Cincinnati Financial Annual Report 2006

Plain-text annual report

Cincinnati Financial Corporation Claims Service Sells Insurance Responding, reserving and building relationships for long-term results 2006 Annual Report 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 About Your Company 1 Financial Highlights Cincinnati Financial Corporation, formed in Financial highlights provide a snapshot of your company’s ﬁnancial performance and strength. 1968, offers property 2 To Our Shareholders Consolidated Pretax Investment Income Less expenses (Dollars in millions) 0 7 6 5 2 5 5 4 4 5 6 4 2 9 4 A letter from the chairman and vice chairman discusses events of 2006, your company’s performance and issues that may affect us in 2007 and beyond. 03 02 04 05 06 Condensed Balance Sheets and Income Statements Six-year Summary of Financial Information Property Casualty Net Earned Premiums (Dollars in millions) Personal lines Commercial lines 2,919 3,058 3,164 2,653 8 0 9 , 1 2,391 1 2 7 , 1 6 2 1 , 2 4 5 2 , 2 2 0 4 , 2 0 7 6 02 5 4 7 03 3 9 7 4 0 8 2 6 7 04 05 06 Financial Performance Overview 2006 results for property casualty insurance operations, including commercial lines and personal lines; life insurance operations; and investment operations. 7 8 9 12 Claims Service Sells Insurance 20 Corporate Ofﬁcers and Directors 21 Subsidiary Ofﬁcers and Directors 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, our results and three-year trends, giving clear and thorough explanations with supporting data. Inside Back Cover Shareholder Information, Common Stock Price and Dividend Data. casualty insurance – its main business – through subsidiary companies. The Cincinnati Insurance Company, founded in 1950, leads the property casualty group. 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. Shareholder Information Cincinnati Financial Corporation had approximately 12,000 shareholders of record as of December 31, 2006. Many of the company’s independent agent representatives and most of the 4,048 associates of its subsidiaries own the company’s common stock. Stock Listing Common shares are traded under the symbol CINF on the NASDAQ Global Select Market. Annual Meeting The Annual Meeting of Shareholders of Cincinnati Financial Corporation will take place at 9:30 a.m. on Saturday, May 5, 2007, 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 2007, Cincinnati Financial Corporation tentatively has scheduled reports of interim results as follows: First quarter ending March 31 Second quarter ending June 30 Third quarter ending September 30 May 2 August 7 October 31 Information regarding actual interim release dates and quarterly conference call webcasts is available approximately two weeks after the end of each quarter on www.cinﬁn.com, by calling 513-870-2768 or by e-mailing investor_inquiries@cinﬁn.com. Corporate Headquarters Cincinnati Financial Corporation 6200 South Gilmore Road Fairﬁeld, Ohio 45014-5141 Phone: 513-870-2000 Fax: 513-870-2066 Independent Registered Public Accounting Firm Deloitte & Touche LLP 250 East Fifth Street Cincinnati, Ohio 45202-5109 Common Stock Price and Dividend Data __________________________________________________________________________________________________ 2006 ___________________________________________________________________________________________________ 2005 Quarter: High . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Low . . . . . . . . . . . . . . . . . . . . . . . . . . . . Period-end close . . . . . . . . . . . . . . . . . . Cash dividends declared . . . . . . . . . . . . __________________ 1st 45.56 42.07 42.07 0.335 __________________ 2nd $ 47.01 41.43 47.01 0.335 __________________ 3rd $ 48.44 45.93 48.12 0.335 4th 49.07 44.25 45.31 0.335 $ $ 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 __________________ __________________ __________________ 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 beginning on Page 25, for factors that could cause results to differ materially from those discussed. Source: NASDAQ Global Select Market The common stock prices and dividend data above are adjusted to reﬂect the 5 percent stock dividend paid April 26, 2005. Financial Highlights Cincinnati Financial Corporation and Subsidiaries (In millions except per share data) Revenue Highlights Years ended December 31, 2006 2005 Change % Revenues (Dollars in millions) Revenues 4 1 6 3 , 1 8 1 3 , 3 4 8 2 , 0 5 5 7 4 6 7 3 , , Earned premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment income, net of expenses . . . . . . . . . . . . . . . . . . . . . . . . . Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,278 570 4,550 Income Statement Data Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net realized investment gains and losses, after tax . . . . . . . . . . . . . Net income before realized investment gains and losses* . . . . . . . . $ $ 930 434 496 $ 3,164 526 3,767 $ $ 602 40 562 Per Share Data (diluted) 5.30 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.48 Net realized investment gains and losses, after tax . . . . . . . . . . . . . Net income before realized investment gains and losses* . . . . . . . . 2.82 1.34 Cash dividends declared . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Book value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39.38 Weighted average shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . 175,451,341 $ $ $ $ 3.40 0.23 3.17 1.21 34.88 177,116,126 $ $ 3.6 8.4 20.8 54.5 993.0 (11.8) 55.9 978.3 (11.0) 11.2 12.9 (0.9) Balance Sheet Data Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 17,222 6,808 $ 16,003 6,086 7.6 11.9 Ratio Data Property casualty statutory combined ratio . . . . . . . . . . . . . . . . . . . Return on equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on equity based on comprehensive income . . . . . . . . . . . . . 93.9% 14.4 16.4 89.0% 9.8 1.6 * 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. 03 02 04 Realized investment gain from Alltel common stock sale 06 05 Revenue growth continued in 2006 with growth in pretax investment income and consolidated property casualty earned premiums. Revenues and net income in each year reflect realized investment gains and losses including gains from the sale of our Alltel common stock holdings in 2006. Net Income/ Dividends Paid Per common share (Dollars) Net income before realized investment gains and losses (before one-time item in 2003)* Net income (before one-time item in 2003)* Dividends paid 0 3 . 5 8 2 . 3 4 9 . 2 0 4 . 3 7 1 . 3 2 8 . 2 1.02 1.16 1.31 7 6 . 1 2 3 . 1 6 1 . 2 1 0 . 2 0.80 0.89 03* 06 04 02 Realized investment gain (after tax) from Alltel common stock sale 05 2006 operating income reflected lower consolidated property casualty underwriting profit. Cash dividends paid to shareholders rose at a 12.1 percent compound annual rate over the past five years. In February 2007, the board increased the indicated annual cash dividend for the 47th consecutive year. Book Value Per common share (Dollars) 8 3 . 9 3 0 1 . 5 3 0 6 . 5 3 8 8 . 4 3 3 4 . 1 3 02 04 05 03 06 Book value reached a record high of $39.38 at year-end 2006. The $4.50 increase over 2005 reflected after-tax appreciation in the equity portfolio and earnings from operations. 1 To Our Shareholders: Property Casualty Net Earned Premiums (Dollars in millions) Personal lines Commercial lines 2,919 3,058 3,164 2,653 8 0 9 1 , 2,391 1 2 7 1 , 6 2 1 , 2 4 5 2 , 2 2 0 4 2 , 0 7 6 5 4 7 3 9 7 4 0 8 2 6 7 02 04 06 03 05 Property casualty net earned premiums increased 3.5 percent in 2006. On the statutory basis that facilitates industry comparisons, net written premiums rose 3.3 percent and the company continued its track record of outpacing industry growth, estimated at 2.6 percent. For better and for worse, your company set many records in 2007. Revenues rose to an all-time high, including record pretax investment income. Record new reinsurance premiums that we pay. We also anticipate a combined ratio in the range of 97 percent to 99 percent, up from 93.9 percent on a statutory basis in 2006. This target business premiums boosted total net written considers a number of factors, including premiums. Market value appreciation 5.5 percentage points on the combined ratio for contributed to record book value at catastrophe losses, just as high as in 2006. December 31, 2006. We reported our highest We are not at all discouraged. We believe ever realized gains on the sale of one large it’s a great time to be in the insurance business. equity holding, leading to record net income Through all markets – for better or for worse – of $930 million, or $5.30 per share. we’re going to continue growing ahead of the Excluding those substantial investment overall industry, balancing growth and gains, operating income declined 11.8 percent proﬁtability by careful underwriting and to $2.82 per share. Lower underwriting proﬁts pricing, and identifying new ways to build on from property casualty insurance, our main the strengths that give us a competitive edge. business, reﬂected record catastrophe losses and Three commitments differentiate your record large losses in the $1 million-plus company, making it possible over time to Consolidated Assets (Dollars in millions) category. In addition, expenses rose more increase your shareholders’ equity and rapidly than premiums as we continued shareholder dividends. We measure our 9 0 5 , 5 1 7 0 1 , 6 1 3 0 0 , 6 1 2 2 2 , 7 1 2 2 1 , 4 1 investing in people and infrastructure, including achievements, opportunities and initiatives to technology that makes it easier for independent tap those opportunities in terms of their ability agents to do business with our company. to help us meet those commitments: We expect this higher level of catastrophe Strong Agency Relationships losses and expenses may continue in 2007. We establish strong relationships with the most Further, price competition is accelerating in our professional independent agencies in each industry, making it harder to achieve premium growth and underwriting proﬁtability. While the industry overall was very proﬁtable in 2006, A.M. Best Co. estimates that total premiums may be ﬂat in 2007, and the industry combined ratio may rise 3.5 percentage points to 96.8 percent. Our expectations for our own near-term results consider these trends. We anticipate a 2007 growth rate in the low single digits, reduced by an increase of $22 million in the community, supporting them with a team of ﬁeld representatives authorized to make decisions at the local level. Over the past 10 years, we have selectively added more than 400 highly professional agencies. We ﬁnished 2006 with 1,289 agency locations marketing our policies in 32 states, including 55 new agency appointments over the course of the year. As part of our plans for 2007, we expect to appoint at least 50 more agencies. We are working on plans to enter 05 06 02 03 04 Over the past ﬁve years, assets grew at a 4.3 percent compound annual rate, primarily because of 3.6 percent compound annual growth in invested assets. 2 New Mexico and eastern Washington, appointing our ﬁrst agencies during 2007. By the ﬁfth year following an appointment, we typically earn a prominent position among the carriers serving that agency, with annual premiums rising to an average of approximately $2 million. Our agency-centered focus led to healthy commercial lines growth in 2006, with net written premiums up 6.7 percent and new business written by our agencies up 14.9 percent to a record $324 million. While pricing trended down over the year, agents appreciate the personal attention our ﬁeld teams provide to their accounts. Agents gave us plenty of chances to quote new commercial accounts and to offer loss control or other value-added John J. Schiff, Jr., CPCU, chairman and chief executive ofﬁcer, and James E. Benoski, vice chairman, president and chief operating ofﬁcer services that made the sale. Additionally, we homeowner and personal auto policies. With made commercial renewals easier for more competitive rates, our agents found it policyholders and agents, in many cases, by easier to again sell Cincinnati service and extending the policy period under the same value to their preferred clientele. We don’t terms and conditions. Many policyholders expect to quickly solve our personal lines respond positively to such policy extensions, challenges, but personal lines is moving in the choosing to keep their coverage with an insurer right direction. Our pricing is more competitive; that brings stability to the marketplace, carries our Web-based processing system is active in an A++ A.M. Best rating and has high standards 13 states and deploying to several more in for claims service. 2007; and our product portfolio is expanding Personal lines net written premiums with several new or improved coverage decreased 6.4 percent for the year; however, in endorsements. Identity Theft Expense and the second half of the year, retention improved Advocacy Services Coverage is available now and new business growth reached 17.6 percent, in the 25 states where 794 agency locations rebounding after several quarters of lower actively market homeowner policies. new business. Replacement Cost Auto and Personal Auto Plus That second half improvement led from our will be available later this year in the 22 states July introduction of policy credits that where we have 772 agency locations actively incorporate insurance scores into pricing of marketing personal auto policies. 3 Property Casualty Statutory Surplus Ratio Net written premiums to surplus Estimated industry net written premiums to surplus (A.M. Best) 1.3 1.2 1 1 . 0 1 . 1.1 1.0 0.9 7 0 . 7 0 . 7 0 . 03 04 02 06 05 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 in the past three years. Life Statutory Capital and Surplus Ratio (Percent) Adjusted capital and surplus to liabilities Estimated industry adjusted capital and surplus to liabilities (A.M. Best) 7 . 9 3 2 . 9 3 2 . 0 4 3 . 7 3 8 . 7 3 In Florida, we requested in February 2007 Our three non-property casualty insurance that our agents hold off on sending us new subsidiaries also operate primarily to extend the business of any type due to uncertain market capabilities of our agents to provide full service conditions. We are renewing and servicing to the families and businesses in their policies already on the books, but prefer to take communities. In 2006, The Cincinnati Life a wait-and-see approach until there is more free Insurance Company focused mainly on term market competition that supports stable insurance, introducing a return-of-premium insurance markets. product series that was well received by agents. Over the years, we have increased our The company’s two ﬁnancial services share of business from each of the agencies that subsidiaries continued to successfully leverage markets our policies by offering a full line of our insurance relationships and broaden coverages that meet the needs of their clients. our offerings. As of December 31, 2006, In recent years, they have indicated a desire to CFC Investment Company, which offers offer our products and services to commercial equipment and vehicle leases and loans, accounts that require the ﬂexibility of excess reported 2,897 accounts representing and surplus lines. Generally, excess and surplus $108 million of contract receivables. CinFin lines insurance carriers provide insurance that is Capital Management Company, which unavailable to businesses in the standard offers asset management services, reported market due to market conditions or due to $960 million under management in 64 accounts. characteristics of the insured risk that are Together, the CFC Investment and CinFin caused by nature, the insured’s history or the Capital Management Companies contributed nature of their business. 2 cents to 2006 earnings. We have studied the option of putting some Superior Claims Service of our capital to work by starting a new Prompt, fair claims service with a human touch company for this purpose, and we believe it can proves the value of our insurance programs and 10.0 10.5 10.7 10.6 10.7 contribute to our long-term objectives. We have validates the agent’s decision to make us the 05 02 03 06 04 The ratio of statutory adjusted capital and surplus to liabilities for Cincinnati Life remained at more than three times the estimated industry average in 2006. The higher the ratio, the stronger a life insurer’s security for policyholders and its capacity to support business growth. started the process of incorporating a new subsidiary, determining its structure and forming a team to research and develop appropriate policy terms and conditions, rates and underwriting guidelines. While we don’t anticipate premiums from excess and surplus lines this year, we do expect our increased ability to compete for additional commercial accounts to contribute to long-term growth. carrier of choice for value-oriented clients. Again in 2006, policyholders had ample opportunities to beneﬁt from the Cincinnati relationship. Severe weather in 2006, mainly across the Midwest, contributed to $175 million of catastrophe losses. As a result, policyholders reported approximately 13,000 claims through February 28, 2007. Our ﬁeld claims representatives have closed 95 percent of the claims, their prompt responses and personal 4 approach reﬂecting positively on our agents. continued growth in the range of 6.5 percent Our claims management system and new to 7.0 percent. tools, such as tablet computers, add speed and Our equity investments also drive the efﬁciency to all of our claims processes, and that company’s long-term net worth, ﬁnancial was especially beneﬁcial in these catastrophe ﬂexibility and stability. Your shareholders’ situations. We focus in the following pages of equity rose to an all-time high of $6.808 billion, this report on our claims operation, catastrophe or $39.38 per share, at the end of 2006, an response and claims technology. Here, we will increase of 12.9 percent on a per share basis. simply note that the promotion in May of our While the sale of our Alltel Corporation senior claims ofﬁcer, Jim Benoski, to president common stock holdings early in the year and chief operating ofﬁcer of Cincinnati accounted for a large portion of the increase in Financial and president and chief executive 2006 net income, it was not a factor in the ofﬁcer of The Cincinnati Insurance Company increase in book value. That increase was speaks a thousand words about the centrality of attributable to the contribution of insurance our claims operation to our business structure operations and investment income, along with and strategy. signiﬁcant appreciation over the course of the Also in May, Chief Financial Ofﬁcer Ken year in the rest of the equity portfolio. Stecher was named executive vice president of The equity portfolio supports the Cincinnati Financial and The Cincinnati accumulation over time of unrealized gains that Insurance Company, and chairman of the latter. build book value for shareholders. This cushion Ken’s leadership extends beyond his areas of of ﬁnancial strength and ﬂexibility also responsibility, inﬂuencing our company’s beneﬁts agents and policyholders, supporting a success as he continues to capably oversee the long-term perspective that leads us to behave continuous improvement of our ﬁnancial data, consistently in the marketplace; make prompt, transparency and estimates, including reserves fair claims payments; set adequate reserves; and for not yet paid claims. continue investing in the infrastructure for Successful Total Return Investing We use available cash ﬂow to cover growth. Our insurance strategies and investment strategies are a good match, and we believe current insurance liabilities by purchasing their combined results will continue bringing ﬁxed-maturity securities, then purchase equity you value in 2007. securities with the potential to bring us increasing dividend income and long-term appreciation. Our buy-and-hold equity investing strategy led to another year of record pretax net investment income, up 8.4 percent to $570 million. Our outlook for 2007 is for During 2006, three independent ratings organizations afﬁrmed our high ﬁnancial strength ratings. A.M. Best awards our property casualty companies its highest rating, A++ (Superior), assigned to fewer than 2 percent of insurers. Fitch Ratings awards the 5 Consolidated Pretax Investment Income Less expenses (Dollars in millions) 0 7 6 5 2 5 5 4 4 5 6 4 2 9 4 02 03 04 05 06 Consolidated pretax investment income rose 8.4 percent in 2006. Common stocks in the portfolio announced dividend increases during 2006 that should add $16 million to investment income in 2007. AA (Very Strong) rating to all of our insurance The board determined that 10 of the current companies. Standard & Poor’s assigns the 15 members meet the applicable criteria AA- (Very Strong) rating to the insurance for independence. companies, and revised its outlook to stable Early in 2007, the board formalized several from negative in July. Moody’s Investors current company practices with updates to the Service maintains an excellent Aa3 rating on corporate governance guidelines on board the property casualty insurance companies. membership criteria, director elections and Working for You We look beyond 2006 and 2007 with conﬁdence. We remain committed to providing a stable market for our agents’ high-quality business, underwriting this business carefully and producing steady value for our shareholders, as represented by the board of directors’ recent decision to increase our 2007 indicated annual dividend by 6 percent, stock ownership guidelines for directors and ofﬁcers. Your company’s management and directors purposefully align business decisions with our mission, which includes fulﬁlling the company’s obligations to independent agents, policyholders and shareholders as well as associates, suppliers and communities we serve. We are working diligently to act with integrity and to assure we will meet those obligations far which would mark the 47th consecutive year into the future. Respectfully, John J . Schiff, Jr., CPCU James E. Benoski Chairman Chief Executive Ofﬁcer Vice Chairman President Chief Operating Ofﬁcer Chief Insurance Ofﬁcer March 1, 2007 of increase in that measure. Their action reﬂected our belief that we can achieve above-industry-average growth in written premiums and industry-leading proﬁtability over the long term by building on our proven strategies: strong agency relationships supported by local decision making; superior claims service including solid reserves; and total return investing that drives ﬁnancial strength. The board also announced director transitions in 2006. Michael Brown and John M. Shepherd, current directors, will not stand for re-election on May 5, 2007, due to the company’s guidelines on director age. Gregory T. Bier, CPA (Ret.), appointed by the board in November, will stand for election at the annual shareholders’ meeting this spring. 6 Condensed Balance Sheets and Income Statements Cincinnati Financial Corporation and Subsidiaries (Dollars in millions) Assets At December 31, 2006 2005 Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,759 202 1,128 683 1,450 _________ $ 17,222 _________ _________ $ 5,305 1,579 1,653 371 28 392 1,086 _________ 10,414 _________ 1,406 2,786 3,379 (763) _________ 6,808 _________ $ 17,222 _________ _________ $ 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 _________ _________ (Dollars in millions except per share data) Revenues 2006 Years ended December 31, 2005 2004 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,278 570 684 18 _________ 4,550 _________ 2,128 630 463 _________ 3,221 _________ Income Before Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,329 Provision for Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399 _________ $ 930 _________ _________ Per Common Share Net income–basic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net income–diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ 5.36 5.30 $ 3,164 526 61 16 _________ 3,767 _________ 1,911 627 406 _________ 2,944 _________ 823 221 _________ $ 602 _________ _________ $ $ 3.44 3.40 $ 3,020 492 91 11 _________ 3,614 _________ 1,846 615 353 _________ 2,814 _________ 800 216 _________ $ 584 _________ _________ $ $ 3.30 3.28 2006: The company sold its holdings in Alltel common stock. The sale contributed $647 million (pretax) to realized investment gains and revenues and $412 million (after tax), or $2.35 per share, to net income. 7 Six-year Summary Financial Information Cincinnati Financial Corporation and Subsidiaries (Dollars in millions except per share data) 2006 2005 2004 2003 2002 2001 Years ended December 31, 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 $ $ $ $ $ $ 930 – 930 434 496 1,057 5.30 – 5.30 2.48 2.82 1.34 39.38 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* . . 6.8% 11.0 14.4 16.4 $ $ $ $ $ $ 602 – 602 40 562 99 3.40 – 3.40 0.23 3.17 1.21 34.88 7.0% 11.5 9.8 1.6 $ $ $ $ $ $ 584 – 584 60 524 287 3.28 – 3.28 0.34 2.94 1.04 35.60 7.2% 11.2 9.4 4.6 $ $ $ $ $ $ 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 $ $ $ $ $ $ 193 – 193 (17) 210 150 1.07 – 1.07 (0.10) 1.17 0.76 33.62 7.5% 8.9 6.0 13.5 7.9% 9.7 4.1 (4.0) 8.1% 9.2 3.2 2.5 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,178 3,172 3,164 $ 3,076 3,097 3,058 $ 2,997 3,026 2,919 $ 2,815 2,789 2,653 $ 2,613 2,496 2,391 $ 2,590 2,188 2,073 51.9% 11.6 30.4 93.9% 93.9% 49.2% 10.0 29.8 89.0% 89.0% 49.8% 10.3 29.3 89.4% 89.4% 56.1% 11.6 26.5 94.2% 95.0% 61.5% 11.4 25.5 98.4% 99.6% 66.8% 10.1 22.6 99.5% 103.6% $ 4,723 $ 4,194 $ 4,191 $ 2,783 $ 2,340 $ 2,533 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)* . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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)* . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,442 2,435 2,402 $ 2,290 2,306 2,254 $ 2,186 2,209 2,126 $ 2,031 2,009 1,908 $ 1,905 1,795 1,721 $ 1,827 1,551 1,453 48.4% 12.7 29.7 90.8% 90.8% 736 737 762 62.9% 8.3 32.4 103.6% 103.6% $ 46.6% 11.0 29.5 87.1% 87.1% 786 791 804 56.7% 7.2 30.4 94.3% 94.3% $ 43.4% 10.9 29.4 83.7% 83.7% 811 817 793 66.7% 8.9 29.0 104.6% 104.6% $ 51.2% 12.7 27.0 90.9% 91.6% 784 780 745 68.8% 8.9 25.2 102.9% 103.9% $ 57.8% 12.5 25.0 95.3% 96.8% 708 701 670 71.0% 8.7 26.8 106.5% 106.8% $ 62.6% 11.8 22.3 96.7% 100.7% 763 637 620 76.7% 6.2 23.0 105.9% 110.4% 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 . . . . . . . . . . . . . . . $ 161 (1) 28 56,971 2,026 $ 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 $ 102 21 15 27,534 1,329 556 67 511 52 491 47 443 50 420 47 457 44 * 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 Financial Performance Overview This is a brief overview of 2006 ﬁnancial results. We encourage you to read the Management’s Discussion and Analysis in our Annual Report on Form 10-K, Page 31, for additional details. Insurance results for the year were mixed. In the face of growing competition, our local independent agents brought us the highest level of new business and property casualty insurance premiums in our history. Underwriting proﬁts were $181 million, tempered by higher catastrophe losses, increased loss severity and less savings from favorable development of prior period losses as well as higher underwriting expenses. Investment results were the highlight of the year. Our equity-focused investment strategy led to another record-setting year for investment income and book value. Property Casualty Insurance Operations prior period losses compared with the unusually Value-oriented policyholders continued in high level of the past few years. 2006 to respond favorably to their local Other highlights of 2006 performance independent agents’ presentation of Cincinnati’s included: advantages. In the second half of the year, (cid:129) 3.3 percent increase in property casualty net agents and personal lines policyholders written premiums, ahead of the estimated responded to new pricing for Cincinnati’s industry average growth rate of 2.6 percent. personal lines products, leading to higher (cid:129) 93.9 percent statutory property casualty customer retention rates and rising new combined ratio, slightly above the estimated business. industry average of 93.3 percent. Our Offsetting those favorable growth trends, combined ratio included 5.5 percentage nine catastrophe events, primarily storms points due to catastrophe losses compared Premium Mix Percent of 2006 consolidated net earned premiums (Percent) Life 4% Personal lines 23% Commercial lines 73% Property Casualty Net Written Premium Growth Statutory (Percent) The Cincinnati Insurance Companies Estimated industry (A.M. Best) 14.0 15.1 11.7 9.6 6.5 4.4 2.6 -0.2 affecting our policyholders in the Midwest, led with 1.7 percentage points estimated for 02* 03* 04 05 to a record level of catastrophe losses. Loss the industry. severity crept upward. And expenses rose more (cid:129) A net increase of 37 reporting agency rapidly than premiums as we made ongoing locations. At year-end 2006, we had 1,066 investments in our people and our agency relationships with 1,289 reporting infrastructure, including technology and locations marketing our insurance products. systems to make it easier for agents to do (cid:129) Full-year 2006 net savings from favorable business with our company. development improved the combined ratio As anticipated, this year’s earnings by 3.7 percentage points. In 2005, savings reﬂected the adoption of stock option expensing improved the ratio by 5.2 percentage points. and less savings from favorable development on * 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. 3.3 2.6 06 9 Commercial Lines Insurance Highlights states representing 44 percent of BOP and (cid:129) 6.7 percent growth in commercial lines net DBOP premiums. Property Casualty Combined Ratio Statutory (Percent) The Cincinnati Insurance Companies Estimated industry (A.M. Best) 107.3 100.2 98.5 100.8 93.3 . 6 9 9 . 0 5 9 . 4 9 8 . 0 9 8 . 9 3 9 written premiums. Business policyholders are continuing to respond favorably to their local independent agents’ presentation of the Cincinnati value proposition – customized, multi-year coverage packages, superior claims service, our A++ rating from A.M. Best Co. and a local ﬁeld force. (cid:129) 14.9 percent increase in new commercial lines business to a record $324 million. As 02* 03* 04 05 06 competition continues in our regional markets, we believe we can sustain healthy growth by outworking the competition. For Cincinnati, that means maintaining strong relationships with our established agencies, writing a signiﬁcant portion of each agency’s business, giving outstanding claims service to their clients and attracting new agencies. (cid:129) $208 million commercial lines GAAP underwriting proﬁt, reﬂecting 90.8 percent full-year statutory commercial lines combined ratio. The ratio rose 3.7 percentage points on softer pricing, increasing loss severity, less savings from favorable development on prior-period reserves and adoption of stock option expensing. (cid:129) Growth for the commercial lines portion of the insurance industry was estimated at 1.0 percent in 2006, with a statutory combined ratio of 94.3 percent. (cid:129) 2007 plans include integration with agency management systems for WinCPP®, the company’s online, real-time commercial lines rate quoting system used by all agencies. Plans also include roll-out of Businessowner and Dentist’s Package Policy capabilities in 12 additional states for e-CLAS®, the company’s Web-based policy processing system currently used in seven Personal Lines Insurance Operations (cid:129) 6.4 percent decrease in personal lines net written premiums, in part due to reduced pricing effective July 2006. With pricing reduced to better compete in the current market, agents had more opportunity to sell service and value. (cid:129) 17.6 percent increase in new personal lines business written directly by agencies for the second half of 2006, following the mid-2006 pricing changes. Second-half new business growth offset the decline in the ﬁrst half of 2006, leading to 1.6 percent full-year new business growth. (cid:129) 103.6 percent 2006 statutory combined ratio. The 9.3 percentage-point increase reﬂected a 5.0 percentage point rise in the catastrophe loss ratio. Other factors were lower earned premiums, less savings from favorable development on prior period reserves, a third-quarter 2006 increase in loss severity and higher expenses. (cid:129) Growth for the personal lines portion of the insurance industry was estimated at 2.0 percent in 2006, with an estimated combined ratio of 92.0 percent. (cid:129) 82 percent of agencies writing personal lines policies now use Diamond, the company’s personal lines policy processing system. Approximately 90 percent of total 2006 personal lines earned premium volume was written in the 13 active Diamond states. Agents in Pennsylvania and Virginia began using Diamond early this year, with additional states planned for later in 2007. * 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 Cincinnati Life — Gross Life Policy Face Amounts In Force Excluding annuities, accident and health business (Dollars in millions) 1 7 9 6 5 , 3 9 4 1 5 , 1 2 9 4 4 , 2 9 4 8 3 , 6 8 4 2 3 , 02 03 04 05 06 Life Insurance Operations decreased to $30 million in 2006 from The Cincinnati Life Insurance Company $88 million in 2005. contributed 19 cents to our company’s 2006 operating earnings. Overall, the life (cid:129) 27.2 percent rise in 2006 term life insurance net written premiums reﬂecting competitive operation continues to provide a consistent advantages of providing competitive, income stream for our agents and the company, up-to-date products, close personal attention helping to offset some of the inevitable ﬂuctuations in property casualty results. and policies backed by ﬁnancial strength and stability. (cid:129) $161 million in 2006 total life insurance (cid:129) $19 million increase in full-year 2006 operations net written premiums, compared beneﬁts and expenses, principally due to with $205 million in 2005. Written premiums for life insurance operations reserve and mortality expense increases associated with growth and aging of life include life insurance, annuity and accident insurance in force. Mortality experience and health premiums. Since late 2005, the company has de-emphasized annuities because of an unfavorable interest rate remained within pricing guidelines. Adoption of stock option expensing contributed approximately $1 million to environment. Written annuity premiums operating expenses. Investment Operations (cid:129) $684 million in full-year 2006 net realized Our buy-and-hold equity investing strategy investment gains (pretax), including is key to the company’s long-term growth and $647 million from the ﬁrst-quarter sale stability. In 2007, we anticipate allocating a of the company’s holdings of Alltel higher proportion of cash available for common stock. investment to equity securities. We continue to (cid:129) 2.6 million shares repurchased in 2006, identify companies with the potential for under the board’s current authorization, revenue, earnings and dividend growth, a strong at a total cost of $118 million. management team and favorable outlook. These (cid:129) Book value of $39.38 at year-end 2006, up equities offer a steadily increasing ﬂow of dividend income along with the potential for capital appreciation. Highlights of 2006 investment operations included: (cid:129) 8.4 percent increase in pretax net investment income. This growth reﬂected new $4.50 from year-end 2005 level. Invested assets rose because of new investments and appreciation in the equity portfolio. Our equity holdings outperformed the Standard & investments, higher interest income from the Poor’s 500 Index in 2006, growing ﬁxed-maturity portfolio and returning 16.1 percent. While increased dividend income from the common we fell below that benchmark stock portfolio. (cid:129) $16 million annually in additional investment income expected during 2007 from dividend increases announced during 2006 by Fifth Third Bancorp and another for the ﬁve-year period that just ended, total return on the equity portfolio also surpassed the return on the Index over the 10- and 15-year periods 37 of the 50 common stock holdings in the that better measure our success equity portfolio. as a buy-and-hold investor. Consolidated Investment Portfolio As of December 31, 2006 (Dollars in millions) Book Value Market (Fair) Value 13,699 8,455 (In millions) Book Value Market (Fair) Taxable ﬁxed maturity Tax-exempt ﬁxed maturity Common equity Preferred equity Short-term Total $ 3,357 2,382 2,400 221 95 $ 8,455 Value $ 3,389 2,416 7,564 235 95 $13,699 11 Cincinnati has no cute no celebrity pitchmen to mascot, no clever slogan, get our name in front of consumers. Instead, our actions speak for us, creating satisﬁed agents and Field Authority Drives the Claims Response Process Cincinnati’s person-to-person approach policyholders who spread the word shapes every stage of our claims about our responsive claims service. response, heightening accountability and Our organizational structure and methods grow out of our approach to creating satisﬁed agency clients. Notiﬁcation. Policyholders report claims to the same local agency that sold their policy. claims, which centers on the The agency has authority to quickly pay independent agency system. We sell most covered claims up to $2,500. policies exclusively through the 1,066 agencies that are our customers. The agency sends a notice of loss electronically to our automated system, which forwards it to the We believe our company can prosper agency’s assigned ﬁeld claims over the long term only when each of these appointed agencies succeeds. representative who veriﬁes appropriate coverage is in force. Contact. Within 24 hours of Outstanding claims service to their receiving the notice, a local ﬁeld claims clients builds our agents’ good representative typically makes contact reputations and increases our chances to write their best accounts. Superior with the policyholder or claimant and inspects the damage. The ﬁeld claims representative often recommends or takes service sells insurance. steps to increase safety or reduce the Accordingly, we dedicate almost a policyholder’s risk of further damage or disruption. fourth of our 4,048 associates to claims functions at our Cincinnati Fact-ﬁnding. The ﬁeld claims representative works with the policyholder or claimant to document the facts of the case, including coverage liability, damage and valuation. headquarters and across 32 states. Policyholders select their own repair shops and vendors, and the ﬁeld That includes a ﬁeld force of approximately 732 ﬁeld claims claims representative veriﬁes that estimates are reasonable. The ﬁeld claims representative has authority to settle the claim on the spot and is fully equipped to issue a settlement check during the ﬁrst visit with a representatives and managers. Their policyholder or claimant. job is delivering on the promises our continued on page 14 12 Loss Control While we’re in the business of helping people recover ﬁnancially after a loss, we ﬁnd it’s better to prevent losses from ever happening. Loss control introduces safety measures for businesses that protect lives and reduce disruption to families and workplaces. Our agents appreciate local loss control representatives at their service for sales presentations, renewal meetings and sound advice. Agents and policyholders alike can turn to loss control for help in reducing workers’ compensation losses, ﬁre losses and other losses Wrap-up. The ﬁeld claims representative sends estimates, photos, statements and other documentation electronically to our system, where it is immediately available for review by managers who assist with losses over $35,000. This claims data ﬂows to ﬁnancial and reporting systems. The ﬁeld claims representative may submit a risk review to the underwriting department, request loss control services stemming from safety issues. or refer new business prospects to the agency. Headquarters managers may send satisfaction surveys. Loss control helps keep claims low, which can reduce costs for our company, the agency and the policyholder. “The claims setting is our best opportunity to show policyholders that their local agents and Cincinnati act with their best interests in mind.” —Jim Benoski, vice chairman, president, chief operating ofﬁcer and chief insurance ofﬁcer Help Always at Hand In 2006, Cincinnati’s ﬁeld claims representatives cut the last cord to their ofﬁces with new tablet personal computers. Outﬁtted with wireless cards, the tablets allow representatives to carry their ofﬁces with them. This mobility allows associates to handle multiple claims, complete documentation, print checks and even add to the electronic ﬁle that other authorized reviewers can access. Our agile and responsive claims operation is at the core of policyholder satisfaction. See the Consumer Information Source at www.naic.org for Cincinnati’s low complaint ratios. 