10-K 1 l18781ae10vk.htm CINCINNATI FINANCIAL CORPORATION 10-K/FYE 12-31-05 Cincinnati Financial Corp. 10-K
Table of Contents

 
 
United States Securities and Exchange Commission
Washington, D.C. 20549
Form 10-K
     
þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
For the fiscal year ended December 31, 2005.
     
o   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 þ   No o
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 o   No þ
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 þ      No o
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. o
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 þ      Accelerated filer o      Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No þ
The aggregate market value of voting stock held by nonaffiliates of the Registrant was $6,181,583,530 as of June 30, 2005. As of February 28, 2006, there were 174,106,280 shares of common stock outstanding.
Document Incorporated by Reference
Portions of the definitive Proxy Statement for Cincinnati Financial Corporation’s Annual Meeting of Shareholders to be held on May 6, 2006, are incorporated by reference into Parts II and III of this Form 10-K.
 
 

 


TABLE OF CONTENTS

Part I
Item 1. Business
Item 1A. Risk Factors
Item 1B. Unresolved Staff Comments
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
Part II
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and            Issuer Purchases of Equity Securities
Item 6. Selected Financial Data
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of            Operations
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures
Item 9B. Other Information
Part III
Item 10. Directors and Executive Officers of the Registrant
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13. Certain Relationships and Related Transactions
Item 14. Principal Accountant Fees and Services
Part IV
Item 15. Exhibits and Financial Statement Schedules
EX-23
EX-31(A)
EX-31(B)
EX-32


Table of Contents

Part I
Item 1. Business
Cincinnati Financial Corporation – Introduction
We are an Ohio corporation formed in 1968. Through our subsidiaries, we have been in business since 1950, marketing commercial, personal and life insurance through independent insurance agencies to businesses and individuals. Our headquarters is in Fairfield, Ohio. At year-end 2005, we had 3,983 associates, with approximately 2,800 headquarters associates providing support to approximately 1,150 field associates.
Cincinnati Financial Corporation (CFC) owns 100 percent of three subsidiaries: The Cincinnati Insurance Company, CFC Investment Company and CinFin Capital Management Company. The Cincinnati Insurance Company owns 100 percent of our three smaller insurance subsidiaries: The Cincinnati Casualty Company, The Cincinnati Indemnity Company and The Cincinnati Life Insurance Company.
The Cincinnati Insurance Company, founded in 1950, leads the property casualty group known as The Cincinnati Insurance Companies. The Cincinnati Casualty Company and The Cincinnati Indemnity Company round out the property casualty insurance group, providing flexibility in pricing and underwriting while ceding substantially all of their business to The Cincinnati Insurance Company. The Cincinnati Life Insurance Company primarily markets life insurance and annuities. CFC Investment Company complements the insurance subsidiaries with leasing and financing services. CinFin Capital Management Company provides asset management services to institutions, corporations and high net worth individuals.
Our filings with the Securities and Exchange Commission (SEC) are available, free of charge, on our Web site, www.cinfin.com, as soon as possible after they have been filed with the SEC. These filings include our annual reports on Form 10-K, our quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. In the following pages we reference various Web sites. These Web sites, including our own, are not incorporated by reference in this Annual Report on Form 10-K.
Periodically, we refer to estimated industry data so that we can give information about our performance versus the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best Co., a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory basis. When we provide our results on a comparable statutory basis, we label it as such; all other company data is presented in accordance with accounting principles generally accepted in the United States of America (GAAP) .
Our Business and Our Strategy
Introduction
Our company was founded more than 50 years ago by independent agents to support the ability of local independent property casualty insurance agents to deliver quality financial protection to people and businesses in their communities. Today, we operate much the same way, actively marketing commercial insurance policies in 32 states through a select group of independent insurance agencies. We actively market all of our personal lines insurance policies in 22 of those states. We seek to become the life insurance carrier of choice for the agencies that market our property casualty insurance products and offer other financial services to help agents and their clients – the policyholders.
Our company distinguishes itself in three ways:
  We cultivate relationships with the independent insurance agents who market our policies and we make our decisions at the local level
  We achieve claims excellence, covering the spectrum from our response to reported claims to our approach to establishing reserves for not-yet-paid claims
  We invest for long-term total return, using available cash flow to purchase equity securities after covering insurance liabilities by purchasing fixed-maturity securities
Cultivating Relationships with Independent Insurance Agents
The U.S. property casualty insurance industry is a highly competitive marketplace with approximately 3,100 stock and mutual companies operating independently or in groups. No single company or group dominates across all product lines and states. Insurance companies (carriers) can market a broad array of products nationally or:
  choose to sell a limited product line or only one type of insurance (monoline carrier)
  target a certain segment of the market (for example, personal insurance)

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  focus on one or more states or regions (regional carrier)
Property casualty insurers generally market their products through one or more distribution channels:
  independent agents, who represent multiple carriers,
  captive agents, who represent one carrier exclusively, or
  direct marketing through the mail or Internet
Some carriers use more than one channel. For the most part, we compete with insurance companies that market through independent insurance agents.
Independent Agency Distribution System
We are committed to the independent agency distribution system, offering a broad array of commercial, personal and life insurance products through this channel. We recognize that locally based independent agencies have relationships in their communities that can lead to policyholder satisfaction, loyalty and profitable business. Our field associates provide service and accountability to the agencies, living in the communities they serve and working from offices in their homes, providing 24/7 availability to our agents.
At year-end 2005, our 1,024 agency relationships had 1,253 reporting agency locations marketing our insurance products. An increasing number of agencies have multiple, separately identifiable locations, reflecting their growth and consolidation of ownership within the independent agency marketplace. We believe “reporting agency locations,” a new measure for our company, accurately describes our agents’ scope of business and our presence within our 32 active states. At year-end 2004, we had 986 agency relationships with 1,213 reporting agency locations. At year-end 2003, we had 957 agency relationships with 1,185 reporting agency locations. In addition to providing data on reporting agency locations, we continue to give agency relationships metrics, such as our penetration within each agency relationship.
Property Casualty Agency Earned Premiums by State
In our 10 highest volume states, 853 reporting agency locations wrote 71.1 percent of our 2005 total property casualty agency earned premium volume. Agency earned premiums are premiums before reinsurance.
                                         
(Dollars in millions)   Earned     Percent           Reporting     Avg premium  
    premium     of total     Change %     agency locations     per location  
 
Year ended December 31, 2005
                                       
Ohio
  $ 737       23.1 %     2.2       224     $ 3.3  
Illinois
    299       9.4       1.7       112       2.7  
Indiana
    238       7.4       0.9       99       2.4  
Pennsylvania
    192       6.0       8.0       63       3.0  
Michigan
    173       5.4       (1.2 )     88       2.0  
Georgia
    141       4.4       9.5       59       2.4  
Virginia
    134       4.2       4.8       53       2.5  
North Carolina
    130       4.1       10.7       68       1.9  
Wisconsin
    125       3.9       6.4       49       2.6  
Kentucky
    102       3.2       5.0       38       2.7  
All other states
    923       28.9       8.9       400       2.3  
 
                                 
Total
  $ 3,194       100.0 %     5.1       1,253       2.5  
 
                                 
 
                                       
Year ended December 31, 2004
                                       
Ohio
  $ 722       23.7 %     7.1       224     $ 3.2  
Illinois
    294       9.7       7.7       113       2.6  
Indiana
    235       7.7       5.5       96       2.5  
Pennsylvania
    177       5.8       14.8       63       2.8  
Michigan
    175       5.8       12.2       83       2.1  
Georgia
    129       4.2       10.1       56       2.3  
Virginia
    127       4.2       12.8       51       2.5  
Wisconsin
    118       3.9       10.4       49       2.4  
North Carolina
    117       3.9       15.8       66       1.8  
Kentucky
    97       3.2       10.3       35       2.8  
All other states
    849       27.9       14.9       377       2.2  
 
                                 
Total
  $ 3,040       100.0 %     10.8       1,213       2.5  
 
                                 
In 2004, the most recent period for which data is available, Cincinnati Insurance was the No. 1 or No. 2 carrier in 74 percent of the reporting agency locations that have represented us for more than five years. The independent agencies that we choose to market our products share our philosophies. They do business person to person; offer broad, value-added services; maintain sound balance sheets and manage their agencies professionally. On average, we have a 17.3 percent share of the property casualty insurance in our

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reporting agency locations. Our share is 24.3 percent in reporting agency locations that have represented us for more than 10 years; 11.5 percent in agencies that have represented us for five to 10 years; 5.1 percent in agencies that have represented us for one to five years; and less than 1 percent in agencies that have represented us for less than one year.
Over the next decade, industry analysts predict successful agencies will have opportunities to increase their size on average almost three-fold. Agencies are expected to continue to pursue consolidation opportunities, buying or merging with other agencies to create stronger organizations and expand service. In addition to the growing networks of agency locations owned by banks and brokers, other agencies are addressing the consolidation by forming voluntary associations. These associations, or “clusters,” share back office and other functions to enhance economies, while maintaining their individual ownership structures.
No single agency relationship accounted for more than 1.1 percent of our total agency earned premiums in 2005. Some of our agency relationships are with individual offices of bank- or broker-owned organizations. Our relationships are with each office separately, however, no bank- or broker-owned organization, in aggregate, accounted for more than 2.0 percent of our total agency earned premiums in 2005.
Strengthening Our Agency Relationships
We follow a number of strategies to strengthen our relationships with the independent property casualty insurance agencies that represent us:
Risk-specific Underwriting
We seek to be a consistent, predictable and reasonable carrier that agencies can rely on to serve their clients. Our field and headquarters underwriters make risk-specific decisions about both new business and renewals. On a case-by-case basis, we select risks we can cover on acceptable terms and at adequate prices rather than underwriting solely by geographic location or business class.
For new commercial lines business, this case-by-case underwriting and pricing is coordinated by the local field marketing representatives. Our agents and our field marketing, loss control, bond and machinery and equipment representatives know the people and businesses in their communities and can make informed decisions about each risk. These field marketing representatives also are responsible for selecting new independent agencies, coordinating field teams of specialized company representatives and promoting all of the company’s products within the agencies they serve. Commercial lines policy renewals are managed by headquarters underwriters who are assigned to specific agencies and consult with local field staff, as needed.
We apply our risk-specific underwriting philosophy to personal lines new and renewal business in a different process. Each agency brings us personal lines business from within the geographic territory that it serves using its knowledge of the risks in those communities. New and renewal business activities are supported by headquarters associates assigned to individual agencies.
Competitive Insurance Products
We are committed to offering the products and services local agents need to serve their clients – the policyholders. Our commercial lines products are structured to allow flexible combinations of coverages in a single package with a single expiration date. Our intent is to write personal auto and homeowners coverages in personal lines packages that may also include personal umbrella and other coverages. The package approach brings policyholders convenience, discounts and a reduced risk of coverage gaps or disputes. At the same time, it increases account retention and saves time and expense for the agency and our company.
Our commercial lines packages are typically offered on a three-year policy term for most insurance coverages, a key competitive advantage. Although we offer three-year policy terms, premiums for some coverages within those policies are adjustable at anniversary for the subsequent annual period, and policies may be cancelled at any time at the discretion of the policyholder. Contract terms often provide that rates for property, general liability, inland marine and crime coverages, as well as policy terms and conditions, are fixed for the term of the policy. The general liability exposure basis may be audited annually. Commercial auto, workers compensation, professional liability and most umbrella liability coverages within multi-year packages are rated at each of the policy’s annual anniversaries for the next one-year period. The annual pricing could incorporate rate changes approved by state insurance regulatory authorities between the date the policy was written and its annual anniversary date, as well as changes in risk exposures and premium credits or debits relating to loss experience, competition and other underwriting judgment factors. We estimate that approximately 75 percent of 2005 commercial premiums were subject to annual rating or were written on a one-year policy term.
In our experience, multi-year packages are somewhat less price sensitive for the quality-conscious insurance buyers who we believe are typical clients of our independent agents. Customized insurance programs on a three-year term complement the long-term relationships these policyholders typically have with their agents and with the company. By reducing annual administrative efforts, multi-year policies lower expenses for our company and for our agents. The commitment we make to policyholders encourages long-term relationships and reduces their need to annually re-evaluate their insurance carrier or agency. We believe that the

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advantages of three-year policies in terms of policyholder convenience, account retention and reduced administrative costs outweigh the potential disadvantage of these policies, even in periods of rising rates.
Technology Solutions
We seek to continuously improve service to and communication with our agencies through an expanding portfolio of software:
  Web-based quoting and policy processing systems that allow our agencies and our field and headquarters associates to collaborate more efficiently on new and renewal business and that give our agencies choice and control
  Systems that automate our internal processes so our associates can spend more time serving agents and policyholders
Agencies access our quoting and policy processing systems via CinciLink®, our secure agency-only Web site. CinciLink also provides other content that makes it easier to do business with us, such as online policy loss information, software updates, online courses on the company’s products and services and electronic coverage forms libraries.
We also are giving independent agents enhanced access to Cincinnati’s systems and client data quickly and easily through their agency systems. We recognize the investment agencies have made in agency management systems. In 2005, we gave agents access to CinciLink directly from their agency systems by leveraging industry leading integration products, TransactNOW® and Transformation Station®. In 2006, we plan to advance our usage of these products. For commercial lines, we will enable upload of select client data from the leading agency systems to our new commercial lines pricing and policy systems. For personal lines, agencies will be able to access Diamond billing information and policy detail directly from their agency systems.
Three commercial lines and one personal lines system form the core of our quoting and policy processing systems:
  WinCPP® is an online commercial lines rate quoting system for businessowners, commercial package, commercial auto and workers compensation policies. WinCPP is available in all 32 states and used by all of our reporting agency locations. During 2006, we will add data sharing capabilities with agency systems and roll out quoting for small specialty programs for metalworkers, professional artisan contractors and garage owners. (A businessowners policy combines property, liability and business interruption coverages for small businesses.)
  e-CLAS™ is a commercial lines policy processing system. e-CLAS will make it easier and more efficient for our agencies to issue and administer our commercial lines policies. In 2005, we introduced e-CLAS to all of our agencies in Ohio to process new and renewal businessowners policies.
    Our primary long-term technology objectives are to:
  o   complete development of e-CLAS for all of our commercial lines of business and
 
  o   roll out the system to agencies in all of the states in which we do business
    During 2006, we expect to roll out businessowners policy processing to four additional states and provide dentists package policy processing in all five e-CLAS states. We also will begin developing commercial auto and commercial package policy processing capabilities.
  CinciBond™ is an automated system to process license and permit surety bonds. CinciBond enables agents to issue and print bonds at their offices. CinciBond was delivered to all Ohio agencies and initial groups of Indiana and Illinois agencies in 2005. During 2006, we will continue to deploy CinciBond in Indiana and Illinois.
  Diamond is a real-time personal lines policy processing system, supporting all six of our personal lines of business and allowing once and done processing. After its introduction in Kansas in 2002, we began full deployment of Diamond in 2004. At year-end, Diamond was in use in agencies representing approximately 70 percent of our 2005 personal lines premium volume, including those in Alabama, Florida, Kansas, Illinois, Indiana, Michigan and Ohio. In 2005, $417 million of our $786 million of personal lines written premium was issued through Diamond. During 2005, we improved the system’s stability and speed and made additional enhancements requested by our agencies. Training for agents in six states that represent another 21.5 percent of our premium volume is scheduled for 2006. Agents in Georgia, Kentucky and Wisconsin began using Diamond in early 2006 with Minnesota, Missouri and Tennessee roll-outs planned for later in the year.
Two systems that automate our internal processes so our associates can spend more time serving agents and policyholders are accessed through CFCNet®, our secure intranet:
  CMS™ is a claims file management system. CMS, initially deployed in late 2003, allows simultaneous access to claim files by headquarters and field claims associates. Field and headquarters claims associates use CMS to process all reported claims in a virtual claim file. We continue to refine the system

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    to add capabilities to make our associates more effective. Agent access to selected information is planned for 2006.
  i-View™ is a commercial lines policy imaging and workflow system. This system’s online policy viewing capability should speed the delivery and booking of policies as well as help expedite the claims process. We began rolling out i-View in 2004 and it was in use by approximately 50 percent of commercial lines underwriting teams at year-end 2005. Enhancements and infrastructure updates were completed in late 2005. Roll-out to the remaining teams began in January 2006 and we expect it will be completed during 2006.
Life Insurance Offerings Diversify Revenues and Earnings
We support the independent agencies affiliated with our property casualty operations in their programs to sell life insurance. The products offered by our life insurance subsidiary round out and protect accounts and improve account persistency. At the same time, the life operation looks to increase diversification of revenue and profitability sources for both the agency and our company.
Our property casualty agencies make up the main distribution system for our life insurance products. We also develop life business from other independent life insurance agencies. We are careful to solicit business from these other agencies in a manner that does not conflict with or compete with the marketing and sales efforts of our property casualty agencies. We emphasize up-to-date products, responsive underwriting and high quality service as well as competitive commissions.
Superior Financial Strength Ratings
In addition to the ratings of our parent company senior debt, our property casualty and life operations are awarded insurer financial strength ratings. Insurer financial strength ratings assess an insurer’s ability to meet its financial obligations to policyholders and do not necessarily address matters that may be important to shareholders. As of March 3, 2006, our financial strength ratings were:
                         
            Property Casualty    
    Parent Company   Insurance   Life Insurance
    Senior Debt   Subsidiaries   Subsidiary
 
Financial Strength Ratings:
                       
A. M. Best Co.
  aa-     A++       A+  
Fitch Ratings
    A+     AA   AA
Moody’s Investors Services
    A2     Aa3      
Standard & Poor’s Ratings Services
    A     AA-   AA-
 
                       
Property Casualty Statutory Ratings:
                       
Risk-Based Capital (RBC)
          $ 4,254          
Authorized control level risk-based capital
            635          
Property casualty statutory surplus
            4,194          
Property casualty written premium-surplus ratio
            0.7 x        
 
                       
Life Statutory Ratings:
                       
Risk-Based Capital (RBC)
                  $ 511  
Authorized control level risk-based capital
                    52  
Life statutory surplus
                    451  
Life statutory risk-based adjusted surplus-liabilities ratio
                    37.3 %
We believe that our superior insurer financial strength ratings are clear, competitive advantages in the segment of the insurance marketplace that our agents serve. Our financial strength supports the consistent, predictable performance that our policyholders, agents, associates and shareholders have always expected and received, and it must be able to withstand significant challenges. The most important way we seek to ensure that we remain consistent and predictable is to align agents’ interests with those of the company, giving agents outstanding service and compensation to earn their best business.
  A.M. Best – In June 2005, A.M. Best affirmed its top A++ (Superior) financial strength ratings and stable outlook for our property casualty subsidiaries. Less than 2 percent of the 1,064 insurer groups A.M. Best reviews annually qualify for the A++ rating.
    A.M. Best cited our superior risk-based capitalization, successful business position developed through building a network of independent agents, very strong financial flexibility and liquidity, excellent interest coverage measures and modest financial leverage. A.M. Best said its ratings take into account our high common stock leverage, elevated investment concentration and somewhat geographically concentrated market profile. A.M. Best stated that it expects the property casualty group’s overall operating results and

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    capitalization will remain strong in the near term due to our focused underwriting strategy, strong agency relations and consistently sound loss reserving practices.
    Also in June 2005, A.M. Best affirmed its A+ (Superior) rating for The Cincinnati Life Insurance Company. A.M. Best cited our life insurance subsidiary’s strategic position within Cincinnati Financial Corporation, our continuing focus on growth with a broad portfolio of life insurance products, expanding geographical presence, emphasis on full-time life insurance specialists, consistently positive statutory operating performance and adequate level of capitalization to manage our risks. A.M. Best said its rating considered the life subsidiary’s significant exposure to common stocks, lower operating profitability due to losses from accident and health business and the effect on surplus of acquisition costs related to writing increased amounts of new business.
  Fitch Ratings – In August 2005, Fitch affirmed its AA (Very Strong) insurer financial strength ratings and stable outlook for our property casualty subsidiaries and life insurance subsidiary. Fitch cited the strong financial condition of our operating subsidiaries, excellent financial flexibility, successful total return investment strategy and competitive advantage derived from long-term relationships with independent agents who distribute our products.
    Fitch said its ratings consider the property casualty group’s significant investment concentration in a small number of common stocks, geographic concentration that contributes to sizable catastrophe exposure and regulatory concentration and underperforming homeowner line of business. Fitch stated that it expects that financial leverage will remain at or near its current level over the intermediate term.
  Moody’s Investors Service – Following our announcement of third-quarter 2005 results, Moody’s commented that the company’s strong balance sheet and conservative financial and operating leverage metrics continue to support the property casualty subsidiaries’ Aa3 ratings. Moody’s said that its ratings took into account the increased volatility risk to capital and surplus presented by our equity exposure, along with its potential liabilities.
    Moody’s noted that the company was on track to achieve growth and profitability targets in line with Moody’s expectations for the current ratings. Moody’s said it expects the company will maintain our commercial pricing discipline along with our commitment to agency relationships, an integral filter in the underwriting process. Further, Moody’s expects full deployment of our policy processing system will simplify the process to introduce rate and product changes within our personal lines market.
  Standard & Poor’s Ratings Services – In October 2005, Standard & Poor’s issued a corporate ratings report with the rationale for its AA- (Very Strong) ratings of the property casualty subsidiaries and its negative outlook. Standard & Poor’s based the ratings, affirmed in September 2004, on the group’s strong competitive position afforded by its extremely loyal and productive independent agency force, high business persistency, extremely strong capitalization and high degree of financial flexibility. Standard & Poor’s said its outlook took into account the company’s underperformance in our homeowner business; very aggressive investment strategies; slow, deliberate response to changing markets, and volatility related to geographic concentration.
    Standard & Poor’s stated that it expects that the company should continue to perform well in its largest business segment, commercial lines, while lagging peers in personal lines profitability over the near term. Although progress could be tempered by slower growth, the sizeable equity position, adverse regulatory or judicial decisions or catastrophes, Standard & Poor’s said, it expects capitalization and growth will remain extremely strong and growth will be solid as new agency appointments and territory subdivisions partially offset possible weakening in industry pricing.
    A December 2005 corporate ratings report gave the rationale for Standard & Poor’s AA- (Very Strong) rating of The Cincinnati Life Insurance Company. Standard & Poor’s based the rating, affirmed in September 2004, on the life subsidiary’s strategic position within our group of companies, an extraordinarily superior capital position, extremely strong liquidity and the strength of its marketing position among independent agents. Standard & Poor’s said its rating considered the modest but growing penetration of our property casualty customer base, a narrow but growing product line and asset/liability management in the early stage of development. Standard & Poor’s outlook included expectations for premium growth of 9 percent, continued broadening of our product portfolio, improved asset/liability management, continued extremely strong capital and liquidity, as well as improved benchmarks for tracking penetration of the property casualty customer base.
While the potential for volatility exists due to our catastrophe exposures, investment philosophy and bias toward incremental change, the ratings agencies consistently have asserted that we have built appropriate financial strength and flexibility to manage that volatility. We remain committed to strategies that emphasize long-term stability over short-term benefits that might accrue by quick reaction to changes in market conditions.
For example, through all market and economic cycles we maintain strong insurance company statutory surplus, a solid reinsurance program, sound reserving practices and low interest rate risk, as well as low debt and

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strong capital at the parent-company level. Investments at the parent company give us flexibility to support our capitalization policies for the subsidiaries, improve the ability of the insurance companies to write additional premiums and maintain high insurer financial strength ratings.
In 2004, we transferred approximately 32 million shares of our Fifth Third Bancorp (Nasdaq: FITB) common stock holding to the insurance subsidiary from the parent company to reduce parent company investment assets. The transfer raised our property casualty statutory surplus and reduced our ratio of net written premiums to statutory surplus. This ratio is a common measure of operating leverage used in the property casualty industry. It serves as an indicator of the company’s premium growth capacity. The estimated property casualty industry net written premium to statutory surplus ratio was 1.0 percent, 1.1 percent and 1.2 percent in 2005, 2004 and 2003, respectively. We do not intend to leverage our lower ratio following the asset transfer by accelerating growth or strengthening loss reserves. Rather, the transfer allowed us to retain the financial flexibility that continues to support our high insurer financial strength ratings.
Cincinnati Life’s statutory adjusted risk-based surplus increased 4.1 percent to $511 million at December 31, 2005, from $491 million a year earlier. Statutory adjusted risk-based surplus as a percentage of liabilities, a key measure of life insurance company capital strength, was 37.3 percent at year-end 2005 compared with an estimated industry average ratio of 10.4 percent. The higher the ratio, the stronger an insurer’s security for policyholders and its capacity to support business growth.
At year-end 2005 and 2004, the risk-based capital (RBC) for our property casualty and life operations was exceptionally strong and well above levels that would have required regulatory action.
Programs, Products and Services to Support Agency Growth
We continue to expand the services we provide that support agency opportunities. Accessible field representatives are the first layer of support. Headquarters associates also provide agencies with underwriting, accounting and technology assistance and training. Company executives, headquarters underwriters and special teams regularly travel to visit agencies. Agents have opportunities for direct, personal conversations with our senior management team, and headquarters associates have opportunities to refresh their knowledge of marketplace conditions and field activities.
The field marketing representatives are joined by field claims, loss control, machinery and equipment, bond, premium audit, life insurance and leasing specialists. For example, our field engineering and loss control representatives perform inspections and recommend specific actions to improve the safety of the policyholder’s operations and the quality of the agent’s insurance account.
We complement the property casualty operations by providing products and services that help attract and retain high-quality independent insurance agencies. CFC Investment Company offers equipment and vehicle leases and loans for independent insurance agencies, their commercial clients and other businesses. It also provides commercial real estate loans to help agencies operate and expand their businesses. CinFin Capital Management markets asset management services to agencies and their clients, as well as other institutions, corporations and high net worth individuals.
When we appoint agencies, we look for organizations with knowledgeable, professional staffs. In turn, we make an exceptionally strong commitment to assist them in keeping their knowledge up to date and educating new people they bring on board as they grow. Numerous activities at our headquarters, in regional and agency locations and online fulfill this commitment:
  At our headquarters, we conduct roundtables for agency principals, as well as our regular schedule of commercial lines, personal lines and life insurance agent schools and seminars. These generally focus on Cincinnati product and underwriting information and sales tips. In addition to schools for agents, we have opened seats for agents in our structured classroom training for new underwriting associates. Agency staff may return to their agencies after the class or stay and become fully grounded in Cincinnati philosophy by serving as an associate for a few years before returning to the agency.
  Associates travel to regional and agency locations to instruct classes and provide a variety of educational support services. Teams conduct personal lines customer service representative training and marketing seminars to promote cross-serving and sales of bonds, leasing services, life worksite marketing, inland marine coverages and our program for dentists. Other teams help agencies learn to use our new systems or get the most from their own agency management systems. Cincinnati associates even co-host client seminars with our agencies on the benefits of worksite marketing or risk management and risk transfer techniques, with customized programs that address liability issues specific to contractor or dentist audiences.
  We now bring courses to agency desktops, where at any time agency staff can access the Agency Learning Center through CinciLink, our secure agency-only Web site. The Learning Center offers convenient, online courses and Web conferences, including Cincinnati product information, Microsoft® Office topics and general business subjects. Our new producer and customer service representative curricula guide students through a progression of online courses and classroom instruction.

