal lines profitability over the near term. Although progress could be tempered by slower growth, the sizeable equity position, adverse regulatory or judicial decisions or catastrophes, Standard & Poor’s said, it expects capitalization and growth will remain extremely strong and growth will be solid as new agency appointments and territory subdivisions partially offset possible weakening in industry pricing. A December 2005 corporate ratings report gave the rationale for Standard & Poor’s AA- (Very Strong) rating of The Cincinnati Life Insurance Company. Standard & Poor’s based the rating, affirmed in September 2004, on the life subsidiary’s strategic position within our group of companies, an extraordinarily superior capital position, extremely strong liquidity and the strength of its marketing position among independent agents. Standard & Poor’s said its rating considered the modest but growing penetration of our property casualty customer base, a narrow but growing product line and asset/liability management in the early stage of development. Standard & Poor’s outlook included expectations for premium growth of 9 percent, continued broadening of our product portfolio, improved asset/liability management, continued extremely strong capital and liquidity, as well as improved benchmarks for tracking penetration of the property casualty customer base. While the potential for volatility exists due to our catastrophe exposures, investment philosophy and bias toward incremental change, the ratings agencies consistently have asserted that we have built appropriate financial strength and flexibility to manage that volatility. We remain committed to strategies that emphasize long-term stability over short-term benefits that might accrue by quick reaction to changes in market conditions. For example, through all market and economic cycles we maintain strong insurance company statutory surplus, a solid reinsurance program, sound reserving practices and low interest rate risk, as well as low debt and 2005 10-K Page 6 strong capital at the parent-company level. Investments at the parent company give us flexibility to support our capitalization policies for the subsidiaries, improve the ability of the insurance companies to write additional premiums and maintain high insurer financial strength ratings. In 2004, we transferred approximately 32 million shares of our Fifth Third Bancorp (Nasdaq: FITB) common stock holding to the insurance subsidiary from the parent company to reduce parent company investment assets. The transfer raised our property casualty statutory surplus and reduced our ratio of net written premiums to statutory surplus. This ratio is a common measure of operating leverage used in the property casualty industry. It serves as an indicator of the company’s premium growth capacity. The estimated property casualty industry net written premium to statutory surplus ratio was 1.0 percent, 1.1 percent and 1.2 percent in 2005, 2004 and 2003, respectively. We do not intend to leverage our lower ratio following the asset transfer by accelerating growth or strengthening loss reserves. Rather, the transfer allowed us to retain the financial flexibility that continues to support our high insurer financial strength ratings. Cincinnati Life’s statutory adjusted risk-based surplus increased 4.1 percent to $511 million at December 31, 2005, from $491 million a year earlier. Statutory adjusted risk-based surplus as a percentage of liabilities, a key measure of life insurance company capital strength, was 37.3 percent at year-end 2005 compared with an estimated industry average ratio of 10.4 percent. The higher the ratio, the stronger an insurer’s security for policyholders and its capacity to support business growth. At year-end 2005 and 2004, the risk-based capital (RBC) for our property casualty and life operations was exceptionally strong and well above levels that would have required regulatory action. Programs, Products and Services to Support Agency Growth We continue to expand the services we provide that support agency opportunities. Accessible field representatives are the first layer of support. Headquarters associates also provide agencies with underwriting, accounting and technology assistance and training. Company executives, headquarters underwriters and special teams regularly travel to visit agencies. Agents have opportunities for direct, personal conversations with our senior management team, and headquarters associates have opportunities to refresh their knowledge of marketplace conditions and field activities. The field marketing representatives are joined by field claims, loss control, machinery and equipment, bond, premium audit, life insurance and leasing specialists. For example, our field engineering and loss control representatives perform inspections and recommend specific actions to improve the safety of the policyholder’s operations and the quality of the agent’s insurance account. We complement the property casualty operations by providing products and services that help attract and retain high-quality independent insurance agencies. CFC Investment Company offers equipment and vehicle leases and loans for independent insurance agencies, their commercial clients and other businesses. It also provides commercial real estate loans to help agencies operate and expand their businesses. CinFin Capital Management markets asset management services to agencies and their clients, as well as other institutions, corporations and high net worth individuals. When we appoint agencies, we look for organizations with knowledgeable, professional staffs. In turn, we make an exceptionally strong commitment to assist them in keeping their knowledge up to date and educating new people they bring on board as they grow. Numerous activities at our headquarters, in regional and agency locations and online fulfill this commitment: • At our headquarters, we conduct roundtables for agency principals, as well as our regular schedule of commercial lines, personal lines and life insurance agent schools and seminars. These generally focus on Cincinnati product and underwriting information and sales tips. In addition to schools for agents, we have opened seats for agents in our structured classroom training for new underwriting associates. Agency staff may return to their agencies after the class or stay and become fully grounded in Cincinnati philosophy by serving as an associate for a few years before returning to the agency. • Associates travel to regional and agency locations to instruct classes and provide a variety of educational support services. Teams conduct personal lines customer service representative training and marketing seminars to promote cross-serving and sales of bonds, leasing services, life worksite marketing, inland marine coverages and our program for dentists. Other teams help agencies learn to use our new systems or get the most from their own agency management systems. Cincinnati associates even co-host client seminars with our agencies on the benefits of worksite marketing or risk management and risk transfer techniques, with customized programs that address liability issues specific to contractor or dentist audiences. • We now bring courses to agency desktops, where at any time agency staff can access the Agency Learning Center through CinciLink, our secure agency-only Web site. The Learning Center offers convenient, online courses and Web conferences, including Cincinnati product information, Microsoft® Office topics and general business subjects. Our new producer and customer service representative curricula guide students through a progression of online courses and classroom instruction. 2005 10-K Page 7 Except travel-related expenses for courses held at our headquarters, most programs are offered at no cost to our agencies. While that approach may be extraordinary in our industry today, the result is quality service for our policyholders and increased success for our independent agencies. Third-party Measures of Satisfaction and Performance The National Association of Insurance Commissioners’ Online Consumer Information Source (www.naic.org) measured our complaint ratio at a very low 0.25 versus the national median score of 1.00 for all property coverages in 2004, the most recent year for which data is available. NAIC members head the state departments of insurance that regulate insurance. The Professional Insurance Agents Association of Ohio surveyed its members in 2005 on satisfaction with their insurance companies. We scored higher than any other insurer in the categories of claims handling, commercial lines competitiveness and agency compensation. Offsetting these top scores and other strong scores in personal lines policy service, company management and field marketing support, were scores lower than all other insurers in both the homeowner competitiveness and the personal auto competitiveness categories. As discussed in Item 7, Personal Lines Insurance Results of Operations, Page 47, we are taking steps to restore a competitive position in personal lines. In a 2005 study, Ward Group named Cincinnati Insurance to its annual top 50 lists of property casualty and life/health insurers in America. Insurers and groups qualify based on financial safety, consistency and performance over a five-year period. Cincinnati is one of only eight property casualty insurers that have qualified for the list in each of its 15 years and one of only 10 property casualty insurers whose life insurance affiliates also qualified. Growing with Our Agencies One of our primary objectives is to increase our written premiums more rapidly than the industry. We believe our agencies are growing more rapidly than the industry, and we seek to maintain or increase our penetration within each agency as it grows. Further improving service through the creation of smaller marketing territories that permit our local field marketing representatives to devote more time to each agency relationship should help us maintain or increase our penetration within each agency. At year-end 2005, we had 100 field marketing territories, up from 92 at the end of 2004 and 87 at the end of 2003. A new Delaware/Maryland territory represented both the subdivision of our existing Maryland territory and our entry into Delaware, our first new state since 2000. While we continually study the regulatory and competitive environment in states where we could decide to actively market our property casualty products, we have not announced plans to enter any of those states in the near future. Another way we seek to increase overall premiums is to selectively appoint new agency relationships within our current marketing territories. In 2004, we set an objective to establish approximately 50 new agency relationships each year. In 2005, we established 41 new agency relationships, and in 2004, we established 50 new relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 40 in 2005 and 22 in 2004. We are very careful to protect the franchise for current agencies when selecting and appointing new agencies. ACHIEVING CLAIMS EXCELLENCE Our claims philosophy reflects our belief that we will prosper as a company by responding to claims person to person, paying covered claims promptly, preventing false claims from unfairly adding to overall premiums and building financial strength to meet future obligations. We also believe that our company should have the financial strength to pay claims while also creating value for shareholders, leading to our emphasis on the establishment of adequate claims reserves. Superior Claims Service Our 751 locally based field claims representatives work from their homes, assigned to specific agencies. They respond personally to policyholders and claimants, typically within 24 hours of receiving an agency’s claim report. We believe the person-to-person approach, together with the resulting high level of service that field claims representatives, familiar with an agency and its policyholders, can provide, gives us a competitive advantage. We also help our agencies provide prompt service to policyholders by giving agencies authority to immediately pay most first-party claims up to $2,500. Catastrophe Response Teams are comprised of volunteers from our experienced field claims staff. As hurricanes threaten, these associates travel to strategic locations near the expected impact area. This puts them in position to quickly get to the affected area, set up temporary offices and start calling on policyholders. Cincinnati takes pride in giving our field personnel the tools and authority they need to do their jobs. In times of widespread loss, our field claims representatives confidently and quickly resolve claims, often writing checks for damages on the same day they inspect the loss. Our Claims Management System introduced new efficiencies that are especially evident during catastrophes. Electronic claim files allow for fast initial contact of 2005 10-K Page 8 policyholders and easy sharing of information between rotating storm teams, headquarters and local field claims representatives. Cincinnati’s claims associates work hard to control costs where appropriate. We have several relationships with vendors that offer our insureds and claimants preferred rates. However, our biggest cost control program is our field claims representatives. Field claims representatives are educated continuously on new techniques and repair trends. These representatives have experience with area body shops, which helps them negotiate the right price with any facility the policyholder chooses. We staff a Special Investigations Unit (SIU) with former law enforcement and claims professionals who are available to gather facts to help determine the fair amount to pay under a claim. While we believe it’s our job to pay all that is due under each policy, we also want to prevent false claims from unfairly increasing overall premiums. Our SIU also operates a computer forensic lab, using sophisticated software to recover data and mitigating the cost of computer-related claims for business interruption and loss of records. Loss and Loss Expense Reserves When claims are made by or against policyholders, any amounts that our property casualty operations pay or expect to pay for covered claims are termed losses. The costs we incur in investigating, resolving and processing these claims are termed loss expenses. Our consolidated financial statements include property casualty loss and loss expense reserves that estimate the costs of not-yet-paid claims incurred through December 31 of each year. The reserves include estimates for claims that have been reported to us plus our estimates for claims that have been incurred but not yet reported, along with our estimate for loss expenses associated with processing and settling those claims. We develop the various estimates based on individual claim evaluations and statistical projections. We reduce the loss reserves by an estimate for the amount of salvage and subrogation we expect to recover. For at least the past 10 years, our annual review of our estimates has led to savings from favorable development of loss reserves from prior accident years. We encourage you to review several sections of the Management’s Discussion and Analysis where we discuss our loss reserves in greater depth. In Item 7, Critical Accounting Estimates, Property Casualty Loss and Loss Expense Reserves, Page 35, we discuss our process for analyzing potential losses and establishing reserves. In Item 7, Property Casualty Insurance Reserves, Page 61, we review reserve levels, including 10-year development of our property casualty loss reserves. INVESTING FOR LONG-TERM TOTAL-RETURN While we seek to generate an underwriting profit in our insurance operations, our investments historically have provided our primary source of net income and contributed to our financial strength, driving long-term growth in shareholders’ equity and book value. Under the direction of the investment committee of the board of directors, our portfolio managers seek to balance current investment income opportunities and long-term appreciation so that current cash flows can be compounded to achieve above-average long-term total return. We invest some portion of cash flow in tax-advantaged fixed-maturity and equity securities to maximize after-tax earnings. With premiums generally received before claims are made under the policies purchased with those premiums, particularly for business lines such as workers compensation, we have substantial cash flow available for investment. Insurance regulatory and statutory requirements established to protect policyholders from investment risk have always influenced our investment decisions on an individual insurance company basis. After covering both our intermediate and long-range insurance obligations with fixed-maturity investments, we historically used available cash flow to invest in equity securities. Investment in equity securities has played an important role in achieving our portfolio objectives and has contributed to net unrealized investment gains of $5.067 billion at year-end 2005. We remain committed to our long-term equity focus, which we believe is key to our company’s long-term growth and stability. OUR SEGMENTS Consolidated financial results primarily reflect the results of our four reporting segments. These segments are defined based on financial information we use to evaluate performance and to determine the allocation of assets. • Commercial lines property casualty insurance • Personal lines property casualty insurance • Life insurance Investments • We also frequently evaluate results for our consolidated property casualty operations, which is the total of our commercial lines and personal lines segments. Our consolidated property casualty operations generated 80.8 percent of our revenues in 2005. Revenues, income before income taxes, and identifiable assets for each 2005 10-K Page 9 segment are shown in a table in Item 8, Note 17 to the Consolidated Financial Statements, Page 98. Some of that information also is discussed in this section of this report, where we explain the business operations of each segment. The financial performance of each segment is discussed in the Management’s Discussion and Analysis of Financial Condition and Results of Operations, which begins on Page 31. COMMERCIAL LINES PROPERTY CASUALTY INSURANCE SEGMENT The commercial lines property casualty insurance segment contributed $2.254 billion in net earned premiums to total revenues and $285 million to income before income taxes in 2005. Commercial lines net earned premiums grew 6.0 percent in 2005, 11.4 percent in 2004 and 10.8 percent in 2003. Four business lines – commercial multi-peril, workers compensation, commercial auto and other liability – accounted for 89.7 percent of our commercial lines earned premiums. • Commercial multi-peril coverage is a combination of property and liability coverages. Property insurance covers damages such as those caused by fire, wind, hail, water, theft, vandalism and business interruption resulting from a covered loss. Liability coverage insures businesses against third-party liability from accidents occurring on their premises or arising out of their operations, such as injuries sustained from products sold. • Workers compensation coverages protect employers against specified benefits payable under state or federal law for workplace injuries to employees. In some of our active states, including Ohio, workers compensation coverage is a state monopoly, provided solely by the state instead of by private insurers. • Commercial auto coverages protect businesses against liability to others for both bodily injury and property damage, medical payments to insureds and occupants of their vehicles, physical damage to an insured’s own vehicle from collision and various other perils, and damages caused by uninsured motorists. • Other liability coverages include commercial umbrella, commercial general liability and most executive risk policies, which cover liability exposures including bodily injury, directors and officers and employment practices, property damage arising from products sold and general business operations. The remainder of our commercial lines earned premiums derives from a variety of other types of insurance products that we offer to businesses, including fire and allied lines commercial property policies, inland marine policies, fiduciary and surety bonds and machinery and equipment policies. We market our full portfolio of commercial insurance products in 1,245 of our reporting agency locations and all 32 states where we actively market property casualty insurance. There are eight reporting agency locations that market only our surety bond products. Our emphasis is on products that agents can market to small- to mid-size businesses in their communities. In 2005, our 10 highest volume commercial lines states generated 68.8 percent of our agency earned premium compared with 70.0 percent in the prior year. Agency earned premiums in the 10 highest volume states rose 5.2 percent in 2005 and 10.4 percent in 2004. Agency earned premiums in the remaining 22 states rose 10.5 percent in 2005 and 16.2 percent in 2004. Agency earned premiums are premiums before reinsurance. 2005 10-K Page 10 Commercial Lines Agency Earned Premiums by State (Dollars in millions) Year ended December 31, 2005 Ohio Illinois Pennsylvania Indiana Michigan North Carolina Virginia Wisconsin Iowa Georgia All other states Total Year ended December 31, 2004 Ohio Illinois Pennsylvania Indiana Michigan North Carolina Virginia Wisconsin Iowa Tennessee All other states Total Earned premium Percent of total Change % Reporting agency locations Avg premium per location $ $ $ $ 432 241 174 164 130 125 112 98 82 79 739 2,376 415 234 162 160 130 112 107 90 77 72 666 2,225 18.2 % 10.1 7.3 6.9 5.5 5.3 4.7 4.1 3.4 3.3 31.2 100.0 % 18.7 % 10.5 7.3 7.2 5.8 5.0 4.8 4.1 3.4 3.2 30.0 100.0 % 4.0 2.8 7.9 2.9 0.2 11.1 4.6 8.7 6.6 13.6 10.5 6.8 8.1 7.7 14.4 6.8 11.3 15.9 13.5 11.1 12.4 14.4 16.2 12.0 224 $ 112 63 99 88 68 53 49 45 59 393 1,253 $ 224 113 63 96 83 66 51 49 44 30 393 1,212 1.9 2.1 2.8 1.7 1.5 1.8 2.1 2.0 1.8 1.3 1.9 1.9 1.9 2.1 2.6 1.7 1.6 1.7 2.1 1.8 1.7 2.4 1.7 1.8 Commercial Lines Insurance Marketplace For commercial lines, our competition predominately consists of those companies that also distribute through independent agents. The independent agencies that market our commercial lines products typically represent four to 12 standard market insurance carriers, including both national and regional carriers, some of which may be mutual companies. Generally, we believe regional carriers offer us the greatest competition on small- and mid-size commercial accounts because they often are familiar with the local market and focus on differentiating themselves through personal relationships with agencies. Carriers with a national presence provide formidable competition on large commercial accounts and have increasingly targeted smaller commercial accounts, marketing a service-center approach that some agencies find efficient. In our experience, the level of competition varies state by state and region by region, regardless of the carriers represented within a specific agency. Since late 2003, the softening commercial lines marketplace has been characterized by increased competition, particularly for quality new business. Generally, the level of competition has varied by market, by line of business and by size of account. In most markets where we compete, disciplined underwriting generally has remained the norm. We believe carriers are modifying prices rather than changing policy terms and conditions. Prior to Hurricanes Katrina, Rita and Wilma, we anticipated commercial lines insurance market trends in 2006 would reflect accelerated competition with pressure on pricing from the industry’s increasing surplus and improving profitability. We are uncertain what effect the hurricanes, and the related rise in the cost of reinsurance, may have on commercial lines pricing throughout 2006. PERSONAL LINES PROPERTY CASUALTY INSURANCE SEGMENT The personal lines property casualty insurance segment contributed $804 million in net earned premiums to total revenues and $45 million to income before income taxes in 2005. Personal lines net earned premiums grew 1.4 percent in 2005, 6.4 percent in 2004 and 11.2 percent in 2003. The personal auto line of business accounted for 53.8 percent and the homeowner line of business accounted for 35.5 percent of personal lines net earned premium in 2005. • Personal auto coverages protect against liability to others for both bodily injury and property damage, medical payments to insureds and occupants of their vehicle, physical damage to an insured’s own vehicle from collision and various other perils, and damages caused by uninsured motorists. In addition, many 2005 10-K Page 11 states require policies to provide first-party personal injury protection, frequently referred to as no-fault coverage. • Homeowner coverages protect against losses to dwellings and contents from a wide variety of perils, as well as liability arising out of personal activities both on and off the covered premises. The company also offers coverage for condominium unit owners and renters. The remainder of our personal lines earned premium was derived from a variety of other types of insurance products we offer to individuals such as dwelling fire, inland marine, personal umbrella liability and watercraft coverages. We market both homeowner and personal auto insurance products through 773 of our 1,253 reporting agency locations in 22 of the 32 states in which we market commercial lines insurance. We market homeowner products through 22 locations in three additional states (Maryland, North Carolina and West Virginia.) The remaining 458 locations are in states where we either do not actively market these products or where we have determined, in conjunction with agency management, that our personal lines products are not appropriate for their agencies at this time. In 2005, our 10 highest volume personal lines states generated 85.0 percent of our agency earned premium compared with 85.1 percent in the prior year. Agency earned premiums in the 10 highest volume states rose 0.3 percent in 2005 and 6.5 percent in 2004. Agency earned premiums in the remaining states rose 1.1 percent in 2005 and 12.9 percent in 2004. Agency earned premiums are premiums before reinsurance. Personal Lines Agency Earned Premiums by State (Dollars in millions) Year ended December 31, 2005 Ohio Indiana Illinois Georgia Michigan Alabama Kentucky Wisconsin Florida Virginia All other states Total Year ended December 31, 2004 Ohio Indiana Illinois Georgia Michigan Alabama Kentucky Wisconsin Florida Virginia All other states Total $ $ $ $ Earned premium Percent of total Change % Reporting agency locations Avg premium per location 305 74 59 62 43 40 37 27 26 21 124 818 306 76 61 60 45 38 36 28 25 20 120 815 37.4 % 9.0 7.2 7.6 5.2 4.9 4.6 3.3 3.2 2.6 15.0 100.0 % 37.6 % 9.3 7.4 7.3 5.5 4.7 4.4 3.4 3.0 2.5 14.9 100.0 % (0.3) (3.1) (2.5) 4.8 (5.3) 4.3 5.3 (1.2) 6.9 5.8 1.1 0.4 5.7 2.7 7.7 5.9 14.9 2.9 13.3 8.2 4.7 9.1 12.9 7.4 211 $ 65 78 46 66 24 33 30 10 23 209 795 202 $ 67 80 44 60 25 31 30 10 22 207 778 1.4 1.1 0.8 1.4 0.6 1.7 1.1 0.9 2.6 0.9 0.6 1.0 1.5 1.1 0.8 1.3 0.8 1.5 1.1 0.9 2.5 0.9 0.6 1.0 Personal Lines Insurance Marketplace In addition to carriers that market through independent agents, our personal lines competition also includes carriers that market through captive agents and direct writers, which our agencies’ clients may investigate independently. The independent agencies that market our personal lines products typically represent five to eight standard personal lines carriers. In 2003, competition increased in the personal lines marketplace, driven by industrywide improvement in results and favorable frequency and severity trends. This followed several years of rising personal auto and homeowner rates and stricter enforcement of underwriting standards across the industry. The increased competition in the past several years also reflected implementation of tiered rating systems by a growing number of carriers. Carriers that have adopted these systems use multiple variables to segment the market, relying in part on credit-based information and offering a greater number of rate levels. 2005 10-K Page 12 We expect that competition in the personal auto and homeowners markets will continue to increase over the next 12 to 24 months. Despite the record level of industrywide catastrophe losses in 2005 and 2004, many personal lines carriers have reported strong operating results in the past two years and continue to have healthy capital to support business growth. We believe these carriers are focused on gaining market share through the introduction of new products and services, increased advertising expenditures and the use of tiered rating systems that may allow them to target higher quality risks with lower prices. LIFE INSURANCE SEGMENT The life insurance segment contributed $106 million of net earned premiums and $7 million in income before income taxes in 2005. Life insurance segment profitability is discussed in detail in Item 7, Life Insurance Results of Operations, Page 52. The overall mission of our company is supported by The Cincinnati Life Insurance Company. Cincinnati Life helps meet the needs of our agencies, including increasing and diversifying agency revenues. We primarily focus on life products that produce revenue growth through a steady stream of premium payments. By diversifying revenue and profitability for both the agency and our company, this strategy enhances the already strong relationship built by the combination of the property casualty and life companies. Cincinnati Life seeks to become the life insurance carrier of choice for the independent agencies that work with our property casualty operations. We emphasize up-to-date products, responsive underwriting and high quality service as well as competitive commissions. At year-end 2005, approximately 80 percent of our 1,253 property casualty reporting agency locations offered Cincinnati Life’s products to their clients. We also develop life business from other independent life insurance agencies. We are careful to solicit business from these other agencies in a manner that does not conflict with or compete with the marketing and sales efforts of our property casualty agencies. Business Lines Four lines of business – term insurance, whole life insurance, universal life insurance and worksite products – account for approximately 86 percent of the life insurance segment’s revenues: • Term insurance – policies under which the benefit is payable only if the insured dies during a specified period of time or term; no benefit is payable if the insured survives to the end of the term. While premiums are fixed, they must be paid as scheduled. The proposed insured is evaluated using normal underwriting standards. • Whole life insurance – policies that provide life insurance for the entire lifetime of the insured; the death benefit is guaranteed never to decrease and premiums are guaranteed never to increase. While premiums are fixed, they must be paid as scheduled. These policies provide guaranteed cash values that are available to withdrawing policyholders. The proposed insured is evaluated using normal underwriting standards. • Universal life insurance – long-duration life insurance policies. Contract premiums are neither fixed nor guaranteed; however, the contract does specify a minimum interest crediting rate and a maximum cost of insurance charge and expense charge. Premiums are not fixed and may be varied by the contract owner. The cash values available to withdrawing policyholders are not guaranteed and depend on the amount and timing of actual premium payments and the amount of actual contract assessments. The proposed insured is evaluated using normal underwriting standards. • Worksite products – term insurance, whole life insurance, universal life and disability insurance offered to employees through their employer. Premiums are collected by the employer using payroll deduction. Polices are issued using a simplified underwriting approach and for smaller face amounts than similar, regularly underwritten policies. Worksite insurance products provide our property casualty agency force with excellent cross-serving opportunities for both commercial and personal accounts. Agents report that offering worksite marketing to employees of their commercial accounts provides a benefit to the employees at low cost to the employer. Worksite marketing also connects agents with new customers who may not have previously benefited from receiving the services of a professional independent insurance agent. In addition, Cincinnati Life markets: • Disability income insurance - provides monthly benefits to offset the loss of income when the insured person is unable to work due to accident or illness. • Deferred annuities - provide regular income payments that commence after the end of a specified period or when the annuitant attains a specified age. During the deferral period, any payments made under the contract accumulate at the crediting rate declared by the company but not less than a contract-specified guaranteed minimum interest rate. A deferred annuity may be surrendered during the deferral period for a cash value equal to the accumulated payments plus interest less the surrender charge, if any. 2005 10-K Page 13 • Immediate annuities - provide some combination of regular income and lump sum payments in exchange for a single premium. Most of the immediate annuities written by our life insurance segment are purchased by our property casualty companies to settle casualty claims. Life Insurance Marketplace Our life insurance company markets its products through approximately 1,000 of our reporting agency locations in all but one of the 32 states where we actively market property casualty insurance and through 453 additional independent life agencies in a total of 48 states. We do not market life insurance products in Alaska and New York. We market our life insurance products either through independent agencies affiliated with our property casualty operations or through independent life agencies. Our property casualty agencies comprise the main distribution system for our life insurance products. Other life insurance carriers continue to expand the use of nontraditional distribution channels such as banks and financial planners as alternatives to the agency channel. We intend to market solely through independent agencies, with an emphasis on enhancing our relationships with the agencies affiliated with our property casualty insurance operations. When marketing through our property casualty agencies we have several specific competitive advantages. Because our property casualty operations are held in high regard, the property casualty agency’s management is predisposed to consider carefully our proposals to sell our life products. All of our marketing efforts, property casualty and life, are directed by our field marketing department, which assures consistency of message. Our life field marketing representatives regularly meet face-to-face with the agency personnel responsible for life insurance production. The resources of our life headquarters underwriters and other associates are available to the field team to assist in the placement of agency business. We find fewer and fewer of our competitors provide direct, personal contact between the agent and the insurance carrier. Also, we continue to emphasize the cross-serving opportunities between worksite marketing of life insurance products and the property casualty agency’s commercial accounts. For example, in 2006, we are exploring additional programs to simplify the worksite sales process, including electronic enrollment software. We also intend to enhance our worksite product portfolio to make it more attractive to agents. In both the property casualty and independent life agency distribution systems we enjoy the competitive advantages of offering competitive, up-to-date products, providing close personal attention and exhibiting financial strength and stability. We primarily offer products targeted at addressing the needs of small businesses that require key person coverage and individuals who require mortality coverage. Term insurance is our largest life insurance product line. We continue to introduce new term products with features our agents indicate are important. A new term series, which included a return-of-premium feature, replaced the existing term portfolio during 2005. Reaction to the new portfolio has been favorable with approximately 25 percent of applications requesting the return-of- premium feature. In 2006 we are introducing a new universal life product that offers a secondary guarantee that keeps the death benefit in force provided a competitive minimum premium requirement is met. Because of our strong capital position, we can offer a competitive product portfolio including guaranteed products, giving our agents a marketing edge. Our life insurance company maintained strong insurer financial strength ratings in 2005: A.M. Best – A+ (Superior), Fitch -- AA (Very Strong) and Standard & Poor's – AA- (Very Strong, negative outlook). Offsetting our competitive advantages we continue to see consolidation within the life insurance industry and an increased presence of large, well-capitalized carriers. The larger carriers can offer a broader product line, including variable and equity-indexed products. Our competitive advantage can be diminished because we do not have these types of products, particularly during a time when the stock market is performing well. Current statutory laws and regulations require redundant reserves, particularly for preferred risk underwriting classes. These redundant reserves, in turn, depress statutory earnings and require a large commitment of capital. Redundant reserves are a significant issue, not just for our life insurance operations, but for all writers of term insurance and universal life with secondary guarantees. However, larger carriers may be able to better absorb or may be able to securitize the statutory reserve strain associated with competitively priced term insurance and universal life with secondary guarantees. The NAIC recognizes the problems caused by redundant reserves and is following a two-step approach to provide relief. First, the NAIC has asked for comments on an amendment to the mortality table mandated for statutory reserves to incorporate preferred underwriting classifications. The amended table would lower reserve requirements for term insurance products. It may be available for use in statutory statements by December 31, 2006. Second, the NAIC proposes amending the actuarial guidelines for reserve requirements for universal life policies with secondary guarantees. The amendment would allow the use of low-level lapse rates in calculating reserves for these types of universal life plans and also would result in lower reserves. It may be available for use in statutory statements by December 31, 2007. 2005 10-K Page 14 For the longer term, the NAIC has asked for comment proposals on implementing a principles-based reserving system rather than the current formulaic system. While still capturing all material risks, a principles-based system would allow a company to use its own experience, subject to credibility standards and appropriate margins for uncertainty. Also, under the proposed principles-based system, the insurer would fully document and disclose all its assumptions and methods to regulatory officials. INVESTMENTS SEGMENT The investment segment contributed $587 million of our total revenues in 2005, primarily from net investment income and realized investment gains and losses from investment portfolios managed for the holding company and each of the operating subsidiaries. After deducting interest credited to contract holders of the life insurance segment, the investments segment contributed $536 million of income before income taxes, or 65.1 percent of our total income before income taxes. The fair value (market value) of our investment portfolio was $12.657 billion and $12.639 billion at year-end 2005 and 2004, respectively. The cash we generate from insurance operations historically has been invested in three broad categories of investments: • Fixed-maturity investments – Includes taxable and tax-exempt bonds and redeemable preferred stocks • Equity investments – Includes common and nonredeemable preferred stocks • Short-term investments – Primarily commercial paper (In millions) Taxable fixed maturities Tax-exempt fixed maturities Common equities Preferred equities Short-term investments Total At December 31, 2005 2004 Book value Fair value Book value Fair value $ $ 3,304 $ 2,083 1,961 167 75 7,590 $ 3,359 $ 2,117 6,936 170 75 12,657 $ 3,161 $ 1,622 1,918 27 71 6,799 $ 3,376 1,694 7,466 32 71 12,639 Primarily as part of our program to support our high financial strength ratings almost all of our insurance subsidiary’s available cash flow since the second quarter of 2004 has been used to purchase fixed-maturity investments. Our objective was to bring the property casualty subsidiary’s ratio of common stock to statutory surplus in line with our historic sub-100 percent level. The ratio of common stock to statutory surplus for the property casualty insurance group portfolio was 97.0 percent at year-end 2005 compared with 103.5 percent at year-end 2004 and 114.7 percent at year-end 2003. During the same period, we took actions to reduce the parent company's ratio of investment assets to total assets for the parent company below 40 percent, for the reasons we discuss in Item 1A, Risk Factors, Page 21. The ratio of investment assets to total assets for the parent company was 33.9 percent at year-end 2005, compared with 36.3 percent at year-end 2004 and 58.6 percent at year-end 2003. Going forward, we will take into consideration insurance department regulations and ratings agency comments, as well as the trend in these ratios, to determine what portion of new cash flow should be invested in equity securities at the parent and insurance subsidiary levels. In the past, we also have separately reported convertible security investments, which make up approximately 2.4 percent of the total fair value of the investment portfolio. Beginning this year, we are reporting and analyzing convertible securities as either fixed-maturity or equity investments, based on the characteristics of the underlying security (bond or preferred stock). Fixed-maturity and Short-term Investments By maintaining a well diversified fixed-maturity portfolio, we attempt to reduce overall risk. We invest new money in the bond market on a continuous basis, targeting what we believe to be optimal risk-adjusted after- tax yields. Risk, in this context, includes interest rate, call, reinvestment rate, credit and liquidity risks. We do not make a concerted effort to alter duration on a portfolio basis in response to anticipated movements in interest rates. By continuously investing in the bond market, we build a broad, diversified portfolio that we believe mitigates the impact of adverse economic factors. In recent years, we have taken into account the trend toward a flatter corporate yield curve by purchasing higher-quality corporate bonds with intermediate maturities as well as tax-exempt municipal bonds and U.S. agency paper. Our focus on long-term total return may result in variability in the levels of realized and unrealized investment gains or losses from one period to the next. We place a strong emphasis on purchasing current income-producing securities for the insurance companies' portfolios. Within the fixed-maturity portfolio, we invest in a blend of taxable and tax-exempt securities to 2005 10-K Page 15 minimize our corporate taxes. With the exception of U.S. agency paper, no individual issuer's securities accounted for more than 1.0 percent of the fixed-maturity portfolio at December 31, 2005. Taxable Fixed-maturities Taxable fixed-maturity bonds include: • $973 million in U.S. agency paper, which is rated AAA by both Moody’s and Standard & Poor’s. • $1.750 billion in investment-grade corporate bonds that have a Moody's rating at or above Baa 3 or a Standard & Poor's rating at or above BBB-. • $358 million in high-yield corporate bonds that have a Moody's rating below Baa 3 or a Standard & Poor's rating below BBB-. • $278 million in convertible bonds and redeemable preferred stocks. We seek to balance current income with potential changes in market value as well as changes in credit risk when determining whether or not to hold these securities to maturity. Similar to the equity portfolio, the taxable fixed-maturity portfolio is most heavily concentrated in the financials sector, including banks, brokerage, finance and investment and insurance companies. The financials sector represented 26.1 percent and 26.6 percent, respectively, of book value and fair value of the taxable fixed- maturity portfolio at December 31, 2005, compared with 24.1 percent and 24.6 percent of book value and fair value at December 31, 2004. Although it is our largest concentration in a single sector, we believe our percentage in the financials sector is below average for the corporate bond market as a whole. No other sector or industry accounted for more than 10 percent of the taxable fixed-maturity portfolio. Tax-exempt Fixed-maturities We traditionally have purchased municipal bonds focusing on schools and essential services, such as sewer, water or others. While no single municipal issuer accounted for more than 1.2 percent of the tax-exempt municipal bond portfolio at December 31, 2005, there are higher concentrations within individual states. Holdings in Illinois, Indiana, Michigan, Ohio and Texas accounted for 60.6 percent of the municipal bond portfolio at year-end 2005. Fixed-maturity and Short-term Portfolio Ratings Our investments in U.S. agency paper and insured municipal bonds over the past several years have led to a significant rise in the percentage of A and higher rated fixed-maturity and short-term holdings, based on fair value. The majority of our non-rated securities are tax-exempt municipal bonds from smaller municipalities that chose not to pursue a credit rating. Credit ratings as of December 31, 2005 and 2004, for the fixed-maturity and short-term portfolio were: (Dollars in millions) Moody's Ratings Aaa, Aa, A Baa Ba B Caa Ca C Non-rated Total Standard & Poor's Ratings AAA, AA, A BBB BB B CCC CC D Non-rated Total 2005 Fair value Percent to total 2004 Fair value Percent to total 65.8 % $ 19.7 5.8 2.0 0.2 0.0 0.0 6.5 100.0 % $ 58.3 % $ 20.0 6.4 2.1 0.0 0.0 0.0 13.2 100.0 % $ 3,101 1,069 363 125 23 11 0 449 5,141 2,865 1,095 340 154 5 11 4 667 5,141 60.3 % 20.8 7.1 2.4 0.5 0.2 0.0 8.7 100.0 % 55.7 % 21.3 6.6 3.0 0.1 0.2 0.1 13.0 100.0 % $ $ $ $ 3,651 1,094 324 110 13 0 0 359 5,551 3,233 1,112 354 117 2 0 0 733 5,551 2005 10-K Page 16 Attributes of the fixed-maturity portfolio include: Weighted average yield-to-book value Weighted average maturity Weighted average duration to worst Weighted average modified duration Years ended December 31, 2005 2004 5.4 % 9.5 yrs 5.4 yrs 7.1 yrs 5.8 % 9.4 yrs 4.8 yrs 6.9 yrs The decline in the yield-to-book between 2005 and 2004 was due to investments of new cash flow as well as the reinvestment of calls and redemptions at interest rates below historic norms. The average maturity was essentially unchanged. The modified duration remained nearly flat while modified duration to worst, an option adjusted measure, increased. This was primarily due to a slight