13 agents made, generating the best advertising money can buy. We approach claims differently than the typical insurance company. Superior Service Sells Insurance First, Cincinnati ﬁeld claims We hear it over and over from agents, representatives are assigned to speciﬁc agencies, not to types of claims. When policyholders and claimants: Prompt and personal ﬁeld claims service exceeded expectations, not only settling a claim, but agents sell our policies, they likely winning a customer, selling an insurance already know who will respond to policy or securing a renewal. future claims. Their Cincinnati ﬁeld claims representatives don’t work You don’t know what your insurance premium dollar is worth until you ﬁle a claim. It’s worth everything when from regional ofﬁces; they work from you can repair your hail-damaged their homes right in the community. They respond to emergencies day or roof and get your family back in your home, when you can quickly regain the use of your company’s night and have the local knowledge to delivery van after an accident, or quickly assess and resolve claims. when a valued customer injured on Second, most of our ﬁeld claims representatives are true multi-line your property receives prompt payment of medical bills. Service sets us apart, attracting professionals, authorized to address our agents’ value-oriented clients. most claims whether on property or It is the reason commercial casualty, personal lines or commercial policyholders ask agents to place their personal policies with us and lines policies. This difference generations of families and businesses leverages their local knowledge. It means agents and policyholders can expect the consistency and comfort of “Whenever our service exceeds expectations, we’re going a known relationship. The same high to sell a policy – to a neighbor, friend, the insured by way standards apply to claims involving a of renewal, or through the agency by way of satisfaction fender bender in the family car, an and reputation.” injury at the ofﬁce or a ﬁre at a —Bud Stoneburner, CPCU, vice president and manager of ﬁeld claims continued on page 16 14 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 balance sheets; and manage their agencies Cincinnati Market Share Within Reporting Agency Location Based on 2005 Direct Written Premiums (Percent) 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 75 percent of the reporting agency locations that we have served for more than ﬁve years. There is tremendous potential in the 239 reporting agency locations that have marketed our products for less than ﬁve years, even as we continue to grow with the 1,050 more established reporting locations. 22.4 9.9 4.3 1.2 Less than 1 year 1 to 5 years 5 to 10 years 10 or more years stay with us. Satisﬁed policyholders are the reason our policy retention rate is high in both personal lines and commercial lines. Our ﬁeld claims representatives watch for ways to assist the Cincinnati underwriting and sales teams by helping to review renewal business or submitting risk reports. They go along when agents present coverage proposals, giving potential policyholders a chance to shake hands with the person who might someday look them in the eye and say, “I’m here to help you. Let’s get started.” Storm Teams The ﬁeld claims representatives who respond to weather catastrophes are volunteers on temporary assignment from their home territories. Our own experienced associates know our policy coverages and service standards, seamlessly providing prompt, accurate claims service. Storm teams mobilize on short notice whenever large numbers of losses occur in a concentrated area – sometimes deploying to a staging area even before the bad weather hits. In addition to the help our storm team quickly provides “on the ground,” headquarters and other ﬁeld claims associates may assist in prioritizing claims through our electronic system, initiating contact, advising emergency measures and allowing smooth transitions as storm teams rotate after two weeks. 15 manufacturing plant. Even when complex or unusual claims require specialists for support, the agency’s assigned ﬁeld claims representative People Come First remains the contact person. We make all of our technology investments with people in Third, Cincinnati ﬁeld claims mind. Our business is helping people recover ﬁnancially after insured losses, working to preserve their dignity in representatives are trained to look for the process. coverage, paying what is due under In the ﬁeld, tools such as tablet PCs, digital cameras and the policy. Our business is paying covered claims. This approach mobile printers allow ﬁeld claims representatives to quickly document and process the claim. They can write estimates and print checks on the spot using software that supports the long-term relationships streamlines property claim estimates. What better way to with agents and policyholders that exceed policyholder expectations than to inspect the loss lead to sustainable growth and proﬁtability. and present the check in the same meeting? At headquarters, claims supervisors have immediate access to information through the claims management Our ﬁeld claims representatives system, allowing them to manage large loss ﬁles and take action both to pay covered claims litigation, as well as review reserves set aside to pay each and to reduce risk for the policyholder and our company. Based on ﬁrst-hand claim. The system enables efﬁcient ﬁle management, accurate ﬁnancial reporting and check authentication to prevent fraud, keeping costs down both for the company and observations made during the claim for policyholders. process, they may bring in our loss control services to consult on safety measures or write a risk report, providing information that supports proper underwriting and pricing at the next renewal. They may refer claimants or policyholders who need an evaluation of their insurance needs Product growth Cincinnati is a regional carrier, serving local markets and working with our agents account by account. This approach has made us the 23rd largest insurance carrier based on net premiums written. In selected product lines, it has made us an even more signiﬁcant player. We rank nationally as one of the top 20 carriers for commercial property, commercial auto and commercial casualty to an agent. This experience makes insurance. We achieve those ranks even them the best candidates when we continued on page 18 16 though our market share in those product lines is less than 3 percent, showing the potential that remains as we continue to meet agents’ needs. Cincinnati's Highest Volume Lines National Market Share and Rank Based on 2005 Direct Written Premiums (Percent) 1.8 #15 1.5 1.3 0.6 #18 #15 #29 ' s r e k r o W n o i t a s n e p m o C y t l a u s a C l a i c r e m m o C o t u A l a i c r e m m o C y t r e p o r P l a i 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 0.3 #46 e t a v i r P o t u A r e g n e s s a P “We compete by excelling at agency relationships, claims service and total return investing.” —Jack Schiff, Jr., CPCU, chairman and chief executive ofﬁcer Managing Risk Field claims representatives do more than work with policyholders to resolve claims. They directly observe and often prepare risks reports on the quality of the risks we insure. Their assessments help determine appropriate support or actions by other business areas that manage our policyholder and agency relationships. Information they provide also contributes to our understanding of the diversity of our book of business and concentrations of risk within that book. Whether evaluating our exposure to risk from a single policy or from overall business operations, our approach recognizes the correlation and interdependence of risks across our entire company. At the department level, various associates have primary responsibility for addressing speciﬁc risk types and communicating risks that may affect other departments; at the enterprise level, a senior ofﬁcer, leads a cross- departmental team that is building a formal framework to identify, aggregate, measure and manage risks across our organization. 17 Special Investigations Unit Cincinnati has its own staff of more than two dozen specialists who investigate potential fraud. These claims professionals and former police ofﬁcers cooperate with law enforcement agencies who investigate and prosecute criminal activity such as arson, theft or false injury claims. Through its computer forensic lab, SIU uses sophisticated software and data recovery techniques to help restore a policyholder’s valuable business records and save time lost to business interruption. Their proprietary techniques often reclaim irreplaceable information, even from equipment that seems hopelessly charred, such as the computer shown at left. Reserves Help Us Honor Obligations need to recruit for headquarters claims management positions. The capstone of our claims philosophy is our commitment to maintain the ﬁnancial strength that backs our policies. Our ability to meet policyholder obligations is evidenced After evaluating a reported claim, a ﬁeld claims representative quickly by strong ratings, including an A++ estimates the potential loss amount from A.M. Best Co., its highest rating – establishing a case reserve. Routed awarded to less than 2 percent of insurers. through our automated claims system, headquarters claims representatives at various levels The ﬁscal integrity of our claims review and approve initial case operations contributes to the reserve amounts greater than $35,000 and revisit case reserves at company’s overall ﬁnancial strength 90-day intervals. as well. In paying covered claims Some losses are not known to the Information Flow (cid:129) Workﬂow (cid:129) Reports to agencies (cid:129) Diaries (cid:129) Financial data (cid:129) External reporting quickly and efﬁciently, we help claimants recover while minimizing administrative expenses. In working to policyholder nor reported as claims to the company for months, or even years, after they occur. For example, you may not be aware that your roof was damaged in a storm until the following spring. We take seriously our identify and deter fraud, we keep such obligation to pay those claims in our usual prompt and personal fashion, costs from inﬂating policyholders’ whenever they are reported to us. premiums. In recovering costs through Our actuarial staff estimates quarterly the total cost of claims that statistically could have occurred, with particularly detailed reviews subrogation and salvage activities, we occurring at the ends of the third and fourth quarters. These analyses form further protect the interests of the bases for the monthly reserves we carry. Taken as an expense, the policyholders and the company. We seek to set reserves that are sufﬁcient actuarial estimate encompasses both case reserves for already reported claims and reserves for paying not yet reported claims. Shareholders beneﬁt as we set aside loss reserves in an amount adequate to maximize and fair, proven over time to represent future predictability, regardless of the timing of claims payments. our future obligations to policyholders Our reserving practices have distinguished our company. In each of the for their past losses. 18 past 15 years, our actuaries’ detailed review has shown our prudence in establishing estimates of amounts needed for future claims due to past losses. Our sound practices have led to savings from favorable development on prior period reserves in each of those years. File Management Support (cid:129) Paperless ﬁles (cid:129) Anywhere communication (cid:129) Digital ﬁle documentation (cid:129) Catastrophe response (cid:129) Privacy and security safeguards Field Claims Representative Human Expertise (cid:129) Senior management support (cid:129) Coverage experts (cid:129) Local ﬁeld team (cid:129) Help Desk support (cid:129) Service consultants Education, Experience, Ethics Our ﬁeld claims representative training is or more. After getting some ﬁeld experience, tailored to the needs and strengths of each the trainees return to headquarters for student. Rigorous classroom work combines advanced classes. with personal mentorship to lay a foundation Experienced ﬁeld claims representatives of knowledge, commitment and integrity. new to Cincinnati might start in a territory The process takes at least three years for with a mentor, then take the intermediate trainees who have no prior claims classroom training series. Through it all, we experience. They study general insurance work to build the professional skills of the subjects, investigative techniques, individual, conducting training the way we interpersonal skills and company culture. conduct our business, without cookie Online courses supplement group sessions, cutters. Rather, we invest in the person, and and trainees have a mentor for six months it pays off. Room to grow Meeting the needs of our independent insurance agencies allows us to grow more rapidly than the overall industry. Substantial potential remains in our 32 active states. In 26 states, our market share is less than 1 percent. To tap this potential, we have accelerated efforts to appoint new agencies. In 2005 and 2006, we added 112 agency relationships. We anticipate 50 new agency appointments in 2007, and potentially our ﬁrst appointments in New Mexico and eastern Washington. We plan to enter those states as we usually do – focusing on commercial lines and later evaluating personal lines options. Cincinnati Market Share by State Based on 2005 Direct Written Premiums (Percent) Above 5% 1% to 5% Less than 1% Inactive states Future active states announced in 2007 Headquarters (no branches) 19 Cincinnati Financial Corporation Ofﬁcers and Directors (as of March 1, 2007) Directors William F. Bahl, CFA, CIC Chairman Bahl & Gaynor Investment Counsel, Inc. Director since 1995 (1)(3)(4)(5*) James E. Benoski Vice Chairman, President, Chief Operating Ofﬁcer and Chief Insurance Ofﬁcer Cincinnati Financial Corporation Director since 2000 (3)(4) Gregory T. Bier, CPA (Ret.) Managing Partner (Ret.), Cincinnati Ofﬁce Deloitte & Touche LLP Director since 2006 (1)(4) Michael Brown President Cincinnati Bengals, Inc. Director since 1980 (3) Dirk J. Debbink President MSI General Corporation (design/build/construction) 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 Former Vice President - Finance & Accounting Global Operations Procter & Gamble Director since 2002 (1)(2) John J. Schiff, Jr., CPCU Chairman and Chief Executive Ofﬁcer Cincinnati Financial Corporation Director since 1968 (3*)(4*) Ofﬁcers John J. Schiff, Jr., CPCU Chairman and Chief Executive Ofﬁcer James E. Benoski Vice Chairman, President, Chief Operating Ofﬁcer and Chief Insurance Ofﬁcer Kenneth W. Stecher Chief Financial Ofﬁcer, Executive Vice President, Secretary and Treasurer 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. (food distribution) Director since 2004 (1) John F. Steele, Jr. Chairman and Chief Executive Ofﬁcer Hilltop Basic Resources, Inc. (aggregates/concrete supplier) Director since 2005 (1) Larry R. Webb, CPCU President Webb Insurance Agency, Inc. Director since 1979 (3) E. Anthony Woods Chairman Deaconess Associations, Inc. (health care) Director since 1998 (2)(4) (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 * Committee Chair Kenneth S. Miller, CLU, ChFC Chief Investment Ofﬁcer, Senior Vice President, Assistant Secretary and Assistant Treasurer Eric N. Mathews, CPCU, AIAF Vice President, Assistant Secretary and Assistant Treasurer Directors Emeriti Vincent H. Beckman Robert J. Driehaus John E. Field, CPCU Jackson H. Randolph Lawrence H. Rogers II John Sawyer 20 Robert C. Schiff Frank J. Schultheis David B. Sharrock Thomas J. Smart Alan R. Weiler, CPCU William H. Zimmer W.F. Bahl J.E. Benoski G.T. Bier D.J. Debbink K.C. Lichtendahl W.R. McMullen G.W. Price J.J. Schiff, Jr. T.R. Schiff D.S. Skidmore J. F. Steele, Jr. L.R. Webb E.A. Woods J.M. Shepherd M. Brown Michael Brown and John Shepherd are not standing for re-election in May 2007. Mr. Brown has been a director since 1980, participating in activities of the compensation, executive and nominating committees. Mr. Shepherd has served on our board for six years, participating in activities of the audit, executive and nominating committees. Your company has beneﬁted from their perspectives as business owners with wide responsibilities to others, sharing much in common with the independent businesses operated by our agencies and the businesses we typically insure. We thank Mr. Brown and Mr. Shepherd, as we also thank our shareholders who elected them. Subsidiary Officers and Directors As of March 1, 2007, listed alphabetically The Cincinnati Insurance Company (CIC) The Cincinnati Indemnity Company (CID) Executive Officers James E. Benoski CIC, CID, CCC Vice Chairman, Chief Executive Officer and Chief Insurance Officer CIC, CID President CLIC Chief Executive Officer and Chief Insurance Officer 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 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, ARe 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, CCC, CLIC Chairman of the Executive Committee; Director CFC-I Director Joan O. Shevchik, CPCU, CLU CIC, CID, CCC Senior Vice President – Corporate Communications Kenneth W. Stecher CIC, CID, CCC, CLIC Chairman, Chief Financial Officer, Executive Vice President and Secretary CFC-I Chief Financial Officer and 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 CIC, CID, CCC, CLIC, CCM Vice President – Investments 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 Mark R. DesJardins, CPCU, AIM, AIC, ARP CIC, CID, CCC Vice President – Education & Training W. Dane Donham, AIM CIC, CID, CCC Vice President – Commercial Lines The Cincinnati Casualty Company (CCC) The Cincinnati Life Insurance Company (CLIC) CFC Investment Company (CFC-I) CinFin Capital Management (CCM) Donald J. Doyle, Jr., CPCU, AIM CIC, CID, CCC, CLIC Senior Vice President – Excess & Surplus Lines 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 Gregory D. Schmidt, CPCU, ARP, CPP, ACP, ARC CIC, CID, CCC, CLIC Vice President – Staff Underwriting 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, AAI CIC, CID, CCC Vice President – Commercial Lines CIC, CID, CCC Vice President – Bond & Executive Risk Steven A. Soloria, CFA, CPCU Gary B. Givler CIC, CID, CCC Vice President – Headquarters Claims David T. Groff, CPCU, FCAS CIC, CID, CCC Vice President – Staff Underwriting 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, CPCU 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, CLIC, CFC-I Vice President – Purchasing/Fleet Robyn C. Muhlberg CIC, CID, CCC, CLIC Vice President – Information Technology 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, CFA, CPCU, 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 Ronald L. Robinson 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 – Inspection Services & Facilities 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 – Special Investigations Stephen A. Ventre, CPCU, AIM CIC, CID, CCC Vice President – Commercial Lines Jody L. Wainscott CIC, CID, CCC Vice President – Research & Development Michael B. Wedig, CPA CIC, CID, CCC, CLIC Vice President – Corporate Accounting 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 CIC, CID, CCC, CLIC Director Gregory T. Bier, CPA (Ret.) 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 21 Definitions of Non-GAAP Information and Reconciliation to Comparable GAAP Measures Cincinnati Financial Corporation prepares its public consolidated 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 is calculated by excluding net realized investment gains and losses (defined as realized investment gains and losses after applicable federal and state income taxes) 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. 22 • Statutory accounting rules: For public reporting, insurance companies prepare consolidated 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 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 a $39 million one-time, pretax charge incurred in 2000. Reconciliation of Consolidated Financial Data Cincinnati Financial Corporation and Subsidiaries (Dollars in millions except per share data) Years ended December 31, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 2005 2004 2003 2002 2001 $ $ $ 930 - 930 434 496 5.30 - 5.30 2.48 $ $ $ 602 - 602 40 562 3.40 - 3.40 0.23 $ $ $ 584 - 584 60 524 3.28 - 3.28 0.34 $ $ $ 374 15 359 (27) 386 2.10 0.09 2.01 (0.15) $ $ $ 238 - 238 (62) 300 1.32 - 1.32 (0.35) 193 - 193 (17) 210 1.07 - 1.07 (0.10) $ 2.82 $ 3.17 $ 2.94 $ 2.16 $ 1.67 $ 1.17 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 Return on average equity based on comprehensive income One-time items Return on average equity based on comprehensive income before one-time items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14.4 % - 14.4 % 16.4 % - 16.4 % 9.8 % - 9.8 % 1.6 % - 1.6 % 9.4 % - 9.4 % 4.6 % - 6.3 % (0.3) 6.0 % 13.8 % (0.3) 4.1 % - 4.1 % (4.0) % - 4.6 % 13.5 % (4.0) % 3.2 % - 3.2 % 2.5 % - 2.5 % Reconciliation of 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) Combined ratio (reported) Codification(2) Written premium adjustment One-time items Combined ratio (adjusted) Catastrophe losses Combined ratio excluding catastrophe losses (adjusted) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 2005 2004 2003 2002 2001 Years ended December 31, 3,172 - 6 3,178 (14) 3,164 $ $ 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 $ $ 2.4 % 3.3 3.5 93.9 % - nm - 93.9 (5.5) 88.4 % 2.3 % 2.6 4.8 89.0 % - nm - 89.0 (4.1) 84.9 % 8.5 % 6.5 10.0 89.4 % - nm - 89.4 (5.1) 84.3 % 11.7 % 7.7 10.9 94.2 % - nm 0.8 95.0 (3.6) 91.4 % 14.0 % 0.9 15.4 98.4 % - 1.2 - 99.6 (3.6) 96.0 % 2,188 402 - 2,590 (517) 2,073 13.0 % 37.7 13.3 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. 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) Combined ratio (reported) Codification(2) Written premium adjustment One-time items Combined ratio (adjusted) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Catastrophe losses Combined ratio excluding catastrophe losses (adjusted) 2006 2005 2004 2003 2002 2001 Years ended December 31, 2,435 - 7 2,442 (40) 2,402 $ $ 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 $ $ 5.6 % 6.7 6.6 90.8 % - nm - 90.8 (3.7) 87.1 % 4.4 % 4.7 6.0 87.1 % - nm - 87.1 (3.4) 83.7 % 10.0 % 7.6 11.4 83.7 % - nm - 83.7 (3.4) 80.3 % 11.9 % 6.6 10.8 90.9 % - nm 0.7 91.6 (2.2) 89.4 % 15.8 % 4.2 18.6 95.3 % - 1.5 - 96.8 (2.3) 94.5 % 1,551 276 - 1,827 (374) 1,453 16.9 % 43.3 17.9 96.7 % 4.0 - - 100.7 (1.9) 98.8 % Reconciliation of Personal 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) Combined ratio (reported) Codification(2) Written premium adjustment One-time items Combined ratio (adjusted) Catastrophe losses Combined ratio excluding catastrophe losses (adjusted) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2006 2005 2004 2003 2002 2001 Years ended December 31, 737 - (1) 736 26 762 $ $ (6.8) % (6.4) (5.3) 103.6 % - nm - 103.6 (11.3) 92.3 % 791 - (5) 786 18 804 $ $ (3.2) % (3.0) 1.4 94.3 % - nm - 94.3 (6.3) 88.0 % 817 - (6) 811 (18) 793 $ $ 4.7 % 3.4 6.4 104.6 % - nm - 104.6 (9.7) 94.9 % 780 - 4 784 (39) 745 $ $ 701 - 7 708 (38) 670 $ $ 12.0 % 10.8 11.2 102.9 % - nm 1.0 103.9 (7.3) 96.6 % 9.8 % (7.2) 8.1 106.5 % - 0.3 - 106.8 (7.1) 99.7 % 637 126 - 763 (143) 620 4.6 % 26.1 4.0 105.9 % 4.6 - - 110.5 (5.8) 104.7 % Reconciliation of Life Insurance Company Data (Statutory)(1) The Cincinnati Life Insurance Company (Dollars in millions) Gross written premiums (reported) Bank-owned life insurance (BOLI) adjustments Gross written premiums (adjusted) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ $ Years ended December 31, 2006 2005 2004 2003 2002 2001 206 - 206 $ $ 249 - 249 $ $ 230 (10) 220 $ $ 173 - 173 $ $ 244 (34) 210 $ $ 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. 24 Cincinnati Financial Corporation 2006 Annual Report on Form 10-K Table of Contents 10-K Page Part I Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Item 1 Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Item 1A Item 1B Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Item 2 Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Item 3 Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Item 4 Part II Item 5 Item 6 Item 7 Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Item 7A Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . . 72 Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Item 8 Includes: Responsibility for Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 Management's Annual Report on Internal Control Over Financial Reporting . . . . . 79 Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . 80 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 Item 9 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Item 9A Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Item 9B Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Part III Item 10 Item 11 Item 12 Item 13 Item 14 Part IV Item 15 Directors and Executive Ofﬁcers of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104 Security Ownership of Certain Beneﬁcial Owners and Management and Related Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 Exhibits and Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 25 United States Securities and Exchange Commission Washington, D.C. 20549 Form 10-K (cid:59) (cid:133) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the fiscal year ended December 31, 2006. TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from _____________________ to _____________________. Commission file number 0-4604 Cincinnati Financial Corporation (Exact name of registrant as specified in its charter) Ohio (State of incorporation) 31-0746871 (I.R.S. Employer Identification No.) 6200 S. Gilmore Road Fairfield, Ohio 45014-5141 (Address of principal executive offices) (Zip Code) (513) 870-2000 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: $2.00 par, common stock (Title of Class) 6.125% Senior Notes due 2034 (Title of Class) 6.9% Senior Debentures due 2028 (Title of Class) 6.92% Senior Debentures due 2028 (Title of Class) Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes (cid:59) No (cid:134) Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes (cid:134) No (cid:59) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes (cid:59) No (cid:133) Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (cid:133) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer” and “large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer (cid:59) Accelerated filer (cid:133) Non-accelerated filer (cid:133) Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes (cid:134) No (cid:59) The aggregate market value of voting stock held by nonaffiliates of the Registrant was $7,397,523,700 as of June 30, 2006. As of February 16, 2007, there were 172,835,849 shares of common stock outstanding. Portions of the definitive Proxy Statement for Cincinnati Financial Corporation’s Annual Meeting of Shareholders to be held on May 5, 2007, are incorporated by reference into Parts II and III of this Form 10-K. Document Incorporated by Reference 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 2006, we had 4,048 associates, with 2,888 headquarters associates providing support to 1,160 field associates. Cincinnati Financial Corporation (CFC) owns 100 percent of three subsidiaries: The Cincinnati Insurance Company, CFC Investment Company and CinFin Capital Management Company. In addition, the parent company has an investment portfolio and is responsible for corporate borrowings and shareholder dividends. 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 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 also 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 over 3,900 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) 2006 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 2006, our 1,066 agency relationships had 1,289 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. Reporting agency locations describes our agents’ scope of business and our presence within our 32 active states. At year-end 2005, we had 1,024 agency relationships with 1,252 reporting agency locations. At year-end 2004, we had 998 agency relationships with 1,213 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 Earned Premiums by State In our 10 highest volume states, 877 reporting agency locations wrote 70.0 percent of our 2006 total property casualty earned premium volume compared with 69.7 percent in 2005. (Dollars in millions) Year ended December 31, 2006 Ohio Illinois Indiana Pennsylvania Michigan Georgia North Carolina Virginia Wisconsin Kentucky Year ended December 31, 2005 Ohio Illinois Indiana Pennsylvania Michigan Georgia Virginia North Carolina Wisconsin Kentucky Earned premiums Percent of total earned Reporting agency locations Avg premium per location $ $ 695 291 225 190 160 147 144 142 119 103 687 281 222 182 164 133 126 121 119 98 22.0 % 9.2 7.1 6.0 5.1 4.6 4.5 4.5 3.8 3.2 22.5 % 9.2 7.3 5.9 5.4 4.3 4.1 3.9 3.9 3.2 220 116 98 75 92 62 70 55 51 38 224 112 99 63 88 59 53 68 49 38 $ $ 3.2 2.5 2.3 2.5 1.7 2.4 2.1 2.6 2.3 2.7 3.1 2.5 2.2 2.9 1.9 2.3 2.4 1.8 2.4 2.6 In 2005, the most recent period for which data is available, Cincinnati Insurance was the No. 1 or No. 2 carrier in 75 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 15.7 percent share of the property casualty insurance in our reporting agency locations. Our share is 22.4 percent in reporting agency locations that have represented us for more than 10 years; 9.9 percent in agencies that have represented us for five to 10 years; 4.3 percent in agencies that have represented us for one to five years; and 1.2 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, 2006 10-K Page 2 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 1.2 percent of our total agency earned premiums in 2006. 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 2.3 percent of our total agency earned premiums in 2006. Strengthening Our Agency Relationships We follow a number of strategies to strengthen our relationships with the independent property casualty insurance agencies that represent us. Emphasis on Relationships and Local Decision-making 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 representatives specializing in claims, loss control, machinery and equipment, bond, premium audit, life insurance and leasing. For example, our field machinery and equipment 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 account. 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. Risk-specific Underwriting We seek to be a consistent, predictable and reasonable property casualty 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 get to 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 selects personal lines business from within the geographic territory that it serves, based on the agent’s knowledge of the risks in those communities or familiarity with the policyholder. New and renewal business activities are supported by headquarters associates assigned to individual agencies. Competitive Insurance Products We are committed to offering the property casualty 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 offer personal auto and homeowners coverages together with other coverages such as personal umbrella. This 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 next 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 2006 10-K Page 3 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 2006 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 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. Our personal lines policies are offered on a one-year term, except for homeowner policies in five states. Competitive advantages of our personal lines coverages include a generous credit structure and customizable endorsements for both the personal auto and homeowner policies. A newly introduced personal auto policy endorsement is replacement cost coverage for newly purchased vehicles. Popular homeowner endorsements include replacement cost for contents, inflation guard, identity theft mitigation and advocacy, flexible water damage coverages and enhanced replacement cost coverage for older homes. Technology Solutions We seek to employ technology solutions and business process improvements that complement our core values of local underwriting decisions, strong relationships with our independent agencies and superior claims service. In recent years, we have made significant investments in state-of-the-art information technology platforms, systems and Internet-based applications to: • allow our agencies and our field and headquarters associates to collaborate more efficiently, • provide our agencies the ability to access our systems and client data to process business transactions from their offices, • automate our internal processes so our associates can spend more time serving agents and policyholders, and • reduce duplication and make our processes more effective to reduce company and agency costs. Agencies access our systems and other electronic services via CinciLink®, our secure agency-only portal. CinciLink provides an array of Web-based services and content that make it easier to do business with us, such as commercial and personal lines rating and processing systems, policy loss information, sales and marketing materials, educational courses on our products and services, and electronic libraries for property and casualty coverage forms and state rating manuals. Commercial Lines Technology – Through our WinCPP® commercial lines premium quoting system, agency and company representatives are able to complete online, real-time premium quotes for new business and renewals. WinCPP is used by all of our agency locations in the 32 states in which we actively market insurance and provides quoting capabilities for nearly 100 percent of our new and renewal commercial lines business. In 2007, we will introduce agency integration technology for WinCPP; CinciBridge™ allows automated movement of key underwriting data from an agent’s management system to WinCPP, reducing agents’ data entry and allowing seamless quoting and rating capabilities. Some small business accounts written as Businessowner Policies (BOP) and Dentist’s Package Policies (DBOP) are eligible to be issued at our agency locations through our Web-based e-CLAS® policy processing system. (A businessowner policy combines property, liability and business interruption coverages for small businesses.) e-CLAS provides full policy lifecycle transactions including: quoting, issuance, policy changes, renewal processing and policy printing at the agency location. These features make it easier and more efficient for our agencies to issue and service these policies. e-CLAS is in use in seven states representing 44 percent of the BOP and DBOP premiums. During 2007, we expect to roll-out e-CLAS to an additional 12 states for these policy types. We also intend to introduce the CinciBridge agency integration technology with e-CLAS. Our primary long-term technology objective is to complete development of e-CLAS for all of our commercial lines of business. Since 2004, we have been streamlining internal processes and achieving operational efficiencies in our headquarters commercial lines operations through deployment of i-View™, a policy imaging and workflow system. This system provides online access to electronic copies of policy files, enabling our underwriters to respond to agent requests and inquiries more quickly and efficiently. i-View also automates internal workflows through electronic routing of underwriting and processing work tasks. Sixty percent of non-workers’ compensation commercial lines policy files now are administered and retained electronically in i-View and our field claims representatives can access these records to help them efficiently verify coverage and process claims. We expect more than 90 percent of non-workers’ compensation commercial lines policy files will be retained in i-View by year-end 2007. 2006 10-K Page 4 Personal Lines Technology – 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. Diamond incorporates features frequently requested by our agencies such as direct bill and monthly payment plans, local and headquarters policy printing options, data transfer to and from popular agency management systems and real-time integration with data from third party sources needed to calculate final premiums such as insurance scores, MVR reports and address verification. At year-end 2006, Diamond was in use in 13 states representing approximately 90 percent of our personal lines premium volume. Agents in Pennsylvania and Virginia began using Diamond in early 2007 with additional states planned for later in the year. In 2006, we introduced PL-efiles, a policy imaging system, to our personal lines operations. Through year-end 2006, we had transitioned more than one-third of our Diamond personal lines files to PL-efiles, replacing paper format with electronic copies of policy documents. PL-efiles complements the Diamond system by giving personal lines underwriters and support staff online access to policy documents and data that enable them to respond to agent requests and inquiries quickly and efficiently. Claims Technology – Our property and casualty claims operation has streamlined processes and achieved operational efficiencies through the use of CMS™, our claims file management system. Initially deployed in late 2003, CMS 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 to add capabilities to make our associates more effective. During 2006, we issued tablet computers to our field claims representatives. These units allow our claims representatives to view and enter information into CMS from any location, including an insured’s home or agent’s office, and to print claim checks using portable printers. Agent access to selected CMS information is planned for 2007. Surety and Executive Risk Technology – Advances in automation and streamlined business processes have enabled us to offer our agencies a more efficient means to process certain surety bonds. This helps agencies offer a complete package to their commercial clients. Since 2005, we have introduced CinciBond®, an automated system to process license and permit surety bonds, to agents in 11 states representing 803 agency reporting locations. CinciBond enables agents to rate, issue and print bonds at their offices. During 2007, we expect to complete rollout in remaining states and add other popular surety bond types. Life Insurance Offerings Round Out Agency Relationships 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 to provide us with penetration in geographic markets not served through our property casualty 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, high quality service and competitive pricing. Programs, Products and Services to Support Agency Growth 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 agency management 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 seminars on a variety of topics, such as marketing seminars to promote cross-marketing of our products. Cincinnati associates also co-host client seminars with our agencies on a 2006 10-K Page 5 variety of topics such as risk transfer techniques. These customized programs address liability issues specific to classes of business, such as contractors or dentists. • 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. 