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Except travel-related expenses for courses held at our headquarters, most programs are offered at no cost to our agencies. While that approach may be extraordinary in our industry today, the result is quality service for our policyholders and increased success for our independent agencies.
Third-party Measures of Satisfaction and Performance
The National Association of Insurance Commissioners’ Online Consumer Information Source (www.naic.org) measured our complaint ratio at a very low 0.25 versus the national median score of 1.00 for all property coverages in 2004, the most recent year for which data is available. NAIC members head the state departments of insurance that regulate insurance.
The Professional Insurance Agents Association of Ohio surveyed its members in 2005 on satisfaction with their insurance companies. We scored higher than any other insurer in the categories of claims handling, commercial lines competitiveness and agency compensation. Offsetting these top scores and other strong scores in personal lines policy service, company management and field marketing support, were scores lower than all other insurers in both the homeowner competitiveness and the personal auto competitiveness categories. As discussed in Item 7, Personal Lines Insurance Results of Operations, Page 47, we are taking steps to restore a competitive position in personal lines.
In a 2005 study, Ward Group named Cincinnati Insurance to its annual top 50 lists of property casualty and life/health insurers in America. Insurers and groups qualify based on financial safety, consistency and performance over a five-year period. Cincinnati is one of only eight property casualty insurers that have qualified for the list in each of its 15 years and one of only 10 property casualty insurers whose life insurance affiliates also qualified.
Growing with Our Agencies
One of our primary objectives is to increase our written premiums more rapidly than the industry. We believe our agencies are growing more rapidly than the industry, and we seek to maintain or increase our penetration within each agency as it grows.
Further improving service through the creation of smaller marketing territories that permit our local field marketing representatives to devote more time to each agency relationship should help us maintain or increase our penetration within each agency. At year-end 2005, we had 100 field marketing territories, up from 92 at the end of 2004 and 87 at the end of 2003. A new Delaware/Maryland territory represented both the subdivision of our existing Maryland territory and our entry into Delaware, our first new state since 2000. While we continually study the regulatory and competitive environment in states where we could decide to actively market our property casualty products, we have not announced plans to enter any of those states in the near future.
Another way we seek to increase overall premiums is to selectively appoint new agency relationships within our current marketing territories. In 2004, we set an objective to establish approximately 50 new agency relationships each year. In 2005, we established 41 new agency relationships, and in 2004, we established 50 new relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 40 in 2005 and 22 in 2004. We are very careful to protect the franchise for current agencies when selecting and appointing new agencies.
Achieving Claims Excellence
Our claims philosophy reflects our belief that we will prosper as a company by responding to claims person to person, paying covered claims promptly, preventing false claims from unfairly adding to overall premiums and building financial strength to meet future obligations. We also believe that our company should have the financial strength to pay claims while also creating value for shareholders, leading to our emphasis on the establishment of adequate claims reserves.
Superior Claims Service
Our 751 locally based field claims representatives work from their homes, assigned to specific agencies. They respond personally to policyholders and claimants, typically within 24 hours of receiving an agency’s claim report. We believe the person-to-person approach, together with the resulting high level of service that field claims representatives, familiar with an agency and its policyholders, can provide, gives us a competitive advantage. We also help our agencies provide prompt service to policyholders by giving agencies authority to immediately pay most first-party claims up to $2,500.
Catastrophe Response Teams are comprised of volunteers from our experienced field claims staff. As hurricanes threaten, these associates travel to strategic locations near the expected impact area. This puts them in position to quickly get to the affected area, set up temporary offices and start calling on policyholders. Cincinnati takes pride in giving our field personnel the tools and authority they need to do their jobs. In times of widespread loss, our field claims representatives confidently and quickly resolve claims, often writing checks for damages on the same day they inspect the loss. Our Claims Management System introduced new efficiencies that are especially evident during catastrophes. Electronic claim files allow for fast initial contact of

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policyholders and easy sharing of information between rotating storm teams, headquarters and local field claims representatives.
Cincinnati’s claims associates work hard to control costs where appropriate. We have several relationships with vendors that offer our insureds and claimants preferred rates. However, our biggest cost control program is our field claims representatives. Field claims representatives are educated continuously on new techniques and repair trends. These representatives have experience with area body shops, which helps them negotiate the right price with any facility the policyholder chooses.
We staff a Special Investigations Unit (SIU) with former law enforcement and claims professionals who are available to gather facts to help determine the fair amount to pay under a claim. While we believe it’s our job to pay all that is due under each policy, we also want to prevent false claims from unfairly increasing overall premiums. Our SIU also operates a computer forensic lab, using sophisticated software to recover data and mitigating the cost of computer-related claims for business interruption and loss of records.
Loss and Loss Expense Reserves
When claims are made by or against policyholders, any amounts that our property casualty operations pay or expect to pay for covered claims are termed losses. The costs we incur in investigating, resolving and processing these claims are termed loss expenses. Our consolidated financial statements include property casualty loss and loss expense reserves that estimate the costs of not-yet-paid claims incurred through December 31 of each year. The reserves include estimates for claims that have been reported to us plus our estimates for claims that have been incurred but not yet reported, along with our estimate for loss expenses associated with processing and settling those claims. We develop the various estimates based on individual claim evaluations and statistical projections. We reduce the loss reserves by an estimate for the amount of salvage and subrogation we expect to recover. For at least the past 10 years, our annual review of our estimates has led to savings from favorable development of loss reserves from prior accident years.
We encourage you to review several sections of the Management’s Discussion and Analysis where we discuss our loss reserves in greater depth. In Item 7, Critical Accounting Estimates, Property Casualty Loss and Loss Expense Reserves, Page 35, we discuss our process for analyzing potential losses and establishing reserves. In Item 7, Property Casualty Insurance Reserves, Page 61, we review reserve levels, including 10-year development of our property casualty loss reserves.
Investing for Long-term Total-return
While we seek to generate an underwriting profit in our insurance operations, our investments historically have provided our primary source of net income and contributed to our financial strength, driving long-term growth in shareholders’ equity and book value.
Under the direction of the investment committee of the board of directors, our portfolio managers seek to balance current investment income opportunities and long-term appreciation so that current cash flows can be compounded to achieve above-average long-term total return. We invest some portion of cash flow in tax-advantaged fixed-maturity and equity securities to maximize after-tax earnings. With premiums generally received before claims are made under the policies purchased with those premiums, particularly for business lines such as workers compensation, we have substantial cash flow available for investment.
Insurance regulatory and statutory requirements established to protect policyholders from investment risk have always influenced our investment decisions on an individual insurance company basis. After covering both our intermediate and long-range insurance obligations with fixed-maturity investments, we historically used available cash flow to invest in equity securities. Investment in equity securities has played an important role in achieving our portfolio objectives and has contributed to net unrealized investment gains of $5.067 billion at year-end 2005. We remain committed to our long-term equity focus, which we believe is key to our company’s long-term growth and stability.
Our segments
Consolidated financial results primarily reflect the results of our four reporting segments. These segments are defined based on financial information we use to evaluate performance and to determine the allocation of assets.
  Commercial lines property casualty insurance
  Personal lines property casualty insurance
  Life insurance
  Investments
We also frequently evaluate results for our consolidated property casualty operations, which is the total of our commercial lines and personal lines segments. Our consolidated property casualty operations generated 80.8 percent of our revenues in 2005. Revenues, income before income taxes, and identifiable assets for each

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segment are shown in a table in Item 8, Note 17 to the Consolidated Financial Statements, Page 98. Some of that information also is discussed in this section of this report, where we explain the business operations of each segment. The financial performance of each segment is discussed in the Management’s Discussion and Analysis of Financial Condition and Results of Operations, which begins on Page 31.
Commercial Lines Property Casualty Insurance Segment
The commercial lines property casualty insurance segment contributed $2.254 billion in net earned premiums to total revenues and $285 million to income before income taxes in 2005. Commercial lines net earned premiums grew 6.0 percent in 2005, 11.4 percent in 2004 and 10.8 percent in 2003.
Four business lines – commercial multi-peril, workers compensation, commercial auto and other liability – accounted for 89.7 percent of our commercial lines earned premiums.
  Commercial multi-peril coverage is a combination of property and liability coverages. Property insurance covers damages such as those caused by fire, wind, hail, water, theft, vandalism and business interruption resulting from a covered loss. Liability coverage insures businesses against third-party liability from accidents occurring on their premises or arising out of their operations, such as injuries sustained from products sold.
  Workers compensation coverages protect employers against specified benefits payable under state or federal law for workplace injuries to employees. In some of our active states, including Ohio, workers compensation coverage is a state monopoly, provided solely by the state instead of by private insurers.
  Commercial auto coverages protect businesses against liability to others for both bodily injury and property damage, medical payments to insureds and occupants of their vehicles, physical damage to an insured’s own vehicle from collision and various other perils, and damages caused by uninsured motorists.
  Other liability coverages include commercial umbrella, commercial general liability and most executive risk policies, which cover liability exposures including bodily injury, directors and officers and employment practices, property damage arising from products sold and general business operations.
The remainder of our commercial lines earned premiums derives from a variety of other types of insurance products that we offer to businesses, including fire and allied lines commercial property policies, inland marine policies, fiduciary and surety bonds and machinery and equipment policies.
We market our full portfolio of commercial insurance products in 1,245 of our reporting agency locations and all 32 states where we actively market property casualty insurance. There are eight reporting agency locations that market only our surety bond products. Our emphasis is on products that agents can market to small- to mid-size businesses in their communities.
In 2005, our 10 highest volume commercial lines states generated 68.8 percent of our agency earned premium compared with 70.0 percent in the prior year. Agency earned premiums in the 10 highest volume states rose 5.2 percent in 2005 and 10.4 percent in 2004. Agency earned premiums in the remaining 22 states rose 10.5 percent in 2005 and 16.2 percent in 2004. Agency earned premiums are premiums before reinsurance.

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Commercial Lines Agency Earned Premiums by State
                                         
(Dollars in millions)   Earned     Percent           Reporting     Avg premium  
    premium     of total     Change %     agency locations     per location  
 
Year ended December 31, 2005
                                       
Ohio
  $ 432       18.2 %     4.0       224     $ 1.9  
Illinois
    241       10.1       2.8       112       2.1  
Pennsylvania
    174       7.3       7.9       63       2.8  
Indiana
    164       6.9       2.9       99       1.7  
Michigan
    130       5.5       0.2       88       1.5  
North Carolina
    125       5.3       11.1       68       1.8  
Virginia
    112       4.7       4.6       53       2.1  
Wisconsin
    98       4.1       8.7       49       2.0  
Iowa
    82       3.4       6.6       45       1.8  
Georgia
    79       3.3       13.6       59       1.3  
All other states
    739       31.2       10.5       393       1.9  
 
                                 
Total
  $ 2,376       100.0 %     6.8       1,253       1.9  
 
                                 
 
                                       
Year ended December 31, 2004
                                       
Ohio
  $ 415       18.7 %     8.1       224     $ 1.9  
Illinois
    234       10.5       7.7       113       2.1  
Pennsylvania
    162       7.3       14.4       63       2.6  
Indiana
    160       7.2       6.8       96       1.7  
Michigan
    130       5.8       11.3       83       1.6  
North Carolina
    112       5.0       15.9       66       1.7  
Virginia
    107       4.8       13.5       51       2.1  
Wisconsin
    90       4.1       11.1       49       1.8  
Iowa
    77       3.4       12.4       44       1.7  
Tennessee
    72       3.2       14.4       30       2.4  
All other states
    666       30.0       16.2       393       1.7  
 
                                 
Total
  $ 2,225       100.0 %     12.0       1,212       1.8  
 
                                 
Commercial Lines Insurance Marketplace
For commercial lines, our competition predominately consists of those companies that also distribute through independent agents. The independent agencies that market our commercial lines products typically represent four to 12 standard market insurance carriers, including both national and regional carriers, some of which may be mutual companies. Generally, we believe regional carriers offer us the greatest competition on small- and mid-size commercial accounts because they often are familiar with the local market and focus on differentiating themselves through personal relationships with agencies. Carriers with a national presence provide formidable competition on large commercial accounts and have increasingly targeted smaller commercial accounts, marketing a service-center approach that some agencies find efficient. In our experience, the level of competition varies state by state and region by region, regardless of the carriers represented within a specific agency.
Since late 2003, the softening commercial lines marketplace has been characterized by increased competition, particularly for quality new business. Generally, the level of competition has varied by market, by line of business and by size of account. In most markets where we compete, disciplined underwriting generally has remained the norm. We believe carriers are modifying prices rather than changing policy terms and conditions. Prior to Hurricanes Katrina, Rita and Wilma, we anticipated commercial lines insurance market trends in 2006 would reflect accelerated competition with pressure on pricing from the industry’s increasing surplus and improving profitability. We are uncertain what effect the hurricanes, and the related rise in the cost of reinsurance, may have on commercial lines pricing throughout 2006.
Personal Lines Property Casualty Insurance Segment
The personal lines property casualty insurance segment contributed $804 million in net earned premiums to total revenues and $45 million to income before income taxes in 2005. Personal lines net earned premiums grew 1.4 percent in 2005, 6.4 percent in 2004 and 11.2 percent in 2003.
The personal auto line of business accounted for 53.8 percent and the homeowner line of business accounted for 35.5 percent of personal lines net earned premium in 2005.
  Personal auto coverages protect against liability to others for both bodily injury and property damage, medical payments to insureds and occupants of their vehicle, physical damage to an insured’s own vehicle from collision and various other perils, and damages caused by uninsured motorists. In addition, many

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    states require policies to provide first-party personal injury protection, frequently referred to as no-fault coverage.
  Homeowner coverages protect against losses to dwellings and contents from a wide variety of perils, as well as liability arising out of personal activities both on and off the covered premises. The company also offers coverage for condominium unit owners and renters.
The remainder of our personal lines earned premium was derived from a variety of other types of insurance products we offer to individuals such as dwelling fire, inland marine, personal umbrella liability and watercraft coverages.
We market both homeowner and personal auto insurance products through 773 of our 1,253 reporting agency locations in 22 of the 32 states in which we market commercial lines insurance. We market homeowner products through 22 locations in three additional states (Maryland, North Carolina and West Virginia.) The remaining 458 locations are in states where we either do not actively market these products or where we have determined, in conjunction with agency management, that our personal lines products are not appropriate for their agencies at this time.
In 2005, our 10 highest volume personal lines states generated 85.0 percent of our agency earned premium compared with 85.1 percent in the prior year. Agency earned premiums in the 10 highest volume states rose 0.3 percent in 2005 and 6.5 percent in 2004. Agency earned premiums in the remaining states rose 1.1 percent in 2005 and 12.9 percent in 2004. Agency earned premiums are premiums before reinsurance.
Personal Lines Agency Earned Premiums by State
                                         
(Dollars in millions)   Earned     Percent           Reporting     Avg premium  
    premium     of total     Change %     agency locations     per location  
 
Year ended December 31, 2005
                                       
Ohio
  $ 305       37.4 %     (0.3 )     211     $ 1.4  
Indiana
    74       9.0       (3.1 )     65       1.1  
Illinois
    59       7.2       (2.5 )     78       0.8  
Georgia
    62       7.6       4.8       46       1.4  
Michigan
    43       5.2       (5.3 )     66       0.6  
Alabama
    40       4.9       4.3       24       1.7  
Kentucky
    37       4.6       5.3       33       1.1  
Wisconsin
    27       3.3       (1.2 )     30       0.9  
Florida
    26       3.2       6.9       10       2.6  
Virginia
    21       2.6       5.8       23       0.9  
All other states
    123       15.0       1.1       209       0.6  
 
                                 
Total
  $ 818       100.0 %     0.4       795       1.0  
 
                                 
Year ended December 31, 2004
                                       
Ohio
  $ 306       37.6 %     5.7       202     $ 1.5  
Indiana
    76       9.3       2.7       67       1.1  
Illinois
    61       7.4       7.7       80       0.8  
Georgia
    60       7.3       5.9       44       1.3  
Michigan
    45       5.5       14.9       60       0.8  
Alabama
    38       4.7       2.9       25       1.5  
Kentucky
    36       4.4       13.3       31       1.1  
Wisconsin
    28       3.4       8.2       30       0.9  
Florida
    25       3.0       4.7       10       2.5  
Virginia
    20       2.5       9.1       22       0.9  
All other states
    120       14.9       12.9       207       0.6  
 
                                 
Total
  $ 815       100.0 %     7.4       778       1.0  
 
                                 
Personal Lines Insurance Marketplace
In addition to carriers that market through independent agents, our personal lines competition also includes carriers that market through captive agents and direct writers, which our agencies’ clients may investigate independently. The independent agencies that market our personal lines products typically represent five to eight standard personal lines carriers.
In 2003, competition increased in the personal lines marketplace, driven by industrywide improvement in results and favorable frequency and severity trends. This followed several years of rising personal auto and homeowner rates and stricter enforcement of underwriting standards across the industry. The increased competition in the past several years also reflected implementation of tiered rating systems by a growing number of carriers. Carriers that have adopted these systems use multiple variables to segment the market, relying in part on credit-based information and offering a greater number of rate levels.

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We expect that competition in the personal auto and homeowners markets will continue to increase over the next 12 to 24 months. Despite the record level of industrywide catastrophe losses in 2005 and 2004, many personal lines carriers have reported strong operating results in the past two years and continue to have healthy capital to support business growth. We believe these carriers are focused on gaining market share through the introduction of new products and services, increased advertising expenditures and the use of tiered rating systems that may allow them to target higher quality risks with lower prices.
Life Insurance Segment
The life insurance segment contributed $106 million of net earned premiums and $7 million in income before income taxes in 2005. Life insurance segment profitability is discussed in detail in Item 7, Life Insurance Results of Operations, Page 52.
The overall mission of our company is supported by The Cincinnati Life Insurance Company. Cincinnati Life helps meet the needs of our agencies, including increasing and diversifying agency revenues. We primarily focus on life products that produce revenue growth through a steady stream of premium payments. By diversifying revenue and profitability for both the agency and our company, this strategy enhances the already strong relationship built by the combination of the property casualty and life companies.
Cincinnati Life seeks to become the life insurance carrier of choice for the independent agencies that work with our property casualty operations. We emphasize up-to-date products, responsive underwriting and high quality service as well as competitive commissions. At year-end 2005, approximately 80 percent of our 1,253 property casualty reporting agency locations offered Cincinnati Life’s products to their clients. We also develop life business from other independent life insurance agencies. We are careful to solicit business from these other agencies in a manner that does not conflict with or compete with the marketing and sales efforts of our property casualty agencies.
Business Lines
Four lines of business – term insurance, whole life insurance, universal life insurance and worksite products – account for approximately 86 percent of the life insurance segment’s revenues:
  Term insurance – policies under which the benefit is payable only if the insured dies during a specified period of time or term; no benefit is payable if the insured survives to the end of the term. While premiums are fixed, they must be paid as scheduled. The proposed insured is evaluated using normal underwriting standards.
  Whole life insurance – policies that provide life insurance for the entire lifetime of the insured; the death benefit is guaranteed never to decrease and premiums are guaranteed never to increase. While premiums are fixed, they must be paid as scheduled. These policies provide guaranteed cash values that are available to withdrawing policyholders. The proposed insured is evaluated using normal underwriting standards.
  Universal life insurance – long-duration life insurance policies. Contract premiums are neither fixed nor guaranteed; however, the contract does specify a minimum interest crediting rate and a maximum cost of insurance charge and expense charge. Premiums are not fixed and may be varied by the contract owner. The cash values available to withdrawing policyholders are not guaranteed and depend on the amount and timing of actual premium payments and the amount of actual contract assessments. The proposed insured is evaluated using normal underwriting standards.
  Worksite products – term insurance, whole life insurance, universal life and disability insurance offered to employees through their employer. Premiums are collected by the employer using payroll deduction. Polices are issued using a simplified underwriting approach and for smaller face amounts than similar, regularly underwritten policies. Worksite insurance products provide our property casualty agency force with excellent cross-serving opportunities for both commercial and personal accounts. Agents report that offering worksite marketing to employees of their commercial accounts provides a benefit to the employees at low cost to the employer. Worksite marketing also connects agents with new customers who may not have previously benefited from receiving the services of a professional independent insurance agent.
In addition, Cincinnati Life markets:
  Disability income insurance — provides monthly benefits to offset the loss of income when the insured person is unable to work due to accident or illness.
  Deferred annuities — provide regular income payments that commence after the end of a specified period or when the annuitant attains a specified age. During the deferral period, any payments made under the contract accumulate at the crediting rate declared by the company but not less than a contract-specified guaranteed minimum interest rate. A deferred annuity may be surrendered during the deferral period for a cash value equal to the accumulated payments plus interest less the surrender charge, if any.

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  Immediate annuities — provide some combination of regular income and lump sum payments in exchange for a single premium. Most of the immediate annuities written by our life insurance segment are purchased by our property casualty companies to settle casualty claims.
Life Insurance Marketplace
Our life insurance company markets its products through approximately 1,000 of our reporting agency locations in all but one of the 32 states where we actively market property casualty insurance and through 453 additional independent life agencies in a total of 48 states. We do not market life insurance products in Alaska and New York.
We market our life insurance products either through independent agencies affiliated with our property casualty operations or through independent life agencies. Our property casualty agencies comprise the main distribution system for our life insurance products. Other life insurance carriers continue to expand the use of nontraditional distribution channels such as banks and financial planners as alternatives to the agency channel. We intend to market solely through independent agencies, with an emphasis on enhancing our relationships with the agencies affiliated with our property casualty insurance operations.
When marketing through our property casualty agencies we have several specific competitive advantages. Because our property casualty operations are held in high regard, the property casualty agency’s management is predisposed to consider carefully our proposals to sell our life products. All of our marketing efforts, property casualty and life, are directed by our field marketing department, which assures consistency of message. Our life field marketing representatives regularly meet face-to-face with the agency personnel responsible for life insurance production. The resources of our life headquarters underwriters and other associates are available to the field team to assist in the placement of agency business. We find fewer and fewer of our competitors provide direct, personal contact between the agent and the insurance carrier.
Also, we continue to emphasize the cross-serving opportunities between worksite marketing of life insurance products and the property casualty agency’s commercial accounts. For example, in 2006, we are exploring additional programs to simplify the worksite sales process, including electronic enrollment software. We also intend to enhance our worksite product portfolio to make it more attractive to agents.
In both the property casualty and independent life agency distribution systems we enjoy the competitive advantages of offering competitive, up-to-date products, providing close personal attention and exhibiting financial strength and stability.
We primarily offer products targeted at addressing the needs of small businesses that require key person coverage and individuals who require mortality coverage. Term insurance is our largest life insurance product line. We continue to introduce new term products with features our agents indicate are important. A new term series, which included a return-of-premium feature, replaced the existing term portfolio during 2005. Reaction to the new portfolio has been favorable with approximately 25 percent of applications requesting the return-of-premium feature. In 2006 we are introducing a new universal life product that offers a secondary guarantee that keeps the death benefit in force provided a competitive minimum premium requirement is met.
Because of our strong capital position, we can offer a competitive product portfolio including guaranteed products, giving our agents a marketing edge. Our life insurance company maintained strong insurer financial strength ratings in 2005: A.M. Best – A+ (Superior), Fitch — AA (Very Strong) and Standard & Poor’s – AA- (Very Strong, negative outlook).
Offsetting our competitive advantages we continue to see consolidation within the life insurance industry and an increased presence of large, well-capitalized carriers. The larger carriers can offer a broader product line, including variable and equity-indexed products. Our competitive advantage can be diminished because we do not have these types of products, particularly during a time when the stock market is performing well.
Current statutory laws and regulations require redundant reserves, particularly for preferred risk underwriting classes. These redundant reserves, in turn, depress statutory earnings and require a large commitment of capital. Redundant reserves are a significant issue, not just for our life insurance operations, but for all writers of term insurance and universal life with secondary guarantees. However, larger carriers may be able to better absorb or may be able to securitize the statutory reserve strain associated with competitively priced term insurance and universal life with secondary guarantees.
The NAIC recognizes the problems caused by redundant reserves and is following a two-step approach to provide relief. First, the NAIC has asked for comments on an amendment to the mortality table mandated for statutory reserves to incorporate preferred underwriting classifications. The amended table would lower reserve requirements for term insurance products. It may be available for use in statutory statements by December 31, 2006. Second, the NAIC proposes amending the actuarial guidelines for reserve requirements for universal life policies with secondary guarantees. The amendment would allow the use of low-level lapse rates in calculating reserves for these types of universal life plans and also would result in lower reserves. It may be available for use in statutory statements by December 31, 2007.

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For the longer term, the NAIC has asked for comment proposals on implementing a principles-based reserving system rather than the current formulaic system. While still capturing all material risks, a principles-based system would allow a company to use its own experience, subject to credibility standards and appropriate margins for uncertainty. Also, under the proposed principles-based system, the insurer would fully document and disclose all its assumptions and methods to regulatory officials.
Investments Segment
The investment segment contributed $587 million of our total revenues in 2005, primarily from net investment income and realized investment gains and losses from investment portfolios managed for the holding company and each of the operating subsidiaries. After deducting interest credited to contract holders of the life insurance segment, the investments segment contributed $536 million of income before income taxes, or 65.1 percent of our total income before income taxes.
The fair value (market value) of our investment portfolio was $12.657 billion and $12.639 billion at year-end 2005 and 2004, respectively. The cash we generate from insurance operations historically has been invested in three broad categories of investments:
  Fixed-maturity investments – Includes taxable and tax-exempt bonds and redeemable preferred stocks
 
  Equity investments – Includes common and nonreedemable preferred stocks
 
  Short-term investments – Primarily commercial paper
                                 
(In millions)           At December 31,          
    2005     2004  
    Book value     Fair value     Book value     Fair value  
 
Taxable fixed maturities
  $ 3,304     $ 3,359     $ 3,161     $ 3,376  
Tax-exempt fixed maturities
    2,083       2,117       1,622       1,694  
Common equities
    1,961       6,936       1,918       7,466  
Preferred equities
    167       170       27       32  
Short-term investments
    75       75       71       71  
 
                       
Total
  $ 7,590     $ 12,657     $ 6,799     $ 12,639  
 
                       
Primarily as part of our program to support our high financial strength ratings almost all of our insurance subsidiary’s available cash flow since the second quarter of 2004 has been used to purchase fixed-maturity investments. Our objective was to bring the property casualty subsidiary’s ratio of common stock to statutory surplus in line with our historic sub-100 percent level. The ratio of common stock to statutory surplus for the property casualty insurance group portfolio was 97.0 percent at year-end 2005 compared with 103.5 percent at year-end 2004 and 114.7 percent at year-end 2003.
During the same period, we took actions to reduce the parent company’s ratio of investment assets to total assets for the parent company below 40 percent, for the reasons we discuss in Item 1A, Risk Factors, Page 21. The ratio of investment assets to total assets for the parent company was 33.9 percent at year-end 2005, compared with 36.3 percent at year-end 2004 and 58.6 percent at year-end 2003.
Going forward, we will take into consideration insurance department regulations and ratings agency comments, as well as the trend in these ratios, to determine what portion of new cash flow should be invested in equity securities at the parent and insurance subsidiary levels.
In the past, we also have separately reported convertible security investments, which make up approximately 2.4 percent of the total fair value of the investment portfolio. Beginning this year, we are reporting and analyzing convertible securities as either fixed-maturity or equity investments, based on the characteristics of the underlying security (bond or preferred stock).
Fixed-maturity and Short-term Investments
By maintaining a well diversified fixed-maturity portfolio, we attempt to reduce overall risk. We invest new money in the bond market on a continuous basis, targeting what we believe to be optimal risk-adjusted after-tax yields. Risk, in this context, includes interest rate, call, reinvestment rate, credit and liquidity risks. We do not make a concerted effort to alter duration on a portfolio basis in response to anticipated movements in interest rates. By continuously investing in the bond market, we build a broad, diversified portfolio that we believe mitigates the impact of adverse economic factors. In recent years, we have taken into account the trend toward a flatter corporate yield curve by purchasing higher-quality corporate bonds with intermediate maturities as well as tax-exempt municipal bonds and U.S. agency paper. Our focus on long-term total return may result in variability in the levels of realized and unrealized investment gains or losses from one period to the next.
We place a strong emphasis on purchasing current income-producing securities for the insurance companies’ portfolios. Within the fixed-maturity portfolio, we invest in a blend of taxable and tax-exempt securities to

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minimize our corporate taxes. With the exception of U.S. agency paper, no individual issuer’s securities accounted for more than 1.0 percent of the fixed-maturity portfolio at December 31, 2005.
Taxable Fixed-maturities
Taxable fixed-maturity bonds include:
  $973 million in U.S. agency paper, which is rated AAA by both Moody’s and Standard & Poor’s.
 