increase in rates in the intermediate range of the yield curve and our continued emphasis on purchasing municipal bonds, which have a lower pretax yield. We discuss the maturity of our fixed-maturity portfolio in Item 8, Note 2 to the Consolidated Financial Statements, Page 88. Equity Investments Our equity investment portfolio includes both common stocks and nonredeemable preferred stocks. Approximately 87.8 percent of the equity portfolio is made up of a core group of common stocks that we monitor closely to gain an in-depth understanding of their organization and industry. The portfolio also includes a broader group of smaller positions that are a source of trading flexibility and other risk management advantages. Our equity investments had an average dividend yield-to-cost of 11.7 percent at December 31, 2005, compared with 11.5 percent at December 31, 2004. Common Stocks At December 31, 2005, 35.1 percent of our common stock holdings (measured by fair value) were held at the parent company level. Our common stock investments generally are securities with annual dividend yields of 1.5 percent to 3.0 percent and histories of dividend increases. Other criteria we evaluate include increasing sales and earnings, proven management and a favorable outlook. When investing in common stock, we seek to identify some companies in which we can accumulate more than 5 percent of their outstanding shares. At year-end 2005, we held more than 5 percent of Fifth Third, FirstMerit Corporation, Piedmont Natural Gas Company and First Financial Bancorp. There also is a core group of common stocks in which the company holds a fair value of at least $100 million each. At year-end 2005, there were 14 holdings in that core group. Largest Common Stock Holdings (Dollars in millions) As of and for the year ended December 31, 2005 Fifth Third Bancorp ALLTEL Corporation ExxonMobil Corporation The Procter & Gamble Company National City Corporation PNC Financial Services Group, Inc. Wyeth Alliance Capital Management Holding L.P. U.S. Bancorp Wells Fargo & Company FirstMerit Corporation Johnson & Johnson Piedmont Natural Gas Company, Inc. Sky Financial Group, Inc. All other common stock holdings Total Actual cost Fair value Percent of fair value 283 $ 117 133 105 171 62 62 53 113 66 54 115 62 91 474 1,961 $ 2,745 801 503 335 329 291 204 179 172 139 139 139 134 130 696 6,936 39.6 % $ 11.6 7.3 4.8 4.7 4.2 2.9 2.6 2.5 2.0 2.0 2.0 1.9 1.9 10.0 100.0 % $ Earned dividend income 106 20 10 6 14 10 4 9 7 5 6 3 4 4 22 230 Earned dividend to fair value 3.9 % 2.5 2.0 1.8 4.3 3.2 2.0 5.0 4.1 3.2 4.2 2.0 2.9 3.2 3.2 3.3 $ $ In 2005, we sold 475,000 shares of our holdings of ALLTEL Corporation, which was our second largest common stock holding at year-end. We completed the sale of the remaining 12,700,164 shares of ALLTEL common stock in January 2006. ALLTEL was an excellent investment for the company for over 40 years, bringing an increasing flow of dividend income and healthy market value appreciation. Because of the restructuring that ALLTEL announced in late 2005, we determined that it no longer met our investment parameters. This emphasis on a small group of equities and long-term investment horizon has resulted in significant concentrations within the portfolio, as this buy-and-hold strategy over many years has built up significant accumulated unrealized appreciation within the equity portfolio. At year-end 2005, the largest industry 2005 10-K Page 17 concentrations within our common stock holdings were the financials sector at 63.4 percent of total fair value and the healthcare sector at 6.4 percent of total fair value. Nonredeemable Preferred Stocks We evaluate preferred stocks similar to the evaluation we make for fixed-maturity investments, seeking attractive relative yields. We generally focus on investment-grade preferred stocks issued by companies that have a strong history of paying common dividends, which provides us with another layer of protection. Additionally, when possible we seek out preferred stocks that offer a dividend received deduction. Additional information regarding the composition of investments is included in Item 8, Note 2 to the Consolidated Financial Statements, Page 88. OTHER We report as “Other” the operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding investment activities) as well as other income of our insurance subsidiary. As of December 31, 2005, CFC Investment Company had 2,815 accounts and $101 million in gross receivables, compared with 2,489 and $92 million at December 31, 2004. As of December 31, 2005, CinFin Capital had 64 institutional, corporate and individual clients and $864 million under management, compared with 60 and $827 million at December 31, 2004. REGULATION STATE REGULATION The business of insurance primarily is regulated by state law. Although our insurance subsidiaries are domiciled in Ohio and primarily subject to Ohio insurance laws and regulations, we also are subject to state regulatory authorities of all states in which we write insurance. The state laws and regulations that have the most significant effect on our insurance operations and financial reporting are discussed below. • Insurance Holding Company Regulation – Our subsidiaries primarily engage in the property casualty insurance business and secondarily in the life insurance business, both subject to regulation as an insurance holding company system by the State of Ohio. These regulations require that we annually furnish financial and other information about the operations of the individual companies within the holding company system. All transactions within a holding company affecting insurers must be fair and equitable. Notice to the state insurance commissioner is required prior to the consummation of transactions affecting the ownership or control of an insurer and prior to certain material transactions between an insurer and any person or entity in its holding company. In addition, some of those transactions cannot be consummated without the commissioner’s prior approval. • Subsidiary Dividends -- The dividend-paying capacity of our insurance subsidiaries is regulated by the laws of Ohio, the domiciliary state. This regulation requires an insurance subsidiary to provide a 10-day advance informational notice to the Ohio insurance department prior to payment of any dividend or distribution to its shareholders (all of our smaller insurance subsidiaries are 100 percent owned by The Cincinnati Insurance Company, which is 100 percent owned by Cincinnati Financial Corporation). Ordinary dividends must be paid from earned surplus, which is the amount of unassigned funds set forth in an insurance subsidiary’s most recent statutory financial statement. The Ohio Department of Insurance must give prior approval before the payment of an extraordinary dividend by an insurance subsidiary to shareholders. You can find information about the dividends paid by our insurance subsidiary in 2005 in Item 8, Note 8 to the Consolidated Financial Statements, Page 91. • Insurance Operations – All of our insurance subsidiaries are subject to licensing and supervision by departments of insurance in the states in which they do business. The nature and extent of such regulations vary, but generally have their source in statutes that delegate regulatory, supervisory and administrative powers to state insurance departments. Such regulations, supervision and administration of the insurance subsidiaries include, among others, the standards of solvency which must be met and maintained; the licensing of insurers and their agents; the nature and limitations on investments; deposits of securities for the benefit of policyholders; regulation of policy forms and premium rates; policy cancellations and non-renewals; periodic examination of the affairs of insurance companies; annual and other reports required to be filed on the financial condition of insurers or for other purposes; requirements regarding reserves for unearned premiums, losses and other matters; the nature of and limitations on dividends to policyholders and shareholders; the nature and extent of required participation in insurance guaranty funds; and the involuntary assumption of hard-to-place or high-risk insurance business, primarily workers compensation insurance. 2005 10-K Page 18 • Insurance Guaranty Associations -- Each state has insurance guaranty association laws under which the associations may assess life and property casualty insurers doing business in the state for certain obligations of insolvent insurance companies to policyholders and claimants. Typically, states assess each member insurer in an amount related to the insurer’s proportionate share of business written by all member insurers in the state. In 2005, our insurance subsidiaries incurred a negative $3 million for guaranty associations. In 2004, our insurance subsidiaries incurred $2 million. We cannot predict the amount and timing of any future assessments or refunds on our insurance subsidiaries under these laws. • Shared Market and Joint Underwriting Plans -- State insurance regulation requires insurers to participate in assigned risk plans, reinsurance facilities and joint underwriting associations, which are mechanisms that generally provide applicants with various basic insurance coverages when they are not available in voluntary markets. Such mechanisms are most commonly instituted for automobile and workers compensation insurance, but many states also mandate participation in FAIR Plans or Windstorm Plans, which provide basic property coverages. Participation is based upon the amount of a company’s voluntary market share in a particular state for the classes of insurance involved. Underwriting results related to these organizations, which tend to be adverse to our company, have been immaterial to our results of operations. • Statutory Accounting -- For public reporting, insurance companies prepare financial statements in accordance with GAAP. However, certain data also must be calculated according to statutory accounting rules as defined in the NAIC’s Accounting Practices and Procedures Manual. 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. • Insurance Reserves -- State insurance laws require that property casualty and life insurance subsidiaries analyze the adequacy of reserves annually. Our appointed actuaries must submit an opinion that reserves are adequate for policy claims-paying obligations and related expenses. • Risk-Based Capital Requirements -- The NAIC’s risk-based capital (RBC) requirements for property casualty and life insurers serve as an early warning tool for the NAIC and the state regulators to identify companies that may be undercapitalized and may merit further regulatory action. The NAIC has a standard formula for annually assessing RBC. The formula for calculating RBC for property casualty companies takes into account asset and credit risks but places more emphasis on underwriting factors for reserving and pricing. The formula for calculating RBC for life insurance companies takes into account factors relating to insurance, business, asset and interest rate risks. FEDERAL REGULATION Although the federal government and its regulatory agencies generally do not directly regulate the business of insurance, federal initiatives often have an impact. Some of the current and proposed federal measures that may significantly affect our business are discussed below. • The Terrorism Risk Insurance Act of 2002 (TRIA) – TRIA was signed into law on November 26, 2002, and extended on December 22, 2005, in a revised form. TRIA provides a temporary federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. TRIA now is scheduled to expire December 31, 2007. Under regulations promulgated under this statute, insurers are required to offer terrorism coverage for certain lines of property casualty insurance, including property, commercial multi-peril, fire, ocean marine, inland marine, liability, aircraft, surety and workers compensation. In the event of a terrorism event defined by TRIA, the federal government will reimburse terrorism claim payments subject to the insurer’s deductible. The deductible is calculated as a percentage of subject written premiums for the preceding calendar year. Our deductible was $328 million (15 percent of 2004 subject premiums) in 2005, $199 million in 2004 (10 percent of 2003 subject premiums) and $136 million in 2003 (7 percent of 2002 subject premiums). For 2006, the deductible is an estimated $318 million (17.5 percent of 2005 subject premiums). • Health Insurance Portability and Accountability Act of 1996 (HIPAA) – We protect consumer health information pursuant to regulations promulgated under HIPAA. Regulations effective April 14, 2003, require health care providers such as doctors and hospitals, as well as health and long-term care insurers and health care clearinghouses, to institute physical and procedural safeguards to protect the health records of patients and insureds. Effective October 16, 2003, additional regulations required health plans to electronically transmit and receive standardized health care information. These rules and regulations have had a minimal effect on us, as our health insurance writings are limited to our self-funded health plan for our associates and a small number of run-off medical and hospital expense insurance policies. We do not actively market health, medical and hospital expense insurance policies. 2005 10-K Page 19 • Office on Foreign Asset Control (OFAC) — Subject to an Executive Order signed on September 24, 2001, intended to thwart financing of terrorists and sponsors of terrorism, financial institutions were required to block and report transactions and attempted transactions between their organization and persons and organizations named in a list published by OFAC. We currently use a combination of software, third-party vendor and manual searches to accomplish our transaction blocking and reporting activities. • Investment Advisers Act of 1940 -- Our subsidiary, CinFin Capital Management Company, operates an investment advisory business and is therefore subject to regulation by the SEC as a registered investment adviser under the Investment Advisers Act of 1940. This law imposes certain annual reporting, recordkeeping, client disclosure and compliance obligations on CinFin Capital Management. 2005 10-K Page 20 Item 1A. Risk Factors Our business involves various risks and uncertainties that may affect achievement of our business objectives. Many of the risks could have ramifications across our integrated business activities. For example, while risks related to setting insurance rates and establishing and adjusting loss reserves are insurance activities, errors in these areas could have an impact on our investment activities. The following discussion should be viewed as a starting point for understanding the significant risks we face. It is not a definitive summary of their potential impact or of our strategies to manage and control the risks. Please see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, Page 31, for a discussion of those strategies. The risks and uncertainties below are not the only ones we face. There are additional risks and uncertainties that we currently do not believe are material. There also may be risk and uncertainties of which we are not aware. If any risks or uncertainties discussed here develop into actual events, they could have a material adverse effect on our business, financial condition or results of operations. In that case, the market price of our common stock could decline materially. Readers should carefully consider this information together with the other information we have provided in this report and in other reports and materials we file periodically with the Securities and Exchange Commission as well as news releases and other information we disseminate publicly. We rely exclusively on independent insurance agents to distribute our products. We market our products through independent, non-exclusive insurance agents. These agents are not obligated to promote our products and can and do sell our competitors’ products. We must offer insurance products that meet the needs of these agencies and their clients. We need to maintain good relationships with the agencies that market our products. If we do not, these agencies may market our competitors’ products instead of ours, which may lead to us having a less desirable mix of business, which could affect our results of operations. Events or conditions that could diminish a competitive advantage that our independent agencies enjoy: • Downgrade of the financial strength ratings of our insurance subsidiaries. We believe our strong insurer financial strength ratings, in particular the A++ rating from A.M. Best of our property casualty insurance subsidiaries, are an important competitive advantage. Only 16 other insurance groups, or 1.7 percent of all insurance groups, qualify for the A++, A.M. Best’s highest rating. If our property casualty ratings were downgraded, our agents might find it more difficult to market our products or might choose to emphasize the products of other carriers, which could adversely affect our results of operations. • Concerns that doing business with us is difficult or perceptions that our level of service is no longer a distinguishing characteristic in the marketplace. If agents or policyholders believed that we were no longer providing the prompt, reliable personal service that has long been a distinguishing characteristic of our insurance operations, our results of operations could be adversely affected. • Delays in the development, implementation, performance and benefits of technology projects and enhancements or independent agent perceptions that our technology solutions are inadequate to match their needs. A reduction in the number of independent agencies marketing our products, the failure of these agencies to successfully market our products or the choice of these agencies to reduce their writings of our products could reduce our revenues and our results of operations if we were unable to replace them with agencies that produce adequate premiums. Further, policyholders may choose a competitor’s product rather than our own because of real or perceived differences in price, terms and conditions, coverage or service. If the quality of the independent agencies with which we do business were to decline, that also might cause policyholders to purchase their insurance through different agencies or channels. Increased comfort in Internet purchasing could further reduce independent agencies' writings of personal lines products. Please see Item 1, Our Business and Our Strategy, Page 1, for a discussion of our relationships with independent insurance agents. Competition could adversely affect our ability to sell policies at rates we deem adequate. The insurance industry is highly competitive. Competition in our insurance business is based on many factors, including: • Competitiveness of premiums charged • Underwriting and pricing methodologies that allow insurers to identify and flexibly price risks • Underwriting discipline • Terms and conditions of insurance coverage • Rate at which products are brought to market 2005 10-K Page 21 • Technological innovation • Ability to control expenses • Adequacy of financial strength ratings by independent ratings agencies such as A.M. Best • Quality of services provided to agents and policyholders If we were unable to compete effectively because of one or more of these factors, our premium writings could decline and our results of operations and financial condition could be materially adversely affected. Please see Item 7, Commercial Lines, Personal Lines and Life Insurance Results of Operations, Page 41, Page 47, and Page 52, for a discussion of our competitive position in the insurance marketplace. Managing technology initiatives and meeting new data security requirements are significant challenges. While technology can streamline many business processes and ultimately reduce the cost of operations, technology initiatives present short-term cost and implementation risks. In addition, we may have inaccurate expense projections, implementation schedules or expectations regarding the efficacy of the end product. These issues could escalate over time. Data security is subject to increasing regulation. We face rising costs and competing time constraints in meeting compliance requirements of new and proposed regulations. Computer viruses, hackers and other external hazards could expose our data systems to security breaches. These increased risks and expanding regulatory requirements could expose us to data loss, damages and significant increases in compliance costs. Please see Item 1, Technology Solutions, Page 4, for a discussion of our technology initiatives. The effects of emerging or latent claim and coverage issues on our business are uncertain. As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to insurance claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued the insurance policies that could be affected by the changes. As a result, the full extent of liability under our insurance contracts may not be known for many years after a policy is issued. The effects of such unforeseeable emerging and latent claim and coverage issues could adversely affect our results of operations. Please see Item 7, Property Casualty and Life Insurance Reserves, Page 61 and Page 67, for a discussion of our reserving practices. Our loss reserves, our largest liability, are based on estimates and could be inadequate to cover our actual losses. Our financial statements are prepared using GAAP. These principles require us to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ materially from those estimates. For a discussion of the significant accounting policies we use to prepare our financial statements and the material implications of uncertainties associated with the methods, assumptions and estimates underlying our critical accounting policies, please refer to Item 7, Property Casualty Insurance Loss And Loss Expense Reserves, Page 35, and Item 8, Note 1 to the Consolidated Financial Statements, Page 84. Our most critical accounting estimate is of loss reserves. Loss reserves are the amounts we expect to pay for covered claims and expenses we incur to adjust those claims. The loss reserves we establish in our financial statements represent an estimate of amounts needed to pay and administer claims arising from insured events that have occurred, including events that have not yet been reported to us. Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability. Accordingly, our loss reserves for past periods could prove to be inadequate to cover our actual losses and related expenses. Any changes in these estimates are reflected in our results of operations during the period in which the changes are made. An increase in our loss reserves would decrease earnings, while a decrease in our loss reserves would increase earnings. The estimation process for unpaid loss and loss expense obligations involves uncertainty by its very nature. We continually review the estimates and adjust the reserve as facts regarding individual claims develop, additional losses are reported and new information becomes known. Adjustments due to loss development for prior years are reflected in the calendar year in which they are identified. 2005 10-K Page 22 Unforeseen losses, the type and magnitude of which we cannot predict, may emerge in the future. These additional losses could arise from changes in the legal environment, catastrophic events, increases in loss severity or frequency, or other causes. Such future losses could be substantial. Please see Item 7, Property Casualty and Life Insurance Reserves, Page 61 and Page 67, for a discussion of our reserving practices. We could experience an unusually high level of losses due to catastrophic or terrorism events or risk concentrations. Our financial condition, cash flow and results of operations depend on our ability to underwrite and set rates accurately for a full spectrum of risks. We establish our pricing based on assumptions regarding the level of losses that will occur within classes of business, geographic regions and other criteria. A number of factors could cause our assumptions regarding future losses to be inaccurate. In the normal course of our business, we provide coverage for exposures for which estimates of losses are highly uncertain, in particular catastrophic and terrorism events. Catastrophes can be caused by a number of events, including hurricanes, tornadoes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Due to the nature of these events, we are unable to predict precisely the frequency or potential cost of catastrophe occurrences. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. We have catastrophe exposure to: • Hurricanes in the gulf and southeastern coastal regions. • Earthquakes in the New Madrid fault zone, which lies within the central Mississippi valley, extending from northeast Arkansas through southeast Missouri, western Tennessee and western Kentucky to southern Illinois, southern Indiana and parts of Ohio. Tornado, wind and hail in the Midwest, Southeast, mid-Atlantic and Western regions. • We have identified terrorism exposure to general commercial risks in the metropolitan Chicago area as well as small co-op utilities, small shopping malls and small colleges throughout our 32 active states. Additionally, our life insurance subsidiary could be adversely affected in the event of an epidemic such as the avian flu, particularly if the epidemic affects a broad range of the population beyond just the very young or the very old. Our results of operations would be adversely affected if the level of losses we experienced over a period of time exceeded our actuarially determined expectations. In addition, our financial condition would be adversely affected if we were required to sell securities prior to maturity or at unfavorable prices to pay an unusually high level of loss and loss expenses. Securities pricing might be even less favorable if a number of insurance companies needed to sell securities during a short period of time because of unusually high losses from catastrophic events. Our geographic concentration ties our performance to business, economic and regulatory conditions in certain states. We market our property casualty insurance product in 32 states, but our business is concentrated in the Midwest and Southeast. We also have exposure in states where we do not actively market insurance when clients of our independent agencies have business or properties in multiple states. The Cincinnati Insurance Company also participates in three assumed reinsurance treaties with two reinsurers that spread the risk of very high catastrophe losses among many insurers. In 2006, we have exposure to assumed losses of 1 percent of property losses between $400 million and $1.2 billion from a single event under an assumed reinsurance treaty for Munich Re Group. The other two assumed reinsurance treaties are immaterial. In the event of a severe catastrophic event or terrorist attack elsewhere in the world, our insurance losses may be immaterial. However, the companies in which we invest might be severely affected, which could affect our financial condition and results of operations. Please see Item 7, Property Casualty and Life Insurance Reserves, Page 61 and Page 67, for a discussion of our reserving practices. Our ability to obtain or collect on our reinsurance protection could affect our business, financial condition and results of operations. We buy property casualty and life reinsurance coverage to mitigate the liquidity risk of an unexpected rise in claims severity or frequency from catastrophic events or a single large loss. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. If we are unable to obtain reinsurance on acceptable terms and in appropriate amounts, our business and financial condition may be adversely affected. 2005 10-K Page 23 In addition, we are subject to credit risk with respect to our reinsurers. Although we purchase reinsurance to manage our risks and exposures to losses, this reinsurance does not discharge our direct obligations under the policies we write. We would remain liable to our policyholders even if we were unable to recover what we believe we are entitled to receive under our reinsurance contracts. Reinsurers might refuse or fail to pay losses that we cede to them, or they might delay payment. For long-term cases, the creditworthiness of our reinsurers may change before we can recover amounts to which we are entitled. A reinsurer’s insolvency, inability or unwillingness to make payments under the terms of its reinsurance agreement with our insurance subsidiaries could have a material adverse effect on our financial position and results of operations. Prior to 2003, we participated in USAIG, a joint underwriting association of individual insurance companies that collectively function as a worldwide insurance market for all types of aviation and aerospace accounts. At year- end 2005, 36.9 percent, or $251 million, of our total reinsurance receivables were related to USAIG, primarily for September 11, 2001, events. Although more than 99 percent of the reinsurance recoverables associated with USAIG are backed by securities on deposit, if we are unable to collect these receivables, our financial position and results of operations could be materially affected. We no longer participate in new business generated by USAIG and its members. Please see Item 7, 2006 Reinsurance Programs, Page 68, for a discussion of our reinsurance treaties. Our ability to realize our investment objectives could affect our financial condition or our results of operation. We invest premiums received from policyholders and other available cash to generate investment income and capital appreciation, maintaining sufficient liquidity to pay covered claims and operating expenses, service our debt obligations and pay dividends. At year-end 2005, our investment portfolio was $12.657 billion, or 79.1 percent of our total assets. In 2005, our investment operations contributed 15.6 percent of our revenue and 65.1 percent of our total income before income taxes. Investment income is an important component of our revenues and net income. The ability to achieve our investment objectives is affected by factors that are beyond our control, such as inflation, economic growth, interest rates, world political conditions, terrorism attacks or threats and other widespread unpredictable events. These events may adversely affect the economy generally and could cause our investment income or the value of securities we own to decrease. A significant decline in our investment income could have an adverse effect on our net income, and thereby on our shareholders’ equity and our policyholders’ surplus. For more detailed discussion of risks associated with our investments; please refer to Item 7A, Qualitative and Quantitative Disclosures About Market Risk, Page 70. Our investment performance also could suffer because of the types of investments, industry groups and/or individual securities in which we choose to invest. Market value changes related to these choices could cause a material change in our financial condition or results of operations. One of our investments, Fifth Third, accounted for 26.3 percent of our shareholders’ equity at year-end 2005 and dividends earned from our Fifth Third investment were 20.2 percent of our investment income in 2005. If Fifth Third’s common stock price were to further decline significantly, our financial condition could be materially affected. If Fifth Third were to decrease or discontinue its dividend, our results of operation could be materially affected. Because we currently own more than 10 percent of Fifth Third’s outstanding shares, we are limited in the amount of Fifth Third stock we could sell in any given period. This limitation could lead us to hold a sizeable position in Fifth Third even if it would no longer meet our investment parameters. This could result in a variety of adverse consequences depending on the reason we had concluded Fifth Third no longer met our investment parameters. For example, if Fifth Third were to stop paying dividends on its common stock, we would not be able to reinvest quickly in other income-earning investments, which would have a material affect on our results of operations. Please see Item 1, Investments Segment, Page 15, and Item 7, Investments Results of Operations, Page 54, and Liquidity and Capital Resources, Page 57, for discussion of our investment activities. 2005 10-K Page 24 Our status as an insurance holding company with no direct operations could affect our ability to pay dividends in the future. Cincinnati Financial Corporation is a holding company that transacts substantially all of its business through its subsidiaries. Our primary assets are the stock in our operating subsidiaries and our investments. Consequently, our cash flow to pay cash dividends and interest on our long-term debt depends on dividends we receive from our operating subsidiaries and income earned on investments held at the parent-company level. Dividends paid to us by our insurance subsidiary are restricted by the insurance laws of Ohio, our domiciliary state. These laws establish minimum solvency and liquidity thresholds and limits. Currently, the maximum dividend that may be paid without prior regulatory approval is limited to the greater of 10 percent of statutory surplus or 100 percent of statutory net income for the prior calendar year, up to the amount of statutory unassigned surplus as of the end of the prior calendar year. Dividends exceeding these limitations may be paid only with prior approval of the Ohio Department of Insurance. Consequently, at times, we might not be able to receive dividends from our insurance subsidiary or we might not receive dividends in the amounts necessary to meet our debt obligations or to pay dividends on our common stock. This could affect our financial position. Please see Item 1, Regulation, Page 18, and Item 8, Note 8 to the Consolidated Financial Statements, Page 91, for discussion of insurance holding company dividend regulations. We could make investment decisions or experience market value fluctuations that trigger restrictions applicable to the parent company under the Investment Company Act of 1940. Compared to other insurance holding companies, we hold a significant level of investment assets at the parent company level. If these investment assets grow to account for more than 40 percent of parent company’s total assets, excluding assets of our subsidiaries, we might become subject to regulation under the Investment Company Act of 1940. Our operations are limited by the constraint that investment securities held at the holding company level should remain below the 40 percent threshold described above. Efforts to stay below the threshold could result in: • Disposal of otherwise desirable investment securities, possibly under undesirable conditions. Such dispositions could result in a lower return on investment, loss of investment income, and if we were unable to manage the timing of the dispositions, we also might realize unnecessary capital gains, which would increase our annual tax payment. • Limited opportunities to purchase equity securities that hold the potential for market value appreciation, which could hamper book value growth over the long term. • Maintenance of a greater portion of our portfolio of equity securities at the insurance subsidiary, which would cause the parent to be more reliant on its subsidiaries for cash to fund parent-company obligations, including shareholder dividends and interest on long-term debt. If the parent company’s investment assets were to exceed the 40 percent ratio to total assets, excluding investment in its subsidiaries, and if it were determined that the holding company was an unregistered investment company, the holding company might be unable to enforce contracts with third parties, and third parties could seek rescission of transactions with the holding company undertaken during the period that it was an unregistered investment company, subject to equitable considerations set forth in the Investment Company Act. In addition, the holding company could become subject to monetary penalties or injunctive relief, or both, in an action brought by the SEC. Please see Item 8, Note 15 to the Consolidated Financial Statements, Page 96, for discussion of the Investment Company Act of 1940. Item 1B. None Unresolved Staff Comments 2005 10-K Page 25 Properties Item 2. Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building contains approximately 800,000 total square feet. The property, including land, is carried in our financial statements at $73 million as of December 31, 2005, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (1 percent). In 2004, we decided to undertake a $100 million building expansion at our headquarters location in Fairfield, Ohio. Construction of an underground garage and third office tower began in early 2005. The new tower will contain more than 690,000 total square feet, including the garage. It will rise seven stories above three underground parking levels with 700 parking spaces. We estimate a completion date of September 2008 for the project. We believe this expansion will accommodate our business needs for the foreseeable future. The construction project is on schedule and on budget. As of December 31, 2005, construction costs totaled $18 million. Cincinnati Financial Corporation owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property in Fairfield, Ohio. This is a four-story office building containing approximately 124,000 square feet. The property is carried in the financial statements at $7 million as of December 31, 2005, and is classified as land, building and equipment, net, for company use. CFC and our subsidiaries occupy approximately 90 percent of the rentable square feet and unaffiliated tenants occupy approximately 10 percent. The Cincinnati Life Insurance Company owns a four-story office building in the Tri-County area of Cincinnati, Ohio. It contains approximately 102,000 rentable square feet. This property is carried in the financial statements at $3 million as of December 31, 2005, and is classified as other invested assets. Three tenants occupy approximately 50 percent of the rentable square feet. The remaining space is available for lease. Item 3. Neither the company nor any of our subsidiaries is involved in any material litigation other than ordinary, routine litigation incidental to the nature of our business. Item 4. No matters were submitted to a vote of security holders of Cincinnati Financial during the fourth quarter of 2005. Submission of Matters to a Vote of Security Holders Legal Proceedings 2005 10-K Page 26 Part II Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Cincinnati Financial Corporation had approximately 12,000 shareholders of record as of December 31, 2005. Many of our independent agent representatives and most of the 3,983 associates of our subsidiaries own the company’s common stock. We are unable to accurately quantify those holdings because many are beneficially held. Our common shares are traded under the symbol CINF on the Nasdaq National Market. The common stock prices and dividend data below reflect the 5 percent stock dividends paid June 15, 2004 and April 26, 2005. (Source: Nasdaq National Market) Quarter: 1st 2nd 2005 3rd 4th 1st 2004 2nd 3rd High Low Period-end close Cash dividends declared $ 43.92 $ 40.84 41.53 0.290 43.12 $ 38.38 39.56 0.305 42.64 $ 39.00 41.89 0.305 45.95 $ 39.91 44.68 0.305 41.61 $ 37.02 39.41 0.250 41.78 $ 37.90 41.45 0.262 41.70 $ 37.46 39.26 0.262 4th 43.52 36.57 42.15 0.262 Our ability to pay cash dividends may depend on the ability of our insurance subsidiary to pay dividends to the parent company. The dividend restrictions of our insurance company subsidiaries are discussed in Item 8, Note 8 to the Consolidated Financial Statements, Page 91. Information regarding securities authorized for issuance under our equity compensation plans appears in the Proxy Statement under “Equity Compensation Plan Information.” This portion of the Proxy Statement is incorporated herein by reference. Additional information about options granted under our equity compensation plans is available in Item 8, Note 8 and Note 16 to the Consolidated Financial Statements, Pages 91 and 97. The board of directors has authorized share repurchases since 1996. We discuss the board authorization in Item 7, Uses of Capital, Page 61. In 2005, we repurchased a total of 1,500,000 shares (unadjusted for stock dividends). Month January 1 -31, 2005 February 1-28, 2005 March 1-31, 2005 April 1-30, 2005 May 1-31, 2005 June 1-30, 2005 July 1-31, 2005 August 1-31, 2005 September 1-30, 2005 October 1-31, 2005 November 1-30, 2005 December 1-31, 2005 Totals Total number of shares purchased Average price paid per share Total number of shares purchased as part of publicly announced plans or programs Maximum number of shares that may yet be purchased under the plans or programs 0 $ 0 115,000 162,728 379,172 308,100 0 1,035 159,157 0 0 374,808 1,500,000 0.00 0.00 45.54 39.58 39.26 39.41 0.00 39.95 41.74 0.00 0.00 45.13 41.54 0 0 115,000 162,728 379,172 308,100 0 1,035 159,157 0 0 374,808 1,500,000 3,705,977 3,705,977 3,590,977 3,428,249 3,049,077 2,740,977 2,740,977 2,739,942 9,840,843 9,840,843 9,840,843 9,466,035 a) The current repurchase program became effective on September 1, 2005. It replaced a program announced on February 6, 1999, which replaced a program approved in 1996 and updated in 1998. b) The share amount approved for repurchase in 2005 was 10 million shares and the share amount approved for repurchase in 1999 was 17 million shares. c) The current repurchase program has no expiration date. d) No repurchase program has expired during the period covered by the above table. e) The program approved in 1999 was terminated prior to the expiration date when the board approved the current program in August 2005. The program approved in 1996 and updated in 1998 was terminated prior to expiration when the board approved a program in February 1999. There have been no programs for which the issuer has not intended to make further purchases. 2005 10-K Page 27 Item 6. Selected Financial Data (In millions except per share data) Consolidated Income Statement Data Earned premiums Investment income, net of expenses Gross realized investment gains and losses Total revenues Net income Net income per common share: Basic Diluted Cash dividends per common share: Declared Paid Shares outstanding Weighted average, diluted Consolidated Balance Sheet Data Invested assets Deferred policy acquisition costs Total assets Loss and loss expense reserves Life policy reserves Long-term debt Shareholders' equity Book value per share Property Casualty Insurance Operations Earned premiums Unearned premiums Loss and loss expense reserves Investment income, net of expenses Loss ratio Loss expense ratio Expense ratio Combined ratio $ $ $ $ Years ended December 31, 2005 2004 2003 2002 $ $ $ $ 3,164 526 61 3,767 602 3.44 3.40 1.205 1.162 177 12,702 429 16,003 3,661 1,343 791 6,086 34.88 3,058 1,557 3,629 338 49.2 % 10.0 30.0 89.2 % $ $ $ $ 3,020 492 91 3,614 584 3.30 3.28 1.04 1.02 178 12,677 400 16,107 3,549 1,194 791 6,249 35.60 2,919 1,537 3,514 289 49.8 % 10.3 29.7 89.8 % $ $ $ $ 2,748 465 (41) 3,181 374 2.11 2.10 0.90 0.89 178 12,485 372 15,509 3,415 1,025 420 6,204 35.10 2,653 1,444 3,386 245 56.1 % 11.6 27.0 94.7 % 2,478 445 (94) 2,843 238 1.33 1.32 0.81 0.80 180 11,226 343 14,122 3,176 917 420 5,598 31.43 2,391 1,317 3,150 234 61.5 % 11.4 26.8 99.7 % Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2005. One-time charges or adjustments: 2003 -- As the result of a settlement negotiated with a vendor, pretax results included the recovery of $23 million of the $39 million one-time, pretax charge incurred in 2000. 2000 -- The company recorded a one-time charge of $39 million, pretax, to write down previously capitalized costs related to the development of software to process property casualty policies. 2000 -- The company earned $5 million in interest in the first quarter from a $303 million single-premium bank-owned life insurance (BOLI) policy booked at the end of 1999 that was segregated as a Separate Account effective April 1, 2000. Investment income and realized investment gains and losses from separate accounts generally accrue directly to the contract holder and, therefore, are not included in the company’s consolidated financials. 2005 10-K Page 28 2001 2000 1999 1998 1997 1996 1995 $ $ $ $ $ $ $ $ 2,152 421 (25) 2,561 193 1.10 1.07 0.76 0.74 179 11,534 286 13,964 2,887 724 426 5,998 33.62 2,073 1,060 2,894 223 66.6 % 10.1 28.2 104.9 % $ $ $ $ 1,907 415 (2) 2,331 118 0.67 0.67 0.69 0.67 181 11,276 259 13,274 2,473 641 449 5,995 33.80 1,828 920 2,416 223 71.1 % 11.3 30.4 112.8 % $ $ $ $ 1,732 387 0 2,128 255 1.40 1.37 0.62 0.60 186 10,156 226 11,795 2,154 885 456 5,421 30.35 1,658 835 2,093 208 61.6 % 10.0 28.6 100.2 % $ $ $ $ 1,613 368 65 2,054 242 1.31 1.28 0.55 0.54 190 10,296 143 11,484 2,055 536 472 5,621 30.58 1,543 458 1,979 204 65.4 % 9.3 29.6 104.3 % $ $ $ $ 1,516 349 69 1,942 299 1.64 1.61 0.50 0.49 188 8,778 135 9,867 1,937 482 58 4,717 25.71 1,454 442 1,889 199 58.3 % 10.1 30.0 98.4 % $ $ $ $ 1,423 327 48 1,809 224 1.21 1.17 0.44 0.43 191 6,340 128 7,397 1,881 440 80 3,163 17.19 1,367 424 1,824 190 61.6 % 13.8 28.2 103.6 % 1,314 300 31 1,656 227 1.24 1.19 0.39 0.38 191 5,525 120 6,439 1,744 403 80 2,658 14.33 1,263 407 1,691 180 57.6 % 14.7 27.8 100.1 % 2005 10-K Page 29 10-K Page Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Introduction Executive Summary Critical Accounting Estimates Results of Operations Consolidated Property Casualty Insurance Results of Operations Commercial Lines Insurance Results of Operations Personal Lines Insurance Results of Operations Life Insurance Results of Operations Investments Results of Operations Liquidity and Capital Resources Sources of Liquidity Uses of Liquidity Property Casualty Insurance Reserves Life Insurance Reserves 2006 Reinsurance Programs Safe Harbor Statement 31 31 35 39 40 41 47 52 54 57 57 59 61 67 68 69 Item 7A. Quantitative and Qualitative Disclosures About Market Risk Introduction Fixed-maturity Investments Short-term Investments Equity Investments Unrealized Investment Gains and Losses 70 71 72 72 74 2005 10-K Page 30 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations INTRODUCTION The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial position. Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Pages 28 and 29, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 77. We present per share data on a diluted basis unless otherwise noted and we have adjusted those amounts for all stock splits and dividends, including the 5 percent stock dividend paid on April 26, 2005. We begin with an executive summary of our results of operations and outlook, as well as details on critical accounting policies and estimates. Periodically, we refer to estimated industry data so that we can give information on our performance versus the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best, a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory basis. When we provide our results on a comparable statutory basis, we label it as such; all other company data is presented on a GAAP basis. EXECUTIVE SUMMARY Cincinnati Financial Corporation is the parent company of the nation’s 19th largest publicly traded property casualty insurer, based on statutory net written premium volume through the first nine months of 2005. We primarily market commercial lines and personal lines property casualty insurance products through a select group of independent insurance agencies in 32 states. As we discussed in the business description in Item 1, we believe three characteristics distinguish our company and allow us to build shareholder value: • We cultivate relationships with the independent insurance agents who market our policies and we make our decisions at the local level • We achieve claims excellence, covering the spectrum from our response to reported claims to our approach to establishing reserves for not-yet-paid claims • We invest for long-term total return, using available cash flow to purchase equity securities after covering insurance liabilities by purchasing fixed-maturity securities We provide additional detail on these subjects in the Results of Operations and Liquidity and Capital Resources sections of this discussion. Among the factors that influence the consolidated results of operations and financial position of the company, we consider our relationships with independent insurance agents to be the most significant. We seek to be an indispensable partner in each agency’s success. To continue to achieve our performance targets, we must maintain these strong relationships, write a significant portion of each agency’s business and attract new agencies. Conditions in the property casualty markets were challenging in 2005, as we discuss in the business description in Item 1, Our Business and Our Strategy, Page 1. In the commercial lines marketplace, competition continues to accelerate, resulting in a lower premium growth rate. In the personal lines marketplace, our personal lines rates in some territories have not been in a competitive range that would allow our agents to market the benefits of our products, resulting in declining policy retention and lower new business. We believe consistently applying our long-term strategies rather than taking short-term actions will allow us to address these challenges. We seek to meet our agents’ needs, with an eye toward solutions and approaches that will give us an advantage for five, 10 or even more years. As we appoint new agencies, we are looking to build relationships that will grow as successfully as those we have had for 40 or 50 years. In 2005, we achieved most of our objectives for creating shareholder value, as we discuss on Page 33. Although unrealized gains have been down in the past several years because of the decline in the market value of our Fifth Third investment, we believe our portfolio continues to have the potential to increase investment income and provide capital appreciation over the long term. Below we review highlights of our financial results for the past three years and measures of the success of our efforts to create shareholder value. 2005 10-K Page 31 CORPORATE FINANCIAL HIGHLIGHTS Income Statement and Per Share Data (Dollars in millions except share data) Income statement data Earned premiums Investment income, net of expenses Net realized gains and losses (pretax) Total revenues Net income Per share data (diluted) Net income Cash dividends declared 2005 2004 2003 2005-2004 Change % 2004-2003 Change % $ 3,164 $ 526 61 3,767 602 3.40 1.205 3,020 $ 492 91 3,614 584 3.28 1.04 2,748 465 (41) 3,181 374 2.10 0.90 4.8 6.9 (33.1) 4.2 3.1 3.7 16.1 (0.7) 9.9 5.7 321.7 13.6 56.0 56.4 14.4 0.0 Weighted average shares outstanding 177,116,126 178,376,848 178,292,248 In 2005, we reported record results, as described in detail in the results of operations. Revenue growth was slower in 2005 than in 2004 because of slowing consolidated property casualty earned premium growth due to market conditions. Pretax investment income growth accelerated over the three years. Realized gains made a positive contribution in 2005 and 2004 although we recorded a realized loss in 2003. Net income and net income per share reached record levels in 2005 although the growth rates were substantially lower in 2005 than in 2004. A number of factors affected the annual growth rates, including: • The consolidated property casualty underwriting profit improved substantially in 2004 and we sustained healthy profitability in 2005. The factors behind the improvement are discussed in the Results of Operations. • Realized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that will be recognized in any period. That discretion generally is independent of the insurance underwriting process. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. Security sales led to realized gains in 2005 and 2004 while write-downs of impaired assets led to realized losses in 2003. ○ 2005 − Realized investment gains raised net income by $40 million, or 23 cents per share, after tax ○ 2004 − Realized investment gains raised net income by $60 million, or 34 cents per share, after tax ○ 2003 − Realized investment losses reduced net income by $27 million, or 15 cents per share, after tax • Weighted average shares outstanding may fluctuate from period to period because we regularly repurchase shares under board authorizations and we issue shares when associates exercise stock options. At year-end 2005, weighted average shares outstanding on a diluted basis had declined 1.3 million from year-end 2004. • In 2003, we recovered $23 million pretax from a settlement negotiated with a vendor. The recovery added $15 million, or 8 cents per share, to net income. The negotiated settlement related to the $39 million one-time, pretax charge incurred in 2000 to write off previously capitalized software development costs. The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. Cash dividends declared per share rose 16.1 percent and 14.4 percent in 2005 and 2004. Balance Sheet Data and Performance Measures (Dollars in millions except share data) $ Balance Sheet Data Invested assets Total assets Long-term debt Shareholders' equity Book value per share Performance measures Comprehensive income Return on equity Return on equity, based on comprehensive income Debt-to-capital ratio $ 2005 2004 2003 $ 12,702 16,003 791 6,086 34.88 $ 99 9.8 % 1.6 11.5 $ 12,677 16,107 791 6,249 35.60 $ 287 9.4 % 4.6 11.2 12,485 15,509 420 6,204 35.10 815 6.3 % 13.8 8.9 2005-2004 Change % 2004-2003 Change % 0.2 (0.6) 0.0 (2.6) (2.0) 1.5 3.9 88.4 0.7 1.4 (65.8) (64.8) 2005 10-K Page 32 Invested assets and total assets have been relatively flat over the past two years as strong cash flow has been offset by lower unrealized investment gains. This led to a modest decline in shareholders’ equity and book value in 2005. Comprehensive income is net income plus the change in net other accumulated comprehensive income. Change in net other accumulated comprehensive income is the year-over-year difference in unrealized gains on investments. In 2005 and 2004, comprehensive income declined because lower unrealized gains more than offset the increase in net income. Unrealized gains were down primarily because of a decline in the market value of our Fifth Third investment. With net income growing and shareholders’ equity declining, return on equity rose over the past three years. Return on equity based on comprehensive income, however, declined in line with total comprehensive income. We issued $375 million of long-term debt in 2004, raising total long-term debt to $791 million at year-end 2005 and 2004. Our ratio of long-term debt to capital (long-term debt plus shareholders’ equity) rose in 2004 following the new debt issue and remained stable in 2005. Property Casualty Highlights (Dollars in millions) Property casualty highlights Written premiums Underwriting profit GAAP combined ratio Statutory combined ratio 2005 2004 2003 $ $ 3,076 330 89.2 % 89.0 $ 2,997 298 89.8 % 89.4 2,815 140 94.7 % 94.2 2005-2004 Change % 2004-2003 Change % 2.6 10.8 6.5 113.3 The declining trend in overall written premium growth reflected the market factors discussed in Item 1, Commercial Lines and Personal Lines Property Casualty Insurance Segments, Page 10 and Page 11. In each of the past three years, our overall written premium growth rate has exceeded that of the industry. The estimated industry growth rate was 0.7 percent, 4.7 percent and 9.6 percent in 2005, 2004 and 2003, respectively. The 2005 overall industry premium growth rate included an estimated 33.9 percent decline in reinsurance sector premiums. Our consolidated property casualty insurance underwriting profit rose in 2005 and 2004, and our combined ratio improved each year. (The combined ratio is the percentage of each premium dollar spent on claims plus all expenses -- the lower the ratio, the better the performance.) The 2005 improvement reflected lower catastrophe losses, continued strong commercial lines underwriting results, a return to underwriting profitability for personal lines and above-average savings from favorable loss reserve development from prior accident years. The 2004 improvement reflected growth in premiums, in particular more adequate premium per policy, the benefits of other underwriting efforts and above-average savings from favorable loss reserve development from prior accident years. The estimated industry average statutory combined ratios were 102.0 percent, 98.1 percent and 100.2 percent for 2005, 2004 and 2003, respectively. The 2005 overall industry combined ratio included an estimated 150.7 percent reinsurance sector ratio. We also measure a variety of non-financial metrics for our property casualty operations. For example, we monitor our rank within our reporting agency locations. In 2004, we ranked No. 1 or No. 2 by premium volume in 74 percent of the locations that have marketed our products for more than five years. Other measures include subdivision of territories and new agency appointments. In 2005, we subdivided eight field territories, raising the total to 100, and appointed 41 new agency relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 40 in 2005. Agent satisfaction with our technology solutions is, and will continue to be, a requirement for maintaining our strong relationships with these agencies. In 2005, we made additional progress in implementing technology solutions that we believe should make it easier for agencies to do business with us. Among other milestones, we deployed our new commercial lines policy processing system to all of our agencies in Ohio for use in processing new and renewal businessowners policies. We also deployed our personal lines policy processing system in two additional states and made important upgrades and enhancements. MEASURING OUR SUCCESS IN 2006 AND BEYOND We use a variety of metrics to measure the success of our strategies: • Maintaining our strong relationships with our established agencies, writing a significant portion of each agency’s business and attracting new agencies – In 2006, we expect to continue to rank No. 1 or No. 2 by premium volume in at least 74 percent or more of the locations that have marketed our products for more than five years. We expect to subdivide three field territories in 2006 and we are targeting 50 new agency appointments. 2005 10-K Page 33 In 2006, we expect to make further progress in our efforts to improve service to and communication with our agencies through our expanding portfolio of software. In particular, we will continue to deploy our commercial lines and personal lines quoting and policy processing systems that allow our agencies and our field and headquarters associates to collaborate on new and renewal business more efficiently and give our agencies choice and control. We discuss our technology plans for 2006 in Item 1, Technology Solutions, Page 4. • Achieving above-industry-average growth in property casualty statutory net written premiums and maintaining industry-leading profitability by leveraging our regional franchise and proven agency-centered business strategy -- We believe our consolidated property casualty written premiums will be flat to slightly up in 2006 compared with the 2.6 percent increase in 2005. We may not achieve our objective of above- industry-average growth in 2006 because the modest growth we anticipate in commercial lines written premiums, despite increasing competition, may be offsetting the rate-driven declines we anticipate in personal lines written premiums. In addition, the overall industry premium growth is estimated at 3.3 percent in 2006, which includes an estimated 18.6 percent reinsurance sector growth rate. The 2006 industry growth rate for the commercial lines sector is estimated at 2.3 percent and the personal lines sector is estimated at 2.9 percent. Our combined ratio estimate for 2006 is 92 percent to 94 percent on either a GAAP or statutory basis compared with 89.2 percent on a GAAP basis in 2005. We believe the most significant difference will be a lower level of savings from favorable loss reserve development from prior accident years. In 2006, we believe that savings is likely to reduce the combined ratio in the range of 2 to 3 percentage points. Higher-than-normal savings, particularly for liability coverages, reduced the 2005 combined ratio by 5.2 percentage points and the 2004 combined ratio by 6.7 percentage points. We also have raised slightly our estimate of the impact to the 2006 combined ratio from catastrophe losses to the range of 4.0 and 4.5 percentage points from our historic range of 3.0 to 3.5 percentage points. We are taking into account the potential for severe weather, as we’ve seen in the past two years, and the higher retention on our new catastrophe reinsurance treaty. Both the loss and loss expense ratio and underwriting expense ratio trends could affect the combined ratios for our commercial lines and personal lines segments: ○ The degree of price softening in the commercial lines marketplace will affect the 2006 loss and loss expense ratio for that business area, as that ratio may move up slightly as pricing becomes more competitive. ○ The personal lines 2006 loss and loss expense ratio primarily will reflect our ability to offer competitive prices for our personal lines products in that changing marketplace. We believe we have taken the appropriate actions to maintain that ratio near the improved level we achieved in 2005. ○ For both commercial lines and personal lines, lower growth rates could lead to further unfavorable year-over-year comparisons in the ratios of deferred acquisition costs and other underwriting expenses to earned premiums. Continued investment in technology also may contribute to an increase in other underwriting expenses. The estimated industry average 2006 combined ratio is 98.7 percent. • Pursuing a total return investment strategy that generates both strong investment income growth and capital appreciation − In 2006, we are estimating pretax investment income growth to again be in the range of 6.5 percent to 7.0 percent. This outlook is based on the higher anticipated level of dividend income from equity holdings, the investment of insurance operations cash flow and the higher-than- historical allocation of new cash flow to fixed-maturity securities over the past 18 months. We do not establish annual capital appreciation targets. Over the long term, our target is to have the equity portfolio outperform the Standard & Poor’s 500 Index. Over the five years ended December 31, 2005, our compound annual equity portfolio return was a negative 0.8 percent compared with a compound annual total return of 0.5 percent for the Index. In 2005, our compound annual equity portfolio was a negative 4.2 percent, compared with a compound annual total return of 4.9 percent for the Index. Our equity portfolio underperformed the market for these periods because of the decline in the market value of our holdings of Fifth Third common stock over the past five years. • Increasing the total return to shareholders through a combination of higher earnings per share, growth in book value and increasing dividends − We do not announce annual targets for earnings per share or book value. Earnings results in 2006 will be tempered by the first quarter adoption of Statement of Financial Accounting Standards (SFAS) No. 123(R) “Share-Based Payments,” which requires expensing the cost of associate options on our income statement. Our estimate of pro forma option expense, as detailed in Item 8, Note 1 to the Consolidated Financial Statements, Page 84, would have reduced earnings per share by 7 cents to 8 cents in each of the past three years. 2005 10-K Page 34 Over the long term, we look for our earnings per share growth to outpace that of a peer group of national and regional property casualty insurance companies. Long-term book value growth should approximate that of our equity portfolio. The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. In February 2006, the board increased the indicated annual dividend rate 9.8 percent, marking the 46th consecutive year of increases in our indicated dividend rate. We believe our record of dividend increases is matched by only 11 other publicly traded corporations. Over the long-term, we seek to increase earnings per share, book value and dividends at a rate that would allow long-term total return to our shareholders to exceed that of the Standard & Poor’s Composite 1500 Property Casualty Insurance Index. Over the past five years, our total return to shareholders of 40.9 percent matched the return on that Index. • Maintaining financial strength by keeping the ratio of debt to capital below 15 percent and purchasing reinsurance to provide investment flexibility − Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2006. As a result, we believe our debt-to-capital ratio will remain in the range of 11 percent to 12 percent. In December 2005, we finalized our reinsurance program for 2006, updating it to maintain the balance between the cost of the program and the level of risk we retain. Under the new program, our 2006 reinsurance premiums are expected to be $7 million lower than 2005, without taking into account the reinstatement premium incurred in 2005. We provide more detail on our reinsurance programs in 2006 Reinsurance Programs, Page 68. Factors supporting our outlook for 2006 are discussed below in the Results of Operations for each of the four business segments. CRITICAL ACCOUNTING ESTIMATES Cincinnati Financial Corporation’s financial statements are prepared using GAAP. These principles require management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ materially from those estimates. The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 to the Consolidated Financial Statements, Page 84. In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company’s critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate. PROPERTY CASUALTY INSURANCE LOSS AND LOSS EXPENSE RESERVES Overview Our most significant estimates relate to our reserves for property casualty loss and loss expenses. We believe that the stability of our business makes our historical data the most important source for establishing adequate reserve levels. We base reserve estimates on company experience and information from internal analyses and obtain additional information from the appointed actuary. When reviewing reserves, we analyze historical data and estimate the effect of various loss factors. We believe that the following represent the primary risks to our ability to estimate loss reserves accurately: • Court decisions or legislation that result in unanticipated coverage expansions on past and existing policies • Changes in medical inflation and mortality rates that affect workers compensation claims • Changes in claim cost trends, including the effects of general economic and tort cost inflation, not reflected in the historical data used to estimate loss reserves • Changes in reinsurance coverage, not reflected in reserving data, that affect the company's net payments and net case reserves • Payment and reporting pattern changes attributable to the implementation of a new claims management system • Reporting pattern changes attributable to changes in case reserving practices, particularly with respect to umbrella liability claims • Absence of cost-effective methods for accurately assessing asbestos and environmental claim liabilities (see Property Casualty Insurance Reserves, Asbestos and Environmental Reserves, Page 63, for discussion of related reserve levels and trends) 2005 10-K Page 35 Any of these factors could cause our ultimate loss experience to be better or worse than reserves held, and the difference could be material. To the extent that reserves are inadequate and strengthened, the amount of such increase is treated as a charge in the period that the deficiency is recognized, raising the loss and loss expense ratio and reducing earnings. To the extent that reserves are redundant and released, the amount of the release is a credit in the period that the redundancy is recognized, reducing the loss and loss expense ratio and increasing earnings. A reserve change of $31 million would have a 1 percentage point effect on the loss and loss expense ratio, based on 2005 earned premiums, a $20 million effect on income and an 11 cent effect on net income per share. Establishing Reserves Reserves are established for the total of unpaid loss and loss expenses, including estimates for claims that have been reported, estimates for claims that have been incurred but not yet reported (IBNR) and estimates of loss expenses associated with processing and settling those claims. Reserves are determined for the various lines of business. Loss reserves are reduced by salvage and subrogation reserves. We establish case reserves for claims that have been reported within the parameters of coverage provided in the policy. Individual case reserves greater than $35,000 established by field claims representatives are reviewed by experienced headquarters claims supervisors while case reserves greater than $100,000 also are reviewed by headquarters claims managers. The estimates reflect informed judgment and experience of our claims associates based on general insurance reserving practices and their experience with the company. Case reserves are reviewed on a 90-day cycle, or more frequently if specific circumstances require, based on events such as the status of ongoing negotiations. The anticipated effect of inflation is implicitly considered when estimating reserves for loss and loss expenses. While anticipated cost increases due to inflation are considered in estimating ultimate claim costs, increases in average severity of claims are caused by a number of factors that vary by individual type of policy. Average severity projections are based on historical trends adjusted for anticipated changes in underwriting standards, policy provisions and general economic trends. We do not discount any of our property casualty loss and loss expense reserves. In 2001, we began to establish higher initial case reserves on serious injury claims to reflect recent experience indicating the likelihood that juries would ignore significant liability issues in cases involving seriously injured claimants. To establish IBNR reserves on an annual basis, we use a variety of tools, including actuarial and statistical methods. These may include but are not limited to: • • • The Case Incurred Development Method The Paid Development Method The Bornhuetter-Ferguson Method • Probability Trend Family Methods Supplemental statistical information is compiled and reviewed to aid in the application of the actuarial methods. The supplemental data also is used to evaluate the reasonableness of estimates derived from the actuarial methods. This information includes: • Industry loss frequency and severity and premium trends • Past, present and anticipated product pricing • Anticipated premium growth • Other quantifiable trends • Projected ultimate loss ratios We conduct our thorough evaluation of the adequacy of reserves as of the end of the third quarter of each year. As a result, the most significant refinements in reserves historically have been implemented in the fourth quarter. Beginning in 2006, we are conducting a detailed supplemental review as of the end of the fourth quarter of each year in parallel with the outside actuarial review. Less detailed, periodic reviews of reserve adequacy are made at the other quarter ends. A loss review committee, including internal actuaries and representatives from management of multiple operating departments, is responsible for the quarterly review process. The internal actuaries provide a point estimate and a range to summarize their analysis. At year-end 2005 and 2004, IBNR reserves differed from the internal actuarial point estimate by less than 1 percent of our loss and loss expense reserve. 2005 10-K Page 36 Adjusting Reserves While we believe that reported reserves provide for all unpaid loss and loss expense obligations, the estimation processes involve a number of variables and assumptions. We believe this uncertainty is mitigated by the historical stability of our book of business and by our periodic reviews of estimates. As loss experience develops and new information becomes known, the reserves are reviewed and adjusted as appropriate. In this process, we monitor trends in the industry, cost trends, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional exposures to loss. If we determine that reserves established in prior years were not sufficient or were excessive, the change is reflected in current-year results. Actuarial Review As part of our internal processes, we utilize an appointed actuary to provide management with an opinion regarding an acceptable range for adequate statutory reserves based on generally accepted actuarial guidelines. Historically, we have established adequate reserves that have fallen in the upper half of the appointed actuary's range. This approach has resulted in recognition of reserve redundancies for the past 10 years, as we discuss in Development of Loss and Loss Expenses, Page 62. Modestly redundant reserves support our business strategy to retain high financial strength ratings and remain a market for agencies' business in all market conditions. The appointed actuary conducts a thorough evaluation of the adequacy of reserves as of the end of the third quarter of each year and conduct a supplemental review of full-year data at year-end. ASSET IMPAIRMENT Fixed-maturity and equity investments are our largest assets. Certain estimates and assumptions made by management relative to investment portfolio assets are critical. The company's asset impairment committee continually monitors investments and all other assets for signs of other-than-temporary and/or permanent impairment. Among other signs, the committee monitors significant decreases in the market value of the 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, uncollectability of all other assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure to pay interest or dividends or signs indicating that the carrying amount may not be recoverable. The application of our impairment policy resulted in other-than-temporary impairment charges and write-offs of investments that reduced our income before income taxes by $1 million, $6 million and $80 million in 2005, 2004 and 2003, respectively. Other-than-temporary impairment in the value of securities is defined by the company as declines in valuation that meet specific criteria established in the asset impairment policy. Such declines often occur in conjunction with events taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing corporation. These specific criteria include a declining trend in market value, the extent of the market value decline and the length of time the value of the security has been depressed, as well as subjective measures such as pending events and issuer liquidity. Generally, these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and market conditions. We provide information regarding valuation of our invested assets in Item 8, Note 2 to the Consolidated Financial Statements, Page 88. Our portfolio managers constantly monitor the status of their assigned portfolios for indications of potential problems or issues that may be possible impairment issues. If an impairment indicator is noted, the portfolio managers even more closely scrutinize the security. Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, there is little expectation that the value will be recouped in the foreseeable future. The impairment policy defines a security as distressed when it is trading below 70 percent of book value or has a Moody's or Standard & Poor's credit rating below B3/B-. Distressed securities receive additional scrutiny. In 2005 and earlier, a security would have been written down in the event of a declining market value for four consecutive quarters with quarter-end market value below 50 percent of book value, or when a security’s market value is 50 percent below book value for three consecutive quarters. Effective January 1, 2006, a security may be written down in the event of a declining market value for four consecutive quarters with quarter-end market value below 70 percent of book value, or when a security’s market value is 70 percent below book value for three consecutive quarters. A sudden and severe drop in market value that does not otherwise meet the above criteria is reviewed for possible immediate impairment. When evaluating other-than-temporary impairments, the committee considers the company's ability to retain a security for a period adequate to recover a significant percentage of cost. Because of the company's investment philosophy and strong capitalization, it can hold securities that have the potential to recover value until their scheduled redemption, when they might otherwise be deemed impaired. Investment assets that 2005 10-K Page 37 have already been impaired are evaluated based on their adjusted book value and further written down, if deemed appropriate. The decision to sell or write down an asset with impairment indications reflects, at least in part, management's opinion that the security no longer meets the company's investment objectives. We provide detailed information about securities trading in a continuous loss position at year-end 2005 in Item 7A, Unrealized Investment Gains and Losses, Page 74. Other-than-temporary declines in the fair value of investments are recognized in net income as realized losses at the time when facts and circumstances indicate such write-downs are warranted. Permanent impairment charges (write-offs) are defined as those for which management believes there is little potential for future recovery, for example, following the bankruptcy of the issuing corporation. These permanent declines in the fair value of investments are written off at the time when facts and circumstances indicate such write-downs are warranted, and they are reflected in realized losses. Other-than-temporary and permanent impairments are distinct from the ordinary fluctuations seen in the value of a security when considered in the context of overall economic and market conditions. Securities considered to have a temporary decline would be expected to recover their market value, which may be at maturity. Under the same accounting treatment as market value gains, temporary declines (changes in the fair value of these securities) are reflected on our balance sheet in other comprehensive income, net of tax, and have no impact on reported net income. LIFE INSURANCE POLICY RESERVES We establish the reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions. We establish reserves for our universal life, deferred annuity and investment contracts equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals. EMPLOYEE BENEFIT PENSION PLAN We have a defined benefit pension plan covering substantially all employees. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates and expected return on plan assets, which are updated each year. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions. The key assumptions used in developing the 2005 net pension expense were a 5.75 percent discount rate, an 8.0 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent. The 8.0 percent return on plan assets assumption is based partially on the fact that substantially all of the investments held by the pension plan are common stocks that pay annual dividends. We believe this rate is representative of the expected long-term rate of return on these assets. These assumptions were consistent with the prior year except that the discount rate was reduced by one fourth of one percent due to current market conditions. In 2005, the net pension expense was $13 million. In 2006, we expect a net pension expense of $17 million, primarily as a result of a 0.25 percent reduction in the discount rate and increased service costs. Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate would lower our 2006 net income before income taxes by $2 million. Likewise, a 0.5 percentage point decline in the expected return on plan assets would lower our 2005 income before income taxes by $1 million. In addition, the fair value of the plan assets exceeded the accumulated benefit obligation by $8 million at year- end 2005 and $16 million at year-end 2004. The fair value of the plan assets was less than the projected plan benefit obligation by $62 million at year-end 2005 and $41 million at year-end 2004. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. We expect to contribute approximately $10 million to the pension plan in 2006. DEFERRED ACQUISITION COSTS We establish a deferred asset for costs that vary with, and are primarily related to, acquiring property casualty and life business. These costs are principally agent commissions, premium taxes and certain underwriting costs, which are deferred and amortized into income as premiums are earned. Deferred acquisition costs track with the change in premiums. Underlying assumptions are updated periodically to reflect actual experience. Changes in the amounts or timing of estimated future profits could result in adjustments to the accumulated amortization of these costs. 2005 10-K Page 38 For property casualty policies, deferred acquisition costs are amortized over the terms of the policies. For life policies, acquisition costs are amortized into income either over the premium-paying period of the policies or the life of the policy, depending on the policy type. CONTINGENT COMMISSION ACCRUAL Another significant estimate relates to our accrual for contingent (profit-sharing) commissions. We base the contingent commission accrual estimates on property casualty underwriting results and on supplemental property casualty information. Contingent commissions are paid to agencies using a formula that takes into account agency profitability and other factors, such as prompt monthly payment of amounts due to the company. Due to the complexity of the calculation and the variety of factors that can affect contingent commissions for an individual agency, the amount accrued can differ from the actual contingent commissions paid. The contingent commission accrual of $108 million in 2005 contributed 3.5 percentage points to the property casualty combined ratio. If commissions paid were to vary from that amount by 5 percent, it would affect 2006 net income by $4 million, or 2 cents per share, and the combined ratio by approximately 0.2 percentage points. SEPARATE ACCOUNTS We issue life contracts, referred to as bank-owned life insurance policies (BOLI). Based on the specific contract provisions, the assets and liabilities for some BOLIs are legally segregated and recorded as assets and liabilities of the separate accounts. Other BOLIs are included in the general account. For separate account BOLIs, minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders. Separate account assets are carried at fair value. Separate account liabilities primarily represent the contract holders' claims to the related assets and also are carried at the fair value of the assets. Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holders and, therefore, are not included in our Consolidated Statements of Income. However, each separate account contract includes a negotiated realized gain and loss sharing arrangement with the company. This share is transferred from the separate account to our general account and is recognized as revenue or expense. 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 our earnings. For our most significant separate account, written in 1999, realized gains and losses are retained in the separate account and are deferred and amortized to the contract holder over a five-year period, subject to certain limitations. Upon termination or maturity of this separate account contract, any unamortized deferred gains and/or losses will revert to the general account. In the event this separate account holder were to exchange the contract for the policy of another carrier, there would be a surrender charge equal to 10 percent of the contract’s account value during the first five years. Beginning in year six, the surrender charge decreases 2 percent a year to 0 percent in year 11. At year-end 2005, net unamortized realized gains amounted to $1 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded, and charged to the general account. Potentially, losses could be material; however, unrealized losses in the separate account portfolio were less than $4 million at year-end 2005. RECENT ACCOUNTING PRONOUNCEMENTS Information regarding recent accounting pronouncements is provided in Item 8, Note 1 to the Consolidated Financial Statements, Page 84. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements. RESULTS OF OPERATIONS The consolidated results of operations reflect the operating results of each of our four segments along with the parent company and other non-insurance activities. The four segments are: • Commercial lines property casualty insurance • Personal lines property casualty insurance • Life insurance Investments operations • We measure profit or loss for our property casualty and life segments based upon underwriting results. Insurance underwriting results (profit or loss) represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also measure aspects of the performance of our commercial lines 2005 10-K Page 39 and personal lines segments on a combined property casualty insurance operations basis. Underwriting results and segment pretax operating income are not a substitute for net income determined in accordance with GAAP. For the combined property casualty insurance operations as well as the commercial lines and personal lines segments, statutory accounting data and ratios are key performance indicators that we use to assess business trends and to make comparisons to industry results, since GAAP-based industry data generally is not readily available. We also use statutory accounting data and ratios as key performance indicators for our life insurance operations. We do not believe that inflation has had a material effect on consolidated results of operations, except to the extent that inflation may affect interest rates and claim costs. Investments held by the parent company and the investment portfolios for the property casualty and life insurance subsidiaries are managed and reported as the investments segment, separate from the underwriting businesses. Net investment income and net realized investment gains and losses for our investment portfolios are discussed in the Investments Results of Operations. The calculations of segment data are described in more detail in Item 8, Note 17 of the Consolidated Financial Statements, Page 98. The following sections review results of operations for each of the four segments. Commercial Lines Insurance Results of Operations begins on Page 41, Personal Lines Insurance Results of Operations begins on Page 47, Life Insurance Results of Operations begins on Page 52, and Investments Results of Operations begins on Page 54. We begin with an overview of our consolidated property casualty operations, which is the total of our commercial lines and personal lines segments. Our consolidated property casualty operations generated 81.2 percent of our revenues in 2005, and certain factors affected both of our property casualty segments. CONSOLIDATED PROPERTY CASUALTY INSURANCE RESULTS OF OPERATIONS (Dollars in millions) Written premiums Earned premiums Loss and loss expenses excluding catastrophes Catastrophe loss and loss expenses Commission expenses Underwriting expenses Policyholder dividends Underwriting profit Ratios as a percent of earned premiums: Loss and loss expenses excluding catastrophes Catastrophe loss and loss expenses Loss and loss expenses Commission expenses Underwriting expenses Policyholder dividends Combined ratio 2005 2004 2003 2005-2004 Change % 2004-2003 Change % 2.6 4.8 5.0 (14.8) 1.6 16.3 (52.3) 10.8 6.5 10.0 (5.6) 53.4 15.0 40.6 (25.0) 113.3 $ $ $ 3,076 3,058 1,685 127 592 319 5 330 $ $ $ 55.1 % 4.1 59.2 19.4 10.4 0.2 89.2 % 2,997 2,919 1,605 148 583 274 11 298 $ $ $ 55.0 % 5.1 60.1 20.0 9.4 0.3 89.8 % 2,815 2,653 1,700 97 507 194 15 140 64.1 % 3.6 67.7 19.1 7.3 0.6 94.7 % Factors that affected written premiums for property casualty insurance operations included: • New business written directly by agencies – New business written directly by agencies was $314 million, $330 million and $328 million in 2005, 2004 and 2003, respectively. New business levels reflect market conditions for commercial and personal lines. • Reinsurance reinstatement premiums – To restore affected layers of property catastrophe reinsurance programs, we incurred $8 million and $11 million in reinsurance reinstatement premiums in 2005 and 2004. Favorable development of loss reserves from prior accident years affected the combined ratio for property casualty insurance operations. The 2005 and 2004 ratios benefited from higher than normal savings. The 2004 and 2003 ratios benefited from uninsured motorist/underinsured motorist (UM/UIM) reserve releases. Following an Ohio Supreme Court decision in late 2003 to limit its 1999 Scott-Pontzer vs. Liberty Mutual decision, we released UM/UIM reserves as follows: • 2003 − We released $38 million pretax of previously established UM/UIM reserves, adding $25 million, or 14 cents per share, to net income in 2003. • 2004 − In 2004, we reviewed outstanding UM/UIM claims for which litigation was pending. Those claims represented approximately $37 million in previously established case reserves. During the first quarter of 2004, we filed motions for dismissal in various jurisdictions for specific claims and released an additional $32 million in related case reserves. The reserve releases in 2004 added $21 million, or 12 cents per share, to net income. • 2005 − In 2005, we stopped separately reporting on UM/UIM-related reserve actions. The discussions of property casualty segments provide additional detail regarding these factors. 2005 10-K Page 40 COMMERCIAL LINES INSURANCE RESULTS OF OPERATIONS Overview -- Three-year Highlights Performance highlights for the commercial lines segment include: • Premiums – As competition in our commercial markets continues to increase, our written premium growth rate has slowed because of the more competitive pricing environment and the underwriting discipline we have maintained for both renewal and new business. The primary source of growth in the past three years has been higher pricing on new and renewal commercial business aided by property insurance-to-value initiatives and more accurate risk classification. These more than offset our deliberate decisions not to write or renew certain business and the loss of some smaller accounts due to competition. We believe that our written premium growth rate continues to exceed the average for the overall commercial lines industry, which was estimated at 2.7 percent for 2005 and 2.3 percent for 2004. Earned premium growth has slowed because of the declining growth rate of written premiums. Reinsurance reinstatement premiums allocated to commercial lines reduced earned premium growth by 0.2 and 0.3 percentage points in 2005 and 2004, respectively. • Combined ratio – Our commercial lines combined ratio was very strong in 2005 and 2004 largely due to our programs to obtain more adequate premiums per policy and our underwriting efforts. The 3.3 percentage point increase in the 2005 ratio primarily was due to a rise in the loss and loss expense ratio. The increase reflected a single large loss in 2005 that increased the ratio by 1.1 percentage points and savings from favorable loss reserve development below the 2004 level. We discuss large losses and other factors affecting the combined ratio beginning on Page 42. We discuss the savings from favorable loss reserve development by commercial lines of business on Page 45. Our commercial lines statutory combined ratio was 87.1 percent in 2005 compared with 83.7 percent in 2004 and 91.6 percent in 2003. By comparison, the estimated industry commercial lines combined ratio was 99.1 percent in 2005, 102.5 percent in 2004 and 100.2 percent in 2003. Growth and Profitability As competition in the commercial markets has increased, we have maintained our pricing discipline for both renewal and new business. Our independent agents reported steady pressure on pricing during 2005 and communicated that winning new business and retaining renewals required more pricing flexibility and careful risk selection. With the commercial lines pricing environment growing more competitive, we continue to rely on factors other than price to drive sales. Our agents look for the best insurance program for their clients, not just the best price. They serve policyholders well by presenting our value proposition – customized coverage packages, personal claims service and high financial strength ratings – all wrapped up in a convenient three-year commercial policy. We intend to remain a stable market for our agencies’ best business, and believe that our case-by-case approach gives us a clear advantage. Our field marketing associates and our independent agents work together to select risks and respond appropriately to local pricing trends. Historically, they have proven capable of balancing risk and price to achieve growth in new business over the longer term. Staying abreast of evolving market conditions is a critical function, accomplished in both an informal and a formal manner. Informally, our field marketing representatives and underwriters are in constant receipt of market intelligence from the agencies with which they work. Formally, our commercial lines product management group and field marketing associates complete periodic market surveys to obtain competitive intelligence. This market information helps to identify the top competitors by line of business or specialty program and also identifies our market strengths and weaknesses. The analysis encompasses pricing, breadth of coverage and underwriting/eligibility issues. In addition to reviewing our competitive position, our product management group and our underwriting audit group review compliance with our underwriting standards as well as the pricing adequacy of our commercial insurance programs and coverages. Further, our research and development department analyzes opportunities and develops new products, new coverage options and improvements to existing insurance products. In 2003 and 2004, all lines of business grew because of higher premiums per policy. In 2005, growth largely was driven by commercial multi-peril and other liability coverages with commercial auto premiums declining. Commercial auto is one of the first lines to experience pricing pressure because it often represents the largest portion of insurance costs for commercial policyholders. Commercial auto also is one of the larger, annually priced components of our three-year policies. We have more aggressively identified and measured exposures to match coverage amounts and premiums to the risk. Where this matching is not possible, accounts are not renewed unless there are mitigating factors. As a result, we experienced no growth in overall commercial lines policy counts from 2003 to 2005. Agents tell us they agree with the need to carefully select risks and assure pricing adequacy. They appreciate the time our associates invest in creating solutions for their clients while protecting profitability, whether that means working on an individual case or developing modified policy terms and conditions that preserve flexibility, choice and other sales advantages. 