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. Superior Financial Strength Ratings In addition to the ratings of our parent company senior debt, independent ratings firms award our property casualty and life operations insurer financial strength ratings based on their quantitative and qualitative analyses. These ratings assess an insurer’s ability to meet its financial obligations to policyholders and do not necessarily address all of the matters that may be important to shareholders. We believe that our strong surplus position and 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. We seek to ensure that our performance remains consistent and predictable by aligning agents’ interests with those of the company, giving agents outstanding service and compensation and earning their best business by enhancing their ability to serve the businesses and individuals in their communities. As of December 31, 2006, our financial strength ratings were unchanged from those reported in our 2005 Annual Report on Form 10-K. The outlook from Standard & Poor’s was raised to stable from negative. Parent Company Senior Debt Rating Property Casualty Insurance Subsidiaries Financial Strength Ratings Life Insurance Subsidiary Financial Strength Ratings A. M. Best Co. Fitch Ratings Moody's Investors Services Standard & Poor's Ratings Services aa- A+ A2 A A++ Superior AA Very Strong Aa3 Excellent AA- Very Strong Rating Tier 1 of 16 4 of 21 4 of 12 4 of 21 Superior A+ AA Very Strong - - AA- Very Strong Rating Tier 2 of 16 4 of 21 - 4 of 21 Outlook Stable Stable Stable Stable • A.M. Best Co. - On April 28, 2006, A.M. Best affirmed its financial strength rating (FSR) of A++ (Superior) for our property casualty group, citing its superior risk-adjusted capitalization, very strong operating performance, network of independent agents and strong overall underwriting results despite challenges to achieve profitability in its personal lines business. Concurrently, A.M. Best downgraded its issuer credit ratings for our property casualty insurance companies to aa+ from aaa, reflecting the company’s investment and geographic risk concentrations at current rating levels. Additionally, A.M. Best affirmed the FSR of A+ (Superior) and the issuer credit rating of aa- of The Cincinnati Life Insurance Company. The outlook for all ratings is stable. • Fitch Ratings - On September 15, 2006, Fitch affirmed the AA insurer financial strength ratings of our three property casualty companies and The Cincinnati Life Insurance Company. Fitch said the ratings are based on the strong financial condition of our operating subsidiaries, excellent financial flexibility and successful total return investment strategy. The ratings consider the property casualty group’s investment concentration in a small number of common stocks and geographic concentration in Ohio and Midwestern states. • Moody’s Investors Service –In July 2006, Moody’s issued its Analysis, stating that overall, its Top 10 ratio metrics suggest that our property casualty group continues to be appropriately positioned within the Aa insurance financial strength rating category. Further, in its November 2006 comment after our third- quarter earnings announcements, Moody’s said the stable outlook is supported by our conservative financial and operational leverage profiles and by Moody’s belief that our operating model will enable us to continue to compete effectively in our core markets. Moody’s noted that challenges include the increasingly competitive environment in small and middle market commercial lines, lagging technology systems, a concentrated portfolio and payment of sizable common stock dividends that reduce our fixed charge coverage levels. • Standard & Poor’s Ratings Services - On July 25, 2006, Standard & Poor’s Ratings Services affirmed its AA- (Very Strong) financial strength and counterparty credit ratings on the property casualty group and The Cincinnati Life Insurance Company. At the same time, Standard & Poor’s revised its outlook on the company, our property casualty operating companies and Cincinnati Life to stable from negative. 2006 10-K Page 6 Standard & Poor’s said the revised outlook reflected the improved results on our homeowner book of business, as well as its view of our ability to benefit from corrective actions we have effected over recent years. Standard & Poor’s said it believes our unique approach to agency relationships should drive profitable growth even in a softer pricing environment. Statutory surplus for our property casualty insurance subsidiary was $4.723 billion at December 31, 2006, with the ratio of property casualty common stock to statutory surplus at 97.3 percent, in line with our targeted sub-100 percent level. At year-end 2005, property casualty statutory surplus was $4.220 billion, with the ratio of common stock to surplus at 96.4 percent. Life statutory surplus was $479 million at December 31, 2006, with the ratio of life common stock to statutory adjusted capital and surplus at 88.8 percent. At year-end 2005, life statutory surplus was $451 million, with the ratio of common stock to statutory adjusted capital and surplus at 83.5 percent. Cincinnati Life’s statutory adjusted risk-based surplus increased 8.7 percent to $556 million at December 31, 2006, from $511 million a year earlier. Statutory adjusted risk-based surplus as a percentage of liabilities, a key measure of life insurance company capital strength, was 37.8 percent at year-end 2006 compared with an estimated industry average ratio of 10.7 percent. A higher ratio indicates an insurer’s stronger security for policyholders and capacity to support business growth. At year-end 2006 and 2005, 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. We continue to review the risk management and capital requirement changes that rating agencies have proposed for our industry. Additionally, we began a formal implementation of enterprise risk management in 2005. Responsibility for enterprise risk management has been assigned at the officer level, supported by a team of representatives from business areas. The team reports to our president, our chief executive officer and our board of directors, as appropriate, on detailed and summary risk assessments, risk metrics and risk plans. Our use of operational audits, strategic plans and departmental business plans, as well as our culture of open communications and our fundamental respect for our code of conduct, continue to help us manage risks on an ongoing basis. 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, conservative reinsurance program, sound reserving practices and low interest rate risk, as well as low debt and 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. We believe that our property catastrophe reinsurance program provides adequate protection for large loss events. Our strong capital position would allow the payment of claims if an event exceeded our reinsurance program. Currently participating on our property per risk and casualty per-occurrence programs are Hannover Reinsurance Company, Munich Reinsurance America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation and its subsidiaries, all of which have A.M. Best insurer financial strength ratings of A (Excellent) or A+ (Superior). Over the past several years, we also modified earthquake deductibles in selected Midwestern states for both commercial and personal lines property coverages to reduce our exposure to a single significant catastrophic event. 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, which was 0.7 at year-end 2006, 2005 and 2004. 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 0.9 at year-end 2006, 1.0 at year-end 2005 and 1.1 at year-end 2004. 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. 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. To help us maintain or increase our penetration within each agency, we are further improving service through the creation of smaller marketing territories that permit our local field marketing representatives to devote 2006 10-K Page 7 more time to each agency relationship. At year-end 2006, we had 102 field marketing territories, up from 100 at the end of 2005 and 92 at the end of 2004. We continually study the regulatory and competitive environment in states where we could decide to actively market our property casualty products. In January 2007, we announced we were working on plans to enter New Mexico and eastern Washington within the next year. We will soon begin the process by preparing policy forms and rates to submit to the departments of insurance in those states. Marketing efforts in New Mexico and Washington will begin following our initial agency appointments. Another way we seek to increase overall premiums is to expand our agency plant within our current marketing territories. Our objective is to appoint approximately 50 additional sales offices, or points of distribution, each year. In measuring progress towards this goal, we include appointment of new agency relationships with Cincinnati (the primary focus of our goal). For those that we believe will produce a meaningful amount of new business premiums, we also include appointment of agencies that merge with a Cincinnati agency and new branch offices opened by existing Cincinnati agencies. We made 55, 57 and 58 new appointments in 2006, 2005 and 2004 respectively. Of these new appointments, 42, 41, and 48, respectively, were new relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 37 in 2006, 39 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 loss reserves. Superior Claims Service Our 748 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 we have a competitive advantage because of the person-to-person approach and the resulting high level of service that our field claims representatives provide. 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 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. They have vendor resources that provide negotiated pricing to our insureds and claimants and that help us determine appropriate pricing for medical cost-related claims. Our field claims representatives also are educated continuously on new techniques and repair trends. They can leverage their local knowledge and 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 uncover potential fraud. While we believe it’s our job to pay what 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 called IBNR, 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 2006 10-K Page 8 amount of salvage and subrogation we expect to recover. For more than 10 years, our annual review has led to savings from favorable development of loss reserves on 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 63, 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 investment department 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. Premium payments, generally received before claims are made, particularly for casualty business lines, create substantial cash flow 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 significantly to total net unrealized investment gains of $5.244 billion (pretax) at year-end 2006. 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 an unusually low 69.5 percent of our total revenues in 2006 due to the sale of our Alltel Corporation common stock holding. Revenues, income before income taxes, and identifiable assets for each segment are shown in a table in Item 8, Note 17 to the Consolidated Financial Statements, Page 102. 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 $2.402 billion in net earned premiums to total revenues and $208 million to income before income taxes in 2006. Commercial lines net earned premiums grew 6.6 percent in 2006, 6.0 percent in 2005 and 11.4 percent in 2004. Approximately 95 percent of our commercial lines premiums are written to provide accounts with coverages from more than one of our business lines. As a result, we believe that commercial lines is best measured and evaluated on a segment basis. However, we provide the line of business data to summarize growth and profitability trends separately for our business lines. The seven commercial business lines are: • Commercial casualty – Commercial casualty insurance provides coverage to businesses against third-party liability from accidents occurring on their premises or arising out of their operations, including liability coverage for injuries sustained from products sold as well as coverage for professional services, such as dentistry. Specialized casualty policies may include liability coverage for employment practices liability (EPLI), which protects businesses against claims by employees that their legal rights as employees of the company have been violated, and other acts or failures to act under specified circumstances as well as excess insurance and umbrella liability, including personal umbrella written as an endorsement to commercial umbrella coverages. The commercial casualty business line includes liability coverage written 2006 10-K Page 9 on both a discounted and non-discounted basis as part of commercial package policies. Our ceded participation in USAIG, a joint underwriting association, from 2003 and prior is included in the commercial casualty business line. • Commercial property – Commercial property insurance provides coverage for loss or damage to buildings, inventory and equipment caused by fire, wind, hail, water, theft and vandalism as well as business interruption resulting from a covered loss. Commercial property also includes crime insurance, which provides coverage for losses due to embezzlement or misappropriation of funds by an employee, and inland marine insurance, which provides coverage for a variety of mobile equipment, such as builder’s risk, contractor’s equipment, cargo and electronic data processing equipment. Various property coverages can be written as stand-alone policies or can be added to a package policy. The commercial property business line includes property coverage written on both a non-discounted and discounted basis as part of commercial package policies. • Commercial auto – 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. • Workers’ compensation – Workers’ compensation coverage protects employers against specified benefits payable under state or federal law for workplace injuries to employees. We write workers’ compensation coverage in all of our active states except North Dakota, Ohio and West Virginia, where coverage is provided solely by the state instead of by private insurers. • Specialty packages – Specialty packages include coverages for property, liability and business interruption tailored to meet the needs of specific industry classes, such as artisan contractors, dentists, garage operators, financial institutions, metalworkers, printers, religious institutions, or smaller, main street businesses. Businessowner policies, which combine property, liability and business interruption coverages for small businesses, are included in specialty packages. • Surety and executive risk – This business line includes: ○ Contract and commercial surety bonds, which guarantee a payment or reimbursement for financial losses resulting from dishonesty, failure to perform and other acts. ○ Fidelity bonds, which cover losses that policyholders incur as a result of fraudulent acts by specified individuals or dishonest acts by employees. ○ Director and officer liability insurance, which covers liability for alleged errors in judgment, breaches of duty and wrongful acts related to activities of for-profit or nonprofit organizations. Our director and officer liability policy can optionally include EPLI coverage. • Machinery and equipment – Specialized machinery and equipment coverage can provide protection for loss or damage to boilers and machinery, including production and computer equipment, from sudden and accidental mechanical breakdown, steam explosion, or artificially generated electrical current. Our emphasis is on products that agents can market to small- to mid-size businesses in their communities. Of our 1,289 reporting agency locations, six market only our surety and executive risk products and one markets only our personal lines products. The remaining 1,282 locations, located in all 32 states in which we actively do business, market some or all of our general commercial insurance products. In 2006, our 10 highest volume commercial lines states generated 67.7 percent of our earned premiums compared with 67.1 percent in the prior year. Earned premiums in the 10 highest volume states rose 7.4 percent in 2006 and rose 5.0 percent in the remaining 22 states. 2006 10-K Page 10 Commercial Lines Earned Premiums by State (Dollars in millions) Year ended December 31, 2006 Ohio Illinois Pennsylvania Indiana North Carolina Michigan Virginia Wisconsin Georgia Tennessee Year ended December 31, 2005 Ohio Illinois Pennsylvania Indiana Michigan North Carolina Virginia Wisconsin Iowa Tennessee Earned premiums Percent of total earned Reporting agency locations Avg premium per location $ $ 410 238 172 160 136 124 120 96 84 81 389 224 164 151 122 115 105 92 76 73 17.1 % 9.9 7.2 6.7 5.7 5.2 5.0 4.0 3.5 3.4 17.2 % 10.0 7.3 6.7 5.4 5.1 4.7 4.1 3.4 3.2 219 116 75 98 70 92 55 51 62 37 224 112 63 99 88 68 53 49 45 32 $ $ 1.9 2.1 2.3 1.6 1.9 1.3 2.2 1.9 1.4 2.2 1.7 2.0 2.6 1.5 1.4 1.7 2.0 1.9 1.7 2.3 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. Regional carriers traditionally have offered 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. National carriers traditionally have provided 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 in non-coastal markets, particularly for quality new business, and there are no signs that trend is abating. In 2006, competition for new business continued to intensify, and we also began to see significant market softening extend to renewals. As market conditions have softened, we also believe distinctions between regional and national carriers have blurred. Over the course of 2006, anecdotal reports of very aggressive pricing became somewhat more frequent. But on balance we believed the market remained healthy and we continued to see underwriting taking place and terms and conditions remaining fairly stable. Generally, we believe carriers are modifying prices rather than changing policy terms and conditions, but we have begun to see underwriting discipline slip to capture market share in late 2006 and early 2007. The hurricane activity that occurred in 2005 is still having significant impacts on the cost of catastrophe reinsurance and property pricing remains very firm in catastrophe prone areas. We are uncertain what effect the hurricanes, and the related rise in the cost of reinsurance, may have on commercial lines pricing in non-coastal areas throughout 2007. PERSONAL LINES PROPERTY CASUALTY INSURANCE SEGMENT The personal lines property casualty insurance segment contributed $762 million in net earned premiums to total revenues and reported a $27 million loss before income taxes in 2006. Personal lines net earned premiums declined 5.3 percent in 2006 after rising 1.4 percent in 2005 and 6.4 percent in 2004. We prefer to write personal lines coverage on an account basis that includes both auto and homeowner coverages as well as coverages from the other personal business line. As a result, we believe that personal lines is best measured and evaluated on a segment basis. However, we provide the line of business data to summarize growth and profitability trends separately for the three business lines: • Personal auto – This business line includes personal auto coverages that protect against liability to others for both bodily injury and property damage, medical payments to insureds and occupants of their vehicle, 2006 10-K Page 11 physical damage to an insured’s own vehicle from collision and various other perils, and damages caused by uninsured motorists. In addition, many states require policies to provide first-party personal injury protection, frequently referred to as no-fault coverage. • Homeowners – This business line includes homeowner coverages that 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. • Other personal lines – This includes the 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 772 of our 1,289 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 495 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 2006, our 10 highest volume personal lines states generated 84.7 percent of our earned premiums compared with 83.3 percent in the prior year. Earned premiums in the 10 highest volume states declined 3.7 percent in 2006 and declined 13.1 percent in the remaining states. Personal Lines Earned Premiums by State (Dollars in millions) Year ended December 31, 2006 Ohio Indiana Georgia Illinois Alabama Kentucky Michigan Wisconsin Florida Virginia Year ended December 31, 2005 Ohio Indiana Georgia Illinois Michigan Kentucky Alabama Wisconsin Virginia Florida Earned premiums Percent of total earned Reporting agency locations Avg premium per location $ $ 285 65 63 53 39 38 36 23 22 22 299 71 60 57 42 38 36 27 21 20 37.4 % 8.5 8.3 6.9 5.1 5.0 4.7 3.1 2.9 2.8 37.2 % 8.8 7.5 7.0 5.3 4.7 4.4 3.3 2.6 2.5 204 65 52 76 25 33 64 28 10 19 211 65 46 78 66 33 24 30 23 10 $ $ 1.4 1.0 1.2 0.7 1.6 1.2 0.6 0.8 2.2 1.2 1.4 1.1 1.3 0.7 0.6 1.2 1.5 0.9 0.9 2.0 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. Prior to 2003, the industry had experienced several years of rising personal auto and homeowner rates and stricter enforcement of underwriting standards across the industry. Since 2003, we have seen increased competition in the personal lines marketplace, driven by industrywide improvement in results and favorable frequency and severity trends. 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. 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 three 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 they believe allow them to target higher quality risks with lower prices. 2006 10-K Page 12 LIFE INSURANCE SEGMENT The life insurance segment contributed $115 million of net earned premiums and a $1 million loss before income taxes in 2006. Life insurance segment profitability is discussed in detail in Item 7, Life Insurance Results of Operations, Page 54. Life insurance net earned premiums grew 7.9 percent in 2006, 5.7 percent in 2005 and 5.5 percent in 2004. 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 2006, approximately 81 percent of our 1,289 property casualty reporting agency locations offered Cincinnati Life’s products to their clients. We also develop life business from 507 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, universal life insurance, worksite products and whole life insurance – account for approximately 90.6 percent of the life insurance segment’s revenues: • Term insurance – policies under which a death benefit is payable only if the insured dies during a specific period of time or term. For policies without a return of premium provision, no benefit is payable if the insured survives to the end of the term. For policies with a return of premium provision, a benefit equal to the sum of all paid premiums 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. • 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 as a loan collateralized by the cash surrender value 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. • 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 as a loan collateralized by the cash surrender value to withdrawing policyholders. The proposed insured is evaluated using normal underwriting standards. 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. • 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. 2006 10-K Page 13 Life Insurance Marketplace 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 are available to 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 agents and field team to assist in the placement of business. We find fewer and fewer of our competitors provide direct, personal contact between the agent and the insurance carrier. We continue to emphasize the cross-serving opportunities between worksite marketing of life insurance products and the property casualty agency’s commercial accounts. In both the property casualty and independent life agency distribution systems we enjoy the 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 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, such as a return of premium rider. Reaction to our term portfolio was favorable in 2006 with approximately 25 percent of applications requesting the return-of- premium feature. • In 2007 we plan to enhance our term and other life insurance products, including an expanded worksite product portfolio, and investigate new survivor universal life and whole life products. The priority is expansion within the insurance agencies marketing our property casualty insurance products. 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 2006: A.M. Best – A+ (Superior), Fitch -- AA (Very Strong) and Standard & Poor's – AA- (Very Strong). Our life insurance company has not chosen to establish a Moody’s rating. 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. We do not offer variable or equity-indexed products because of the associated financial risk. That decision can affect our premium growth, particularly during times 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 National Association of Insurance Commissioners recognizes the problems caused by redundant reserves and is considering 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 $1.254 billion of our total revenues in 2006, 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 $1.200 billion of income before income taxes, or 90.3 percent of our total income before income taxes. 2006 10-K Page 14 The fair value (market value) of our investment portfolio was $13.699 billion and $12.657 billion at year-end 2006 and 2005, 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, 2006 At December 31, 2005 Book value Fair value Book value Fair value $ $ 3,357 $ 2,382 2,400 221 95 8,455 $ 3,389 $ 2,416 7,564 235 95 13,699 $ 3,304 $ 2,083 1,961 167 75 7,590 $ 3,359 2,117 6,936 170 75 12,657 During 2006, our allocation of cash flows for new fixed-maturities and equity investments more closely approximated our historical levels. The primary reason for the increase in the market value of the common equity portfolio in 2006 was market appreciation of our holdings. The sale of our Alltel common stock and other equity holdings more than offset new equity purchases. In 2005 and the second half of 2004, almost all of our insurance subsidiary’s available cash flow was 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 subsidiary portfolio was 97.3 percent at year-end 2006 compared with 96.4 percent at year-end 2005 and 103.5 percent at year-end 2004. 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 20. The ratio of investment assets to total assets for the parent company was 31.5 percent at year-end 2006 compared with 33.9 percent at year-end 2005 and 36.3 percent at year-end 2004. Going forward, we also 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. 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 risk. 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 minimize our corporate taxes. With the exception of U.S. agency paper (government-sponsored entities), no individual issuer's securities accounted for more than 0.8 percent of the fixed-maturity portfolio at December 31, 2006. Taxable Fixed-maturities Our taxable fixed-maturity portfolio (at fair value) includes: • $972 million in U.S. agency paper, which is rated AAA by both Moody’s and Standard & Poor’s. • $1.818 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-. • $321 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 2006 10-K Page 15 represented 27.2 percent and 27.7 percent, respectively, of book value and fair value of the taxable fixed-maturity portfolio at December 31, 2006, compared with 26.1 percent and 26.6 percent of book value and fair value at December 31, 2005. 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 1.1 percent of the tax-exempt municipal bond portfolio at December 31, 2006, there are higher concentrations within individual states. Holdings in Illinois, Indiana, Michigan, Ohio and Texas accounted for 61.9 percent of the municipal bond portfolio at year-end 2006. 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 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 Attributes of the fixed-maturity portfolio include: Weighted average yield-to-book value Weighted average maturity Effective duration At December 31, 2006 Fair value Percent to total At December 31, 2005 Fair value Percent to total $ $ $ $ 4,039 1,086 266 122 28 0 0 359 5,900 3,631 1,044 310 131 10 0 0 774 5,900 68.5 % $ 18.4 4.5 2.1 0.5 0.0 0.0 6.0 100.0 % $ 61.5 % $ 17.7 5.3 2.2 0.2 0.0 0.0 13.1 100.0 % $ 3,651 1,094 324 110 13 0 0 359 5,551 3,233 1,112 354 117 2 0 0 733 5,551 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 % Years ended December 31, 2006 2005 5.3 % 8.7 yrs 5.1 yrs 5.4 % 9.5 yrs 5.2 yrs We discuss the maturity of our fixed-maturity portfolio in Item 8, Note 2 to the Consolidated Financial Statements, Page 90. Equity Investments Our equity investment portfolio includes both common stocks and nonredeemable preferred stocks. Approximately 82.4 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 organizations and industries. The portfolio also includes a broader group of smaller positions that are a source of trading flexibility and other risk management advantages. Following the sale of our Alltel common stock holding, average dividend yield-to-cost for our equity investments declined to 9.9 percent at December 31, 2006, compared with 11.7 percent at December 31, 2005. Common Stocks At December 31, 2006, 32.7 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 2006 10-K Page 16 ranging from 1.5 percent to 4.0 percent and with 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 2006, we held more than 5 percent of three companies: Fifth Third, FirstMerit Corporation and Piedmont Natural Gas Company. Those holdings are part of a core group of common stocks in which we hold a fair value of at least $100 million each. At year-end 2006, there were 13 holdings in that core group. Largest Common Stock Holdings (Dollars in millions) As of and for the year ended December 31, 2006 Fifth Third Bancorp Exxon Mobil Corporation The Procter & Gamble Company National City Corporation PNC Financial Services Group, Inc. AllianceBernstein Holding L.P. U.S. Bancorp Johnson & Johnson Wyeth Wells Fargo & Company Piedmont Natural Gas Company, Inc. Sky Financial Group, Inc. FirstMerit Corporation All other common stock holdings Total Actual cost Fair value Percent of fair value Earned dividend income Earned dividend to fair value $ $ 283 $ 133 192 171 62 60 150 194 62 96 64 91 55 787 2,400 $ 2,979 687 469 358 348 266 251 238 225 193 151 133 129 1,137 7,564 39.4 % $ 9.1 6.2 4.7 4.6 3.5 3.3 3.1 3.0 2.5 2.0 1.8 1.7 15.1 100.0 % $ 115 11 8 15 10 12 9 5 4 6 5 4 6 31 241 3.9 % 1.7 1.8 4.2 2.9 4.3 3.7 2.1 2.0 3.0 3.6 3.3 4.7 2.6 In January 2006, we sold 12,700,164 shares of our holdings of Alltel after selling 475,000 shares in December 2005. Alltel had been our second largest common stock holding. 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. At year-end 2006, the largest industry concentrations within our common stock holdings were the financials sector at 66.6 percent of total fair value and the healthcare sector at 7.9 percent. 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 90. 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, 2006, CFC Investment Company had 2,897 accounts and $108 million in receivables, compared with 2,815 accounts and $105 million in receivables at December 31, 2005. As of December 31, 2006, CinFin Capital had 64 institutional, corporate and individual clients and $960 million under management, compared with 64 and $864 million at December 31, 2005. Assets under management rose because a single account placed additional funds with CinFin Capital in 2006. 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. 2006 10-K Page 17 • 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 group. 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 2006 in Item 8, Note 8 to the Consolidated Financial Statements, Page 93. • • 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. 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. Our insurance subsidiaries received a net refund of $500,000 and $3 million from guaranty associations in 2006 and 2005. 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 2006 10-K Page 18 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 $318 million (17.5 percent of 2005 subject premiums) in 2006, $328 million (15 percent of 2004 subject premiums) in 2005 and $199 million (10 percent of 2003 subject premiums) in 2004. For 2007, the deductible is an estimated $388 million (20.0 percent of 2006 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. • 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. 2006 10-K Page 19 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 risks 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 and 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 17 other insurance groups, or 1.6 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. • Concerns that doing business with us is difficult or perceptions that our level of service is no longer a distinguishing characteristic in the marketplace. This could occur if agents or policyholders believe that we were no longer providing the prompt, reliable personal service that has long been a distinguishing characteristic of our insurance operations. • 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 affect 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 cyclical and intensely competitive. From time to time, the insurance industry goes through prolonged periods of intense competition during which it is more difficult to attract new business and maintain profitability. 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 • Speed at which products are brought to market 2006 10-K Page 20 • 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 • Claims satisfaction and reputation 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 42, Page 49, and Page 54, 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 litigation, 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 changes in industry practices and regulations on our business are uncertain. As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to insurance pricing, claims and coverage may emerge. These issues may adversely affect our business by impeding our ability to obtain adequate rates for covered risks, extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, unforeseeable emerging and latent claim and coverage issues 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 changes could adversely affect our results of operations. Please see Item 7, Property Casualty and Life Insurance Reserves, Page 63 and Page 69, 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 85. Our most critical accounting estimate is loss reserves. Loss reserves are the amounts we expect to pay for covered claims and expenses we incur to settle 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 reserves as facts regarding individual claims develop, additional losses are reported and new information becomes known. Adjustments due to loss development on prior years are reflected in the calendar year in which they are identified. 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. 2006 10-K Page 21 Please see Item 7, Property Casualty and Life Insurance Reserves, Page 63 and Page 69, 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 against perils 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 and Southeast and, to a certain extent, the mid-Atlantic. • 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 a terrorist event or an epidemic such as the avian flu, particularly if the epidemic were to affect 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 2007, we have exposure of up to $8 million of assumed losses in three layers, from $875 million to $1.500 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. A catastrophe event also could affect our operations by damaging our headquarters facility or disrupting our associates’ ability to perform their assigned tasks. Please see Item 7, Property Casualty and Life Insurance Reserves, Page 63 and Page 69, for a discussion of our reserving practices. Our ability to obtain or collect on our reinsurance protection could affect our business, financial condition, results of operations and cash flows. 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. 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 2006 10-K Page 22 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, results of operations and cash flows. Prior to 2003, we participated in USAIG, a joint underwriting association of individual insurance companies that collectively functions as a worldwide insurance market for all types of aviation and aerospace accounts. At year-end 2006, 35.5 percent, or $242 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 69, for a discussion of our reinsurance treaties. Our ability to realize our investment objectives could affect our financial condition, our results of operations or cash flows. 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 2006, our investment portfolio was $13.699 billion, or 79.5 percent of our total assets. In 2006, our investment operations contributed 27.6 percent of our revenue and 94.3 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 72. 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 25.7 percent of our shareholders’ equity at year-end 2006 and dividends earned from our Fifth Third investment were 20.2 percent of our investment income in 2006. If Fifth Third’s common stock price were to decline significantly, our financial condition could be materially affected. If Fifth Third were to decrease or discontinue its dividend, our results of operations and cash flows 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 quickly sell a part of our holdings to reinvest in other income-earning investments, which would have a material effect on our results of operations. Please see Item 1, Investments Segment, Page 14, and Item 7, Investments Results of Operations, Page 56, and Liquidity and Capital Resources, Page 59, for discussion of our investment activities. 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 17, and Item 8, Note 8 to the Consolidated Financial Statements, Page 93, for discussion of insurance holding company dividend regulations. 2006 10-K Page 23 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 with 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 its 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 99, for discussion of the Investment Company Act of 1940. Our business depends on the uninterrupted operation of our facilities, systems and business functions. Our business depends on our associate’s ability to perform necessary business functions, such as processing new and renewal policies and claims. We increasingly rely on technology and systems to accomplish these business functions in an efficient and uninterrupted fashion. Our inability to access our headquarters facilities or a failure of technology, telecommunications or other systems could significantly impair our ability to perform such functions on a timely basis. If sustained or repeated, such a business interruption or system failure could result in a deterioration of our ability to write and process new and renewal business, serve our agents and policyholders, pay claims in a timely manner or perform other necessary business functions. This could result in a materially adverse effect on our operating results and financial condition. Item 1B. None Unresolved Staff Comments 2006 10-K Page 24 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 $71 million as of December 31, 2006, 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). Construction of a 690,000 total square foot underground garage and third office tower at our headquarters building began in early 2005. We estimate a completion date of September 2008 for the project. We believe this estimated $100 million expansion will accommodate our business needs for the foreseeable future. The construction project is on schedule and on budget. As of December 31, 2006, construction costs totaled $41 million, which is classified as land, building and equipment, net, for company use. Cincinnati Financial Corporation owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property. 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, 2006, 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 Springdale, Ohio, approximately four miles from our headquarters. It contains approximately 102,000 rentable square feet. This property is carried in the financial statements at $3 million as of December 31, 2006, and is classified as other invested assets. At year-end 2006, two tenants occupied approximately 37 percent of the rentable square feet. The remaining space is available for lease. The property is available for sale. In 2006, The Cincinnati Insurance Company purchased an unoccupied building on 16 acres of land in Springfield Township, Ohio, approximately six miles from our headquarters. We plan to renovate the 51,000 square foot building to serve as a data processing center and a disaster recovery center. The property, including land, is carried on our financial statements at $3 million as of December 31, 2006, and is classified as land, building and equipment, net, for company use. 