  $1.750 billion in investment-grade corporate bonds that have a Moody’s rating at or above Baa 3 or a Standard & Poor’s rating at or above BBB-.
 
  $358 million in high-yield corporate bonds that have a Moody’s rating below Baa 3 or a Standard & Poor’s rating below BBB-.
 
  $278 million in convertible bonds and redeemable preferred stocks.
We seek to balance current income with potential changes in market value as well as changes in credit risk when determining whether or not to hold these securities to maturity.
Similar to the equity portfolio, the taxable fixed-maturity portfolio is most heavily concentrated in the financials sector, including banks, brokerage, finance and investment and insurance companies. The financials sector represented 26.1 percent and 26.6 percent, respectively, of book value and fair value of the taxable fixed-maturity portfolio at December 31, 2005, compared with 24.1 percent and 24.6 percent of book value and fair value at December 31, 2004. Although it is our largest concentration in a single sector, we believe our percentage in the financials sector is below average for the corporate bond market as a whole. No other sector or industry accounted for more than 10 percent of the taxable fixed-maturity portfolio.
Tax-exempt Fixed-maturities
We traditionally have purchased municipal bonds focusing on schools and essential services, such as sewer, water or others. While no single municipal issuer accounted for more than 1.2 percent of the tax-exempt municipal bond portfolio at December 31, 2005, there are higher concentrations within individual states. Holdings in Illinois, Indiana, Michigan, Ohio and Texas accounted for 60.6 percent of the municipal bond portfolio at year-end 2005.
Fixed-maturity and Short-term Portfolio Ratings
Our investments in U.S. agency paper and insured municipal bonds over the past several years have led to a significant rise in the percentage of A and higher rated fixed-maturity and short-term holdings, based on fair value. The majority of our non-rated securities are tax-exempt municipal bonds from smaller municipalities that chose not to pursue a credit rating. Credit ratings as of December 31, 2005 and 2004, for the fixed-maturity and short-term portfolio were:
                                 
(Dollars in millions)   2005     2004  
    Fair     Percent     Fair     Percent  
    value     to total     value     to total  
 
Moody’s Ratings
                               
Aaa, Aa, A
  $ 3,651       65.8 %   $ 3,101       60.3 %
Baa
    1,094       19.7       1,069       20.8  
Ba
    324       5.8       363       7.1  
B
    110       2.0       125       2.4  
Caa
    13       0.2       23       0.5  
Ca
    0       0.0       11       0.2  
C
    0       0.0       0       0.0  
Non-rated
    359       6.5       449       8.7  
 
                       
Total
  $ 5,551       100.0 %   $ 5,141       100.0 %
 
                       
 
                               
Standard & Poor’s Ratings
                               
AAA, AA, A
  $ 3,233       58.3 %   $ 2,865       55.7 %
BBB
    1,112       20.0       1,095       21.3  
BB
    354       6.4       340       6.6  
B
    117       2.1       154       3.0  
CCC
    2       0.0       5       0.1  
CC
    0       0.0       11       0.2  
D
    0       0.0       4       0.1  
Non-rated
    733       13.2       667       13.0  
 
                       
Total
  $ 5,551       100.0 %   $ 5,141       100.0 %
 
                       

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Attributes of the fixed-maturity portfolio include:
                 
    Years ended December 31,
    2005   2004
 
Weighted average yield-to-book value
    5.4 %     5.8 %
Weighted average maturity
  9.5  yrs   9.4  yrs
Weighted average duration to worst
  5.4  yrs   4.8  yrs
Weighted average modified duration
  7.1  yrs   6.9  yrs
The decline in the yield-to-book between 2005 and 2004 was due to investments of new cash flow as well as the reinvestment of calls and redemptions at interest rates below historic norms. The average maturity was essentially unchanged. The modified duration remained nearly flat while modified duration to worst, an option adjusted measure, increased. This was primarily due to a slight increase in rates in the intermediate range of the yield curve and our continued emphasis on purchasing municipal bonds, which have a lower pretax yield. We discuss the maturity of our fixed-maturity portfolio in Item 8, Note 2 to the Consolidated Financial Statements, Page 88.
Equity Investments
Our equity investment portfolio includes both common stocks and nonreedemable preferred stocks. Approximately 87.8 percent of the equity portfolio is made up of a core group of common stocks that we monitor closely to gain an in-depth understanding of their organization and industry. The portfolio also includes a broader group of smaller positions that are a source of trading flexibility and other risk management advantages. Our equity investments had an average dividend yield-to-cost of 11.7 percent at December 31, 2005, compared with 11.5 percent at December 31, 2004.
Common Stocks
At December 31, 2005, 35.1 percent of our common stock holdings (measured by fair value) were held at the parent company level. Our common stock investments generally are securities with annual dividend yields of 1.5 percent to 3.0 percent and histories of dividend increases. Other criteria we evaluate include increasing sales and earnings, proven management and a favorable outlook. When investing in common stock, we seek to identify some companies in which we can accumulate more than 5 percent of their outstanding shares. At year-end 2005, we held more than 5 percent of Fifth Third, FirstMerit Corporation, Piedmont Natural Gas Company and First Financial Bancorp. There also is a core group of common stocks in which the company holds a fair value of at least $100 million each. At year-end 2005, there were 14 holdings in that core group.
Largest Common Stock Holdings
                                         
(Dollars in millions)           As of and for the year ended December 31, 2005        
                            Earned     Earned  
    Actual     Fair     Percent of     dividend     dividend to  
    cost     value     fair value     income     fair value  
 
Fifth Third Bancorp
  $ 283     $ 2,745       39.6 %   $ 106       3.9 %
ALLTEL Corporation
    117       801       11.6       20       2.5  
ExxonMobil Corporation
    133       503       7.3       10       2.0  
The Procter & Gamble Company
    105       335       4.8       6       1.8  
National City Corporation
    171       329       4.7       14       4.3  
PNC Financial Services Group, Inc.
    62       291       4.2       10       3.2  
Wyeth
    62       204       2.9       4       2.0  
Alliance Capital Management Holding L.P.
    53       179       2.6       9       5.0  
U.S. Bancorp
    113       172       2.5       7       4.1  
Wells Fargo & Company
    66       139       2.0       5       3.2  
FirstMerit Corporation
    54       139       2.0       6       4.2  
Johnson & Johnson
    115       139       2.0       3       2.0  
Piedmont Natural Gas Company, Inc.
    62       134       1.9       4       2.9  
Sky Financial Group, Inc.
    91       130       1.9       4       3.2  
All other common stock holdings
    474       696       10.0       22       3.2  
 
                               
Total
  $ 1,961     $ 6,936       100.0 %   $ 230       3.3  
 
                               
In 2005, we sold 475,000 shares of our holdings of ALLTEL Corporation, which was our second largest common stock holding at year-end. We completed the sale of the remaining 12,700,164 shares of ALLTEL common stock in January 2006. ALLTEL was an excellent investment for the company for over 40 years, bringing an increasing flow of dividend income and healthy market value appreciation. Because of the restructuring that ALLTEL announced in late 2005, we determined that it no longer met our investment parameters.
This emphasis on a small group of equities and long-term investment horizon has resulted in significant concentrations within the portfolio, as this buy-and-hold strategy over many years has built up significant accumulated unrealized appreciation within the equity portfolio. At year-end 2005, the largest industry

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concentrations within our common stock holdings were the financials sector at 63.4 percent of total fair value and the healthcare sector at 6.4 percent of total fair value.
Nonreedemable Preferred Stocks
We evaluate preferred stocks similar to the evaluation we make for fixed-maturity investments, seeking attractive relative yields. We generally focus on investment-grade preferred stocks issued by companies that have a strong history of paying common dividends, which provides us with another layer of protection. Additionally, when possible we seek out preferred stocks that offer a dividend received deduction.
Additional information regarding the composition of investments is included in Item 8, Note 2 to the Consolidated Financial Statements, Page 88.
Other
We report as “Other” the operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding investment activities) as well as other income of our insurance subsidiary. As of December 31, 2005, CFC Investment Company had 2,815 accounts and $101 million in gross receivables, compared with 2,489 and $92 million at December 31, 2004. As of December 31, 2005, CinFin Capital had 64 institutional, corporate and individual clients and $864 million under management, compared with 60 and $827 million at December 31, 2004.
REGULATION
State Regulation
The business of insurance primarily is regulated by state law. Although our insurance subsidiaries are domiciled in Ohio and primarily subject to Ohio insurance laws and regulations, we also are subject to state regulatory authorities of all states in which we write insurance. The state laws and regulations that have the most significant effect on our insurance operations and financial reporting are discussed below.
  Insurance Holding Company Regulation – Our subsidiaries primarily engage in the property casualty insurance business and secondarily in the life insurance business, both subject to regulation as an insurance holding company system by the State of Ohio. These regulations require that we annually furnish financial and other information about the operations of the individual companies within the holding company system. All transactions within a holding company affecting insurers must be fair and equitable. Notice to the state insurance commissioner is required prior to the consummation of transactions affecting the ownership or control of an insurer and prior to certain material transactions between an insurer and any person or entity in its holding company. In addition, some of those transactions cannot be consummated without the commissioner’s prior approval.
 
  Subsidiary Dividends — The dividend-paying capacity of our insurance subsidiaries is regulated by the laws of Ohio, the domiciliary state. This regulation requires an insurance subsidiary to provide a 10-day advance informational notice to the Ohio insurance department prior to payment of any dividend or distribution to its shareholders (all of our smaller insurance subsidiaries are 100 percent owned by The Cincinnati Insurance Company, which is 100 percent owned by Cincinnati Financial Corporation). Ordinary dividends must be paid from earned surplus, which is the amount of unassigned funds set forth in an insurance subsidiary’s most recent statutory financial statement.
The Ohio Department of Insurance must give prior approval before the payment of an extraordinary dividend by an insurance subsidiary to shareholders. You can find information about the dividends paid by our insurance subsidiary in 2005 in Item 8, Note 8 to the Consolidated Financial Statements, Page 91.
  Insurance Operations – All of our insurance subsidiaries are subject to licensing and supervision by departments of insurance in the states in which they do business. The nature and extent of such regulations vary, but generally have their source in statutes that delegate regulatory, supervisory and administrative powers to state insurance departments. Such regulations, supervision and administration of the insurance subsidiaries include, among others, the standards of solvency which must be met and maintained; the licensing of insurers and their agents; the nature and limitations on investments; deposits of securities for the benefit of policyholders; regulation of policy forms and premium rates; policy cancellations and non-renewals; periodic examination of the affairs of insurance companies; annual and other reports required to be filed on the financial condition of insurers or for other purposes; requirements regarding reserves for unearned premiums, losses and other matters; the nature of and limitations on dividends to policyholders and shareholders; the nature and extent of required participation in insurance guaranty funds; and the involuntary assumption of hard-to-place or high-risk insurance business, primarily workers compensation insurance.

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  Insurance Guaranty Associations — Each state has insurance guaranty association laws under which the associations may assess life and property casualty insurers doing business in the state for certain obligations of insolvent insurance companies to policyholders and claimants. Typically, states assess each member insurer in an amount related to the insurer’s proportionate share of business written by all member insurers in the state. In 2005, our insurance subsidiaries incurred a negative $3 million for guaranty associations. In 2004, our insurance subsidiaries incurred $2 million. We cannot predict the amount and timing of any future assessments or refunds on our insurance subsidiaries under these laws.
 
  Shared Market and Joint Underwriting Plans — State insurance regulation requires insurers to participate in assigned risk plans, reinsurance facilities and joint underwriting associations, which are mechanisms that generally provide applicants with various basic insurance coverages when they are not available in voluntary markets. Such mechanisms are most commonly instituted for automobile and workers compensation insurance, but many states also mandate participation in FAIR Plans or Windstorm Plans, which provide basic property coverages. Participation is based upon the amount of a company’s voluntary market share in a particular state for the classes of insurance involved. Underwriting results related to these organizations, which tend to be adverse to our company, have been immaterial to our results of operations.
 
  Statutory Accounting — For public reporting, insurance companies prepare financial statements in accordance with GAAP. However, certain data also must be calculated according to statutory accounting rules as defined in the NAIC’s Accounting Practices and Procedures Manual.
While not a substitute for any GAAP measure of performance, statutory data frequently is used by industry analysts and other recognized reporting sources to facilitate comparisons of the performance of insurance companies.
  Insurance Reserves — State insurance laws require that property casualty and life insurance subsidiaries analyze the adequacy of reserves annually. Our appointed actuaries must submit an opinion that reserves are adequate for policy claims-paying obligations and related expenses.
 
  Risk-Based Capital Requirements — The NAIC’s risk-based capital (RBC) requirements for property casualty and life insurers serve as an early warning tool for the NAIC and the state regulators to identify companies that may be undercapitalized and may merit further regulatory action. The NAIC has a standard formula for annually assessing RBC. The formula for calculating RBC for property casualty companies takes into account asset and credit risks but places more emphasis on underwriting factors for reserving and pricing. The formula for calculating RBC for life insurance companies takes into account factors relating to insurance, business, asset and interest rate risks.
Federal Regulation
Although the federal government and its regulatory agencies generally do not directly regulate the business of insurance, federal initiatives often have an impact. Some of the current and proposed federal measures that may significantly affect our business are discussed below.
  The Terrorism Risk Insurance Act of 2002 (TRIA) – TRIA was signed into law on November 26, 2002, and extended on December 22, 2005, in a revised form. TRIA provides a temporary federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. TRIA now is scheduled to expire December 31, 2007. Under regulations promulgated under this statute, insurers are required to offer terrorism coverage for certain lines of property casualty insurance, including property, commercial multi-peril, fire, ocean marine, inland marine, liability, aircraft, surety and workers compensation. In the event of a terrorism event defined by TRIA, the federal government will reimburse terrorism claim payments subject to the insurer’s deductible. The deductible is calculated as a percentage of subject written premiums for the preceding calendar year. Our deductible was $328 million (15 percent of 2004 subject premiums) in 2005, $199 million in 2004 (10 percent of 2003 subject premiums) and $136 million in 2003 (7 percent of 2002 subject premiums). For 2006, the deductible is an estimated $318 million (17.5 percent of 2005 subject premiums).
 
  Health Insurance Portability and Accountability Act of 1996 (HIPAA) – We protect consumer health information pursuant to regulations promulgated under HIPAA. Regulations effective April 14, 2003, require health care providers such as doctors and hospitals, as well as health and long-term care insurers and health care clearinghouses, to institute physical and procedural safeguards to protect the health records of patients and insureds. Effective October 16, 2003, additional regulations required health plans to electronically transmit and receive standardized health care information. These rules and regulations have had a minimal effect on us, as our health insurance writings are limited to our self-funded health plan for our associates and a small number of run-off medical and hospital expense insurance policies. We do not actively market health, medical and hospital expense insurance policies.

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  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.

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Item 1A. Risk Factors
Our business involves various risks and uncertainties that may affect achievement of our business objectives. Many of the risks could have ramifications across our integrated business activities. For example, while risks related to setting insurance rates and establishing and adjusting loss reserves are insurance activities, errors in these areas could have an impact on our investment activities. The following discussion should be viewed as a starting point for understanding the significant risks we face. It is not a definitive summary of their potential impact or of our strategies to manage and control the risks. Please see Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, Page 31, for a discussion of those strategies.
The risks and uncertainties below are not the only ones we face. There are additional risks and uncertainties that we currently do not believe are material. There also may be risk and uncertainties of which we are not aware. If any risks or uncertainties discussed here develop into actual events, they could have a material adverse effect on our business, financial condition or results of operations. In that case, the market price of our common stock could decline materially.
Readers should carefully consider this information together with the other information we have provided in this report and in other reports and materials we file periodically with the Securities and Exchange Commission as well as news releases and other information we disseminate publicly.
We rely exclusively on independent insurance agents to distribute our products.
We market our products through independent, non-exclusive insurance agents. These agents are not obligated to promote our products and can and do sell our competitors’ products. We must offer insurance products that meet the needs of these agencies and their clients. We need to maintain good relationships with the agencies that market our products. If we do not, these agencies may market our competitors’ products instead of ours, which may lead to us having a less desirable mix of business, which could affect our results of operations.
Events or conditions that could diminish a competitive advantage that our independent agencies enjoy:
  Downgrade of the financial strength ratings of our insurance subsidiaries. We believe our strong insurer financial strength ratings, in particular the A++ rating from A.M. Best of our property casualty insurance subsidiaries, are an important competitive advantage. Only 16 other insurance groups, or 1.7 percent of all insurance groups, qualify for the A++, A.M. Best’s highest rating. If our property casualty ratings were downgraded, our agents might find it more difficult to market our products or might choose to emphasize the products of other carriers, which could adversely affect our results of operations.
 
  Concerns that doing business with us is difficult or perceptions that our level of service is no longer a distinguishing characteristic in the marketplace. If agents or policyholders believed that we were no longer providing the prompt, reliable personal service that has long been a distinguishing characteristic of our insurance operations, our results of operations could be adversely affected.
 
  Delays in the development, implementation, performance and benefits of technology projects and enhancements or independent agent perceptions that our technology solutions are inadequate to match their needs.
A reduction in the number of independent agencies marketing our products, the failure of these agencies to successfully market our products or the choice of these agencies to reduce their writings of our products could reduce our revenues and our results of operations if we were unable to replace them with agencies that produce adequate premiums.
Further, policyholders may choose a competitor’s product rather than our own because of real or perceived differences in price, terms and conditions, coverage or service. If the quality of the independent agencies with which we do business were to decline, that also might cause policyholders to purchase their insurance through different agencies or channels. Increased comfort in Internet purchasing could further reduce independent agencies’ writings of personal lines products.
Please see Item 1, Our Business and Our Strategy, Page 1, for a discussion of our relationships with independent insurance agents.
Competition could adversely affect our ability to sell policies at rates we deem adequate.
The insurance industry is highly competitive. Competition in our insurance business is based on many factors, including:
  Competitiveness of premiums charged
 
  Underwriting and pricing methodologies that allow insurers to identify and flexibly price risks
 
  Underwriting discipline
 
  Terms and conditions of insurance coverage
 
  Rate at which products are brought to market

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  Technological innovation
 
  Ability to control expenses
 
  Adequacy of financial strength ratings by independent ratings agencies such as A.M. Best
 
  Quality of services provided to agents and policyholders
If we were unable to compete effectively because of one or more of these factors, our premium writings could decline and our results of operations and financial condition could be materially adversely affected.
Please see Item 7, Commercial Lines, Personal Lines and Life Insurance Results of Operations, Page 41, Page 47, and Page 52, for a discussion of our competitive position in the insurance marketplace.
Managing technology initiatives and meeting new data security requirements are significant challenges.
While technology can streamline many business processes and ultimately reduce the cost of operations, technology initiatives present short-term cost and implementation risks. In addition, we may have inaccurate expense projections, implementation schedules or expectations regarding the efficacy of the end product. These issues could escalate over time.
Data security is subject to increasing regulation. We face rising costs and competing time constraints in meeting compliance requirements of new and proposed regulations. Computer viruses, hackers and other external hazards could expose our data systems to security breaches. These increased risks and expanding regulatory requirements could expose us to data loss, damages and significant increases in compliance costs.
Please see Item 1, Technology Solutions, Page 4, for a discussion of our technology initiatives.
The effects of emerging or latent claim and coverage issues on our business are uncertain.
As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to insurance claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued the insurance policies that could be affected by the changes. As a result, the full extent of liability under our insurance contracts may not be known for many years after a policy is issued. The effects of such unforeseeable emerging and latent claim and coverage issues could adversely affect our results of operations.
Please see Item 7, Property Casualty and Life Insurance Reserves, Page 61 and Page 67, for a discussion of our reserving practices.
Our loss reserves, our largest liability, are based on estimates and could be inadequate to cover our actual losses.
Our financial statements are prepared using GAAP. These principles require us to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ materially from those estimates. For a discussion of the significant accounting policies we use to prepare our financial statements and the material implications of uncertainties associated with the methods, assumptions and estimates underlying our critical accounting policies, please refer to Item 7, Property Casualty Insurance Loss And Loss Expense Reserves, Page 35, and Item 8, Note 1 to the Consolidated Financial Statements, Page 84.
Our most critical accounting estimate is of loss reserves. Loss reserves are the amounts we expect to pay for covered claims and expenses we incur to adjust those claims. The loss reserves we establish in our financial statements represent an estimate of amounts needed to pay and administer claims arising from insured events that have occurred, including events that have not yet been reported to us. Loss reserves are estimates and are inherently uncertain; they do not and cannot represent an exact measure of liability. Accordingly, our loss reserves for past periods could prove to be inadequate to cover our actual losses and related expenses. Any changes in these estimates are reflected in our results of operations during the period in which the changes are made. An increase in our loss reserves would decrease earnings, while a decrease in our loss reserves would increase earnings.
The estimation process for unpaid loss and loss expense obligations involves uncertainty by its very nature. We continually review the estimates and adjust the reserve as facts regarding individual claims develop, additional losses are reported and new information becomes known. Adjustments due to loss development for prior years are reflected in the calendar year in which they are identified.

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Unforeseen losses, the type and magnitude of which we cannot predict, may emerge in the future. These additional losses could arise from changes in the legal environment, catastrophic events, increases in loss severity or frequency, or other causes. Such future losses could be substantial.
Please see Item 7, Property Casualty and Life Insurance Reserves, Page 61 and Page 67, for a discussion of our reserving practices.
We could experience an unusually high level of losses due to catastrophic or terrorism events or risk concentrations.
Our financial condition, cash flow and results of operations depend on our ability to underwrite and set rates accurately for a full spectrum of risks. We establish our pricing based on assumptions regarding the level of losses that will occur within classes of business, geographic regions and other criteria. A number of factors could cause our assumptions regarding future losses to be inaccurate.
In the normal course of our business, we provide coverage for exposures for which estimates of losses are highly uncertain, in particular catastrophic and terrorism events. Catastrophes can be caused by a number of events, including hurricanes, tornadoes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Due to the nature of these events, we are unable to predict precisely the frequency or potential cost of catastrophe occurrences. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event.
We have catastrophe exposure to:
  Hurricanes in the gulf and southeastern coastal regions.
 
  Earthquakes in the New Madrid fault zone, which lies within the central Mississippi valley, extending from northeast Arkansas through southeast Missouri, western Tennessee and western Kentucky to southern Illinois, southern Indiana and parts of Ohio.
 
  Tornado, wind and hail in the Midwest, Southeast, mid-Atlantic and Western regions.
We have identified terrorism exposure to general commercial risks in the metropolitan Chicago area as well as small co-op utilities, small shopping malls and small colleges throughout our 32 active states.
Additionally, our life insurance subsidiary could be adversely affected in the event of an epidemic such as the avian flu, particularly if the epidemic affects a broad range of the population beyond just the very young or the very old.
Our results of operations would be adversely affected if the level of losses we experienced over a period of time exceeded our actuarially determined expectations. In addition, our financial condition would be adversely affected if we were required to sell securities prior to maturity or at unfavorable prices to pay an unusually high level of loss and loss expenses. Securities pricing might be even less favorable if a number of insurance companies needed to sell securities during a short period of time because of unusually high losses from catastrophic events.
Our geographic concentration ties our performance to business, economic and regulatory conditions in certain states. We market our property casualty insurance product in 32 states, but our business is concentrated in the Midwest and Southeast. We also have exposure in states where we do not actively market insurance when clients of our independent agencies have business or properties in multiple states.
The Cincinnati Insurance Company also participates in three assumed reinsurance treaties with two reinsurers that spread the risk of very high catastrophe losses among many insurers. In 2006, we have exposure to assumed losses of 1 percent of property losses between $400 million and $1.2 billion from a single event under an assumed reinsurance treaty for Munich Re Group. The other two assumed reinsurance treaties are immaterial.
In the event of a severe catastrophic event or terrorist attack elsewhere in the world, our insurance losses may be immaterial. However, the companies in which we invest might be severely affected, which could affect our financial condition and results of operations.
Please see Item 7, Property Casualty and Life Insurance Reserves, Page 61 and Page 67, for a discussion of our reserving practices.
Our ability to obtain or collect on our reinsurance protection could affect our business, financial condition and results of operations.
We buy property casualty and life reinsurance coverage to mitigate the liquidity risk of an unexpected rise in claims severity or frequency from catastrophic events or a single large loss. The availability, amount and cost of reinsurance depend on market conditions and may vary significantly. If we are unable to obtain reinsurance on acceptable terms and in appropriate amounts, our business and financial condition may be adversely affected.

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In addition, we are subject to credit risk with respect to our reinsurers. Although we purchase reinsurance to manage our risks and exposures to losses, this reinsurance does not discharge our direct obligations under the policies we write. We would remain liable to our policyholders even if we were unable to recover what we believe we are entitled to receive under our reinsurance contracts. Reinsurers might refuse or fail to pay losses that we cede to them, or they might delay payment. For long-term cases, the creditworthiness of our reinsurers may change before we can recover amounts to which we are entitled. A reinsurer’s insolvency, inability or unwillingness to make payments under the terms of its reinsurance agreement with our insurance subsidiaries could have a material adverse effect on our financial position and results of operations.
Prior to 2003, we participated in USAIG, a joint underwriting association of individual insurance companies that collectively function as a worldwide insurance market for all types of aviation and aerospace accounts. At year-end 2005, 36.9 percent, or $251 million, of our total reinsurance receivables were related to USAIG, primarily for September 11, 2001, events. Although more than 99 percent of the reinsurance recoverables associated with USAIG are backed by securities on deposit, if we are unable to collect these receivables, our financial position and results of operations could be materially affected. We no longer participate in new business generated by USAIG and its members.
Please see Item 7, 2006 Reinsurance Programs, Page 68, for a discussion of our reinsurance treaties.
Our ability to realize our investment objectives could affect our financial condition or our results of operation.
We invest premiums received from policyholders and other available cash to generate investment income and capital appreciation, maintaining sufficient liquidity to pay covered claims and operating expenses, service our debt obligations and pay dividends. At year-end 2005, our investment portfolio was $12.657 billion, or 79.1 percent of our total assets. In 2005, our investment operations contributed 15.6 percent of our revenue and 65.1 percent of our total income before income taxes.
Investment income is an important component of our revenues and net income. The ability to achieve our investment objectives is affected by factors that are beyond our control, such as inflation, economic growth, interest rates, world political conditions, terrorism attacks or threats and other widespread unpredictable events. These events may adversely affect the economy generally and could cause our investment income or the value of securities we own to decrease. A significant decline in our investment income could have an adverse effect on our net income, and thereby on our shareholders’ equity and our policyholders’ surplus. For more detailed discussion of risks associated with our investments; please refer to Item 7A, Qualitative and Quantitative Disclosures About Market Risk, Page 70.
Our investment performance also could suffer because of the types of investments, industry groups and/or individual securities in which we choose to invest. Market value changes related to these choices could cause a material change in our financial condition or results of operations.
One of our investments, Fifth Third, accounted for 26.3 percent of our shareholders’ equity at year-end 2005 and dividends earned from our Fifth Third investment were 20.2 percent of our investment income in 2005. If Fifth Third’s common stock price were to further decline significantly, our financial condition could be materially affected. If Fifth Third were to decrease or discontinue its dividend, our results of operation could be materially affected.
Because we currently own more than 10 percent of Fifth Third’s outstanding shares, we are limited in the amount of Fifth Third stock we could sell in any given period. This limitation could lead us to hold a sizeable position in Fifth Third even if it would no longer meet our investment parameters. This could result in a variety of adverse consequences depending on the reason we had concluded Fifth Third no longer met our investment parameters. For example, if Fifth Third were to stop paying dividends on its common stock, we would not be able to reinvest quickly in other income-earning investments, which would have a material affect on our results of operations.
Please see Item 1, Investments Segment, Page 15, and Item 7, Investments Results of Operations, Page 54, and Liquidity and Capital Resources, Page 57, for discussion of our investment activities.