2005 10-K Page 41 For new business, our field marketing associates and agents are working together to select risks and respond appropriately to local pricing trends. New commercial lines business was $282 million in 2005, unchanged from 2004. New business was $268 million in 2003. We discuss growth by commercial lines of business on Page45. Commercial Lines Results (Dollars in millions) Written premiums Earned premiums Loss and loss expenses excluding catastrophes Catastrophe loss and loss expenses Commission expenses Underwriting expenses Policyholder dividends Underwriting profit Ratios as a percent of earned premiums: Loss and loss expenses excluding catastrophes Catastrophe loss and loss expenses Loss and loss expenses Commission expenses Underwriting expenses Policyholder dividends Combined ratio $ $ $ 2005 2004 2003 2,290 2,254 1,222 76 438 228 5 285 $ $ $ 54.2 % 3.4 57.6 19.5 10.1 0.2 87.4 % 2,186 2,126 1,083 71 423 200 11 338 $ $ $ 2,031 1,908 1,176 42 361 147 15 167 50.9 % 61.6 % 3.4 54.3 19.9 9.4 0.5 2.2 63.8 18.9 7.7 0.8 84.1 % 91.2 % 2005-2004 Change % 2004-2003 Change % 4.7 6.0 12.9 6.0 3.6 13.5 (52.3) (15.6) 7.6 11.4 (7.9) 68.9 17.1 36.8 (25.0) 102.3 Over the past three years, we have continued to focus on seeking and maintaining adequate premium per exposure as well as pursuing non-pricing means of enhancing longer-term profitability. These have included identifying the exposures we have for each risk and making sure we offer appropriate coverages, terms and conditions and limits of insurance. We continue to adhere to our underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions, where necessary. In addition, we continue to leverage our strong local presence. Our field marketing representatives have met with every agency to reaffirm agreements on the extent of frontline renewal underwriting to be performed by local agencies. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. Field claims representatives prepare full risk reports on every account reporting a loss above $100,000 or on any risk of concern. Multi-departmental task forces have implemented programs to address concerns for specific areas such as contractor and commercial auto risks. These actions have helped to mitigate rising loss severity. We describe the significant costs components for the commercial lines segment below. Loss and Loss Expenses (excluding catastrophe losses) Loss and loss expenses include both net paid losses and reserve additions for unpaid losses as well as the associated loss expenses. We believe more competitive market conditions were one factor in the 3.3 percentage point rise in the loss and loss expense ratio excluding catastrophes between 2005 and 2004. In addition, 2005 results include a single large loss that was insufficiently covered through our facultative reinsurance programs, which increased the 2005 loss and loss expenses by $24 million, net of reinsurance, or 1.1 percentage points. Savings from favorable loss reserve development was lower in 2005 than 2004, which we discuss by commercial lines of business on Page 45. Underwriting actions that led to higher premiums on a relatively stable level of exposures contributed to the 10.7 percentage point decline in the loss and loss expense ratio excluding catastrophes between 2004 and 2003. In addition, savings from favorable loss reserve development was significantly higher in 2004 than 2003. Re-underwriting our commercial lines book of business in the early 2000s has had an impact on reserve development patterns because we are seeing lower frequency of losses. The favorable development in 2005 and 2004 was also due to the headquarters claims department’s initiative, begun in 2001. Since 2001, we have been establishing higher initial case reserves on severe injury claims because our experience indicated that juries often ignore significant liability issues in cases involving seriously injured claimants. These higher initial amounts produce case reserves that reflect our full exposure more accurately. But some claims settle before reaching a jury and some juries make awards that are less than the “worst-case” scenario. As a result, some change in our case reserve development patterns allowed us to also reduce IBNR in 2005. We monitor incurred losses by size of loss, business line, risk category, geographic region, agency, field marketing territory and duration of policyholder relationship, addressing concentrations or trends as needed. Our 2005 analysis indicated no significant concentrations other than trends in business lines that we address as part of our ongoing business operations. We also measure new losses and case reserve increases greater than $250,000 to track frequency and severity. 2005 10-K Page 42 These commercial lines large losses and case reserve increases have been in the range of 15 percent to 17 percent of annual earned premiums since 2003. The primary reason the contribution of these losses to the loss and loss expense ratio rose in 2005 was higher total new losses greater than $1 million. New losses greater than $1 million rose because of a rise in the number of these losses and the single large loss noted above. Total development and case reserve increases of $250,000 or more rose primarily because of two verdicts that exceeded the reserves we had established. Commercial Lines Losses by Size (Dollars in millions) Losses $1 million or more Losses $250 thousand to $1 million Development and case reserve increases of $250 thousand or more Other losses Total losses incurred excluding catastrophe losses Catastrophe losses Total losses incurred $ $ As a percent of earned premiums: Losses $1 million or more Losses $250 thousand to $1 million Development and case reserve increases of $250 thousand or more Other losses Loss ratio excluding catastrophe losses Catastrophe loss ratio Total loss ratio 2005 2004 2003 124 105 149 596 974 76 1,050 $ $ 5.5 % 4.7 6.6 26.4 43.2 3.4 46.6 % 80 103 133 536 852 71 923 $ $ 3.8 % 4.9 6.2 25.1 40.0 3.4 43.4 % 89 117 121 608 935 42 977 4.6 % 6.2 6.3 31.9 49.0 2.2 51.2 % 2005-2004 Change % 54.3 1.2 12.7 11.1 14.2 6.0 13.6 2004-2003 Change % (9.5) (11.9) 9.9 (11.8) (8.8) 68.9 (5.4) Catastrophe Loss and Loss Expenses Commercial lines catastrophe losses, net of reinsurance and before taxes, were $76 million in 2005 compared with $71 million in 2004 and $42 million in 2003. The following table shows losses incurred, net of reinsurance, and subsequent development, for catastrophe losses in each of the past three years. The Cincinnati Insurance Companies do not appoint agencies to actively market property casualty insurance in Louisiana, Mississippi or Texas. Our Hurricane Katrina and Rita losses included losses associated with commercial accounts written by agents in other states to cover locations and vehicles in multiple states, including Louisiana, Mississippi and Texas. Hurricane Katrina losses also included $18 million in assumed losses. The Cincinnati Insurance Company participates in three assumed reinsurance treaties with two reinsurers that spread the risk of very high catastrophe losses among many insurers. The assumed losses from Hurricane Katrina included $16 million under a treaty with the Munich Re Group to assume 2 percent of property losses between $400 million and $1.2 billion from a single event. Munich Re has reserved its Hurricane Katrina losses above $1.2 billion. We reduced our participation in the Munich Re assumed reinsurance treaty to 1 percent in 2006. 2005 10-K Page 43 Cause of loss (In millions, net of reinsurance) Occurence year 2005 May July August September October November November Total Wind, hail Hurricane Dennis Hurricane Katrina Hurricane Rita Hurricane Wilma Wind, hail Wind Region Midwest South South South South Midwest Midwest, South 2004 May May July August September September September December Others Total Wind, hail Wind, hail Wind, hail Hurricane Charley Hurricane Frances Hurricane Jeanne Hurricane Ivan Wind, ice, snow Midwest, Mid-Atlantic Midwest, Mid-Atlantic, South Midwest, Mid-Atlantic, South South South Mid-Atlantic, South Midwest, Mid-Atlantic, South Midwest, South 2003 and prior April May July July September November Others Total Calendar year total Wind, hail Wind, hail Wind, hail Wind, hail Wind Wind Midwest, South Midwest, South Midwest, Mid-Atlantic, South Midwest, Mid-Atlantic, South Mid-Atlantic, South Midwest, Mid-Atlantic, South Incurred in calendar year ended December 31, 2003 2004 2005 $ $ 4 5 36 3 13 2 2 65 0 $ 0 8 0 1 1 1 0 0 11 0 1 0 (1) 0 0 0 0 76 $ 1 11 7 16 4 4 21 5 3 72 (2) $ 0 2 0 0 (1) 0 (1) 71 $ 5 17 2 6 5 6 1 42 42 Commission Expenses Commercial lines commission expense as a percent of earned premium declined by 0.4 percentage points in 2005 after rising by 1.0 percentage points in 2004. Profit-sharing, or contingent, commissions are calculated on the profitability of an agency’s aggregate book of business, taking into account longer-term profit, with a percentage for prompt payment of premiums and other criteria, and reward our agents’ efforts. These profit- based commissions generally fluctuate with our loss and loss expenses. A refinement and subsequent release of a contingent commission over accrual from 2004 in the first three months of 2005 was responsible for 0.3 percentage points of the decline in 2005. The refinement reflected the use of final 2004 financial data to calculate the contingent commissions paid in 2005. Our 2005 contingent commission accrual reflected our estimate of the profit-sharing commissions that will be paid to our agencies in early 2006. Underwriting Expenses Non commission expenses rose to 10.1 percent of earned premium in 2005 from 9.4 percent in 2004 and 7.7 percent in 2003. The three-year rise in the ratio largely was due to unfavorable deferred acquisition cost comparisons resulting from slower premium growth, higher staffing expenses and increased taxes and fees that were partially due to a state guaranty fund refund in 2003. The software recovery discussed in Corporate Financial Highlights, Page 32, reduced the 2003 ratio by 0.8 percentage points. Policyholder Dividends Policyholder dividend expense was 0.2 percent of earned premium in 2005 compared with 0.5 percent in 2004 and 0.8 percent in 2003. 2005 10-K Page 44 Line of Business Analysis (Dollars in millions) Calendar year Commercial multi-peril: Written premium Earned premium Loss and loss expenses incurred Loss and loss expenses ratio Loss and loss expense ratio excluding catastrophes Workers compensation: Written premium Earned premium Loss and loss expenses incurred Loss and loss expenses ratio Loss and loss expense ratio excluding catastrophes Commercial auto: Written premium Earned premium Loss and loss expenses incurred Loss and loss expenses ratio Loss and loss expense ratio excluding catastrophes Other liability: Written premium Earned premium Loss and loss expenses incurred Loss and loss expenses ratio Loss and loss expense ratio excluding catastrophes Accident year Loss and loss expenses incurred: Commercial multi-peril Workers compensation Commercial auto Other liability Loss and loss expenses ratio: Commercial multi-peril Workers compensation Commercial auto Other liability 2005 2004 2003 2005-2004 Change % 2004-2003 Change % $ $ $ $ $ $ $ $ $ $ 809 796 443 55.7 % 47.5 338 328 300 91.3 % 91.3 447 456 273 59.8 % 59.7 458 442 187 42.4 % 42.4 2005 504 256 297 269 63.4 % 78.0 65.1 60.8 $ $ $ $ $ 767 751 469 62.4 % 54.9 320 313 251 80.3 % 80.3 458 450 236 52.4 % 52.1 424 402 116 28.8 % 28.8 2004 459 245 268 210 61.2 % 78.3 59.6 52.3 713 673 442 65.6 % 59.9 304 293 235 80.5 % 80.5 434 419 240 57.3 % 56.5 377 342 183 53.6 % 53.6 5.4 5.9 (5.5) 5.5 5.1 19.4 (2.4) 1.4 15.7 7.9 9.8 61.7 7.6 11.6 6.1 5.2 6.8 6.6 5.5 7.4 (1.8) 12.5 17.6 (36.8) 2003 2002 2001 $ 411 231 261 193 61.1 % 78.9 62.3 56.5 $ 408 236 251 156 67.2 % 80.2 65.4 56.8 403 230 242 123 75.3 % 91.2 75.6 57.1 In total, the commercial multi-peril, workers compensation, commercial auto and other liability lines of business accounted for 89.7 percent of total commercial lines earned premium compared with 90.1 percent in 2004 and 90.5 percent in 2003. Approximately 95 percent of our commercial lines premiums are written as packages, providing accounts with coverages from more than one business line. We believe that our commercial lines segment is best measured and evaluated on a segment basis. We have provided the table above and the discussion below to summarize growth and profitability trends separately for each of the four primary business lines. The accident year loss data provides current estimates of incurred loss and loss expenses for the past five accident years. Accident year data classifies losses according to the year in which the corresponding loss event occurred, regardless of when the losses are actually reported, booked or paid. Over the past three years, results for the business lines within the commercial lines segment have reflected our emphasis on underwriting and obtaining adequate pricing for covered risks, as discussed above. Commercial Multi-peril In 2005 and 2004, commercial multi-peril written premiums rose more rapidly than the total for commercial lines as a higher proportion of liability coverages were written in discounted packages because of competitive pricing pressures. Commercial multi-peril written premiums were lower in 2003 when some liability coverages were moved to nondiscounted policies. Nondiscounted policies are included in our other liability line of business. Commercial multi-peril is our single largest business line. We believe this business line’s loss data provides the best indicator of the success of the growth and underwriting actions that we have implemented during the past five years. The higher general liability base rates that were effective in most states beginning in 2003 helped to offset a trend toward higher construction costs for 2005 and 2004 property claims. In each of the last three calendar years, reserve changes for prior periods have contributed to results. • 2005 – Favorable development lowered the loss and loss expense ratio by 7.7 percentage points. The favorable development largely was due to lower commercial multi-peril exposures because of 2005 10-K Page 45 prior-year transfers of business to non-discounted policies and to the benefits of changes made in 2002 to our general liability terms and conditions. • 2004 – Reserve strengthening added 0.6 percentage points to the loss and loss expense ratio. Additions to reserves for environment claims were offset by favorable development of case reserves for non- environmental claims due to our headquarters claims department’s initiative to establish higher initial case reserves on severe injury claims. • 2003 – Reserve strengthening added 2.0 percentage points to the loss and loss expense ratio because we added to our reserves for environmental claims. In addition, the large loss discussed above added 2.9 percentage points to the 2005 ratio. Workers Compensation Conditions within the workers compensation market remained stable in 2005 and 2004 after improving between 1999 and 2003 as market pricing rose in most states, albeit offset by continued rising trends in loss severity. In 2005, workers compensation written premiums rose more rapidly than our total commercial lines written premiums as this business line appeared to experience less competitive pricing pressures than the overall commercial lines market in the second half of the year. As the commercial lines market has softened, however, insurers have displayed a greater willingness to write more desirable risks, and growth in the premium volume of state pools for workers compensation is declining. Since 2002, we have chosen not to renew selected policies where we believed the aggregate exposure risk was excessive. Any new or renewal policy covering 200 or more employees at any one location receives added scrutiny as we seek to manage risk aggregation. We make workers compensation available as part of package policies for commercial lines policyholders in selected states as a competitive tool. We pay a lower commission rate on workers compensation business, which means this line has a higher loss and loss expense breakeven point than our other commercial business lines. In Ohio, our largest state, workers compensation coverage is a state monopoly, provided solely by the state instead of by private insurers. The workers compensation loss and loss expense ratio rose in 2005 after remaining steady for several years, largely because of a higher level of reserve strengthening for older accident years. • 2005 – Reserve strengthening added 13.3 percentage points to the loss and loss expense ratio. The reserve strengthening primarily was due to medical cost inflation and longer estimated payout periods compared with our original projections. • 2004 – Reserve strengthening added 4.9 percentage points to the loss and loss expense ratio, which also was due to longer estimated payout periods. • 2003 – Reserve strengthening added 4.3 percentage points to the loss and loss expense ratio, which also was due to medical cost inflation. Commercial Auto Written premiums declined 2.4 percent in 2005 after rising 5.5 percent in 2004, below the overall commercial lines growth rate. Commercial auto is one of the package policy components for which we calculate pricing annually. This line tends to be highly sensitive to competitive pressures. In the past several years, we accelerated efforts to improve commercial auto underwriting and rate levels, making certain that vehicle use was properly classified. As a result of those actions and moderating industrywide severity and frequency trends, the loss and loss expense ratio for commercial auto remained at an acceptable level in 2005 despite pricing pressures, after improving from 2001 through 2004. Further, we continue to adhere to our underwriting guidelines to assure accurate classification and pricing. A significant factor in the calendar year-over-year changes has been savings from favorable loss reserve development for prior years. • 2005 – Favorable development lowered the loss and loss expense ratio by 5.3 percentage points. The savings largely were due to moderating frequency and severity trends. • 2004 – Favorable development lowered the loss and loss expense ratio by 10.5 percentage points, including 4.6 percentage points due to the release of UM/UIM reserves. The remainder of the savings largely was due to moderating frequency and severity trends. • 2003 – Favorable development lowered the loss and loss expense ratio by 8.8 percentage points, including 6.9 percentage points due to the release of UM/UIM case reserves. The release of UM/UIM-related IBNR reserves also contributed. Other Liability Other liability (commercial umbrella, commercial general liability and most executive risk policies) written premiums also grew more rapidly than our total commercial lines written premiums because of the growing number of policies written in non-discounted programs and the continuing rise in liability pricing. The growth 2005 10-K Page 46 rate is decelerating, however, because a higher proportion of accounts are being written in discounted packages because of competitive pricing pressures. Discounted policies are included in our commercial multi- peril line of business. Director and officer coverage accounted for approximately 11 percent of other liability premium in 2005 compared with approximately 13 percent in 2004 and approximately 12 percent in 2003. Our director and officer policies are offered primarily to nonprofit organizations, reducing the risk associated with this line of business. As of December 31, 2005, three of our in-force director and officer policies were for Fortune 500 companies, 38 were for publicly traded companies (excluding banks and savings and loans) and 59 were for banks and savings and loans with more than $500 million in assets. In large part because this business line also includes umbrella coverages, the calendar year loss and loss expense ratio tends to fluctuate significantly on a year-over-year basis. Our headquarters claims department’s initiative to establish higher initial case reserves on severe injury claims has the greatest effect on this business line: • 2005 – Favorable development lowered the loss and loss expense ratio by 18.4 percentage points. Enforcement of stricter underwriting standards and a preference for lower limit policies contributed to favorable development for our commercial umbrella coverages. • 2004 – Favorable development lowered the loss and loss expense ratio by 32.5 percentage points, including 2.0 percentage points due to the release of UM/UIM reserves. • 2003 – Favorable development lowered the loss and loss expense ratio by 23.0 percentage points, including 2.6 percentage points due to the release of UM/UIM reserves. Commercial Lines Insurance Outlook Industrywide commercial lines written premiums are expected to rise approximately 2.3 percent in 2006. During 2005, agents reported that renewal pricing pressure had risen since the end of 2004 and new business pricing was requiring even more flexibility and more careful risk selection. During 2005, we needed to use credits more frequently to retain renewals of quality business – the larger the account, the higher the credits, with variations by geographic region and class of business. At the end of 2005, renewal rates on property coverages were generally flat to modestly down, exclusive of any changes in an account’s exposure. Renewal pricing on liability coverages was less affected by competitive pricing pressures, with some increases possible. We intend to continue to market our products to a broad range of business classes, price our products adequately and take a package approach. We intend to maintain our underwriting selectivity and carefully manage our rate levels, as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions regarding rates, the use of three-year commercial policies and other policy terms on a case-by-case basis, even in lines and classes of business that are under competitive pressure. New marketing territories created over the past several years and new agency appointments will contribute to commercial lines growth. Prior to Hurricanes Katrina, Rita and Wilma, we anticipated 2006 commercial lines insurance market trends would reflect accelerated competition with pressure on pricing from the industry’s increasing surplus and improving profitability. We are uncertain what the effect of the hurricanes will be on commercial lines pricing going forward. We believe their effect on pricing largely will be limited to coastal markets and business lines directly affected by the storms. We believe our approach should allow us to maintain most of the positive underlying improvements in profitability that have occurred over the past several years, but we do not believe favorable reserve development will contribute to underwriting profits as much in 2006 as in 2005 and 2004. In addition, underwriting expenses are rising. We discuss our overall outlook for the property casualty insurance operations in Measuring Our Success in 2006 and Beyond, Page 33,. PERSONAL LINES INSURANCE RESULTS OF OPERATIONS Overview -- Three-year Highlights Performance highlights for the personal lines segment include: • Premiums – During the past three years, we have been working to address personal lines profitability. Because of our actions, the 2005 personal lines combined ratio was below 100 percent for the first time since 1999. However, as other carriers refined their pricing models , our pricing was less competitive and written premiums declined in 2005 after slowing in 2004. Industry average written premium growth was estimated at 3.5 percent for 2005 and 6.6 percent for 2004. Our earned premium growth has slowed as a result of the written premium trend. Reinsurance reinstatement premiums allocated to personal lines reduced our premium growth by 0.3 and 0.8 percentage points for 2005 and 2004, respectively. • Combined ratio – The substantial improvement in the 2005 combined ratio reflected our progress in lowering the homeowner loss and loss expense ratio and our lower catastrophe losses offset by higher 2005 10-K Page 47 noncommission underwriting expenses. The 2004 personal lines combined ratio was slightly above the prior year’s level. Higher catastrophe losses and underwriting expenses offset the improvement in the homeowner and personal auto loss and loss expense ratios excluding catastrophe losses. Our personal lines statutory combined ratio was 94.3 percent in 2005 compared with 104.6 percent in 2004 and 102.9 percent in 2003. By comparison, the estimated industry personal lines combined ratio was 97.3 percent in 2005, 94.9 percent in 2004 and 98.4 percent in 2003. Growth and Profitability Personal lines insurance is a strategic component of our overall relationship with many of our agencies and an important component of agency relationships with their clients. We believe agents recommend Cincinnati personal insurance products for their value-oriented clients who seek to balance quality and price and are attracted by Cincinnati’s superior claims service and the benefits of our package approach. In the past 12 to 18 months, our personal lines rates in some territories did not allow our agents to market these benefits, resulting in a slight decline in our policy retention rate from its historical level above 90 percent. The same factors that reduced policy retention have had an impact on new personal lines business. Personal lines new business premiums written directly by agencies declined 33.9 percent to $32 million in 2005 and declined 19.9 percent to $48 million in 2004. We discuss premium trends by personal lines of business on Page 51. Personal Lines Results (Dollars in millions) Written premiums Earned premiums Loss and loss expenses excluding catastrophes Catastrophe loss and loss expenses Commission expenses Underwriting expenses Underwriting profit (loss) Ratios as a percent of earned premiums: Loss and loss expenses excluding catastrophes Catastrophe loss and loss expenses Loss and loss expenses Commission expenses Underwriting expenses Combined ratio 2005-2004 Change % 2004-2003 Change % (3.0) 1.4 (11.3) (34.2) (3.6) 24.0 214.0 3.4 6.4 (0.4) 41.4 9.7 52.1 45.8 $ $ $ 2005 2004 2003 786 804 463 51 154 91 45 $ $ $ 57.6 % 6.3 63.9 19.2 11.3 94.4 % 811 793 522 77 160 74 (40) $ $ $ 65.9 % 9.7 75.6 20.1 9.3 105.0 % 784 745 524 55 146 47 (27) 70.3 % 7.3 77.6 19.5 6.5 103.6 % Between 2000 and 2003, the industry implemented higher homeowner rates and imposed stricter enforcement of underwriting standards. In late 2004, price competition returned as insurers leveraged their higher profitability and stronger financial positions. The marketplace continued to become more competitive throughout 2005. We began a strategic shift in 2004 from our traditional three-year to one-year homeowner policy terms. We are transitioning to one-year policies in conjunction with the state-by-state deployment of Diamond, our personal lines policy processing system. One-year policies allow us to promptly modify rates, terms and conditions in response to market changes. In mid-2004, we also began modifying policy terms to change homeowner policy earthquake deductibles to 10 percent from 5 percent in selected Midwestern states, reducing the company’s exposure to a single significant catastrophic event. In 2004, as price competition began to emerge, we were in the early stages of our program to improve profitability for our homeowner line by raising rates and making changes to our policy terms and conditions. From mid-2004 to mid-2005, we opted to delay rate changes because we felt it was important to fully commit our programming resources to completing necessary modifications and upgrades to our then-new Diamond policy processing system. During that time period, other carriers began making more aggressive use of segmented pricing models, generating lower rates for higher quality accounts. When some important system modifications were completed in mid-2005, we began filing rate and credit changes to better position our products in the market. The introduction of Diamond in our higher volume states may also have contributed to lower growth rates. The focus required by our agencies to convert to the newer technology and adapt to new work flows may have diverted their resources from new business efforts. Diamond gives agencies additional choices to consider for their business operations and for policyholders. Agents are growing more familiar with the new options and workflow, and many now are seeing benefits from efficiencies as they renew business through the system. During 2005, we increased the system’s processing power and availability and offered additional functionality requested by agency staff. For example, we began offering convenient account billing to direct bill customers, 2005 10-K Page 48 invoicing for multiple policies at one time, and electronic fund transfer, which accommodates new monthly payment plans. We continue to respond to agency requests for enhancements as we prepare Diamond for additional states. Although our homeowner profitability lagged the industry, our actions resulted in substantial improvement in our personal lines combined ratio over the past three years. Our 2005 statutory combined ratio improved to 94.3 percent while the estimated industry combined ratio deteriorated 2.4 points to 97.3 percent. Moreover, we expect to realize additional profit improvements in 2006 as we continue the conversion to one-year policies written with updated rates, terms and conditions. In mid-2006, we will introduce a limited program of rate segments incorporating insurance scores into pricing for our personal auto and homeowner products in states using Diamond and make other changes to our credits in states not yet using Diamond. This step should further improve our ability to compete for our agents’ highest quality personal lines accounts. We believe it will increase the opportunity to work with our agents on marketing the advantages of our personal lines products and services to their clients, which would help us resume growing in this business area. We describe the significant costs components for the personal lines segment below. Loss and Loss Expenses (excluding catastrophe losses) Loss and loss expenses include both net paid losses and reserve additions for unpaid losses as well as the associated loss expenses. The improvement in the loss and loss expense ratio excluding catastrophes over the past three years was due to a 14.4 percentage point improvement in the homeowner ratio excluding catastrophe losses between 2005 and 2003 and a 10.4 percentage point improvement in the personal auto ratio excluding catastrophe losses over the same period. Savings from favorable loss reserve development, including the release of UM/UIM reserves, influenced those improvements. We discuss homeowner and personal auto trends separately beginning on Page 51. We monitor incurred losses by size of loss, business line, risk category, geographic region, agency, field marketing territory and duration of policyholder relationship, addressing concentrations or trends as needed. Our 2005 analysis indicated no significant concentrations other than trends in business lines that we address as part of our ongoing business operations. We also measure new losses and case reserve adjustments greater than $250,000 to track frequency and severity. These personal lines large losses and case reserve increases declined as a percent of earned premiums in 2005 because of higher rates per exposure. Personal Lines Losses by Size (Dollars in millions) Losses $1 million or more Losses $250 thousand to $1 million Development and case reserve increases of $250 thousand or more Other losses Total losses incurred excluding catastrophe losses Catastrophe losses Total losses incurred $ $ As a percent of earned premiums: Losses $1 million or more Losses $250 thousand to $1 million Development and case reserve increases of $250 thousand or more Other losses Loss ratio excluding catastrophe losses Catastrophe loss ratio Total loss ratio 2005 2004 2003 13 34 19 339 405 51 456 $ $ 1.5 % 4.3 2.4 42.2 50.4 6.3 56.7 % 17 43 21 371 452 77 529 $ $ 2.2 % 5.4 2.6 46.8 57.0 9.7 66.7 % 15 41 11 391 458 55 513 2.0 % 5.5 1.5 52.5 61.5 7.3 68.8 % 2005-2004 Change % (26.0) (19.9) (7.7) (8.5) (10.2) (34.2) (13.7) 2004-2003 Change % 14.6 4.9 83.7 (5.2) (1.4) 41.4 3.1 2005 10-K Page 49 Catastrophe Loss and Loss Expenses Personal lines catastrophe losses, net of reinsurance and before taxes, were $51 million in 2005 compared with $77 million in 2004 and $55 million in 2003. The following table shows losses incurred, net of reinsurance, and subsequent development, for catastrophe losses in each of the past three years. Cause of loss (In millions, net of reinsurance) Occurence year 2005 January May July August October November November Total Wind, ice snow, freezing Wind, hail Hurricane Dennis Hurricane Katrina Hurricane Wilma Wind, hail Wind Region Midwest, Mid-Atlantic Midwest South South South Midwest Midwest, South 2004 May May July August September September September December Others Total Wind, hail Wind, hail Wind, hail Hurricane Charley Hurricane Frances Hurricane Jeanne Hurricane Ivan Wind, ice, snow Midwest, Mid-Atlantic Midwest, Mid-Atlantic, South Midwest, Mid-Atlantic, South South South Mid-Atlantic, South Midwest, Mid-Atlantic, South Midwest, South 2003 April May July July September November Others Total Calendar year total Wind, hail Wind, hail Wind, hail Wind, hail Wind Wind Midwest, South Midwest, South Midwest, Mid-Atlantic, South Midwest, Mid-Atlantic, South Mid-Atlantic, South Midwest, Mid-Atlantic, South Incurred in calendar year ended December 31, 2003 2004 2005 $ $ 1 8 2 11 12 9 10 53 0 $ 0 (1) 0 1 0 1 (3) 0 (2) 0 0 0 0 0 0 0 0 51 $ 9 20 5 10 7 2 18 8 2 81 (2) $ 0 (1) 0 (1) 0 0 (4) 77 $ 31 17 5 1 4 1 (4) 55 55 Commission Expenses Commission expense as a percent of earned premium declined by 0.9 percentage points in 2005, largely paralleling the decline in written premiums, after rising 0.6 percentage points in 2004. Profit-sharing, or contingent, commissions are calculated on the profitability of an agency’s aggregate book of business, taking into account longer-term profit, with a percentage for prompt payment of premiums and other criteria. A refinement and subsequent release of a contingent commission over accrual from 2004 in the first three months of 2005 was responsible for 0.2 percentage points of the decline in 2005. Underwriting Expenses Noncommission expenses rose to 11.3 percent of earned premium in 2005 from 9.3 percent in 2004 and 6.5 percent in 2003. The three-year rise in the ratio largely was due to higher technology expenses, unfavorable deferred acquisition cost comparisons resulting from slower premium growth, higher staffing expenses and increased taxes and fees that were partially due to a state guaranty fund refund in 2003. The software recovery discussed in Corporate Financial Highlights Page 32, reduced the 2003 ratio by 1.1 percentage points. 2005 10-K Page 50 Line of Business Analysis (Dollars in millions) Calendar year Personal auto: Written premium Earned premium Loss and loss expenses incurred Loss and loss expenses ratio Loss and loss expense ratio excluding catastrophes Homeowner: Written premium Earned premium Loss and loss expenses incurred Loss and loss expenses ratio Loss and loss expense ratio excluding catastrophes Accident year Loss and loss expenses incurred: Personal auto Homeowner Loss and loss expenses ratio: Personal auto Homeowner 2005 2004 2003 $ $ $ $ $ $ 410 433 261 60.2 % 59.7 290 285 212 74.5 % 58.4 2005 267 215 61.8 % 75.4 $ $ $ 453 451 298 66.1 % 65.1 273 259 249 96.1 % 69.3 2004 297 254 66.0 % 98.1 2005-2004 Change % 2004-2003 Change % (9.4) (4.0) (12.5) 1.2 5.4 (2.1) 6.3 10.2 (14.6) 7.3 8.2 12.2 447 428 304 71.1 % 70.1 254 239 222 92.7 % 72.8 2003 2002 2001 $ 305 227 71.2 % 95.0 $ 289 207 74.3 % 98.6 259 193 71.9 % 101.4 The personal auto and homeowner business lines together accounted for 89.2 percent, 89.5 percent and 89.5 percent of total personal lines earned premiums in 2005, 2004 and 2003, respectively. Our intent is to write personal auto and homeowner coverages in personal lines packages that may also include personal umbrella liability, watercraft and other coverages. As a result, we believe that the personal lines segment is best measured and evaluated on a segment basis. We have provided the table above and the discussion below to summarize growth and profitability trends separately for the two primary business lines. The accident year loss data provides current estimates of incurred loss and loss expenses for the past five accident years. Accident year data classifies losses according to the year in which the corresponding loss event occurred, regardless of when the losses are actually reported, booked or paid. Personal Auto Written and earned premiums for the personal auto line declined in 2005 after rising in 2004. As noted above, the decline in 2005 primarily was due to price competition in some states and territories, which has resulted in lower policy renewal retention and significantly lower new business levels. We are continuing to modify selected rates and credits to address our competitive position. The loss and loss expense ratio for personal auto improved from an already strong level over the three years because of higher pricing. For selected agencies, we use re-underwriting programs to review and to strengthen underwriting standards, requiring motor vehicle reports for insured drivers, and to develop strategies to increase the company’s penetration of the agency’s personal lines business. Calendar year-over-year changes in the loss and loss expense ratio have included loss reserve development. In 2005, savings from favorable loss reserve development from prior accident years lowered the loss and loss expense ratio by 1.6 percentage points. In 2004 and 2003, reserve strengthening added 0.2 percentage points and 2.1 percentage points, respectively, to the loss and loss expense ratio. Homeowner Written and earned premiums for the homeowner line rose in 2005 and 2004. Written premiums rose because of the effect of rate increases, which served to offset lower policy renewal retention and significantly lower new business levels. Earned premiums continued to benefit from written premium growth in earlier periods. At year-end 2005, approximately 56 percent of all homeowner policies had been converted to a one-year term, up from approximately 27 percent at year-end 2004. We are continuing to renew homeowner policies for three-year terms in nine states until the Diamond roll out is planned for those states. Renewal rates on those three-year policies reflect all rate changes enacted over the past several years. This can cause those policies to renew at a significantly higher cost for the policyholders, even if the price is competitive. The loss and loss expense ratio for the homeowner line excluding catastrophe losses improved in 2005 and 2004. Unusually high catastrophe losses in 2004 interrupted two years of improvement in the loss and loss expense ratio including catastrophe losses. Favorable loss reserve development from prior accident years lowered the loss and loss expense ratio by 1.0 percentage points in 2005, 2.2 percentage points in 2004 and 3.1 percentage points in 2003. We continue to seek to improve homeowner results so that this line achieves profitability. Since we generally do not allocate noncommission expenses to individual business lines, to measure homeowner profitability, 2005 10-K Page 51 we assume total commission and underwriting expenses would contribute approximately 30 percentage points to our homeowner combined ratio. Lower levels of premium growth could affect our ability to attain that level in 2006 and beyond. We also assume catastrophe losses as a percent of homeowner earned premium would be in the range of 17 percent. Over the past three years, catastrophe losses have averaged approximately 21 percent of homeowner earned premiums. We believe it will take until 2007 for the full benefit of our pricing and underwriting actions to be reflected in homeowner results. Personal Lines Insurance Outlook Industry experts currently anticipate industrywide personal lines written premiums will rise approximately 2.9 percent in 2006, with personal auto premiums expected to rise about 2.5 percent and homeowner premiums expected to rise 4.2 percent. A number of factors contribute to our assessment of the potential for personal lines growth: • Competitive rates – We are working on a number of rate setting initiatives to make our personal auto and homeowner rates competitive in all of our territories. We work with our agents to establish rates that are attractive to our agencies’ quality accounts. In mid-2006, we will introduce a limited program of rate segments incorporating insurance scores into rates for our personal auto and homeowner policies to further improve our pricing for our agents’ quality accounts. We believe the opportunity exists to work with our agents to market the advantages of our personal lines products to their clients, which would help us resume growing in this business area. • Policy characteristics – In keeping with industry practices, most of our homeowner products no longer automatically cover guaranteed replacement costs. We add specific charges for some optional coverages previously included at no charge, such as limited replacement cost and water damage coverages. Policyholders who need the water damage protection now can select the amount of coverage that meets their needs. However, these changes and our transition to one-year homeowner policies may have diminished the factors that distinguished our products. • Diamond introduction – The use of the Diamond system by agencies writing approximately 70 percent of personal lines volume is a significant accomplishment. We believe the system ultimately will make it easier for agents to place personal auto, homeowner and other personal lines business with us, while greatly increasing policy-issuance and policy-renewal efficiencies and providing direct-bill capabilities. Agents using Diamond chose direct bill for 37 percent and headquarters printing for 75 percent of policy transactions in 2005, options that generally were not available on our previous system. • New agencies – The availability of Diamond should help us increase the number of agencies that offer our personal lines products, which also should contribute to personal lines growth. We currently market both homeowner and personal auto insurance products through 773 of our 1,253 reporting agency locations in 22 of the 32 states in which we market commercial lines insurance. We market homeowner products through 22 locations in three additional states (Maryland, North Carolina and West Virginia.) In addition to the rate modifications currently underway, we identify several other factors that may affect the personal lines combined ratio in 2006 and beyond. Personal lines underwriters continue to focus on insurance- to-value initiatives to verify that policyholders are buying the correct level of coverage for the value of the insured risk, and we are carefully maintaining underwriting standards. However, if premiums decline more than we expect, the personal lines expense ratio may be higher than the 2005 level, because some of our costs are relatively fixed, such as our planned investments in technology. We discuss our overall outlook for the property casualty insurance operations in Measuring Our Success in 2006 and Beyond, Page 33. LIFE INSURANCE RESULTS OF OPERATIONS Overview -- Three-year Highlights Performance highlights for the life insurance segment include: • Revenues – Revenue growth has accelerated over the past three years as gross in-force policy face amounts increased to $51.493 billion at year-end 2005 from $44.921 billion at year-end 2004 and $38.492 billion at year-end 2003. • Profitability – The life insurance segment reports a small GAAP profit because investment income is included in investment segment results, except investment income credited to contract holders (interest assumed in life insurance policy reserve calculations). Results improved in 2005 and 2004 because operating expenses remained level and mortality experience remained within pricing guidelines as premiums continued to rise. At the same time, we recognize assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life 2005 10-K Page 52 products. For that reason, we also evaluate GAAP data including all investment activities on life insurance- related assets. GAAP net income on that basis grew 23.8 percent in 2005 to $47 million and 74.1 percent in 2004 to $38 million. The life insurance portfolio had pretax realized investment gains of $17 million in 2005 compared with $9 million of gains in 2004 and $10 million of pretax realized investment losses in 2003. Life Insurance Results (In millions) Written premiums Earned premiums Separate account investment management fees Total revenues Contract holders benefits incurred Investment interest credited to contract holders Expenses incurred Total expenses Life insurance segment profit (loss) 2005 2004 2003 $ $ $ 205 $ 106 $ 4 110 102 (51) 52 103 7 $ 193 $ 101 $ 3 104 95 (46) 53 102 2 $ 2005-2004 Change % 6.5 5.7 18.5 6.0 7.2 12.9 (0.3) 0.8 334.2 2004-2003 Change % 34.7 5.5 31.9 6.1 3.5 5.7 0.2 0.9 147.5 143 95 2 97 91 (43) 52 100 (3) Growth We offer term, whole life and universal life products, fixed annuities and disability income products. Revenues in 2005 were derived principally from: • Premiums from traditional products, principally term insurance, which contributed 71.3 percent • Fee income from interest-sensitive products, principally universal life insurance, which contributed 25.5 percent • Separate account investment management fee income, which contributed 3.2 percent Our life insurance subsidiary reported total statutory written premiums of $205 million in 2005 compared with $193 million in 2004, which included premiums for two general account BOLI policies totaling $10 million, and $143 million in 2003. Written premiums for life insurance operations for all periods include life insurance, annuity and accident and health premiums. In 2005, our life insurance segment experienced a 2.0 percent rise in applications submitted and a 4.9 percent increase in gross face amounts issued, primarily due to continued strong sales of term insurance marketed through the company’s property casualty agency force. Over the past several years, we have worked to maintain a portfolio of straightforward and up-to-date products, primarily under the LifeHorizons name. Our product development efforts emphasize death benefit protection and guarantees. For example, a new term series that includes a return-of-premium feature replaced the existing term portfolio in 2005. Reaction to the new portfolio has been favorable with approximately 25 percent of applications requesting the return-of-premium feature. In 2006, we are introducing a new universal life product that offers a secondary guarantee that keeps the death benefit in force provided a competitive minimum premium requirement is met. Distribution expansion remains a high priority. In the past several years, we have added life field marketing representatives for the western and northeastern states. Profitability Life segment expenses consist principally of: • Insurance benefits paid and reserve increases related to traditional life and interest-sensitive products, which accounted for 66.0 percent of 2005 expenses and 64.3 percent of 2004 expenses • Commissions, general and other business expenses, net of deferred acquisition costs, which accounted for 34.0 percent of 2005 expenses and 35.7 percent of 2004 expenses Life segment profitability depends largely on premium levels, the adequacy of product pricing, underwriting skill and operating efficiencies. Life segment results include only investment interest credited to contract holders (interest assumed in life insurance policy reserve calculations). The remaining investment income is reported in the investment segment results. The life investment portfolio is managed to earn target spreads between earned investment rates on general account assets and rates credited to policyholders. We consider the amount of assets under management and investment income for the life investment portfolio as key performance indicators for the life insurance segment. We seek to maintain a competitive advantage with respect to benefits paid and reserve increases by consistently achieving better than average claims experience due to skilled underwriting. Commissions paid by 2005 10-K Page 53 the life insurance operation are on par with industry averages. During the past several years, we have invested in imaging and workflow technology and have significantly improved application processing. We have achieved efficiencies while maintaining our service standards. Life Insurance Outlook As the life insurance company seeks to improve penetration of our property casualty agencies, our objective is to increase premiums and contain expenses. We continue to emphasize the cross-serving opportunities afforded by worksite marketing of life insurance products. In 2006, we are exploring additional programs to simplify the worksite marketing sales process, including electronic enrollment software. We also intend to enhance our worksite product portfolio to make it more attractive to agents. We believe these strategies will allow us to continue to increase our worksite marketing business area. Term insurance is our largest life insurance product line. We continue to introduce new term products with features our agents indicate are important. In addition to the changes in our term life insurance portfolio, we are implementing our new universal life products. Marketplace and regulatory changes during 2004 have affected the cost and availability of reinsurance for term life insurance issued since the beginning of 2005. We are addressing this situation by retaining no more than a $500,000 exposure, ceding the balance using excess over retention mortality coverage and retaining the policy reserve. Retaining the policy reserve has no direct impact on GAAP results. However, because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of capital. We anticipate favorable regulatory changes as we discuss in Item 1, Life Insurance Segment, Page 13. We believe we will be able to continue to grow in the term life insurance marketplace while appropriately managing risk, at a cost that allows the life insurance company to achieve its internal performance targets. INVESTMENTS RESULTS OF OPERATIONS Overview -- Three-year Highlights The investment segment contributes investment income and realized gains and losses to results of operations. Investments provide our primary source of pretax and after-tax profits. • Investment income – Pretax investment income reached a new record in 2005, rising 6.9 percent from the prior record in 2004. Growth in investment income over the past two years has been driven by strong cash flow for new investments, higher interest income from the growing fixed-maturity portfolio and increased dividend income from the common stock portfolio. • Realized gains and losses – We reported realized gains in 2005 and 2004 largely due to investment sales. The realized loss in 2003 was due to other-than-temporary impairment charges. Investment Results (In millions) Investment income: Interest Dividends Other Investment expenses Total net investment income Investment interest credited to contract holders Net realized investment gains and losses: Realized investment gains and losses Change in valuation of embedded derivatives Other-than-temporary impairment charges Net realized investment gains (losses) Investment operations income 2005 2004 2003 2005-2004 Change % 2004-2003 Change % $ $ 280 $ 244 8 (6) 526 (51) 69 (7) (1) 61 536 $ 252 $ 239 6 (5) 492 (46) 87 10 (6) 91 537 $ 235 227 8 (5) 465 (43) 30 9 (80) (41) 381 11.2 2.1 29.4 (22.3) 6.9 12.9 (20.7) (167.2) 78.5 (33.1) (0.4) 7.2 5.0 (23.0) (13.0) 5.6 5.7 189.9 7.9 92.0 321.7 40.6 Investment Income The advantages of strong cash flow in the past three years have been somewhat offset by the challenge of investing in a low interest rate environment. The allocation of new investment dollars to fixed-maturity securities during most of 2005 and 2004 added to investment income growth. Overall, common stock dividends contributed 43.7 percent of pretax investment income in 2005 compared with 43.9 percent in 2004 and 42.3 percent in 2003. Fifth Third, our largest equity holding, contributed 43.6 percent of total dividend income in 2005. We discuss our Fifth Third investment in Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 70. In 2005, 36 of the 49 common stock holdings in the portfolio raised their indicated annual dividend payout, as did 33 of the 51 in 2004 and 29 of 51 in 2003. 