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 its business. Item 4. No matters were submitted to a vote of security holders of Cincinnati Financial during the fourth quarter of 2006. Submission of Matters to a Vote of Security Holders Legal Proceedings 2006 10-K Page 25 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, 2006. Many of our independent agent representatives and most of the 4,048 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 Global Select Market. The common stock prices and dividend data below reflects the 5 percent stock dividend paid April 26, 2005. (Source: Nasdaq Global Select Market) Quarter: 1st 2nd 2006 3rd 4th 1st 2005 2nd 3rd High Low Period-end close Cash dividends declared $ 45.56 $ 42.07 42.07 0.335 47.01 $ 41.43 47.01 0.335 48.44 $ 45.93 48.12 0.335 49.07 $ 44.25 45.31 0.335 43.92 $ 40.84 41.53 0.290 43.12 $ 38.38 39.56 0.305 42.64 $ 39.00 41.89 0.305 4th 45.95 39.91 44.68 0.305 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 93. Information regarding securities authorized for issuance under our equity compensation plans appears in the Proxy Statement under “Securities Authorized for Issuance under Equity Compensation Plans.” This portion of the Proxy Statement is incorporated herein by reference. Additional information about share-based compensation granted under our equity compensation plans is available in Item 8, Note 16 to the Consolidated Financial Statements, Page 100. The board of directors has authorized share repurchases since 1996. We discuss the board authorization in Item 7, Uses of Capital, Page 63. In 2006, we repurchased a total of 2,646,787 shares. Month January 1-31, 2006 February 1-28, 2006 March 1-31, 2006 April 1-30, 2006 May 1-31, 2006 June 1-30, 2006 July 1-31, 2006 August 1-31, 2006 September 1-30, 2006 October 1-31, 2006 November 1-30, 2006 December 1-31, 2006 Totals Total number of shares purchased(1) Average price paid per share Total number of shares purchased as part of publicly announced plans or programs(2) Maximum number of shares that may yet be purchased under the plans or programs 0 $ 537,322 1,316,978 0 0 150,000 0 31,666 113,598 27,345 484,021 46,000 2,706,930 0.00 44.12 43.97 0.00 0.00 45.89 0.00 45.98 46.23 48.44 45.15 44.29 44.48 0 537,322 1,312,678 0 0 150,000 0 31,666 110,900 0 458,221 46,000 2,646,787 9,466,035 8,928,713 7,616,035 7,616,035 7,616,035 7,466,035 7,466,035 7,434,369 7,323,469 7,323,469 6,865,248 6,819,248 (1) Includes 34,343 acquired in 2006, primarily in satisfaction of withholding taxes due upon exercise of stock options. (2) The current repurchase program was announced on August 19, 2005, and became effective on September 1, 2005. It replaced a program which had been in effect since 1999. No repurchase program has expired during the period covered by the above table. All of the repurchases reported in the table above were repurchased under our 2005 program, which was approved for 10 million shares. At the time the 1999 program, which was for 17 million shares, was superseded by the 2005 program, it had 2,739,942 shares remaining. Neither of the programs had an expiration date but no further repurchases will occur under the 1999 program. 2006 10-K Page 26 Cumulative Total Return As depicted in the graph below, the five–year total return on a $100 investment made December 31, 2001, assuming the reinvestment of all dividends, was 49.4 percent for Cincinnati Financial Corporation’s common stock compared with 71.4 percent for the Standard & Poor’s Composite 1500 Property & Casualty Insurance Index and 35.0 percent for the Standard & Poor’s 500 Index. • The Standard & Poor’s Composite 1500 Property & Casualty Insurance Index includes 28 companies: Ace Ltd., Allstate Corporation, AMBAC Financial Group, Berkley (W R) Corporation, Chubb Corporation, Cincinnati Financial Corporation, Fidelity National Financial Inc., First American Corporation, Hanover Insurance Group, Infinity Property Casualty Corporation, Landamerica Financial Group, MBIA Inc., Mercury General Corporation, Ohio Casualty Corporation, Old Republic International Corporation, Philadelphia Consolidated Holding Corporation, Proassurance Corporation, Progressive Corporation, RLI Corporation, Safeco Corporation, Safety Insurance Group, SCPIE Holdings Inc., Selective Insurance Group Inc., St. Paul Travelers Companies Inc., Stewart Information Services, United Fire & Casualty Company, XL Capital Ltd. and Zenith National Insurance Corp. • The Standard & Poor’s 500 Index includes a representative sample of 500 leading companies in a cross section of industries of the U.S. economy. Although this index focuses on the large capitalization segment of the market, it is widely viewed as a proxy for the total market. Total Return Analysis CFC vs. Market Indices December 31 Totals $200 $175 $150 $125 $100 $75 $50 2001 2002 2003 2004 2005 2006 Cincinnati Financial Corporation S&P 500 Index S&P Composite 1500 Property & Casualty Insurance Index 2006 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 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, 2006 2005 2004 2003 $ $ $ $ 3,278 570 684 4,550 930 5.36 5.30 1.34 1.31 175 13,759 453 17,222 3,896 1,409 791 6,808 39.38 3,164 1,576 3,860 367 51.9 % 11.6 30.8 94.3 % $ $ $ $ 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 % One-time charges or adjustments: 2006 – The company sold its holdings in Alltel Corporation common stock. The sale contributed $647 million (pretax) to realized investment gains and revenues and $412 million (after tax), or $2.35 per share, to net income. 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. 2006 10-K Page 28 2002 2001 2000 1999 1998 1997 1996 $ $ $ $ $ $ $ $ 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 % $ $ $ $ 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 % 2006 10-K Page 29 Item 7. Management’s Discussion and Analysis of Financial Condition and 10-K Page 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 Item 7A. Quantitative and Qualitative Disclosures About Market Risk Introduction Fixed-maturity Investments Short-term Investments Equity Investments Unrealized Investment Gains and Losses 31 31 35 40 41 42 49 54 56 59 59 61 63 69 69 71 72 73 74 74 75 2006 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 78. We present per share data on a diluted basis unless otherwise noted and we have adjusted those amounts for all stock splits and dividends. 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 23rd largest property casualty insurer, based on statutory net written premium volume through the first six months of 2006, the most recent period for which this information is available. 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. 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 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 2006, we did not achieve some of our objectives for creating shareholder value. For the year, we reached record levels of new business and total property casualty insurance premiums in the face of growing competition. Business policyholders continued to respond favorably to their local independent agents’ presentation of the Cincinnati value proposition. In the second half of the year, agents and personal lines policyholders responded to new pricing for Cincinnati’s personal lines products with higher customer retention rates and rising new business. Further, our equity-focused investment strategy led to another year of record investment income and record book value. However, other factors dampened our enthusiasm for those favorable results. Nine catastrophe events, primarily storms affecting our policyholders in the Midwest, led to a record level of catastrophe losses even as the industry experienced a lighter catastrophe year. Loss severity crept upward. And ongoing investment in our people and our infrastructure, including technology and systems to make it easier for agents to do business with our company, contributed to expenses rising more rapidly than premiums. Finally, 2006 earnings reflected the adoption of stock option expensing and, as anticipated, savings from favorable development of prior period losses below the unusually high level in 2005. We look beyond 2006 with a measure of optimism. We remain committed to providing a stable market for our agents’ high quality business, underwriting this business carefully and producing steady value for our shareholders, as represented by the board of directors’ recent decision to increase our 2007 indicated annual 2006 10-K Page 31 cash dividend by 6 percent, which would mark the 47th consecutive year of increase in that measure. We believe we can achieve above-industry-average growth in written premiums and industry-leading profitability over the long term by building on our proven strategies: strong agency relationships, local underwriting, quality claims service, solid reserves and total return investing. Over our 56 year history, our growth largely has been driven by increasing our share of the business written by the agencies that market our products, growth of those agencies and, to a lesser extent, appointment of new agencies and our periodic entry into new states. During 2007, we expect to make more than 50 new agency appointments, including our initial appointments in two new states: New Mexico and Washington. Over the years, we have been able to increase our share of our agencies’ business by making available insurance products that meet the needs of the individuals and businesses in their communities. In recent years, our agents have indicated their desire to have Cincinnati available as a market for commercial accounts that require the flexibility of excess and surplus lines coverage. Generally, excess and surplus lines insurance carriers provide insurance that is unavailable to businesses in the standard market due to market conditions or due to characteristics of the insured that are caused by nature, the insured's history or the nature of their business. We have studied the option of providing excess and surplus lines coverage for several years and believe it could contribute to our long-term objectives. Among the potential benefits, we could gain opportunities to compete for additional accounts by having more flexibility in pricing and policy terms and conditions. In 2007, we will take the initial steps necessary to incorporate a new excess and surplus subsidiary and determine its structure. During the year we will appoint a team to begin researching and developing the appropriate terms and conditions, rates and underwriting guidelines. We anticipate little, if any, premium contribution from excess and surplus lines in 2007. 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. Detailed discussion of these topics appears in Results of Operations, Page 40, and the Liquidity and Capital Resources, Page 59. 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 Realized investment gains and losses (pretax) Total revenues Net income Per share data (diluted) Net income Cash dividends declared $ $ Twelve months ended December 31, 2005 2004 2006 2006-2005 Change % 2005-2004 Change % 3,278 $ 570 684 4,550 930 5.30 $ 1.34 3,164 $ 526 61 3,767 602 3.40 $ 1.205 3,020 492 91 3,614 584 3.28 1.04 3.6 8.4 1,026.1 20.8 54.5 55.9 11.2 4.8 6.9 (33.1) 4.2 3.1 3.7 16.1 Weighted average shares outstanding 175,451,341 177,116,126 178,376,848 (0.9) (0.7) Revenues rose in 2006 and 2005. The growth in 2006 primarily reflected the sale of our Alltel common stock holdings. In both years, rising pretax investment income offset slowing consolidated property casualty earned premium growth. Net income and net income per share reached record levels in 2006 and 2005. A number of factors contributed to net income: • The consolidated property casualty underwriting profit declined in 2006 due to higher catastrophe losses, increased loss severity and less savings from favorable development of prior period losses as well as higher underwriting expenses. Underwriting profitability was healthy in 2005. The factors behind these changes 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 investment gains in the past three years. ○ 2006 – Raised net income by $434 million, or $2.48 per share. The sale of our Alltel common stock holding contributed $412 million, or $2.35 per share, of the gain. 2006 10-K Page 32 ○ 2005 - Raised net income by $40 million, or 23 cents per share. ○ 2004 - Raised net income by $60 million, or 34 cents per share. • 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 2006, weighted average shares outstanding on a diluted basis had declined 2 million from year-end 2005. The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. Cash dividends declared per share rose 11.2 percent and 16.1 percent in 2006 and 2005. Balance Sheet Data and Performance Measures (Dollars in millions except share data) Balance sheet data Invested assets Total assets Short-term debt Long-term debt Shareholders' equity Book value per share Debt-to-capital ratio Performance measures Comprehensive income Return on equity Return on equity based on comprehensive income At December 31, 2006 At December 31, 2005 At December 31, 2004 $ $ $ 13,759 17,222 49 791 6,808 39.38 $ 12,702 16,003 0 791 6,086 34.88 12,677 16,107 0 791 6,249 35.60 11.0 % 11.5 % 11.2 % 2006 Years ended December 31, 2005 2004 1,057 $ 14.4 % 16.4 $ 99 9.8 % 1.6 287 9.4 % 4.6 Invested assets and total assets rose in 2006 on new investments and appreciation in the equity portfolio. Invested assets and total assets were flat in 2005 as strong cash flow for new investments was offset by lower unrealized investment gains. Comprehensive income is net income plus the year-over-year difference in unrealized gains on investments. In 2006, comprehensive income rose because of higher unrealized gains in the investment portfolio. In 2005 and 2004, comprehensive income was lower because of reduced unrealized gains primarily due to a decline in the market value of our Fifth Third investment. Return on equity rose in 2006 due to higher realized gains on investments. Return on equity based on comprehensive income grew in 2006 due to the increase in accumulated other comprehensive income. Our ratio of long-term debt to capital (long-term debt plus shareholders’ equity) declined in 2006 due to the increase in shareholders’ equity due to higher accumulated other comprehensive income. Property Casualty Highlights (Dollars in millions) Property casualty highlights Written premiums Earned premiums Underwriting profit GAAP combined ratio Statutory combined ratio Years ended December 31, 2005 2004 2006 2005-2004 2006-2005 Change % Change % $ $ 3,178 3,164 181 94.3 % 93.9 $ 3,076 3,058 330 89.2 % 89.0 2,997 2,919 298 89.8 % 89.4 3.3 3.5 (45.2) 2.6 4.8 10.8 The trend in overall written premium growth reflected the competitive and market factors discussed in Item 1, Commercial Lines and Personal Lines Property Casualty Insurance Segments, Page 9 and Page 11. In each of the past three years, our overall written premium growth rate has exceeded that of the industry. Industry net written premiums were estimated to grow 2.6 percent in 2006 and 4.4 percent in 2004, but declined 0.2 percent in 2005. In the past three years, industry premium trends have been obscured by the reinsurance sector, where premiums were estimated to have risen 25.1 percent in 2006 after declining 28.2 percent in 2005. Our consolidated property casualty insurance underwriting profit declined in 2006 after rising in 2005, matching the trend in our combined ratio. (The combined ratio is the percentage of each premium dollar spent on claims plus all expenses -- the lower the ratio, the better the performance.) 2006 performance was tempered by higher catastrophe losses, increased loss severity and less savings from favorable development on prior period losses as well as higher underwriting expenses. 2006 10-K Page 33 The estimated industry average statutory combined ratios were 93.3 percent, 100.8 percent and 98.5 percent for 2006, 2005 and 2004, respectively. The 144.9 percent estimated reinsurance sector combined ratio obscured the industry combined ratio in 2005. 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 2005, we ranked No. 1 or No. 2 by premium volume in 75 percent of the locations that have marketed our products for more than five years. Other measures include subdivision of territories and new agency appointments. We ended 2006 with 102 field territories, subdividing three new territories and merging one into the surrounding regions. As discussed in Item 1, Growing with Our Agencies, Page 7, we made 55 new agency appointments in 2006, 42 of which were new relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 37 in 2006. Agent satisfaction with our technology solutions is, and will continue to be, a requirement for maintaining our strong relationships with these agencies. In 2006, 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 have deployed our new commercial lines policy processing system to agencies in seven states for use in processing new and renewal businessowners policies. We also deployed our personal lines policy processing system in six additional states and continued to make important upgrades and enhancements. MEASURING OUR SUCCESS IN 2007 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 2007, we expect to continue to rank No. 1 or No. 2 by premium volume in approximately 75 percent or more of the locations that have marketed our products for more than five years. We expect to improve service to our agencies by subdividing or creating four field territories in 2007. We also expect to appoint another 50 agencies. We are working on plans to enter New Mexico and eastern Washington within the next year and will soon begin the process by preparing policy forms and rates to submit to the departments of insurance in those states. In 2007, 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 2007 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 growth in our consolidated property casualty written premiums may be in the low single digits in 2007 compared with the 3.3 percent increase in 2006. Legislative and regulatory developments in early 2007 added to the uncertainty that already existed for the insurance industry in Florida. In February 2007, we asked our agents that they not send us new business submissions. This request, which extends to all lines of insurance and other business areas, may result in lower 2007 premium growth. It does not affect policies in force, which we will continue to support and address at renewal, in line with our current underwriting guidelines and in compliance with Florida rules and regulations. We continue to assess the changing insurance environment in Florida and hope to resume writing policies in the state as the market stabilizes. Overall industry premium growth is projected to be 0.1 percent in 2007, which includes an estimated 18.6 percent reinsurance sector growth rate. Net written premiums for the commercial lines industry are expected to be flat in 2007 while the personal lines sector is expected to grow 1.2 percent. Our combined ratio estimate for 2007 is 97 percent to 99 percent on either a GAAP or statutory basis compared with 94.3 percent on a GAAP basis in 2006. The year-over-year increase reflects four assumptions: ○ Catastrophe losses should contribute approximately 5.5 percentage points to the combined ratio. We think this is an appropriate estimate based on our reinsurance treaty retention and catastrophe loss experience in recent years. ○ Savings from favorable reserve development in line with our historical norms. Savings from favorable development on prior period reserves averaged about 2 percentage points between 2000 and 2003. Between 2004 and 2006, the average rose to an unusually high level of approximately 5 percentage points. ○ Loss ratio deterioration as pricing becomes even more competitive and loss severity increases. 2006 10-K Page 34 ○ Higher other underwriting expenses as we continue to invest in people and technology. We believe the consolidated property casualty 2007 underwriting expense ratio could be approximately 31.5 percent. For these reasons, we may not achieve our objective of an industry-leading combined ratio in 2007. The projected industry average 2007 combined ratio is 96.8 percent. • Pursuing a total return investment strategy that generates both strong investment income growth and • capital appreciation – In 2007, we are estimating pretax investment income growth to 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 current portfolio attributes. 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. In 2006, our compound annual equity portfolio return was 16.1 percent, compared with a compound annual total return of 15.8 percent for the Index. Over the five years ended December 31, 2006, our compound annual equity portfolio return was 2.0 percent compared with a compound annual total return of 6.2 percent for the Index. Our equity portfolio underperformed the market for the five-year period because of the decline in the market value of our holdings of Fifth Third common stock between 2002 and 2005. 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. 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 exceed 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 2007, the board increased the indicated annual dividend rate 6.0 percent, marking the 47th 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 49.4 percent was below the 71.4 percent return for 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 2007. As a result, we believe our debt-to-capital ratio will remain approximately 11 percent. In December 2006, we finalized our property casualty reinsurance program for 2007, updating it to maintain the balance between the cost of the program and the level of risk we retain. Under the new program, our 2007 reinsurance premiums are expected to be $22 million higher than in 2006. We provide more detail on our reinsurance programs in 2007 Reinsurance Programs, Page 69. Factors supporting our outlook for 2007 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 85. 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 2006 10-K Page 35 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 and to the use of a claims mediation process that promotes earlier liability settlement resolution • Reporting pattern changes attributable to case reserving practices, particularly with respect to workers’ compensation claims • Absence of cost-effective methods for accurately assessing asbestos and environmental claim liabilities (see Property Casualty Insurance Reserves, Asbestos and Environmental Reserves, Page 66, for discussion of related reserve levels and trends) 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 $32 million would have a 1 percentage point effect on the loss and loss expense ratio, based on 2006 earned premiums, a $21 million effect on income and a 12 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 anticipated salvage and subrogation recoveries. 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 the 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. The higher reserves reflect experience indicating the likelihood that juries would ignore significant liability issues in cases involving seriously injured claimants. In 2000, we began using a claims mediation process that promotes earlier liability settlement resolution. By 2004, we had introduced the program into several states, which has provided favorable results. To review 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 Models 2006 10-K Page 36 Supplemental statistical information is compiled and reviewed to aid in the application of actuarial methods and models. The supplemental data also is used to evaluate the reasonableness of estimates derived from the actuarial methods and models. 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. In 2006, we began 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 2006 and 2005, IBNR reserves differed from the internal actuarial point estimate by less than 2 percent of our loss and loss expense reserve. 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 64. 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 conducts a supplemental review of full-year data at year-end. ASSET IMPAIRMENT Fixed-maturity and equity investments are our largest assets. The company's asset impairment committee continually monitors these investments and all other assets for signs of other-than-temporary and/or permanent impairment. 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 in both 2006 and 2005 and $6 million in 2004. Our portfolio managers constantly monitor the status of their assigned portfolios for indications of potential problems that may be possible impairment issues. If a security is trading below book value, the portfolio managers even more closely scrutinize the security. 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 quantitative measurements such as 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 qualitative 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 2006 10-K Page 37 market conditions. We provide information regarding valuation of our invested assets in Item 8, Note 2 to the Consolidated Financial Statements, Page 90. 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. A security valued between 90 percent and 100 percent of book value will not be monitored separately by the committee. These assets generally are at this value because of interest rate-driven factors. A security valued below 90 percent of book value is reported to the asset impairment committee. A security valued below 70 percent of book value is defined as distressed. Distressed securities receive additional scrutiny. Effective January 1, 2006, a security will 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 intent and 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. In addition to evaluating the security’s current valuation, the impairment committee reviews objective evidence that indicates the potential for a recovery in value. Information is evaluated regarding the security, such as financial performance, near term prospects and the financial condition of the region and industry in which the entity operates. Securities that 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 a security 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 2006 in Item 7A, Unrealized Investment Gains and Losses, Page 75. An other-than-temporary decline in the fair value of a security is recognized in net income as realized investment losses. 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. A permanent decline in the fair value of a security is written off at the time when facts and circumstances indicate such write-down is warranted, and is reflected in realized investment 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 accumulated 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. Some of our universal life insurance policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance based on expected no-lapse guarantee benefits and expected policy assessments. 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. Key assumptions used in developing the 2006 net pension obligation were a 5.75 percent discount rate and rates of compensation increases ranging from 4 percent to 6 percent. Key assumptions used in developing the 2006 10-K Page 38 2006 net pension expense were a 5.50 percent discount rate, an 8 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent. In 2006, the net pension expense was $19 million. In 2007, we expect a net pension expense of $21 million, primarily as a result of increased service costs, which are expected to more than offset a 0.25 percent reduction in the discount rate. Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate would lower our 2007 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 2006 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 2006 and $8 million at year-end 2005. The fair value of the plan assets was less than the projected plan benefit obligation by $58 million at year-end 2006 and $62 million at year-end 2005. The 2005 accumulated benefit obligation and projected benefit obligation amounts were increased by $6 million and $9 million, respectively, to include the company’s supplemental retirement plan (SERP). Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. 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. 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 property casualty contingent (profit-sharing) commissions. We base the contingent commission accrual estimates on property casualty underwriting results and on supplemental 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 $95 million in 2006 contributed 3.0 percentage points to the property casualty combined ratio. If contingent commissions paid were to vary from that amount by 5 percent, it would affect 2007 net income by $3 million (after tax), or 2 cents per share, and the combined ratio by approximately 0.1 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 in 2007, the account holder would pay a surrender charge equal to 4 percent of the contract’s account value. Since year five, the surrender charge has decreased 2 percent each policy year and will fall to 0 percent in policy year 11. 2006 10-K Page 39 At year-end 2006, net unamortized realized gains amounted to $2 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 $6 million at year-end 2006. RECENT ACCOUNTING PRONOUNCEMENTS Information regarding recent accounting pronouncements is provided in Item 8, Note 1 to the Consolidated Financial Statements, Page 85. 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 (profit or loss), which 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 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. We continue to monitor market trends in construction costs that could affect claim payments and headquarters construction 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 102. The following sections review results of operations for each of the four segments. Commercial Lines Insurance Results of Operations begins on Page 42, Personal Lines Insurance Results of Operations begins on Page 49, Life Insurance Results of Operations begins on Page 54, and Investments Results of Operations begins on Page 56. We begin with an overview of our consolidated property casualty operations, which is the total of our commercial lines and personal lines segments. 2006 10-K Page 40 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 2006-2005 2005-2004 Change % Change % 2.6 3.3 3.5 8.8 37.9 0.7 13.9 208.1 (45.2) 4.8 5.0 (14.8) 1.6 16.3 (52.3) 10.8 $ $ $ 2006 Years ended December 31, 2005 2004 3,178 3,164 1,833 175 596 363 16 181 $ $ $ 58.0 % 5.5 63.5 18.8 11.5 0.5 94.3 % 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 % In addition to the factors discussed in Commercial Lines and Personal Lines Insurance Results of Operations, Page 42 and Page 49, growth and profitability for the property casualty insurance operations were affected by: • New business written directly by agencies – New business written directly by agencies was $357 million, $314 million and $330 million in 2006, 2005 and 2004, respectively. New business levels reflected market conditions for commercial and personal lines as well as the advantages of our agency relationship strategy. • Savings from favorable development on prior period reserves reduced the combined ratio by 3.7 percentage points in 2006 compared with 5.2 and 6.7 percentage points in 2005 and 2004. The unusually high level of savings in 2004 partially reflected the release of uninsured motorist/underinsured motorist (UM/UIM) reserves following an Ohio Supreme Court decision in late 2003 to limit its 1999 Scott-Pontzer vs. Liberty Mutual decision. • The adoption of stock option expensing increased the 2006 combined ratio by 0.5 percentage points. • Catastrophe losses contributed 5.5, 4.1 and 5.1 percentage points to the combined ratio in 2006, 2005 and 2004, respectively. Catastrophe losses in 2006 included wind and hail losses in March, April and October, with incurred losses of $37 million, $37 million and $38 million, respectively. Of the almost 13,000 catastrophe claims reported through January 31, 2007, for all catastrophes in 2006, more than 95 percent are already closed. Our field claims representatives’ prompt responses and personal approach reflect positively on our agents, supporting their marketing efforts. The following table shows catastrophe losses incurred, net of reinsurance, for the past three years as well as the effect of loss development on prior period catastrophe events. The Cincinnati Insurance Companies do not appoint agencies to actively market property casualty insurance in Louisiana, Mississippi or Texas. Our 2005 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 of 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. In 2006, we reduced our participation in the Munich Re assumed reinsurance treaty to 1 percent as discussed in Item 1A, Risk Factors, Page 20. 2006 10-K Page 41 Catastrophe Losses Incurred (In millions, net of reinsurance) Cause of loss Dates 2006 Mar. 11-13 Apr. 2-3 Apr. 6-8 Apr. 13-15 Jun. 18-22 Jul. 19-21 Aug. 23-25 Oct. 2-4 Nov. 30 - Dec. 3 Wind, hail, ice, snow Other 2006 catastrophes Development on 2005 and prior catastrophes Calendar year incurred total Wind, hail Wind, hail Wind, hail Wind, hail Wind, hail, flood Wind, hail, flood Wind, hail, flood Wind, hail, flood 2005 Wind, ice, snow Jan. 4-6 Wind, hail May 6-12 Hurricane Dennis Jul. 9-11 Hurricane Katrina Aug. 25-26 Hurricane Rita Sep. 20-24 Hurricane Wilma Oct. 24 Wind, hail Nov. 6 Nov. 15-16 Wind Other 2005 catastrophes Development on 2004 and prior catastrophes Calendar year incurred total 2004 May 17-19 May 21-27 Jul. 12-14 Aug. 13-14 Sep. 3-4 Sep. 15-21 Sep. 25-29 Dec. 22-25 Other 2004 catastrophes Development on 2003 and prior catastrophes Calendar year incurred total Wind, hail Wind, hail Wind, hail Hurricane Charley Hurricane Frances Hurricane Jeanne Hurricane Ivan Wind, ice, snow Region Midwest, Mid-Atlantic Midwest South South South South Midwest Midwest Midwest, South Midwest, Mid-Atlantic Midwest South South South South Midwest Midwest, South Midwest, Mid-Atlantic Midwest, Mid-Atlantic, South Midwest, Mid-Atlantic, South South South Mid-Atlantic, South Midwest, Mid-Atlantic, South Midwest, South Years ended December 31, Personal lines Commercial lines Total $ $ $ $ $ $ 29 $ 12 13 4 3 4 5 7 4 7 1 89 $ 0 $ 4 5 36 3 13 2 2 0 11 76 $ 1 $ 11 7 16 4 4 21 5 3 (1) 71 $ 8 $ 5 24 6 2 1 2 31 4 3 0 86 $ 1 $ 8 2 11 0 12 9 10 0 (2) 51 $ 9 $ 20 5 10 7 2 18 8 2 (4) 77 $ 37 17 37 10 5 5 7 38 8 10 1 175 1 12 7 47 3 25 11 12 0 9 127 10 31 12 26 11 6 39 13 5 (5) 148 The discussions of property casualty insurance segments provide additional detail regarding these factors. COMMERCIAL LINES INSURANCE RESULTS OF OPERATIONS Overview -- Three-year Highlights Performance highlights for the commercial lines segment include: • Premiums – Although competition in our commercial markets continued to increase, our written premium growth rate increased in 2006, reflecting our agency relationships, strong new business growth, healthy policy retention rates, more accurate risk classification, insurance-to-value initiatives, higher reinsurance treaty retentions and exposure growth due to the healthy economy. These more than offset our deliberate decisions not to write or renew certain business and the loss of some accounts due to competition. In the more competitive pricing environment we have been careful to maintain our underwriting discipline for both renewal and new business. We believe that our written premium growth rate continues to exceed the average for the overall commercial lines industry, which was estimated at 1.0 percent in 2006 after declining 0.4 percent in 2005. Earned premium growth remained relatively steady over the period. • Combined ratio – Our commercial lines combined ratio rose to 91.3 percent in 2006 largely because of softer pricing, increasing loss severity, less savings from favorable development on prior period reserves and the adoption of stock option expensing. The combined ratio was very strong in 2005 and 2004. We continue to focus on sound underwriting fundamentals and seek to obtain adequate premiums per policy. A single large loss in 2005 increased the ratio in that year by 1.0 percentage point. We discuss large 2006 10-K Page 42 losses and other factors affecting the combined ratio beginning on Page 44. We discuss the savings from favorable loss reserve development by commercial lines of business on Page 47. Our commercial lines statutory combined ratio was 90.8 percent in 2006 compared with 87.1 percent in 2005 and 83.7 percent in 2004. By comparison, the estimated industry commercial lines combined ratio was 94.3 percent in 2006, 99.7 percent in 2005 and 102.5 percent in 2004. We believe our results are trending differently than the overall industry because the industry experienced unusually high catastrophe losses in 2004 and 2005 and unusually low catastrophe losses in 2006. Growth and Profitability As competition in commercial markets has increased, we have focused on maintaining our pricing discipline for both renewal and new business. Our independent agents continued to report steady pressure on pricing during 2006 and communicated that winning new business and retaining renewals required more pricing flexibility and careful risk selection. We believe our strong new business growth in 2006 and 2005 primarily was due to the local relationships and efforts of our agents and the field marketing teams that work with them. Our field associates are in our agents’ offices emphasizing the Cincinnati value proposition, calling on prospects with those agents, carefully evaluating risk exposure and working up their best quotes for good accounts. For our renewal business, our headquarters underwriters talk regularly with agents. Our field teams are available to assist the headquarters underwriters by holding renewal review meetings with agency staff to verify that each commercial account retains the characteristics that caused us to write the business initially. For quality risks, our commercial underwriters are offering policyholders the convenience of policy extensions of one and two additional years. Policy extensions provide: • Retention of the terms and conditions that policyholders originally selected, backed by our superior claims service and our A++ rating from A.M. Best Co. • Stable rates on some of the shorter-tail coverages within the policies. 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 independent agents, field marketing representatives and headquarters underwriters 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 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 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 2006, strong new business activity, higher policy retention rates and higher premiums per policy led to net written premium growth in all of our commercial lines of business, with commercial auto rising slightly. In 2005, growth largely was driven by higher commercial casualty premiums 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. From 2004 through 2006, we experienced no growth in overall commercial lines policy counts as growth in accounts with premiums above $10,000 offset a decline in the number of smaller accounts. Agency emphasis and technology considerations were the primary reasons for the shift. 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 $324 million in 2006, up from $282 million in both 2005 and 2004. We discuss growth by commercial lines of business on Page 47. 2006 10-K Page 43 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 2006 Years ended December 31, 2005 2004 2006-2005 2005-2004 Change % Change % 6.7 6.6 12.7 16.6 1.4 17.8 208.1 (27.0) 4.7 6.0 12.9 6.0 3.6 13.5 (52.3) (15.6) $ $ $ 2,442 2,402 1,377 89 444 268 16 208 $ $ $ 57.3 % 3.7 61.0 18.5 11.1 0.7 91.3 % 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 50.9 % 3.4 54.3 19.9 9.4 0.5 84.1 % 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 meet with local agencies to reaffirm agreements on the extent of frontline renewal underwriting they will perform. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. Field claims representatives prepare full risk reports on any account reporting a loss above $100,000 or on any risk of concern. These actions have helped to mitigate rising loss severity. We describe the significant cost 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 changes for unpaid losses as well as the associated loss expenses. We believe more competitive market conditions and softer pricing contributed to the rise in the loss and loss expense ratio excluding catastrophe losses between 2004 and 2006. In addition, 2005 results include a single large loss that was insufficiently covered through our facultative reinsurance programs, which increased 2005 loss and loss expenses by $22 million, net of reinsurance, or 1.0 percentage points. Savings from favorable loss reserve development moved lower over the three years, which we discuss by commercial lines of business on Page 47. Re-underwriting our commercial lines book of business in the early 2000s has had a positive impact on loss cost trends such as frequency of loss, resulting in significant savings from favorable reserve development. The favorable development in 2005 and 2004 also was due to a headquarters claims department initiative, begun in 2001, to establish higher initial case reserves on severe injury claims. The higher reserves reflect our experience that juries often ignore significant liability issues in cases involving seriously injured claimants as well as trends in medical cost inflation and life expectancies. 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. Another factor in the rise in the loss and loss expense ratio excluding catastrophe losses in 2006 was increasing loss severity, reflected primarily by an increase in new losses and case reserve increases greater than $250,000. In total, commercial lines new losses and reserve increases greater than $250,000 rose to 21.3 percent of annual earned premiums in 2006 from 16.8 percent in 2005 and 14.9 percent in 2004. Those amounts included an increase in new losses greater than $1 million. Our analysis indicated no unexpected concentration of these losses and reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. We believe loss severity generally is rising, but we cannot predict the magnitude of future increases. Severe injury was frequently the cause for new losses greater than $1 million. We continue to analyze factors that could be contributing to a rise in severe injuries. 2006 10-K Page 44 Commercial Lines Losses by Size (Dollars in millions) Years ended December 31, 2005 2004 2006 Losses $1 million or more Losses $250 thousand to $1 million Development and case reserve increases of $250 thousand or more Other losses excluding catastrophes Total losses incurred excluding catastrophe losses Catastrophe losses Total losses incurred $ $ 180 139 193 561 1,073 89 1,162 $ $ 124 105 149 596 974 76 1,050 $ $ Ratios 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 excluding catastrophes Loss ratio excluding catastrophe losses Catastrophe losses Total loss ratio 7.5 % 5.8 8.0 23.4 44.7 3.7 48.4 % 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 % 2006-2005 Change % 45.3 32.3 29.5 (5.7) 10.3 16.6 10.7 2005-2004 Change % 54.3 1.2 12.7 11.1 14.2 6.0 13.6 Catastrophe Loss and Loss Expenses Commercial lines catastrophe losses have been relatively stable as a percentage of net earned premiums over the past three years. Commission Expenses Commercial lines commission expense as a percent of earned premium declined by 1.0 and 0.4 percentage points in 2006 and 2005, respectively, primarily due to lower profit-sharing commissions on lower overall underwriting profits. 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 the agencies’ 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 2006 contingent commission accrual reflected our estimate of the profit-sharing commissions that will be paid to our agencies in early 2007. Underwriting Expenses Non-commission underwriting expenses rose to 11.1 percent of earned premiums in 2006 from 10.1 percent in 2005 and 9.4 percent in 2004. We continue to invest in our associates and technology, which is contributing to an increase in other underwriting expenses. Higher technology expense contributed 0.3 and 0.1 percentage points to the increase in 2006 and 2005. Higher staffing expense contributed 0.9 percentage points to the increase in 2006, with stock option expense accounting for 0.5 percentage points of that amount. Policyholder Dividends Policyholder dividend expense was 0.7 percent of earned premium in 2006 compared with 0.2 percent in 2005 and 0.5 percent in 2004. The increase in 2006 was a result of higher paid dividends and increased accrual for future dividends. The increased accrual reflects the improved profitability of workers’ compensation policies with respect to recent policy years. Line of Business Analysis Approximately 95 percent of our commercial lines premiums relate to accounts with coverages from more than one of our business lines. As a result, we believe that commercial lines is best measured and evaluated on a segment basis. However, we provide the line of business data to summarize growth and profitability trends separately for our business lines. 2006 10-K Page 45 (Dollars in millions) Commercial casualty: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Commercial property: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Commercial auto: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Workers' compensation: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Specialty packages: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Surety and executive risk: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Machinery and equipment: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Years ended December 31, 2005 2006 2004 2006-2005 Change % 2005-2004 Change % $ $ $ $ $ $ $ $ $ $ $ $ $ $ 838 831 440 53.0 % 53.0 505 491 282 57.5 % 43.6 450 453 278 61.5 % 60.6 379 366 313 85.4 % 85.4 144 141 94 66.3 % 54.9 97 93 47 50.7 % 50.7 29 27 12 42.0 % 41.6 $ $ $ $ $ $ $ 779 759 302 39.8 % 39.8 476 467 300 64.2 % 49.3 448 457 274 60.1 % 60.0 338 328 299 90.9 % 90.9 138 137 92 67.0 % 61.8 85 80 27 34.2 % 34.2 26 26 6 22.4 % 22.5 708 686 321 46.8 % 46.8 455 440 240 54.5 % 42.1 458 450 236 52.4 % 52.1 320 313 251 80.3 % 80.3 135 133 80 59.9 % 47.4 85 80 21 26.6 % 26.6 25 24 5 20.6 % 20.2 7.7 9.5 45.8 6.1 5.1 (5.9) 0.3 (0.9) 1.5 12.1 11.4 4.7 4.6 3.2 2.1 15.3 16.3 72.2 8.7 5.8 98.7 10.0 10.7 (5.9) 4.5 6.0 24.9 (2.2) 1.5 16.3 5.4 5.1 18.9 2.1 2.5 14.6 (0.1) (0.8) 27.9 6.8 8.0 17.1 The accident year loss data provides current estimates of incurred loss and loss expenses for the past three 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. (Dollars in millions) Loss and loss expenses incurred: Commercial casualty Commercial property Commercial auto Workers' compensation Specialty packages Surety and executive risk Machinery and equipment Loss and loss expenses ratio: Commercial casualty Commercial property Commercial auto Workers' compensation Specialty packages Surety and executive risk Machinery and equipment $ 2006 Accident year 2005 2004 $ 540 278 300 303 91 41 11 64.9 % 56.6 66.1 82.8 64.7 44.4 39.2 $ 420 300 281 254 80 39 7 55.4 % 64.2 61.4 77.4 58.6 48.3 28.6 359 261 269 250 82 29 4 52.4 % 59.3 59.8 79.8 61.2 36.2 18.6 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. 2006 10-K Page 46 Commercial Casualty Commercial casualty is our largest business line. Commercial casualty net written premium growth slowed in 2006, but remained above the overall growth rate for commercial lines. While casualty pricing continues to become more competitive, new business is strong. We also are seeing a boost from the healthy business economy over the past several years as well as related exposure growth. The commercial casualty loss and loss expense ratio rose in 2006 after improving in 2005, but remained within the range we consider appropriate. In each of the last three calendar years, activity in the reserves for prior period losses has been the primary reason for the fluctuations in the loss and loss expense ratio. • 2006 – Favorable development lowered the loss and loss expense ratio by 12.0 percentage points. • 2005 – Favorable development lowered the loss and loss expense ratio by 22.5 percentage points. • 2004 – Favorable development lowered the loss and loss expense ratio by 20.0 percentage points. Over the three years, flat commercial umbrella loss costs helped produce savings through favorable development on prior period reserves. Factors that contributed to the flat loss cost trend included commercial lines re-underwriting efforts, Ohio judicial decisions regarding underinsured/uninsured motorist claims and a claims mediation process that promoted earlier liability settlement resolution, which also contributed to lower loss cost trends for our other general liability coverages. Once these commercial lines and claims initiatives are fully implemented, loss cost trends could be expected to return to normal levels. Another factor that helped produce savings through favorable development was the headquarters claims department initiative to establish higher initial case reserves on serious injury claims. The higher reserves reflect our experience indicating the likelihood that juries would ignore significant liability issues in cases involving seriously injured claimants as well as trends in medical cost inflation and life expectancies. In large part because this business line also includes umbrella coverages, the accident year loss and loss expense ratio can fluctuate significantly on a year-over-year basis. Commercial Property Commercial property is our second largest business line. Commercial property net written premiums rose in 2006 and 2005. The primary reason for the more rapid growth in 2006 was a $5 million ceded reinsurance reinstatement premium in 2005 to restore affected layers of our property catastrophe reinsurance program following Hurricane Katrina. This added 1.2 percentage points to the 2006 growth rate. The commercial property loss and loss expense ratio excluding catastrophe losses improved in 2006 after rising in 2005 and remained within the range we consider appropriate. In each of the last three calendar years, activity in the reserves for prior period losses contributed to the changes in the loss and loss expense ratio. • 2006 – Reserve strengthening raised the loss and loss expense ratio by 0.9 percentage points. • 2005 – Reserve strengthening raised the loss and loss expense ratio by 3.5 percentage points. • 2004 – Reserve strengthening raised the loss and loss expense ratio by 0.3 percentage points. In addition, the large loss discussed on Page 42 added 5.0 percentage points to the 2005 ratio. Commercial Auto Commercial auto net written premiums rose slightly in 2006 after declining 2.2 percent in 2005. We are beginning to see the impact of the downward pressure on pricing on underwriting results. Commercial auto is one of the business lines that we renew and price annually, so market trends may be reflected here more quickly than in other lines. Commercial auto also is generally one of the larger components of the typical package. As a result of our underwriting activities and moderating industrywide severity and frequency trends, the loss and loss expense ratio for commercial auto remained at an acceptable level in 2006 and 2005 despite increasing due to pricing pressures. The increase in the loss and loss expense ratio in 2006 also reflected a 2.9 percentage point rise in the ratio of $1 million plus losses to commercial auto earned premiums. In each of the last three calendar years, favorable development on prior period losses, due to commercial lines re-underwriting efforts and favorable frequency and severity trends, contributed to the changes in the loss and loss expense ratio. • 2006 – Favorable development lowered the loss and loss expense ratio by 4.6 percentage points. • 2005 – Favorable development lowered the loss and loss expense ratio by 5.0 percentage points. • 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. 2006 10-K Page 47 Workers’ Compensation In 2006 and 2005, workers’ compensation written premiums rose more rapidly than our total commercial lines written premiums. Workers’ compensation premiums are benefiting from the healthy business economy and related payroll growth. Premiums also are benefiting from initiatives to modestly expand our workers’ compensation business in selected states. We cannot offer workers’ compensation coverage in Ohio, our highest volume state, because it is provided solely by the state instead of private insurers. 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. The workers’ compensation loss and loss expense ratio rose in 2005 after remaining steady for several years and remained above our target levels in 2006. The 2005 rise largely was due to a higher level of reserve strengthening for older accident years. The ratio remained above our target level in 2006 because of modest reserve strengthening and seven new losses greater than $1 million, primarily in the second half of the year. The seven losses in 2006 totaled $18 million and added 4.9 percentage points to the workers’ compensation loss and loss expense ratio. There was only one similarly sized loss, for $1.6 million, in 2005 and none in 2004. Our philosophy is to establish case reserves when we learn of a loss to reflect our best estimate of ultimate payouts. The higher initial reserves established in 2006 for newly reported claims demonstrate our commitment to applying our claims reserving philosophy to this business line. In 2006, we also reviewed each of our established workers’ compensation case reserves above $100,000 in light of current trends in medical cost inflation and estimated payout periods. The review led to the allocation of approximately $60 million to case reserves held for specific claims from accident years going back as much as 20 years. Reductions to IBNR reserves offset approximately $44 million of those reserve increases. We had raised workers’ compensation IBNR reserves in 2005, in light of the trends identified in the workers’ compensation market. However, small shifts in medical cost inflation and payout periods could have a significant effect on our potential future liability compared with our current projections. Activity in the reserves for prior period losses in the past three years included: • 2006 – Reserve strengthening raised the loss and loss expense ratio by 2.6 percentage points, as discussed above. • 2005 – Reserve strengthening raised the loss and loss expense ratio by 12.9 percentage points. The reserve strengthening primarily was due to medical cost inflation and longer estimated payout periods compared with our original projections. • 2004 – Reserve strengthening raised the loss and loss expense ratio by 4.9 percentage points, which also was due to medical cost inflation. Specialty Packages Specialty packages net written premiums rose in 2006 and 2005. The rollout we have begun of our commercial lines policy processing system should help us meet changing agency needs and address pricing, technology and service systems other carriers have introduced for similar products in recent years. The loss and loss expense ratio excluding catastrophe losses improved in 2006 after rising in 2005, but remained within the range we consider appropriate. In each of the last three calendar years, activity in the reserves for prior period losses contributed to the fluctuations in the loss and loss expense ratio. • 2006 – Reserve strengthening raised the loss and loss expense ratio by 1.6 percentage points. • 2005 – Reserve strengthening raised the loss and loss expense ratio by 10.9 percentage points. • 2004 – Reserve strengthening raised the loss and loss expense ratio by 3.7 percentage points. Surety and Executive Risk Surety and executive risk net written premiums rose in 2006 and were unchanged in 2005. Healthy economic activity drove the 2006 growth. The loss and loss expense ratio rose in 2006 and 2005; however, surety and executive risk losses can fluctuate significantly, and we do not believe that the increases indicate any new trend or risk. Director and officer liability coverage accounted for 59.0 percent of surety and executive risk premiums in 2006 compared with 61.7 percent in 2005 and 65.7 percent in 2004. Our director and officer liability policies are offered primarily to nonprofit organizations, reducing the risk associated with this line of business. As of December 31, 2006, two of our in-force director and officer liability policies covered Fortune 500 companies, 36 covered publicly traded companies (excluding banks and savings and loans) and 57 covered banks and savings and loans with more than $500 million in assets. 2006 10-K Page 48 In each of the last three calendar years, activity in the reserves for prior period losses contributed to the changes in the loss and loss expense ratio. • 2006 – Reserve strengthening raised the loss and loss expense ratio by 21.1 percentage points due to case reserves additions for director and officer liability claims. • 2005 – Favorable development lowered the loss and loss expense ratio by 5.4 percentage points. • 2004 – Favorable development lowered the loss and loss expense ratio by 9.3 percentage points. Machinery and Equipment Machinery and equipment net written premiums rose in 2006 and 2005. Marketing by machinery and equipment and field marketing representatives contributed to the 2006 growth. The loss and loss expense ratio rose in 2006; however, machinery and equipment losses can fluctuate significantly, and we do not believe that the increase indicates any new trend or risk. In each of the last three calendar years, activity in the reserves for prior period losses contributed to the changes in the loss and loss expense ratio. • 2006 – Reserve strengthening raised the loss and loss expense ratio by 0.8 percentage points. • 2005 – Favorable development lowered the loss and loss expense ratio by 3.7 percentage points. • 2004 – Favorable development lowered the loss and loss expense ratio by 1.3 percentage points. Commercial Lines Insurance Outlook Industrywide commercial lines written premiums are expected to decline approximately 1.0 percent in 2007. During 2006, agents again reported that renewal pricing pressure had risen and new business pricing was requiring even more flexibility and more careful risk selection. During 2006, we continued to need 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. By year-end 2006, our field marketing representatives reported pricing down about 10 percent to 15 percent on average to write the same piece of new business we would have quoted in 2005. By comparison, 5 percent to 10 percent rate declines seem to be typical for renewal business. 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. We believe our approach should allow us to continue to underwrite commercial lines business profitably in 2007, but we do not believe favorable reserve development will contribute to underwriting profits as much in 2007 as in the past three years. In addition, underwriting expenses are rising. We discuss our overall outlook for our property casualty insurance operations in Measuring Our Success in 2007 and Beyond, Page 34. PERSONAL LINES INSURANCE RESULTS OF OPERATIONS Overview -- Three-year Highlights Performance highlights for the personal lines segment include: • Premiums – As competition in our personal lines markets continued to increase and we continued to work to generate consistent profitability in our personal lines market, our written premiums declined again in 2006, reflecting lower new business and policy retention rates through the first half of the year and lower pricing in the second half of the year. Industry average written premium growth was estimated at 2.0 percent for 2006, 3.7 percent for 2005 and 6.6 percent for 2004. Personal lines new business premiums written directly by agencies increased 1.6 percent to $33 million in 2006 after declining 33.9 percent to $32 million in 2005 and 19.9 percent to $48 million in 2004. • Combined ratio – After improving substantially in 2005, the combined ratio increased in 2006 due to higher catastrophe losses, less savings from favorable development on prior period reserves, an increase in loss severity and higher expenses. Lower earned premiums exacerbated the year-over-year comparisons. Our personal lines statutory combined ratio was 103.6 percent in 2006 compared with 94.3 percent in 2005 and 104.6 percent in 2004. By comparison, the estimated industry personal lines combined ratio was 92.0 percent in 2006, 97.6 percent in 2005 and 94.9 percent in 2004. We believe our results are trending differently than the overall industry because of the competitive and pricing factors discussed below. 2006 10-K Page 49 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 late 2004, price competition returned to the personal lines market as insurers leveraged the higher profitability and stronger financial positions that were the outcome of industrywide increases in homeowner rates and stricter enforcement of underwriting standards between 2000 and 2003. When price competition emerged in 2004, we were in the early stages of a program to improve profitability for our homeowner line by raising rates and making changes to our policy terms and conditions. We raised our personal lines rates in some territories too high to allow our agents to market the benefits of a Cincinnati policy, leading to declines in our policy retention rates and lower new business levels between 2002 and 2005. We opted to delay certain rate changes to address the competitive situation until mid-2005 because we felt it was more 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, offering 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, but written premiums, new business and retention rates continued to decline. During the 2003 to 2005 period, we also were introducing Diamond in our higher volume states, which may have contributed to lower growth rates. The focus required by our agencies to convert to our newer technology and make the necessary adaptations to their 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 work flow, and many now are seeing benefits from efficiencies as they renew business through the system. During 2005 and 2006, 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, invoicing for multiple policies at one time, and electronic funds transfer, which accommodates new monthly payment plans. We continue to respond to agency requests for enhancements as we prepare Diamond for additional states. In mid-2006, we introduced a limited program of policy credits to incorporate insurance scores into homeowner and personal auto pricing. These were intended to improve our ability to compete for our agents’ highest quality personal lines accounts, increasing the opportunity for our agents to market the advantages of our personal lines products and services to their clients. The policy credits contributed to increases in new business for both personal auto and homeowner for the first time in several years. The new credit structure also led to improved retention of current business. However, new business did not rise sufficiently to offset the lower prices that our current personal lines policyholders received at renewal with these policy credits. As a result, total net written premiums continued to decline in the second half of 2006. To build on the new business and retention trends of the second half of 2006, we will need to monitor the competitiveness of our personal auto and homeowner rates on an ongoing basis and make refinements as necessary. Strategies to accelerate our personal lines growth are discussed in Personal Lines Outlook, Page 54. We discuss premium trends by personal lines of business on Page 53. 2006 10-K Page 50 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 2006 Years ended December 31, 2005 2004 2006-2005 2005-2004 Change % Change % (6.4) (5.3) (1.5) 69.8 (1.6) 4.2 (160.0) (3.0) 1.4 (11.3) (34.2) (3.6) 24.0 214.0 $ $ $ 736 762 456 86 152 95 (27) $ $ $ 59.9 % 11.3 71.2 19.9 12.5 103.6 % 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 % In 2006, we did not achieve the profit levels we had hoped to realize, following the improvement of the personal lines combined ratio in 2005. Instead, higher catastrophe losses and other factors caused the 2006 combined ratio to rise. We describe the significant cost 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 changes for unpaid losses as well as the associated loss expenses. The change in the loss and loss expense ratio excluding catastrophe losses between 2004 and 2006 largely was due to pricing and loss cost trends. Increased loss severity was seen primarily in higher new losses and case reserve increases greater than $250,000. In total, personal lines new losses and case reserve increases greater than $250,000 were 11.1 percent of annual earned premiums in 2006 compared with 8.2 percent in 2005 and 10.2 percent in 2004. Personal lines new losses and case reserve increases declined as a percent of earned premiums in 2005, in part because of higher rates per exposure. Our analysis indicated no unexpected concentration of these losses and case reserve increases by risk category, geographic region, policy inception, agency or field marketing territory. In 2006, homeowner fires, which spiked in the third quarter, were the most frequent cause for new losses greater than $1 million. We believe loss severity generally is rising, but we cannot predict the magnitude of future increases. Savings from favorable loss reserve development moved lower over the three years, which we discuss by personal lines of business on Page 53. 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 excluding catastrophes Total losses incurred excluding catastrophe losses Catastrophe losses Total losses incurred $ $ Ratios 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 excluding catastrophes Loss ratio excluding catastrophe losses Catastrophe losses Total loss ratio Years ended December 31, 2005 2004 2006 23 39 22 309 393 86 479 $ $ 3.0 % 5.2 2.9 40.5 51.6 11.3 62.9 % 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 % 2006-2005 Change % 79.1 14.5 16.8 (8.9) (3.0) 69.8 5.1 2005-2004 Change % (26.0) (19.9) (7.7) (8.5) (10.2) (34.2) (13.7) Catastrophe Loss and Loss Expenses Personal lines catastrophe losses, net of reinsurance and before taxes, contributed 5 percentage points more to the combined ratio in 2006 because of an increase of $35 million in incurred catastrophe losses and lower earned premium. The majority of these losses related to wind and hail from storms in Indiana and Ohio. 2006 10-K Page 51 Commission Expenses Personal lines commission expense as a percent of earned premium rose by 0.7 percentage points in 2006 after declining by 0.9 percentage points in 2005. The 2006 change was primarily due to higher profit-sharing commissions resulting from accrual and allocation adjustments. 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 the agencies’ 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 0.2 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 2006 contingent commission accrual reflected our estimate of the profit-sharing commissions that will be paid to our agencies in early 2007. Underwriting Expenses Non-commission underwriting expenses increased 1.2 percentage points in 2006 and 2.0 percentage points in 2005. We continue to invest in our associates and technology, which is contributing to an increase in non-commission underwriting expenses. Higher technology expense contributed 0.8 and 0.5 percentage points to the increase in 2006 and 2005. Higher staffing expense contributed 0.8 to the increase in 2006, with stock option expense accounting for 0.5 percentage points of that amount. Increases in those amounts in 2006 were offset partially by savings in taxes, licenses and fees. The increase in 2005 reflected an unfavorable deferred acquisition cost comparison of 1.0 percentage points due to premium declines. Line of Business Analysis We prefer to write personal lines coverage on an account basis that includes both auto and homeowner coverages as well as coverages from the other personal business line. As a result, we believe that personal lines is best measured and evaluated on a segment basis. However, we provide the line of business data to summarize growth and profitability trends separately for the three business lines. (Dollars in millions) Personal auto: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Homeowner: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Other personal: Written premiums Earned premiums Loss and loss expenses incurred Loss and loss expense ratio Loss and loss expense ratio excluding catastrophes Years ended December 31, 2005 2006 2004 2006-2005 Change % 2005-2004 Change % $ $ $ $ $ $ 359 385 250 65.0 % 62.2 290 289 240 83.0 % 59.3 87 88 52 59.4 % 52.0 $ $ $ 409 433 259 59.9 % 59.3 288 282 213 75.5 % 58.6 89 89 40 44.6 % 41.6 453 451 298 66.1 % 65.1 270 256 247 96.3 % 69.0 88 86 55 63.7 % 60.0 (12.4) (11.2) (3.5) (9.6) (4.0) (13.0) 0.7 2.3 12.4 6.7 10.4 (13.4) (2.0) (1.1) 31.6 1.3 3.4 (27.6) The accident year loss data provides current estimates of incurred loss and loss expenses for the past three 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. (Dollars in millions) Loss and loss expenses incurred: Personal Auto Homeowner Other Personal Loss and loss expenses ratio: Personal Auto Homeowner Other Personal 2006 Accident year 2005 2004 $ $ 248 235 77 64.5 % 81.5 88.0 $ 272 219 58 62.8 % 77.6 65.4 303 255 64 67.3 % 99.6 74.4 2006 10-K Page 52 Personal Auto Written and earned premiums for the personal auto line declined in 2006 and 2005. As noted above, the decline primarily was due to price competition in some states and territories, which resulted in lower policy renewal retention and significantly lower new business levels through mid-2006. We continue to monitor and modify selected rates and credits to address our competitive position. The loss and loss expense ratio for personal auto has remained satisfactory. For selected agencies, we use re-underwriting programs to review and to strengthen underwriting standards, such as requiring motor vehicle reports for insured drivers. We work with agencies to develop strategies to increase the company’s penetration of the agency’s personal lines business. The rise in the ratio in 2006 was due to price reductions. In each of the last three calendar years, activity in the reserves for prior period losses contributed to the changes in the loss and loss expense ratio. • 2006 – Reserve strengthening raised the loss and loss expense ratio by 0.6 percentage points. • 2005 – Favorable development lowered the loss and loss expense ratio by 1.9 percentage points. • 2004 – Reserve strengthening raised the loss and loss expense ratio by 0.2 percentage points. Homeowner The growth rate of written and earned premiums for the homeowner line slowed over the three-year period. As discussed above, until mid-2006, the benefit of rate increases in 2004 and 2005 was being increasingly offset by lower policy renewal retention rates and significantly lower new business levels. Earned premiums rose more rapidly because of the benefit of higher written premium growth in earlier periods. We began a strategic shift in 2004 to a more conventional one-year homeowner policy term from our traditional three-year policy term. 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 modify rates, terms and conditions more promptly in response to market changes. At year-end 2006, approximately 85 percent of all homeowner policies had been converted to a one-year term, up from approximately 56 percent at year-end 2005. We are continuing to renew homeowner policies for three-year terms in five states that currently account for less than 1 percent of total personal lines premiums. The loss and loss expense ratio for the homeowner line excluding catastrophe losses rose in 2006 after improving in 2005. The increase in 2006 reflected a higher contribution from large losses. In each of the last three calendar years, activity in the reserves for prior period losses also contributed to the changes in the loss and loss expense ratio. • 2006 – Reserve strengthening raised the loss and loss expense ratio by 1.5 percentage points. • 2005 – Favorable development lowered the loss and loss expense ratio by 0.4 percentage points. • 2004 – Favorable development lowered the loss and loss expense ratio by 2.7 percentage points. We continue to seek to improve homeowner results so that this line achieves profitability. Since we generally do not allocate non-commission expenses to individual business lines, to measure homeowner profitability, we now assume total commission and underwriting expenses would contribute approximately 33 percentage points to our homeowner combined ratio, up from a 32 percent assumption in prior years. Lower levels of premium growth affected our ability to attain our expense ratio target in 2006 and may continue to do so in the future. 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 22.2 percent of homeowner earned premiums. We did not change our catastrophe loss assumption because the geographic concentration of these losses has been unusual in the past three years. We had hoped that by 2007 the full benefit of our pricing and underwriting actions would be reflected in homeowner results and this line would be approaching breakeven. Pricing changes enacted in mid-2006, however, have slowed our progress toward overall homeowner profitability. Other Personal Other personal written premiums were down slightly in 2006 after rising slightly in 2005. Lower retention and new business for homeowner and personal auto during 2005 and the first half of 2006 contributed to the decline, since most of our other personal coverages are endorsed to homeowner or auto policies. The loss and loss expense ratio for other personal rose in 2006 due to higher personal umbrella and dwelling fire losses in the second quarter. Personal umbrella losses can fluctuate significantly, and we do not believe that the increase indicated any new trend or risk. In each of the last three calendar years, activity in the reserves for prior period losses also contributed to the changes in the loss and loss expense ratio. • 2006 – Favorable development lowered the loss and loss expense ratio by 28.6 percentage points. • 2005 – Favorable development lowered the loss and loss expense ratio by 28.7 percentage points. 2006 10-K Page 53 • 2004 – Favorable development lowered the loss and loss expense ratio by 18.9 percentage points. Personal Lines Insurance Outlook Industry experts currently anticipate industrywide personal lines written premiums will rise approximately 1.2 percent in 2007. While the rise in new business levels and policy retention rates in the second half of 2006 are positive indications for our personal lines business, we believe our growth rate will be below that of the industry in 2007. We are pursuing a number of strategies in our personal lines business to achieve our long-term objectives for this segment: • Competitive rates –In mid-2006, we introduced insurance scores into our program of policy credits for homeowner and personal auto pricing. That action led to the increased new business for both personal auto and homeowners in the second half of 2006. It also led to improved retention of current business. While these pricing refinements have reduced premiums per policy, we believe they present an opportunity to attract our agents’ more quality conscious clientele. • Policy characteristics – In keeping with industry practices, most of our homeowner products no longer automatically provide guaranteed full replacement cost coverage in our basic policies. 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 have diminished some of the factors that distinguished our products. • Diamond introduction –The Diamond system is in use by agencies writing approximately 90 percent of personal lines premium volume. 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 47 percent and headquarters printing for 81 percent of policy transactions in 2006. • 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 and geographic diversity. We currently market both homeowner and personal auto insurance products through 772 of our 1,289 reporting agency locations in 22 of the 32 states where we market commercial lines insurance. We market homeowner products through 22 locations in three additional states (Maryland, North Carolina and West Virginia). During 2007, we hope to add personal lines for 30 to 35 agency locations in the 13 states in which Diamond is in use that currently market only our commercial lines products. During 2007, our field teams and personal lines associates are contacting these agencies to re-introduce them to our personal lines product line and technology. Expanding into these agencies would provide additional sources of premiums and help geographically diversify our personal lines portfolio. We identify several other factors that may affect the personal lines combined ratio in 2007 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 2006 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 2007 and Beyond, Page 34. 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 $56.971 billion at year-end 2006 from $51.493 billion at year-end 2005 and $44.921 billion at year-end 2004. • Profitability – The life insurance segment reports a small GAAP loss because its investment income is included in investment segment results, except investment income credited to contract holders (interest assumed in life insurance policy reserve calculations). The segment operating profit declined in 2006 after improving in 2005 due to: ○ Higher mortality expenses compared with the year-earlier periods principally due to growth in life insurance in force. Mortality experience remained within pricing guidelines. ○ Adoption of stock option expensing, which added approximately $1 million to 2006 other operating expenses. 2006 10-K Page 54 At the same time, we recognize that 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 products. For that reason, we also evaluate GAAP data, including all investment activities on life insurance-related assets, which grew 32.6 percent in 2006 to $63 million and 23.8 percent in 2005 to $47 million. The life insurance company portfolio had pretax realized investment gains of $45 million in 2006 compared with $17 million in 2005 and $9 million in 2004. 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 Operating expenses incurred Total benefits and expenses Life insurance segment profit (loss) Years ended December 31, 2005 2006 2004 $ $ $ 161 $ 115 $ 3 118 122 (54) 51 119 (1) $ 205 $ 106 $ 4 110 102 (51) 52 103 7 $ 193 101 3 104 95 (46) 53 102 2 2006-2005 Change % (21.3) 2005-2004 Change % 6.5 7.9 (0.3) 7.6 20.1 5.7 (1.8) 16.1 (115.4) 5.7 18.5 6.0 7.2 12.9 (0.3) 0.8 334.2 Growth We offer term, whole life and universal life products, fixed annuities and disability income products. Total statutory life insurance net written premiums were $161 million in 2006 compared with $205 million in 2005 and $193 million in 2004. Total statutory written premiums for life insurance operations for all periods include life insurance, annuity and accident and health premiums. The change primarily was due to: • Statutory written premiums for term and other life insurance products rose 12.7 percent to $127 million for 2006 and declined 4.2 percent to $113 million for 2005. • Statutory written annuity premiums declined $58 million in 2006 and increased $18 million in 2005. Since late 2005, we have de-emphasized annuities because of an unfavorable interest rate environment. Fee income from universal life products declined 14.9 percent to $23 million in 2006 and rose 2.7 percent in 2005 to $27 million. Separate account investment management fee income contributed $3 million, $4 million and $3 million to total revenues in 2006, 2005 and 2004. In 2006, our life insurance segment experienced a 0.3 percent rise in life applications submitted and a 10.6 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 banner. Our product development efforts emphasize death benefit protection and guarantees. Distribution expansion within our property casualty insurance agencies 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: • Contract holders benefits incurred related to traditional life and interest-sensitive products accounted for 70.3 percent of 2006 total benefits and expenses, 66.0 percent of 2005 total benefits and expenses and 64.3 percent of 2004 total benefits and expenses. • Operating expenses incurred, net of deferred acquisition costs, accounted for 29.7 percent of 2006 total benefits and expenses, 34.0 percent of 2005 total benefits and expenses and 35.7 percent of 2004 total benefits and expenses. Stock option expense added $1 million, or 0.7 percentage points, to expenses in 2006. 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 value 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 the life insurance operation are on par with industry averages. During the past several years, we have invested 2006 10-K Page 55 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. 