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Our status as an insurance holding company with no direct operations could affect our ability to pay dividends in the future.
Cincinnati Financial Corporation is a holding company that transacts substantially all of its business through its subsidiaries. Our primary assets are the stock in our operating subsidiaries and our investments. Consequently, our cash flow to pay cash dividends and interest on our long-term debt depends on dividends we receive from our operating subsidiaries and income earned on investments held at the parent-company level.
Dividends paid to us by our insurance subsidiary are restricted by the insurance laws of Ohio, our domiciliary state. These laws establish minimum solvency and liquidity thresholds and limits. Currently, the maximum dividend that may be paid without prior regulatory approval is limited to the greater of 10 percent of statutory surplus or 100 percent of statutory net income for the prior calendar year, up to the amount of statutory unassigned surplus as of the end of the prior calendar year. Dividends exceeding these limitations may be paid only with prior approval of the Ohio Department of Insurance. Consequently, at times, we might not be able to receive dividends from our insurance subsidiary or we might not receive dividends in the amounts necessary to meet our debt obligations or to pay dividends on our common stock. This could affect our financial position.
Please see Item 1, Regulation, Page 18, and Item 8, Note 8 to the Consolidated Financial Statements, Page 91, for discussion of insurance holding company dividend regulations.
We could make investment decisions or experience market value fluctuations that trigger restrictions applicable to the parent company under the Investment Company Act of 1940.
Compared to other insurance holding companies, we hold a significant level of investment assets at the parent company level. If these investment assets grow to account for more than 40 percent of parent company’s total assets, excluding assets of our subsidiaries, we might become subject to regulation under the Investment Company Act of 1940. Our operations are limited by the constraint that investment securities held at the holding company level should remain below the 40 percent threshold described above. Efforts to stay below the threshold could result in:
  Disposal of otherwise desirable investment securities, possibly under undesirable conditions. Such dispositions could result in a lower return on investment, loss of investment income, and if we were unable to manage the timing of the dispositions, we also might realize unnecessary capital gains, which would increase our annual tax payment.
 
  Limited opportunities to purchase equity securities that hold the potential for market value appreciation, which could hamper book value growth over the long term.
 
  Maintenance of a greater portion of our portfolio of equity securities at the insurance subsidiary, which would cause the parent to be more reliant on its subsidiaries for cash to fund parent-company obligations, including shareholder dividends and interest on long-term debt.
If the parent company’s investment assets were to exceed the 40 percent ratio to total assets, excluding investment in its subsidiaries, and if it were determined that the holding company was an unregistered investment company, the holding company might be unable to enforce contracts with third parties, and third parties could seek rescission of transactions with the holding company undertaken during the period that it was an unregistered investment company, subject to equitable considerations set forth in the Investment Company Act. In addition, the holding company could become subject to monetary penalties or injunctive relief, or both, in an action brought by the SEC.
Please see Item 8, Note 15 to the Consolidated Financial Statements, Page 96, for discussion of the Investment Company Act of 1940.
Item 1B. Unresolved Staff Comments
None

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Item 2. Properties
Cincinnati Financial Corporation owns our headquarters building located on 100 acres of land in Fairfield, Ohio. This building contains approximately 800,000 total square feet. The property, including land, is carried in our financial statements at $73 million as of December 31, 2005, and is classified as land, building and equipment, net, for company use. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (1 percent).
In 2004, we decided to undertake a $100 million building expansion at our headquarters location in Fairfield, Ohio. Construction of an underground garage and third office tower began in early 2005. The new tower will contain more than 690,000 total square feet, including the garage. It will rise seven stories above three underground parking levels with 700 parking spaces. We estimate a completion date of September 2008 for the project. We believe this expansion will accommodate our business needs for the foreseeable future. The construction project is on schedule and on budget. As of December 31, 2005, construction costs totaled $18 million.
Cincinnati Financial Corporation owns the Fairfield Executive Center, which is located on the northwest corner of our headquarters property in Fairfield, Ohio. This is a four-story office building containing approximately 124,000 square feet. The property is carried in the financial statements at $7 million as of December 31, 2005, and is classified as land, building and equipment, net, for company use. CFC and our subsidiaries occupy approximately 90 percent of the rentable square feet and unaffiliated tenants occupy approximately 10 percent.
The Cincinnati Life Insurance Company owns a four-story office building in the Tri-County area of Cincinnati, Ohio. It contains approximately 102,000 rentable square feet. This property is carried in the financial statements at $3 million as of December 31, 2005, and is classified as other invested assets. Three tenants occupy approximately 50 percent of the rentable square feet. The remaining space is available for lease.
Item 3. Legal Proceedings
Neither the company nor any of our subsidiaries is involved in any material litigation other than ordinary, routine litigation incidental to the nature of our business.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders of Cincinnati Financial during the fourth quarter of 2005.

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Part II
Item 5.   Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Cincinnati Financial Corporation had approximately 12,000 shareholders of record as of December 31, 2005. Many of our independent agent representatives and most of the 3,983 associates of our subsidiaries own the company’s common stock. We are unable to accurately quantify those holdings because many are beneficially held.
Our common shares are traded under the symbol CINF on the Nasdaq National Market. The common stock prices and dividend data below reflect the 5 percent stock dividends paid June 15, 2004 and April 26, 2005.
                                                                 
(Source: Nasdaq National Market)           2005                   2004    
Quarter:   1st   2nd   3rd   4th   1st   2nd   3rd   4th
 
High
  $ 43.92     $ 43.12     $ 42.64     $ 45.95     $ 41.61     $ 41.78     $ 41.70     $ 43.52  
Low
    40.84       38.38       39.00       39.91       37.02       37.90       37.46       36.57  
Period-end close
    41.53       39.56       41.89       44.68       39.41       41.45       39.26       42.15  
Cash dividends declared
    0.290       0.305       0.305       0.305       0.250       0.262       0.262       0.262  
Our ability to pay cash dividends may depend on the ability of our insurance subsidiary to pay dividends to the parent company. The dividend restrictions of our insurance company subsidiaries are discussed in Item 8, Note 8 to the Consolidated Financial Statements, Page 91.
Information regarding securities authorized for issuance under our equity compensation plans appears in the Proxy Statement under “Equity Compensation Plan Information.” This portion of the Proxy Statement is incorporated herein by reference. Additional information about options granted under our equity compensation plans is available in Item 8, Note 8 and Note 16 to the Consolidated Financial Statements, Pages 91 and 97.
The board of directors has authorized share repurchases since 1996. We discuss the board authorization in Item 7, Uses of Capital, Page 61. In 2005, we repurchased a total of 1,500,000 shares (unadjusted for stock dividends).
                                 
                    Total number of shares   Maximum number of
                    purchased as part of   shares that may yet be
    Total number of   Average price   publicly announced   purchased under the
Month   shares purchased   paid per share   plans or programs   plans or programs
 
January 1 -31, 2005
    0     $ 0.00       0       3,705,977  
February 1-28, 2005
    0       0.00       0       3,705,977  
March 1-31, 2005
    115,000       45.54       115,000       3,590,977  
April 1-30, 2005
    162,728       39.58       162,728       3,428,249  
May 1-31, 2005
    379,172       39.26       379,172       3,049,077  
June 1-30, 2005
    308,100       39.41       308,100       2,740,977  
July 1-31, 2005
    0       0.00       0       2,740,977  
August 1-31, 2005
    1,035       39.95       1,035       2,739,942  
September 1-30, 2005
    159,157       41.74       159,157       9,840,843  
October 1-31, 2005
    0       0.00       0       9,840,843  
November 1-30, 2005
    0       0.00       0       9,840,843  
December 1-31, 2005
    374,808       45.13       374,808       9,466,035  
 
                               
Totals
    1,500,000       41.54       1,500,000          
 
                               
 
a)   The current repurchase program became effective on September 1, 2005. It replaced a program announced on February 6, 1999, which replaced a program approved in 1996 and updated in 1998.
 
b)   The share amount approved for repurchase in 2005 was 10 million shares and the share amount approved for repurchase in 1999 was 17 million shares.
 
c)   The current repurchase program has no expiration date.
 
d)   No repurchase program has expired during the period covered by the above table.
 
e)   The program approved in 1999 was terminated prior to the expiration date when the board approved the current program in August 2005. The program approved in 1996 and updated in 1998 was terminated prior to expiration when the board approved a program in February 1999. There have been no programs for which the issuer has not intended to make further purchases.

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Item 6. Selected Financial Data
                                 
(In millions except per share data)           Years ended December 31,    
    2005   2004   2003   2002
 
Consolidated Income Statement Data
                               
Earned premiums
  $ 3,164     $ 3,020     $ 2,748     $ 2,478  
Investment income, net of expenses
    526       492       465       445  
Gross realized investment gains and losses
    61       91       (41 )     (94 )
Total revenues
    3,767       3,614       3,181       2,843  
Net income
    602       584       374       238  
 
Net income per common share:
                               
Basic
  $ 3.44     $ 3.30     $ 2.11     $ 1.33  
Diluted
    3.40       3.28       2.10       1.32  
Cash dividends per common share:
                               
Declared
    1.205       1.04       0.90       0.81  
Paid
    1.162       1.02       0.89       0.80  
 
Shares outstanding
                               
Weighted average, diluted
    177       178       178       180  
 
Consolidated Balance Sheet Data
                               
Invested assets
  $ 12,702     $ 12,677     $ 12,485     $ 11,226  
Deferred policy acquisition costs
    429       400       372       343  
Total assets
    16,003       16,107       15,509       14,122  
Loss and loss expense reserves
    3,661       3,549       3,415       3,176  
Life policy reserves
    1,343       1,194       1,025       917  
Long-term debt
    791       791       420       420  
Shareholders’ equity
    6,086       6,249       6,204       5,598  
Book value per share
    34.88       35.60       35.10       31.43  
 
Property Casualty Insurance Operations
                               
Earned premiums
  $ 3,058     $ 2,919     $ 2,653     $ 2,391  
Unearned premiums
    1,557       1,537       1,444       1,317  
Loss and loss expense reserves
    3,629       3,514       3,386       3,150  
Investment income, net of expenses
    338       289       245       234  
Loss ratio
    49.2 %     49.8 %     56.1 %     61.5 %
Loss expense ratio
    10.0       10.3       11.6       11.4  
Expense ratio
    30.0       29.7       27.0       26.8  
Combined ratio
    89.2 %     89.8 %     94.7 %     99.7 %
 
 
    Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2005.
One-time charges or adjustments:
2003 — As the result of a settlement negotiated with a vendor, pretax results included the recovery of $23 million of the $39 million one-time, pretax charge incurred in 2000.
2000 — The company recorded a one-time charge of $39 million, pretax, to write down previously capitalized costs related to the development of software to process property casualty policies.
2000 — The company earned $5 million in interest in the first quarter from a $303 million single-premium bank-owned life insurance (BOLI) policy booked at the end of 1999 that was segregated as a Separate Account effective April 1, 2000. Investment income and realized investment gains and losses from separate accounts generally accrue directly to the contract holder and, therefore, are not included in the company’s consolidated financials.

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2001     2000   1999   1998   1997   1996   1995
 
 
$ 2,152
    $ 1,907     $ 1,732     $ 1,613     $ 1,516     $ 1,423     $ 1,314  
 
421
      415       387       368       349       327       300  
 
(25
)     (2 )     0       65       69       48       31  
 
2,561
      2,331       2,128       2,054       1,942       1,809       1,656  
 
193
      118       255       242       299       224       227  
 
 
$   1.10
    $ 0.67     $ 1.40     $ 1.31     $ 1.64     $ 1.21     $ 1.24  
 
1.07
      0.67       1.37       1.28       1.61       1.17       1.19  
 
0.76
      0.69       0.62       0.55       0.50       0.44       0.39  
 
0.74
      0.67       0.60       0.54       0.49       0.43       0.38  
 
 
179
      181       186       190       188       191       191  
 
 
$11,534
    $ 11,276     $ 10,156     $ 10,296     $ 8,778     $ 6,340     $ 5,525  
 
286
      259       226       143       135       128       120  
 
13,964
      13,274       11,795       11,484       9,867       7,397       6,439  
 
2,887
      2,473       2,154       2,055       1,937       1,881       1,744  
 
724
      641       885       536       482       440       403  
 
426
      449       456       472       58       80       80  
 
5,998
      5,995       5,421       5,621       4,717       3,163       2,658  
 
33.62
      33.80       30.35       30.58       25.71       17.19       14.33  
 
 
$ 2,073
    $ 1,828     $ 1,658     $ 1,543     $ 1,454     $ 1,367     $ 1,263  
 
1,060
      920       835       458       442       424       407  
 
2,894
      2,416       2,093       1,979       1,889       1,824       1,691  
 
223
      223       208       204       199       190       180  
 
66.6
%     71.1 %     61.6 %     65.4 %     58.3 %     61.6 %     57.6 %
 
10.1
      11.3       10.0       9.3       10.1       13.8       14.7  
 
28.2
      30.4       28.6       29.6       30.0       28.2       27.8  
 
104.9
%     112.8 %     100.2 %     104.3 %     98.4 %     103.6 %     100.1 %

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    10-K Page  
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
    31  
Executive Summary
    31  
Critical Accounting Estimates
    35  
Results of Operations
    39  
Consolidated Property Casualty Insurance Results of Operations
    40  
Commercial Lines Insurance Results of Operations
    41  
Personal Lines Insurance Results of Operations
    47  
Life Insurance Results of Operations
    52  
Investments Results of Operations
    54  
Liquidity and Capital Resources
    57  
Sources of Liquidity
    57  
Uses of Liquidity
    59  
Property Casualty Insurance Reserves
    61  
Life Insurance Reserves
    67  
2006 Reinsurance Programs
    68  
Safe Harbor Statement
    69  
 
       
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Introduction
    70  
Fixed-maturity Investments
    71  
Short-term Investments
    72  
Equity Investments
    72  
Unrealized Investment Gains and Losses
    74  

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Introduction
The purpose of Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s consolidated results of operations and financial position. Management’s Discussion and Analysis should be read in conjunction with Item 6, Selected Financial Data, Pages 28 and 29, and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 77. We present per share data on a diluted basis unless otherwise noted and we have adjusted those amounts for all stock splits and dividends, including the 5 percent stock dividend paid on April 26, 2005.
We begin with an executive summary of our results of operations and outlook, as well as details on critical accounting policies and estimates. Periodically, we refer to estimated industry data so that we can give information on our performance versus the overall insurance industry. Unless otherwise noted, the industry data is prepared by A.M. Best, a leading insurance industry statistical, analytical and financial strength rating organization. Information from A.M. Best is presented on a statutory basis. When we provide our results on a comparable statutory basis, we label it as such; all other company data is presented on a GAAP basis.
Executive Summary
Cincinnati Financial Corporation is the parent company of the nation’s 19th largest publicly traded property casualty insurer, based on statutory net written premium volume through the first nine months of 2005. We primarily market commercial lines and personal lines property casualty insurance products through a select group of independent insurance agencies in 32 states. As we discussed in the business description in Item 1, we believe three characteristics distinguish our company and allow us to build shareholder value:
  We cultivate relationships with the independent insurance agents who market our policies and we make our decisions at the local level
  We achieve claims excellence, covering the spectrum from our response to reported claims to our approach to establishing reserves for not-yet-paid claims
  We invest for long-term total return, using available cash flow to purchase equity securities after covering insurance liabilities by purchasing fixed-maturity securities
We provide additional detail on these subjects in the Results of Operations and Liquidity and Capital Resources sections of this discussion.
Among the factors that influence the consolidated results of operations and financial position of the company, we consider our relationships with independent insurance agents to be the most significant. We seek to be an indispensable partner in each agency’s success. To continue to achieve our performance targets, we must maintain these strong relationships, write a significant portion of each agency’s business and attract new agencies.
Conditions in the property casualty markets were challenging in 2005, as we discuss in the business description in Item 1, Our Business and Our Strategy, Page 1. In the commercial lines marketplace, competition continues to accelerate, resulting in a lower premium growth rate. In the personal lines marketplace, our personal lines rates in some territories have not been in a competitive range that would allow our agents to market the benefits of our products, resulting in declining policy retention and lower new business.
We believe consistently applying our long-term strategies rather than taking short-term actions will allow us to address these challenges. We seek to meet our agents’ needs, with an eye toward solutions and approaches that will give us an advantage for five, 10 or even more years. As we appoint new agencies, we are looking to build relationships that will grow as successfully as those we have had for 40 or 50 years.
In 2005, we achieved most of our objectives for creating shareholder value, as we discuss on Page 33. Although unrealized gains have been down in the past several years because of the decline in the market value of our Fifth Third investment, we believe our portfolio continues to have the potential to increase investment income and provide capital appreciation over the long term.
Below we review highlights of our financial results for the past three years and measures of the success of our efforts to create shareholder value.

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Corporate Financial Highlights
Income Statement and Per Share Data
                                         
(Dollars in millions except share data)                           2005-2004   2004-2003
    2005   2004   2003   Change %   Change %
 
Income statement data
                                       
Earned premiums
  $ 3,164     $ 3,020     $ 2,748       4.8       9.9  
Investment income, net of expenses
    526       492       465       6.9       5.7  
Net realized gains and losses (pretax)
    61       91       (41 )     (33.1 )     321.7  
Total revenues
    3,767       3,614       3,181       4.2       13.6  
Net income
    602       584       374       3.1       56.0  
Per share data (diluted)
                                       
Net income
    3.40       3.28       2.10       3.7       56.4  
Cash dividends declared
    1.205       1.04       0.90       16.1       14.4  
Weighted average shares outstanding
    177,116,126       178,376,848       178,292,248       (0.7 )     0.0  
In 2005, we reported record results, as described in detail in the results of operations.
Revenue growth was slower in 2005 than in 2004 because of slowing consolidated property casualty earned premium growth due to market conditions. Pretax investment income growth accelerated over the three years. Realized gains made a positive contribution in 2005 and 2004 although we recorded a realized loss in 2003.
Net income and net income per share reached record levels in 2005 although the growth rates were substantially lower in 2005 than in 2004. A number of factors affected the annual growth rates, including:
  The consolidated property casualty underwriting profit improved substantially in 2004 and we sustained healthy profitability in 2005. The factors behind the improvement are discussed in the Results of Operations.
  Realized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that will be recognized in any period. That discretion generally is independent of the insurance underwriting process. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. Security sales led to realized gains in 2005 and 2004 while write-downs of impaired assets led to realized losses in 2003.
  o   2005 — Realized investment gains raised net income by $40 million, or 23 cents per share, after tax
 
  o   2004 — Realized investment gains raised net income by $60 million, or 34 cents per share, after tax
 
  o   2003 — Realized investment losses reduced net income by $27 million, or 15 cents per share, after tax
  Weighted average shares outstanding may fluctuate from period to period because we regularly repurchase shares under board authorizations and we issue shares when associates exercise stock options. At year-end 2005, weighted average shares outstanding on a diluted basis had declined 1.3 million from year-end 2004.
  In 2003, we recovered $23 million pretax from a settlement negotiated with a vendor. The recovery added $15 million, or 8 cents per share, to net income. The negotiated settlement related to the $39 million one-time, pretax charge incurred in 2000 to write off previously capitalized software development costs.
The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. Cash dividends declared per share rose 16.1 percent and 14.4 percent in 2005 and 2004.
Balance Sheet Data and Performance Measures
                                         
(Dollars in millions except per share data)                           2005-2004   2004-2003
    2005   2004   2003   Change %   Change %
 
Balance Sheet Data
                                       
Invested assets
  $ 12,702     $ 12,677     $ 12,485       0.2       1.5  
Total assets
    16,003       16,107       15,509       (0.6 )     3.9  
Long-term debt
    791       791       420       0.0       88.4  
Shareholders’ equity
    6,086       6,249       6,204       (2.6 )     0.7  
Book value per share
    34.88       35.60       35.10       (2.0 )     1.4  
Performance measures
                                       
Comprehensive income
  $ 99     $ 287     $ 815       (65.8 )     (64.8 )
Return on equity
    9.8 %     9.4 %     6.3 %                
Return on equity, based on comprehensive income
    1.6       4.6       13.8                  
Debt-to-capital ratio
    11.5       11.2       8.9                  

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Invested assets and total assets have been relatively flat over the past two years as strong cash flow has been offset by lower unrealized investment gains. This led to a modest decline in shareholders’ equity and book value in 2005.
Comprehensive income is net income plus the change in net other accumulated comprehensive income. Change in net other accumulated comprehensive income is the year-over-year difference in unrealized gains on investments. In 2005 and 2004, comprehensive income declined because lower unrealized gains more than offset the increase in net income. Unrealized gains were down primarily because of a decline in the market value of our Fifth Third investment.
With net income growing and shareholders’ equity declining, return on equity rose over the past three years. Return on equity based on comprehensive income, however, declined in line with total comprehensive income.
We issued $375 million of long-term debt in 2004, raising total long-term debt to $791 million at year-end 2005 and 2004. Our ratio of long-term debt to capital (long-term debt plus shareholders’ equity) rose in 2004 following the new debt issue and remained stable in 2005.
Property Casualty Highlights
                                         
(Dollars in millions)                           2005-2004   2004-2003
    2005   2004   2003   Change %   Change %
 
Property casualty highlights
                                       
Written premiums
  $ 3,076     $ 2,997     $ 2,815       2.6       6.5  
Underwriting profit
    330       298       140       10.8       113.3  
GAAP combined ratio
    89.2 %     89.8 %     94.7 %                
Statutory combined ratio
    89.0       89.4       94.2                  
The declining trend in overall written premium growth reflected the market factors discussed in Item 1, Commercial Lines and Personal Lines Property Casualty Insurance Segments, Page 10 and Page 11. In each of the past three years, our overall written premium growth rate has exceeded that of the industry. The estimated industry growth rate was 0.7 percent, 4.7 percent and 9.6 percent in 2005, 2004 and 2003, respectively. The 2005 overall industry premium growth rate included an estimated 33.9 percent decline in reinsurance sector premiums.
Our consolidated property casualty insurance underwriting profit rose in 2005 and 2004, and our combined ratio improved each year. (The combined ratio is the percentage of each premium dollar spent on claims plus all expenses — the lower the ratio, the better the performance.) The 2005 improvement reflected lower catastrophe losses, continued strong commercial lines underwriting results, a return to underwriting profitability for personal lines and above-average savings from favorable loss reserve development from prior accident years. The 2004 improvement reflected growth in premiums, in particular more adequate premium per policy, the benefits of other underwriting efforts and above-average savings from favorable loss reserve development from prior accident years.
The estimated industry average statutory combined ratios were 102.0 percent, 98.1 percent and 100.2 percent for 2005, 2004 and 2003, respectively. The 2005 overall industry combined ratio included an estimated 150.7 percent reinsurance sector ratio.
We also measure a variety of non-financial metrics for our property casualty operations. For example, we monitor our rank within our reporting agency locations. In 2004, we ranked No. 1 or No. 2 by premium volume in 74 percent of the locations that have marketed our products for more than five years. Other measures include subdivision of territories and new agency appointments. In 2005, we subdivided eight field territories, raising the total to 100, and appointed 41 new agency relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 40 in 2005.
Agent satisfaction with our technology solutions is, and will continue to be, a requirement for maintaining our strong relationships with these agencies. In 2005, we made additional progress in implementing technology solutions that we believe should make it easier for agencies to do business with us. Among other milestones, we deployed our new commercial lines policy processing system to all of our agencies in Ohio for use in processing new and renewal businessowners policies. We also deployed our personal lines policy processing system in two additional states and made important upgrades and enhancements.
Measuring Our Success in 2006 and Beyond
We use a variety of metrics to measure the success of our strategies:
  Maintaining our strong relationships with our established agencies, writing a significant portion of each agency’s business and attracting new agencies – In 2006, we expect to continue to rank No. 1 or No. 2 by premium volume in at least 74 percent or more of the locations that have marketed our products for more than five years. We expect to subdivide three field territories in 2006 and we are targeting 50 new agency appointments.

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    In 2006, we expect to make further progress in our efforts to improve service to and communication with our agencies through our expanding portfolio of software. In particular, we will continue to deploy our commercial lines and personal lines quoting and policy processing systems that allow our agencies and our field and headquarters associates to collaborate on new and renewal business more efficiently and give our agencies choice and control. We discuss our technology plans for 2006 in Item 1, Technology Solutions, Page 4.
  Achieving above-industry-average growth in property casualty statutory net written premiums and maintaining industry-leading profitability by leveraging our regional franchise and proven agency-centered business strategy — We believe our consolidated property casualty written premiums will be flat to slightly up in 2006 compared with the 2.6 percent increase in 2005. We may not achieve our objective of above-industry-average growth in 2006 because the modest growth we anticipate in commercial lines written premiums, despite increasing competition, may be offsetting the rate-driven declines we anticipate in personal lines written premiums. In addition, the overall industry premium growth is estimated at 3.3 percent in 2006, which includes an estimated 18.6 percent reinsurance sector growth rate. The 2006 industry growth rate for the commercial lines sector is estimated at 2.3 percent and the personal lines sector is estimated at 2.9 percent.
  Our combined ratio estimate for 2006 is 92 percent to 94 percent on either a GAAP or statutory basis compared with 89.2 percent on a GAAP basis in 2005. We believe the most significant difference will be a lower level of savings from favorable loss reserve development from prior accident years. In 2006, we believe that savings is likely to reduce the combined ratio in the range of 2 to 3 percentage points. Higher-than-normal savings, particularly for liability coverages, reduced the 2005 combined ratio by 5.2 percentage points and the 2004 combined ratio by 6.7 percentage points.
 
  We also have raised slightly our estimate of the impact to the 2006 combined ratio from catastrophe losses to the range of 4.0 and 4.5 percentage points from our historic range of 3.0 to 3.5 percentage points. We are taking into account the potential for severe weather, as we’ve seen in the past two years, and the higher retention on our new catastrophe reinsurance treaty. Both the loss and loss expense ratio and underwriting expense ratio trends could affect the combined ratios for our commercial lines and personal lines segments:
  o   The degree of price softening in the commercial lines marketplace will affect the 2006 loss and loss expense ratio for that business area, as that ratio may move up slightly as pricing becomes more competitive.
 
  o   The personal lines 2006 loss and loss expense ratio primarily will reflect our ability to offer competitive prices for our personal lines products in that changing marketplace. We believe we have taken the appropriate actions to maintain that ratio near the improved level we achieved in 2005.
 
  o   For both commercial lines and personal lines, lower growth rates could lead to further unfavorable year-over-year comparisons in the ratios of deferred acquisition costs and other underwriting expenses to earned premiums. Continued investment in technology also may contribute to an increase in other underwriting expenses.
  The estimated industry average 2006 combined ratio is 98.7 percent.
  Pursuing a total return investment strategy that generates both strong investment income growth and capital appreciation - In 2006, we are estimating pretax investment income growth to again be in the range of 6.5 percent to 7.0 percent. This outlook is based on the higher anticipated level of dividend income from equity holdings, the investment of insurance operations cash flow and the higher-than-historical allocation of new cash flow to fixed-maturity securities over the past 18 months.
 
    We do not establish annual capital appreciation targets. Over the long term, our target is to have the equity portfolio outperform the Standard & Poor’s 500 Index. Over the five years ended December 31, 2005, our compound annual equity portfolio return was a negative 0.8 percent compared with a compound annual total return of 0.5 percent for the Index. In 2005, our compound annual equity portfolio was a negative 4.2 percent, compared with a compound annual total return of 4.9 percent for the Index. Our equity portfolio underperformed the market for these periods because of the decline in the market value of our holdings of Fifth Third common stock over the past five years.
  Increasing the total return to shareholders through a combination of higher earnings per share, growth in book value and increasing dividends - We do not announce annual targets for earnings per share or book value. Earnings results in 2006 will be tempered by the first quarter adoption of Statement of Financial Accounting Standards (SFAS) No. 123(R) “Share-Based Payments,” which requires expensing the cost of associate options on our income statement. Our estimate of pro forma option expense, as detailed in Item 8, Note 1 to the Consolidated Financial Statements, Page 84, would have reduced earnings per share by 7 cents to 8 cents in each of the past three years.