2005 10-K Page 54 Net Realized Investment Gains and Losses Net realized investment gains and losses are made up of realized investment gains and losses on the sale of securities, changes in the valuation of embedded derivatives within certain convertible securities and other- than-temporary impairment charges. These three areas are discussed below. Realized Investment Gains and Losses Realized investment gains in 2005 and 2004 largely were due to the sale of equity holdings. We buy and sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. In 2005 and 2003, we had gains from the sale of equity holdings that no longer met our investment parameters or were obtained from convertible securities whose underlying common stock was never intended to be a long-term holding. Included in 2005 were the initial sales of a portion of our ALLTEL holding. We completed the sale of our entire ALLTEL position in January 2006. We discuss this sale in Item 1, Investments Segment, Page 15, and Item 8, Note 2 to the Consolidated Financial Statements, Page 88. In 2004, we sold $356 million in equity holdings as part of a program to support the financial strength ratings of our property casualty insurance operations. We selected holdings to sell primarily based on the belief of the investment committee and management that these securities would have a lower dividend growth rate over the next several years when compared with other holdings in the portfolio. We also considered the potential tax effect of any unrealized gains. Partial sales of holdings in which we held over $100 million in fair value at year-end 2003 contributed $311 million. We sold fixed-maturity investments during the past three years as part of our portfolio management strategies. The majority of these were bonds disposed of due to rating or credit concerns, including several in the airline and auto related industries. Although we prefer to hold fixed-maturity investments until they mature, a decision to sell reflects our perception of a change in the underlying fundamentals of the security and preference to allocate those funds to investments that more closely meet the established parameters for long-term stability and growth. Our opinion that a security fundamentally no longer meets our investment parameters may reflect a loss of confidence in the issuer’s management, a change in underlying risk factors (such as political risk, regulatory risk, sector risk or credit risk), or a recovery from a previously impaired value. Realized gains in the past three years also have included gains from the sale of previously impaired securities. Change in the Valuation of Embedded Derivatives In 2005, we recorded $7 million in fair value declines compared with $10 million in fair value increases in 2004 and $9 million in fair value increases in 2003. These changes in fair value are due to the application of SFAS No. 133, which requires measurement of the fluctuations in the value of the embedded derivative features in selected convertible securities. The changes in fair values are recognized in net income in the period they occur. See Item 8, Note 1 to the Consolidated Financial Statements, Page 84, for details on the accounting for convertible security embedded options. Other-than-temporary Impairment Charges In 2005, we recorded $1 million in write-downs of investments that we deemed had experienced an other-than- temporary decline in market value versus $6 million in 2004 and $80 million in 2003. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 37. The other-than-temporary impairment charges represented less than 0.1 percent of our total invested assets at year-end 2005 and 2004 and 0.6 percent of our total invested assets at year-end 2003. Other-than-temporary impairment charges also include unrealized losses of holdings that we have identified for sale but not yet completed a transaction. The significant decline in other-than-temporary impairment in 2005 and 2004 was due to prior impairments in the portfolio, disposition of certain securities in prior years and an improvement in the general financial climate. The majority of the other-than-temporary write-downs in the past three years were due to: • 2005 – one auto-related convertible preferred security for $1 million • 2004 – two airline-related tax-exempt municipal bonds totaling $5 million • 2003 – 31 high-yield corporate bonds written down $39 million and 10 convertible securities written down $26 million. Market value declines in 2003 largely related to events specific to the issuer rather than industry issues, although $58 million of the $80 million write-downs were concentrated in the utility/merchant energy trading, airline and healthcare industries. 2005 10-K Page 55 Other-than temporary impairment charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 15, are summarized below: (Dollars in millions) Taxable fixed maturities: Number of securities impaired Percent to total owned Impairment amount New book value Percent to total owned Tax-exempt fixed maturities: Number of securities impaired Percent to total owned Impairment amount New book value Percent to total owned Common equities: Number of securities impaired Percent to total owned Impairment amount New book value Percent to total owned Preferred equities: Number of securities impaired Percent to total owned Impairment amount New book value Percent to total owned Short-term investments: Number of securities impaired Percent to total owned Impairment amount New book value Percent to total owned Total: Number of securities impaired Percent to total owned Impairment amount New book value Percent to total owned Years ended December 31, 2004 2003 2005 2 0 % (1) 1 0 % $ 0 0 % 0 0 0 % $ 0 0 % 0 0 0 % $ 0 0 % 0 0 0 % $ 0 0 % 0 0 0 % $ 2 0 % (1) 1 0 % $ $ 1 1 % 0 2 1 % 2 0 % (5) 9 1 % 1 2 % (1) 0 0 % 0 0 % 0 0 0 % 0 0 % 0 0 0 % $ $ $ $ $ 4 0 % (6) 11 0 % $ $ 42 6 % (66) 36 1 % 5 1 % (6) 3 0 % 2 4 % (8) 5 0 % 0 0 % 0 0 0 % 0 0 % 0 0 0 % 49 3 % (80) 44 1 % $ $ $ $ $ $ $ Other-than temporary impairment charges from the investment portfolio by industry are summarized as follows: (Dollars in millions) Automotive Airline Utility/merchant energy/trading Healthcare Other Total Years ended December 31, 2004 2003 2005 (1) 0 0 0 0 (1) $ $ 0 (5) 0 0 (1) (6) $ $ (1) (18) (30) (10) (21) (80) $ $ Investments Outlook We believe investment income growth for 2006 could be in the range of 6.5 percent to 7.0 percent. Our outlook is based on the anticipated level of dividend income, the strong cash flow from insurance operations and the higher-than-normal allocation of new cash flow to fixed-maturity securities over the past 18 months. Dividend increases within the last 12 months by Fifth Third and another 35 of the 49 common stock holdings in the equity portfolio should add $15 million to annualized investment income. In 2006, our investment department will allocate the after-tax proceeds of the ALLTEL common stock sale in line with our overall investment philosophy, with a focus on replacing the approximately $20 million in ALLTEL dividend income received in 2005. 2005 10-K Page 56 We believe impairments in 2006 should be limited to securities that have been identified for sale or that have experienced a sharp decline in fair value with little or no warning because of issuer-specific events. All but two securities in the portfolio were trading at or above 70 percent of book value at December 31, 2005. Our asset impairment committee continues to monitor the investment portfolio. The current asset impairment policy is in Critical Accounting Estimates, Asset Impairment, Page 37. OTHER In 2005, other income of the insurance subsidiaries, parent company operations and non-investment operations of CFC Investment Company and CinFin Capital Management Company resulted in $12 million in revenues compared with $8 million in 2004 and $7 million in 2003. Losses before income taxes of $50 million in 2005 were primarily due to $52 million in interest expense from debt of the parent company. Losses before income taxes were $37 million in 2004 and $38 million in 2003, when interest expense was $36 million and $33 million, respectively. TAXES Income tax expense was $221 million in 2005 compared with $216 million in 2004 and $106 million in 2003. The effective tax rate for 2005 was 26.8 percent compared with 27.0 percent in 2004 and 22.0 percent in 2003. In addition to higher underwriting profits, the higher tax rate in 2005 and 2004 reflected a higher level of capital gains, compared with capital losses in 2003. We pursue a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. Details regarding our effective tax rate are found in Item 8, Note 10 to the Consolidated Financial Statements, Page 93. LIQUIDITY AND CAPITAL RESOURCES Liquidity and capital resources represent the overall financial strength of our company and our ability to generate cash flows to meet the short- and long-term cash requirements of business obligations and growth needs. We seek to maintain prudent levels of liquidity and financial strength for the protection of our policyholders, creditors and shareholders. The parent company’s primary means of meeting liquidity requirements are dividends from our insurance subsidiary and income from investments held at the parent-company level supported by our capital resources. At year-end 2005, we had shareholders’ equity of $6.086 billion and total debt of $791 million. Our ability to access the capital markets and short-term bank borrowing provide other potential sources of liquidity. One way we seek to maintain financial strength is by keeping our ratio of debt to capital below 15 percent. Our parent company’s cash requirements include dividends to shareholders, interest payments on our long-term debt, common stock repurchases and general operating expenses. Our insurance subsidiary’s primary sources of liquidity are premiums and investment income. Its cash needs primarily consist of paying property casualty and life insurance loss and loss expenses as well as ongoing operating expenses and payments of dividends to the parent company. Although we have never sold investments to pay claims, the sale of investments would provide an additional source of liquidity, if required. After satisfying operating cash requirements, excess cash flows are invested in fixed-maturity and equity securities, leading to the potential for increases in future investment income and unrealized appreciation. SOURCES OF LIQUIDITY Subsidiary Dividends Our insurance subsidiary declared dividends to the parent company of $275 million in 2005, $175 million in 2004 and $50 million in 2003. State of Ohio regulatory requirements restrict the dividends insurance subsidiaries can pay. Generally, the most Ohio-domiciled insurance subsidiaries can pay without prior regulatory approval is 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 Ohio Department of Insurance. During 2006, total dividends that our lead insurance subsidiary can pay to our parent company without regulatory approval are approximately $517 million. Insurance Underwriting Our property casualty and life insurance operations provide liquidity because premiums generally are received before losses are paid under the policies purchased with those premiums. After satisfying our cash requirements, excess cash flows are used for investment, increasing future investment income. 2005 10-K Page 57 This table shows a summary of cash flow of the insurance subsidiary (direct method): (In millions) Written premiums Loss and loss expenses paid Commissions and other underwriting expenses paid Insurance subsidiary cash flow from underwriting Investment income received Insurance subsidiary operating cash flow Years ended December 31, 2004 2003 2005 $ $ 3,187 $ 1,752 951 484 427 911 $ 3,055 $ 1,694 889 472 362 834 $ 2,771 1,617 774 380 332 712 Historically, cash receipts from property casualty and life insurance premiums, along with investment income, have been more than sufficient to pay claims, operating expenses and dividends to the parent company. While first-year life insurance expenses normally exceed the premiums, subsequent premiums are used to generate investment income until the time the policy benefits are paid. After paying claims and operating expenses, cash flows from underwriting were essentially unchanged in 2005 after rising 21.5 percent in 2004. We discuss our future obligations for claims payments in Contractual Obligations, Page 59, and our future obligations for underwriting expenses in Commissions and Other Underwriting Expenses, Page 60. Based on our outlook for commercial lines, personal lines and life insurance, we believe that cash flows from underwriting could decline in 2006. A lower level of cash flow available for investment could lead to reduced potential for increases in future investment income and capital gains. Investing Activities Investment income is a primary source of liquidity for both the parent company and insurance subsidiary. The transfer of equity holdings to our insurance subsidiary from the parent company in 2004 increased the amount of investment income generated at the subsidiary level but had no effect on consolidated investment income. As we discuss under Investments Results of Operations, Page 54, investment income rose in each of the past three years, and we expect investment income to grow 6.5 percent to 7.0 percent in 2006. Realized gains also can provide liquidity, although we follow a buy-and-hold investment philosophy seeking to compound cash flows over the long-term. When we dispose of investments, we generally reinvest the gains in new investment securities. Disposition of investments occurs for a number of reasons: • Sales of fixed-maturity investments – We prefer to hold fixed-maturity securities until maturity. Any decision to sell or to reduce a holding reflects our perception of a change in the underlying fundamentals of the security and our preference to allocate those funds to investments that more closely meet our established parameters for long-term stability and growth. • Call or maturity of fixed-maturity investments – Calls and maturities of fixed-maturity investments are a function of the yield curve. The pace of calls of fixed maturities declined in 2005 because of a stabilization of interest rates. In the past several years, we have purchased U.S. agency paper with higher coupons and shorter call protection features. • Sales of equity securities investments – In 2005, we continued to sell equity positions previously identified. We also recorded the initial ALLTEL sales in 2005. Sales of equity securities rose in 2004 due to the sale of $356 million in equity holdings as part of our program to support the financial strength ratings of our property casualty insurance operations. Holdings to be sold were selected primarily based on the investment committee’s and management’s belief that these securities would have a lower dividend growth rate over the next several years when compared with other holdings in the portfolio. We also considered the potential tax effect of any unrealized gains. We generally have substantial discretion in the timing of investment sales and, therefore, the resulting gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process. In 2006, we expect to continue to limit the disposition of investments to those that no longer meet our investment parameters or those that reach maturity or are called by the issuer. The sale of equity investments that no longer meet our investment criteria can provide cash for investment in common stocks that we perceive to have greater potential for capital appreciation and income growth. Capital Resources At year-end 2005, our debt-to-capital ratio was 11.5 percent. We had $791 million of long-term debt and no borrowings on our short-term lines of credit. We generally have minimized our reliance on debt financing although we may utilize lines of credit to fund short-term cash needs. We provide details of our three long-term notes in Item 8, Note 7 of the Consolidated Financial Statements, Page 91. None of the notes are encumbered by rating triggers. 2005 10-K Page 58 We issued $375 million aggregate principal amount of 6.125% senior notes in 2004. The $368 million net proceeds from the offering: • Paid off $183 million in short-term debt. • Are financing the construction of an estimated $100 million office building and parking garage to be situated at the headquarters located in Fairfield beginning in 2005, as announced in August 2004. • Are available for general corporate purposes. As of March 3, 2006, our senior debt issues were rated aa- by A.M. Best, A+ by Fitch, A2 by Moody’s and A by Standard & Poor’s. At year-end 2005, we had two lines of credit totaling $125 million with no outstanding balance. One line of credit for $75 million was established more than five years ago and has no financial covenants. The second line of credit is an unsecured $50 million line of credit from Fifth Third Bank established in 2005. It is available for general corporate purposes and contains customary financial covenants. Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2006. As a result, we believe our debt-to-capital ratio will remain in the range of 11 percent to 12 percent. As a long-term investor, we historically have followed a buy-and-hold investing strategy. This policy has generated a significant amount of unrealized appreciation on equity investments. Unrealized appreciation, before deferred income taxes, was $5.067 billion and $5.840 billion at year-end 2005 and 2004, respectively. On an after-tax basis, it constituted 54.0 percent of total shareholders' equity at year-end 2005. Off-balance Sheet Arrangements We do not utilize any special-purpose financing vehicles or have any undisclosed off-balance sheet arrangements (as that term is defined in applicable SEC rules) that are reasonably likely to have a current or future material effect on the company’s financial condition, results of operation, liquidity, capital expenditures or capital resources. Similarly, the company holds no fair-value contracts for which a lack of marketplace quotations would necessitate the use of fair-value techniques. USES OF LIQUIDITY Our parent company and insurance subsidiary have contractual and other obligations. In addition, one of our primary uses of cash is to enhance shareholder return. Contractual Obligations At December 31, 2005, we estimated our future contractual obligations as follows: (In millions) Payment due by period Within 1 year Years 2-3 Years 4-5 More than 5 years Total Contractual obligations: Net property casualty claims payments Net life claims payments Interest on long-term debt Long-term debt Annuitization obligations Headquarters building expansion Computer hardware and software Other invested assets Total $ $ 1,009 $ 6 52 0 15 20 10 9 1,121 $ 1,054 $ 0 104 0 45 63 2 10 1,278 $ 474 $ 0 104 0 30 0 1 1 610 $ 574 $ 0 1,048 795 104 0 1 0 2,522 $ 3,111 6 1,308 795 194 83 14 20 5,531 Claims Payments Our estimate of material commitments for net property casualty claims payments was approximately 56.2 percent of the estimated contractual obligations at year-end 2005. We direct our associates to settle claims and pay losses as quickly as practical and made $1.752 billion in net claim payments during 2005. At year-end 2005, we had net property casualty reserves of $3.111 billion, reflecting $1.605 billion in unpaid amounts on reported claims (case reserves), $669 million in loss expense reserves and $837 million in estimates of IBNR claims. The specific amounts and timing of obligations related to case reserves and associated loss expenses are not set contractually. The amounts and timing of obligations for IBNR claims and related loss expenses are unknown. We discuss the adequacy of our property casualty and life insurance loss and loss expense reserves in Property Casualty Insurance Reserves, Page 61. The historic pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The modified duration of our fixed-maturity portfolio was 7.1 years at year-end 2005. By contrast, the duration of our loss and loss expense reserves was 3.1 years and the duration of all liabilities was 2.8 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow 2005 10-K Page 59 from operations is sufficient to meet these obligations. In addition, our investment strategy has led to substantial unrealized gains from holdings in equity securities. These equity holdings could be liquidated to meet higher than anticipated loss and loss expenses. We believe that our insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen circumstances such as catastrophe losses, reinsurer insolvencies, changes in the timing of claims payments, increases in claims severity, reserve deficiencies or inadequate premium rates. We believe catastrophic events are the most likely cause of an unexpected rise in claims severity or frequency. Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover for losses under one of our reinsurance agreements depends on the financial viability of the reinsurer. While we believe that historical performance of property casualty and life loss payment patterns is a reasonable source for projecting future claims payments, there is inherent uncertainty in this estimate of contractual obligations. We believe that we could meet our obligations under a significant and unexpected change in the timing of these payments because of the liquidity of our invested assets, strong financial position and access to lines of credit. Long-term Debt and Interest on Long-Term Debt Our estimate of material commitments for long-term debt was approximately 14.4 percent and our estimate of material commitments for interest on long-term debt was approximately 23.6 percent of the estimated contractual obligations at year-end 2005. Our interest expense rose in 2005 to an annual rate of approximately $52 million due to our 2004 issuance of $375 million aggregate principal amount of 6.125% senior notes due 2034. We generally have tried to minimize our reliance on debt financing and do not expect a material increase in interest expense in the near future. Annuitization Obligations Our estimate of material commitments for obligations due under annuities written by our life insurance subsidiary was approximately 3.5 percent of the estimated contractual obligations at year-end 2005. Headquarters Building Expansion The construction of our new office building and parking garage to be situated at our headquarters located in Fairfield is expected to require approximately $83 million over the next three years. The construction project is on schedule and on budget. As of December 31, 2005, construction costs totaled $18 million. We expect construction to be completed by September 2008. We invested $100 million of the proceeds from our 2004 issuance of $375 million aggregate principal amount of 6.125% senior notes due 2034 in short-term investments to fund this obligation. Computer Hardware and Software We expect to need approximately $14 million over the next five years for material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discuss below the non-contractual expenses we anticipate for computer hardware and software in 2006. Commissions and Other Underwriting Expenses In addition to our contractual obligations, our insurance operations use cash for commission and other underwriting expenses. As discussed above, commissions and other underwriting expenses paid rose in each the past two years, reflecting the operating expense trends we discuss in the Commercial Lines and Personal Lines Insurance Results of Operations, Page 41 and Page 47. Commission payments also include contingent, or profit-sharing, commissions, which are paid to agencies using a formula that takes into account agency profitability and other factors, such as prompt monthly payment of amounts due to the company. Commission payments generally track with written premiums. Contingent commission payments in 2006 will be influenced by the excellent profitability we generated in 2005 and 2004. Many of our operating expenses are not contractual obligations, but reflect the ongoing expenses of our business. Staffing is the largest component of our operating expenses and is expected to rise again in 2006, reflecting the 4.3 percent average annual growth in our associate base over the past three years. Our associate base has grown as we focus on enhancing service to our agencies and staffing additional field territories. Other expenses should rise in line with our growth. In addition to contractual obligations for hardware and software, we anticipate investing approximately $16 million in key technology initiatives in 2006, including spending for the development and rollout of our 2005 10-K Page 60 commercial lines policy processing systems that we discuss in Item 1, Technology Solutions, Page 4. Capitalized development costs related to key technology initiatives totaled $11 million in 2005. These activities are conducted at our discretion and we have no material contractual obligations for activities planned as part of these projects. Investing Activities Excess cash flows from underwriting, investment and other corporate activities are invested in fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. See Item 1, Investments Segment, Page 15, for a discussion of our investment strategy, portfolio allocation and quality. Since the second quarter of 2004, virtually all of our available cash flow has been used to purchase fixed-maturity investments to reduce our property casualty subsidiary’s ratio of common stock to statutory surplus. Purchases of fixed-maturity securities rose significantly in 2005 and 2004. Due to the allocation of a higher percentage of new investment dollars to fixed-maturity investments, equity securities purchases in 2005 and 2004 were below the level of 2003. Purchases in 2005 included $144 million of nonredeemable preferred stock. We evaluate nonreedemable preferred stocks similar to the evaluation we make for fixed-maturity investments, seeking attractive relative yields. In 2006, we anticipate continuing to use the majority of available cash flow to purchase fixed-maturity investments and preferred stock. Common stock purchases primarily will be funded with proceeds of common stock sales. The trend of ratios we monitor could permit some common stock purchases with cash flow from operations. Uses of Capital Uses of cash to enhance shareholder return include: • Dividends to shareholders – Over the past 10 years, the company has paid an average of 42 percent of net income as dividends, with the remaining 58 percent available to reinvest for future growth and for share repurchases. The ability of the company to continue paying cash dividends is subject to factors the board of directors may deem relevant. In February 2006, the board of directors authorized a 9.8 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.34 per share. In 2005, 2004 and 2003, we paid cash dividends of $204 million, $177 million and $156 million. • Common stock repurchase – Our board believes that stock repurchases can help fulfill our commitment to enhancing shareholder value. Consequently, the board has authorized the repurchase of outstanding shares. Common stock repurchases for treasury have continued at a steady pace over the last several years and occur when we believe that stock prices on the open market are favorable for such repurchases. At a minimum, we would expect the repurchase to offset dilution of option exercises. In 2005, 2004 and 2003, we used $63 million, $66 million and $55 million for share repurchase. In 2005, the board authorized a 10 million share repurchase program to replace a program authorized in 1999. At year-end 2005, 9.5 million shares remained authorized for repurchase under the 2005 program. The details of the repurchase activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 27. Between February 1999 and year-end 2005, we have repurchased 14.8 million shares at a total cost to the company of $543 million. We do not adjust number of shares repurchased and average price per repurchased share for stock dividends. PROPERTY CASUALTY INSURANCE RESERVES At year-end 2005, the total reserve balance, net of reinsurance, was $3.111 billion, compared with $2.977 billion at year-end 2004 and $2.845 billion at year-end 2003. We provide a reconciliation of the property casualty reserve balances with the loss and loss expense liability on the balance sheet in Item 8, Note 4 to the Consolidated Financial Statements, Page 90. The reserves reflected in the financial statements are management’s best estimate. The appointed actuary's range for adequate statutory reserves, net of reinsurance, was $2.921 billion to $3.153 billion for 2005; $2.794 billion to $3.032 billion for 2004; and $2.696 billion to $2.906 billion for 2003. The assumptions used to establish the recommended ranges were consistent with the actuary’s practices. Historically, we have established reserves in the upper half of the actuary's range, as discussed in Critical Accounting Estimates, Property Casualty Loss and Loss Expense Reserves, Page 35. In addition to our conclusions regarding adequate reserve levels, other factors that have affected reserve levels over the past three years included: • Increases in coverage in force in selected business lines • New business 2005 10-K Page 61 • Higher initial case reserves on liability claims • Judicial decisions and mass tort claims Loss cost inflation in selected lines • The types of coverages we offer and the risk levels retained have a direct influence on the development of claims. Specifically, claims that develop quickly and have lower risk retention levels generally are more predictable. As we discuss in Commercial Lines Insurance Segment Reserves, Page 64, re-underwriting the commercial lines book of business beginning in 2000, including decisions to non-renew certain policyholders due to risk levels and to increase rates to better reflect exposure levels, has resulted in improved profitability. We believe the program has led to a lower risk profile for the overall commercial lines segment, which has contributed to favorable loss reserve trends. As we discuss in Personal Lines Insurance Segment Reserves, Page 66, we are seeking to improve our personal lines segment performance, in particular the homeowner business line, partially by reducing risk exposure through changes in policy terms and conditions. We do not expect our actions in personal lines to have a material impact on loss reserve trends, largely due to the relatively short-tail nature of homeowner claims. In 2003 and 2004, $70 million in reserves were released following the November 2003 Ohio Supreme Court's limiting of its 1999 Scott-Pontzer v. Liberty Mutual decision. The reserve releases were primarily made in the commercial auto and other liability business lines. Following the fourth-quarter 2003 reserve review, reserve levels were modified to reflect management’s assessment that mold claims behaved similar to asbestos and environmental claims, and reserves for these claims should be estimated using similar methods. These changes have been seen predominately in the commercial multi-peril business line. We expect that mold exclusions added to our commercial policies beginning in 2003 will mitigate this issue after 2006. Further, beginning in 2003, reserve levels reflected the need to establish higher expense reserves because of the rise in litigation costs due to larger and more complex claims. These changes have been seen predominately in commercial multi-peril and other liability business lines. Beginning in 2002, our conclusions regarding reserve levels for all business lines reflected refinement of the manner in which the value of future salvage and subrogation for claims already incurred were estimated. Development of Loss and Loss Expenses We reconcile the beginning and ending balances of our reserve for loss and loss expenses at December 31, 2005, 2004 and 2003, in Item 8, Note 4 to the Consolidated Financial Statements, Page 90. The reconciliation of our year-end 2004 reserve balance to net incurred losses one year later recognizes approximately $160 million in redundant reserves. The table below shows the development of the estimated reserves for loss and loss expenses the past 10 years. • Section A shows our total property casualty loss and loss expense reserves recorded at the balance sheet date for each of the indicated calendar years on a gross and net basis. Those reserves represent the estimated amount of loss and loss expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that have been incurred but not yet reported to the company. • Section B shows the cumulative net amount paid with respect to the previously recorded reserve as of the end of each succeeding year. For example, as of December 31, 2005, we had paid $1.053 billion of loss and loss expenses in calendar years 1996 through 2005, for losses that occurred in accident years 1995 and prior. An estimated $130 million of losses remain unpaid as of year-end 2005 (net re-estimated reserves of $1.183 billion less cumulative paid loss and loss expenses of $1.053 billion). • Section C shows the re-estimated amount of the previously reported reserves based on experience as of the end of each succeeding year. The estimate is increased or decreased as we learn more about the frequency and severity of claims. • Section D, cumulative net redundancy, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 1995, had developed a $398 million redundancy over 10 years, net of reinsurance, which has been reflected in income over the 10 years. The effects on income in 2005, 2004 and 2003 of changes in estimates of the reserves for loss and loss expenses for all accident years are shown in the reconciliation below. 2005 10-K Page 62 (In millions) A. Originally reported reserves for unpaid loss and loss expenses: 1995 1996 1997 1998 Calendar year ended December 31, 2000 1999 2001 2002 2003 2004 2005 Gross of reinsurance Reinsurance recoverable Net of reinsurance B. Cumulative net paid as of: One year later Two years later Three years later Four years later Five years later Six years later Seven years later Eight years later Nine years later Ten years later C. Net reserves re-estimated as of: One year later Two years later Three years later Four years later Five years later Six years later Seven years later Eight years later Nine years later Ten years later D. Cumulative net redundancy as of: One year later Two years later Three years later Four years later Five years later Six years later Seven years later Eight years later Nine years later Ten years later Net liability re-estimated—latest Re-estimated recoverable—latest Gross liability re-estimated—latest Cummulative gross redundancy $ $ $ $ $ $ $ $ 1,690 $ 109 1,581 $ 1,824 $ 122 1,702 $ 1,889 $ 112 1,777 $ 1,978 $ 138 1,840 $ 2,093 $ 161 1,932 $ 2,401 $ 219 2,182 $ 2,865 $ 513 2,352 $ 3,150 $ 542 2,608 $ 3,386 $ 541 2,845 $ 3,514 $ 537 2,977 $ 3,629 518 3,111 395 $ 630 801 881 946 977 1,009 1,031 1,045 1,053 1,429 $ 1,380 1,279 1,236 1,227 1,189 1,205 1,210 1,208 1,183 152 $ 201 302 345 354 392 376 371 373 398 453 $ 732 884 992 1,049 1,093 1,123 1,146 1,159 1,582 $ 1,470 1,405 1,380 1,326 1,333 1,333 1,332 1,305 120 $ 232 297 322 376 369 369 370 397 499 $ 761 965 1,075 1,152 1,205 1,239 1,260 522 $ 853 1,067 1,207 1,283 1,333 1,366 591 $ 943 1,195 1,327 1,412 1,464 697 $ 758 $ 799 $ 817 $ 907 1,116 1,378 1,526 1,623 1,194 1,455 1,614 1,235 1,519 1,293 1,623 $ 1,551 1,520 1,465 1,466 1,463 1,460 1,435 1,724 $ 1,728 1,636 1,615 1,608 1,602 1,577 1,912 $ 1,833 1,802 1,771 1,757 1,733 2,120 $ 2,083 2,052 2,010 1,999 2,307 $ 2,263 2,178 2,153 2,528 $ 2,377 2,336 2,649 $ 2,546 2,817 154 $ 226 257 312 311 314 317 342 116 $ 112 204 225 232 238 263 20 $ 99 130 161 175 199 62 $ 99 130 172 183 45 $ 89 174 199 80 $ 231 272 196 $ 299 160 1,183 $ 179 1,362 $ 1,305 $ 174 1,479 $ 1,435 $ 189 1,624 $ 1,577 $ 214 1,791 $ 1,733 $ 222 1,955 $ 1,999 $ 248 2,247 $ 2,153 $ 513 2,666 $ 2,336 $ 548 2,884 $ 2,546 $ 526 3,072 $ 2,817 539 3,356 328 $ 345 $ 265 $ 187 $ 138 $ 154 $ 199 $ 266 $ 314 $ 158 In evaluating the development of our estimated reserves for loss and loss expenses for the past 10 years, note that each amount includes the effects of all changes in amounts for prior periods. For example, payments or reserve adjustments related to losses settled in 2005 but incurred in 1999 are included in the cumulative deficiency or redundancy amount for 2000 and each subsequent year. In addition, this table presents calendar year data, not accident or policy year development data, which readers may be more accustomed to analyzing. Conditions and trends that have affected development of the reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this data. Differences between the property casualty reserves reported in the accompanying consolidated balance sheets (prepared in accordance with GAAP) and those same reserves reported in the annual statements (filed with state insurance departments in accordance with statutory accounting practices – SAP), relate principally to the reporting of reinsurance recoverables, which are recognized as receivables for GAAP and as an offset to reserves for SAP. Asbestos and Environmental Reserves We believe that our asbestos and environmental reserves, including mold reserves, are adequate at this time and that these coverage areas are immaterial to our financial position due to the types of accounts we have insured in the past. Loss and loss expenses incurred for all asbestos and environmental claims were $12 million, or 0.7 percent of total loss and loss expenses in 2005, compared with $41 million, or 2.4 percent in 2004, and $28 million, or 1.6 percent, in 2003. The increase in 2004 was primarily due to mold claims prior to the introduction of the mold exclusion to our policy forms. 2005 10-K Page 63 Net reserves for all asbestos and environmental claims were $132 million in 2005 compared with $135 million in 2004 and $105 million in 2003. Net reserves for all asbestos and environmental claims were 4.2 percent, 4.5 percent and 3.7 percent of total reserves, in 2005, 2004 and 2003, respectively. We generally wrote commercial accounts after the development of coverage forms that exclude asbestos cleanup costs. We believe our exposure to risks associated with past production and/or installation of asbestos materials is minimal because we primarily were a personal lines company when most of the asbestos exposure occurred. The commercial coverage we did offer was predominantly related to local-market construction activity rather than asbestos manufacturing. Further, over the past four years, to limit our exposure to mold and other environmental risks going forward, we have revised policy terms where permitted by state regulation. We continue to evaluate our exposure to silicosis and welding claims, but believe our exposure is minimal. Commercial Lines Insurance Segment Reserves For the business lines in the commercial lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves. The rise in total gross reserves for our commercial business lines was related to our growth. Commercial multi-peril reserve growth also was related to the higher proportion of commercial lines catastrophe losses in 2005 compared with 2004. Workers compensation reserve growth also was related to medical cost inflation and longer estimated payout periods as we discussed in Commercial Lines Insurance Results of Operations, Page 41. (In millions) At December 31, 2005 Commercial multi-peril Workers compensation Commercial auto Other liability All other lines of business Total At December 31, 2004 Commercial multi-peril Workers compensation Commercial auto Other liability All other lines of business Total Loss reserves Case reserves IBNR reserves Loss expense reserves Total gross reserves Percent of total $ $ $ $ 505 $ 283 267 312 277 1,644 $ 465 $ 258 254 288 289 1,554 $ 101 $ 333 56 368 24 882 $ 123 $ 278 58 377 19 855 $ 228 $ 79 65 140 135 647 $ 227 $ 75 64 111 130 607 $ 834 695 388 820 436 3,173 815 611 376 776 438 3,016 26.3 % 21.9 12.2 25.9 13.7 100.0 % 27.0 % 20.3 12.5 25.7 14.5 100.0 % As a result of underwriting actions taken since 2000 and a generally favorable insurance marketplace, the commercial lines segment has been able to obtain higher premium per exposure. As a result, profitability has improved due to higher revenue on stable loss and loss expenses. 