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, we introduced new universal life products including cash value accumulation products for adults and children. Marketplace and regulatory changes continued to affect the availability of cost-effective reinsurance for term life insurance. 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. Because of the conservative nature of statutory reserving principles, retaining the policy reserve requires a large commitment of capital and reduces statutory earnings. However, we believe the long-term profitability of term life insurance serves to enhance GAAP results. Although the exact timing and details are uncertain, the NAIC continues to make progress toward comprehensive reforms of statutory reserving principles, as we discuss in 2007 Reinsurance Programs, Page 69. In the future, we expect that assets under management, capital appreciation and investment income, which are reported in investment segment results, will continue to be integral to our evaluation of the success of the life insurance operations. While life insurance segment profit may continue to fluctuate near break-even, when we also consider life insurance investment activities, we continue to believe the life insurance operations will continue to provide a steady income stream to help offset the fluctuations of the property casualty insurance business. 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 2006, rising 8.4 percent from the prior record in 2005. 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 investment gains and losses – We reported realized investment gains in 2006 and 2005 largely due to investment sales. The sale of our Alltel common stock holding contributed $647 million (pretax) of the 2006 gain. 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 Investment operations income Years ended December 31, 2005 2006 2004 2006-2005 2005-2004 Change % Change % $ $ 300 $ 262 15 (7) 570 (54) 678 7 (1) 684 1,200 $ 280 $ 244 8 (6) 526 (51) 69 (7) (1) 61 536 $ 252 239 6 (5) 492 (46) 87 10 (6) 91 537 7.1 7.5 90.0 (19.3) 8.4 5.7 883.0 200.7 41.7 1,026.0 124.0 11.2 2.1 29.4 (22.3) 6.9 12.9 (20.7) (167.2) 78.5 (33.1) (0.4) Investment Income Growth in investment income reflected new investments, higher interest income from the growing fixed- maturity portfolio and increased dividend income from the common stock portfolio. The advantages of strong cash flow in the past three years for new investments have been somewhat offset by the challenge of investing in a low interest rate environment. In 2006, proceeds from the sale of the Alltel holding that were later used to make the applicable tax payments during the year were invested in short-term instruments that generated approximately $5 million in interest income. Overall, common stock dividends contributed 42.4 percent of pretax investment income in 2006 compared with 43.7 percent in 2005 and 43.9 percent in 2004. Fifth Third, our largest equity holding, contributed 2006 10-K Page 56 43.8 percent of total dividend income in 2006. We discuss our Fifth Third investment in Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 75. In 2006, 38 of the 50 common stock holdings in the portfolio raised their indicated annual dividend payout, as did 36 of 49 in 2005 and 33 of 51 in 2004. 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 the past three years 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. • 2006 – We sold the remainder of our Alltel common stock holdings. We discuss this sale in Item 1, Investments Segment, Page 14, and Item 8, Note 2 to the Consolidated Financial Statements, Page 90. • 2005 – 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 gains from the initial sales of a portion of our Alltel holding. • 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 strategic shift in business strategy that is not consistent with our long-term outlook. 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 2006, we recorded $7 million in fair value increases compared with $7 million in fair value declines in 2005 and $10 million in fair value increases in 2004. 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 the discussion of Derivative Financial Instruments and Hedging Activities in Item 8, Note 1 to the Consolidated Financial Statements, Page 85, for details on the accounting for convertible security embedded options. Other-than-temporary Impairment Charges In 2006 and 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. 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 2006, 2005 and 2004. 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 the past three years was due to prior impairments in the portfolio, disposition of certain securities in prior years and an improvement in the general financial climate. Other-than-temporary impairment charges from the investment portfolio by industry are summarized as follows: (In millions) Automotive Airline Other Total Years ended December 31, 2005 2004 2006 $ $ (1) 0 0 (1) $ $ (1) 0 0 (1) $ $ 0 (5) (1) (6) 2006 10-K Page 57 Other-than-temporary impairment charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 14, are summarized below: (Dollars in millions) Taxable fixed maturities: Impairment amount New book value Percent to total owned Number of securities impaired Percent to total owned Tax-exempt fixed maturities: Impairment amount New book value Percent to total owned Number of securities impaired Percent to total owned Common equities: Impairment amount New book value Percent to total owned Number of securities impaired Percent to total owned Total: Impairment amount New book value Percent to total owned Number of securities impaired Percent to total owned $ $ $ $ $ $ $ $ Years ended December 31, 2005 2004 2006 $ $ (1) 0 0 % 1 0 % $ $ 0 0 0 % 0 0 % $ $ 0 0 0 % 0 0 % $ $ (1) 0 0 % 1 0 % $ $ $ $ $ $ $ $ (1) 0 0 % 2 0 % 0 0 0 % 0 0 % 0 0 0 % 0 0 % (1) 0 0 % 2 0 % 0 2 1 % 1 1 % (5) 9 1 % 2 0 % (1) 0 0 % 1 2 % (6) 11 0 % 4 0 % Investments Outlook We believe investment income growth for 2007 could 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 current portfolio attributes. In 2007, we expect to allocate a higher proportion of cash available for investment to equity securities, taking into consideration insurance department regulations and ratings agency comments. We continue to identify companies with the potential for revenue, earnings and dividend growth, a strong management team and favorable outlook. These equities offer the potential for steadily increasing dividend income along with capital appreciation. Dividend increases within the last 12 months by Fifth Third and another 37 of the 50 common stock holdings in the equity portfolio should add $16 million to annualized investment income. We believe impairments in 2007 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 securities in the portfolio were trading at or above 70 percent of book value at December 31, 2006. 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 2006, other income of the insurance subsidiaries, parent company operations and non-investment operations of CFC Investment Company and CinFin Capital Management Company resulted in $14 million in revenues compared with $12 million in 2005 and $8 million in 2004. Losses before income taxes of $51 million in 2006 were primarily due to $51 million in interest expense from debt of the parent company. Losses before income taxes were $50 million and $37 million in 2005 and 2004, when interest expense was $52 million and $36 million, respectively. TAXES Income tax expense was $399 million in 2006 compared with $221 million in 2005 and $216 million in 2004. The effective tax rate for 2006 was 30.0 percent compared with 26.8 percent in 2005 and 27.0 percent in 2004. The sale of our Alltel common stock holdings in the first three months of 2006, which generated a $647 million pretax gain, was the primary reason for the change in effective tax rate for the year. Growth in the tax-exempt municipal bond portfolio, higher investment income from dividends and lower operating earnings also contributed to the change in the effective tax rate for 2006. 2006 10-K Page 58 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. For our insurance subsidiaries, approximately 85 percent of income from tax-advantaged fixed-maturity investments is exempt from federal tax calculations. Our non-insurance subsidiaries own no tax-advantaged fixed-maturity investments. For our insurance subsidiaries, the dividend received deduction exempts approximately 60 percent of dividends from qualified equities from federal tax calculations. The dividend received deduction exempts 70 percent of dividends from qualified equities for our non-insurance subsidiaries. Details regarding our effective tax rate are found in Item 8, Note 10 to the Consolidated Financial Statements, Page 95. 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 2006, we had shareholders’ equity of $6.808 billion and total debt of $840 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 collection of 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, 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 both 2006 and 2005 and $175 million in 2004. State of Ohio regulatory requirements restrict the dividends insurance subsidiaries can pay. During 2007, total dividends that our lead insurance subsidiary can pay to our parent company without regulatory approval are approximately $572 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. This table shows a summary of cash flow of the insurance subsidiary (direct method): (In millions) Premiums collected 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, 2005 2006 2004 $ $ 3,285 $ (1,859) (1,036) 390 471 861 $ 3,187 $ (1,752) (995) 440 427 867 $ 3,055 (1,694) (894) 467 362 829 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 declined in 2006 from the level of 2005 and 2004. We discuss our future obligations for claims payments in Contractual Obligations, Page 61, and our future obligations for underwriting expenses in Commissions and Other Underwriting Expenses, Page 62. Insurance subsidiary operating cash flow remained stable over the three years, however, due to rising investment income. Based on our outlook for commercial lines, personal lines and life insurance, we believe that cash flows from underwriting could decline again in 2007. A lower level of cash flow available for investment could lead to lower investment income and reduced potential for capital gains. 2006 10-K Page 59 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 56, investment income rose in each of the past three years, and we expect investment income could grow 6.5 percent to 7.0 percent in 2007. 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 continued to decline in 2006 as interest rates generally shifted upward. • Sales of equity securities investments – The decision to divest an equity position is generally reached after careful analysis regarding the direction the company is headed and how well it meets our investment parameters. In 2006, we completed the sale of our Alltel common stock holdings and made other sales of all or part of smaller holdings. 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 2007, 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 dividend growth and capital appreciation. Capital Resources 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 $5.244 billion and $5.067 billion at year-end 2006 and 2005, respectively. On an after-tax basis, it constituted 49.6 percent of total shareholders' equity at year-end 2006. At year-end 2006, our debt-to-capital ratio was 11.0 percent. Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2007. As a result, we believe our debt-to-capital ratio will remain approximately 11 percent. We had $791 million of long-term debt and $49 million in 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 93. None of the notes are encumbered by rating triggers. On April 28, 2006, A.M. Best affirmed its senior debt ratings and issuer credit rating (ICR) of aa- of Cincinnati Financial Corporation. On September 15, 2006, Fitch Ratings affirmed its AA- issuer default rating and A+ senior debt ratings of Cincinnati Financial Corporation. Moody’s maintains our senior debt ratings at A2-. On July 25, 2006, Standard & Poor’s Ratings Services affirmed its A (Strong) counterparty credit rating on Cincinnati Financial Corporation. At December 31, 2006, we had two lines of credit totaling $125 million with $49 million outstanding. 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 and renewed annually. It is available for general corporate purposes and contains customary financial covenants. During 2006, CFC Investment Company, our commercial leasing and financing subsidiary, replaced $49 million of intercompany debt with $49 million in borrowings against our $75 million line of credit to improve cash flow for the parent company. This line of credit matures on February 28, 2007, and we expect to renew it under terms and conditions that are essentially unchanged. During 2006, we entered into an interest-rate swap as an economic cash flow hedge of variable interest payments for certain variable-rate debt obligations ($49 million notional amount). Under this interest-rate swap contract, we have agreed to pay a fixed rate of interest for a three-year period. The contract is intended to be a hedge against changes in the amount of future cash flows associated with the related interest payments. The interest-rate swap contract is reflected at fair value in our balance sheet. SFAS No. 133 “Accounting for Derivative Financial Instruments and Hedging Activities,” as amended, requires changes in the fair value of the 2006 10-K Page 60 company’s derivative financial instruments to be recognized periodically as realized gains or losses on the consolidated statement of income or as a component of accumulated other comprehensive income in shareholders’ equity, respectively. We recorded a $324,000 investment loss in 2006 due to the decline in the fair value of the interest-rate swap. In October 2006, we completed the necessary requirements for the interest-rate swap to qualify for hedge accounting treatment under SFAS No. 133. We expect that the interest-rate swap will be a highly effective hedge and that future changes in the fair value of the interest-rate swap will be recorded as a component of accumulated other comprehensive income. As a result, we do not expect any significant amounts to be reclassified into earnings in the next 12 months. 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 obligations and other commitments. In addition, one of our primary uses of cash is to enhance shareholder return. Contractual Obligations At December 31, 2006, we estimated our future contractual obligations as follows: (In millions) Interest on long-term debt Long-term debt Short-term debt Annuitization obligations Headquarters building expansion Computer hardware and software Other invested assets Net life claims payments Subtotal Net property casualty claims payments Total Within 1 year Payment due by period Years Years 4-5 2-3 More than 5 years Total $ $ 52 $ 0 49 17 45 9 10 9 191 1,074 1,265 $ 104 $ 0 0 47 17 11 12 0 191 1,150 1,341 $ 104 $ 0 0 30 0 2 3 0 139 493 632 $ 996 $ 795 0 104 0 0 1 0 1,896 639 2,535 $ 1,256 795 49 198 62 22 26 9 2,417 3,356 5,773 Long-term Debt and Interest on Long-Term Debt Our estimate of material commitments for interest on long-term debt was approximately 21.8 percent and our estimate of material commitments for long-term debt was 13.8 percent of the estimated contractual obligations at year-end 2006. Our interest expense remained unchanged in 2006 at an annual rate of approximately $52 million. We generally have tried to minimize our reliance on debt financing and do not expect a material increase in interest expense from long-term debt in the near future. Short-term Debt Our estimate of material commitments for short-term debt was 1.0 percent of material commitments at year-end 2006. On February 28, 2007, we plan to renew our $49 million outstanding note payable drawn on our $75 million in line of credit. Annuitization Obligations Our estimate of material commitments for obligations due under annuities written by our life insurance subsidiary was approximately 3.4 percent of the estimated contractual obligations at year-end 2006. Headquarters Building Expansion The completion of our new office building and parking garage to be situated at our headquarters located in Fairfield is expected to require approximately $62 million over the next two years. The construction project is on schedule and on budget. As of December 31, 2006, construction costs totaled $41 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. 2006 10-K Page 61 Computer Hardware and Software We expect to need approximately $22 million over the next five years for current 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 2007. Property Casualty Claims Payments Our estimate of material commitments for net property casualty claims payments was approximately 58.1 percent of the estimated contractual obligations at year-end 2006. We direct our associates to settle claims and pay losses as quickly as practical and made $1.763 billion in net claim payments during 2006. At year-end 2006, we had net property casualty reserves of $3.356 billion, reflecting $1.843 billion in unpaid amounts on reported claims (case reserves), $771 million in loss expense reserves and $742 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 63. 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 effective duration of our fixed-maturity portfolio was 5.1 years at year-end 2006. By contrast, the duration of our loss and loss expense reserves was 2.9 years and the duration of all liabilities was 2.6 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow 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. Other Commitments In addition to our contractual obligations, we have other operational commitments. Commissions and Other Underwriting Expenses As discussed above, commissions and non-commission 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 42 and Page 49. 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. Commission payments generally track with written premiums. Contingent commission payments in 2007 will be influenced by the decline in profitability we experienced in 2006. 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 2007, reflecting the 2.9 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 $35 million in key technology initiatives in 2007, of which approximately $14 million will be capitalized. Technology projects for 2007 include continued spending on our personal lines policy processing system and investment in the development and rollout of our commercial lines policy processing system that we discuss in Item 1, Technology Solutions, Page 4. Capitalized development costs related to key technology initiatives totaled $15 million in 2006. These activities are conducted at our discretion and we have no material contractual obligations for activities planned as part of these projects. 2006 10-K Page 62 Data Processing and Disaster Recovery Center We expect to spend approximately $5 million in 2007 to begin renovation of a newly purchased building that will serve as our data processing and disaster recovery center. Qualified Pension Plan Effective in 2008, the Pension Protection Act of 2006 changes the manner in which pension funding is determined. We currently are assessing the impact of this Act but do not except it to have a material effect on our results of operations or financial position. We anticipate contributing $10 million to the plan in 2007. Investing Activities After fulfilling operating requirements, 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 14, for a discussion of our investment strategy, portfolio allocation and quality. From the second quarter of 2004 until year-end 2005, virtually all of our available cash flow was used to purchase fixed-maturity investments to reduce our property casualty subsidiary’s ratio of common stock to statutory surplus. In 2006, equity purchases returned to a more significant level. In 2007 we anticipate a resumption of active equity investing while also continuing to be cognizant of rating agency and regulatory guidelines. See Item 1, Investments Segment, Page 14, for a discussion of our investment strategy, portfolio allocation and quality. 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 38 percent of net income as dividends, with the remaining 62 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 2007, the board of directors authorized a 6.0 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.42 per share. In 2006, 2005 and 2004, we paid cash dividends of $228 million and $204 million and $177 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 from share-based compensation. In 2006, 2005 and 2004, we used $120 million, $63 million and $66 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 2006, 6.8 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 26. Between February 1999 and year-end 2006, we have repurchased 17.4 million shares at a total cost to the company of $661 million. We do not adjust the number of shares repurchased and average price per repurchased share for stock dividends. PROPERTY CASUALTY INSURANCE RESERVES At year-end 2006, the total reserve balance, net of reinsurance, was $3.356 billion, compared with $3.111 billion at year-end 2005 and $2.977 billion at year-end 2004. 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 92. The reserves reflected in the consolidated financial statements are management’s best estimate. The appointed actuary's range for adequate statutory reserves, net of reinsurance, was $3.194 billion to $3.440 billion for 2006; $2.921 billion to $3.153 billion for 2005; and $2.794 billion to $3.032 billion for 2004. 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 activity • Higher initial case reserves on liability claims 2006 10-K Page 63 • Workers’ compensation case reserving practices • • Increased loss expenses due to higher legal fees Judicial decisions and mass tort claims • Changes in reinsurance treaty retentions • Loss cost inflation in selected lines • Higher loss adjustment expense due to a claims mediation process that promotes earlier liability settlement resolution 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 66, 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, contributing to favorable loss reserve trends. As we discuss in Personal Lines Insurance Segment Reserves, Page 68, 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 2006, we reviewed each of our established workers’ compensation case reserves above $100,000 in light of current trends in medical cost inflation and estimated payout periods. The review led to the allocation of additional amounts to case reserves held for specific claims from accident years going back as many as 20 years. Our intent is to bring workers’ compensation case reserve adequacy more in line with our other business lines although our success may be affected by additional medical cost inflation and longer life spans. In 2003 and 2004, $70 million in reserves were released following the November 2003 Ohio Supreme Court's decision limiting its 1999 Scott-Pontzer v. Liberty Mutual decision. The reserve releases were primarily made in the commercial auto and commercial casualty 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 casualty 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 the commercial casualty business line. 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, 2006, 2005 and 2004, in Item 8, Note 4 to the Consolidated Financial Statements, Page 92. The reconciliation of our year-end 2005 reserve balance to net incurred losses one year later recognizes approximately $116 million in redundant reserves. The table on Page 65 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 unpaid loss and loss expenses for claims arising in the indicated calendar year and all prior accident years 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, 2006, we had paid $1.175 billion of loss and loss expenses in calendar years 1997 through 2006, for losses that occurred in accident years 1996 and prior. An estimated $148 million of losses remained unpaid as of year-end 2006 (net re-estimated reserves of $1.323 billion from Section C less cumulative paid loss and loss expenses of $1.175 billion). 2006 10-K Page 64 • 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, 1996, had developed a $379 million redundancy over 10 years, net of reinsurance, which was reflected in income over the 10 years. The table shows redundant reserves as a negative number. The effects on income in 2006, 2005 and 2004 of changes in estimates of the reserves for loss and loss expenses for all accident years are shown in the reconciliation below. 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 2006 but incurred in 2000 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. (In millions) A. Originally reported reserves for unpaid loss and loss expenses: 1996 1997 1998 1999 Calendar year ended December 31, 2001 2000 2002 2003 2004 2005 2006 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 Cumulative gross redundancy $ $ $ $ $ $ $ $ 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 $ 3,860 504 3,356 453 $ 732 884 992 1,049 1,093 1,123 1,146 1,159 1,175 1,582 $ 1,470 1,405 1,380 1,326 1,333 1,333 1,332 1,305 1,323 (120) $ (232) (297) (322) (376) (369) (369) (370) (397) (379) 499 $ 761 965 1,075 1,152 1,205 1,239 1,260 1,279 1,623 $ 1,551 1,520 1,465 1,466 1,463 1,460 1,435 1,456 (154) $ (226) (257) (312) (311) (314) (317) (342) (321) 522 $ 833 1,067 1,207 1,283 1,333 1,366 1,390 591 $ 943 1,195 1,327 1,412 1,464 1,496 697 $ 758 $ 799 $ 817 $ 907 $ 944 1,116 1,378 1,526 1,623 1,680 1,194 1,455 1,614 1,717 1,235 1,519 1,716 1,293 1,626 1,426 1,724 $ 1,728 1,636 1,615 1,608 1,602 1,577 1,593 1,912 $ 1,833 1,802 1,771 1,757 1,733 1,739 2,120 $ 2,083 2,052 2,010 1,999 1,992 2,307 $ 2,263 2,178 2,153 2,127 (116) $ (112) (204) (225) (232) (238) (263) (247) (20) $ (99) (130) (161) (175) (199) (193) (62) $ (99) (130) (172) (183) (190) (45) $ (89) (174) (199) (225) 2,528 $ 2,377 2,336 2,299 2,649 $ 2,546 2,489 2,817 $ 2,743 2,995 (80) $ (231) (272) (309) (196) $ (299) (356) (160) $ (234) (116) 1,323 $ 183 1,506 $ 1,456 $ 198 1,654 $ 1,593 $ 224 1,817 $ 1,739 $ 230 1,969 $ 1,992 $ 259 2,251 $ 2,127 $ 532 2,659 $ 2,299 $ 568 2,867 $ 2,489 $ 547 3,036 $ 2,743 $ 551 3,294 $ 2,995 517 3,512 (318) $ (235) $ (161) $ (124) $ (150) $ (206) $ (283) $ (350) $ (220) $ (117) 2006 10-K Page 65 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 0.6 percent of total loss and loss expenses in 2006, compared with $12 million, or 0.7 percent in 2005 and $42 million, or 2.4 percent, in 2004. Net reserves for all asbestos and environmental claims were $131 million in 2006 compared with $130 million in 2005 and $128 million in 2004. Net reserves for all asbestos and environmental claims were 3.9 percent, 4.2 percent and 4.3 percent of total reserves in 2006, 2005 and 2004, 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 we have revised policy terms where permitted by state regulation to limit our exposure to mold and other environmental risks going forward. 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 is partially due to our growth. The increase also reflected higher loss expense reserves due to a claims mediation process that promoted earlier liability settlement resolution and increased loss expenses due to higher legal fees. In addition, commercial casualty, workers’ compensation and surety and executive risk gross reserves rose because of the increase in large losses as we discussed in Commercial Lines Insurance Results of Operations, Page 42. Reserve practices discussed above also contributed. (In millions) At December 31, 2006 Commercial casualty Commercial property Commercial auto Workers' compensation Specialty packages Surety and executive risk Machinery and equipment Total At December 31, 2005 Commercial casualty Commercial property Commercial auto Workers' compensation Specialty packages Surety and executive risk Machinery and equipment Total Loss reserves Case reserves IBNR reserves Loss expense reserves Total gross reserves Percent of total $ $ $ $ 923 $ 132 274 411 80 67 5 1,892 $ 859 $ 135 268 283 63 36 3 1,647 $ 437 $ 31 52 277 1 1 3 802 $ 451 $ 40 55 333 0 0 3 882 $ 483 36 64 99 5 32 1 720 $ 423 $ 36 65 79 12 32 0 647 $ 1,843 199 390 787 86 100 9 3,414 1,733 211 388 695 75 68 6 3,176 54.0 % 5.8 11.4 23.1 2.5 2.9 0.3 100.0 % 54.6 % 6.6 12.2 21.9 2.4 2.1 0.2 100.0 % 2006 10-K Page 66 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, 2006 2005 accident year 2004 accident year 2003 accident year 2002 accident year 2001 accident year 2000 accident year 1999 and prior accident years Deficiency/(redundancy) Reserves as originally estimated Reserves re-estimated as of December 31, 2006 Deficiency/(redundancy) Impact on loss and loss expense ratio 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 Deficiency/(redundancy) Reserves as originally estimated Reserves re-estimated as of December 31, 2005 Deficiency/(redundancy) Impact on loss and loss expense ratio As of December 31, 2004 2001 accident year 2000 accident year 1999 accident year 1998 accident year 1997 accident year 1996 accident year 1995 and prior accident years Deficiency/(redundancy) Reserves as originally estimated Reserves re-estimated as of December 31, 2004 Deficiency/(redundancy) Impact on loss and loss expense ratio Commercial casualty Commercial property Commercial auto Workers' compensation Specialty packages Surety & executive risk Machinery & equipment Totals $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ (52) (21) (12) 2 (9) (9) 2 (99) 1,359 1,260 (99) (12.0) % (78) (51) (17) (7) 8 (1) (25) (171) 1,332 1,161 (171) (22.5) % (46) (44) (27) (19) (1) (1) 2 (136) 1,280 1,144 (136) (20.0) % $ $ $ $ $ $ $ $ $ $ $ $ 17 (3) (3) (1) (4) (1) 0 5 160 165 5 0.9 % 23 (3) (3) (1) 0 0 1 17 104 121 17 3.5 % 7 (2) (7) 0 0 0 0 (2) 101 99 (2) (0.3) % $ $ $ $ $ $ $ $ $ $ $ $ (17) 1 1 (2) (2) (1) (1) (21) 386 365 (21) (4.6) % (15) (5) (1) (1) 0 0 (1) (23) 372 349 (23) (5.0) % (11) (10) (4) (5) (7) (3) (8) (48) 382 334 (48) (10.5) % $ $ $ $ $ $ $ $ $ $ $ $ (2) 5 0 (3) (1) 1 9 9 634 643 9 2.6 % 9 13 8 3 3 3 2 41 558 599 41 12.9 % (5) 1 6 3 2 1 6 14 515 529 14 4.9 % $ $ $ $ $ $ $ $ $ $ $ $ 3 (1) 1 0 0 (1) 0 2 73 75 2 1.6 % 7 3 2 0 2 0 1 15 72 87 15 10.9 % 3 1 1 0 0 0 0 5 75 80 5 3.7 % $ $ $ $ $ $ $ $ $ $ $ $ 7 (3) (1) 1 1 0 0 5 63 68 5 6.3 % 2 (4) 0 (1) 0 0 (1) (4) 64 60 (4) (5.4) % (1) (3) (1) (1) 0 0 (1) (7) 57 50 (7) (9.3) % $ $ $ $ $ $ $ $ $ $ $ $ 1 0 0 0 0 0 0 1 6 7 1 2.8 % (1) 0 0 0 0 0 0 (1) 5 4 (1) (3.7) % 0 0 0 0 0 0 0 0 5 5 0 (1.3) % (43) (22) (14) (3) (15) (11) 10 (98) 2,681 2,583 (98) (4.1) % (53) (47) (11) (7) 13 2 (23) (126) 2,507 2,381 (126) (5.6) % (53) (57) (32) (22) (6) (3) (1) (174) 2,415 2,241 (174) (8.2) % 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 commercial casualty. 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 The initiative, begun in 2000 and expanded to other states in 2004, to use a claims mediation process that promotes earlier liability settlement resolution Increased loss expenses due to higher legal fees • Workers’ compensation claim reserve practices • Higher than expected medical inflation affecting the workers’ compensation line • Changes in reinsurance treaty retentions • 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 2006 10-K Page 67 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 2005 due to the decline in premiums in this business line. Homeowner gross reserves reflected the increase in large losses as we discussed in Personal Lines Insurance Results of Operations, Page 49. (In millions) At December 31, 2006 Personal auto Homeowners Other personal Total At December 31, 2005 Personal auto Homeowners Other personal Total Loss reserves Case reserves IBNR reserves Loss expense reserves Total gross reserves Percent of total $ $ $ $ 169 $ 69 55 293 $ 175 $ 70 52 297 $ 5 $ 24 61 90 $ 4 $ 21 67 92 $ 32 $ 17 14 63 $ 34 $ 18 12 64 $ 206 110 130 446 213 109 131 453 46.2 % 24.7 29.1 100.0 % 47.1 % 24.0 28.9 100.0 % 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, 2006 2005 accident year 2004 accident year 2003 accident year 2002 accident year 2001 accident year 2000 accident year 1999 and prior accident years Deficiency/(redundancy) Reserves as originally estimated Reserves re-estimated as of December 31, 2006 Deficiency/(redundancy) Impact on loss and loss expense ratio As of December 31, 2005 2002 accident year 2001 accident year 2000 accident year 1999 accident year 1998 accident year 1997 accident year 1996 and prior accident years Deficiency/(redundancy) Reserves as originally estimated Reserves re-estimated as of December 31, 2005 Deficiency/(redundancy) Impact on loss and loss expense ratio As of December 31, 2004 2001 accident year 2000 accident year 1999 accident year 1998 accident year 1997 accident year 1996 accident year 1995 and prior accident years Deficiency/(redundancy) Reserves as originally estimated Reserves re-estimated as of December 31, 2004 Deficiency/(redundancy) Impact on loss and loss expense ratio Personal auto Homeowner Other personal Totals $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 4 6 (3) (2) (2) (1) 0 2 213 215 2 0.6 % 0 0 (3) (4) (1) 0 0 (8) 231 223 (8) (1.9) % 9 1 (3) (3) (1) (1) (1) 1 224 225 1 0.2 % $ $ $ $ $ $ $ $ $ $ $ $ 5 1 0 (1) 0 0 0 5 99 104 5 1.5 % 0 (2) 0 0 0 1 0 (1) 114 113 (1) (0.4) % (1) (1) (4) (1) 0 0 0 (7) 90 83 (7) (2.7) % (7) (2) (4) (4) (2) (3) (3) (25) 118 93 (25) (28.6) % (5) (11) (3) (3) 0 0 (3) (25) 125 100 (25) (28.7) % (3) (4) (5) (3) 0 0 (1) (16) 116 100 (16) (18.9) % $ $ $ $ $ $ $ $ $ $ $ $ 2 5 (7) (7) (4) (4) (3) (18) 430 412 (18) (2.4) % (5) (13) (6) (7) (1) 1 (3) (34) 470 436 (34) (4.3) % 5 (4) (12) (7) (1) (1) (2) (22) 430 408 (22) (2.8) % 2006 10-K Page 68 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: • The initiative, begun in 2001, to establish higher initial case reserves on liability claims in the period in which the claim is reported • Settlements that differed from the established case reserves • Changes in reinsurance treaty retentions • 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 $1.409 billion at year-end 2006, compared with $1.343 billion at year-end 2005. 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. Some of our universal life insurance policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance based on expected no-lapse guarantee benefits and expected policy assessments. 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. 2007 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 and financial 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 (RMS) and Applied Insurance Research (AIR) models to evaluate exposures 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 Hannover Reinsurance Company, Munich Reinsurance America, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation and its subsidiaries, 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 European markets. Primary components of the 2007 property and casualty reinsurance program include: • Property per risk treaty – The primary purpose of the property treaty is to provide 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 $35 million for 2007, compared with $30 million in 2006 and $29 million in 2005. We retain the first $4 million of each loss. Losses between $4 million and $25 million are reinsured at 100 percent. 2006 10-K Page 69 • Casualty per occurrence treaty – The casualty treaty provides 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 $50 million in 2007, compared with $45 million in 2006 and $64 million in 2005. We retain the first $4 million of each loss. Losses between $4 million and $25 million are reinsured at 100 percent. We have modified our casualty per occurrence treaty for director and officer policies for four Fortune 1000 companies and one financial services company. For one of the five companies, our retention could be as high as $15 million rather than the $4 million for a typical policy; for one of the companies, our retention could be as high as $10 million; for the remaining three 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 2007 and is comparable with the premium paid in 2006. 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 2007, comparable with the premium paid in 2006. • 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 2007 treaty, ceded premiums are estimated to be $49 million, up from $38 million in 2006, and $29 million, excluding the reinstatement premium, in 2005. The premium increase for 2007 primarily was due to the difficult market conditions brought on in part by the record catastrophe losses experienced by reinsurance companies in recent years. Our retention on this program remains at $45 million and we will retain: ○ 5 percent of losses between $45 million and $200 million ○ 14 percent of losses between $200 million and $300 million ○ 18 percent of losses between $300 million and $500 million Our maximum exposure to a 2007 catastrophic event that resulted in $500 million in losses would be $103 million compared with $68 million in 2006. The largest catastrophe loss in our history was $87 million before reinsurance. 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 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 five 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. In addition, our property catastrophe treaty provides coverage for personal risks and the majority of our reinsurers provide limited coverage for commercial risks with total insured values of $10 million or less. 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 2006 10-K Page 70 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, and contains protection for extra-contractual liability coverage losses. For term life insurance business written prior to 2005, we retain 10 percent to 25 percent of each term policy, not to exceed $500,000, ceding the balance or mortality risk and policy reserve. 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 our Item 1A, Risk Factors, Page 20. 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 Increased frequency and/or severity of claims Inaccurate estimates or assumptions used for critical accounting estimates • • • Events or actions, including unauthorized intentional circumvention of controls, that reduce the company’s future ability to maintain effective internal control over financial reporting under the Sarbanes-Oxley Act of 2002 • 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 ○ Perceptions that the company’s level of service, particularly claims service, is no longer a distinguishing characteristic in the marketplace • Delays or inadequacies in the development, implementation, performance and benefits of technology projects and enhancements • Ability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased, financial strength of reinsurers and the potential for non-payment or delay in payment by reinsurers • 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 • Actions of insurance departments, state attorneys general or other regulatory agencies that: ○ Restrict our ability to exit or reduce writings of unprofitable coverages or lines of business ○ Place the insurance industry under greater regulatory scrutiny or result in new statutes, rules and regulations Increase our expenses ○ ○ Add assessments for guaranty funds, other insurance related assessments or mandatory reinsurance arrangements; or that impair our ability to recover such assessments through future surcharges or other rate changes ○ Limit our ability to set fair, adequate and reasonable rates ○ Place us at a disadvantage in the marketplace or ○ Restrict our ability to execute our business model, including the way we compensate agents • Sustained decline in overall stock market values negatively affecting the company’s equity portfolio and book value; in particular a sustained decline in the market value of Fifth Third shares, a significant equity holding • Recession or other economic conditions or regulatory, accounting or tax changes resulting in lower demand for insurance products 2006 10-K Page 71 • 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 or interest-rate fluctuations that result in declining values of fixed-maturity investments • Adverse outcomes from litigation or administrative proceedings • Investment activities or market value fluctuations that trigger restrictions applicable to the parent company under the Investment Company Act of 1940 • Events, such as an avian flu epidemic, natural catastrophe, terrorism or construction delays, that could hamper our ability to assemble our workforce at our headquarters location 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. 