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    Over the long term, we look for our earnings per share growth to outpace that of a peer group of national and regional property casualty insurance companies. Long-term book value growth should approximate that of our equity portfolio.
 
    The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. In February 2006, the board increased the indicated annual dividend rate 9.8 percent, marking the 46th consecutive year of increases in our indicated dividend rate. We believe our record of dividend increases is matched by only 11 other publicly traded corporations.
 
    Over the long-term, we seek to increase earnings per share, book value and dividends at a rate that would allow long-term total return to our shareholders to exceed that of the Standard & Poor’s Composite 1500 Property Casualty Insurance Index. Over the past five years, our total return to shareholders of 40.9 percent matched the return on that Index.
  Maintaining financial strength by keeping the ratio of debt to capital below 15 percent and purchasing reinsurance to provide investment flexibility - Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2006. As a result, we believe our debt-to-capital ratio will remain in the range of 11 percent to 12 percent.
 
    In December 2005, we finalized our reinsurance program for 2006, updating it to maintain the balance between the cost of the program and the level of risk we retain. Under the new program, our 2006 reinsurance premiums are expected to be $7 million lower than 2005, without taking into account the reinstatement premium incurred in 2005. We provide more detail on our reinsurance programs in 2006 Reinsurance Programs, Page 68.
Factors supporting our outlook for 2006 are discussed below in the Results of Operations for each of the four business segments.
Critical Accounting Estimates
Cincinnati Financial Corporation’s financial statements are prepared using GAAP. These principles require management to make estimates and assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. Actual results could differ materially from those estimates.
The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 to the Consolidated Financial Statements, Page 84. In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company’s critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate.
Property Casualty Insurance Loss and Loss Expense Reserves
Overview
Our most significant estimates relate to our reserves for property casualty loss and loss expenses. We believe that the stability of our business makes our historical data the most important source for establishing adequate reserve levels. We base reserve estimates on company experience and information from internal analyses and obtain additional information from the appointed actuary. When reviewing reserves, we analyze historical data and estimate the effect of various loss factors. We believe that the following represent the primary risks to our ability to estimate loss reserves accurately:
  Court decisions or legislation that result in unanticipated coverage expansions on past and existing policies
  Changes in medical inflation and mortality rates that affect workers compensation claims
  Changes in claim cost trends, including the effects of general economic and tort cost inflation, not reflected in the historical data used to estimate loss reserves
  Changes in reinsurance coverage, not reflected in reserving data, that affect the company’s net payments and net case reserves
  Payment and reporting pattern changes attributable to the implementation of a new claims management system
  Reporting pattern changes attributable to changes in case reserving practices, particularly with respect to umbrella liability claims
  Absence of cost-effective methods for accurately assessing asbestos and environmental claim liabilities (see Property Casualty Insurance Reserves, Asbestos and Environmental Reserves, Page 63, for discussion of related reserve levels and trends)

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Any of these factors could cause our ultimate loss experience to be better or worse than reserves held, and the difference could be material. To the extent that reserves are inadequate and strengthened, the amount of such increase is treated as a charge in the period that the deficiency is recognized, raising the loss and loss expense ratio and reducing earnings. To the extent that reserves are redundant and released, the amount of the release is a credit in the period that the redundancy is recognized, reducing the loss and loss expense ratio and increasing earnings.
A reserve change of $31 million would have a 1 percentage point effect on the loss and loss expense ratio, based on 2005 earned premiums, a $20 million effect on income and an 11 cent effect on net income per share.
Establishing Reserves
Reserves are established for the total of unpaid loss and loss expenses, including estimates for claims that have been reported, estimates for claims that have been incurred but not yet reported (IBNR) and estimates of loss expenses associated with processing and settling those claims. Reserves are determined for the various lines of business. Loss reserves are reduced by salvage and subrogation reserves.
We establish case reserves for claims that have been reported within the parameters of coverage provided in the policy. Individual case reserves greater than $35,000 established by field claims representatives are reviewed by experienced headquarters claims supervisors while case reserves greater than $100,000 also are reviewed by headquarters claims managers. The estimates reflect informed judgment and experience of our claims associates based on general insurance reserving practices and their experience with the company. Case reserves are reviewed on a 90-day cycle, or more frequently if specific circumstances require, based on events such as the status of ongoing negotiations.
The anticipated effect of inflation is implicitly considered when estimating reserves for loss and loss expenses. While anticipated cost increases due to inflation are considered in estimating ultimate claim costs, increases in average severity of claims are caused by a number of factors that vary by individual type of policy. Average severity projections are based on historical trends adjusted for anticipated changes in underwriting standards, policy provisions and general economic trends. We do not discount any of our property casualty loss and loss expense reserves.
In 2001, we began to establish higher initial case reserves on serious injury claims to reflect recent experience indicating the likelihood that juries would ignore significant liability issues in cases involving seriously injured claimants.
To establish IBNR reserves on an annual basis, we use a variety of tools, including actuarial and statistical methods. These may include but are not limited to:
  The Case Incurred Development Method
  The Paid Development Method
  The Bornhuetter-Ferguson Method
  Probability Trend Family Methods
Supplemental statistical information is compiled and reviewed to aid in the application of the actuarial methods. The supplemental data also is used to evaluate the reasonableness of estimates derived from the actuarial methods. This information includes:
  Industry loss frequency and severity and premium trends
  Past, present and anticipated product pricing
  Anticipated premium growth
  Other quantifiable trends
  Projected ultimate loss ratios
We conduct our thorough evaluation of the adequacy of reserves as of the end of the third quarter of each year. As a result, the most significant refinements in reserves historically have been implemented in the fourth quarter. Beginning in 2006, we are conducting a detailed supplemental review as of the end of the fourth quarter of each year in parallel with the outside actuarial review. Less detailed, periodic reviews of reserve adequacy are made at the other quarter ends. A loss review committee, including internal actuaries and representatives from management of multiple operating departments, is responsible for the quarterly review process.
The internal actuaries provide a point estimate and a range to summarize their analysis. At year-end 2005 and 2004, IBNR reserves differed from the internal actuarial point estimate by less than 1 percent of our loss and loss expense reserve.

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Adjusting Reserves
While we believe that reported reserves provide for all unpaid loss and loss expense obligations, the estimation processes involve a number of variables and assumptions. We believe this uncertainty is mitigated by the historical stability of our book of business and by our periodic reviews of estimates. As loss experience develops and new information becomes known, the reserves are reviewed and adjusted as appropriate. In this process, we monitor trends in the industry, cost trends, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional exposures to loss. If we determine that reserves established in prior years were not sufficient or were excessive, the change is reflected in current-year results.
Actuarial Review
As part of our internal processes, we utilize an appointed actuary to provide management with an opinion regarding an acceptable range for adequate statutory reserves based on generally accepted actuarial guidelines.
Historically, we have established adequate reserves that have fallen in the upper half of the appointed actuary’s range. This approach has resulted in recognition of reserve redundancies for the past 10 years, as we discuss in Development of Loss and Loss Expenses, Page 62. Modestly redundant reserves support our business strategy to retain high financial strength ratings and remain a market for agencies’ business in all market conditions.
The appointed actuary conducts a thorough evaluation of the adequacy of reserves as of the end of the third quarter of each year and conduct a supplemental review of full-year data at year-end.
Asset Impairment
Fixed-maturity and equity investments are our largest assets. Certain estimates and assumptions made by management relative to investment portfolio assets are critical. The company’s asset impairment committee continually monitors investments and all other assets for signs of other-than-temporary and/or permanent impairment. Among other signs, the committee monitors significant decreases in the market value of the assets, changes in legal factors or in the business climate, an accumulation of costs in excess of the amount originally expected to acquire or construct an asset, uncollectability of all other assets, or other factors such as bankruptcy, deterioration of creditworthiness, failure to pay interest or dividends or signs indicating that the carrying amount may not be recoverable.
The application of our impairment policy resulted in other-than-temporary impairment charges and write-offs of investments that reduced our income before income taxes by $1 million, $6 million and $80 million in 2005, 2004 and 2003, respectively.
Other-than-temporary impairment in the value of securities is defined by the company as declines in valuation that meet specific criteria established in the asset impairment policy. Such declines often occur in conjunction with events taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing corporation. These specific criteria include a declining trend in market value, the extent of the market value decline and the length of time the value of the security has been depressed, as well as subjective measures such as pending events and issuer liquidity. Generally, these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and market conditions. We provide information regarding valuation of our invested assets in Item 8, Note 2 to the Consolidated Financial Statements, Page 88.
Our portfolio managers constantly monitor the status of their assigned portfolios for indications of potential problems or issues that may be possible impairment issues. If an impairment indicator is noted, the portfolio managers even more closely scrutinize the security.
Impairment charges are recorded for other-than-temporary declines in value, if, in the asset impairment committee’s judgment, there is little expectation that the value will be recouped in the foreseeable future. The impairment policy defines a security as distressed when it is trading below 70 percent of book value or has a Moody’s or Standard & Poor’s credit rating below B3/B-. Distressed securities receive additional scrutiny. In 2005 and earlier, a security would have been written down in the event of a declining market value for four consecutive quarters with quarter-end market value below 50 percent of book value, or when a security’s market value is 50 percent below book value for three consecutive quarters. Effective January 1, 2006, a security may be written down in the event of a declining market value for four consecutive quarters with quarter-end market value below 70 percent of book value, or when a security’s market value is 70 percent below book value for three consecutive quarters. A sudden and severe drop in market value that does not otherwise meet the above criteria is reviewed for possible immediate impairment.
When evaluating other-than-temporary impairments, the committee considers the company’s ability to retain a security for a period adequate to recover a significant percentage of cost. Because of the company’s investment philosophy and strong capitalization, it can hold securities that have the potential to recover value until their scheduled redemption, when they might otherwise be deemed impaired. Investment assets that

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have already been impaired are evaluated based on their adjusted book value and further written down, if deemed appropriate. The decision to sell or write down an asset with impairment indications reflects, at least in part, management’s opinion that the security no longer meets the company’s investment objectives. We provide detailed information about securities trading in a continuous loss position at year-end 2005 in Item 7A, Unrealized Investment Gains and Losses, Page 74. Other-than-temporary declines in the fair value of investments are recognized in net income as realized losses at the time when facts and circumstances indicate such write-downs are warranted.
Permanent impairment charges (write-offs) are defined as those for which management believes there is little potential for future recovery, for example, following the bankruptcy of the issuing corporation. These permanent declines in the fair value of investments are written off at the time when facts and circumstances indicate such write-downs are warranted, and they are reflected in realized losses.
Other-than-temporary and permanent impairments are distinct from the ordinary fluctuations seen in the value of a security when considered in the context of overall economic and market conditions. Securities considered to have a temporary decline would be expected to recover their market value, which may be at maturity. Under the same accounting treatment as market value gains, temporary declines (changes in the fair value of these securities) are reflected on our balance sheet in other comprehensive income, net of tax, and have no impact on reported net income.
Life Insurance Policy Reserves
We establish the reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
We establish reserves for our universal life, deferred annuity and investment contracts equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals.
Employee Benefit Pension Plan
We have a defined benefit pension plan covering substantially all employees. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates and expected return on plan assets, which are updated each year. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions.
The key assumptions used in developing the 2005 net pension expense were a 5.75 percent discount rate, an 8.0 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent. The 8.0 percent return on plan assets assumption is based partially on the fact that substantially all of the investments held by the pension plan are common stocks that pay annual dividends. We believe this rate is representative of the expected long-term rate of return on these assets. These assumptions were consistent with the prior year except that the discount rate was reduced by one fourth of one percent due to current market conditions. In 2005, the net pension expense was $13 million. In 2006, we expect a net pension expense of $17 million, primarily as a result of a 0.25 percent reduction in the discount rate and increased service costs.
Holding all other assumptions constant, a 0.5 percentage point decline in the discount rate would lower our 2006 net income before income taxes by $2 million. Likewise, a 0.5 percentage point decline in the expected return on plan assets would lower our 2005 income before income taxes by $1 million.
In addition, the fair value of the plan assets exceeded the accumulated benefit obligation by $8 million at year-end 2005 and $16 million at year-end 2004. The fair value of the plan assets was less than the projected plan benefit obligation by $62 million at year-end 2005 and $41 million at year-end 2004. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. We expect to contribute approximately $10 million to the pension plan in 2006.
Deferred Acquisition Costs
We establish a deferred asset for costs that vary with, and are primarily related to, acquiring property casualty and life business. These costs are principally agent commissions, premium taxes and certain underwriting costs, which are deferred and amortized into income as premiums are earned. Deferred acquisition costs track with the change in premiums. Underlying assumptions are updated periodically to reflect actual experience. Changes in the amounts or timing of estimated future profits could result in adjustments to the accumulated amortization of these costs.

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For property casualty policies, deferred acquisition costs are amortized over the terms of the policies. For life policies, acquisition costs are amortized into income either over the premium-paying period of the policies or the life of the policy, depending on the policy type.
Contingent Commission Accrual
Another significant estimate relates to our accrual for contingent (profit-sharing) commissions. We base the contingent commission accrual estimates on property casualty underwriting results and on supplemental property casualty information. Contingent commissions are paid to agencies using a formula that takes into account agency profitability and other factors, such as prompt monthly payment of amounts due to the company. Due to the complexity of the calculation and the variety of factors that can affect contingent commissions for an individual agency, the amount accrued can differ from the actual contingent commissions paid. The contingent commission accrual of $108 million in 2005 contributed 3.5 percentage points to the property casualty combined ratio. If commissions paid were to vary from that amount by 5 percent, it would affect 2006 net income by $4 million, or 2 cents per share, and the combined ratio by approximately 0.2 percentage points.
Separate Accounts
We issue life contracts, referred to as bank-owned life insurance policies (BOLI). Based on the specific contract provisions, the assets and liabilities for some BOLIs are legally segregated and recorded as assets and liabilities of the separate accounts. Other BOLIs are included in the general account. For separate account BOLIs, minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders.
Separate account assets are carried at fair value. Separate account liabilities primarily represent the contract holders’ claims to the related assets and also are carried at the fair value of the assets. Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holders and, therefore, are not included in our Consolidated Statements of Income. However, each separate account contract includes a negotiated realized gain and loss sharing arrangement with the company. This share is transferred from the separate account to our general account and is recognized as revenue or expense. In the event that the asset value of contract holders’ accounts is projected below the value guaranteed by the company, a liability is established through a charge to our earnings.
For our most significant separate account, written in 1999, realized gains and losses are retained in the separate account and are deferred and amortized to the contract holder over a five-year period, subject to certain limitations. Upon termination or maturity of this separate account contract, any unamortized deferred gains and/or losses will revert to the general account. In the event this separate account holder were to exchange the contract for the policy of another carrier, there would be a surrender charge equal to 10 percent of the contract’s account value during the first five years. Beginning in year six, the surrender charge decreases 2 percent a year to 0 percent in year 11. At year-end 2005, net unamortized realized gains amounted to $1 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded, and charged to the general account. Potentially, losses could be material; however, unrealized losses in the separate account portfolio were less than $4 million at year-end 2005.
Recent Accounting Pronouncements
Information regarding recent accounting pronouncements is provided in Item 8, Note 1 to the Consolidated Financial Statements, Page 84. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
Results of Operations
The consolidated results of operations reflect the operating results of each of our four segments along with the parent company and other non-insurance activities. The four segments are:
  Commercial lines property casualty insurance
  Personal lines property casualty insurance
  Life insurance
  Investments operations
We measure profit or loss for our property casualty and life segments based upon underwriting results. Insurance underwriting results (profit or loss) represent net earned premium less loss and loss expenses and underwriting expenses on a pretax basis. We also measure aspects of the performance of our commercial lines

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and personal lines segments on a combined property casualty insurance operations basis. Underwriting results and segment pretax operating income are not a substitute for net income determined in accordance with GAAP.
For the combined property casualty insurance operations as well as the commercial lines and personal lines segments, statutory accounting data and ratios are key performance indicators that we use to assess business trends and to make comparisons to industry results, since GAAP-based industry data generally is not readily available. We also use statutory accounting data and ratios as key performance indicators for our life insurance operations. We do not believe that inflation has had a material effect on consolidated results of operations, except to the extent that inflation may affect interest rates and claim costs.
Investments held by the parent company and the investment portfolios for the property casualty and life insurance subsidiaries are managed and reported as the investments segment, separate from the underwriting businesses. Net investment income and net realized investment gains and losses for our investment portfolios are discussed in the Investments Results of Operations.
The calculations of segment data are described in more detail in Item 8, Note 17 of the Consolidated Financial Statements, Page 98. The following sections review results of operations for each of the four segments. Commercial Lines Insurance Results of Operations begins on Page 41, Personal Lines Insurance Results of Operations begins on Page 47, Life Insurance Results of Operations begins on Page 52, and Investments Results of Operations begins on Page 54. We begin with an overview of our consolidated property casualty operations, which is the total of our commercial lines and personal lines segments. Our consolidated property casualty operations generated 81.2 percent of our revenues in 2005, and certain factors affected both of our property casualty segments.
Consolidated Property Casualty Insurance Results of Operations
                                         
(Dollars in millions)                           2005-2004     2004-2003  
    2005     2004     2003     Change %     Change %  
 
Written premiums
  $ 3,076     $ 2,997     $ 2,815       2.6       6.5  
 
                                 
 
                                       
Earned premiums
  $ 3,058     $ 2,919     $ 2,653       4.8       10.0  
 
                                       
Loss and loss expenses excluding catastrophes
    1,685       1,605       1,700       5.0       (5.6 )
Catastrophe loss and loss expenses
    127       148       97       (14.8 )     53.4  
Commission expenses
    592       583       507       1.6       15.0  
Underwriting expenses
    319       274       194       16.3       40.6  
Policyholder dividends
    5       11       15       (52.3 )     (25.0 )
 
                                 
Underwriting profit
  $ 330     $ 298     $ 140       10.8       113.3  
 
                                 
 
                                       
Ratios as a percent of earned premiums:
                                       
Loss and loss expenses excluding catastrophes
    55.1 %     55.0 %     64.1 %                
Catastrophe loss and loss expenses
    4.1       5.1       3.6                  
 
                                 
Loss and loss expenses
    59.2       60.1       67.7                  
Commission expenses
    19.4       20.0       19.1                  
Underwriting expenses
    10.4       9.4       7.3                  
Policyholder dividends
    0.2       0.3       0.6                  
 
                                 
Combined ratio
    89.2 %     89.8 %     94.7 %                
 
                                 
Factors that affected written premiums for property casualty insurance operations included:
  New business written directly by agencies – New business written directly by agencies was $314 million, $330 million and $328 million in 2005, 2004 and 2003, respectively. New business levels reflect market conditions for commercial and personal lines.
  Reinsurance reinstatement premiums – To restore affected layers of property catastrophe reinsurance programs, we incurred $8 million and $11 million in reinsurance reinstatement premiums in 2005 and 2004.
Favorable development of loss reserves from prior accident years affected the combined ratio for property casualty insurance operations. The 2005 and 2004 ratios benefited from higher than normal savings. The 2004 and 2003 ratios benefited from uninsured motorist/underinsured motorist (UM/UIM) reserve releases. Following an Ohio Supreme Court decision in late 2003 to limit its 1999 Scott-Pontzer vs. Liberty Mutual decision, we released UM/UIM reserves as follows:
  2003 — We released $38 million pretax of previously established UM/UIM reserves, adding $25 million, or 14 cents per share, to net income in 2003.
  2004 — In 2004, we reviewed outstanding UM/UIM claims for which litigation was pending. Those claims represented approximately $37 million in previously established case reserves. During the first quarter of 2004, we filed motions for dismissal in various jurisdictions for specific claims and released an additional $32 million in related case reserves. The reserve releases in 2004 added $21 million, or 12 cents per share, to net income.
  2005 — In 2005, we stopped separately reporting on UM/UIM-related reserve actions.
The discussions of property casualty segments provide additional detail regarding these factors.

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Commercial Lines Insurance Results of Operations
Overview — Three-year Highlights
Performance highlights for the commercial lines segment include:
  Premiums – As competition in our commercial markets continues to increase, our written premium growth rate has slowed because of the more competitive pricing environment and the underwriting discipline we have maintained for both renewal and new business. The primary source of growth in the past three years has been higher pricing on new and renewal commercial business aided by property insurance-to-value initiatives and more accurate risk classification. These more than offset our deliberate decisions not to write or renew certain business and the loss of some smaller accounts due to competition. We believe that our written premium growth rate continues to exceed the average for the overall commercial lines industry, which was estimated at 2.7 percent for 2005 and 2.3 percent for 2004. Earned premium growth has slowed because of the declining growth rate of written premiums. Reinsurance reinstatement premiums allocated to commercial lines reduced earned premium growth by 0.2 and 0.3 percentage points in 2005 and 2004, respectively.
  Combined ratio – Our commercial lines combined ratio was very strong in 2005 and 2004 largely due to our programs to obtain more adequate premiums per policy and our underwriting efforts. The 3.3 percentage point increase in the 2005 ratio primarily was due to a rise in the loss and loss expense ratio. The increase reflected a single large loss in 2005 that increased the ratio by 1.1 percentage points and savings from favorable loss reserve development below the 2004 level. We discuss large losses and other factors affecting the combined ratio beginning on Page 42. We discuss the savings from favorable loss reserve development by commercial lines of business on Page 45.
 
    Our commercial lines statutory combined ratio was 87.1 percent in 2005 compared with 83.7 percent in 2004 and 91.6 percent in 2003. By comparison, the estimated industry commercial lines combined ratio was 99.1 percent in 2005, 102.5 percent in 2004 and 100.2 percent in 2003.
Growth and Profitability
As competition in the commercial markets has increased, we have maintained our pricing discipline for both renewal and new business. Our independent agents reported steady pressure on pricing during 2005 and communicated that winning new business and retaining renewals required more pricing flexibility and careful risk selection. With the commercial lines pricing environment growing more competitive, we continue to rely on factors other than price to drive sales. Our agents look for the best insurance program for their clients, not just the best price. They serve policyholders well by presenting our value proposition – customized coverage packages, personal claims service and high financial strength ratings – all wrapped up in a convenient three-year commercial policy. We intend to remain a stable market for our agencies’ best business, and believe that our case-by-case approach gives us a clear advantage. Our field marketing associates and our independent agents work together to select risks and respond appropriately to local pricing trends. Historically, they have proven capable of balancing risk and price to achieve growth in new business over the longer term.
Staying abreast of evolving market conditions is a critical function, accomplished in both an informal and a formal manner. Informally, our field marketing representatives and underwriters are in constant receipt of market intelligence from the agencies with which they work. Formally, our commercial lines product management group and field marketing associates complete periodic market surveys to obtain competitive intelligence. This market information helps to identify the top competitors by line of business or specialty program and also identifies our market strengths and weaknesses. The analysis encompasses pricing, breadth of coverage and underwriting/eligibility issues. In addition to reviewing our competitive position, our product management group and our underwriting audit group review compliance with our underwriting standards as well as the pricing adequacy of our commercial insurance programs and coverages. Further, our research and development department analyzes opportunities and develops new products, new coverage options and improvements to existing insurance products.
In 2003 and 2004, all lines of business grew because of higher premiums per policy. In 2005, growth largely was driven by commercial multi-peril and other liability coverages with commercial auto premiums declining. Commercial auto is one of the first lines to experience pricing pressure because it often represents the largest portion of insurance costs for commercial policyholders. Commercial auto also is one of the larger, annually priced components of our three-year policies.
We have more aggressively identified and measured exposures to match coverage amounts and premiums to the risk. Where this matching is not possible, accounts are not renewed unless there are mitigating factors. As a result, we experienced no growth in overall commercial lines policy counts from 2003 to 2005. Agents tell us they agree with the need to carefully select risks and assure pricing adequacy. They appreciate the time our associates invest in creating solutions for their clients while protecting profitability, whether that means working on an individual case or developing modified policy terms and conditions that preserve flexibility, choice and other sales advantages.

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For new business, our field marketing associates and agents are working together to select risks and respond appropriately to local pricing trends. New commercial lines business was $282 million in 2005, unchanged from 2004. New business was $268 million in 2003.
We discuss growth by commercial lines of business on Page 45.
Commercial Lines Results
                                         
(Dollars in millions)                           2005-2004     2004-2003  
    2005     2004     2003     Change %     Change %  
 
Written premiums
  $ 2,290     $ 2,186     $ 2,031       4.7       7.6  
 
                                 
 
                                       
Earned premiums
  $ 2,254     $ 2,126     $ 1,908       6.0       11.4  
 
                                       
Loss and loss expenses excluding catastrophes
    1,222       1,083       1,176       12.9       (7.9 )
Catastrophe loss and loss expenses
    76       71       42       6.0       68.9  
Commission expenses
    438       423       361       3.6       17.1  
Underwriting expenses
    228       200       147       13.5       36.8  
Policyholder dividends
    5       11       15       (52.3 )     (25.0 )
 
                                 
Underwriting profit
  $ 285     $ 338     $ 167       (15.6 )     102.3  
 
                                 
 
                                       
Ratios as a percent of earned premiums:
                                       
Loss and loss expenses excluding catastrophes
    54.2 %     50.9 %     61.6 %                
Catastrophe loss and loss expenses
    3.4       3.4       2.2                  
 
                                 
Loss and loss expenses
    57.6       54.3       63.8                  
Commission expenses
    19.5       19.9       18.9                  
Underwriting expenses
    10.1       9.4       7.7                  
Policyholder dividends
    0.2       0.5       0.8                  
 
                                 
Combined ratio
    87.4 %     84.1 %     91.2 %                
 
                                 
Over the past three years, we have continued to focus on seeking and maintaining adequate premium per exposure as well as pursuing non-pricing means of enhancing longer-term profitability. These have included identifying the exposures we have for each risk and making sure we offer appropriate coverages, terms and conditions and limits of insurance. We continue to adhere to our underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions, where necessary. In addition, we continue to leverage our strong local presence. Our field marketing representatives have met with every agency to reaffirm agreements on the extent of frontline renewal underwriting to be performed by local agencies. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. Field claims representatives prepare full risk reports on every account reporting a loss above $100,000 or on any risk of concern. Multi-departmental task forces have implemented programs to address concerns for specific areas such as contractor and commercial auto risks. These actions have helped to mitigate rising loss severity.
We describe the significant costs components for the commercial lines segment below.
Loss and Loss Expenses (excluding catastrophe losses)
Loss and loss expenses include both net paid losses and reserve additions for unpaid losses as well as the associated loss expenses. We believe more competitive market conditions were one factor in the 3.3 percentage point rise in the loss and loss expense ratio excluding catastrophes between 2005 and 2004. In addition, 2005 results include a single large loss that was insufficiently covered through our facultative reinsurance programs, which increased the 2005 loss and loss expenses by $24 million, net of reinsurance, or 1.1 percentage points. Savings from favorable loss reserve development was lower in 2005 than 2004, which we discuss by commercial lines of business on Page 45.
Underwriting actions that led to higher premiums on a relatively stable level of exposures contributed to the 10.7 percentage point decline in the loss and loss expense ratio excluding catastrophes between 2004 and 2003. In addition, savings from favorable loss reserve development was significantly higher in 2004 than 2003.
Re-underwriting our commercial lines book of business in the early 2000s has had an impact on reserve development patterns because we are seeing lower frequency of losses. The favorable development in 2005 and 2004 was also due to the headquarters claims department’s initiative, begun in 2001. Since 2001, we have been establishing higher initial case reserves on severe injury claims because our experience indicated that juries often ignore significant liability issues in cases involving seriously injured claimants. These higher initial amounts produce case reserves that reflect our full exposure more accurately. But some claims settle before reaching a jury and some juries make awards that are less than the “worst-case” scenario. As a result, some change in our case reserve development patterns allowed us to also reduce IBNR in 2005.
We monitor incurred losses by size of loss, business line, risk category, geographic region, agency, field marketing territory and duration of policyholder relationship, addressing concentrations or trends as needed. Our 2005 analysis indicated no significant concentrations other than trends in business lines that we address as part of our ongoing business operations. We also measure new losses and case reserve increases greater than $250,000 to track frequency and severity.