2005 10-K Page 64 The following table provides the amounts of net reserve changes made over the past three years by commercial line of business and accident year: (Dollars in millions) As of December 31, 2005 2004 accident year 2003 accident year 2002 accident year 2001 accident year 2000 accident year 1999 accident year 1998 and prior accident years Redundancy/(deficiency) Reserves as originally estimated Reserves re-estimated as of December 31, 2005 Redundancy/(deficiency) Impact on loss and loss expense ratio As of December 31, 2004 2003 accident year 2002 accident year 2001 accident year 2000 accident year 1999 accident year 1998 accident year 1997 and prior accident years Redundancy/(deficiency) Reserves as originally estimated Reserves re-estimated as of December 31, 2004 Redundancy/(deficiency) Impact on loss and loss expense ratio As of December 31, 2003 2002 accident year 2001 accident year 2000 accident year 1999 accident year 1998 accident year 1997 accident year 1996 and prior accident years Redundancy/(deficiency) Reserves as originally estimated Reserves re-estimated as of December 31, 2003 Redundancy/(deficiency) Impact on loss and loss expense ratio Commercial multi-peril Workers compensation Commercial auto Other liability $ $ $ $ $ $ $ $ $ $ $ $ 5 22 9 7 0 2 16 61 760 699 61 7.7 % (5) 2 5 4 0 1 (11) (4) 691 695 (4) (0.6) % (3) 2 (10) 5 (2) (2) (3) (13) 609 622 (13) (2.0) % $ $ $ $ $ $ $ $ $ $ $ $ (9) (13) (8) (3) (3) (3) (4) (43) 557 600 (43) (13.3) % 5 (1) (6) (3) (2) (1) (7) (15) 514 529 (15) (4.9) % (1) (3) (2) (1) 0 (1) (5) (13) 477 490 (13) (4.3) % $ $ $ $ $ $ $ $ $ $ $ $ 16 5 2 1 0 0 10 34 372 338 34 7.4 % 11 10 4 4 7 3 8 47 381 334 47 10.5 % 11 2 7 11 2 1 3 37 383 346 37 8.8 % 36 32 6 1 (8) 0 (17) 50 599 549 50 11.2 % 36 41 27 13 2 0 12 131 635 504 131 32.5 % 36 15 5 6 3 5 9 79 580 501 79 23.0 % $ $ $ $ $ $ $ $ $ $ $ $ The overall favorable development recorded in the commercial lines reserves illustrates the potential for revisions inherent in estimating reserves, especially in long-tail lines such as other liability. With the exception of the UM/UIM reserve releases and other significant changes in assumptions discussed above, commercial lines reserve development over the past three years was consistent with: • The initiative, begun in 2001, to establish higher initial case reserves on liability claims in the period in which the claim is reported. • Higher than expected medical inflation affecting the workers compensation line • Settlements that differed from the established case reserves • Changes in case reserves based on new information for specific claims or classes of claims • Differences in the timing of actual settlements compared with the payout patterns assumed in the accident year IBNR reductions • Lower risk profile after 2001 due to commercial lines underwriting initiatives 2005 10-K Page 65 Personal Lines Insurance Segment Reserves For the business lines in the personal lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were down slightly from year-end 2004 due to normal claims activity on a lower policy count and lower personal lines catastrophe reserves in 2005 than in 2004. (In millions) At December 31, 2005 Personal auto Homeowners All other lines of business Total At December 31, 2004 Personal auto Homeowners All other lines of business Total Loss reserves Case reserves IBNR reserves Loss expense reserves Total gross reserves Percent of total $ $ $ $ 175 $ 70 55 300 $ 181 $ 81 57 319 $ 4 $ 21 67 92 $ 15 $ 21 73 109 $ 34 $ 18 12 64 $ 35 $ 23 12 70 $ 213 109 134 456 231 125 142 498 46.9 % 23.8 29.3 100.0 % 46.4 % 25.1 28.5 100.0 % Over the past three years, higher-than-normal catastrophe losses have contributed to the personal lines loss and loss expenses. The following table provides the amounts of net reserve changes made over the past three years by personal line of business and accident year: (Dollars in millions) As of December 31, 2005 2004 accident year 2003 accident year 2002 accident year 2001 accident year 2000 accident year 1999 accident year 1998 and prior accident years Redundancy/(deficiency) Reserves as originally estimated Reserves re-estimated as of December 31, 2005 Redundancy/(deficiency) Impact on loss and loss expense ratio As of December 31, 2004 2003 accident year 2002 accident year 2001 accident year 2000 accident year 1999 accident year 1998 accident year 1997 and prior accident years Redundancy/(deficiency) Reserves as originally estimated Reserves re-estimated as of December 31, 2004 Redundancy/(deficiency) Impact on loss and loss expense ratio As of December 31, 2003 2002 accident year 2001 accident year 2000 accident year 1999 accident year 1998 accident year 1997 accident year 1996 and prior accident years Redundancy/(deficiency) Reserves as originally estimated Reserves re-estimated as of December 31, 2003 Redundancy/(deficiency) Impact on loss and loss expense ratio 2005 10-K Page 66 Personal auto Homeowners $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 2 0 2 4 1 1 2 12 231 219 12 2.7 % (9) (1) 3 3 1 1 1 (1) 224 225 (1) (0.2) % (8) (4) 0 2 0 1 0 (9) 201 210 (9) (2.1) % 1 2 0 1 0 (1) 0 3 114 111 3 1.0 % 0 1 4 1 0 0 0 6 89 83 6 2.2 % 2 5 0 1 0 0 0 8 96 88 8 3.1 % The overall favorable development recorded in the personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. Personal lines reserve development over the past three years was consistent with: • Settlements that differed from the established case reserves • Changes in case reserves based on new information for specific claims or classes of claims • Differences in the timing of actual settlements compared with the payout patterns assumed in the accident year IBNR reductions • Recognition of favorable case reserve development LIFE INSURANCE RESERVES Gross life policy reserves were $1.343 billion at year-end 2005, compared with $1.194 billion at year-end 2004. We establish reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions. We establish reserves for our universal life, deferred annuity and investment contracts equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals. We regularly review our life insurance business to ensure that any deferred acquisition cost associated with the business is recoverable and that our actuarial liabilities (life insurance segment reserves) make sufficient provision for future benefits and related expenses. 2005 10-K Page 67 2006 REINSURANCE PROGRAMS A single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event could present us with a liquidity risk. In an effort to control such losses, we forego marketing property casualty insurance in specific geographic areas, monitor our exposure in certain coastal regions, review aggregate exposures to huge disasters and purchase reinsurance. We use the Risk Management Solutions and Applied Insurance Research models to evaluate exposures to a once-in-250-year event in determining appropriate reinsurance coverage programs. In conjunction with these activities, we also continue to evaluate information provided by our reinsurance broker. These various sources explore and analyze credible scientific evidence, including the impact of global climate change, which may affect our exposure under insurance policies. Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions regarding the appropriate level of property casualty risk retention are affected by various factors, including changes in our underwriting practices, capacity to retain risks and reinsurance market conditions. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover for losses covered under one of our reinsurance agreements depends on the financial viability of the reinsurer. Currently participating on our property and casualty per-occurrence programs are American Reinsurance Company, GE Insurance Solutions, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of which have A.M. Best insurer financial strength ratings of A (Excellent) or A+ (Superior). Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and Europe markets. The estimated incremental premium savings is $7 million for the 2006 property casualty reinsurance agreements, without taking into account the reinstatement premium incurred in 2005. The savings primarily is due to higher retention levels and to lower rates for the casualty per occurrence program, which offset higher rates for the property per occurrence and property catastrophe programs. Primary components of the 2006 property and casualty reinsurance program include: • Property per risk treaty – The primary purpose of the property treaty is to provide excess limits capacity up to $25 million, supplying adequate capacity for the majority of the risks we write and also includes protection for extra-contractual liability coverage losses. The ceded premium is estimated to be $30 million for 2006, compared with $29 million in 2005 and $27 million in 2004. In 2006, we are retaining the first $4 million of each loss. Losses between $4 million and $25 million are reinsured at 100 percent. The $4 million base retention is new for 2006. Last year, we retained the first $3 million of every property loss. Losses in excess of $3 million were reinsured at 100 percent up to $25 million in 2005. • Casualty per occurrence treaty – The casualty treaty provides excess limits capacity up to $25 million. Similar to the property treaty, this provides sufficient capacity to cover the vast majority of casualty accounts we insure and also includes protection for extra-contractual liability coverage losses. The ceded premium is estimated to be $47 million in 2006, compared with $64 million in 2005 and $61 million in 2004. In 2006, we are changing to a flat $4 million retention. Previously, we retained the first $2 million of each casualty loss, and 60 percent of the next $2 million of loss. Losses in excess of $4 million are reinsured at 100 percent up to $25 million. In mid-2005, we modified our casualty per occurrence treaty for director and officer policies for five Fortune 1000 companies and one financial services company. For three of the six companies, our retention per policy could be as high as $15 million rather than the $4 million for a typical policy; for one of the other companies, our retention per policy could be as high as $14 million; for the other two companies, our retention per policy could be as high as $5 million. We believe the additional risk undertaken with these selected policies remains at an acceptable level based on our financial strength. We arranged for this exception for this small group of companies to maintain business relationships with key agencies and insureds. We intend to review this element of our working treaties on an ongoing basis. • Casualty excess treaties – We purchase a casualty reinsurance treaty that provides an additional $25 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $50 million of protection for workers compensation, extra-contractual liability coverage and clash coverage losses, which is used when there is a single occurrence involving multiple policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated to be $2 million in 2006 up only slightly from 2005 and 2004. We purchase another casualty excess treaty, which provides an additional $20 million in casualty loss coverage. This treaty also provides catastrophic coverage for workers compensation and extra-contractual liability coverage losses. The ceded premium is estimated to be $1 million for 2006, similar to the premium paid in 2005. 2005 10-K Page 68 • Property catastrophe treaty – To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, we purchase property catastrophe reinsurance, with a limit up to $500 million. For the 2006 treaty, ceded premiums are estimated to be $38 million, up from $29 million in 2005, excluding the reinstatement premium, and $27 million in 2004, excluding the reinstatement premium. The premium increase for 2006 primarily is due to the difficult market conditions brought on in part by the record catastrophe losses experienced by reinsurance companies in 2005. We increased our retention on this program to $45 million and we will retain 5 percent of losses between $45 million and $500 million. In 2005, we retained the first $25 million of losses arising out of a single event, 40 percent of losses from $25 million to $45 million and 5 percent of all losses in excess of $45 million, up to $500 million. Individual risks with insured values in excess of $25 million as identified in the policy are handled through a different reinsurance mechanism. We reinsure property coverage for individual risks with insured values between $25 million and $50 million under an automatic facultative treaty. For those risks with property values exceeding $50 million, we negotiate the purchase of facultative coverage on an individual certificate basis. For casualty coverage on individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis. Responding to the challenges presented by terrorism has become a very important issue for the insurance industry over the last three years. Terrorism coverage at various levels has been secured in all of our reinsurance agreements. The broadest coverage for this peril is found in the property and casualty working treaties, which provide coverage for commercial and personal risks. Our property catastrophe treaty provides coverage for personal risks and the majority of its reinsurers provide limited coverage for commercial risks with total insured values of $10 million or less. For insured values between $10 million and $25 million, there also may be coverage in the property working treaty. Reinsurance protection for the company’s surety business is covered under separate treaties with many of the same reinsurers that write the property casualty working treaties. Reinsurance protection for our life insurance business is covered under separate treaties with many of the same reinsurers that write the property casualty working treaties. In 2005, we modified our reinsurance protection for our term life insurance business due to changes in the marketplace that affected the cost and availability of reinsurance for term life insurance. We are retaining no more than a $500,000 exposure, ceding the balance using excess over retention mortality coverage, and retaining the policy reserve. Retaining the policy reserve has no direct impact on GAAP results. However, because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of our capital. We also have catastrophe reinsurance coverage on our life insurance operations that reimburses us up to $20 million for covered net losses in excess of $5 million. The treaty contains a reinstatement provision, provided the covered losses were not due to terrorism. The NAIC has asked for comments on proposals to modify statutory accounting procedures to reduce the negative effect on statutory life insurance income. We expect the NAIC proposals will be adopted. If they are not, we believe we will be able to structure a reinsurance program to provide the life insurance company with the ability to continue to grow in the term life insurance marketplace while appropriately managing risk, at a cost that allows us to achieve our life insurance company profit targets. SAFE HARBOR STATEMENT This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. Some of those risks and uncertainties are discussed in Item 1A, Risk Factors, Page 21. Although we often review or update our forward-looking statements when events warrant, we caution our readers that we undertake no obligation to do so. Factors that could cause or contribute to such differences include, but are not limited to: • Unusually high levels of catastrophe losses due to risk concentrations, changes in weather patterns, environmental events, terrorism incidents or other causes • Ability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased and financial strength of reinsurers • Increased frequency and/or severity of claims • Events or conditions that could weaken or harm the company’s relationships with its independent agencies and hamper opportunities to add new agencies, resulting in limitations on the company’s opportunities for growth, such as: ○ Downgrade of the company’s financial strength ratings, ○ Concerns that doing business with the company is too difficult or 2005 10-K Page 69 ○ Perceptions that the company’s level of service, particularly claims service, is no longer a distinguishing characteristic in the marketplace • Increased competition that could result in a significant reduction in the company’s premium growth rate • Underwriting and pricing methods adopted by competitors that could allow them to identify and flexibly price risks, which could decrease our competitive advantages • Insurance regulatory actions, legislation or court decisions or legal actions that increase expenses or place us at a disadvantage in the marketplace • Delays or inadequacies in the development, implementation, performance and benefits of technology projects and enhancements • Inaccurate estimates or assumptions used for critical accounting estimates, including loss reserves • Events that reduce the company’s ability to maintain effective internal control over financial reporting under the Sarbanes-Oxley Act of 2002 in the future • Recession or other economic conditions or regulatory, accounting or tax changes resulting in lower demand for insurance products • Sustained decline in overall stock market values negatively affecting the company’s equity portfolio; in particular a sustained decline in the market value of Fifth Third shares, a significant equity holding • Events that lead to a significant decline in the value of a particular security and impairment of the asset • Prolonged low interest rate environment or other factors that limit the company’s ability to generate growth in investment income • Adverse outcomes from litigation or administrative proceedings • Effect on the insurance industry as a whole, and thus on the company’s business, of the actions undertaken by the Attorney General of the State of New York and other regulators against participants in the insurance industry, as well as any increased regulatory oversight that might result • Investment activities or market value fluctuations that trigger restrictions applicable to the parent company under the Investment Company Act of 1940 Further, the company’s insurance businesses are subject to the effects of changing social, economic and regulatory environments. Public and regulatory initiatives have included efforts to adversely influence and restrict premium rates, restrict the ability to cancel policies, impose underwriting standards and expand overall regulation. The company also is subject to public and regulatory initiatives that can affect the market value for its common stock, such as recent measures affecting corporate financial reporting and governance. The ultimate changes and eventual effects, if any, of these initiatives are uncertain. Readers are cautioned that the company undertakes no obligation to review or update the forward-looking statements included herein. Item 7A. Quantitative and Qualitative Disclosures About Market Risk INTRODUCTION Market risk is the potential for a decrease in securities value resulting from broad yet uncontrollable forces such as: inflation, economic growth, interest rates, world political conditions or other widespread unpredictable events. It is comprised of many individual risks that, when combined, create a macroeconomic impact. The company accepts and manages risks in the investment portfolio as part of the means of achieving portfolio objectives. Some of the risks are: • Political – the potential for a decrease in market value due to the real or perceived impact of governmental policies or conditions • Regulatory – the potential for a decrease in market value due to the impact of legislative proposals or changes in laws or regulations • Economic – the potential for a decrease in value due to changes in general economic factors (recession, inflation, deflation, etc.) • Revaluation – the potential for a decrease in market value due to a change in relative value (change in market multiple) of the market brought on by general economic factors • Interest-rate – the potential for a decrease in market value of a security or portfolio due to its sensitivity to changes (increases or decreases) in the general level of interest rates 2005 10-K Page 70 Company-specific risk is the potential for a particular issuer to experience a decline in valuation due to the impact of sector or market risk on the holding or because of issues specific to the firm: • Fraud – the potential for a negative impact on an issuer’s performance due to actual or alleged illegal or improper activity of individuals it employs • Credit – the potential for deterioration in an issuer’s financial profile due to specific company issues, problems it faces in the course of its operations or industry-related issues • Default – the possibility that an issuer will not make a required payment (interest payment or return of principal) on its debt. Generally this occurs after its financial profile has deteriorated (credit risk) and it no longer has the means to make its payments The investment committee of the board of directors monitors the investment risk management process primarily through its executive oversight of our investment activities. We take an active approach to managing market and other investment risks, including the accountabilities and controls over these activities. Actively managing these market risks is integral to our operations and could require us to change the character of future investments purchased or sold or require us to shift the existing asset portfolios to manage exposure to market risk within acceptable ranges. Sector risk is the potential for a negative impact on a particular industry due to its sensitivity to factors that make up market risk. Market risk affects general supply/demand factors for an industry and will affect companies within that industry to varying degrees. Risks associated with the five asset classes described in Item 1, Investments Segment, Page 15, can be summarized as follows (H – high, A – average, L – low): Political Regulatory Economic Revaluation Interest rate Fraud Credit Default Taxable Tax-exempt fixed maturities A A A A H A A A fixed maturities H A A A H L L L Common equities A A H H A A A A Preferred equities A A A A H A A A Short-term investments L L L L L L L L FIXED-MATURITY INVESTMENTS For investment-grade corporate bonds, the inverse relationship between interest rates and bond prices leads to falling bond values during periods of increasing interest rates. Although the potential for a worsening financial condition, and ultimately default, does exist with investment-grade corporate bonds, their higher-quality financial profiles make credit risk less of a concern than for lower-quality investments. We address this risk by consistently investing within a particular maturity range, which has, over the years, provided the portfolio with a laddered maturity schedule, which we believe is less subject to large swings in value due to interest rate changes. While a single maturity range may see values drop due to general interest rate levels, other maturity ranges will be less affected by those changes. Additionally, purchases are spread across a wide spectrum of industries and companies, diversifying our holdings and minimizing the impact of specific industries or companies with greater sensitivities to interest rate fluctuations. The primary risk related to high-yield corporate bonds is credit risk or the potential for a deteriorating financial structure. A weak financial profile can lead to rating downgrades from the credit rating agencies, which can put further downward pressure on bond prices. Interest rate risk is less of a factor with high-yield corporate bonds, as valuation is related more directly to underlying operating performance than to general interest rates. This puts more emphasis on the financial results achieved by the issuer rather than general economic trends or statistics within the marketplace. We address this concern by analyzing issuer- and industry-specific financial results and by closely monitoring holdings within this asset class. The primary risks related to tax-exempt bonds are interest rate risk and political risk associated with the specific economic environment within the political boundaries of the issuing municipal entity. We address these concerns by focusing on municipalities' general-obligation debt and on essential-service bonds. Essential- service bonds derive a revenue stream from the services provided by the municipality, which are vital to the people living in the area (water service, sewer service, etc.). Another risk related to tax-exempt bonds is regulatory risk or the potential for legislative changes that would negate the benefit of owning tax-exempt bonds. We monitor regulatory activity for situations that may negatively affect current holdings and its ongoing strategy for investing in these securities. The final, less significant risk is a small exposure to credit risk for a portion of the tax-exempt portfolio that has support from corporate entities. Examples are bonds insured by corporate bond insurers or bonds with interest payments made by a corporate entity through a municipal conduit/authority. While decisions regarding these 2005 10-K Page 71 investments primarily consider the underlying municipal situation, the existence of third-party insurance reduces risk in the event of default. In circumstances in which the municipality is unable to meet its obligations, risk would be increased if the insuring entity were experiencing financial duress. Because of our diverse exposure and selection of higher-rated entities with strong financial profiles, we do not believe this is a material concern. Interest Rate Sensitivity Analysis Because of our strong surplus, long-term investment horizon and ability to hold most fixed-maturity investments until maturity, we believe the company is well positioned if interest rates were to rise. A higher rate environment would provide the opportunity to invest cash flow in higher-yielding securities, while reducing the likelihood of calls of the higher-yielding U.S. agency paper purchased over the past year. While higher interest rates would be expected to continue to increase the number of fixed-maturity holdings trading below 100 percent of book value, we believe lower fixed-maturity security values due solely to interest rate changes would not signal a decline in credit quality. A dynamic financial planning model developed during 2002 uses analytical tools to assess market risks. As part of this model, the modified duration of the fixed-maturity portfolio is continually monitored by our investment department to evaluate the theoretical impact of interest rate movements. We measure modified duration and duration to worst. The table below summarizes the effect of hypothetical changes in interest rates on the fixed-maturity portfolio under both duration scenarios: (In millions) At December 31, 2005 At December 31, 2004 Fair value of fixed maturity portfolio Modified duration 100 basis point spread decrease 100 basis point spread increase $ 5,476 $ 5,868 $ 5,070 5,445 5,084 4,695 Duration to worst 100 basis point spread decrease 100 basis point spread increase $ 5,779 $ 5,326 5,173 4,814 The modified duration of our portfolio is currently 7.1 years and the modified duration of the redeemable preferred portfolio is currently 10.4 years. A 100 basis-point movement in interest rates would result in an approximately 7.2 percent change in the market value of the combined portfolios. Generally speaking, the higher a bond’s rating, the more directly correlated movements in its market value will be to changes in the general level of interest rates. Therefore, the municipal bond portfolio is more likely to respond to a changing interest rate scenario. Our U.S. agency paper portfolio, because it generally has very little call protection, has a low duration and would not be expected to be as responsive to rate movements. Lower investment grade and high-yield corporate bond values are driven by credit spreads, as well as their durations, in response to interest rate movements. In the dynamic financial planning model, the selected interest rate change of 100 basis points represents our views of a shift in rates that is quite possible over a one-year period. The rates modeled should not be considered a prediction of future events as interest rates may be much more volatile in the future. The analysis is not intended to provide a precise forecast of the effect of changes in rates on our results or financial condition, nor does it take into account any actions that we might take to reduce exposure to such risks. SHORT-TERM INVESTMENTS Our short-term investments present minimal risk as we generally purchase the highest quality commercial paper. EQUITY INVESTMENTS Common stocks are subject to a variety of risk factors encompassed under the umbrella of market risk. General economic swings influence the performance of the underlying industries and companies within those industries. A downturn in the economy will have a negative impact on an equity portfolio. Industry- and company-specific risks have the potential to substantially affect the market value of the company's equity portfolio. We address these risks by maintaining investments in a small group of holdings that we can analyze closely, better understanding their business and the related risk factors. At December 31, 2005, the company held 14 individual equity positions valued at approximately $100 million or above, see Item 1, Investments Segment, Page 15, for additional details on these holdings. These equity positions accounted for approximately 93.8 percent of the unrealized appreciation of the entire portfolio. We believe our equity investment style – centered on companies that pay and increase dividends to shareholders – is an appropriate long-term strategy. While our long-term financial position would be affected by prolonged changes in the market valuation of our investments, we believe our strong surplus position and cash flow provide a cushion against short-term fluctuations in valuation. We believe that the continued payment of cash dividends by the issuers of the common equities we hold also should provide a floor to their valuation. 2005 10-K Page 72 Our investments are heavily weighted toward the financials sector, which represented 63.4 percent of the total fair value of the common stock portfolio at December 31, 2005. Financials sector investments typically underperform the overall market during periods when interest rates are expected to rise. We historically have seen these types of short-term fluctuations in market value of its holdings as potential buying opportunities but are cognizant that a prolonged downturn in this sector could create a long-term negative effect on the portfolio. Over the longer term, our objective is for the performance of our equity portfolio to exceed that of the broader market. Over the five years ended December 31, 2005, our compound annual equity portfolio return was a negative 0.8 percent compared with a compound annual total return of 0.5 percent for the Standard & Poor’s 500 Index, a common benchmark of market performance. In 2005, our compound annual equity portfolio was a negative 4.2 percent, compared with a compound annual total return of 4.9 percent for that Index. Our equity portfolio underperformed the market for these periods because of the decline in the market value of our holdings of Fifth Third common stock over the past five years. The primary risk related to preferred stock is similar to those related to investment grade corporate bonds. Falling interest rates will adversely impact market values due the normal inverse relationship between rates and yields. Credit risk exists due to their subordinate position in the capital structure. We minimize this risk by primarily purchasing investment grade preferred stocks of issuers with a strong history of paying a common stock dividend. Fifth Third Bancorp Holding One of our common stock holdings, Fifth Third, accounted for 26.3 percent of our shareholders’ equity at year- end 2005 and dividends earned from our Fifth Third investment were 20.2 percent of our investment income in 2005. (In millions except market price data) Fifth Third Bancorp common stock holding: Dividends earned Percent of total investment income Shares held Closing market price of Fifth Third Book value of holding Fair value of holding After-tax unrealized gain Market value as a percent of total equity investments Market value as a percent of invested assets Market value as a percent of total shareholders' equity After-tax unrealized gain as a percent of total shareholders' equity $ $ 2005 Years ended December 31, 2004 2003 $ 106 20.2 % $ 95 19.4 % 82 17.7 % At December 31, 2005 2004 $ 73 37.72 283 2,745 1,600 38.6 % 21.6 45.1 26.3 73 47.30 283 3,443 2,054 45.9 % 27.2 55.1 32.9 Based on 2005 results, a 10 percent change in dividends earned from our Fifth Third holding would result in an $11 million change in pretax investment income and a $9 million change in after-tax earnings. Every $1.00 change in the market price of Fifth Third’s common stock has approximately a 27 cent impact on our book value per share. A 20 percent change in the market price of Fifth Third’s common stock from its year-end 2005 closing price would result in a $549 million change in assets and a $357 million change in after-tax unrealized gains. Fifth Third’s market value over the past three years has been impacted by a difficult interest rate environment and the residual effects of a regulatory review that was concluded in early 2004. We believe that they have come out of the process a stronger bank operationally and we believe the management team can execute on the strategy for growth they have defined. During this challenging period for the bank, we have continued to benefit from their superior dividend growth. In September 2005, Fifth Third increased its indicated annual dividend by 8.6 percent, which is expected to contribute an additional $9 million to investment income on an annualized basis. 2005 10-K Page 73 UNREALIZED INVESTMENT GAINS AND LOSSES At December 31, 2005, unrealized investment gains before taxes totaled $5.145 billion and unrealized investment losses in the investment portfolio amounted to $78 million. Unrealized Investment Gains The unrealized gains at year-end 2005 were primarily due to long-term gains from the company's holdings in the common stock of Fifth Third (Nasdaq: FITB) and Alltel Corporation (NYSE: AT). Reflecting the company’s long-term investment philosophy, of the 1,082 securities trading at or above book value, 767, or 70.9 percent, have shown unrealized gains for more than 24 months. Unrealized Investment Losses – Potential Other-than-temporary Impairments The asset impairment policy evaluates significant decreases in the market value of the assets; changes in legal factors or in the business climate; or other such factors indicating whether or not the carrying amount may be recoverable. A declining trend in market value, the extent of the market value decline and the length of time in which the value has been depressed are objective measures that can be outweighed by subjective measures such as impending events and issuer liquidity. In 2005 and earlier, impairment is evaluated in the event of a declining market value for four consecutive quarters with quarter-end market value below 50 percent of book value, or when a security’s market value is 50 percent below book value for three consecutive quarters. Effective January 1, 2006, impairment may be evaluated in the event a declining market value for four consecutive quarters with quarter-end market value below 70 percent of book value, or when a security’s market value is 70 percent below book value for three consecutive quarters. In addition to applying the impairment policy, the status of the portfolio is constantly monitored by the company’s portfolio managers for indications of potential problems or issues that may be possible impairment issues. If an impairment indicator is noted, the portfolio managers even more closely scrutinize the security. During 2005 and 2004, a total of six securities were written down as other-than-temporarily impaired. We expect the number of securities trading below 100 percent of book value to fluctuate as interest rates rise or fall. Further, book values for some securities have been revised due to impairment charges recognized during 2003 and 2002. At December 31, 2005, 732 of the 1,814 securities we owned were trading below 100 percent of book value compared with 208 of the 1,593 securities we owned at December 31, 2004. Of the 732 holdings trading below book value at December 31, 2005, 714 were trading between 90 percent and 100 percent of book value. The 732 holdings trading below book value at December 31, 2005, represented 22.3 percent of invested assets and $78 million in unrealized losses. We deem the risk related to securities trading between 70 percent and 100 percent of book value to be relatively minor and at least partially offset by the earned income potential of these investments. • 714 of these holdings were trading between 90 percent and 100 percent of book value. The value of these securities fluctuates primarily because of changes in interest rates. The fair value of these 714 securities was $2.717 billion at December 31, 2005, and they accounted for $57 million in unrealized losses. • 18 of these holdings were trading below 90 percent of book value at December 31, 2005. The fair value of these holdings was $111 million, and they accounted for the remaining $21 million in unrealized losses. These holdings are being monitored for credit- and industry-related risk factors. Of these securities, seven are bonds or convertible preferred stocks of auto industry-related issuers and one is a common stock of a pharmaceutical company. These eight securities account for $69 million of the fair value of holdings trading below 90 percent of book value. The remaining ten are smaller positions in a variety of industries. Holdings trading below 70 percent of book value are monitored more closely for potential other-than-temporary impairment. At December 31, 2005, two auto-related holdings with a fair value of $8 million were trading below 70 percent of book value. At year-end 2004, no securities were trading below 70 percent of book value. As discussed in Critical Accounting Estimates, Asset Impairment, Page37, when evaluating other-than-temporary impairments, we consider our ability to retain a security for a period adequate to recover a substantial portion of its cost. Because of our investment philosophy and strong capitalization, we can hold securities until their scheduled redemption that might otherwise be deemed impaired as we evaluate their potential for recovery based economic, industry or company factors. 2005 10-K Page 74 The following table summarizes the investment portfolio by period of time: (Dollars in millions) 6 Months or less > 6 - 12 Months > 12 - 24 Months > 24 - 36 Months Number of issues Gross unrealized gain/loss Number of issues Gross unrealized gain/loss Number of issues Gross unrealized gain/loss Number of issues Gross unrealized gain/loss Taxable fixed maturities: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Total Tax-exempt fixed maturities: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Total Common equities: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Total Preferred equities: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Total Short-term investments: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Total Summary: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Total 2 $ 185 37 224 0 357 51 408 0 1 5 6 0 8 11 19 0 0 2 2 (4) (22) 3 (23) 0 (8) 1 (7) 0 0 3 3 0 (2) 1 (1) 0 0 0 0 0 $ 57 14 71 0 32 43 75 0 1 1 2 0 0 4 4 0 0 0 0 0 (17) 1 (16) 0 (3) 1 (2) 0 0 1 1 0 0 1 1 0 0 0 0 0 $ 46 35 81 0 32 105 137 0 2 4 6 0 0 3 3 0 0 0 0 0 (12) 5 (7) 0 (3) 3 0 0 (5) 8 3 0 0 0 0 0 0 0 0 0 $ 5 346 351 0 3 384 387 0 0 35 35 0 1 2 3 0 0 0 0 0 (1) 102 101 0 0 43 43 0 0 4,968 4,968 0 (1) 4 3 0 0 0 0 2 551 106 659 $ (4) (32) 8 (28) 0 90 62 152 $ 0 (20) 4 (16) 0 80 147 227 $ 0 (20) 16 (4) 0 9 767 776 $ 0 (2) 5,117 5,115 2005 10-K Page 75 The following table summarizes the investment portfolio: (Dollars in millions) At December 31, 2005 Taxable fixed maturities: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Securities sold in current year Total Tax-exempt fixed maturities: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Securities sold in current year Total Common equities: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Securities sold in current year Total Preferred equities: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Securities sold in current year Total Short-term investments: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Securities sold in current year Total Portfolio summary: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Securities sold in current year Total At December 31, 2004 Portfolio summary: Trading below 70% of book value Trading at 70% to less than 100% of book value Trading at 100% and above of book value Securities sold in current year Total Number of issues Book value Fair value Gross unrealized gain/loss Gross investment income 2 $ 12 $ 8 $ 293 432 0 727 0 424 583 0 1,007 0 4 45 0 49 0 9 20 0 29 0 0 2 0 2 2 730 1,082 0 1,814 $ 0 $ 208 1,385 0 1,593 $ 1,839 1,453 0 3,304 0 941 1,142 0 2,083 0 51 1,910 0 1,961 0 63 104 0 167 0 0 75 0 75 12 2,894 4,684 0 7,590 $ 0 $ 900 5,899 0 6,799 $ 1,787 1,564 0 3,359 0 927 1,190 0 2,117 0 46 6,890 0 6,936 0 60 110 0 170 0 0 75 0 75 8 2,820 9,829 0 12,657 $ 0 $ 883 11,756 0 12,639 $ (4) $ (52) 111 0 55 0 (14) 48 0 34 0 (5) 4,980 0 4,975 0 (3) 6 0 3 0 0 0 0 0 (4) (74) 5,145 0 5,067 $ 0 $ (17) 5,857 0 5,840 $ 1 84 99 15 199 0 32 55 3 90 0 1 229 0 230 0 1 3 0 4 0 0 1 0 1 1 118 387 18 524 0 32 427 32 491 2005 10-K Page 76 Item 8. Financial Statements and Supplementary Data RESPONSIBILITY FOR FINANCIAL STATEMENTS We have prepared the consolidated financial statements of Cincinnati Financial Corporation and our subsidiaries for the year ended December 31, 2005, in accordance with accounting principles generally accepted in the United States of America (GAAP). We are responsible for the integrity and objectivity of these financial statements. The amounts, presented on an accrual basis, reflect our best estimates and judgment. These statements are consistent in all material aspects with other financial information in the Annual Report on Form 10-K. Our accounting system and related internal controls are designed to assure that our books and records accurately reflect the company’s transactions in accordance with established policies and procedures as implemented by qualified personnel. Our board of directors has established an audit committee of independent outside directors. We believe these directors are free from any relationships that could interfere with their independent judgment as audit committee members. The audit committee meets periodically with management, our independent registered public accounting firm and our internal auditors to discuss how each is handling responsibilities. The audit committee reports on their findings to the board of directors. The audit committee recommends to the board the annual appointment of the independent registered public accounting firm. The audit committee reviews with this firm the scope of the audit assignment and the adequacy of internal controls and procedures. Deloitte & Touche LLP, our independent registered public accounting firm, audited the consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2005. Their report is on Page 79. Deloitte’s auditors met with our audit committee to discuss the results of their examination. They have the opportunity to present their opinions about the adequacy of internal controls and the quality of financial reporting without management present. 2005 10-K Page 77 MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of Cincinnati Financial Corporation and its subsidiaries is responsible for establishing and maintaining adequate internal controls, designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America (GAAP). The company’s internal control over financial reporting includes those policies and procedures that: 1. Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; 2. Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP and that receipts and expenditures of the company are being made only in accordance with authorizations of management and the directors of the company; and 3. Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements. All internal control systems, no matter how well designed, have inherent limitations, including the possibility of human error and the circumvention of overriding controls. Accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation and presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time. The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2005, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment is based on the criteria established in the Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and was designed to provide reasonable assurance that the company maintained effective internal control over financial reporting as of December 31, 2005. The assessment led management to conclude that, as of December 31, 2005, the company’s internal control over financial reporting was effective based on those criteria. The company’s independent registered public accounting firm has issued an attestation report on our internal control over financial reporting as of December 31, 2005, and the company’s management assessment of our internal control over financial reporting. This report appears below. /S/ John J. Schiff, Jr. Chairman, President and Chief Executive Officer /S/ Kenneth W. Stecher Chief Financial Officer, Senior Vice President, Secretary and Treasurer (Principal Accounting Officer) March 10, 2006 2005 10-K Page 78 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of Cincinnati Financial Corporation: We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the company) as of December 31, 2005 and 2004, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedules listed in the Index at Item 15(c). We also have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting report, that the company maintained effective internal control over financial reporting as of December 31, 2005, based on the criteria established in the Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedules, an opinion on management’s assessment, and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. A company’s internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the company as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, management’s assessment that the company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, the company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. /S/ Deloitte & Touche LLP Cincinnati, Ohio March 6, 2006 2005 10-K Page 79 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in millions except per share data) ASSETS Investments Fixed maturities, at fair value (amortized cost: 2005—$5,387; 2004—$4,783) Equity securities, at fair value (cost: 2005—$2,128; 2004—$1,945) Short-term investments, at fair value (cost: 2005—$75; 2004—$71) Other invested assets Cash and cash equivalents Investment income receivable Finance receivable Premiums receivable Reinsurance receivable Prepaid reinsurance premiums Deferred policy acquisition costs Land, building and equipment, net, for company use (accumulated depreciation: 2005—$232; 2004—$206) Other assets Separate accounts Total assets LIABILITIES Insurance reserves Loss and loss expense reserves Life policy reserves Unearned premiums Other liabilities Deferred income tax 6.125% senior notes due 2034 6.9% senior debentures due 2028 6.92% senior debenture due 2028 Separate accounts Total liabilities SHAREHOLDERS' EQUITY Common stock, par value-$2 per share; authorized: 2005-500 million shares, 2004- 200 million shares; issued: 2005-194 million shares, 2004-185 million shares Paid-in capital Retained earnings Accumulated other comprehensive income—unrealized gains on investments and derivatives Treasury stock at cost (2005—20 million shares, 2004—18 million shares) Total shareholders' equity Total liabilities and shareholders' equity Accompanying notes are an integral part of this statement. At December 31, 2005 2004 5,476 $ 7,106 75 45 119 117 105 1,116 681 14 429 168 66 486 16,003 $ 3,661 $ 1,343 1,559 455 1,622 371 28 392 486 9,917 389 969 2,088 3,284 (644) 6,086 16,003 $ 5,070 7,498 71 38 306 107 95 1,119 680 15 400 156 75 477 16,107 3,549 1,194 1,539 474 1,834 371 420 0 477 9,858 370 618 2,057 3,787 (583) 6,249 16,107 $ $ $ $ 2005 10-K Page 80 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In millions except per share data) REVENUES Earned premiums Property casualty Life Investment income, net of expenses Realized investment gains and losses Other income Total revenues BENEFITS AND EXPENSES Insurance losses and policyholder benefits Commissions Other operating expenses Taxes, licenses and fees Increase in deferred policy acquisition costs Interest expense Other expenses Total benefits and expenses INCOME BEFORE INCOME TAXES PROVISION (BENEFIT) FOR INCOME TAXES Current Deferred Total provision for income taxes NET INCOME PER COMMON SHARE Net income—basic Net income—diluted Accompanying notes are an integral part of this statement. 