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 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. 2006 10-K Page 72 Risks associated with the five asset classes described in Item 1, Investments Segment, Page 14, 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 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 untimely redemptions of currently callable securities. 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 effective duration of the fixed-maturity portfolio is continually monitored by our investment department to evaluate the theoretical impact of interest rate movements. 2006 10-K Page 73 The table below summarizes the effect of hypothetical changes in interest rates on the fixed-maturity portfolio: (In millions) At December 31, 2006 At December 31, 2005 Fair value of fixed maturity portfolio 100 basis point spread decrease Effective duration $ 5,805 $ 5,476 6,099 $ 5,759 100 basis point spread increase 5,511 5,194 The effective duration of the fixed maturity portfolio is currently 5.1 years. A 100 basis point movement in interest rates would result in an approximately 5.1 percent change in the market value of the fixed maturity portfolio. Generally speaking, the higher a bond is rated, the more directly correlated movements in its market value will be to changes in the general level of interest rates, exclusive of call features. The market values of average- to lower-rated corporate bonds are additionally influenced by the expansion or contraction of credit spreads. In prior reporting periods we have expressed our interest rate sensitivity using both modified duration and duration to worst measures. Going forward, we will use effective duration, a measure we believe more accurately depicts duration on an option-adjusted basis. 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 can 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, 2006, the company held 13 individual equity positions valued at approximately $100 million or above, see Item 1, Investments Segment, Page 14, for additional details on these holdings. These equity positions accounted for approximately 91.8 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. Our investments are heavily weighted toward the financials sector, which represented 66.6 percent of the total fair value of the common stock portfolio at December 31, 2006. 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 our 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, 2006, our compound annual equity portfolio return was 2.0 percent compared with a compound annual total return of 6.2 percent for the Standard & Poor’s 500 Index, a common benchmark of market performance. In 2006, our annual equity portfolio return was 16.1 percent, compared with an annual total return of 15.8 percent for that Index. Our equity portfolio underperformed the market for the five-year period because of the decline in the market value of our holdings of Fifth Third common stock between 2002 and year-end 2005. The primary risks related to preferred stocks are similar to those related to investment grade corporate bonds. Falling interest rates adversely affect market values due to the normal inverse relationship between rates and yields. Credit risk exists due to the subordinate position of preferred stocks 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. 2006 10-K Page 74 Fifth Third Bancorp Holding One of our common stock holdings, Fifth Third, accounted for 25.7 percent of our shareholders’ equity at year-end 2006 and dividends earned from our Fifth Third investment were 20.2 percent of our investment income in 2006. (In millions except market price data) Fifth Third Bancorp common stock holding: Dividends earned Percent of total net 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 $ $ Years ended December 31, 2005 2006 $ 115 20.2 % 106 20.2 % At December 31, 2006 At December 31, 2005 $ 73 40.93 283 2,979 1,752 38.2 % 21.7 43.8 25.7 73 37.72 283 2,745 1,600 38.6 % 21.6 45.1 26.3 Based on 2006 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 $10 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 2006 closing price would result in a $596 million change in assets and a $387 million change in after-tax unrealized gains. The market value of Fifth Third, our largest holding, has been affected by the residual effects of a regulatory review concluded in 2004 and, more recently, by a difficult interest rate environment. We believe that its management team can execute on the strategy for growth its management has defined. During this challenging period for the bank, we have continued to benefit from its superior dividend growth. In June 2006, Fifth Third increased its indicated annual dividend by 5.3 percent, which is expected to contribute an additional $6 million to investment income on an annualized basis. UNREALIZED INVESTMENT GAINS AND LOSSES At December 31, 2006, unrealized investment gains before taxes totaled $5.303 billion and unrealized investment losses in the investment portfolio amounted to $59 million. Unrealized Investment Gains The unrealized gains at December 31, 2006, were due to long-term gains from our holdings of Fifth Third common stock, which contributed 51.9 percent of the gain, and from our other common stock holdings, including ExxonMobil Corporation, The Procter & Gamble Company and PNC Financial Services Group, which each contributed at least 5 percent of the gain. Reflecting the company’s long-term investment philosophy, of the 1,294 securities trading at or above book value, 633, or 48.9 percent, have shown unrealized gains for more than 24 months. Unrealized Investment Losses – Potential Other-than-temporary Impairments During 2006 and 2005, a total of three 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, 2006, 679 of the 1,973 securities we owned were trading below 100 percent of book value compared with 732 of the 1,814 securities we owned at December 31, 2005, and 208 of the 1,593 securities we owned at December 31, 2004. The 679 holdings trading below book value at December 31, 2006, represented 19.8 percent of invested assets and $59 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. • 671 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 671 securities was $2.698 billion at December 31, 2006, and they accounted for $55 million in unrealized losses. 2006 10-K Page 75 • Eight of these holdings were trading below 90 percent of book value at December 31, 2006. The fair value of these holdings was $30 million, and they accounted for the remaining $4 million in unrealized losses. These holdings are being monitored for credit- and industry-related risk factors, but we believe the changes in value primarily are due to normal fluctuations and economic factors. Of these securities, the largest is a media-related convertible debenture with a fair value of $9 million and an unrealized loss of $1.5 million. No other security had an unrealized loss in excess of $1 million. • No holdings were trading below 70 percent of book value at December 31, 2006. As discussed in Critical Accounting Estimates, Asset Impairment, Page 37, when evaluating other-than-temporary impairments, we consider our intent and 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 on economic, industry or company factors. The following table summarizes the length of time securities in the investment portfolio have been in a continuous unrealized gain or loss position. (Dollars in millions) 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 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 0 $ 28 145 173 0 95 437 532 0 0 7 7 0 0 24 24 0 1 2 3 0 124 615 739 $ 0 (2) 12 10 0 (1) 9 8 0 0 10 10 0 0 6 6 0 0 0 0 0 (3) 37 34 0 $ 55 12 67 0 12 14 26 0 1 6 7 0 2 2 4 0 0 0 0 0 (3) 2 (1) 0 0 1 1 0 (2) 267 265 0 0 0 0 0 0 0 0 0 $ 195 7 202 0 213 3 216 0 1 2 3 0 1 0 1 0 0 0 0 0 (33) 1 (32) 0 (3) 0 (3) 0 0 14 14 0 0 0 0 0 0 0 0 0 $ 40 258 298 0 34 337 371 0 0 33 33 0 1 5 6 0 0 0 0 0 (12) 67 55 0 (2) 31 29 0 0 4,875 4,875 0 (1) 8 7 0 0 0 0 0 70 34 104 $ 0 (5) 270 265 0 410 12 422 $ 0 (36) 15 (21) 0 75 633 708 $ 0 (15) 4,981 4,966 2006 10-K Page 76 The following table summarizes the investment portfolio: (Dollars in millions) Number of issues Book value Fair value Gross unrealized gain/loss Gross investment income At December 31, 2006 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, 2005 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 0 $ 0 $ 0 $ 0 $ 318 422 0 740 0 354 791 0 1,145 0 2 48 0 50 0 4 31 0 35 0 1 2 0 3 1,943 1,414 0 3,357 0 785 1,597 0 2,382 0 35 2,365 0 2,400 0 18 203 0 221 0 6 89 0 95 1,893 1,496 0 3,389 0 778 1,638 0 2,416 0 33 7,531 0 7,564 0 18 217 0 235 0 6 89 0 95 (50) 82 0 32 0 (7) 41 0 34 0 (2) 5,166 0 5,164 0 0 14 0 14 0 0 0 0 0 0 679 1,294 0 1,973 $ 2 $ 730 1,082 0 1,814 $ 0 2,787 5,668 0 8,455 $ 12 $ 2,894 4,684 0 7,590 $ 0 2,728 10,971 0 13,699 $ 8 $ 2,820 9,829 0 12,657 $ 0 (59) 5,303 0 5,244 $ (4) $ (74) 5,145 0 5,067 $ 0 100 93 10 203 0 26 72 3 101 0 0 240 1 241 0 1 11 0 12 0 0 0 5 5 0 127 416 19 562 1 118 387 18 524 2006 10-K Page 77 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, 2006, 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, 2006. Their report is on Page 80. 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. 2006 10-K Page 78 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, 2006, 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, 2006. The assessment led management to conclude that, as of December 31, 2006, 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, 2006, and the company’s management assessment of our internal control over financial reporting. This report appears below. /S/ John J. Schiff, Jr. ___________________________ John J. Schiff, Jr., CPCU Chairman and Chief Executive Officer /S/ Kenneth W. Stecher ___________________________ Kenneth W. Stecher Chief Financial Officer, Executive Vice President, Secretary and Treasurer (Principal Accounting Officer) February 23, 2007 2006 10-K Page 79 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Shareholders and Board of Directors of Cincinnati Financial Corporation: We have audited the consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the company) as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. 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 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, 2006, 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, 2006 and 2005, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, 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, 2006, 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, 2006, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As discussed in Note 1 to the Consolidated Financial Statements, the company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share Based Payment, on January 1, 2006, and the recognition and related disclosure provisions of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension Plans and Other Postretirement Benefit Plans on December 31, 2006. /S/ Deloitte & Touche LLP Cincinnati, Ohio February 23, 2007 2006 10-K Page 80 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Dollars in millions except per share data) ASSETS Investments Fixed maturities, at fair value (amortized cost: 2006—$5,739; 2005—$5,387) Equity securities, at fair value (cost: 2006—$2,621; 2005—$2,128) Short-term investments, at fair value (amortized cost: 2006—$95; 2005—$75) Other invested assets Total investments 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: 2006—$261; 2005—$232) Other assets Separate accounts Total assets LIABILITIES Insurance reserves Loss and loss expense reserves Life policy reserves Unearned premiums Other liabilities Deferred income tax Note payable 6.125% senior notes due 2034 6.9% senior debentures due 2028 6.92% senior debentures due 2028 Separate accounts Total liabilities Commitments and contingent liabilities (Note 15) SHAREHOLDERS' EQUITY Common stock, par value—$2 per share; (authorized: 2006—500 million shares, 2005—500 million shares; issued: 2006—196 million shares, 2005—194 million shares) Paid-in capital Retained earnings Accumulated other comprehensive income Treasury stock at cost (2006—23 million shares, 2005—20 million shares) Total shareholders' equity Total liabilities and shareholders' equity Accompanying notes are an integral part of this statement. December 31, 2006 December 31, 2005 5,805 $ 7,799 95 60 13,759 202 121 108 1,128 683 13 453 193 58 504 17,222 $ 3,896 $ 1,409 1,579 533 1,653 49 371 28 392 504 10,414 5,476 7,106 75 45 12,702 119 117 105 1,116 681 14 429 168 66 486 16,003 3,661 1,343 1,559 455 1,622 0 371 28 392 486 9,917 — — 391 1,015 2,786 3,379 (763) 6,808 17,222 $ 389 969 2,088 3,284 (644) 6,086 16,003 $ $ $ $ 2006 10-K Page 81 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 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. 2006 Years ended December 31, 2005 2004 3,163 $ 115 570 684 18 4,550 2,128 630 354 77 (21) 53 3,221 1,329 404 (5) 399 930 $ 5.36 $ 5.30 3,058 $ 106 526 61 16 3,767 1,911 627 302 72 (19) 51 2,944 823 188 33 221 602 $ 3.44 $ 3.40 2,919 101 492 91 11 3,614 1,846 615 270 75 (30) 38 2,814 800 171 45 216 584 3.30 3.28 $ $ $ 2006 10-K Page 82 CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY 2006 Years ended December 31, 2005 2004 (In millions) 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 Share-based compensation 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 Other comprehensive income, net Cumulative effect of change in accounting for pension obligations End of year TREASURY STOCK Beginning of year Purchase Reissued End of year $ 389 $ 0 2 391 370 $ 18 1 389 969 0 0 28 17 1 1,015 2,088 930 0 (232) 2,786 3,284 127 (32) 3,379 (644) (120) 1 (763) 618 341 0 9 0 1 969 2,057 602 (359) (212) 2,088 3,787 (503) 0 3,284 (583) (63) 2 (644) Total shareholders' equity $ 6,808 $ 6,086 $ COMMON STOCK - NUMBER OF SHARES OUTSTANDING Beginning of year 5% stock dividend Shares issued Purchase of treasury shares End of year COMPREHENSIVE INCOME Net income Other comprehensive income, net Total comprehensive income Accompanying notes are an integral part of this statement. 174 0 1 (2) 173 $ $ 930 $ 127 1,057 $ 167 9 0 (2) 174 602 $ (503) 99 $ 2006 10-K Page 83 352 18 0 370 306 312 (3) 3 0 0 618 1,986 584 (330) (183) 2,057 4,084 (297) 0 3,787 (524) (66) 7 (583) 6,249 160 8 0 (1) 167 584 (297) 287 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, amortization and other non-cash items Realized gains on investments Share-based compensation 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 Call or maturity of fixed maturities Sale of equity securities Collection of finance receivables Purchase of fixed maturities Purchase of equity securities 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 of treasury shares Increase in notes payable Proceeds from stock options exercised Contract holder funds deposited Contract holder funds withdrawn Excess tax benefits on share-based compensation Other 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 (net of capitalized interest: 2006—$2; 2005—$1; 2004—$0) Income taxes paid Non-cash activities: Conversion of fixed maturity to equity security and fixed maturity investments Equipment acquired under capital lease obligations Accompanying notes are an integral part of this statement. 2006 10-K Page 84 Years ended December 31, 2005 2004 2006 $ 930 $ 602 $ 38 (684) 17 31 (3) (13) (21) 17 235 81 20 (5) (5) (23) 615 110 343 859 35 (753) (689) (15) (52) (41) 0 (11) (214) 0 0 (228) (120) 49 27 32 (78) 2 (2) (318) 83 119 202 $ 53 $ 429 50 $ 12 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) 0 0 (221) (187) 306 119 $ 51 $ 195 42 $ 0 $ $ $ 584 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) 0 0 (7) 215 91 306 34 188 23 0 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 consolidated 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, 2006, including the 5 percent stock dividend paid April 26, 2005. Share-based Compensation We grant qualified and non-qualified stock options (share-based compensation) under our plans. These stock options are granted to associates at an exercise price that is not less than market price at the date of grant and are exercisable over 10 year periods. Prior to January 1, 2006, we accounted for those plans under the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, as permitted by the Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation. No stock-based employee compensation cost was recognized in the Statement of Income for the years ended December 31, 2005 and 2004, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), Share Based Payment, using the modified-prospective-transition method. We have elected to use the alternative method for determining the beginning balance of the additional paid-in capital pool, as described in FASB Staff Position 123(R)-3. See Note 16, Page 100, for more information regarding our share-based compensation. Property Casualty Insurance Property casualty policy written premiums are deferred and recorded as earned premiums 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. The expenses associated with issuing insurance policies – primarily commissions, premium taxes and underwriting costs – are deferred and amortized over the terms of policies. Certain property casualty policies are not booked before the effective date. An actuarial estimate is made to determine the amount of unbooked written premiums. The majority of the estimate is unearned and does not have a material impact on earned premium. 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 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 year insurance losses and policyholder benefits. The Cincinnati Insurance Companies actively market property casualty insurance policies in 32 states. Our 10 largest states generated 70.0 percent and 69.7 percent of total property casualty premiums in 2006 and 2005. Ohio, our largest state, accounted for 22.0 percent and 22.5 percent of total earned premiums in 2006 and 2005. Agencies in Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each contributed between 4 percent and 10 percent of premium volume in 2006. No single agency relationship accounted for more than 1.2 percent of the company's total agency direct earned premiums in 2006. 2006 10-K Page 85 Policyholder Dividends Certain workers’ compensation policies include the possibility of an insured earning a return of a portion of their premium, called a policyholder dividend. The dividend is generally calculated by determining the profitability of a policy year along with the associated premium. We reserve for all probable future policyholder dividend payments. 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 record premiums 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 policy 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. Some of our universal life policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance, based on expected no-lapse guarantee benefits and expected policy assessments. 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 policy 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. 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. 2006 10-K Page 86 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 related to 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 our general account and is recognized as revenue or expense. Reinsurance We 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 at fair value in the consolidated financial statements. Fixed-maturity investments (taxable bonds, tax-exempt bonds and redeemable preferred stocks) and equity investments (common and non-redeemable preferred stocks) are classified as available for sale and recorded at fair value in the consolidated financial statements. Short-term investments are classified as available for sale and recorded at amortized cost, which approximates fair value, in the consolidated 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 intend to hold 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 effective 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 primarily 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. When a price is not available from these sources, as the case of securities that are not publicly traded, we determine the fair value using quotes from independent brokers. The fair value of investments priced by independent brokers is less than 1 percent of the fair value of our total investment portfolio. 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 and notes payable 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. In 2006, CFC Investment Company, our commercial leasing and financing subsidiary, replaced $49 million of intercompany debt with borrowings against one of our short-term lines of credit to improve cash flow for the parent company. During the third quarter, we entered into an interest-rate swap to manage the variability of interest payments for certain variable-rate debt obligations ($49 million notional amount). Under this interest- rate swap contract, we have agreed to pay a fixed rate of interest for a three-year period. The contract is intended to be a hedge against changes in the amount of future cash flows associated with the related interest 2006 10-K Page 87 payments for our short-term line of credit. The interest-rate swap contract is reflected at fair value in our consolidated balance sheet. SFAS No. 133, as amended, requires changes in the fair value of the company’s derivative financial instruments to be recognized periodically as realized gains or losses on the consolidated statement of income or as a component of accumulated other comprehensive income in shareholders’ equity, respectively. We recognized a $324,000 pretax realized investment loss due to the decline in the fair value of the interest rate swap prior to qualifying for hedge accounting treatment. In October, we completed the necessary requirements for the interest-rate swap to qualify for hedge accounting treatment under SFAS No. 133. We expect that the interest-rate swap will be a highly effective hedge and that future changes in the fair value of the interest-rate swap will be recorded as a component of accumulated other comprehensive income. We do not expect any significant amounts to be reclassified into earnings in the next 12 months. The fair value of the company’s interest rate swap was $430,000 at December 31, 2006. Securities Lending Program In 2006, we began actively participating in a securities lending program under which certain fixed-maturity securities from our investment portfolio are loaned to other institutions for short periods of time. We require collateral in excess of the market value of the loaned securities. The collateral is invested in accordance with our guidelines in high-quality, short-duration instruments to generate additional investment income. The market value of the loaned securities is monitored on a daily basis and additional collateral is added or refunded as the market value of the loaned securities changes. The securities lending collateral is recognized as an asset, and classified as securities lending collateral, with a corresponding liability for the obligation to return the collateral. We maintain the right and ability to redeem the fixed-maturity securities loaned on short notice and continue to earn interest on the securities. We maintain effective control over the securities that we have loaned, which are classified as invested assets on our consolidated balance sheets. Interest income on collateral, net of fees, was $697,000 for the twelve months ended December 31, 2006. At December 31, 2006, we had no securities on loan and held no collateral. We recalled our securities on loan prior to year end for statutory reporting reasons. We have continued the securities lending program in 2007. 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. Certain equipment held under capital leases also is classified as property and equipment with the related lease obligations recorded as liabilities. 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 2006, 2005 and 2004 was $38 million, $33 million and $30 million, respectively. We monitor land, building and equipment for potential impairments. Potential impairments may 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 2006 10-K Page 88 changes) to shareholders’ equity in accumulated other comprehensive income. We charge deferred taxes associated with other differences to income. New Accounting Pronouncements SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, an amendment of SFAS Nos. 133 and 140 In February 2006, Financial Accounting Standards Board (FASB) issued SFAS No. 155. This accounting standard permits fair value re-measurement for any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify them as freestanding derivatives or as hybrid financial instruments containing an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS No. 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument pertaining to a beneficial interest other than another derivative financial instrument. SFAS No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year beginning after September 15, 2006. We adopted SFAS No. 155 on January 1, 2007, to permit fair value re-measurement for our hybrid financial instruments that contain embedded derivatives that required bifurcation under the original provisions of SFAS No. 133. The adoption is not expected to have a material impact on our results of operations or financial position. SFAS No. 157, Fair Value Measurements In September 2006, FASB issued SFAS No. 157, which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 are effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We currently are evaluating the timing and impact of adopting SFAS No. 157 on our financial position. SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of SFAS Nos. 87, 88, 106, and 132(R) In September 2006, FASB issued SFAS No. 158, which requires that we recognize the over-funded or under- funded status of our defined benefit plans as an asset or liability. SFAS No. 158 is effective as of December 31, 2006, with changes in the funded status recognized through accumulated other comprehensive income in the year in which they occur. The adoption of SFAS No. 158 resulted in an increase in liabilities of approximately $32 million on an after-tax basis with a corresponding reduction in accumulated other comprehensive income and shareholders’ equity. SFAS No. 158 did not change the amount of net periodic benefit expense recognized in an entity’s results of operations. SAB No. 108, Considering the Effects of Prior Year Misstatements when Qualifying Misstatements in Current Year Financial Statements In September 2006, the SEC issued Staff Accounting Bulletin (SAB) No. 108 to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that we quantify misstatements based on their impact on each of our financial statements and related disclosures. SAB 108 is effective as of December 31, 2006, allowing a one-time transitional cumulative effect adjustment to retained earnings as of January 1, 2006, for errors that were not previously deemed material, but are material under the guidance in SAB No. 108.The impact of adopting SAB No. 108 did not result in a material effect on our results of operations and financial position. Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109 In July 2006, FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. FIN 48 is an interpretation of SFAS No. 109, Accounting for Income Taxes. This Interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. This Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This Interpretation is effective for fiscal years beginning after December 15, 2006. We adopted FIN 48 as of January 1, 2007, as required. In the first quarter of 2007, we will record a cumulative effect adjustment of a change in accounting principle as prescribed by FIN 48. We do not expect FIN 48 to have a material effect on our results or operations or financial position. 2006 10-K Page 89 SOP 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts In October 2005, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 05-1, which provides accounting guidance for deferred policy acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. Internal replacement contracts are those that are substantially changed from the replaced contract and are accounted for as an extinguishment of the replaced contract. Nonintegrated contract features are accounted for as separately issued contracts. Modifications resulting from the election of a feature or coverage within a contract or from an integrated contract feature generally do not result in an internal replacement contract subject to SOP 05-1 provided certain conditions are met. The provisions of SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. We do not expect this statement to have a material impact on our results of operations or financial position. 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 summary: 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 Other Total Change in unrealized investment gains and losses and other summary: Fixed maturities Equity securities Adjustment to deferred acquisition costs and life policy reserves Other Income taxes on above Total Years ended December 31, 2005 2004 2006 $ $ $ $ $ $ 300 $ 262 15 577 7 570 $ 27 $ (2) (1) 656 (5) 0 7 2 684 $ (23) $ 200 2 2 (54) 127 $ 280 $ 244 8 532 6 526 $ 36 $ (1) (1) 40 (6) 0 (7) 0 61 $ (198) $ (575) 6 18 246 (503) $ 252 239 6 497 5 492 36 (20) (5) 101 (30) (1) 10 0 91 (6) (448) 3 (6) 160 (297) At December 31, 2006, contractual maturity dates for fixed-maturity and short-term investments were: (In millions) Maturity dates occurring: 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 $ $ 203 $ 787 2,860 1,729 255 5,834 $ 204 802 2,865 1,763 266 5,900 3.5 % 13.6 48.5 29.9 4.5 100.0 % 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, 2006, investments with book value of $64 million and fair value of $66 million were on deposit with various states in compliance with regulatory requirements. 2006 10-K Page 90 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, 2006 Fixed maturities: States, municipalities and political subdivisions Convertibles and bonds with warrants attached Public utilities United States government Government-sponsored enterprises Foreign government All other corporate bonds and short-term investments Total Equity securities 2005 Fixed maturities: States, municipalities and political subdivisions Convertibles and bonds with warrants attached Public utilities United States government Government-sponsored enterprises Foreign government All other corporate bonds and short-term investments Total Equity securities Cost or amortized cost Gross unrealized gains losses Fair value $ $ $ $ $ $ 2,382 $ 264 140 5 995 3 2,045 5,834 $ 2,621 $ 2,083 $ 270 139 5 992 3 1,970 5,462 $ 2,128 $ 40 $ 17 4 0 0 0 61 122 $ 5,181 $ 48 $ 17 5 0 0 0 89 159 $ 4,986 $ 6 $ 3 2 0 23 0 22 56 $ 3 $ 14 $ 9 1 0 19 0 27 70 $ 8 $ 2,416 278 142 5 972 3 2,084 5,900 7,799 2,117 278 143 5 973 3 2,032 5,551 7,106 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, 2006 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 Government-sponsored enterprises Foreign government All other corporate bonds and short-term investments Total Equity securities: Total 2005 Fixed maturities: States, municipalities and political subdivisions Convertibles and bonds with warrants attached Public utilities United States government Government-sponsored enterprises All other corporate bonds and short-term investments Total Equity securities: Total $ $ $ $ 190 $ 6 4 3 1 3 88 295 39 334 $ 754 $ 73 44 1 607 387 1,866 59 1,925 $ 1 $ 0 0 0 0 0 2 3 2 5 $ 8 $ 3 1 0 8 11 31 2 33 $ 589 $ 43 54 1 970 0 726 2,383 11 2,394 $ 173 $ 39 6 0 354 284 856 47 903 $ 5 $ 3 2 0 23 0 20 53 1 54 $ 6 $ 6 0 0 11 16 39 6 45 $ 779 $ 49 58 4 971 3 814 2,678 50 2,728 $ 927 $ 112 50 1 961 671 2,722 106 2,828 $ 6 3 2 0 23 0 22 56 3 59 14 9 1 0 19 27 70 8 78 At December 31, 2006, 482 fixed-maturity investments with a total unrealized loss of $53 million and three equity securities 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. 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. 2006 10-K Page 91 Investments in companies that exceed 10 percent of our shareholders’ equity at December 31 include: (In millions) Issuers: Fifth Third Bancorp common stock Exxon Mobil Corporation common stock Alltel Corporation common stock and fixed maturity 2006 2005 Cost Fair value Cost Fair value $ 283 $ 133 0 2,979 $ 687 0 283 $ 133 122 2,745 503 807 We sold 12,700,164 shares of our holdings of Alltel Corporation common stock in January 2006 and 475,000 shares in December 2005. The sale contributed $647 million and $27 million to our 2006 and 2005 pretax realized gains. The sale contributed $412 million and $15 million to net income in 2006 and 2005, respectively. 3. This table summarizes components of our deferred policy acquisition costs asset: DEFERRED ACQUISITION COSTS (In millions) Deferred policy acquisition costs asset at beginning of year Capitalized deferred policy acquisition costs Amortized deferred policy acquisition costs Amortized shadow deferred policy acquisition costs Deferred policy acquisition costs asset at end of year 2006 At December 31, 2005 2004 $ $ 429 $ 706 (685) 3 453 $ 400 $ 683 (664) 10 429 $ 372 657 (626) (3) 400 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 Years ended December 31, 2005 2004 2006 $ $ 3,629 $ 518 3,111 3,514 $ 537 2,977 2,124 (116) 2,008 819 944 1,763 1,972 (160) 1,812 772 906 1,678 3,356 504 3,860 $ 3,111 518 3,629 $ 3,386 541 2,845 1,949 (196) 1,753 804 817 1,621 2,977 537 3,514 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 $116 million, $160 million and $196 million in calendar years 2006, 2005 and 2004. 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. The reserve for loss and loss expenses in the consolidated balance sheets also includes $36 million, $32 million and $35 million at December 31, 2006, 2005 and 2004, respectively, for certain life and health losses. 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. 2006 10-K Page 92 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. Some of our universal life policies contain no-lapse guarantee provisions. For these policies, we establish a reserve in addition to the account balance, based on expected no-lapse guarantee benefits and expected policy assessments. Here is a summary of our life policy reserves: (In millions) Ordinary/traditional life Universal life Annuities Other Total At December 31, 2006 2005 $ $ 453 $ 396 537 23 1,409 $ 419 376 523 25 1,343 At both December 31, 2006 and 2005, the fair value associated with the annuities shown above was approximately $563 million. NOTES PAYABLE 6. We had two lines of credit with commercial banks amounting to $125 million with an outstanding balance of $49 million at year-end 2006. We had no compensating balance requirement on short-term debt for either 2006 or 2005. We had two lines of credit with commercial banks amounting to $125 million with no outstanding balance at year-end 2005. Interest rates charged on such borrowings ranged from 5.90 percent to 6.03 percent during 2006. The company’s subsidiary, CFC Investment Company, entered into an interest-rate swap agreement during 2006, which expires in three years, to hedge future cash flows (thereby obtaining a fixed interest rate of 5.985 percent) related to certain variable rate debt obligations. This swap is reflected at fair value in the consolidated balance sheets and the unrealized loss, net of tax, at December 31, 2006, of $69,000 is a component of shareholders’ equity in accumulated other comprehensive income. The company does not expect any significant amounts to be reclassified into earnings as a result of interest rate changes in the next 12 months. 7. This table summarizes the principal amounts of our long-term debt excluding unamortized discounts: SENIOR DEBT (In millions) Interest Year of rate issue 6.90% 1998 6.92% 2005 6.125% 2004 Senior debentures, due 2028 Senior debentures, due 2028 Senior notes, due 2034 Total At December 31, 2006 2005 $ $ 28 $ 392 375 795 $ 28 392 375 795 The fair value of our senior debt approximated $850 million at year-end 2006 and $870 million at year-end 2005. None of the notes are encumbered by rating triggers. SHAREHOLDERS’ EQUITY AND DIVIDEND RESTRICTIONS 8. Our insurance subsidiary declared dividends to the parent company of $275 million in 2006, $275 million in 2005 and $175 million in 2004. 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 2007, the total dividends that our lead insurance subsidiary may pay to our parent company without regulatory approval will be approximately $572 million. As of December 31, 2006, 11.6 million shares of common stock were available for future stock option grants. Declared cash dividends per share were $1.34, $1.21 and $1.04 for the years ended December 31, 2006, 2005 and 2004, respectively. 2006 10-K Page 93 Accumulated Other Comprehensive Income The change in unrealized gains and losses on investments and derivatives included: (In millions) Accumulated unrealized gains (losses) on securities available for sale at January 1 Net unrealized gains (losses) Reclassification adjustment for (gains) losses included in net income Adjustment to deferred acquisition costs and life policy reserves Effect on other comprehensive income Accumulated unrealized gains (losses) on securities available for sale at December 31 Accumulated unrealized gains (losses) on derivatives used in cash flow hedging relationships at January 1 Net unrealized gains (losses) Reclassification adjustment for (gains) losses included in net income Effect on other comprehensive income Accumulated unrealized gains (losses) on derivatives used in cash flow hedging relationships at December 31 Accumulated unrealized losses for pension obligations at January 1 Cumulative effect of change in accounting for pension obligations Accumulated unrealized losses for pension obligations at December 31 Accumulated other comprehensive income at January 1 Other comprehensive income (loss) Cumulative effect of change in accounting for pension obligations Accumulated other comprehensive income at December 31 Before tax 2006 Income tax Net Years ended December 31, 2005 Income tax Before tax Net Before tax 2004 Income tax Net $ 5,060 $ 880 1,776 $ 298 3,284 $ 582 5,809 $ (692) 2,022 $ (226) 3,787 $ (466) 6,269 $ (372) 2,183 $ (131) 4,086 (241) (701) (245) (456) (61) (21) (40) (91) (31) (60) 2 181 1 54 1 127 4 1 3 3 1 2 (749) (246) (503) (460) (161) (299) $ 5,241 $ 1,830 $ 3,411 $ 5,060 $ 1,776 $ 3,284 $ 5,809 $ 2,022 $ 3,787 $ $ $ $ $ 0 $ 0 0 $ 0 0 $ 0 0 $ 0 0 $ 0 0 $ 0 (3) $ 0 (1) $ 0 (2) 0 0 0 0 0 0 0 0 0 0 0 0 0 3 3 1 1 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 $ (49) (17) (32) 0 0 0 0 0 (49) $ (17) $ (32) $ 0 $ 0 $ 0 $ 0 $ 0 $ 2 2 0 0 0 0 5,060 $ 181 1,776 $ 54 3,284 $ 127 5,809 $ (749) 2,022 $ (246) 3,787 $ (503) 6,266 $ (457) 2,182 $ (160) 4,084 (297) (49) (17) (32) 0 0 0 0 0 0 $ 5,192 $ 1,813 $ 3,379 $ 5,060 $ 1,776 $ 3,284 $ 5,809 $ 2,022 $ 3,787 9. Our statements of income include earned property casualty premiums on assumed and ceded business: REINSURANCE (In millions) Direct earned premiums Assumed earned premiums Ceded earned premiums Net earned premiums Years ended December 31, 2005 2006 2004 $ $ 3,296 $ 26 (158) 3,164 $ 3,209 $ 28 (179) 3,058 $ 3,062 32 (175) 2,919 2006 10-K Page 94 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 Years ended December 31, 2005 2006 2004 $ $ 2,072 $ 13 (77) 2,008 $ 1,898 $ 40 (126) 1,812 $ 1,870 17 (134) 1,753 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 Other Total Net deferred tax liability At December 31, 2006 2005 1,824 $ 142 36 2,002 190 109 22 28 349 1,653 $ 1,788 135 32 1,955 179 108 26 20 333 1,622 $ $ The provision for federal income taxes is based upon a consolidated income tax return for the company and subsidiaries. As of December 31, 2006, 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 Years ended December 31, 2005 2004 2006 35.0 % 35.0 % 35.0 % (2.2) (3.9) 1.1 30.0 % (3.2) (5.7) 0.7 26.8 % (2.5) (5.7) 0.2 27.0 % Filed tax returns for calendar years 2000 through 2005 are currently open with the Internal Revenue Service. As of December 31, 2005, federal income taxes had not been provided for on our life insurance subsidiary’s Policyholder Surplus Account (PSA), which totaled $14 million as of December 31, 2005 and 2004. The American Jobs Creation Act of 2004 suspended for a two-year period beginning January 1, 2005, the tax liability of a stock life insurance company on distributions made from the PSA. In July 2006, the company’s life insurance subsidiary declared and paid a $14 million dividend, eliminating its PSA balance as of December 31, 2006. 