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These commercial lines large losses and case reserve increases have been in the range of 15 percent to 17 percent of annual earned premiums since 2003. The primary reason the contribution of these losses to the loss and loss expense ratio rose in 2005 was higher total new losses greater than $1 million. New losses greater than $1 million rose because of a rise in the number of these losses and the single large loss noted above. Total development and case reserve increases of $250,000 or more rose primarily because of two verdicts that exceeded the reserves we had established.
Commercial Lines Losses by Size
                                         
(Dollars in millions)                           2005-2004     2004-2003  
    2005     2004     2003     Change %     Change %  
 
Losses $1 million or more
  $ 124     $ 80     $ 89       54.3       (9.5 )
Losses $250 thousand to $1 million
    105       103       117       1.2       (11.9 )
Development and case reserve increases of $250 thousand or more
    149       133       121       12.7       9.9  
Other losses
    596       536       608       11.1       (11.8 )
 
                                 
Total losses incurred excluding catastrophe losses
    974       852       935       14.2       (8.8 )
Catastrophe losses
    76       71       42       6.0       68.9  
 
                                 
Total losses incurred
  $ 1,050     $ 923     $ 977       13.6       (5.4 )
 
                                 
 
                                       
As a percent of earned premiums:
                                       
Losses $1 million or more
    5.5 %     3.8 %     4.6 %                
Losses $250 thousand to $1 million
    4.7       4.9       6.2                  
Development and case reserve increases of $250 thousand or more
    6.6       6.2       6.3                  
Other losses
    26.4       25.1       31.9                  
 
                                 
Loss ratio excluding catastrophe losses
    43.2       40.0       49.0                  
Catastrophe loss ratio
    3.4       3.4       2.2                  
 
                                 
Total loss ratio
    46.6 %     43.4 %     51.2 %                
 
                                 
Catastrophe Loss and Loss Expenses
Commercial lines catastrophe losses, net of reinsurance and before taxes, were $76 million in 2005 compared with $71 million in 2004 and $42 million in 2003. The following table shows losses incurred, net of reinsurance, and subsequent development, for catastrophe losses in each of the past three years.
The Cincinnati Insurance Companies do not appoint agencies to actively market property casualty insurance in Louisiana, Mississippi or Texas. Our Hurricane Katrina and Rita losses included losses associated with commercial accounts written by agents in other states to cover locations and vehicles in multiple states, including Louisiana, Mississippi and Texas.
Hurricane Katrina losses also included $18 million in assumed losses. The Cincinnati Insurance Company participates in three assumed reinsurance treaties with two reinsurers that spread the risk of very high catastrophe losses among many insurers. The assumed losses from Hurricane Katrina included $16 million under a treaty with the Munich Re Group to assume 2 percent of property losses between $400 million and $1.2 billion from a single event. Munich Re has reserved its Hurricane Katrina losses above $1.2 billion. We reduced our participation in the Munich Re assumed reinsurance treaty to 1 percent in 2006.

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(In millions, net of reinsurance)       Incurred in calendar year ended December 31,  
Occurence year   Cause of loss   Region   2005     2004     2003  
 
2005
                               
May
  Wind, hail   Midwest   $ 4                  
July
  Hurricane Dennis   South     5                  
August
  Hurricane Katrina   South     36                  
September
  Hurricane Rita   South     3                  
October
  Hurricane Wilma   South     13                  
November
  Wind, hail   Midwest     2                  
November
  Wind   Midwest, South     2                  
 
                             
Total
            65                  
 
                             
 
                               
2004
                               
May
  Wind, hail   Midwest, Mid-Atlantic     0     $ 1          
May
  Wind, hail   Midwest, Mid-Atlantic, South     0       11          
July
  Wind, hail   Midwest, Mid-Atlantic, South     8       7          
August
  Hurricane Charley   South     0       16          
September
  Hurricane Frances   South     1       4          
September
  Hurricane Jeanne   Mid-Atlantic, South     1       4          
September
  Hurricane Ivan   Midwest, Mid-Atlantic, South     1       21          
December
  Wind, ice, snow   Midwest, South     0       5          
Others
            0       3          
 
                           
Total
            11       72          
 
                           
 
                               
2003 and prior
                               
April
  Wind, hail   Midwest, South     0       (2 )   $ 5  
May
  Wind, hail   Midwest, South     1       0       17  
July
  Wind, hail   Midwest, Mid-Atlantic, South     0       2       2  
July
  Wind, hail   Midwest, Mid-Atlantic, South     (1 )     0       6  
September
  Wind   Mid-Atlantic, South     0       0       5  
November
  Wind   Midwest, Mid-Atlantic, South     0       (1 )     6  
Others
            0       0       1  
 
                         
Total
            0       (1 )     42  
 
                         
Calendar year total       $ 76     $ 71     $ 42  
 
                         
Commission Expenses
Commercial lines commission expense as a percent of earned premium declined by 0.4 percentage points in 2005 after rising by 1.0 percentage points in 2004. Profit-sharing, or contingent, commissions are calculated on the profitability of an agency’s aggregate book of business, taking into account longer-term profit, with a percentage for prompt payment of premiums and other criteria, and reward our agents’ efforts. These profit-based commissions generally fluctuate with our loss and loss expenses.
A refinement and subsequent release of a contingent commission over accrual from 2004 in the first three months of 2005 was responsible for 0.3 percentage points of the decline in 2005. The refinement reflected the use of final 2004 financial data to calculate the contingent commissions paid in 2005. Our 2005 contingent commission accrual reflected our estimate of the profit-sharing commissions that will be paid to our agencies in early 2006.
Underwriting Expenses
Non commission expenses rose to 10.1 percent of earned premium in 2005 from 9.4 percent in 2004 and 7.7 percent in 2003. The three-year rise in the ratio largely was due to unfavorable deferred acquisition cost comparisons resulting from slower premium growth, higher staffing expenses and increased taxes and fees that were partially due to a state guaranty fund refund in 2003. The software recovery discussed in Corporate Financial Highlights, Page 32, reduced the 2003 ratio by 0.8 percentage points.
Policyholder Dividends
Policyholder dividend expense was 0.2 percent of earned premium in 2005 compared with 0.5 percent in 2004 and 0.8 percent in 2003.

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Line of Business Analysis
                                         
(Dollars in millions)                           2005-2004   2004-2003
Calendar year   2005   2004   2003   Change %   Change %
 
Commercial multi-peril:
                                       
Written premium
  $ 809     $ 767     $ 713       5.4       7.6  
Earned premium
    796       751       673       5.9       11.6  
Loss and loss expenses incurred
    443       469       442       (5.5 )     6.1  
Loss and loss expenses ratio
    55.7 %     62.4 %     65.6 %                
Loss and loss expense ratio excluding catastrophes
    47.5       54.9       59.9                  
Workers compensation:
                                       
Written premium
  $ 338     $ 320     $ 304       5.5       5.2  
Earned premium
    328       313       293       5.1       6.8  
Loss and loss expenses incurred
    300       251       235       19.4       6.6  
Loss and loss expenses ratio
    91.3 %     80.3 %     80.5 %                
Loss and loss expense ratio excluding catastrophes
    91.3       80.3       80.5                  
Commercial auto:
                                       
Written premium
  $ 447     $ 458     $ 434       (2.4 )     5.5  
Earned premium
    456       450       419       1.4       7.4  
Loss and loss expenses incurred
    273       236       240       15.7       (1.8 )
Loss and loss expenses ratio
    59.8 %     52.4 %     57.3 %                
Loss and loss expense ratio excluding catastrophes
    59.7       52.1       56.5                  
Other liability:
                                       
Written premium
  $ 458     $ 424     $ 377       7.9       12.5  
Earned premium
    442       402       342       9.8       17.6  
Loss and loss expenses incurred
    187       116       183       61.7       (36.8 )
Loss and loss expenses ratio
    42.4 %     28.8 %     53.6 %                
Loss and loss expense ratio excluding catastrophes
    42.4       28.8       53.6                  
                                         
Accident year   2005   2004   2003   2002   2001
 
Loss and loss expenses incurred:
                                       
Commercial multi-peril
  $ 504     $ 459     $ 411     $ 408     $ 403  
Workers compensation
    256       245       231       236       230  
Commercial auto
    297       268       261       251       242  
Other liability
    269       210       193       156       123  
Loss and loss expenses ratio:
                                       
Commercial multi-peril
    63.4 %     61.2 %     61.1 %     67.2 %     75.3 %
Workers compensation
    78.0       78.3       78.9       80.2       91.2  
Commercial auto
    65.1       59.6       62.3       65.4       75.6  
Other liability
    60.8       52.3       56.5       56.8       57.1  
In total, the commercial multi-peril, workers compensation, commercial auto and other liability lines of business accounted for 89.7 percent of total commercial lines earned premium compared with 90.1 percent in 2004 and 90.5 percent in 2003. Approximately 95 percent of our commercial lines premiums are written as packages, providing accounts with coverages from more than one business line. We believe that our commercial lines segment is best measured and evaluated on a segment basis. We have provided the table above and the discussion below to summarize growth and profitability trends separately for each of the four primary business lines.
The accident year loss data provides current estimates of incurred loss and loss expenses for the past five accident years. Accident year data classifies losses according to the year in which the corresponding loss event occurred, regardless of when the losses are actually reported, booked or paid.
Over the past three years, results for the business lines within the commercial lines segment have reflected our emphasis on underwriting and obtaining adequate pricing for covered risks, as discussed above.
Commercial Multi-peril
In 2005 and 2004, commercial multi-peril written premiums rose more rapidly than the total for commercial lines as a higher proportion of liability coverages were written in discounted packages because of competitive pricing pressures. Commercial multi-peril written premiums were lower in 2003 when some liability coverages were moved to nondiscounted policies. Nondiscounted policies are included in our other liability line of business.
Commercial multi-peril is our single largest business line. We believe this business line’s loss data provides the best indicator of the success of the growth and underwriting actions that we have implemented during the past five years. The higher general liability base rates that were effective in most states beginning in 2003 helped to offset a trend toward higher construction costs for 2005 and 2004 property claims.
In each of the last three calendar years, reserve changes for prior periods have contributed to results.
  2005 – Favorable development lowered the loss and loss expense ratio by 7.7 percentage points. The favorable development largely was due to lower commercial multi-peril exposures because of

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    prior-year transfers of business to non-discounted policies and to the benefits of changes made in 2002 to our general liability terms and conditions.
  2004 – Reserve strengthening added 0.6 percentage points to the loss and loss expense ratio. Additions to reserves for environment claims were offset by favorable development of case reserves for non-environmental claims due to our headquarters claims department’s initiative to establish higher initial case reserves on severe injury claims.
  2003 – Reserve strengthening added 2.0 percentage points to the loss and loss expense ratio because we added to our reserves for environmental claims.
In addition, the large loss discussed above added 2.9 percentage points to the 2005 ratio.
Workers Compensation
Conditions within the workers compensation market remained stable in 2005 and 2004 after improving between 1999 and 2003 as market pricing rose in most states, albeit offset by continued rising trends in loss severity. In 2005, workers compensation written premiums rose more rapidly than our total commercial lines written premiums as this business line appeared to experience less competitive pricing pressures than the overall commercial lines market in the second half of the year. As the commercial lines market has softened, however, insurers have displayed a greater willingness to write more desirable risks, and growth in the premium volume of state pools for workers compensation is declining.
Since 2002, we have chosen not to renew selected policies where we believed the aggregate exposure risk was excessive. Any new or renewal policy covering 200 or more employees at any one location receives added scrutiny as we seek to manage risk aggregation. We make workers compensation available as part of package policies for commercial lines policyholders in selected states as a competitive tool. We pay a lower commission rate on workers compensation business, which means this line has a higher loss and loss expense breakeven point than our other commercial business lines. In Ohio, our largest state, workers compensation coverage is a state monopoly, provided solely by the state instead of by private insurers.
The workers compensation loss and loss expense ratio rose in 2005 after remaining steady for several years, largely because of a higher level of reserve strengthening for older accident years.
  2005 – Reserve strengthening added 13.3 percentage points to the loss and loss expense ratio. The reserve strengthening primarily was due to medical cost inflation and longer estimated payout periods compared with our original projections.
  2004 – Reserve strengthening added 4.9 percentage points to the loss and loss expense ratio, which also was due to longer estimated payout periods.
  2003 – Reserve strengthening added 4.3 percentage points to the loss and loss expense ratio, which also was due to medical cost inflation.
Commercial Auto
Written premiums declined 2.4 percent in 2005 after rising 5.5 percent in 2004, below the overall commercial lines growth rate. Commercial auto is one of the package policy components for which we calculate pricing annually. This line tends to be highly sensitive to competitive pressures.
In the past several years, we accelerated efforts to improve commercial auto underwriting and rate levels, making certain that vehicle use was properly classified. As a result of those actions and moderating industrywide severity and frequency trends, the loss and loss expense ratio for commercial auto remained at an acceptable level in 2005 despite pricing pressures, after improving from 2001 through 2004. Further, we continue to adhere to our underwriting guidelines to assure accurate classification and pricing.
A significant factor in the calendar year-over-year changes has been savings from favorable loss reserve development for prior years.
  2005 – Favorable development lowered the loss and loss expense ratio by 5.3 percentage points. The savings largely were due to moderating frequency and severity trends.
  2004 – Favorable development lowered the loss and loss expense ratio by 10.5 percentage points, including 4.6 percentage points due to the release of UM/UIM reserves. The remainder of the savings largely was due to moderating frequency and severity trends.
  2003 – Favorable development lowered the loss and loss expense ratio by 8.8 percentage points, including 6.9 percentage points due to the release of UM/UIM case reserves. The release of UM/UIM-related IBNR reserves also contributed.
Other Liability
Other liability (commercial umbrella, commercial general liability and most executive risk policies) written premiums also grew more rapidly than our total commercial lines written premiums because of the growing number of policies written in non-discounted programs and the continuing rise in liability pricing. The growth

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rate is decelerating, however, because a higher proportion of accounts are being written in discounted packages because of competitive pricing pressures. Discounted policies are included in our commercial multi-peril line of business.
Director and officer coverage accounted for approximately 11 percent of other liability premium in 2005 compared with approximately 13 percent in 2004 and approximately 12 percent in 2003. Our director and officer policies are offered primarily to nonprofit organizations, reducing the risk associated with this line of business. As of December 31, 2005, three of our in-force director and officer policies were for Fortune 500 companies, 38 were for publicly traded companies (excluding banks and savings and loans) and 59 were for banks and savings and loans with more than $500 million in assets.
In large part because this business line also includes umbrella coverages, the calendar year loss and loss expense ratio tends to fluctuate significantly on a year-over-year basis. Our headquarters claims department’s initiative to establish higher initial case reserves on severe injury claims has the greatest effect on this business line:
  2005 – Favorable development lowered the loss and loss expense ratio by 18.4 percentage points. Enforcement of stricter underwriting standards and a preference for lower limit policies contributed to favorable development for our commercial umbrella coverages.
  2004 – Favorable development lowered the loss and loss expense ratio by 32.5 percentage points, including 2.0 percentage points due to the release of UM/UIM reserves.
  2003 – Favorable development lowered the loss and loss expense ratio by 23.0 percentage points, including 2.6 percentage points due to the release of UM/UIM reserves.
Commercial Lines Insurance Outlook
Industrywide commercial lines written premiums are expected to rise approximately 2.3 percent in 2006. During 2005, agents reported that renewal pricing pressure had risen since the end of 2004 and new business pricing was requiring even more flexibility and more careful risk selection. During 2005, we needed to use credits more frequently to retain renewals of quality business – the larger the account, the higher the credits, with variations by geographic region and class of business. At the end of 2005, renewal rates on property coverages were generally flat to modestly down, exclusive of any changes in an account’s exposure. Renewal pricing on liability coverages was less affected by competitive pricing pressures, with some increases possible.
We intend to continue to market our products to a broad range of business classes, price our products adequately and take a package approach. We intend to maintain our underwriting selectivity and carefully manage our rate levels, as well as our programs that seek to accurately match exposures with appropriate premiums. We will continue to evaluate each risk individually and to make decisions regarding rates, the use of three-year commercial policies and other policy terms on a case-by-case basis, even in lines and classes of business that are under competitive pressure. New marketing territories created over the past several years and new agency appointments will contribute to commercial lines growth.
Prior to Hurricanes Katrina, Rita and Wilma, we anticipated 2006 commercial lines insurance market trends would reflect accelerated competition with pressure on pricing from the industry’s increasing surplus and improving profitability. We are uncertain what the effect of the hurricanes will be on commercial lines pricing going forward. We believe their effect on pricing largely will be limited to coastal markets and business lines directly affected by the storms.
We believe our approach should allow us to maintain most of the positive underlying improvements in profitability that have occurred over the past several years, but we do not believe favorable reserve development will contribute to underwriting profits as much in 2006 as in 2005 and 2004. In addition, underwriting expenses are rising. We discuss our overall outlook for the property casualty insurance operations in Measuring Our Success in 2006 and Beyond, Page 33,.
Personal Lines Insurance Results of Operations
Overview — Three-year Highlights
Performance highlights for the personal lines segment include:
  Premiums – During the past three years, we have been working to address personal lines profitability. Because of our actions, the 2005 personal lines combined ratio was below 100 percent for the first time since 1999. However, as other carriers refined their pricing models , our pricing was less competitive and written premiums declined in 2005 after slowing in 2004. Industry average written premium growth was estimated at 3.5 percent for 2005 and 6.6 percent for 2004. Our earned premium growth has slowed as a result of the written premium trend. Reinsurance reinstatement premiums allocated to personal lines reduced our premium growth by 0.3 and 0.8 percentage points for 2005 and 2004, respectively.
  Combined ratio – The substantial improvement in the 2005 combined ratio reflected our progress in lowering the homeowner loss and loss expense ratio and our lower catastrophe losses offset by higher

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    noncommission underwriting expenses. The 2004 personal lines combined ratio was slightly above the prior year’s level. Higher catastrophe losses and underwriting expenses offset the improvement in the homeowner and personal auto loss and loss expense ratios excluding catastrophe losses.
 
    Our personal lines statutory combined ratio was 94.3 percent in 2005 compared with 104.6 percent in 2004 and 102.9 percent in 2003. By comparison, the estimated industry personal lines combined ratio was 97.3 percent in 2005, 94.9 percent in 2004 and 98.4 percent in 2003.
Growth and Profitability
Personal lines insurance is a strategic component of our overall relationship with many of our agencies and an important component of agency relationships with their clients. We believe agents recommend Cincinnati personal insurance products for their value-oriented clients who seek to balance quality and price and are attracted by Cincinnati’s superior claims service and the benefits of our package approach. In the past 12 to 18 months, our personal lines rates in some territories did not allow our agents to market these benefits, resulting in a slight decline in our policy retention rate from its historical level above 90 percent.
The same factors that reduced policy retention have had an impact on new personal lines business. Personal lines new business premiums written directly by agencies declined 33.9 percent to $32 million in 2005 and declined 19.9 percent to $48 million in 2004.
We discuss premium trends by personal lines of business on Page 51.
Personal Lines Results
                                         
                            2005-2004     2004-2003  
(Dollars in millions)   2005     2004     2003     Change %     Change %  
 
Written premiums
  $ 786     $ 811     $ 784       (3.0 )     3.4  
 
                                 
Earned premiums
  $ 804     $ 793     $ 745       1.4       6.4  
Loss and loss expenses excluding catastrophes
    463       522       524       (11.3 )     (0.4 )
Catastrophe loss and loss expenses
    51       77       55       (34.2 )     41.4  
Commission expenses
    154       160       146       (3.6 )     9.7  
Underwriting expenses
    91       74       47       24.0       52.1  
 
                                 
Underwriting profit(loss)
  $ 45     $ (40 )   $ (27 )     214.0       45.8  
 
                                 
 
                                       
Ratios as a percent of earned premiums:
                                       
Loss and loss expenses excluding catastrophes
    57.6 %     65.9 %     70.3 %                
Catastrophe loss and loss expenses
    6.3       9.7       7.3                  
 
                                 
Loss and loss expenses
    63.9       75.6       77.6                  
Commission expenses
    19.2       20.1       19.5                  
Underwriting expenses
    11.3       9.3       6.5                  
 
                                 
Combined ratio
    94.4 %     105.0 %     103.6 %                
 
                                 
Between 2000 and 2003, the industry implemented higher homeowner rates and imposed stricter enforcement of underwriting standards. In late 2004, price competition returned as insurers leveraged their higher profitability and stronger financial positions. The marketplace continued to become more competitive throughout 2005.
We began a strategic shift in 2004 from our traditional three-year to one-year homeowner policy terms. We are transitioning to one-year policies in conjunction with the state-by-state deployment of Diamond, our personal lines policy processing system. One-year policies allow us to promptly modify rates, terms and conditions in response to market changes. In mid-2004, we also began modifying policy terms to change homeowner policy earthquake deductibles to 10 percent from 5 percent in selected Midwestern states, reducing the company’s exposure to a single significant catastrophic event.
In 2004, as price competition began to emerge, we were in the early stages of our program to improve profitability for our homeowner line by raising rates and making changes to our policy terms and conditions.
From mid-2004 to mid-2005, we opted to delay rate changes because we felt it was important to fully commit our programming resources to completing necessary modifications and upgrades to our then-new Diamond policy processing system. During that time period, other carriers began making more aggressive use of segmented pricing models, generating lower rates for higher quality accounts. When some important system modifications were completed in mid-2005, we began filing rate and credit changes to better position our products in the market.
The introduction of Diamond in our higher volume states may also have contributed to lower growth rates. The focus required by our agencies to convert to the newer technology and adapt to new work flows may have diverted their resources from new business efforts. Diamond gives agencies additional choices to consider for their business operations and for policyholders. Agents are growing more familiar with the new options and workflow, and many now are seeing benefits from efficiencies as they renew business through the system.
During 2005, we increased the system’s processing power and availability and offered additional functionality requested by agency staff. For example, we began offering convenient account billing to direct bill customers,

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invoicing for multiple policies at one time, and electronic fund transfer, which accommodates new monthly payment plans. We continue to respond to agency requests for enhancements as we prepare Diamond for additional states.
Although our homeowner profitability lagged the industry, our actions resulted in substantial improvement in our personal lines combined ratio over the past three years. Our 2005 statutory combined ratio improved to 94.3 percent while the estimated industry combined ratio deteriorated 2.4 points to 97.3 percent. Moreover, we expect to realize additional profit improvements in 2006 as we continue the conversion to one-year policies written with updated rates, terms and conditions.
In mid-2006, we will introduce a limited program of rate segments incorporating insurance scores into pricing for our personal auto and homeowner products in states using Diamond and make other changes to our credits in states not yet using Diamond. This step should further improve our ability to compete for our agents’ highest quality personal lines accounts. We believe it will increase the opportunity to work with our agents on marketing the advantages of our personal lines products and services to their clients, which would help us resume growing in this business area.
We describe the significant costs components for the personal lines segment below.
Loss and Loss Expenses (excluding catastrophe losses)
Loss and loss expenses include both net paid losses and reserve additions for unpaid losses as well as the associated loss expenses. The improvement in the loss and loss expense ratio excluding catastrophes over the past three years was due to a 14.4 percentage point improvement in the homeowner ratio excluding catastrophe losses between 2005 and 2003 and a 10.4 percentage point improvement in the personal auto ratio excluding catastrophe losses over the same period. Savings from favorable loss reserve development, including the release of UM/UIM reserves, influenced those improvements. We discuss homeowner and personal auto trends separately beginning on Page 51.
We monitor incurred losses by size of loss, business line, risk category, geographic region, agency, field marketing territory and duration of policyholder relationship, addressing concentrations or trends as needed. Our 2005 analysis indicated no significant concentrations other than trends in business lines that we address as part of our ongoing business operations. We also measure new losses and case reserve adjustments greater than $250,000 to track frequency and severity. These personal lines large losses and case reserve increases declined as a percent of earned premiums in 2005 because of higher rates per exposure.
Personal Lines Losses by Size
                                         
                            2005-2004     2004-2003  
(Dollars in millions)   2005     2004     2003     Change %     Change %  
 
Losses $1 million or more
  $ 13     $ 17     $ 15       (26.0 )     14.6  
Losses $250 thousand to $1 million
    34       43       41       (19.9 )     4.9  
Development and case reserve increases of $250 thousand or more
    19       21       11       (7.7 )     83.7  
Other losses
    339       371       391       (8.5 )     (5.2 )
 
                                 
Total losses incurred excluding catastrophe losses
    405       452       458       (10.2 )     (1.4 )
Catastrophe losses
    51       77       55       (34.2 )     41.4  
 
                                 
Total losses incurred
  $ 456     $ 529     $ 513       (13.7 )     3.1  
 
                                 
 
                                       
As a percent of earned premiums:
                                       
Losses $1 million or more
    1.5 %     2.2 %     2.0 %                
Losses $250 thousand to $1 million
    4.3       5.4       5.5                  
Development and case reserve increases of $250 thousand or more
    2.4       2.6       1.5                  
Other losses
    42.2       46.8       52.5                  
 
                                 
Loss ratio excluding catastrophe losses
    50.4       57.0       61.5                  
Catastrophe loss ratio
    6.3       9.7       7.3                  
 
                                 
Total loss ratio
    56.7 %     66.7 %     68.8 %                
 
                                 

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Catastrophe Loss and Loss Expenses
Personal lines catastrophe losses, net of reinsurance and before taxes, were $51 million in 2005 compared with $77 million in 2004 and $55 million in 2003. The following table shows losses incurred, net of reinsurance, and subsequent development, for catastrophe losses in each of the past three years.
                                     
(In millions, net of reinsurance)       Incurred in calendar year ended December 31,        
Occurence year   Cause of loss   Region   2005     2004     2003  
 
2005
                               
January
  Wind, ice snow, freezing   Midwest, Mid-Atlantic   $ 1                  
May
  Wind, hail   Midwest     8                  
July
  Hurricane Dennis   South     2                  
August
  Hurricane Katrina   South     11                  
October
  Hurricane Wilma   South     12                  
November
  Wind, hail   Midwest     9                  
November
  Wind   Midwest, South     10                  
 
                             
Total
            53                  
 
                             
 
                               
 
                               
2004
                               
May
  Wind, hail   Midwest, Mid-Atlantic     0     $ 9          
May
  Wind, hail   Midwest, Mid-Atlantic, South     0       20          
July
  Wind, hail   Midwest, Mid-Atlantic, South     (1 )     5          
August
  Hurricane Charley   South     0       10          
September
  Hurricane Frances   South     1       7          
September
  Hurricane Jeanne   Mid-Atlantic, South     0       2          
September
  Hurricane Ivan   Midwest, Mid-Atlantic, South     1       18          
December
  Wind, ice, snow   Midwest, South     (3 )     8          
Others
            0       2          
 
                           
Total
            (2 )     81          
 
                           
 
                               
2003 and prior
                               
April
  Wind, hail   Midwest, South     0       (2 )   $ 31  
May
  Wind, hail   Midwest, South     0       0       17  
July
  Wind, hail   Midwest, Mid-Atlantic, South     0       (1 )     5  
July
  Wind, hail   Midwest, Mid-Atlantic, South     0       0       1  
September
  Wind   Mid-Atlantic, South     0       (1 )     4  
November
  Wind   Midwest, Mid-Atlantic, South     0       0       1  
Others
            0       0       (4 )
 
                         
Total
            0       (4 )     55  
 
                         
Calendar year total
          $ 51     $ 77     $ 55  
 
                         
Commission Expenses
Commission expense as a percent of earned premium declined by 0.9 percentage points in 2005, largely paralleling the decline in written premiums, after rising 0.6 percentage points in 2004. Profit-sharing, or contingent, commissions are calculated on the profitability of an agency’s aggregate book of business, taking into account longer-term profit, with a percentage for prompt payment of premiums and other criteria. A refinement and subsequent release of a contingent commission over accrual from 2004 in the first three months of 2005 was responsible for 0.2 percentage points of the decline in 2005.
Underwriting Expenses
Noncommission expenses rose to 11.3 percent of earned premium in 2005 from 9.3 percent in 2004 and 6.5 percent in 2003. The three-year rise in the ratio largely was due to higher technology expenses, unfavorable deferred acquisition cost comparisons resulting from slower premium growth, higher staffing expenses and increased taxes and fees that were partially due to a state guaranty fund refund in 2003. The software recovery discussed in Corporate Financial Highlights Page 32, reduced the 2003 ratio by 1.1 percentage points.