2005 Years ended December 31, 2004 2003 3,058 $ 106 526 61 16 3,767 1,911 627 290 72 (19) 51 12 2,944 823 188 33 221 2,919 $ 101 492 91 11 3,614 1,846 615 260 75 (30) 38 10 2,814 800 171 45 216 602 $ 584 $ 3.44 $ 3.40 $ 3.30 $ 3.28 $ 2,653 95 465 (41) 9 3,181 1,887 536 204 67 (42) 34 15 2,701 480 130 (24) 106 374 2.11 2.10 $ $ $ $ 2005 10-K Page 81 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions) COMMON STOCK - NUMBER OF SHARES Beginning of year 5% stock dividend Purchase of treasury shares End of year COMMON STOCK Beginning of year 5% stock dividend Stock options exercised End of year PAID-IN CAPITAL Beginning of year 5% stock dividend Stock loan Stock options exercised Other End of year RETAINED EARNINGS Beginning of year Net income 5% stock dividend Dividends declared End of year ACCUMULATED OTHER COMPREHENSIVE INCOME Beginning of year Change in accumulated other comprehensive income, net End of year TREASURY STOCK Beginning of year Purchase Reissued for stock options End of year Total shareholders' equity COMPREHENSIVE INCOME Net income Change in accumulated other comprehensive income, net Total comprehensive income Accompanying notes are an integral part of this statement. 2005 At December 31, 2004 2003 167 9 (2) 174 370 $ 18 1 389 618 341 0 9 1 969 2,057 602 (359) (212) 2,088 3,787 (503) 3,284 (583) (63) 2 (644) 160 8 (1) 167 352 $ 18 0 370 306 312 (3) 3 0 618 1,986 584 (330) (183) 2,057 4,084 (297) 3,787 (524) (66) 7 (583) 6,086 $ 6,249 $ 602 $ (503) 99 $ 584 $ (297) 287 $ 162 0 (2) 160 352 0 0 352 300 0 0 6 0 306 1,772 374 0 (160) 1,986 3,643 441 4,084 (469) (55) 0 (524) 6,204 374 441 815 $ $ $ $ 2005 10-K Page 82 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (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 (gains) losses on investments Negotiated settlement-software cost recovery 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 Deferred income tax Current income tax Net cash provided by operating activities 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 Change in short-term investments, net Investment in buildings and equipment, net Investment in finance receivables Collection of negotiated settlement-software cost recovery Change in other invested assets, net Net cash used in investing activities CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from 6.125% senior notes Debt issuance costs from 6.125% senior notes Payment of cash dividends to shareholders Purchase/issuance of treasury shares Decrease in notes payable Proceeds from stock options exercised Contract holder funds deposited Contract holder funds withdrawn Net cash used in financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Supplemental disclosures of cash flow information: Interest paid Income taxes paid Conversion of fixed maturity to equity security and fixed maturity investments Accompanying notes are an integral part of this statement. Years ended December 31, 2004 2003 2005 $ 602 $ 584 $ 33 (61) 0 28 (10) 2 (19) 5 112 84 20 (17) 33 (7) 805 243 466 104 34 (1,297) (219) (4) (44) (45) 0 (9) (771) 0 0 (204) (61) 0 11 87 (54) (221) (187) 306 119 $ 51 $ 195 42 28 (91) 0 24 (8) (118) (30) (13) 134 109 93 83 45 (17) 823 175 664 536 32 (1,718) (148) (71) (33) (46) 9 (1) (601) 371 (4) (177) (59) (183) 3 93 (51) (7) 215 91 306 $ 34 $ 188 23 $ $ 374 30 41 (23) 23 (1) (97) (42) 17 239 75 127 14 (24) 63 816 192 457 217 25 (1,143) (335) 3 (38) (33) 14 (1) (642) 0 0 (156) (55) 0 6 45 (35) (195) (21) 112 91 34 65 51 2005 10-K Page 83 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Nature of Operations We underwrite insurance through four companies that market through local independent insurance agents. Our products include a broad range of business and personal policies, as well as life and disability income insurance and annuities. We also provide finance/leasing products and asset management services through our CFC Investment Company and CinFin Capital Management Company subsidiaries. Basis of Presentation Our consolidated financial statements include the accounts of the parent company and our wholly owned subsidiaries. We present our statements in accordance with accounting principles generally accepted in the United States of America (GAAP). In consolidating our accounts, we have eliminated significant intercompany balances and transactions. In accordance with GAAP, we have made estimates and assumptions that affect the amounts we report and discuss in the financial statements and accompanying notes. Actual results could differ from our estimates. 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. We calculate net income per common share (diluted) assuming the exercise of stock options. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2005, including the 5 percent stock dividend paid April 26, 2005. Stock Options We have qualified and non-qualified stock option plans under which we grant options to employees. We grant these options, which can be exercised over 10-year periods, at prices that are not less than market price at the date of grant. We apply Accounting Principles Board (APB) Opinion 25 and related interpretations in accounting for these plans. Accordingly, we do not recognize any compensation cost for the plans. Had we determined compensation costs for our stock option plans based on the fair value at the grant dates, consistent with Statement of Financial Accounting Standards (SFAS) No. 123(R) “Share-Based Payments,” our net income and earnings per share would have been reduced to the pro forma amounts indicated below: (In millions except per share data) Net income Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 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, 2004 2003 2005 602 $ 584 $ 13 589 $ 3.44 $ 3.36 3.40 $ 3.32 12 572 $ 3.30 $ 3.24 3.28 $ 3.21 374 12 362 2.11 2.04 2.10 2.03 In determining these pro forma amounts, we estimated the fair value of each option on the date of grant. We used the binomial option-pricing model with the following weighted-average assumptions in 2005, 2004 and 2003, respectively: dividend yield of 2.66 percent, 2.40 percent and 2.40 percent; expected volatility of 25.61 percent, 25.65 percent and 26.03 percent; risk-free interest rates of 4.62 percent, 4.37 percent and 4.20 percent; and expected lives of 10 years for all years. Our compensation expense in the pro forma disclosures does not indicate future amounts, as options vest over several years and we generally make additional grants each year. The options we grant in our plans vest over three years. Property Casualty Insurance Property casualty policy written premiums are deferred and earned on a pro rata basis over the terms of the policies. We record as unearned premium the portion of written premiums that apply to unexpired policy terms. We do not consider investment income potential in setting insurance policy premiums. The expenses associated with issuing insurance policies – primarily insurance agent commissions, premium taxes and underwriting costs – are deferred and amortized over the terms of policies. We establish reserves to cover the expected cost of claims – or losses – and our expenses related to investigating, processing and resolving claims. Although determining the appropriate amount of reserves including reserves for catastrophe losses is inherently uncertain, we base our decisions on past experience and 2005 10-K Page 84 current facts. Reserves are based on claims reported prior to the end of the year and estimates of unreported claims. We take into account the fact that we may recover some of our costs through salvage and subrogation. We regularly review and update reserves using the most current information available. Any resulting adjustments are reflected in current operations. The Cincinnati Insurance Companies actively market property casualty insurance policies in 32 states. Our 10 largest states generated 71.1 percent, 72.1 percent and 73.1 percent of total property casualty premiums in 2005, 2004 and 2003, respectively. Ohio, our largest state, accounted for 23.1 percent, 23.7 percent and 24.6 percent of total earned premiums in 2005, 2004 and 2003. Agencies in Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each contributed between 4 percent and 10 percent of premium volume in 2005. No single agency accounted for more than 1.1 percent of the company's total agency direct earned premiums in 2005. Life and Health Insurance We offer several types of life and health insurance and we account for each according to the duration of the contract. Short-duration contracts are written to cover claims that arise during a short, fixed term of coverage. We generally have the right to change the amount of premium charged or cancel the coverage at the end of each contract term. Group life insurance is an example. We account for short-duration contracts similarly to property casualty contracts. Long-duration contracts are written to provide coverage for an extended period of time. Traditional long- duration contracts require policyholders to pay scheduled gross premiums, generally not less frequently than annually, over the term of the coverage. Premiums for these contracts are recognized as revenue when due. Whole life insurance is an example. Some traditional long-duration contracts have premium payment periods shorter than the period over which coverage is provided. For these contracts the excess of premium over the amount required to pay expenses and benefits is recognized over the term of the coverage rather than over the premium payment period. Ten-pay whole life insurance is an example. We establish a liability for traditional long-duration contracts as we receive premiums. The amount of this liability is the present value of future expenses and benefits less the present value of future net premiums. Net premium is the portion of gross premium required to provide for all expenses and benefits. We estimate future expenses and benefits and net premium using assumptions for expected expenses, mortality, morbidity, withdrawal rates and investment income. We include a provision for adverse deviation, meaning we allow for some uncertainty in making our assumptions. We establish our assumptions when the contract is issued and we generally maintain those assumptions for the life of the contract. We use both our own experience and industry experience, adjusted for historical trends, in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumption for expected expenses. We base our assumption for expected investment income on our own experience, adjusted for current economic conditions. When we issue a traditional long-duration contract, we capitalize acquisition costs. Acquisition costs are costs which vary with, and are primarily related to, the production of new business. We then charge these deferred acquisition costs to expenses over the premium paying period of the contract and we use the same assumptions that we use when we establish the liability for the contract. Universal life contracts are long-duration contracts for which contractual provisions are not fixed, unlike whole life insurance. Universal life contracts allow policyholders to vary the amount of premium, within limits, without our consent. However we may vary the mortality and expense charges, within limits, and the interest crediting rate used to accumulate policy values. We do not record universal life premiums as revenue. Instead we recognize as revenue the mortality charges, administration charges and surrender charges when received. Some of our universal life contracts assess administration charges in the early years of the contract that are compensation for services we will provide in the later years of the contract. These administration charges are deferred and are recognized over the period when we provide those future services. For universal life long-duration contracts we maintain a liability equal to the policyholder account value. There is no provision for adverse deviation. When we issue a universal life long-duration contract we capitalize acquisition costs. We then charge these capitalized costs to expenses over the term of coverage of the contract. When we charge deferred acquisition costs to expenses, we use assumptions based on our best estimates of long-term experience. We review and modify these assumptions on a regular basis. Separate Accounts We issue life contracts with guaranteed minimum returns, referred to as bank-owned life insurance contracts (BOLIs). We legally segregate and record as separate accounts the assets and liabilities for some of our BOLIs, based on the specific contract provisions. We guarantee minimum investment returns, account values and death benefits for our separate account BOLIs. Our other BOLIs are general account products. 2005 10-K Page 85 We carry the assets of separate account BOLIs at fair value. The liabilities on separate account BOLIs primarily are the contract holders’ claims to the related assets and are carried at the fair value of the assets. If the BOLI asset value is projected below the value we guaranteed, a liability is established by a charge to the company’s earnings. Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holder and we do not include them in the Consolidated Statements of Income. Revenues and expenses for the company related to the separate accounts consist of contractual fees and mortality, surrender and expense risk charges. Also, each separate account BOLI includes a negotiated gain and loss sharing arrangement with the company. A percentage of each separate account’s realized gain and loss representing contract fees and assessments accrues to us and is transferred from the separate account to the company’s general account and is recognized as revenue or expense. Reinsurance We work to reduce risk and uncertainty by buying property casualty and life reinsurance. Reinsurance contracts do not relieve us from our duty to policyholders, but rather help protect our financial strength to perform that duty. We estimate loss amounts recoverable from our reinsurers based on the reinsurance policy terms. Historically, our claims with reinsurers have been paid. We do not have an allowance for uncollectible reinsurance. We also serve in a limited way as a reinsurer for other insurance companies, reinsurers and involuntary state pools. We record our transactions for such assumed reinsurance based on reports provided to us by the ceding reinsurer. Cash and Cash Equivalents Cash and cash equivalents include cash and money market funds. Investments Our portfolio investments are primarily in publicly traded fixed-maturity, equity and short-term investments, classified as available for sale in the accompanying financial statements. Valuations of all of our investments are based on either listed prices or data provided by an outside resource that supplies global securities pricing. Changes in the fair value of these securities, based on the listed prices or information from the outside resource, are reported on the balance sheet in other comprehensive income, net of tax. Fixed-maturity investments (taxable and tax-exempt bonds) and equity investments (common and preferred stocks) are classified as available for sale and recorded at fair value in the financial statements. Short-term investments are classified as available for sale and recorded at amortized cost, which approximates fair value, in the financial statements. The number of fixed-maturity securities trading below 100 percent of book value can be expected to fluctuate as interest rates rise or fall. Because of our strong surplus and long-term investment horizon, we expect to hold most fixed-maturity investments until maturity, regardless of short-term fluctuations in fair values. We include unrealized gains and losses on investments, net of taxes, in shareholders’ equity as accumulated other comprehensive income. Realized gains and losses on investments are recognized in net income on a specific identification basis. Investment income consists mainly of interest and dividends. We record interest on an accrual basis and record dividends at the ex-dividend date. We amortize premiums and discounts on fixed-maturity securities using the interest method. Facts and circumstances sometimes warrant investment write-downs. We record such other-than-temporary declines as realized investment losses. Fair Value Disclosures We base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on data provided by an outside resource that supplies global securities pricing. We estimate fair value for liabilities under investment-type insurance contracts (annuities) using discounted cash flow calculations. We base the calculations on interest rates offered on contracts of similar nature and maturity. We base fair value for long-term senior notes on the quoted market prices for such notes. Derivative Financial Instruments and Hedging Activities Some of our investments contain embedded options. These investments include convertible debt and convertible preferred stock. We calculate fair value and account for the embedded options separately. The changes in fair values of embedded derivates are recognized in net income in the period they occur. SFAS No. 133 “Accounting for Derivative Financial Instruments and Hedging Activities,” as amended, or any subsequent changes in fair values of these instruments, have not had a significant impact on the accompanying consolidated financial statements. We do not engage in any hedging activities. 2005 10-K Page 86 Lease/Finance Our CFC Investment Company subsidiary provides auto and equipment direct financing (leases and loans) to commercial and individual clients. We generally transfer ownership of the property to the client as the terms of the leases expire. Our lease contracts contain bargain purchase options. We record income over the financing term using the interest method. We capitalize and amortize lease or loan origination costs over the life of the financing using the interest method. These costs may include, but are not limited to: finder fees, broker fees, filing fees and the cost of credit reports. Asset Management Our CinFin Capital Management subsidiary generates revenue from management fees. We set those fees based on the market value of assets under management, and we record our revenue as it is earned. Land, Building and Equipment We record building and equipment at cost less accumulated depreciation. Our depreciation is based on estimated useful lives (ranging from three years to 39½ years) using straight-line and accelerated methods. Depreciation expense recorded in 2005, 2004 and 2003 was $33 million, $30 million and $31 million, respectively. We monitor land, building and equipment for potential impairments. Potential impairments include a significant decrease in the market values of the assets, considerable cost overruns on projects or a change in legal factors or business climate, or other factors that indicate that the carrying amount may not be recoverable. We capitalize costs for internally developed computer software during the application development stage. These costs generally consist of external consulting, payroll and payroll-related costs. Income Taxes We calculate deferred income tax liabilities and assets using tax rates in effect for the time when temporary differences in book and taxable income are estimated to reverse. We recognize deferred income taxes for numerous temporary differences between our 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. We charge deferred income taxes associated with unrealized appreciation (except the amounts related to the effect of income tax rate changes) to shareholders’ equity in accumulated other comprehensive income. We charge deferred taxes associated with other differences to income. New Accounting Pronouncements Statement of Financial Accounting Standards No. 123(R) In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25. On April 21, 2005, the Securities and Exchange Commission amended the effective date, stating that companies can choose implementation in either the reporting period beginning after June 15, 2005, or December 15, 2005. We intend to adopt SFAS No. 123(R) in the first quarter of 2006. SFAS No. 123(R) permits companies to adopt its requirements using either a modified prospective or a modified retrospective method. We currently utilize a standard option-pricing model (binomial option-pricing model) to measure the fair value of stock options granted to associates. Upon the adoption of SFAS No. 123(R), we will use the modified prospective method to measure the fair value of associate stock options. Subject to a complete review of the requirements of SFAS No. 123(R), based on stock options granted to associates through year-end 2005, we estimate that the adoption of SFAS No. 123(R) will reduce 2006 net income by approximately 8 cents per share. Statement of Financial Accounting Standards No. 154 In May 2005, the FASB issued SFAS No. 154, which eliminated the requirement in APB Opinion No. 20, “Accounting Changes,” that modified the requirements for the accounting and reporting of a change in accounting principles. APB Opinion No. 20 required changes in accounting principles be included as an accumulated amount in the income statement in the period of change. SFAS No. 154 requires that changes in accounting principles be retrospectively applied. The new accounting principle is applied at the beginning of the first period presented, as if that principle had always been used. The cumulative effect is applied to the applicable assets and liabilities with a corresponding offset to opening retained earnings. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. We do not expect SFAS No. 154 to have any material impact on the company’s consolidated financial statements. 2005 10-K Page 87 Reclassifications We have reclassified certain prior-year amounts to conform with current-year classifications. 2. (In millions) INVESTMENTS Investment income summarized by investment category: Interest on fixed maturities Dividends on equity securities Other investment income Total Less investment expenses Total Realized investment gains and losses summarized by investment category: Fixed maturities: Gross realized gains Gross realized losses Other-than-temporary impairments Equity securities: Gross realized gains Gross realized losses Other-than-temporary impairments Embedded derivatives Total Change in unrealized investment gains and losses summarized by investment category: Fixed maturities Equity securities Adjustment to deferred acquisition costs and life policy reserves Other Income taxes on above Total 2005 Years ended December 31, 2004 2003 $ $ $ $ $ $ 280 244 8 532 6 526 36 (1) (1) 40 (6) 0 (7) 61 (198) (575) 6 18 246 (503) $ $ $ $ $ $ 252 239 6 497 5 492 36 (20) (5) 101 (30) (1) 10 91 (6) (448) 3 (6) 160 (297) $ $ $ $ $ $ 235 227 7 469 4 465 35 (25) (73) 37 (17) (7) 9 (41) 211 488 (13) (9) (236) 441 The fair value of the conversion features embedded in convertible securities was a loss of $7 million at year-end 2005, a gain of $10 million at year-end 2004 and a gain of $9 million at year-end 2003. At December 31, 2005, contractual maturity dates for fixed-maturity and short-term investments were: (In millions) Maturity dates occuring: Less than one year One year through five years After five years through ten years After ten years through twenty years Over twenty years Total Amortized cost Fair value % of Fair value $ $ 154 602 2,900 1,550 256 5,462 $ $ 156 613 2,919 1,599 264 5,551 2.8 % 11.0 52.6 28.8 4.8 100.0 % Actual maturities may differ from contractual maturities when there is a right to call or prepay obligations with or without call or prepayment penalties. At December 31, 2005, investments with book value of $63 million and fair value of $65 million were on deposit with various states in compliance with regulatory requirements. 2005 10-K Page 88 The following table analyzes cost or amortized cost, gross unrealized gains, gross unrealized losses and fair value for our investments: (In millions) At December 31, 2005 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 and short-term investments Total Equity securities 2004 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 and short-term investments Total Equity securities $ $ $ $ $ $ Cost or amortized cost Gross unrealized gains losses Fair value 2,083 $ 269 139 1,000 1,971 5,462 $ 2,128 $ 1,622 $ 368 134 1,076 1,654 4,854 $ 1,945 $ 48 $ 17 6 0 88 159 $ 4,986 $ 75 $ 56 13 4 151 299 $ 5,558 $ 14 $ 8 1 20 27 70 $ 8 $ 3 $ 2 1 4 2 12 $ 5 $ 2,117 278 144 980 2,032 5,551 7,106 1,694 422 146 1,076 1,803 5,141 7,498 This table reviews unrealized losses and fair values by investment category and by length of time securities have been in a continuous unrealized loss position: (In millions) At December 31, 2005: Fixed maturities: Less than 12 months Fair value Unrealized losses 12 months or more Fair value Unrealized losses Total Fair value Unrealized losses 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 and short-term investments Total Equity securities: Total 2004: 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 and short-term investments Total Equity securities: Total $ $ $ $ 754 $ 73 44 608 387 1,866 59 1,925 $ 194 $ 26 10 295 101 626 59 685 $ 8 $ 3 1 8 11 31 2 33 $ 2 $ 1 0 3 1 7 4 11 $ 173 $ 39 6 354 284 856 47 903 $ 59 $ 27 5 70 14 175 23 198 $ 6 $ 6 0 11 16 39 6 45 $ 1 $ 1 1 1 1 5 1 6 $ 927 $ 112 50 962 671 2,722 106 2,828 $ 253 $ 53 15 365 115 801 82 883 $ 14 9 1 19 27 70 8 78 3 2 1 4 2 12 5 17 At December 31, 2005, 177 fixed-maturity investments with a total unrealized loss of $39 million and three equity securities with a total unrealized loss of $6 million had been in that position for 12 months or more. All were trading between 70 percent to less than 100 percent of book value. At December 31, 2004, 23 fixed-maturity investments with a total unrealized loss of $5 million and one equity security with a total unrealized loss of $1 million had been in that position for 12 months or more. All were trading between 70 percent to less than 100 percent of book value. 2005 10-K Page 89 Investments in companies that exceed 10 percent of our shareholders’ equity at December 31 include: (In millions) Issuers: Fifth Third Bancorp common stock ALLTEL Corporation common stock and fixed maturity $ 2005 2004 Cost Fair value Cost Fair value 283 $ 122 2,745 $ 807 283 $ 137 3,443 794 In December 2005, we sold 475,000 shares of our holdings of ALLTEL Corporation common stock. On January 24, 2006, we completed the sale of our remaining 12,700,164 shares. The sale contributed $27 million to our 2005 pretax realized gains. The $549 million gain from the sale in 2006 will be recognized in pretax realized investment gains and losses in the first quarter of 2006. After-tax proceeds from the sale totaled approximately $558 million. 3. This table summarizes components of our deferred policy acquisition costs asset: DEFERRED ACQUISITION COSTS (In millions) Deferred policy acquisition costs asset beginning of year Capitalized deferred policy acquisition costs Amortized deferred policy acquisition costs Amortized shadow deferred policy acquisition costs Deferred policy acquisition costs asset end of year 2005 At December 31, 2004 2003 $ $ 400 $ 683 (664) 10 429 $ 372 $ 657 (626) (3) 400 $ 343 615 (573) (13) 372 4. This table summarizes activity in the reserve for loss and loss expenses: PROPERTY CASUALTY LOSS AND LOSS EXPENSES (In millions) Gross loss and loss expense reserves, January 1 Less reinsurance receivable Net loss and loss expense reserves, January 1 Net incurred loss and loss expenses related to: Current accident year Prior accident years Total incurred Net paid loss and loss expenses related to: Current accident year Prior accident years Total paid Net loss and loss expense reserves, December 31 Plus reinsurance receivable Gross loss and loss expense reserves, December 31 2005 Years ended December 31, 2004 2003 $ $ 3,514 $ 537 2,977 1,972 (160) 1,812 772 906 1,678 3,111 518 3,629 $ 3,386 $ 541 2,845 1,949 (196) 1,753 804 817 1,621 2,977 537 3,514 $ 3,150 542 2,608 1,877 (80) 1,797 762 799 1,561 2,845 541 3,386 We base property casualty loss and loss expenses reserve estimates on our experience and on information gathered from internal analyses and our appointed actuary. When reviewing reserves, we analyze historical data and estimate the effect of various other factors, such as industry loss frequency and severity and premium trends; past, present and anticipated product pricing; anticipated premium growth; other quantifiable trends; and projected ultimate loss ratios. Because of changes in estimates of insured events in prior years, we decreased the provision for loss and loss expenses by $160 million, $196 million and $80 million in calendar years 2005, 2004 and 2003. These decreases are partly due to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for amounts less than expected. Following the Ohio Supreme Court’s late 2003 decision to limit its 1999 Scott-Pontzer v. Liberty Mutual decision, we released $38 million pretax of previously established uninsured/under-insured motorist (UM/UIM) reserves. In 2004, we released an additional $32 million in related case reserves. After that release, we stopped separately reporting on UM/UIM related reserve actions. We reported total catastrophe losses, net of reinsurance and before taxes, of $127 million for 2005, compared with $148 million for 2004 and $97 million in 2003. Most catastrophe losses are incurred in the calendar year of the event. The reserve for loss and loss expenses in the accompanying balance sheets also includes $32 million, $35 million and $29 million at December 31, 2005, 2004 and 2003, respectively, for certain life health losses. 2005 10-K Page 90 LIFE POLICY RESERVES 5. We establish the reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience, adjusted for historical trends, in arriving at our assumptions for expected mortality, morbidity and withdrawal rates as well as for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions. We establish reserves for the company’s universal life, deferred annuity and investment contracts equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals. Here is a summary of our life policy reserves: (In millions) Ordinary/traditional life Universal life Annuities Other Total At December 31, 2005 2004 $ $ 419 $ 376 523 25 1,343 $ 378 358 435 23 1,194 At December 31, 2005, and 2004, the fair value associated with the annuities shown above was approximately $563 million and $477 million, respectively. NOTES PAYABLE 6. We had two lines of credit with commercial banks amounting to $125 million with no outstanding balance at year-end 2005. We had no compensating balance requirement on short-term debt for either 2005 or 2004. We did not use either of these lines of credit in 2005. We had one line of credit with a commercial bank amounting to $75 million with no outstanding balance at year-end 2004. During 2004, we terminated an interest-rate swap entered into by CFC Investment Company in 2001 as a cash hedge of variable interest payments for certain variable-rate debt obligations. When we paid off the underlying debt, we terminated this agreement at a cost of $2 million, net of tax. 7. This table summarizes the principal amounts of our long-term debt: SENIOR DEBT (In millions) Interest Year of rate issue 6.125% 2004 6.92% 2005 6.90% 1998 Senior notes, due 2034 Senior debentures, due 2028 Senior debentures, due 2028 Total At December 31, 2005 2004 $ $ 375 $ 392 28 795 $ 375 0 420 795 The fair value of our senior debt approximated $870 million at year-end 2005 and approximated $843 million at year-end 2004. During 2005, we completed the exchange of outstanding 6.125% senior notes due 2034 for up to $375 million aggregate principal amount of newly issued 6.125% series B senior notes due 2034, which are substantially identical to the old 6.125% senior notes except that they have been registered under the Securities Act of 1933, as amended. As of the expiration of the exchange offer, $365 million aggregate principal amount of the outstanding notes had been tendered and accepted for exchange. That transaction had no effect on the company’s financial statements. We also completed our offer to exchange outstanding 6.90% senior debentures due 2028 for up to $420 million aggregate principal amount of newly issued 6.92% senior debentures due 2028. Holders of $392 million aggregate principal amount of the 6.90% senior debentures opted to exchange their bonds for newly issued 6.92% senior debentures. None of the notes are encumbered by rating triggers. SHAREHOLDERS’ EQUITY AND DIVIDEND RESTRICTIONS 8. Our insurance subsidiary declared dividends to the company of $275 million in 2005, $175 million in 2004 and $50 million in 2003. State of Ohio regulatory requirements restrict the dividends insurance subsidiaries can pay. Generally, the most Ohio-domiciled insurance subsidiaries can pay without prior regulatory approval is 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 2005 10-K Page 91 these limitations may be paid only with approval of the Ohio Department of Insurance. During 2006, the total dividends that our lead insurance subsidiary may pay to our parent company without regulatory approval will be approximately $517 million. Our board of directors on August 19, 2005, announced a program to repurchase up to 10 million shares of outstanding stock effective September 1, 2005. The new program replaced a 1999 repurchase authorization. Between September 1, 2005, and December 31, 2005, we purchased 534,000 shares at a cost of $24 million. At year-end 2005, 9.5 million shares remained authorized for repurchase at any time in the future. Repurchase shares are not adjusted for stock dividends. As of December 31, 2005, 13 million shares of common stock were available for future stock option grants. Declared cash dividends per share were $1.21, $1.04 and 90 cents for the years ended December 31, 2005, 2004 and 2003, respectively. Accumulated Other Comprehensive Income The change in unrealized gains and losses on investments and derivatives included: (In millions) Unrealized holding investment gains and losses on securities and derivatives Reclassification adjustment: Adjustment to deferred acquisition costs and life policy reserves Net realized (gain) loss on investments and derivatives Income taxes on above Total $ $ Income taxes relate to each component above ratably. 2005 Years ended December 31, 2004 2003 (694) $ 6 (61) 246 (503) $ (369) $ 3 (91) 160 (297) $ 649 (13) 41 (236) 441 9. Our statements of income include earned property casualty premiums on assumed and ceded business: REINSURANCE (In millions) Direct written premiums Assumed written premiums Ceded written premiums Net written premiums Direct earned premiums Assumed earned premiums Ceded earned premiums Net earned premiums 2005 Years ended December 31, 2004 2003 $ $ $ $ 3,231 $ 23 (178) 3,076 $ 3,209 $ 28 (179) 3,058 $ 3,141 $ 33 (177) 2,997 $ 3,062 $ 32 (175) 2,919 $ 2,949 44 (178) 2,815 2,808 56 (211) 2,653 Our statements of income include incurred property casualty loss and loss expenses on assumed and ceded business: (In millions) Direct incurred loss and loss expenses Assumed incurred loss and loss expenses Ceded incurred loss and loss expenses Net incurred loss and loss expenses 2005 Years ended December 31, 2004 2003 $ $ 1,898 $ 40 (126) 1,812 $ 1,870 $ 17 (134) 1,753 $ 1,856 44 (103) 1,797 2005 10-K Page 92 10. Here is a summary of the major components of our net deferred tax liability: INCOME TAXES (In millions) Deferred tax liabilities: Unrealized gains on investments and derivatives Deferred acquisition costs Other Total Deferred tax assets: Loss and loss expense reserves Unearned premiums Life policy reserves Capital loss carryforward Other Total Net deferred tax liability At December 31, 2005 2004 1,788 $ 135 32 1,955 179 108 26 0 20 333 1,622 $ 2,033 129 38 2,200 180 107 28 19 32 366 1,834 $ $ The provision for federal income taxes is based upon a consolidated income tax return for the company and subsidiaries. As of December 31, 2005, we had no capital loss carry forwards. The differences between the statutory income tax rates and our effective income tax rates are as follows: Tax at statutory rate Increase (decrease) resulting from: Tax-exempt municipal bonds Dividend exclusion Other Effective rate 2005 Years ended December 31, 2004 2003 35.0 % (3.2) (5.7) 0.7 26.8 % 35.0 % (2.5) (5.7) 0.2 27.0 % 35.0 % (3.8) (8.6) (0.6) 22.0 % Filed tax returns for calendar years 2000 through 2004 are currently open with the Internal Revenue Service. Federal income taxes are not provided for on our life insurance subsidiary’s Policyholder Surplus Account (PSA), which totaled $14 million at December 31, 2005, 2004 and 2003. Prior to 2005, U.S. tax rules provided that tax was due only on amounts distributed from the PSA. Had a distribution from the PSA occurred prior to 2005, tax due would have been approximately $5 million at current federal income tax rates. The tax liability of a stock life insurance company on distributions made from the PSA was suspended beginning January 1, 2005, by the American Jobs Creation Act of 2004. As a result of this legislation, our life insurance subsidiary has the ability to distribute amounts from its PSA to the parent company prior to December 31, 2006, without incurring federal income tax, thereby permanently eliminating the $5 million tax previously disclosed. NET INCOME PER COMMON SHARE 11. Basic earnings per share are computed based on the weighted average number of shares outstanding. Diluted earnings per share are computed based on the weighted average number of common and dilutive potential common shares outstanding. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2005. Here are calculations for basic and diluted earnings per share: (Dollars in millions except share data) Numerator: Net income—basic and diluted Denominator: Weighted-average common shares outstanding Effect of stock options Adjusted weighted-average shares Earnings per share: Basic Diluted 2005 Years ended December 31, 2004 2003 602 $ 584 $ 374 175,062,669 2,053,457 177,116,126 176,476,722 1,900,126 178,376,848 177,119,594 1,172,654 178,292,248 3.44 $ 3.40 $ 3.30 $ 3.28 $ 2.11 2.10 $ $ $ The only current source of dilution of our common shares is outstanding stock options to purchase shares of common stock. At year-end 2005, all outstanding options were included in the calculation. At year-end 2004 2005 10-K Page 93 and 2003, there were 0.3 million and 2.2 million outstanding options that we did not include in this calculation. We did not include these options in the computation of net income per common share (diluted) because their exercise prices were greater than the average market price of the common shares. PENSION PLAN 12. We sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension plan covering substantially all employees. We do not contribute to the 401(k) plan. Benefits for the defined benefit plan are based on years of credited service and compensation level. Contributions are based on the frozen entry age actuarial cost method. We also maintained a supplemental executive retirement plan, with liabilities of approximately $4 million, at year-end 2005 and 2004. Our pension expense is composed of several components that are determined using the projected unit credit actuarial cost method, and they are based on certain actuarial assumptions. Here is more detailed information about our defined benefit pension plan: (In millions) Change in benefit obligation: Benefit obligation at beginning of year Service cost Interest cost Actuarial loss Benefits paid Benefit obligation at end of year Accumulated benefit obligation Change in plan assets: Fair value of plan assets at beginning of year Actual return on plan assets Employer contributions 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 Accrued pension cost Years ended December 31, 2005 2004 199 13 12 18 (7) 235 165 158 12 10 (7) 173 (62) 52 (1) 7 (4) $ $ $ $ $ $ $ 167 11 10 14 (3) 199 142 138 15 8 (3) 158 (41) 34 (1) 7 (1) $ $ $ $ $ $ $ We use a December 31 measurement date for our plans. The accumulated benefit obligation was $165 million and $142 million at December 31, 2005, and 2004, respectively. The fair value of our stock comprised $29 million (17 percent of total plan assets) at December 31, 2005, and $27 million (17 percent of total plan assets) at December 31, 2004. We evaluate our pension plan assumptions annually and update them as necessary. The discount rate assumptions for our benefit obligation track with Moody’s Aa bond yield, and yearly adjustments reflect any changes to those bond yields. Compensation increase assumptions reflect historical calendar year compensation increases. Here is a summary of the assumptions we use to determine our benefit obligation: Discount rate Rate of compensation increase Here is a breakdown of the components of our net periodic benefit cost: Years ended December 31, 2005 2004 5.50 % 5-7 5.75 % 5-7 (In millions) Service cost Interest cost Expected return on plan assets Amortization of actuarial gain Net pension expense 2005 Years ended December 31, 2004 2003 $ $ 13 12 (13) 1 13 $ $ 11 10 (12) 0 9 $ $ 9 9 (13) (1) 4 We expect to contribute approximately $10 million to our pension plan in 2006. 2005 10-K Page 94 Here is a summary of the assumptions we use to determine our net expense for the plan: Discount rate Expected return on plan assets Rate of compensation increase Our pension plan asset allocations by category are: (In millions) Asset category: Equity securities Fixed maturities Cash and cash equivalents Total 2005 Years ended December 31, 2004 5.75 % 8.00 5-7 6.00 % 8.00 5-7 2003 6.50 % 8.00 5-7 At December 31, 2005 2004 93 % 5 2 100 % 91 % 7 2 100 % For 2006, we expect to target 90 percent of our pension plan assets for equity securities and 10 percent for fixed maturities and cash. We expect to make the following benefit payments, which reflect expected future service: (In millions) For the years ended December 31, 2006 2007 2008 2009 2010 Years 2011-2015 Pension benefits $ STATUTORY ACCOUNTING INFORMATION 13. Insurance companies use statutory accounting practices (SAP) as prescribed by regulatory authorities. Statutory accounting differs in certain respects from GAAP. The following table reconciles GAAP consolidated net income for the years ended December 31, and shareholders’ equity at December 31, with total statutory net income and capital and surplus: (In millions) Consolidated net income per GAAP Adjustments: Deferred policy acquisition costs Deferred income taxes Income from derivatives Elimination of intercompany realized gain Parent company and undistributed net income of non insurance subsidiaries Other Insurance subsidiaries net income per SAP Balances by major business type: Property casualty insurance Life insurance Total $ $ $ $ 2005 Years ended December 31, 2004 602 $ 584 $ 2003 (19) 13 19 (2) (41) (19) 553 532 21 553 $ $ $ (30) 73 (10) 88 (84) 6 627 599 28 627 $ $ $ 5 7 10 10 9 84 374 (42) (13) (9) 0 (67) 10 253 233 20 253 2005 10-K Page 95 (In millions) Consolidated shareholders' equity per GAAP Adjustments: Deferred policy acquisition costs Investments at fair value Deferred income taxes Parent company and undistributed net income of non-insurance subsidiaries Reserves and non-admitted assets Other Insurance subsidiaries shareholders' equity per SAP Balances by major business type: Property casualty insurance Life insurance Total At December 31, 2005 2004 6,086 $ 6,249 (429) (102) 172 (1,439) (13) (81) 4,194 3,743 451 4,194 $ $ $ (400) (272) 238 (1,550) (11) (63) 4,191 3,752 439 4,191 $ $ $ $ TRANSACTIONS WITH AFFILIATED PARTIES 14. We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $6 million, $11 million and $19 million on premium volume of approximately $41 million, $76 million, and $132 million for 2005, 2004 and 2003, respectively. On November 15, 2004, we repurchased 1 million shares of Cincinnati Financial common stock from Robert C. Schiff, Trustee, Robert C. Schiff Revocable Trust originally dated November 21, 2001. Robert C. Schiff is a founder of the company and retired as director of Cincinnati Financial Corporation in November 2004. The stock was sold to Cincinnati Financial at an aggregate purchase price equal to 99 percent of the product of (a) 1,000,000 multiplied by (b) $43.45, the last reported sale price per share of the common stock on the Nasdaq National Market at the close of trading on November 12, 2004. CONTINGENCIES 15. Legal issues are part of the normal course of business for all companies. As such, we have various litigation and claims against us in process and pending. Having analyzed those claims with our legal counsel, we believe the outcomes of normal insurance matters will not have a material effect on our consolidated financial position or results of operations. We further believe that the outcomes of non-insurance matters will be covered by insurance coverage or will not have a material effect on our consolidated financial position or results of operations. As previously reported, in June 2004 we discovered some uncertainty regarding the status of the Cincinnati Financial Corporation holding (parent) company under the Investment Company Act of 1940. Several tests and enumerated exemptions determine whether a company meets the definition of an investment company under the Investment Company Act. In particular, one test states that a company may be an investment company if it owns investment securities with a value greater than 40 percent of its total assets (excluding assets of its subsidiaries), a level which the holding company exceeded between 1991 and August 2004. On June 28, 2004, Cincinnati Financial Corporation filed an application with the SEC formally requesting an exemption for the holding company under Section 3(b)(2) of the Investment Company Act. Section 3(b)(2) specifically permits the SEC to exempt entities primarily engaged in business other than that of investing, reinvesting, owning, holding or trading in securities. Cincinnati Financial Corporation alternatively asked the SEC for relief pursuant to Section 6(c) of the Investment Company Act, which would exempt it from all the provisions of the Act because doing so is necessary or appropriate in the public interest, consistent with the protection of investors and consistent with the purposes intended by the Investment Company Act. Following its SEC filing, the holding company transferred investment securities to our subsidiary, The Cincinnati Insurance Company, in August 2004, lowering the holding company’s ratio of investment securities to holding- company-only assets below 40 percent. We have maintained that ratio below the 40 percent level since the time of the transfer. Because the ratio is below 40 percent, we believe the SEC staff is not actively considering the application. We strongly believe the holding company is, and has been, outside the intended scope of the Investment Company Act because the company is, and has been, primarily engaged in the business of property casualty and life insurance through its subsidiaries. As a registered investment company, the holding company would not be permitted to operate its business as it currently operates, nor would a registered investment company be permitted to have many of the relationships that the holding company has with its affiliated companies. 