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, 2006. 2006 10-K Page 95 Here are calculations for basic and diluted earnings per share: (In millions) 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 Number of anti-dilutive option shares Exercise price of anti-dilutive option shares Years ended December 31, 2005 2004 2006 930 $ 602 $ 584 173,423,395 2,027,946 175,451,341 175,062,669 2,053,457 177,116,126 176,476,722 1,900,126 178,376,848 5.36 $ 5.30 1,336,150 45.26 3.44 $ 3.40 0 — $ 3.30 3.28 264,602 41.14 $ $ $ The only current source of dilution of our common shares is outstanding stock options to purchase shares of common stock. The above table shows the number of anti-dilutive options shares at year-end 2006, 2005 and 2004. We did not include these options in the computation of net income per common share (diluted) because their exercise would have an anti-dilutive effect. 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 but we do pay all operating expenses. Benefits for the defined benefit pension plan are based on years of credited service and compensation level. Contributions are based on the frozen entry age actuarial cost method. We also maintain a supplemental retirement plan (SERP) with liabilities of approximately $5 million to $9 million at year-end 2006 and 2005. The SERP is included in the obligation and expense amounts. Our pension expense is composed of several components that are determined using the projected unit credit actuarial cost method and are based on certain actuarial assumptions. Key assumptions used in developing the 2006 net pension obligation were a 5.75 percent discount rate and rates of compensation increases ranging from 4 percent to 6 percent. To determine the discount rate, the plan’s particular liability characteristics – the amounts, timing and interest sensitivity of expected benefit payments – were evaluated and then matched to a yield curve based on actual high-quality corporate bonds across a full maturity spectrum. Once the plan’s projected cash flows matched the yield curve, a present value was developed, which was then calibrated to a single-equivalent discount rate. That discount rate, when applied to a single sum, would generate the necessary cash flows to pay benefits when due. It was increased by 0.25 percentage points in 2006 due to market interest rates conditions. We based the rates of compensation increase on the company’s historical data, which led us to lower the range from the 5 percent to 7 percent used in previous years. Key assumptions used in developing the 2006 net pension expense were a 5.50 percent discount rate, an 8 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent. The 8 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 0.25 percentage points due to market interest rate conditions. 2006 10-K Page 96 Benefit obligation activity using an actuarial measurement date at December 31 follows: (In millions) Change in projected benefit obligation: Benefit obligation at beginning of year Service cost Interest cost Plan amendments Actuarial loss Benefits paid Projected 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 (unfunded) status: Funded (unfunded) status at end of year Qualified Pension Plan 2005 2006 Supplemental Pension Plan Totals 2006 2005 2006 2005 $ $ $ $ $ $ 235 $ 16 14 0 11 (10) 266 $ 200 $ 173 35 10 (10) 208 $ 199 $ 13 12 0 18 (7) 235 $ 165 $ 158 12 10 (7) 173 $ 9 $ 0 0 0 0 (4) 5 $ 4 $ 0 0 4 (4) 0 $ 5 $ 0 1 3 0 0 9 $ 6 $ 0 $ 0 0 0 0 $ 244 $ 16 14 0 11 (14) 271 $ 204 $ 173 $ 35 14 (14) 208 $ 204 13 13 3 18 (7) 244 171 158 12 10 (7) 173 (58) $ (62) $ (5) $ (9) $ (63) $ (71) The accumulated benefit obligation was $204 million and $171 million at December 31, 2006 and 2005, respectively. The fair value of our stock comprised $29 million (14 percent of total plan assets) at December 31, 2006, and $29 million (17 percent of total plan assets) at December 31, 2005. At December 31, 2005 there were no amounts recognized in accumulated other comprehensive income for the plans. A reconciliation follows of the funded status at the end of the measurement period to the amounts recognized in the statement of financial position at December 31, 2006: (In millions) Amounts recognized in the statement of financial position consist of: Noncurrent liability Total Amounts recognized in accumulated other comprehensive income not yet recognized as a component of net periodic benefit cost consist of: Net actuarial loss/(gain) Prior service cost Total Qualified Supplemental Pension Plan Pension Plan Total $ $ $ $ (58) $ (58) $ (5) $ (5) $ (63) (63) 40 $ 6 46 $ (1) $ 4 3 $ 39 10 49 The projected benefit obligation and fair value of plan assets for pension plans with a projected benefit obligation in excess of plan assets at December 31 follows: (In millions) Projected benefit obligation in excess of plan assets: Projected benefit obligation at end of year Fair value of plan assets at end of year Qualified Pension Plan 2005 2006 Supplemental Pension Plan Total 2006 2005 2006 2005 $ 266 $ 208 235 $ 173 5 $ 0 9 $ 0 271 $ 208 244 173 The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for pension plans with an accumulated benefit obligation in excess of plan assets at December 31 follows: (In millions) Accumulated benefit obligation in excess of plan assets: Projected benefit obligation at end of year Accumulated benefit obligation at end of year Fair value of plan assets at end of year Supplemental Pension Plan 2006 2005 $ 5 $ 4 0 9 6 0 The weighted-average assumptions used to determine benefit obligations at December 31 follows: Discount rate Rate of compensation increase 2006 2005 5.75 % 4-6 5.50 % 5-7 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 2006 10-K Page 97 changes to those bond yields. Compensation increase assumptions reflect historical calendar year compensation increases. Here are the components of our net periodic benefit cost at December 31: (In millions) $ Service cost Interest cost Expected return on plan assets Amortization of actuarial gain, prior service cost and transition asset Net periodic benefit cost $ Qualified Pension Plan 2005 2004 2006 16 $ 14 (14) 13 $ 12 (13) 11 $ 10 (12) 2 18 $ 1 13 $ 0 9 $ Supplemental Pension Plan 2005 2004 2006 0 $ 0 0 1 1 $ 0 $ 1 0 0 1 $ 0 $ 0 0 0 0 $ Total 2005 2004 2006 16 $ 14 (14) 13 $ 13 (13) 3 19 $ 1 14 $ 11 10 (12) 0 9 Here is a summary of the weighted-average assumptions we use to determine our net expense for the plan: Qualified Pension Plan 2005 2004 2006 Supplemental Pension Plan 2005 2004 2006 Discount rate Expected return on plan assets Rate of compensation increase 5.50 % 8.00 5-7 5.75 % 8.00 5-7 6.00 % 8.00 5-7 5.50 % 5.75 % 6.00 % NA 5-7 NA 5-7 NA 5-7 Our pension plan asset allocations by category are: Asset category: Equity securities Fixed maturities Cash and cash equivalents Total At December 31, 2005 2006 94 % 4 2 100 % 93 % 5 2 100 % We expect to contribute approximately $10 million to our pension plan in 2007 with a target allocation of 90 percent equity securities and 10 percent 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, 2007 2008 2009 2010 2011 Years 2012-2016 Qualified Supplemental Pension Plan Pension Plan $ 9 $ Total 9 14 13 12 15 109 0 $ 2 0 2 0 1 12 13 10 15 108 The estimated costs that will be amortized from accumulated other comprehensive income into net periodic benefit cost over the next year are as follows: (In millions) Actuarial (gain)/loss Prior service cost Total Qualified Pension Plan $ $ 2 0 2 Supplemental Pension Plan (1) 1 0 $ $ Total 1 1 2 $ $ The incremental effect of applying SFAS No. 158 on individual line items in the statement of financial position at December 31, 2006, follows: (In millions) Qualified Pension Plan With FAS 158 Increase/ (Decrease) Without FAS 158 Supplemental Pension Plan With FAS 158 Increase/ (Decrease) Without FAS 158 Without FAS 158 Total With FAS 158 Other liabilities Deferred income tax Accumulated other comprehensive income $ 12 $ (4) 58 $ (20) 46 $ (16) 0 (30) (30) 2 $ (1) 0 5 $ (2) (2) 3 $ (1) (2) Increase/ (Decrease) 49 (17) 63 $ (22) 14 $ (5) 0 (32) (32) STATUTORY ACCOUNTING INFORMATION 13. Insurance companies use statutory accounting practices (SAP) as prescribed by regulatory authorities. The three primary differences between SAP and GAAP are: • policy acquisition costs are expensed when incurred, • life insurance reserves are based upon different actuarial assumptions and • deferred income taxes are valued and established using a different basis. 2006 10-K Page 98 Statutory net income and capital and surplus determined in accordance with SAP prescribed or permitted by insurance regulatory authorities for four legal entities, our insurance subsidiary and its three insurance subsidiaries, are as follows: (In millions) SAP Net Income The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company $ 572 $ 15 2 28 517 $ 13 2 21 588 9 2 28 Years ended December 31, 2005 2004 2006 $ Capital and Surplus At December 31, 2006 2005 4,723 $ 282 62 479 4,220 263 63 451 Statutory capital and surplus for our insurance subsidiary, The Cincinnati Insurance Company, includes capital and surplus of its three insurance subsidiaries. TRANSACTIONS WITH AFFILIATED PARTIES 14. We paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $7 million, $6 million and $11 million on premium volume of approximately $40 million, $41 million and $76 million for 2006, 2005 and 2004, respectively. COMMITMENTS AND CONTINGENT LIABILITIES 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, results of operations or cash flows. We further believe that the outcomes of non-insurance matters will be covered by insurance coverage or will not have a material effect on our consolidated financial position, results of operations or cash flows. 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. 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 2006 10-K Page 99 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. EQUITY COMPENSATION PLANS 16. As a result of adopting SFAS No. 123(R) on January 1, 2006, our income before income taxes for the year ended December 31, 2006, was reduced by $17 million. Our net income for the year ended December 31, 2006, was reduced by $14 million. If we had continued to account for stock-based compensation under APB Opinion No. 25, there would have been no effect on net income. The weighted- average grant-date fair value of options granted during 2006 and 2005 was $10.09 and $12.49, respectively. The total intrinsic value of options exercised during the years ended December 31, 2006, 2005 and 2004, was $22 million, $9 million and $6 million, respectively. The total intrinsic value of options vested during the years ended December 31, 2006, 2005 and 2004, was $10 million, $12 million and $11 million. (Intrinsic value is the market price less the exercise price.) Under the modified-prospective-transition method, in 2006, we recognized: • • • compensation cost for all stock options granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R) compensation cost for all non-vested stock options granted prior to January 1, 2006, that vested during 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and compensation cost for all non-vested stock options that have nonsubstantive vesting requirements, such as those to associates who are eligible for retirement. Results for prior periods have not been retrospectively adjusted for SFAS No. 123(R). As of December 31, 2006, we had $14 million of unrecognized total compensation cost related to non-vested stock options. That cost will be recognized over a weighted-average period of 1.7 years. SFAS No. 123(R) also requires us to classify certain tax benefits related to share-based compensation deductions as cash from financing activities. As of December 31, 2006, these tax benefits totaled $2 million. In determining the share-based compensation amounts for 2006, the fair value of each option granted in 2006 was estimated on the date of grant using the binomial option-pricing model with the following weighted average assumptions used for grants in 2006: dividend yield of 3.22 percent; expected volatility ranging from 20.25 to 27.12 percent; risk-free interest rates ranging from 4.5 to 4.61 percent; and expected lives of five to seven years. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to options granted under our stock option plans prior to our adoption of SFAS No. 123(R) on January 1, 2006. For purposes of this pro forma disclosure, the fair value of each option was estimated on the date of grant using the binomial option-pricing model with the following weighted-average assumptions used for grants in: • 2005 – Dividend yield of 2.66 percent; expected volatility of 25.61 percent; risk-free interest rate of 4.62 percent; and expected lives of 10 years. • 2004 – Dividend yield of 2.40 percent; expected volatility of 25.65 percent; risk-free interest rate of 4.37 percent; and expected lives of 10 years. 2006 10-K Page 100 (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 Here is a summary of options information: (Dollars in millions, shares in thousands) As reported Pro forma As reported Pro forma As reported Pro forma 2006 Outstanding at beginning of year Granted/reinstated Exercised Forfeited/revoked Outstanding at end of period Options exercisable at end of period Weighted-average fair value of options granted during the period 2005 Outstanding at beginning of year Granted/reinstated Exercised Forfeited/revoked Outstanding at end of period Options exercisable at end of period Weighted-average fair value of options granted during the period 2004 Outstanding at beginning of year Granted/reinstated Exercised Forfeited/revoked Outstanding at end of period Options exercisable at end of period Weighted-average fair value of options granted during the period Years ended December 31, 2005 2004 $ $ $ $ 602 $ 13 589 $ 3.44 $ 3.36 3.40 $ 3.32 584 12 572 3.30 3.24 3.28 3.21 Weighted- average exercise Aggregate intrinsic value Shares 10,589 $ 1,372 (1,084) (210) 10,667 7,985 $ 9,698 $ 1,504 (467) (146) 10,589 7,794 $ 8,791 $ 1,439 (397) (135) 9,698 7,050 $ 33.70 45.26 24.93 36.16 36.03 $ 33.70 $ 10.09 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 99 93 116 101 98 82 Cash received from the exercise of options was $27 million, $11 million and $10 million for the years ended December 31, 2006, 2005 and 2004, respectively. The tax benefit realized on options exercised was $3 million for the year ended December 31, 2006, and less than $1 million for the years ended December 31, 2005 and 2004. Options outstanding and exercisable consisted of the following at December 31, 2006: (Shares in thousands) Range of exercise prices $15.00 to $19.99 $20.00 to $24.99 $25.00 to $29.99 $30.00 to $34.99 $35.00 to $39.99 $40.00 to $44.99 $45.00 to $49.99 Total Options outstanding Weighted-average remaining contractual life 0.11 yrs 0.28 yrs 3.01 yrs 4.19 yrs 5.31 yrs 6.94 yrs 9.08 yrs 5.28 yrs $ Weighted- average exercise price 19.34 20.60 27.07 32.66 38.44 41.54 45.26 36.03 Shares 2 161 944 4,571 1,968 1,685 1,336 10,667 Options exercisable Weighted- average exercise price 19.34 20.60 27.07 32.66 38.34 41.45 45.26 33.70 Shares 2 $ 161 944 4,571 1,535 757 15 7,985 The weighted-average remaining contractual life for exercisable awards as of December 31, 2006, was 4.24 years. As of December 31, 2006, 11.6 million shares of common stock were available for future stock option grants. We currently issue new shares for option exercises. 2006 10-K Page 101 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 non-investment operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding client 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 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: • • • 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 calculate underwriting income or loss by recording 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 separately 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. 2006 10-K Page 102 This table summarizes segment information: (In millions) Revenues: Commercial lines insurance Commercial casualty Commercial property Commercial auto Workers' compensation Specialty packages Surety and executive risk Machinery and equipment Total commercial lines insurance Personal lines insurance Personal auto Homeowner Other personal lines Total personal lines insurance Life insurance Investment operations Other Consolidated eliminations 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 Years ended December 31, 2005 2004 2006 $ $ $ $ $ $ 831 $ 491 453 366 141 93 27 2,402 385 289 88 762 118 1,254 15 (1) 4,550 $ 208 $ (27) (1) 1,200 (51) 1,329 $ 759 $ 467 457 328 137 80 26 2,254 433 282 89 804 110 587 12 0 3,767 $ 285 $ 45 7 536 (50) 823 $ 686 440 450 313 133 80 24 2,126 451 256 86 793 104 583 8 0 3,614 338 (40) 2 537 (37) 800 2,220 $ 886 13,820 296 17,222 $ 2,167 845 12,774 217 16,003 QUARTERLY SUPPLEMENTARY DATA (UNAUDITED) This table includes unaudited quarterly financial information for the years ended December 31, 2006 and 2005: (Dollars in millions except per share data) 2006 Revenues Income before income taxes Net income Net income per common share—basic Net income per common share—diluted 2005 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 $ $ 1,607 $ 834 552 3.17 3.13 916 $ 195 144 0.82 0.81 981 $ 175 132 0.77 0.76 940 $ 215 158 0.90 0.89 967 $ 148 115 0.67 0.66 944 $ 151 117 0.67 0.66 995 $ 172 130 0.75 0.75 967 $ 261 183 1.04 1.03 4,550 1,329 930 5.36 5.30 3,767 823 602 3.44 3.40 Note: The sum of the quarterly reported amounts may not equal the full year as each is computed independently. First-quarter and full-year 2006 – The company sold its holdings in Alltel Corporation common stock in the first quarter of 2006. The sale contributed $647 million to revenues and $412 million, or $2.35 per share, to net income. 2006 10-K Page 103 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 Evaluation of Disclosure 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, 2006. 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 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. • Changes in Internal Control over Financial Reporting – During the three months ended December 31, 2006, there were no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our 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 79 and 80. 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 2007 Annual Meeting of Shareholders no later than April 13, 2007. 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 the Board of 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” appeared 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 “Compensation of Named Executive Officers and Directors,” which includes the “Report of the Compensation Committee” and the “Compensation Discussion and Analysis.” Executive Compensation 2006 10-K Page 104 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 “Compensation of Named Executive Officers and Directors,” which includes “Securities Authorized for Issuance under Equity Compensation Plans.” Additional information on share-based compensation under our equity compensation plans is available in Item 8, Note 16 to the Consolidated Financial Statements, Page 100. 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 “Audit-related Matters,” which includes the “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 81-85 b) Exhibits – see Index of Exhibits, Page 117 c) Financial Statement Schedules Schedule I – Summary of Investments -- Other than Investments in Related Parties, Page 106 Schedule II – Condensed Financial Statements of Registrant, Page 108 Schedule III – Supplementary Insurance Information, Page 111 Schedule IV – Reinsurance, Page 113 Schedule V – Valuation and Qualifying Accounts, Page 114 Schedule VI – Supplementary Information Concerning Property Casualty Insurance Operations, Page 115 2006 10-K Page 105 SCHEDULE I (In millions) Type of investment Fixed maturities: United States government: The Cincinnati Insurance Company The Cincinnati Life Insurance Company Total Government-sponsored enterprises: The Cincinnati Insurance Company The Cincinnati Casualty Company The Cincinnati Indemnity Company The Cincinnati Life Insurance Company Total Foreign government: The Cincinnati 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 Life Insurance 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 Cincinnati Financial Corporation and Subsidiaries Summary of Investments - Other than Investments in Related Parties Cost or amortized cost At December 31, 2006 Fair value Balance sheet amount $ $ 1 $ 4 5 1 $ 4 5 620 6 2 367 995 3 3 2,218 127 32 5 2,382 55 4 1 78 2 140 163 92 9 264 605 6 2 359 972 3 3 2,248 129 32 7 2,416 56 4 1 79 2 142 174 95 9 278 977 27 10 819 117 1,950 5,739 $ 995 29 11 837 117 1,989 5,805 $ 1 4 5 605 6 2 359 972 3 3 2,248 129 32 7 2,416 56 4 1 79 2 142 174 95 9 278 995 29 11 837 117 1,989 5,805 2006 10-K Page 106 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 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 Life Insurance Company CinFin Capital Management Company Cincinnati Financial Corporation Total Total equity securities Short-term investments: The Cincinnati Insurance Company The Cincinnati Life Insurance Company Total short-term investments Other invested assets: Real estate: The Cincinnati Life Insurance Company Policy loans: The Cincinnati Life Insurance Company Limited partnerships: Cincinnati Financial Corporation Total other invested assets Total investments Cost or amortized cost At December 31, 2006 Fair value Balance sheet amount $ $ $ $ $ $ $ 82 $ 2 11 1 29 125 466 16 59 1 502 1,044 703 19 6 118 4 381 1,231 169 38 0 14 221 2,621 $ 92 $ 3 95 $ 3 32 25 60 8,515 144 $ 7 28 1 86 266 2,485 84 182 2 1,813 4,566 1,784 71 18 283 5 571 2,732 182 39 0 14 235 7,799 $ 92 $ 3 95 $ — — — — — $ $ $ 144 7 28 1 86 266 2,485 84 182 2 1,813 4,566 1,784 71 18 283 5 571 2,732 182 39 0 14 235 7,799 92 3 95 3 32 25 60 13,759 2006 10-K Page 107 SCHEDULE II (In millions) Cincinnati Financial Corporation (parent company only) Condensed Balance Sheets At December 31, 2006 2005 ASSETS Investments Fixed maturities, at fair value Equity securities, 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: 2006—$64; 2005—$61) Prepaid federal income tax Other assets Due from subsidiaries Total assets LIABILITIES Dividends declared but unpaid Deferred federal income tax 6.92% senior debentures due 2028 6.9% senior debentures due 2028 6.125% senior notes due 2034 Other liabilities Total liabilities SHAREHOLDERS' EQUITY Common stock Paid-in capital Retained earnings Accumulated other comprehensive income Treasury stock at cost Total shareholders' equity Total liabilities and shareholders' equity $ 128 $ 2,484 25 38 5,303 16 121 0 19 150 8,284 $ 58 $ 526 392 28 371 101 1,476 391 1,015 2,786 3,379 (763) 6,808 8,284 $ $ $ $ 123 2,444 13 7 4,685 17 98 32 17 144 7,580 53 635 392 28 371 15 1,494 389 969 2,088 3,284 (644) 6,086 7,580 This condensed financial information should be read in conjunction with the Consolidated Financial Statements and Notes included in Part II, Item 8, Page 78. 2006 10-K Page 108 Cincinnati Financial Corporation (parent company only) Condensed Statements of Income Years ended December 31, 2005 2004 2006 SCHEDULE II (CONTINUED) (In millions) REVENUES Dividends from subsidiaries Investment income, net of expenses Realized gains on investments Other revenue Total revenues EXPENSES Interest expense Depreciation expense Other expenses Total expenses INCOME BEFORE INCOME TAXES AND EARNINGS OF SUBSIDIARIES PROVISION (BENEFIT) FOR INCOME TAXES Current Deferred Total provision for income taxes NET INCOME BEFORE EARNINGS OF SUBSIDIARIES Increase in undistributed earnings of subsidiaries $ 275 $ 98 410 10 793 51 3 18 72 721 153 (11) 142 579 351 275 $ 89 2 10 376 52 3 16 71 305 (27) 20 (7) 312 290 175 110 18 9 312 36 3 14 53 259 (17) 20 3 256 328 584 NET INCOME $ 930 $ 602 $ This condensed financial information should be read in conjunction with the Consolidated Financial Statements and Notes included in Part II, Item 8, Page 78. 2006 10-K Page 109 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) 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-maturities Call or maturity of fixed-maturities Sale of equity securities Purchase of fixed-maturities Purchase of equity securities 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, 2005 2004 2006 $ 930 $ 602 $ 1 (410) 1 48 (11) 2 16 (351) 226 4 36 511 (42) (351) 3 (26) (8) 127 0 0 0 (228) (119) 30 (5) (322) 31 7 38 $ 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 $ $ 584 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 This condensed financial information should be read in conjunction with the Consolidated Financial Statements and Notes included in Part II, Item 8, Page 78. 2006 10-K Page 110 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 Consolidated eliminations Total Cincinnati Financial Corporation and Subsidiaries Supplementary Insurance Information 2006 Years ended December 31, 2005 2004 $ $ $ $ $ $ $ $ $ $ 235 $ 80 315 138 453 $ 3,414 $ 446 3,860 1,430 5,290 $ 1,195 $ 382 1,577 2 1,579 $ 0 $ 0 0 15 15 $ 2,402 $ 762 3,164 115 (1) 3,278 $ 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 0 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 0 3,020 2006 10-K Page 111 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 Consolidated eliminations Total 2006 Years ended December 31, 2005 2004 $ $ $ $ $ $ $ $ $ $ 0 $ 0 367 108 475 $ 1,466 $ 542 2,008 122 2,130 $ 504 $ 160 664 21 685 $ 224 $ 87 311 30 341 $ 2,442 $ 736 3,178 3 (1) 3,180 $ 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 0 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 0 3,000 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; and Increase in deferred acquisition costs 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. 2006 10-K Page 112 SCHEDULE IV (Dollars in millions) Gross amounts: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Consolidated eliminations Total Ceded amounts to other companies: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Assumed amounts from other companies: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Total Net amounts: Life insurance in force Earned premiums Commercial lines insurance Personal lines insurance Total property casualty insurance Life insurance Consolidated eliminations Total Percentage of amounts 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 2006 Years ended December 31, 2005 2004 $ $ $ $ $ $ $ $ $ $ $ $ 56,968 2,513 783 3,296 159 (1) 3,454 31,744 134 24 158 44 202 3 24 2 26 0 26 25,227 2,402 762 3,164 115 (1) 3,278 $ $ $ $ $ $ $ $ $ $ $ $ 51,488 2,386 823 3,209 150 0 3,359 30,705 157 22 179 44 223 5 25 3 28 0 28 20,788 2,254 804 3,058 106 0 3,164 $ $ $ $ $ $ $ $ $ $ $ $ 44,916 2,246 816 3,062 138 0 3,200 28,196 148 27 175 37 212 5 28 4 32 0 32 16,725 2,126 793 2,919 101 0 3,020 0.0 % 1.1 % 0.4 0.9 0.0 0.9 0.0 % 1.1 % 0.4 0.9 0.0 0.9 0.0 % 1.3 % 0.5 1.1 0.1 1.1 2006 10-K Page 113 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 2006 At December 31, 2005 2004 $ $ 1 $ 1 0 (1) 1 $ 0 $ 1 0 0 1 $ 0 0 0 0 0 2006 10-K Page 114 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 Personal lines insurance Total Loss and loss expenses incurred related to prior accident years: Commercial lines insurance Personal lines insurance 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 2006 Years ended December 31, 2005 2004 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 235 $ 80 315 $ 3,414 $ 446 3,860 $ 0 $ 1,194 $ 382 1,576 $ 2,402 $ 762 3,164 $ 0 $ 0 367 $ 1,564 $ 560 2,124 $ (98) $ (18) (116) $ 504 $ 160 664 $ 1,218 $ 545 1,763 $ 2,442 $ 736 3,178 $ 226 $ 85 311 $ 3,173 $ 456 3,629 $ 0 $ 1,150 $ 407 1,557 $ 2,254 $ 804 3,058 $ 0 $ 0 338 $ 1,424 $ 548 1,972 $ (126) $ (34) (160) $ 473 $ 168 641 $ 1,126 $ 552 1,678 $ 2,290 $ 786 3,076 $ 218 88 306 3,016 498 3,514 0 1,112 425 1,537 2,126 793 2,919 0 0 289 1,328 621 1,949 (174) (22) (196) 448 162 610 1,062 559 1,621 2,186 811 2,997 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. 2006 10-K Page 115 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, Executive Vice President, Secretary and Treasurer February 28, 2007 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/ Gregory T. Bier Gregory T. Bier /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, Chief Executive Officer and Director Date February 28, 2007 Chief Financial Officer, Executive Vice President, Secretary and Treasurer (Principal Accounting Officer) February 28, 2007 Director February 28, 2007 Vice Chairman, President, Chief Operating Officer, Chief Insurance Officer and Director Director Director Director Director Director Director Director Director Director Director Director Director 2006 10-K Page 116 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 February 28, 2007 INDEX OF EXHIBITS Exhibit Description Exhibit No. 3.1A 3.1B 3.2 4.1 4.2 4.3 4.4 4.5 4.6 4.7 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 10.12 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) 2003 Non-Employee Directors’ Stock Plan (8) Cincinnati Financial Corporation Stock Option Plan No. VI (9) Cincinnati Financial Corporation Stock Option Plan No. VII (10) Standard Form of Nonqualified and Incentive Option Agreements for Stock Option Plan No. VI (7) Cincinnati Financial Corporation Incentive Compensation Plan (11) Cincinnati Financial Corporation 2006 Stock Compensation Plan (11) Standard Form of Combined Incentive/Nonqualified Stock Option for Stock Option Plan VI (12) 364-Day Credit Agreement by and among Cincinnati Financial Corporation and CFC Investment Company, as Borrowers, and Fifth Third Bank, as Lender (13) Director and Named Executive Officer Compensation Summary (11) Executive Compensation Plan (14) Amendment No. 1 to Credit Agreement by and among Cincinnati Financial Corporation and CFC investment Company, as Borrower, and Fifth Third Bank, as lender. (15) (1) (2) (3) (4) Incorporated by reference to the company’s 1999 Annual Report on Form 10-K dated March 23, 2000 (File No. 000-04604). Incorporated by reference to Exhibit 3(i) filed with the company’s Current Report on Form 8-K dated July 15, 2005. Incorporated by reference to the company’s Definitive Proxy Statement dated March 2, 1992, Exhibit 2 (File No. 000-04604). 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. Incorporated by reference to the company’s registration statement on Form S-3 effective May 22, 1998 (File No. 333-51677). (6) (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 Definitive Proxy Statement dated March 21, 2005. Incorporated by reference to the company’s Definitive Proxy Statement dated March 1, 1999 (File No. 000-04604). (9) (10) Incorporated by reference to the company’s Definitive Proxy Statement dated March 8, 2002 (File No. 000-04604). (11) Incorporated by reference to the company’s Definitive Proxy Statement to be filed no later than April 13, 2007. (12) Incorporated by reference to Exhibit 10.3 filed with the company’s Current Report on Form 8-K dated July 15, 2005. (13) Incorporated by reference to Exhibit 10.1 filed with the company’s Current Report on Form 8-K dated May 31, 2005. (14) Incorporated by reference to Exhibit 10.2 filed with the company’s Current Report on Form 8-K dated November 23, 2005. (15) Incorporated by reference to Exhibit 10.01 filed with the company’s Current Report on Form 8-K dated May 26, 2006. 2006 10-K Page 117 10.13 10.14 10.15 10.16 10.17 10.18 10.19 10.20 10.21 10.22 10.23 10.24 11 14 21 23 31.1 31.2 32 Cincinnati Financial Corporation Supplemental Retirement Plan (16) Standard Form of Incentive Stock Option Agreement for Stock Option Plan VII (17) Standard Form of Nonqualified Stock Option Agreement for Stock Option Plan VII (18) Standard Form of Incentive Stock Option Agreement for the 2006 Stock Compensation Plan (19) Standard Form of Nonqualified Stock Option Agreement for the 2006 Stock Compensation Plan (20) Restricted Stock Unit Agreement for John J. Schiff, Jr., dated January 31, 2007 (21) Restricted Stock Unit Agreement for James E. Benoski., dated January 21, 2007 (21) Restricted Stock Unit Agreement for Jacob F. Scherer, Jr., dated January 31, 2007 (21) Restricted Stock Unit Agreement for Kenneth W. Stecher., dated January 31, 2007 (21) Restricted Stock Unit Agreement for Thomas A. Joseph, dated January 31, 2007 (21) Form of Restricted Stock Unit Agreement for use under the Cincinnati Financial Corporation 2006 Stock Purchase Incentive Plan (service-based) Form of Restricted Stock Unit Agreement for use under the Cincinnati Financial Corporation 2006 Stock Purchase Incentive Plan (performance-based) Statement re: Computation of per share earnings for the year ended December 31, 2006 and 2005, contained in Note 11 to the Consolidated Financial Statements included in Part II, Item 8 of this report,, Page 95 Cincinnati Financial Corporation Code of Ethics for Senior Financial Officers (22) Cincinnati Financial Corporation Subsidiaries contained in Part I, Item 1, Page 1 Consent of Independent Registered Public Accounting Firm, Page 119 Certification pursuant to Section 302 of the Sarbanes Oxley Act of 2002 – Chief Executive Officer, Page 120 Certification pursuant to Section 302 of the Sarbanes Oxley Act of 2002 – Chief Financial Officer, Page 121 Certification pursuant to Section 906 of the Sarbanes Oxley Act of 2002, Page 122 __________________________________________________________ (16) Incorporated by reference to Exhibit 10.17 filed with the company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2006. (17) Incorporated by reference to Exhibit 10.1 filed with the company’s Current Report on Form 8-K dated October 20, 2006. (18) Incorporated by reference to Exhibit 10.2 filed with the company’s Current Report on Form 8-K dated October 20, 2006. (19) Incorporated by reference to Exhibit 10.3 filed with the company’s Current Report on Form 8-K dated October 20, 2006. (20) Incorporated by reference to Exhibit 10.4 filed with the company’s Current Report on Form 8-K dated October 20, 2006. (21) Incorporated by reference to the company’s Current Report on Form 8-K dated January 31, 2007. (22) Incorporated by reference to the company’s Definitive Proxy Statement dated March 18, 2004. 2006 10-K Page 118 EXHIBIT 23 Consent of Independent Registered Public Accounting Firm We consent to the incorporation by reference in Registration Statement 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), as amended, of Cincinnati Financial Corporation of our report dated February 23, 2007, relating to the consolidated financial statements and financial statement schedules of Cincinnati Financial Corporation and subsidiaries and management's report of the effectiveness of internal control over financial reporting (which report expresses an unqualified opinion and includes an explanatory paragraph relating to the company’s adoption of Statement of Financial Accounting Standards No. 123(R), Share Based Payment, on January 1, 2006, and the recognition and related disclosure provisions of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension Plans and Other Postretirement Benefit Plans, on December 31, 2006) appearing in this Annual Report on Form 10-K of Cincinnati Financial Corporation for the year ended December 31, 2006. /S/ Deloitte & Touche LLP ________________________ Deloitte & Touche LLP Cincinnati, Ohio February 28, 2007 2006 10-K Page 119 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: February 28, 2007 /S/ John J. Schiff, Jr. ________________________ John J. Schiff, Jr., CPCU Chairman and Chief Executive Officer 2006 10-K Page 120 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: February 28, 2007 /S/ Kenneth W. Stecher ________________________ Kenneth W. Stecher Chief Financial Officer, Executive Vice President, Secretary and Treasurer (Principal Accounting Officer) 2006 10-K Page 121 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: February 28, 2007 /S/ John J. Schiff, Jr. ________________________ John J. Schiff, Jr., CPCU Chairman and Chief Executive Officer /S/ Kenneth W. Stecher ________________________ Kenneth W. Stecher Chief Financial Officer, Executive Vice President, Secretary and Treasurer (Principal Accounting Officer) 2006 10-K Page 122 About Your Company 1 Financial Highlights Cincinnati Financial Corporation, formed in Financial highlights provide a snapshot of your company’s ﬁnancial performance and strength. 1968, offers property 2 To Our Shareholders Consolidated Pretax Investment Income Less expenses (Dollars in millions) 0 7 6 5 2 5 5 4 4 5 6 4 2 9 4 A letter from the chairman and vice chairman discusses events of 2006, your company’s performance and issues that may affect us in 2007 and beyond. 03 02 04 05 06 Condensed Balance Sheets and Income Statements Six-year Summary of Financial Information Property Casualty Net Earned Premiums (Dollars in millions) Personal lines Commercial lines 2,919 3,058 3,164 2,653 8 0 9 , 1 2,391 1 2 7 , 1 6 2 1 , 2 4 5 2 , 2 2 0 4 , 2 0 7 6 02 5 4 7 03 3 9 7 4 0 8 2 6 7 04 05 06 Financial Performance Overview 2006 results for property casualty insurance operations, including commercial lines and personal lines; life insurance operations; and investment operations. 7 8 9 12 Claims Service Sells Insurance 20 Corporate Ofﬁcers and Directors 21 Subsidiary Ofﬁcers and Directors 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, our results and three-year trends, giving clear and thorough explanations with supporting data. Inside Back Cover Shareholder Information, Common Stock Price and Dividend Data. casualty insurance – its main business – through subsidiary companies. The Cincinnati Insurance Company, founded in 1950, leads the property casualty group. 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. Shareholder Information Cincinnati Financial Corporation had approximately 12,000 shareholders of record as of December 31, 2006. Many of the company’s independent agent representatives and most of the 4,048 associates of its subsidiaries own the company’s common stock. Stock Listing Common shares are traded under the symbol CINF on the NASDAQ Global Select Market. Annual Meeting The Annual Meeting of Shareholders of Cincinnati Financial Corporation will take place at 9:30 a.m. on Saturday, May 5, 2007, 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 2007, Cincinnati Financial Corporation tentatively has scheduled reports of interim results as follows: First quarter ending March 31 Second quarter ending June 30 Third quarter ending September 30 May 2 August 7 October 31 Information regarding actual interim release dates and quarterly conference call webcasts is available approximately two weeks after the end of each quarter on www.cinﬁn.com, by calling 513-870-2768 or by e-mailing investor_inquiries@cinﬁn.com. Corporate Headquarters Cincinnati Financial Corporation 6200 South Gilmore Road Fairﬁeld, Ohio 45014-5141 Phone: 513-870-2000 Fax: 513-870-2066 Independent Registered Public Accounting Firm Deloitte & Touche LLP 250 East Fifth Street Cincinnati, Ohio 45202-5109 Common Stock Price and Dividend Data __________________________________________________________________________________________________ 2006 ___________________________________________________________________________________________________ 2005 Quarter: High . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ Low . . . . . . . . . . . . . . . . . . . . . . . . . . . . Period-end close . . . . . . . . . . . . . . . . . . Cash dividends declared . . . . . . . . . . . . __________________ 1st 45.56 42.07 42.07 0.335 __________________ 2nd $ 47.01 41.43 47.01 0.335 __________________ 3rd $ 48.44 45.93 48.12 0.335 4th 49.07 44.25 45.31 0.335 $ $ 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 __________________ __________________ __________________ 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 beginning on Page 25, for factors that could cause results to differ materially from those discussed. Source: NASDAQ Global Select Market The common stock prices and dividend data above are adjusted to reﬂect the 5 percent stock dividend paid April 26, 2005. Cincinnati Financial Corporation Claims Service Sells Insurance Responding, reserving and building relationships for long-term results 2006 Annual Report 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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