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Line of Business Analysis
                                         
(Dollars in millions)                           2005-2004   2004-2003
Calendar year   2005   2004   2003   Change %   Change %
 
Personal auto:
                                       
Written premium
  $ 410     $ 453     $ 447       (9.4 )     1.2  
Earned premium
    433       451       428       (4.0 )     5.4  
Loss and loss expenses incurred
    261       298       304       (12.5 )     (2.1 )
Loss and loss expenses ratio
    60.2 %     66.1 %     71.1 %                
Loss and loss expense ratio excluding catastrophes
    59.7       65.1       70.1                  
Homeowner:
                                       
Written premium
  $ 290     $ 273     $ 254       6.3       7.3  
Earned premium
    285       259       239       10.2       8.2  
Loss and loss expenses incurred
    212       249       222       (14.6 )     12.2  
Loss and loss expenses ratio
    74.5 %     96.1 %     92.7 %                
Loss and loss expense ratio excluding catastrophes
    58.4       69.3       72.8                  
                                         
Accident year   2005   2004   2003   2002   2001
 
Loss and loss expenses incurred:
                                       
Personal auto
  $ 267     $ 297     $ 305     $ 289     $ 259  
Homeowner
    215       254       227       207       193  
Loss and loss expenses ratio:
                                       
Personal auto
    61.8 %     66.0 %     71.2 %     74.3 %     71.9 %
Homeowner
    75.4       98.1       95.0       98.6       101.4  
The personal auto and homeowner business lines together accounted for 89.2 percent, 89.5 percent and 89.5 percent of total personal lines earned premiums in 2005, 2004 and 2003, respectively. Our intent is to write personal auto and homeowner coverages in personal lines packages that may also include personal umbrella liability, watercraft and other coverages. As a result, we believe that the personal lines segment is best measured and evaluated on a segment basis. We have provided the table above and the discussion below to summarize growth and profitability trends separately for the two primary business lines.
The accident year loss data provides current estimates of incurred loss and loss expenses for the past five accident years. Accident year data classifies losses according to the year in which the corresponding loss event occurred, regardless of when the losses are actually reported, booked or paid.
Personal Auto
Written and earned premiums for the personal auto line declined in 2005 after rising in 2004. As noted above, the decline in 2005 primarily was due to price competition in some states and territories, which has resulted in lower policy renewal retention and significantly lower new business levels. We are continuing to modify selected rates and credits to address our competitive position.
The loss and loss expense ratio for personal auto improved from an already strong level over the three years because of higher pricing. For selected agencies, we use re-underwriting programs to review and to strengthen underwriting standards, requiring motor vehicle reports for insured drivers, and to develop strategies to increase the company’s penetration of the agency’s personal lines business.
Calendar year-over-year changes in the loss and loss expense ratio have included loss reserve development. In 2005, savings from favorable loss reserve development from prior accident years lowered the loss and loss expense ratio by 1.6 percentage points. In 2004 and 2003, reserve strengthening added 0.2 percentage points and 2.1 percentage points, respectively, to the loss and loss expense ratio.
Homeowner
Written and earned premiums for the homeowner line rose in 2005 and 2004. Written premiums rose because of the effect of rate increases, which served to offset lower policy renewal retention and significantly lower new business levels. Earned premiums continued to benefit from written premium growth in earlier periods.
At year-end 2005, approximately 56 percent of all homeowner policies had been converted to a one-year term, up from approximately 27 percent at year-end 2004. We are continuing to renew homeowner policies for three-year terms in nine states until the Diamond roll out is planned for those states. Renewal rates on those three-year policies reflect all rate changes enacted over the past several years. This can cause those policies to renew at a significantly higher cost for the policyholders, even if the price is competitive.
The loss and loss expense ratio for the homeowner line excluding catastrophe losses improved in 2005 and 2004. Unusually high catastrophe losses in 2004 interrupted two years of improvement in the loss and loss expense ratio including catastrophe losses. Favorable loss reserve development from prior accident years lowered the loss and loss expense ratio by 1.0 percentage points in 2005, 2.2 percentage points in 2004 and 3.1 percentage points in 2003.
We continue to seek to improve homeowner results so that this line achieves profitability. Since we generally do not allocate noncommission expenses to individual business lines, to measure homeowner profitability, we

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assume total commission and underwriting expenses would contribute approximately 30 percentage points to our homeowner combined ratio. Lower levels of premium growth could affect our ability to attain that level in 2006 and beyond.
We also assume catastrophe losses as a percent of homeowner earned premium would be in the range of 17 percent. Over the past three years, catastrophe losses have averaged approximately 21 percent of homeowner earned premiums. We believe it will take until 2007 for the full benefit of our pricing and underwriting actions to be reflected in homeowner results.
Personal Lines Insurance Outlook
Industry experts currently anticipate industrywide personal lines written premiums will rise approximately 2.9 percent in 2006, with personal auto premiums expected to rise about 2.5 percent and homeowner premiums expected to rise 4.2 percent.
A number of factors contribute to our assessment of the potential for personal lines growth:
  Competitive rates – We are working on a number of rate setting initiatives to make our personal auto and homeowner rates competitive in all of our territories. We work with our agents to establish rates that are attractive to our agencies’ quality accounts. In mid-2006, we will introduce a limited program of rate segments incorporating insurance scores into rates for our personal auto and homeowner policies to further improve our pricing for our agents’ quality accounts. We believe the opportunity exists to work with our agents to market the advantages of our personal lines products to their clients, which would help us resume growing in this business area.
  Policy characteristics – In keeping with industry practices, most of our homeowner products no longer automatically cover guaranteed replacement costs. We add specific charges for some optional coverages previously included at no charge, such as limited replacement cost and water damage coverages. Policyholders who need the water damage protection now can select the amount of coverage that meets their needs. However, these changes and our transition to one-year homeowner policies may have diminished the factors that distinguished our products.
  Diamond introduction – The use of the Diamond system by agencies writing approximately 70 percent of personal lines volume is a significant accomplishment. We believe the system ultimately will make it easier for agents to place personal auto, homeowner and other personal lines business with us, while greatly increasing policy-issuance and policy-renewal efficiencies and providing direct-bill capabilities. Agents using Diamond chose direct bill for 37 percent and headquarters printing for 75 percent of policy transactions in 2005, options that generally were not available on our previous system.
  New agencies – The availability of Diamond should help us increase the number of agencies that offer our personal lines products, which also should contribute to personal lines growth. We currently market both homeowner and personal auto insurance products through 773 of our 1,253 reporting agency locations in 22 of the 32 states in which we market commercial lines insurance. We market homeowner products through 22 locations in three additional states (Maryland, North Carolina and West Virginia.)
In addition to the rate modifications currently underway, we identify several other factors that may affect the personal lines combined ratio in 2006 and beyond. Personal lines underwriters continue to focus on insurance-to-value initiatives to verify that policyholders are buying the correct level of coverage for the value of the insured risk, and we are carefully maintaining underwriting standards. However, if premiums decline more than we expect, the personal lines expense ratio may be higher than the 2005 level, because some of our costs are relatively fixed, such as our planned investments in technology. We discuss our overall outlook for the property casualty insurance operations in Measuring Our Success in 2006 and Beyond, Page 33.
Life Insurance Results of Operations
Overview — Three-year Highlights
Performance highlights for the life insurance segment include:
  Revenues – Revenue growth has accelerated over the past three years as gross in-force policy face amounts increased to $51.493 billion at year-end 2005 from $44.921 billion at year-end 2004 and $38.492 billion at year-end 2003.
  Profitability – The life insurance segment reports a small GAAP profit because investment income is included in investment segment results, except investment income credited to contract holders (interest assumed in life insurance policy reserve calculations). Results improved in 2005 and 2004 because operating expenses remained level and mortality experience remained within pricing guidelines as premiums continued to rise.
 
    At the same time, we recognize assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life

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products. For that reason, we also evaluate GAAP data including all investment activities on life insurance-related assets.
 
GAAP net income on that basis grew 23.8 percent in 2005 to $47 million and 74.1 percent in 2004 to $38 million. The life insurance portfolio had pretax realized investment gains of $17 million in 2005 compared with $9 million of gains in 2004 and $10 million of pretax realized investment losses in 2003.
Life Insurance Results
                                         
                            2005-2004     2004-2003  
(In millions)   2005     2004     2003     Change %     Change %  
 
Written premiums
  $ 205     $ 193     $ 143       6.5       34.7  
 
                                 
Earned premiums
  $ 106     $ 101     $ 95       5.7       5.5  
Separate account investment management fees
    4       3       2       18.5       31.9  
 
                                 
Total revenues
    110       104       97       6.0       6.1  
 
                                 
Contract holders benefits incurred
    102       95       91       7.2       3.5  
Investment interest credited to contract holders
    (51 )     (46 )     (43 )     12.9       5.7  
Expenses incurred
    52       53       52       (0.3 )     0.2  
 
                                 
Total expenses
    103       102       100       0.8       0.9  
 
                                 
Life insurance segment profit (loss)
  $ 7     $ 2     $ (3 )     334.2       147.5  
 
                                 
Growth
We offer term, whole life and universal life products, fixed annuities and disability income products. Revenues in 2005 were derived principally from:
  Premiums from traditional products, principally term insurance, which contributed 71.3 percent
  Fee income from interest-sensitive products, principally universal life insurance, which contributed 25.5 percent
  Separate account investment management fee income, which contributed 3.2 percent
Our life insurance subsidiary reported total statutory written premiums of $205 million in 2005 compared with $193 million in 2004, which included premiums for two general account BOLI policies totaling $10 million, and $143 million in 2003. Written premiums for life insurance operations for all periods include life insurance, annuity and accident and health premiums.
In 2005, our life insurance segment experienced a 2.0 percent rise in applications submitted and a 4.9 percent increase in gross face amounts issued, primarily due to continued strong sales of term insurance marketed through the company’s property casualty agency force.
Over the past several years, we have worked to maintain a portfolio of straightforward and up-to-date products, primarily under the LifeHorizons name. Our product development efforts emphasize death benefit protection and guarantees.
For example, a new term series that includes a return-of-premium feature replaced the existing term portfolio in 2005. Reaction to the new portfolio has been favorable with approximately 25 percent of applications requesting the return-of-premium feature. In 2006, we are introducing a new universal life product that offers a secondary guarantee that keeps the death benefit in force provided a competitive minimum premium requirement is met.
Distribution expansion remains a high priority. In the past several years, we have added life field marketing representatives for the western and northeastern states.
Profitability
Life segment expenses consist principally of:
  Insurance benefits paid and reserve increases related to traditional life and interest-sensitive products, which accounted for 66.0 percent of 2005 expenses and 64.3 percent of 2004 expenses
  Commissions, general and other business expenses, net of deferred acquisition costs, which accounted for 34.0 percent of 2005 expenses and 35.7 percent of 2004 expenses
Life segment profitability depends largely on premium levels, the adequacy of product pricing, underwriting skill and operating efficiencies. Life segment results include only investment interest credited to contract holders (interest assumed in life insurance policy reserve calculations). The remaining investment income is reported in the investment segment results. The life investment portfolio is managed to earn target spreads between earned investment rates on general account assets and rates credited to policyholders. We consider the amount of assets under management and investment income for the life investment portfolio as key performance indicators for the life insurance segment.
We seek to maintain a competitive advantage with respect to benefits paid and reserve increases by consistently achieving better than average claims experience due to skilled underwriting. Commissions paid by

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the life insurance operation are on par with industry averages. During the past several years, we have invested in imaging and workflow technology and have significantly improved application processing. We have achieved efficiencies while maintaining our service standards.
Life Insurance Outlook
As the life insurance company seeks to improve penetration of our property casualty agencies, our objective is to increase premiums and contain expenses. We continue to emphasize the cross-serving opportunities afforded by worksite marketing of life insurance products. In 2006, we are exploring additional programs to simplify the worksite marketing sales process, including electronic enrollment software. We also intend to enhance our worksite product portfolio to make it more attractive to agents. We believe these strategies will allow us to continue to increase our worksite marketing business area.
Term insurance is our largest life insurance product line. We continue to introduce new term products with features our agents indicate are important. In addition to the changes in our term life insurance portfolio, we are implementing our new universal life products.
Marketplace and regulatory changes during 2004 have affected the cost and availability of reinsurance for term life insurance issued since the beginning of 2005. We are addressing this situation by retaining no more than a $500,000 exposure, ceding the balance using excess over retention mortality coverage and retaining the policy reserve. Retaining the policy reserve has no direct impact on GAAP results. However, because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of capital. We anticipate favorable regulatory changes as we discuss in Item 1, Life Insurance Segment, Page 13. We believe we will be able to continue to grow in the term life insurance marketplace while appropriately managing risk, at a cost that allows the life insurance company to achieve its internal performance targets.
Investments Results of Operations
Overview — Three-year Highlights
The investment segment contributes investment income and realized gains and losses to results of operations. Investments provide our primary source of pretax and after-tax profits.
  Investment income – Pretax investment income reached a new record in 2005, rising 6.9 percent from the prior record in 2004. Growth in investment income over the past two years has been driven by strong cash flow for new investments, higher interest income from the growing fixed-maturity portfolio and increased dividend income from the common stock portfolio.
  Realized gains and losses – We reported realized gains in 2005 and 2004 largely due to investment sales. The realized loss in 2003 was due to other-than-temporary impairment charges.
Investment Results
                                         
                            2005-2004     2004-2003  
(In millions)   2005     2004     2003     Change %     Change %  
 
Investment income:
                                       
Interest
  $ 280     $ 252     $ 235       11.2       7.2  
Dividends
    244       239       227       2.1       5.0  
Other
    8       6       8       29.4       (23.0 )
Investment expenses
    (6 )     (5 )     (5 )     (22.3 )     (13.0 )
 
                                 
Total net investment income
    526       492       465       6.9       5.6  
 
                                 
Investment interest credited to contract holders
    (51 )     (46 )     (43 )     12.9       5.7  
 
                                 
Net realized investment gains and losses:                                
Realized investment gains and losses
    69       87       30       (20.7 )     189.9  
Change in valuation of embedded derivatives
    (7 )     10       9       (167.2 )     7.9  
Other-than-temporary impairment charges
    (1 )     (6 )     (80 )     78.5       92.0  
 
                                 
Net realized investment gains (losses)
    61       91       (41 )     (33.1 )     321.7  
 
                                 
Investment operations income
  $ 536     $ 537     $ 381       (0.4 )     40.6  
 
                                 
Investment Income
The advantages of strong cash flow in the past three years have been somewhat offset by the challenge of investing in a low interest rate environment. The allocation of new investment dollars to fixed-maturity securities during most of 2005 and 2004 added to investment income growth.
Overall, common stock dividends contributed 43.7 percent of pretax investment income in 2005 compared with 43.9 percent in 2004 and 42.3 percent in 2003. Fifth Third, our largest equity holding, contributed 43.6 percent of total dividend income in 2005. We discuss our Fifth Third investment in Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 70. In 2005, 36 of the 49 common stock holdings in the portfolio raised their indicated annual dividend payout, as did 33 of the 51 in 2004 and 29 of 51 in 2003.

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Net Realized Investment Gains and Losses
Net realized investment gains and losses are made up of realized investment gains and losses on the sale of securities, changes in the valuation of embedded derivatives within certain convertible securities and other-than-temporary impairment charges. These three areas are discussed below.
Realized Investment Gains and Losses
Realized investment gains in 2005 and 2004 largely were due to the sale of equity holdings. We buy and sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives.
In 2005 and 2003, we had gains from the sale of equity holdings that no longer met our investment parameters or were obtained from convertible securities whose underlying common stock was never intended to be a long-term holding. Included in 2005 were the initial sales of a portion of our ALLTEL holding. We completed the sale of our entire ALLTEL position in January 2006. We discuss this sale in Item 1, Investments Segment, Page 15, and Item 8, Note 2 to the Consolidated Financial Statements, Page 88.
In 2004, we sold $356 million in equity holdings as part of a program to support the financial strength ratings of our property casualty insurance operations. We selected holdings to sell primarily based on the belief of the investment committee and management that these securities would have a lower dividend growth rate over the next several years when compared with other holdings in the portfolio. We also considered the potential tax effect of any unrealized gains. Partial sales of holdings in which we held over $100 million in fair value at year-end 2003 contributed $311 million.
We sold fixed-maturity investments during the past three years as part of our portfolio management strategies. The majority of these were bonds disposed of due to rating or credit concerns, including several in the airline and auto related industries. Although we prefer to hold fixed-maturity investments until they mature, a decision to sell reflects our perception of a change in the underlying fundamentals of the security and preference to allocate those funds to investments that more closely meet the established parameters for long-term stability and growth. Our opinion that a security fundamentally no longer meets our investment parameters may reflect a loss of confidence in the issuer’s management, a change in underlying risk factors (such as political risk, regulatory risk, sector risk or credit risk), or a recovery from a previously impaired value.
Realized gains in the past three years also have included gains from the sale of previously impaired securities.
Change in the Valuation of Embedded Derivatives
In 2005, we recorded $7 million in fair value declines compared with $10 million in fair value increases in 2004 and $9 million in fair value increases in 2003. These changes in fair value are due to the application of SFAS No. 133, which requires measurement of the fluctuations in the value of the embedded derivative features in selected convertible securities. The changes in fair values are recognized in net income in the period they occur. See Item 8, Note 1 to the Consolidated Financial Statements, Page 84, for details on the accounting for convertible security embedded options.
Other-than-temporary Impairment Charges
In 2005, we recorded $1 million in write-downs of investments that we deemed had experienced an other-than-temporary decline in market value versus $6 million in 2004 and $80 million in 2003. The factors we consider when evaluating impairments are discussed in Critical Accounting Estimates, Asset Impairment, Page 37. The other-than-temporary impairment charges represented less than 0.1 percent of our total invested assets at year-end 2005 and 2004 and 0.6 percent of our total invested assets at year-end 2003. Other-than-temporary impairment charges also include unrealized losses of holdings that we have identified for sale but not yet completed a transaction.
The significant decline in other-than-temporary impairment in 2005 and 2004 was due to prior impairments in the portfolio, disposition of certain securities in prior years and an improvement in the general financial climate.
The majority of the other-than-temporary write-downs in the past three years were due to:
  2005 – one auto-related convertible preferred security for $1 million
  2004 – two airline-related tax-exempt municipal bonds totaling $5 million
  2003 – 31 high-yield corporate bonds written down $39 million and 10 convertible securities written down $26 million. Market value declines in 2003 largely related to events specific to the issuer rather than industry issues, although $58 million of the $80 million write-downs were concentrated in the utility/merchant energy trading, airline and healthcare industries.

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Other-than temporary impairment charges from the investment portfolio by the asset class we described in Item 1, Investments Segment, Page 15, are summarized below:
                         
    Years ended December 31,  
(Dollars in millions)   2005     2004     2003  
 
Taxable fixed maturities:
                       
Number of securities impaired
    2       1       42  
Percent to total owned
    0 %     1 %     6 %
Impairment amount
  $ (1 )   $ 0     $ (66 )
New book value
    1       2       36  
Percent to total owned
    0 %     1 %     1 %
 
                       
Tax-exempt fixed maturities:
                       
Number of securities impaired
    0       2       5  
Percent to total owned
    0 %     0 %     1 %
Impairment amount
  $ 0     $ (5 )   $ (6 )
New book value
    0       9       3  
Percent to total owned
    0 %     1 %     0 %
 
                       
Common equities:
                       
Number of securities impaired
    0       1       2  
Percent to total owned
    0 %     2 %     4 %
Impairment amount
  $ 0     $ (1 )   $ (8 )
New book value
    0       0       5  
Percent to total owned
    0 %     0 %     0 %
 
                       
Preferred equities:
                       
Number of securities impaired
    0       0       0  
Percent to total owned
    0 %     0 %     0 %
Impairment amount
  $ 0     $ 0     $ 0  
New book value
    0       0       0  
Percent to total owned
    0 %     0 %     0 %
 
                       
Short-term investments:
                       
Number of securities impaired
    0       0       0  
Percent to total owned
    0 %     0 %     0 %
Impairment amount
  $ 0     $ 0     $ 0  
New book value
    0       0       0  
Percent to total owned
    0 %     0 %     0 %
 
                       
Total:
                       
 
                 
Number of securities impaired
    2       4       49  
 
                 
Percent to total owned
    0 %     0 %     3 %
Impairment amount
  $ (1 )   $ (6 )   $ (80 )
 
                 
New book value
  $ 1     $ 11     $ 44  
 
                 
Percent to total owned
    0 %     0 %     1 %
Other-than temporary impairment charges from the investment portfolio by industry are summarized as follows:
                         
    Years ended December 31,  
(Dollars in millions)   2005     2004     2003  
 
Automotive
  $ (1 )   $ 0     $ (1 )
Airline
    0       (5 )     (18 )
Utility/merchant energy/trading
    0       0       (30 )
Healthcare
    0       0       (10 )
Other
    0       (1 )     (21 )
 
                 
Total
  $ (1 )   $ (6 )   $ (80 )
 
                 
Investments Outlook
We believe investment income growth for 2006 could be in the range of 6.5 percent to 7.0 percent. Our outlook is based on the anticipated level of dividend income, the strong cash flow from insurance operations and the higher-than-normal allocation of new cash flow to fixed-maturity securities over the past 18 months. Dividend increases within the last 12 months by Fifth Third and another 35 of the 49 common stock holdings in the equity portfolio should add $15 million to annualized investment income. In 2006, our investment department will allocate the after-tax proceeds of the ALLTEL common stock sale in line with our overall investment philosophy, with a focus on replacing the approximately $20 million in ALLTEL dividend income received in 2005.

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We believe impairments in 2006 should be limited to securities that have been identified for sale or that have experienced a sharp decline in fair value with little or no warning because of issuer-specific events. All but two securities in the portfolio were trading at or above 70 percent of book value at December 31, 2005. Our asset impairment committee continues to monitor the investment portfolio. The current asset impairment policy is in Critical Accounting Estimates, Asset Impairment, Page 37.
Other
In 2005, other income of the insurance subsidiaries, parent company operations and non-investment operations of CFC Investment Company and CinFin Capital Management Company resulted in $12 million in revenues compared with $8 million in 2004 and $7 million in 2003. Losses before income taxes of $50 million in 2005 were primarily due to $52 million in interest expense from debt of the parent company. Losses before income taxes were $37 million in 2004 and $38 million in 2003, when interest expense was $36 million and $33 million, respectively.
Taxes
Income tax expense was $221 million in 2005 compared with $216 million in 2004 and $106 million in 2003. The effective tax rate for 2005 was 26.8 percent compared with 27.0 percent in 2004 and 22.0 percent in 2003. In addition to higher underwriting profits, the higher tax rate in 2005 and 2004 reflected a higher level of capital gains, compared with capital losses in 2003.
We pursue a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. Details regarding our effective tax rate are found in Item 8, Note 10 to the Consolidated Financial Statements, Page 93.
Liquidity and Capital Resources
Liquidity and capital resources represent the overall financial strength of our company and our ability to generate cash flows to meet the short- and long-term cash requirements of business obligations and growth needs. We seek to maintain prudent levels of liquidity and financial strength for the protection of our policyholders, creditors and shareholders.
The parent company’s primary means of meeting liquidity requirements are dividends from our insurance subsidiary and income from investments held at the parent-company level supported by our capital resources. At year-end 2005, we had shareholders’ equity of $6.086 billion and total debt of $791 million. Our ability to access the capital markets and short-term bank borrowing provide other potential sources of liquidity. One way we seek to maintain financial strength is by keeping our ratio of debt to capital below 15 percent. Our parent company’s cash requirements include dividends to shareholders, interest payments on our long-term debt, common stock repurchases and general operating expenses.
Our insurance subsidiary’s primary sources of liquidity are premiums and investment income. Its cash needs primarily consist of paying property casualty and life insurance loss and loss expenses as well as ongoing operating expenses and payments of dividends to the parent company. Although we have never sold investments to pay claims, the sale of investments would provide an additional source of liquidity, if required. After satisfying operating cash requirements, excess cash flows are invested in fixed-maturity and equity securities, leading to the potential for increases in future investment income and unrealized appreciation.
Sources of Liquidity
Subsidiary Dividends
Our insurance subsidiary declared dividends to the parent company of $275 million in 2005, $175 million in 2004 and $50 million in 2003. State of Ohio regulatory requirements restrict the dividends insurance subsidiaries can pay. Generally, the most Ohio-domiciled insurance subsidiaries can pay without prior regulatory approval is the greater of 10 percent of statutory surplus or 100 percent of statutory net income for the prior calendar year up to the amount of statutory unassigned surplus as of the end of the prior calendar year. Dividends exceeding these limitations may be paid only with approval of the Ohio Department of Insurance. During 2006, total dividends that our lead insurance subsidiary can pay to our parent company without regulatory approval are approximately $517 million.
Insurance Underwriting
Our property casualty and life insurance operations provide liquidity because premiums generally are received before losses are paid under the policies purchased with those premiums. After satisfying our cash requirements, excess cash flows are used for investment, increasing future investment income.

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This table shows a summary of cash flow of the insurance subsidiary (direct method):
                         
    Years ended December 31,  
(In millions)   2005     2004     2003  
 
Written premiums
  $ 3,187     $ 3,055     $ 2,771  
Loss and loss expenses paid
    1,752       1,694       1,617  
Commissions and other underwriting expenses paid
    951       889       774  
 
                 
Insurance subsidiary cash flow from underwriting
    484       472       380  
Investment income received
    427       362       332  
 
                 
Insurance subsidiary operating cash flow
  $ 911     $ 834     $ 712  
 
                 
Historically, cash receipts from property casualty and life insurance premiums, along with investment income, have been more than sufficient to pay claims, operating expenses and dividends to the parent company. While first-year life insurance expenses normally exceed the premiums, subsequent premiums are used to generate investment income until the time the policy benefits are paid.
After paying claims and operating expenses, cash flows from underwriting were essentially unchanged in 2005 after rising 21.5 percent in 2004. We discuss our future obligations for claims payments in Contractual Obligations, Page 59, and our future obligations for underwriting expenses in Commissions and Other Underwriting Expenses, Page 60. Based on our outlook for commercial lines, personal lines and life insurance, we believe that cash flows from underwriting could decline in 2006. A lower level of cash flow available for investment could lead to reduced potential for increases in future investment income and capital gains.
Investing Activities
Investment income is a primary source of liquidity for both the parent company and insurance subsidiary. The transfer of equity holdings to our insurance subsidiary from the parent company in 2004 increased the amount of investment income generated at the subsidiary level but had no effect on consolidated investment income. As we discuss under Investments Results of Operations, Page 54, investment income rose in each of the past three years, and we expect investment income to grow 6.5 percent to 7.0 percent in 2006.
Realized gains also can provide liquidity, although we follow a buy-and-hold investment philosophy seeking to compound cash flows over the long-term. When we dispose of investments, we generally reinvest the gains in new investment securities. Disposition of investments occurs for a number of reasons:
  Sales of fixed-maturity investments – We prefer to hold fixed-maturity securities until maturity. Any decision to sell or to reduce a holding reflects our perception of a change in the underlying fundamentals of the security and our preference to allocate those funds to investments that more closely meet our established parameters for long-term stability and growth.
  Call or maturity of fixed-maturity investments – Calls and maturities of fixed-maturity investments are a function of the yield curve. The pace of calls of fixed maturities declined in 2005 because of a stabilization of interest rates. In the past several years, we have purchased U.S. agency paper with higher coupons and shorter call protection features.
  Sales of equity securities investments – In 2005, we continued to sell equity positions previously identified. We also recorded the initial ALLTEL sales in 2005. Sales of equity securities rose in 2004 due to the sale of $356 million in equity holdings as part of our program to support the financial strength ratings of our property casualty insurance operations. Holdings to be sold were selected primarily based on the investment committee’s and management’s belief that these securities would have a lower dividend growth rate over the next several years when compared with other holdings in the portfolio. We also considered the potential tax effect of any unrealized gains.
We generally have substantial discretion in the timing of investment sales and, therefore, the resulting gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process. In 2006, we expect to continue to limit the disposition of investments to those that no longer meet our investment parameters or those that reach maturity or are called by the issuer. The sale of equity investments that no longer meet our investment criteria can provide cash for investment in common stocks that we perceive to have greater potential for capital appreciation and income growth.
Capital Resources
At year-end 2005, our debt-to-capital ratio was 11.5 percent. We had $791 million of long-term debt and no borrowings on our short-term lines of credit. We generally have minimized our reliance on debt financing although we may utilize lines of credit to fund short-term cash needs.
We provide details of our three long-term notes in Item 8, Note 7 to the Consolidated Financial Statements, Page 91. None of the notes are encumbered by rating triggers.