2005 10-K Page 96 To increase certainty that regulation under the Investment Company Act would not apply to the company in the future, our operations are limited by the constraint that investment securities held at the holding company level should remain below the 40 percent threshold described above. Efforts to stay below the threshold could result in: • A need to dispose of otherwise desirable investment securities, possibly under undesirable conditions. Such dispositions could result in a lower return on investment because of market value fluctuations. Dispositions also could result in loss of investment income that we may be unable to replace in a timely fashion. If we were unable to manage the timing of the dispositions, we also might realize unnecessary capital gains, which would increase our annual tax payment. • Limited opportunities to purchase equity securities that hold the potential for market value appreciation. Historically, the holding company has successfully invested in equity securities that provided both income and capital appreciation, contributing to long-term growth in book value. Constraining our ability to pursue this strategy and invest in equity securities could hamper book value growth over the long term. • Maintenance of a greater portion of our portfolio of equity securities at our insurance subsidiary. As a result of the transfer of assets to ensure compliance with the 40 percent threshold, the holding company now is more reliant on that subsidiary for cash to fund parent-company obligations, including shareholder dividends and interest on long-term debt. Although we intend to manage assets to stay below the 40 percent threshold, events beyond our control, including significant appreciation in the value of certain investment securities, could result in the holding company exceeding the 40 percent threshold. While we believe that even in such circumstances the company would not be an investment company because it is primarily engaged in the business of insurance through its subsidiaries, the SEC, among others, could disagree with this position. If it were determined that the holding company is an unregistered investment company, the holding company might be unable to enforce contracts with third parties, and third parties could seek rescission of transactions with the holding company undertaken during the period that it was an unregistered investment company, subject to equitable considerations set forth in the Investment Company Act. In addition, the holding company could become subject to monetary penalties or injunctive relief, or both, in an action brought by the SEC. 16. See Note 1 for a general description of our stock option plans. Here is a summary of options information: STOCK OPTIONS (Shares in thousands) Years ended December 31, 2005 Outstanding at beginning of year Granted/reinstated Exercised Forfeited/revoked Outstanding at end of year Options exercisable at end of year Weighted-average fair value of options granted during the year 2004 Outstanding at beginning of year Granted/reinstated Exercised Forfeited/revoked Outstanding at end of year Options exercisable at end of year Weighted-average fair value of options granted during the year 2003 Outstanding at beginning of year Granted/reinstated Exercised Forfeited/revoked Outstanding at end of year Options exercisable at end of year Weighted-average fair value of options granted during the year 2005 10-K Page 97 Weighted- average exercise price Shares 9,698 $ 1,504 (467) (146) 10,589 7,794 $ 8,791 $ 1,439 (397) (135) 9,698 7,050 $ 7,845 $ 1,366 (295) (125) 8,791 6,303 $ 32.05 41.62 24.18 35.89 33.70 31.69 12.49 30.63 38.81 24.02 34.29 32.05 30.50 11.18 29.96 32.47 20.47 32.79 30.63 29.57 9.82 Options outstanding and exercisable consisted of the following at December 31, 2005: Options outstanding Options exercisable Range of excercise prices $17.07 to 19.34 $20.37 to 24.14 $26.63 to 29.92 $30.60 to 35.00 $36.17 to 38.87 $41.14 to 41.62 Total Shares 474 309 1,066 4,938 2,065 1,737 10,589 Weighted- average remaining contractual life Weighted- average exercise price Weighted- average exercise price Shares $ 0.36 yrs 1.28 yrs 4.00 yrs 5.16 yrs 6.28 yrs 7.97 yrs 5.40 yrs 18.50 20.70 27.07 32.65 38.46 41.55 33.70 474 $ 309 1,066 4,515 1,162 268 7,794 18.50 20.70 27.07 32.67 38.20 41.15 31.69 SEGMENT INFORMATION 17. We operate primarily in two industries, property casualty insurance and life insurance. We regularly review four different reporting segments to make decisions about allocating resources and assessing performance: • Commercial lines property casualty insurance • Personal lines property casualty insurance • Life insurance Investment operations • We report as “Other” the operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding investment activities) as well as other income of our insurance subsidiary. Revenues come primarily from unaffiliated customers: • All three insurance segments record revenues from insurance premiums earned. Life insurance segment revenues also include fees from separate account investment management fees. • Our investment operations’ revenues are pretax net investment income plus realized investment gains and losses. • Other revenues are primarily finance/lease income. Income or loss before income taxes for each segment is reported based on the nature of that business area’s operations. To explain: • • • • • Income before income taxes for the insurance segments is defined as underwriting income or loss. For commercial lines and personal lines insurance segments, we calculate underwriting income or loss by recording premiums earned minus loss and loss expenses and underwriting expenses incurred. For the life insurance segment, we determine underwriting income or loss by taking premiums earned and separate account investment management fees, minus contract holder benefits and expenses incurred, plus investment interest credited to contract holders. Income before income taxes for the investment operations segment is net investment income plus realized investment gains and losses for all fixed-maturity and equity security investments of the entire company, minus investment interest credited to contract holders of the life insurance segment. Loss before income taxes for the Other category is primarily due to interest expense from debt of the parent company and operating expenses of our headquarters. Identifiable assets are used by each segment in its operations. We do not report the identifiable assets for the commercial or personal lines segments because we do not use that measure to analyze the segments. We include all fixed-maturity and equity security investment assets, regardless of ownership, in the investment operations segment. 2005 10-K Page 98 This table summarizes segment information: (In millions) Revenues: Commercial lines insurance Commercial multi-peril Workers compensation Commercial auto Other liability Other commercial lines Total commercial lines insurance Personal lines insurance Personal auto Homeowner Other personal lines Total personal lines insurance Life insurance Investment operations Other Total Income (loss) before income taxes: Insurance underwriting results: Commercial lines insurance Personal lines insurance Life insurance Investment operations Other Total Identifiable assets: Property casualty insurance Life insurance Investment operations Other Total 2005 Years ended December 31, 2004 2003 673 293 419 342 181 1,908 428 239 78 745 97 424 7 3,181 167 (27) (3) 381 (38) 480 $ $ $ $ $ $ 796 $ 328 456 442 232 2,254 433 285 86 804 110 587 12 3,767 $ 285 $ 45 7 536 (50) 823 $ 2,167 $ 845 12,774 217 16,003 $ 751 $ 313 450 402 210 2,126 451 259 83 793 104 583 8 3,614 $ 338 $ (40) 2 537 (37) 800 $ 2,317 837 12,746 207 16,107 QUARTERLY SUPPLEMENTARY DATA (UNAUDITED) This table includes unaudited quarterly financial information for the years ended December 31, 2005 and 2004: (Dollars in millions except per share data) 2005 Revenues Income before income taxes Net income Net income per common share—basic Net income per common share—diluted 2004 Revenues Income before income taxes Net income Net income per common share—basic Net income per common share—diluted $ $ 1st 2nd Quarter 3rd 4th Full year 916 $ 195 144 0.82 0.81 870 $ 201 146 0.83 0.82 940 $ 215 158 0.90 0.89 923 $ 214 155 0.88 0.87 944 $ 151 117 0.67 0.66 879 $ 113 90 0.51 0.50 967 $ 261 183 1.04 1.03 942 $ 272 192 1.10 1.09 3,767 823 602 3.44 3.40 3,614 800 584 3.30 3.28 Note: The sum of the quarterly reported amounts may not equal the full year as each is computed independently. 2005 10-K Page 99 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure We had no disagreements with the independent registered public accounting firm on accounting and financial disclosure during the last two fiscal years. Item 9A. Controls and Procedures The company maintains disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (Exchange Act)). Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. The company’s management, with the participation of the company’s chief executive officer and chief financial officer, has evaluated the effectiveness of the design and operation of the company’s disclosure controls and procedures as of December 31, 2005. Based upon that evaluation, the company’s chief executive officer and chief financial officer concluded that the design and operation of the company’s disclosure controls and procedures provided reasonable assurance that the disclosure controls and procedures are effective to ensure: • • that information required to be disclosed in the company’s reports under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to the company’s management, including its chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosures. In addition, there was no change in the company’s internal controls over financial reporting (as that term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, the company’s internal control over financial reporting. Management’s Annual Report on Internal Control Over Financial Reporting and the Attestation Report of the Independent Registered Public Accounting Firm are set forth in Item 8, Pages 78 and 79. Item 9B. Other Information None Directors and Executive Officers of the Registrant Part III Our Proxy Statement will be filed with the SEC in preparation for the 2006 Annual Meeting of Shareholders no later than April 14, 2006. As permitted in Paragraph G(3) of the General Instructions for Form 10-K, we are incorporating by reference to that statement portions of the information required by Part III as noted in Item 10 through Item 14 below. Item 10. a) Information about our directors and executive officers is in the Proxy Statement under “Security Ownership of Principal Shareholders and Management,” “Information Regarding Nondirector Executive Officers” and “Information regarding Nominees and Directors.” b) Information about Section 16(a) beneficial ownership reporting compliance appears in the Proxy Statement under “Section 16(a) Beneficial Ownership Reporting Compliance.” c) Information about the “Code of Ethics for Senior Financial Officers” appears in the 2004 Proxy Statement as an appendix and is available in the Investors section of our Web site, www.cinfin.com. Our code of ethics applies to those who are responsible for preparing and disclosing our financial information. This includes our chief executive officer, chief financial officer, chief investment officer and others performing similar functions or reporting directly to these officers. d) Information about our audit committee membership and our financial expert compliance appears in the Proxy Statement under “Information Regarding the Board of Directors” and “Report of the Audit Committee.” e) The procedures under which shareholders may recommend director nominees have not changed during the reporting period. Information on the nominating committee processes appears in the Proxy Statement under “Information Regarding the Board of Directors.” Item 11. Information on executive compensation appears in the Proxy Statement under “Executive Compensation Summary.” Executive Compensation 2005 10-K Page 100 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters a) Information on the security ownership of certain beneficial owners and management appears in the Proxy Statement under “Security Ownership of Principal Shareholders and Management.” b) Information on securities authorized for issuance under equity compensation plans appears in the Proxy Statement under “Equity Compensation Plan Information.” Additional information on options under our equity compensation plans is available in Item 8, Note 8 and Note 16 to the Consolidated Financial Statements, Pages 91 and 97. Item 13. Information about certain relationships and related transactions appears in the Proxy Statement under “Certain Relationships and Transactions” and “Compensation Committee Interlocks and Insider Participation.” Principal Accountant Fees and Services Item 14. Information about independent registered public accounting firm fees and services and audit committee pre- approval policies and procedures appears in the Proxy Statement under “Report of the Audit Committee,” “Fees Billed by the Independent Registered Public Accounting Firm” and “Services Provided by the Independent Registered Public Accounting Firm.” Certain Relationships and Related Transactions Part IV Exhibits and Financial Statement Schedules Item 15. a) Financial Statements – information contained in Part II, Item 8 of this report, Pages 80 - 83 b) Exhibits – see Index of Exhibits, Page 113 c) Financial Statement Schedules Schedule I – Summary of Investments -- Other than Investments in Related Parties, Page 102 Schedule II – Condensed Financial Statements of Registrant, Page 104 Schedule III – Supplementary Insurance Information, Page 107 Schedule IV –Reinsurance, Page 109 Schedule V – Valuation and Qualifying Accounts, Page 110 Schedule VI – Supplementary Information Concerning Property Casualty Insurance Operations, Page 111 2005 10-K Page 101 SCHEDULE I (In millions) Cincinnati Financial Corporation and Subsidiaries Summary of Investments - Other than Investments in Related Parties Type of investment Fixed maturities: United States government and government agencies and authorities: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company Total States, municipalities and political subdivisions: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company Total Public utilities: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company Cincinnati Financial Corporation Total Convertibles and bonds with warrants attached: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company CinFin Capital Management Company Cincinnati Financial Corporation Total All other corporate bonds: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company Cincinnati Financial Corporation Total Total fixed maturities $ $ At December 31, 2005 Cost or amortized cost Fair value Balance sheet amount 623 $ 6 2 369 1,000 1,927 117 34 5 2,083 53 4 1 80 1 139 221 0 1 42 0 5 269 933 30 13 805 115 1,896 5,387 $ 610 $ 7 2 362 981 1,958 118 34 7 2,117 54 4 1 83 1 143 229 0 1 43 0 5 278 958 31 14 837 117 1,957 5,476 $ 610 7 2 362 981 1,958 118 34 7 2,117 54 4 1 83 1 143 229 0 1 43 0 5 278 958 31 14 837 117 1,957 5,476 2005 10-K Page 102 SCHEDULE I (CONTINUED) Cincinnati Financial Corporation and Subsidiaries Summary of Investments - Other than Investments in Related Parties (In millions) Type of investment Equity securities: Common stocks: Public utilities: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Life Insurance Company CinFin Capital Management Company Cincinnati Financial Corporation Total Banks, trust and insurance companies: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company CinFin Capital Management Company Cincinnati Financial Corporation Total Industrial, miscellaneous and all other: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company CinFin Capital Management Company Cincinnati Financial Corporation Total Nonredeemable preferred stocks: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company CinFin Capital Management Company Cincinnati Financial Corporation Total Total equity securities Short-term investments: The Cincinnati Insurance Company Other invested assets: Real estate: The Cincinnati Life Insurance Company Policy loans: The Cincinnati Life Insurance Company Notes receivable: Cincinnati Financial Corporation Total other invested assets Total investments At December 31, 2005 Cost or amortized cost Fair value Balance sheet amount $ $ $ $ $ $ 120 $ 5 14 0 82 221 431 16 0 56 1 433 937 526 19 6 90 3 159 803 128 0 0 31 0 8 167 2,128 $ 75 $ 3 29 13 45 7,635 372 $ 14 67 0 559 1,012 2,228 77 0 162 1 1,603 4,071 1,304 58 15 198 3 275 1,853 132 0 0 30 0 8 170 7,106 $ 75 $ XXXX XXXX XXXX XXXX XXXX XXXX XXXX XXXX $ $ $ 372 14 67 559 1,012 2,228 77 0 162 1 1,603 4,071 1,304 58 15 198 3 275 1,853 132 0 0 30 0 8 170 7,106 75 3 29 13 45 12,702 2005 10-K Page 103 SCHEDULE II (In millions) Cincinnati Financial Corporation (parent company only) Condensed Balance Sheets At December 31, 2005 2004 ASSETS Investments Fixed maturities, at fair value Equity securities, at fair value Short-term investments, at fair value Other invested assets Cash and cash equivalents Equity in net assets of subsidiaries Investment income receivable Land, building and equipment, net, for company use (accumulated depreciation: 2005—$61; 2004—$51) Prepaid federal income tax Other assets Due from subsidiaries Total assets LIABILITIES Dividends declared but unpaid Deferred federal income tax 6.125% senior notes due 2034 6.9% senior debentures due 2028 6.92% senior debentures due 2028 Other liabilities Total liabilities SHAREHOLDERS' EQUITY Common stock Paid-in capital Retained earnings Accumulated other comprehensive income—unrealized gains on investments and derivatives Treasury stock at cost Total shareholders' equity Total liabilities and shareholders' equity $ 123 $ 2,444 0 13 7 4,685 17 98 32 17 144 7,580 $ 53 $ 635 371 28 392 15 1,494 389 969 2,088 3,284 (644) 6,086 7,580 $ $ $ $ 129 2,680 21 7 28 4,732 17 77 21 14 63 7,789 46 688 371 420 0 15 1,540 370 618 2,057 3,787 (583) 6,249 7,789 This condensed financial information should be read in conjunction with the Consolidated Financial Statements and Notes included in Part II, Item 8, Page 77. 2005 10-K Page 104 SCHEDULE II (CONTINUED) (In millions) REVENUES Dividends from subsidiaries Investment income, net of expenses Realized gains (losses) on investments Other revenue Total revenues EXPENSES Interest expense Depreciation expense Other expenses Total expenses Cincinnati Financial Corporation (parent company only) Condensed Statements of Income Years ended December 31, 2004 2003 2005 $ 275 $ 89 2 10 376 52 3 16 71 305 (7) 312 290 175 $ 110 18 9 312 36 3 14 53 259 3 256 328 50 131 (23) 7 165 33 4 15 52 113 (1) 114 260 374 INCOME BEFORE INCOME TAXES AND EARNINGS OF SUBSIDIARIES Income tax provision (benefit) NET INCOME BEFORE EARNINGS OF SUBSIDIARIES Increase in undistributed earnings of subsidiaries NET INCOME $ 602 $ 584 $ This condensed financial information should be read in conjunction with the Consolidated Financial Statements and Notes included in Part II, Item 8, Page 77. 2005 10-K Page 105 SCHEDULE II (CONTINUED) Cincinnati Financial Corporation (parent company only) Condensed Statements of Cash Flows (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 (gains) losses on investments Changes in: Investment income receivable Current federal income taxes Deferred income taxes Other assets Other liabilities Undistributed earnings of subsidiaries Net cash provided by operating activities CASH FLOWS FROM INVESTING ACTIVITIES Sale of fixed-maturity investments Maturity of fixed-maturity investments Sale of equity security investments Purchase of fixed-maturity investments Purchase of equity security investments Change in short-term investments, net Investment in buildings and equipment, net Change in other invested assets, net Net cash (used in) provided by investing activities CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from 6.125% senior notes Debt issuance costs from 6.125% senior notes Decrease in notes payable Payment of cash dividends to shareholders Purchase/issuance of treasury shares Proceeds from stock options exercised Net transfers to subsidiaries Net cash used in financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Years ended December 31, 2004 2003 2005 $ 602 $ 584 $ 3 (2) 0 (12) 19 (3) 0 (290) 317 8 2 18 (9) (12) 21 (24) (8) (4) 0 0 0 (204) (61) 11 (80) (334) (21) 28 7 $ 3 (18) 10 (30) 20 (2) 6 (328) 245 193 50 36 (95) (196) (21) (1) (1) (35) 371 (4) (152) (177) (59) 3 (170) (188) 22 6 28 $ $ 374 4 23 1 (2) (10) (1) 2 (260) 131 50 71 8 (47) (33) 0 (1) 2 50 0 0 0 (156) (55) 6 28 (177) 4 2 6 This condensed financial information should be read in conjunction with the Consolidated Financial Statements and Notes included in Part II, Item 8, Page 77. 2005 10-K Page 106 SCHEDULE III (In millions) Deferred policy acquisition costs: Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Future policy benefits, losses, claims and expense losses: Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total (1) Unearned premiums: Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total (1) Other policy claims and benefits payable: Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total (1) Premium revenues: Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Cincinnati Financial Corporation and Subsidiaries Supplementary Insurance Information 2005 Years ended December 31, 2004 2003 $ $ $ $ $ $ $ $ $ $ 226 $ 85 311 118 429 $ 3,173 $ 456 3,629 1,362 4,991 $ 1,150 $ 407 1,557 2 1,559 $ 0 $ 0 0 13 13 $ 2,254 $ 804 3,058 106 3,164 $ 218 $ 88 306 94 400 $ 3,016 $ 498 3,514 1,213 4,727 $ 1,112 $ 425 1,537 2 1,539 $ 0 $ 0 0 16 16 $ 2,126 $ 793 2,919 101 3,020 $ 207 80 287 85 372 2,933 453 3,386 1,040 4,426 1,037 407 1,444 2 1,446 0 0 0 14 14 1,908 745 2,653 95 2,748 2005 10-K Page 107 SCHEDULE III (CONTINUED) Cincinnati Financial Corporation and Subsidiaries Supplementary Insurance Information (In millions) Investment income, net of expenses: Commercial lines insurance Personal lines insurance Total property casualty insurance (3) Life insurance Total Benefits, claims losses and settlement expenses: Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Amortization of deferred policy acquisition costs: Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total (2) Other operating expenses: Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total (2) Written premiums: Commercial lines insurance Personal lines insurance Total property casualty insurance Accident health insurance Total 2005 Years ended December 31, 2004 2003 $ $ $ $ $ $ $ $ $ $ 0 $ 0 338 99 437 $ 1,298 $ 514 1,812 102 1,914 $ 473 $ 168 641 23 664 $ 198 $ 77 275 29 304 $ 2,290 $ 786 3,076 3 3,079 $ 0 $ 0 289 91 380 $ 1,154 $ 599 1,753 95 1,848 $ 448 $ 162 610 16 626 $ 186 $ 72 258 37 295 $ 2,186 $ 811 2,997 3 3,000 $ 0 0 245 89 334 1,218 579 1,797 91 1,888 398 160 558 15 573 125 33 158 37 195 2,031 784 2,815 3 2,818 Notes to Schedule III: (1) The sum of future policy benefits, losses, claims and expense losses, unearned premium and other policy claims and other policy claims and benefits payable is equal to the sum of loss and loss expense, life policy reserves and unearned premiums reported in the company’s consolidated balance sheets. (2) The sum of amortization of deferred policy acquisition costs and other operating expenses is equal to the sum of Commissions; Other operating expenses; Taxes, licenses and fees; Increase in deferred acquisition costs; and Other expenses shown in the consolidated statements of income, less other expenses not applicable to the above insurance segments. (3) This segment information is not regularly allocated to segments and reviewed by company management in making decisions about resources to be allocated to the segments or to assess their performance. 2005 10-K Page 108 SCHEDULE IV (Dollars in millions) Gross premiums: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Ceded to other companies: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Assumed from other companies: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Net premiums: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Percentage of amount assumed to net: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Cincinnati Financial Corporation and Subsidiaries Reinsurance 2005 Years ended December 31, 2004 2003 $ $ $ $ $ $ $ $ $ $ $ $ 51,488 2,386 823 3,209 150 3,359 30,705 157 22 179 44 223 5 25 3 28 0 28 20,788 2,254 804 3,058 106 3,164 $ $ $ $ $ $ $ $ $ $ $ $ 44,916 2,246 816 3,062 138 3,200 28,196 148 27 175 37 212 5 28 4 32 0 32 16,725 2,126 793 2,919 101 3,020 $ $ $ $ $ $ $ $ $ $ $ $ 38,486 2,046 762 2,808 125 2,933 23,296 193 18 211 30 241 6 55 1 56 0 56 15,196 1,908 745 2,653 95 2,748 0.0 % 0.0 % 0.0 % 1.1 % 0.4 0.9 0.0 0.9 1.3 % 0.5 1.1 0.1 1.1 2.9 % 0.2 2.1 0.1 2.0 2005 10-K Page 109 SCHEDULE V (In millions) Allowance for doubtful receivables: Balance at beginning of period Additions charged to costs and expenses Other additions Deductions Balance at end of period Cincinnati Financial Corporation and Subsidiaries Valuation and Qualifying Accounts 2005 At December 31, 2004 2003 $ $ 0 $ 1 0 0 1 $ 0 $ 0 0 0 0 $ 1 0 0 (1) 0 2005 10-K Page 110 SCHEDULE VI Cincinnati Financial Corporation and Subsidiaries Supplementary Information Concerning Property Casualty Insurance Operations (In millions) Deferred policy acquisition costs: Commercial lines insurance Personal lines insurance Total Reserves for unpaid claims and claim adjustment expenses: Commercial lines insurance Personal lines insurance Total Reserve discount deducted Unearned premiums: Commercial lines insurance Personal lines insurance Total Earned premiums: Commercial lines insurance Personal lines insurance Total Investment income: Commercial lines insurance (1) Personal lines insurance (1) Total Loss and loss expenses incurred related to current accident year: Commercial lines insurance (1) Personal lines insurance (1) Total Loss and loss expenses incurred related to prior accident years: Commercial lines insurance (1) Personal lines insurance (1) Total Amortization of deferred policy acquisition costs: Commercial lines insurance Personal lines insurance Total Paid loss and loss expenses: Commercial lines insurance Personal lines insurance Total Written premiums: Commercial lines insurance Personal lines insurance Total 2005 Years ended December 31, 2004 2003 226 $ 85 311 $ 3,173 $ 456 3,629 $ 218 $ 88 306 $ 3,016 $ 498 3,514 $ 207 80 287 2,933 453 3,386 0 $ 0 $ 0 1,150 $ 407 1,557 $ 2,254 $ 804 3,058 $ 0 $ 0 338 $ 0 $ 0 1,972 $ 0 $ 0 (160) $ 473 $ 168 641 $ 1,126 $ 552 1,678 $ 2,290 $ 786 3,076 $ 1,112 $ 425 1,537 $ 2,126 $ 793 2,919 $ 0 $ 0 289 $ 0 $ 0 1,949 $ 0 $ 0 (196) $ 448 $ 162 610 $ 1,062 $ 559 1,621 $ 2,186 $ 811 2,997 $ 1,037 407 1,444 1,908 745 2,653 0 0 245 0 0 1,877 0 0 (80) 398 160 558 1,003 558 1,561 2,031 784 2,815 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Note to Schedule VI: (1) This segment information is not regularly allocated to segments and not reviewed by company management in making decisions about resources to be allocated to the segments or to assess their performance. 2005 10-K Page 111 SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Cincinnati Financial Corporation /S/ Kenneth W. Stecher _____________________ By: Title: Date: Kenneth W. Stecher Chief Financial Officer, Senior Vice President, Secretary and Treasurer March 10, 2006 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been duly signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature /S/ John J. Schiff, Jr. John J. Schiff, Jr. /S/ Kenneth W. Stecher Kenneth W. Stecher /S/ William F. Bahl William F. Bahl /S/ James E. Benoski James E. Benoski /S/ Michael Brown Michael Brown /S/ Dirk J. Debbink Dirk J. Debbink /S/ Kenneth C. Lichtendahl Kenneth C. Lichtendahl /S/ W. Rodney McMullen W. Rodney McMullen /S/ Gretchen W. Price Gretchen W. Price /S/ Thomas R. Schiff Thomas R. Schiff /S/ John M. Shepherd John M. Shepherd /S/ Douglas S. Skidmore Douglas S. Skidmore /S/ John F. Steele, Jr. John F. Steele, Jr. /S/ Larry R. Webb Larry R. Webb /S/ E. Anthony Woods E. Anthony Woods Title Chairman, President, Chief Executive Officer and Director Date March 6, 2006 Chief Financial Officer, Senior Vice President, Secretary and Treasurer (Principal Accounting Officer) March 10, 2006 Director February 28, 2006 Vice Chairman, Chief Insurance Officer and Director March 1, 2006 Director Director Director Director Director Director Director Director Director Director Director 2005 10-K Page 112 March 1, 2006 March 2, 2006 March 2, 2006 March 1, 2006 March 2, 2006 March 2, 2006 February 28, 2006 March 1, 2006 March 1, 2006 March 2, 2006 March 2, 2006 4.6 10.2 Exhibit No. 3.1A 3.1B 3.2 4.1 4.2 4.3 4.4 4.5 4.7 10.1 INDEX OF EXHIBITS Exhibit Description Amended Articles of Incorporation of Cincinnati Financial Corporation (1) Amendment to Article Fourth of Amended Articles of Incorporation of Cincinnati Financial Corporation (2) Regulations of Cincinnati Financial Corporation (3) Indenture with The Bank of New York Trust Company (4) Supplemental Indenture with The Bank of New York Trust Company (4) Second Supplemental Indenture with The Bank of New York Trust Company (5) Form of 6.125% Exchange Note Due 2034 (included in Exhibit 4.2) Form of 6.92% Debentures Due 2028 (included in Exhibit 4.3) Indenture with the First National Bank of Chicago (subsequently assigned to The Bank of New York Trust Company) (6) Form of 6.90% Debentures Due 2028 (included in Exhibit 4.6) Agreement with Messer Construction (7) Stock Repurchase Agreement dated November 12, 2004 with Robert C. Schiff, Trustee, Robert C. Schiff Revocable Trust (7) Purchase Agreement with J.P. Morgan Securities Inc. and UBS Securities LLC (8) 2003 Non-Employee Directors’ Stock Plan (9) Cincinnati Financial Corporation Stock Option Plan No. V (10) Cincinnati Financial Corporation Stock Option Plan No. VI (11) Cincinnati Financial Corporation Stock Option Plan No. VII (12) Standard Form of Nonqualified and Incentive Option Agreements for Stock Option Plan No. V (7) Standard Form of Nonqualified and Incentive Option Agreements for Stock Option Plan No. VI (7) Standard Form of Nonqualified and Incentive Option Agreements for Stock Option Plan No. VII (7) Cincinnati Financial Corporation Stock Option Plan No. VIII (9) Registration Rights Agreement with J.P. Morgan Securities Inc. and UBS Securities LLC (4) Form of Dealer Manager Agreement between Cincinnati Financial and UBS Securities LLC (13) Standard Form of Incentive Stock Option Agreement for Stock Option Plan VIII (14) Standard Form of Nonqualified Stock Option Agreement for Stock Option Plan VIII (15) Standard Form of Combined Incentive/Nonqualified Stock Option for Stock Option Plan VI (16) 364-Day Credit Agreement by and among Cincinnati Financial Corporation and CFC Investment Company, as Borrowers, and Fifth Third Bank, as Lender (17) Director and Named Executive Officer Compensation Summary (18) Executive Compensation Plan (19) Statement re: Computation of per share earnings for the years ended December 31, 2005, 2004 and 2003, contained in Note 11 to the Consolidated Financial Statements included in Part II, Item 8 of this report, Page 93 Cincinnati Financial Corporation Code of Ethics for Senior Financial Officers (20) Cincinnati Financial Corporation Subsidiaries contained in Part I, Item 1 of this report, Page 1 Consent of Independent Registered Public Accounting Firm, Page 114 Certification pursuant to Section 302 of the Sarbanes Oxley Act of 2002 – Chief Executive Officer, Page 115 Certification pursuant to Section 302 of the Sarbanes Oxley Act of 2002 – Chief Financial Officer, Page 116 Certification pursuant to Section 906 of the Sarbanes Oxley Act of 2002, Page 117 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 10.12 10.13 10.14 10.15 10.16 14 21 23 31.1 31.2 32 10.18 10.19 10.17 11 1 Incorporated by reference to the company’s 1999 Annual Report on Form 10-K dated March 23, 2000 (File No. 000-04604). 2 Incorporated by reference to Exhibit 3(i) filed with the company’s Current Report on Form 8-K dated July 15, 2005. 3 Incorporated by reference to the company’s Definitive Proxy Statement dated March 2, 1992, Exhibit 2 (File No. 000-04604). 4 Incorporated by reference to the company’s Current Report on Form 8-K dated November 2, 2004, filed with respect to the issuance of the company’s 6.125% Senior Notes due November 1, 2034. 5 Incorporated by reference to the company’s Current Report on Form 8-K dated May 9, 2005, filed with respect to the completion of the company’s exchange offer and rescission offer for its 6.90% senior debentures due 2028. 6 Incorporated by reference to the company’s registration statement on Form S-3 effective May 22, 1998 (File No. 333-51677). 7 Incorporated by reference to the company’s 2004 Annual Report on Form 10-K dated March 11, 2005. 8 Incorporated by reference to the company’s Current Report on Form 8-K dated November 1, 2004, filed with respect to the issuance of the company’s 6.125% Senior Notes due November 1, 2034. 9 Incorporated by reference to the company’s Definitive Proxy Statement dated March 21, 2005. 10 Incorporated by reference to the company’s Definitive Proxy Statement dated March 2, 1996 (File No. 000-04604). 11 Incorporated by reference to the company’s Definitive Proxy Statement dated March 1, 1999 (File No. 000-04604). 12 Incorporated by reference to the company’s Definitive Proxy Statement dated March 8, 2002. 13 Incorporated by reference to the company’s Registration Statement on Form S-4 filed March 21, 2005 (File No. 333-123471). 14 Incorporated by reference to Exhibit 10.1 filed with the company’s Current Report on Form 8-K dated July 15, 2005. 15 Incorporated by reference to Exhibit 10.2 filed with the company’s Current Report on Form 8-K dated July 15, 2005. 16 Incorporated by reference to Exhibit 10.3 filed with the company’s Current Report on Form 8-K dated July 15, 2005. 17 Incorporated by reference to Exhibit 10.1 filed with the company’s Current Report on Form 8-K dated May 31, 2005. 18 Incorporated by reference to the company’s Definitive Proxy Statement to be filed no later than April 14, 2006. 19 Incorporated by reference to Exhibit 10.2 filed with the company’s Current Report on Form 8-K dated November 23, 2005. 20 Incorporated by reference to the company’s Definitive Proxy Statement dated March 18, 2004. 2005 10-K Page 113 EXHIBIT 23 Independent Registered Public Accounting Firm Consent We consent to the incorporation by reference in Registration Statements No. 333-85953 (on Form S-8), No. 333-24815 (on Form S-8), No. 333-24817 (on Form S-8), No. 333-49981 (on Form S-8), No. 333-103509 (on Form S-8), No. 333-103511 (on Form S-8), , No. 333-121429 (on Form S-4), No. 333-123471 (on Form S-4), and No. 333-126714 (on Form S-8) of Cincinnati Financial Corporation of our report dated March 6, 2006 relating to the consolidated financial statements and financial statement schedules of Cincinnati Financial Corporation and management's report of the effectiveness of internal control over financial reporting appearing in this Annual Report on Form 10-K of Cincinnati Financial Corporation for the year ended December 31, 2005. /S/ Deloitte & Touche LLP ______________________ Deloitte & Touche LLP Cincinnati, Ohio March 10, 2006 2005 10-K Page 114 EXHIBIT 31A Certification pursuant to Section 302 of the Sarbanes Oxley Act of 2002 I have reviewed this Annual Report on Form 10-K of Cincinnati Financial Corporation; I, John J. Schiff, Jr., certify that: 1. 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) designed such internal control over financial reporting , or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principals; c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 10, 2006 /S/ John J. Schiff, Jr. ____________________ John J. Schiff, Jr. Chairman, President and Chief Executive Officer 2005 10-K Page 115 EXHIBIT 31B Certification pursuant to Section 302 of the Sarbanes Oxley Act of 2002 I have reviewed this Annual Report on Form 10-K of Cincinnati Financial Corporation; I, Kenneth W. Stecher, certify that: 1. 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) designed such internal control over financial reporting , or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principals; c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weaknesses in the design or operation of internal controls over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting Date: March 10, 2006 /S/ Kenneth W. Stecher ____________________ Kenneth W. Stecher Chief Financial Officer, Senior Vice President, Secretary and Treasurer (Principal Accounting Officer) 2005 10-K Page 116 EXHIBIT 32 Certification pursuant to Section 906 of the Sarbanes Oxley Act of 2002 The certification set forth below is being submitted in connection with this report on Form 10-K for the purpose of complying with Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 and Section 1350 of Chapter 63 of Title 18 of the United States Code. John J. Schiff, Jr., the chief executive officer, and Kenneth W. Stecher, the chief financial officer, of Cincinnati Financial Corporation each certifies that, to the best of his knowledge: 1. 2. the report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and the information contained in the report fairly presents, in all material respects, the financial condition and results of operations of Cincinnati Financial Corporation. Date: March 10, 2006 /S/ John J. Schiff, Jr. ____________________ John J. Schiff, Jr. Chairman, President and Chief Executive Officer /S/ Kenneth W. Stecher ____________________ Kenneth W. Stecher Chief Financial Officer, Senior Vice President, Secretary and Treasurer (Principal Accounting Officer) 2005 10-K Page 117 Subsidiary Officers and Directors As of March 10, 2006, listed alphabetically The Cincinnati Insurance Company (CIC) The Cincinnati Indemnity Company (CID) Executive Officers James E. Benoski CIC, CID, CCC Vice Chairman of the Board CIC, CID, CCC, CLIC Chief Insurance Officer and Senior Vice President–Headquarters Claims Director of all subsidiaries Craig W. Forrester, CLU CIC, CID, CCC, CLIC Senior Vice President– Information Technology Thomas A. Joseph, CPCU CIC, CID, CCC Senior Vice President– Commercial Lines; Director Eric N. Mathews, CPCU, AIAF CIC, CID, CCC, CLIC, Senior Vice President– Corporate Accounting Daniel T. McCurdy CIC, CID, CCC Senior Vice President– Bond & Executive Risk; Director Kenneth S. Miller, CLU, ChFC CIC, CID, CCC, CLIC Chief Investment Officer and Senior Vice President–Investments CFC-I President and Chief Operating Officer CCM President Director of all subsidiaries Larry R. Plum, CPCU CCC President CIC, CID Senior Vice President–Personal Lines CIC, CID, CCC, CLIC Director David H. Popplewell, FALU, LLIF CLIC President and Chief Operating Officer; Director J. F. Scherer CIC, CID, CCC, CLIC Senior Vice President– Sales & Marketing; Director CFC-I Director John J. Schiff, Jr., CPCU CIC, CID Chairman, President and Chief Executive Officer CCC Chairman and Chief Executive Officer CLIC Chief Executive Officer CIC, CID, CCC, CLIC, CFC-I Director Joan O. Shevchik, CPCU, CLU CIC, CID, CCC Senior Vice President– Corporate Communications Kenneth W. Stecher CIC, CID, CCC, CLIC, CFC-I Chief Financial Officer and Senior Vice President– Corporate Accounting; Secretary CCM Treasurer Director of all subsidiaries Timothy L. Timmel CIC, CID, CCC, CLIC, CFC-I Senior Vice President–Operations; Director Senior Officers 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 Senior Vice President and Chief Underwriter David L. Burbrink CLIC Vice President–Life Field Services Richard W. Cumming, ChFC, CLU, FSA, MAAA CIC, CID, CCC, CLIC Senior Vice President and Chief Actuary CLIC Director Joel W. Davenport, CPCU, AAI CIC, CID, CCC Vice President–Commercial Lines J. Michael Dempsey, CLU CLIC Vice President–Life Marketing Administration Appendix The Cincinnati Casualty Company (CCC) The Cincinnati Life Insurance Company (CLIC) CFC Investment Company (CFC–I) CinFin Capital Management (CCM) Mark R. DesJardins, CPCU, AIM, AIC, ARP CIC, CID, CCC Vice President–Education & Training Donald J. Doyle, Jr., CPCU, AIM CIC, CID, CCC, CLIC Senior Vice President– Internal Audit Harold L. Eggers, CLU, FLMI, FALU, HIAA CLIC Vice President–Life Policy Issue Frederick A. Ferris CIC, CID, CCC Vice President–Commercial Lines Bruce S. Fisher, CPCU, AIC CIC, CID, CCC Vice President–Headquarters Claims Carl C. Gaede, CPCU, AFSB CIC, CID, CCC Vice President–Bond & Executive Risk Michael J. Gagnon CIC, CID, CCC Vice President–Headquarters Claims Gary B. Givler CIC, CID, CCC Vice President–Headquarters Claims Kevin E. Guilfoyle CFC-I Senior Vice President–Leasing David L. Helmers, CPCU, API, ARe, AIM CIC, CID, CCC Vice President–Personal Lines Theresa A. Hoffer CIC, CID, CCC, CLIC Vice President– Corporate Accounting CIC, CID, CCC Treasurer Martin F. Hollenbeck, CFA CIC, CID, CCC, CLIC, CCM Vice President– Investments Timothy D. Huntington, CPCU, AU CIC, CID, CCC Vice President–Commercial Lines Thomas H. Kelly CIC, CID, CCC Vice President–Bond & Executive Risk Christopher O. Kendall, CPCU, AIT, AIM, ARe, ARM, ARP CIC, CID, CCC Vice President–Commercial Lines Gary J. Kline, CPCU CIC, CID, CCC Vice President–Commercial Lines Robert L. Laymon, CIC, CID, CCC Vice President–Bond & Executive Risk Steven W. Leibel, CPCU, AIM CIC, CID, CCC Vice President–Personal Lines Jerry L. Litton CFC-I Treasurer Richard L. Mathews, CPCU CIC, CID, CCC, CLIC Vice President– Information Technology Richard P. Matson CIC, CID, CCC, CFC-I, CLIC Vice President– Purchasing/Fleet Martin J. Mullen, CPCU CIC, CID, CCC Vice President–Headquarters Claims Gary A. Nichols CIC, CID, CCC Vice President–Headquarters Claims Glenn D. Nicholson, LLIF CLIC Senior Vice President and Senior Marketing Officer; Director Michael K. O'Connor, CPCU, CFA, AFSB CCM Vice President Todd H. Pendery, FLMI CIC, CID, CCC, CLIC Vice President– Corporate Accounting CLIC Treasurer Marc C. Phillips, CPCU, AIM CIC, CCC, CID Vice President–Commercial Lines Charles E. Robinson, CPCU CIC, CID, CCC Vice President–Field Claims Michael A. Rouse CIC, CID, CCC Vice President–Commercial Lines Thomas J. Scheid CIC, CID, CCC, CLIC Vice President– Premium Audit, Loss Control, Machinery & Equipment Specialties Gregory D. Schmidt, CPCU, ARP, CPP, ACP, ARC CIC, CID, CCC, CLIC Vice President– Staff Underwriting Norman R. Settle CIC, CID, CCC Senior Vice President– Administrative Services J. B. Shockey, CPCU, CIC, CLU CIC, CID, CCC Vice President–Sales & Marketing David W. Sloan CFC-I Vice President–Leasing Scott K. Smith, CPCU, ARM, AIM, AU CIC, CID, CCC Vice President–Commercial Lines Steven A. Soloria, CFA CIC, CID, CCC, CLIC, CCM, Vice President– Investments CCM Secretary Charles P. Stoneburner II, CPCU CIC, CID, CCC Vice President–Field Claims Gary B. Stuart CIC, CID, CCC Vice President–Sales & Marketing Duane I. Swanson, CIC CIC, CID, CCC Vice President–Sales & Marketing Philip J. Van Houten, CFE, FCLS CIC, CID, CCC Vice President–Headquarters Claims Stephen A. Ventre, CPCU, AIM CIC, CID, CCC Vice President–Commercial Lines Jody L. Wainscott CIC, CID, CCC Vice President– Research & Development Mark A. Welsh CIC, CID, CCC, CLIC Vice President– Regulatory & Consumer Relations Mark S. Wietmarschen CIC, CID, CCC Vice President–Commercial Lines Heather J. Wietzel CIC, CID, CCC Vice President and Investor Relations Officer Gregory J. Ziegler CIC, CID, CCC, CLIC, CFC–I Vice President– Personnel Teresa C. Cracas CIC, CID, CCC, CLIC Counsel Eugene M. Gelfand CIC, CID, CCC, CLIC Counsel Mark J. Huller CIC, CID, CCC, CLIC Senior Counsel G. Gregory Lewis CIC, CID, CCC, CLIC Counsel Lisa A. Love CIC, CID, CCC, CLIC Senior Counsel Stephen C. Roach CIC, CID, CCC, CLIC Counsel Non-Officer Directors William F. Bahl, CFA CIC, CID, CCC, CLIC Director W. Rodney McMullen CIC, CID, CCC, CLIC Director Thomas R. Schiff CIC, CID, CCC, CLIC Director Larry R. Webb, CPCU CIC, CID CCC Director E. Anthony Woods CIC, CID, CCC, CLIC Director CIC Directors Emeriti Vincent H. Beckman Robert J. Driehaus Richard L. Hildbold, CPCU Robert C. Schiff William H. Zimmer Shareholder Information Cincinnati Financial Corporation had approximately 12,000 shareholders of record as of December 31, 2005. Many of the company’s independent agent representatives and most of the 3,983 associates of its subsidiaries own the company’s common stock. Stock Listing Common shares are traded under the symbol CINF on the Nasdaq National Market. Annual Meeting The Annual Meeting of Shareholders of Cincinnati Financial Corporation will take place at 9:30 a.m. on Saturday, May 6, 2006, at the Cincinnati Art Museum in Eden Park, Cincinnati, Ohio. If you are unable to attend, you may listen to an audio webcast from the Investors section of the company’s Web site, www.cinﬁn.com. Shareholder Services Please direct inquiries about stock transfer, dividend reinvestment, dividend direct deposit, lost certiﬁcates, change of address or electronic delivery 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 shareholder_inquiries@cinﬁn.com. Form 10-K Cincinnati Financial Corporation’s Annual Report on Form 10-K, ﬁled annually with the Securities and Exchange Commission, is included in this Annual Report. Additional copies are available at no cost by contacting Mr. Stecher. You also may access and print this document from the Investors section of www.cinﬁn.com. Interim Communications During 2006, Cincinnati Financial Corporation is tentatively scheduled to report interim results as follows: First quarter ending March 31 Second quarter ending June 30 Third quarter ending September 30 May 3 August 2 November 1 Conﬁrmation of release dates and quarterly conference call webcasts is available approximately two weeks after the end of each quarter on www.cinﬁn.com, or call (513) 870-2768 or inquire via e-mail to investor_inquiries@cinﬁn.com. Corporate Headquarters Independent Registered Public Accounting Firm Cincinnati Financial Corporation 6200 South Gilmore Road Fairﬁeld, Ohio 45014-5141 Phone: (513) 870-2000 Fax: (513) 870-2066 Deloitte & Touche LLP 250 East Fifth Street Cincinnati, Ohio 45202-5109 Common Stock Price and Dividend Data __________________________________________________________________________________________________ 2005 ___________________________________________________________________________________________________ 2004 Quarter: High . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Low . . . . . . . . . . . . . . . . . . . . . . . . . . . . Period-end close . . . . . . . . . . . . . . . . . . Cash dividends declared . . . . . . . . . . . . __________________ 1st 43.92 40.84 41.53 0.290 __________________ 2nd $ 43.12 38.38 39.56 0.305 __________________ 3rd $ 42.64 39.00 41.89 0.305 4th 45.95 39.91 44.68 0.305 $ $ 1st 41.61 37.02 39.41 0.250 __________________ 2nd $ 41.78 37.90 41.45 0.262 $ 3rd 41.70 37.46 39.26 0.262 __________________ 4th $ 43.52 36.57 42.15 0.262 __________________ __________________ __________________ Source: Nasdaq National Market The common stock prices and dividend data above are adjusted to reﬂect the 5 percent stock dividends paid June 15, 2004, and April 26, 2005. 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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