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We issued $375 million aggregate principal amount of 6.125% senior notes in 2004. The $368 million net proceeds from the offering:
  Paid off $183 million in short-term debt.
  Are financing the construction of an estimated $100 million office building and parking garage to be situated at the headquarters located in Fairfield beginning in 2005, as announced in August 2004.
  Are available for general corporate purposes.
As of March 3, 2006, our senior debt issues were rated aa- by A.M. Best, A+ by Fitch, A2 by Moody’s and A by Standard & Poor’s.
At year-end 2005, we had two lines of credit totaling $125 million with no outstanding balance. One line of credit for $75 million was established more than five years ago and has no financial covenants. The second line of credit is an unsecured $50 million line of credit from Fifth Third Bank established in 2005. It is available for general corporate purposes and contains customary financial covenants.
Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2006. As a result, we believe our debt-to-capital ratio will remain in the range of 11 percent to 12 percent.
As a long-term investor, we historically have followed a buy-and-hold investing strategy. This policy has generated a significant amount of unrealized appreciation on equity investments. Unrealized appreciation, before deferred income taxes, was $5.067 billion and $5.840 billion at year-end 2005 and 2004, respectively. On an after-tax basis, it constituted 54.0 percent of total shareholders’ equity at year-end 2005.
Off-balance Sheet Arrangements
We do not utilize any special-purpose financing vehicles or have any undisclosed off-balance sheet arrangements (as that term is defined in applicable SEC rules) that are reasonably likely to have a current or future material effect on the company’s financial condition, results of operation, liquidity, capital expenditures or capital resources. Similarly, the company holds no fair-value contracts for which a lack of marketplace quotations would necessitate the use of fair-value techniques.
Uses of Liquidity
Our parent company and insurance subsidiary have contractual and other obligations. In addition, one of our primary uses of cash is to enhance shareholder return.
Contractual Obligations
At December 31, 2005, we estimated our future contractual obligations as follows:
                                         
    Payment due by period        
    Within     Years     Years     More than        
(In millions)   1 year     2-3     4-5     5 years     Total  
 
Contractual obligations:
                                       
Net property casualty claims payments
  $ 1,009     $ 1,054     $ 474     $ 574     $ 3,111  
Net life claims payments
    6       0       0       0       6  
Interest on long-term debt
    52       104       104       1,048       1,308  
Long-term debt
    0       0       0       795       795  
Annuitization obligations
    15       45       30       104       194  
Headquarters building expansion
    20       63       0       0       83  
Computer hardware and software
    10       2       1       1       14  
Other invested assets
    9       10       1       0       20  
 
                             
Total
  $ 1,121     $ 1,278     $ 610     $ 2,522     $ 5,531  
 
                             
Claims Payments
Our estimate of material commitments for net property casualty claims payments was approximately 56.2 percent of the estimated contractual obligations at year-end 2005.
We direct our associates to settle claims and pay losses as quickly as practical and made $1.752 billion in net claim payments during 2005. At year-end 2005, we had net property casualty reserves of $3.111 billion, reflecting $1.605 billion in unpaid amounts on reported claims (case reserves), $669 million in loss expense reserves and $837 million in estimates of IBNR claims. The specific amounts and timing of obligations related to case reserves and associated loss expenses are not set contractually. The amounts and timing of obligations for IBNR claims and related loss expenses are unknown. We discuss the adequacy of our property casualty and life insurance loss and loss expense reserves in Property Casualty Insurance Reserves, Page 61.
The historic pattern of using premium receipts for the payment of loss and loss expenses has enabled us to extend slightly the maturities of our investment portfolio beyond the estimated settlement date of the loss reserves. The modified duration of our fixed-maturity portfolio was 7.1 years at year-end 2005. By contrast, the duration of our loss and loss expense reserves was 3.1 years and the duration of all liabilities was 2.8 years. We believe this difference in duration does not affect our ability to meet current obligations because cash flow

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from operations is sufficient to meet these obligations. In addition, our investment strategy has led to substantial unrealized gains from holdings in equity securities. These equity holdings could be liquidated to meet higher than anticipated loss and loss expenses.
We believe that our insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen circumstances such as catastrophe losses, reinsurer insolvencies, changes in the timing of claims payments, increases in claims severity, reserve deficiencies or inadequate premium rates. We believe catastrophic events are the most likely cause of an unexpected rise in claims severity or frequency.
Our reinsurance program mitigates the liquidity risk of a single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover for losses under one of our reinsurance agreements depends on the financial viability of the reinsurer.
While we believe that historical performance of property casualty and life loss payment patterns is a reasonable source for projecting future claims payments, there is inherent uncertainty in this estimate of contractual obligations. We believe that we could meet our obligations under a significant and unexpected change in the timing of these payments because of the liquidity of our invested assets, strong financial position and access to lines of credit.
Long-term Debt and Interest on Long-Term Debt
Our estimate of material commitments for long-term debt was approximately 14.4 percent and our estimate of material commitments for interest on long-term debt was approximately 23.6 percent of the estimated contractual obligations at year-end 2005.
Our interest expense rose in 2005 to an annual rate of approximately $52 million due to our 2004 issuance of $375 million aggregate principal amount of 6.125% senior notes due 2034. We generally have tried to minimize our reliance on debt financing and do not expect a material increase in interest expense in the near future.
Annuitization Obligations
Our estimate of material commitments for obligations due under annuities written by our life insurance subsidiary was approximately 3.5 percent of the estimated contractual obligations at year-end 2005.
Headquarters Building Expansion
The construction of our new office building and parking garage to be situated at our headquarters located in Fairfield is expected to require approximately $83 million over the next three years. The construction project is on schedule and on budget. As of December 31, 2005, construction costs totaled $18 million. We expect construction to be completed by September 2008.
We invested $100 million of the proceeds from our 2004 issuance of $375 million aggregate principal amount of 6.125% senior notes due 2034 in short-term investments to fund this obligation.
Computer Hardware and Software
We expect to need approximately $14 million over the next five years for material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discuss below the non-contractual expenses we anticipate for computer hardware and software in 2006.
Commissions and Other Underwriting Expenses
In addition to our contractual obligations, our insurance operations use cash for commission and other underwriting expenses.
As discussed above, commissions and other underwriting expenses paid rose in each the past two years, reflecting the operating expense trends we discuss in the Commercial Lines and Personal Lines Insurance Results of Operations, Page 41 and Page 47. Commission payments also include contingent, or profit-sharing, commissions, which are paid to agencies using a formula that takes into account agency profitability and other factors, such as prompt monthly payment of amounts due to the company. Commission payments generally track with written premiums. Contingent commission payments in 2006 will be influenced by the excellent profitability we generated in 2005 and 2004.
Many of our operating expenses are not contractual obligations, but reflect the ongoing expenses of our business. Staffing is the largest component of our operating expenses and is expected to rise again in 2006, reflecting the 4.3 percent average annual growth in our associate base over the past three years. Our associate base has grown as we focus on enhancing service to our agencies and staffing additional field territories. Other expenses should rise in line with our growth.

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In addition to contractual obligations for hardware and software, we anticipate investing approximately $16 million in key technology initiatives in 2006, including spending for the development and rollout of our commercial lines policy processing systems that we discuss in Item 1, Technology Solutions, Page 4. Capitalized development costs related to key technology initiatives totaled $11 million in 2005. These activities are conducted at our discretion and we have no material contractual obligations for activities planned as part of these projects.
Investing Activities
Excess cash flows from underwriting, investment and other corporate activities are invested in fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. See Item 1, Investments Segment, Page 15, for a discussion of our investment strategy, portfolio allocation and quality. Since the second quarter of 2004, virtually all of our available cash flow has been used to purchase fixed-maturity investments to reduce our property casualty subsidiary’s ratio of common stock to statutory surplus.
Purchases of fixed-maturity securities rose significantly in 2005 and 2004. Due to the allocation of a higher percentage of new investment dollars to fixed-maturity investments, equity securities purchases in 2005 and 2004 were below the level of 2003. Purchases in 2005 included $144 million of nonredeemable preferred stock. We evaluate nonreedemable preferred stocks similar to the evaluation we make for fixed-maturity investments, seeking attractive relative yields.
In 2006, we anticipate continuing to use the majority of available cash flow to purchase fixed-maturity investments and preferred stock. Common stock purchases primarily will be funded with proceeds of common stock sales. The trend of ratios we monitor could permit some common stock purchases with cash flow from operations.
Uses of Capital
Uses of cash to enhance shareholder return include:
  Dividends to shareholders – Over the past 10 years, the company has paid an average of 42 percent of net income as dividends, with the remaining 58 percent available to reinvest for future growth and for share repurchases. The ability of the company to continue paying cash dividends is subject to factors the board of directors may deem relevant.
 
    In February 2006, the board of directors authorized a 9.8 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.34 per share. In 2005, 2004 and 2003, we paid cash dividends of $204 million, $177 million and $156 million.
  Common stock repurchase – Our board believes that stock repurchases can help fulfill our commitment to enhancing shareholder value. Consequently, the board has authorized the repurchase of outstanding shares. Common stock repurchases for treasury have continued at a steady pace over the last several years and occur when we believe that stock prices on the open market are favorable for such repurchases. At a minimum, we would expect the repurchase to offset dilution of option exercises. In 2005, 2004 and 2003, we used $63 million, $66 million and $55 million for share repurchase.
 
    In 2005, the board authorized a 10 million share repurchase program to replace a program authorized in 1999. At year-end 2005, 9.5 million shares remained authorized for repurchase under the 2005 program.
 
    The details of the repurchase activity are described in Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities, Page 27. Between February 1999 and year-end 2005, we have repurchased 14.8 million shares at a total cost to the company of $543 million. We do not adjust number of shares repurchased and average price per repurchased share for stock dividends.
Property Casualty Insurance Reserves
At year-end 2005, the total reserve balance, net of reinsurance, was $3.111 billion, compared with $2.977 billion at year-end 2004 and $2.845 billion at year-end 2003. We provide a reconciliation of the property casualty reserve balances with the loss and loss expense liability on the balance sheet in Item 8, Note 4 to the Consolidated Financial Statements, Page 90. The reserves reflected in the financial statements are management’s best estimate.
The appointed actuary’s range for adequate statutory reserves, net of reinsurance, was $2.921 billion to $3.153 billion for 2005; $2.794 billion to $3.032 billion for 2004; and $2.696 billion to $2.906 billion for 2003. The assumptions used to establish the recommended ranges were consistent with the actuary’s practices. Historically, we have established reserves in the upper half of the actuary’s range, as discussed in Critical Accounting Estimates, Property Casualty Loss and Loss Expense Reserves, Page 35.

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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
  Higher initial case reserves on liability claims
  Judicial decisions and mass tort claims
  Loss cost inflation in selected lines
The types of coverages we offer and the risk levels retained have a direct influence on the development of claims. Specifically, claims that develop quickly and have lower risk retention levels generally are more predictable.
As we discuss in Commercial Lines Insurance Segment Reserves, Page 64, re-underwriting the commercial lines book of business beginning in 2000, including decisions to non-renew certain policyholders due to risk levels and to increase rates to better reflect exposure levels, has resulted in improved profitability. We believe the program has led to a lower risk profile for the overall commercial lines segment, which has contributed to favorable loss reserve trends.
As we discuss in Personal Lines Insurance Segment Reserves, Page 66, we are seeking to improve our personal lines segment performance, in particular the homeowner business line, partially by reducing risk exposure through changes in policy terms and conditions. We do not expect our actions in personal lines to have a material impact on loss reserve trends, largely due to the relatively short-tail nature of homeowner claims.
In 2003 and 2004, $70 million in reserves were released following the November 2003 Ohio Supreme Court’s limiting of its 1999 Scott-Pontzer v. Liberty Mutual decision. The reserve releases were primarily made in the commercial auto and other liability business lines. Following the fourth-quarter 2003 reserve review, reserve levels were modified to reflect management’s assessment that mold claims behaved similar to asbestos and environmental claims, and reserves for these claims should be estimated using similar methods. These changes have been seen predominately in the commercial multi-peril business line. We expect that mold exclusions added to our commercial policies beginning in 2003 will mitigate this issue after 2006.
Further, beginning in 2003, reserve levels reflected the need to establish higher expense reserves because of the rise in litigation costs due to larger and more complex claims. These changes have been seen predominately in commercial multi-peril and other liability business lines. Beginning in 2002, our conclusions regarding reserve levels for all business lines reflected refinement of the manner in which the value of future salvage and subrogation for claims already incurred were estimated.
Development of Loss and Loss Expenses
We reconcile the beginning and ending balances of our reserve for loss and loss expenses at December 31, 2005, 2004 and 2003, in Item 8, Note 4 to the Consolidated Financial Statements, Page 90. The reconciliation of our year-end 2004 reserve balance to net incurred losses one year later recognizes approximately $160 million in redundant reserves.
The table below shows the development of the estimated reserves for loss and loss expenses the past 10 years.
  Section A shows our total property casualty loss and loss expense reserves recorded at the balance sheet date for each of the indicated calendar years on a gross and net basis. Those reserves represent the estimated amount of loss and loss expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that have been incurred but not yet reported to the company.
  Section B shows the cumulative net amount paid with respect to the previously recorded reserve as of the end of each succeeding year. For example, as of December 31, 2005, we had paid $1.053 billion of loss and loss expenses in calendar years 1996 through 2005, for losses that occurred in accident years 1995 and prior. An estimated $130 million of losses remain unpaid as of year-end 2005 (net re-estimated reserves of $1.183 billion less cumulative paid loss and loss expenses of $1.053 billion).
  Section C shows the re-estimated amount of the previously reported reserves based on experience as of the end of each succeeding year. The estimate is increased or decreased as we learn more about the frequency and severity of claims.
  Section D, cumulative net redundancy, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 1995, had developed a $398 million redundancy over 10 years, net of reinsurance, which has been reflected in income over the 10 years. The effects on income in 2005, 2004 and 2003 of changes in estimates of the reserves for loss and loss expenses for all accident years are shown in the reconciliation below.

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    Calendar year ended December 31,  
(In millions)   1995     1996     1997     1998     1999     2000     2001     2002     2003     2004     2005  
 
A. Originally reported reserves for unpaid loss and loss expenses:
                                                                                       
 
                                                                                       
Gross of reinsurance
  $ 1,690     $ 1,824     $ 1,889     $ 1,978     $ 2,093     $ 2,401     $ 2,865     $ 3,150     $ 3,386     $ 3,514     $ 3,629  
Reinsurance recoverable
    109       122       112       138       161       219       513       542       541       537       518  
 
                                                                 
Net of reinsurance
  $ 1,581     $ 1,702     $ 1,777     $ 1,840     $ 1,932     $ 2,182     $ 2,352     $ 2,608     $ 2,845     $ 2,977     $ 3,111  
 
                                                                 
 
                                                                                       
B. Cumulative net paid as of:
                                                                                       
One year later
  $ 453     $ 499     $ 522     $ 591     $ 697     $ 758     $ 799     $ 817     $ 817     $ 907          
Two years later
    732       761       853       943       1,116       1,194       1,235       1,235       1,293                  
Three years later
    884       965       1,067       1,195       1,378       1,455       1,455       1,519                          
Four years later
    992       1,075       1,207       1,327       1,526       1,526       1,614                                  
Five years later
    1,049       1,152       1,283       1,412       1,412       1,623                                          
Six years later
    1,093       1,205       1,333       1,333       1,464                                                  
Seven years later
    1,123       1,146       1,239       1,366                                                          
Eight years later
    1,146       1,045       1,260                                                                  
Nine years later
    1,045       1,159                                                                          
Ten years later
    1,053                                                                                  
 
                                                                                       
C. Net reserves re-estimated as of:
                                                                                       
One year later
  $ 1,429     $ 1,582     $ 1,623     $ 1,724     $ 1,912     $ 2,120     $ 2,307     $ 2,528     $ 2,649     $ 2,817          
Two years later
    1,380       1,470       1,551       1,728       1,833       2,083       2,263       2,377       2,546                  
Three years later
    1,279       1,405       1,520       1,636       1,802       2,052       2,178       2,336                          
Four years later
    1,236       1,380       1,465       1,615       1,771       2,010       2,153                                  
Five years later
    1,227       1,326       1,466       1,608       1,757       1,999                                          
Six years later
    1,189       1,333       1,463       1,602       1,733                                                  
Seven years later
    1,205       1,333       1,460       1,577                                                          
Eight years later
    1,210       1,332       1,435                                                                  
Nine years later
    1,208       1,305                                                                          
Ten years later
    1,183                                                                                  
 
                                                                                       
D. Cumulative net redundancy as of:
                                                                                       
One year later
  $ 152     $ 120     $ 154     $ 116     $ 20     $ 62     $ 45     $ 80     $ 196     $ 160          
Two years later
    201       232       226       112       99       99       89       231       299                  
Three years later
    302       297       257       204       130       130       174       272                          
Four years later
    345       322       312       225       161       172       199                                  
Five years later
    354       376       311       232       175       183                                          
Six years later
    392       369       314       238       199                                                  
Seven years later
    376       369       317       263                                                          
Eight years later
    371       370       342                                                                  
Nine years later
    373       397                                                                          
Ten years later
    398                                                                                  
 
                                                                                       
Net liability re-estimated—latest
  $ 1,208     $ 1,332     $ 1,460     $ 1,602     $ 1,757     $ 2,010     $ 2,178     $ 2,377     $ 2,649     $ 2,817          
Re-estimated recoverable—latest
    180       172       182       209       216       243       504       542       532       539          
 
                                                                   
Gross liability re-estimated—latest
  $ 1,388     $ 1,504     $ 1,642     $ 1,811     $ 1,973     $ 2,253     $ 2,682     $ 2,919     $ 3,181     $ 3,356          
 
                                                                   
 
                                                                                       
Cummulative gross redundancy
  $ 302     $ 320     $ 247     $ 167     $ 120     $ 148     $ 183     $ 231     $ 205     $ 158          
 
                                                                   
In evaluating the development of our estimated reserves for loss and loss expenses for the past 10 years, note that each amount includes the effects of all changes in amounts for prior periods. For example, payments or reserve adjustments related to losses settled in 2005 but incurred in 1999 are included in the cumulative deficiency or redundancy amount for 2000 and each subsequent year. In addition, this table presents calendar year data, not accident or policy year development data, which readers may be more accustomed to analyzing. Conditions and trends that have affected development of the reserves in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this data.
Differences between the property casualty reserves reported in the accompanying consolidated balance sheets (prepared in accordance with GAAP) and those same reserves reported in the annual statements (filed with state insurance departments in accordance with statutory accounting practices – SAP), relate principally to the reporting of reinsurance recoverables, which are recognized as receivables for GAAP and as an offset to reserves for SAP.
Asbestos and Environmental Reserves
We believe that our asbestos and environmental reserves, including mold reserves, are adequate at this time and that these coverage areas are immaterial to our financial position due to the types of accounts we have insured in the past.
Loss and loss expenses incurred for all asbestos and environmental claims were $12 million, or 0.7 percent of total loss and loss expenses in 2005, compared with $41 million, or 2.4 percent in 2004, and $28 million, or 1.6 percent, in 2003. The increase in 2004 was primarily due to mold claims prior to the introduction of the mold exclusion to our policy forms.

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Net reserves for all asbestos and environmental claims were $132 million in 2005 compared with $135 million in 2004 and $105 million in 2003. Net reserves for all asbestos and environmental claims were 4.2 percent, 4.5 percent and 3.7 percent of total reserves, in 2005, 2004 and 2003, respectively.
We generally wrote commercial accounts after the development of coverage forms that exclude asbestos cleanup costs. We believe our exposure to risks associated with past production and/or installation of asbestos materials is minimal because we primarily were a personal lines company when most of the asbestos exposure occurred. The commercial coverage we did offer was predominantly related to local-market construction activity rather than asbestos manufacturing. Further, over the past four years, to limit our exposure to mold and other environmental risks going forward, we have revised policy terms where permitted by state regulation. We continue to evaluate our exposure to silicosis and welding claims, but believe our exposure is minimal.
Commercial Lines Insurance Segment Reserves
For the business lines in the commercial lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves. The rise in total gross reserves for our commercial business lines was related to our growth. Commercial multi-peril reserve growth also was related to the higher proportion of commercial lines catastrophe losses in 2005 compared with 2004. Workers compensation reserve growth also was related to medical cost inflation and longer estimated payout periods as we discussed in Commercial Lines Insurance Results of Operations, Page 41.
                                         
    Loss reserves     Loss     Total        
    Case     IBNR     expense     gross     Percent  
(In millions)   reserves     reserves     reserves     reserves     of total  
 
At December 31, 2005
                                       
Commercial multi-peril
  $ 505     $ 101     $ 228     $ 834       26.3 %
Workers compensation
    283       333       79       695       21.9  
Commercial auto
    267       56       65       388       12.2  
Other liability
    312       368       140       820       25.9  
All other lines of business
    277       24       135       436       13.7  
 
                             
Total
  $ 1,644     $ 882     $ 647     $ 3,173       100.0 %
 
                             
At December 31, 2004
                                       
Commercial multi-peril
  $ 465     $ 123     $ 227     $ 815       27.0 %
Workers compensation
    258       278       75       611       20.3  
Commercial auto
    254       58       64       376       12.5  
Other liability
    288       377       111       776       25.7  
All other lines of business
    289       19       130       438       14.5  
 
                             
Total
  $ 1,554     $ 855     $ 607     $ 3,016       100.0 %
 
                             
As a result of underwriting actions taken since 2000 and a generally favorable insurance marketplace, the commercial lines segment has been able to obtain higher premium per exposure. As a result, profitability has improved due to higher revenue on stable loss and loss expenses.

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The following table provides the amounts of net reserve changes made over the past three years by commercial line of business and accident year:
                                 
    Commercial     Workers     Commercial     Other  
(Dollars in millions)   multi-peril     compensation     auto     liability  
 
As of December 31, 2005
                               
2004 accident year
  $ 5     $ (9 )   $ 16     $ 36  
2003 accident year
    22       (13 )     5       32  
2002 accident year
    9       (8 )     2       6  
2001 accident year
    7       (3 )     1       1  
2000 accident year
    0       (3 )     0       (8 )
1999 accident year
    2       (3 )     0       0  
1998 and prior accident years
    16       (4 )     10       (17 )
 
                       
Redundancy/(deficiency)
  $ 61     $ (43 )   $ 34     $ 50  
 
                       
Reserves as originally estimated
  $ 760     $ 557     $ 372     $ 599  
Reserves re-estimated as of December 31, 2005
    699       600       338       549  
 
                       
Redundancy/(deficiency)
  $ 61     $ (43 )   $ 34     $ 50  
 
                       
Impact on loss and loss expense ratio
    7.7 %     (13.3 )%     7.4 %     11.2 %
 
                               
As of December 31, 2004
                               
2003 accident year
  $ (5 )   $ 5     $ 11     $ 36  
2002 accident year
    2       (1 )     10       41  
2001 accident year
    5       (6 )     4       27  
2000 accident year
    4       (3 )     4       13  
1999 accident year
    0       (2 )     7       2  
1998 accident year
    1       (1 )     3       0  
1997 and prior accident years
    (11 )     (7 )     8       12  
 
                       
Redundancy/(deficiency)
  $ (4 )   $ (15 )   $ 47     $ 131  
 
                       
Reserves as originally estimated
  $ 691     $ 514     $ 381     $ 635  
Reserves re-estimated as of December 31, 2004
    695       529       334       504  
 
                       
Redundancy/(deficiency)
  $ (4 )   $ (15 )   $ 47     $ 131  
 
                       
Impact on loss and loss expense ratio
    (0.6 )%     (4.9 )%     10.5 %     32.5 %
 
                               
As of December 31, 2003
                               
2002 accident year
  $ (3 )   $ (1 )   $ 11     $ 36  
2001 accident year
    2       (3 )     2       15  
2000 accident year
    (10 )     (2 )     7       5  
1999 accident year
    5       (1 )     11       6  
1998 accident year
    (2 )     0       2       3  
1997 accident year
    (2 )     (1 )     1       5  
1996 and prior accident years
    (3 )     (5 )     3       9  
 
                       
Redundancy/(deficiency)
  $ (13 )   $ (13 )   $ 37     $ 79  
 
                       
 
                               
Reserves as originally estimated
  $ 609     $ 477     $ 383     $ 580  
Reserves re-estimated as of December 31, 2003
    622       490       346       501  
 
                       
Redundancy/(deficiency)
  $ (13 )   $ (13 )   $ 37     $ 79  
 
                       
Impact on loss and loss expense ratio
    (2.0 )%     (4.3 )%     8.8 %     23.0 %
The overall favorable development recorded in the commercial lines reserves illustrates the potential for revisions inherent in estimating reserves, especially in long-tail lines such as other liability. With the exception of the UM/UIM reserve releases and other significant changes in assumptions discussed above, commercial lines reserve development over the past three years was consistent with:
  The initiative, begun in 2001, to establish higher initial case reserves on liability claims in the period in which the claim is reported.
  Higher than expected medical inflation affecting the workers compensation line
  Settlements that differed from the established case reserves
  Changes in case reserves based on new information for specific claims or classes of claims
  Differences in the timing of actual settlements compared with the payout patterns assumed in the accident year IBNR reductions
  Lower risk profile after 2001 due to commercial lines underwriting initiatives

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Personal Lines Insurance Segment Reserves
For the business lines in the personal lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were down slightly from year-end 2004 due to normal claims activity on a lower policy count and lower personal lines catastrophe reserves in 2005 than in 2004.
                                         
    Loss reserves     Loss     Total        
    Case     IBNR     expense     gross     Percent  
(In millions)   reserves     reserves     reserves     reserves     of total  
 
At December 31, 2005
                                       
Personal auto
  $ 175     $ 4     $ 34     $ 213       46.9 %
Homeowners
    70       21       18       109       23.8  
All other lines of business
    55       67       12       134       29.3  
 
                             
Total
  $ 300     $ 92     $ 64     $ 456       100.0 %
 
                             
At December 31, 2004
                                       
Personal auto
  $ 181     $ 15     $ 35     $ 231       46.4 %
Homeowners
    81       21       23       125       25.1  
All other lines of business
    57       73       12       142       28.5  
 
                             
Total
  $ 319     $ 109     $ 70     $ 498       100.0 %
 
                             
Over the past three years, higher-than-normal catastrophe losses have contributed to the personal lines loss and loss expenses.

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The following table provides the amounts of net reserve changes made over the past three years by personal line of business and accident year:
                 
    Personal        
(Dollars in millions)   auto     Homeowners  
 
As of December 31, 2005
               
2004 accident year
  $ 2     $ 1  
2003 accident year
    0       2  
2002 accident year
    2       0  
2001 accident year
    4       1  
2000 accident year
    1       0  
1999 accident year
    1       (1 )
1998 and prior accident years
    2       0  
 
           
Redundancy/(deficiency)
  $ 12     $ 3  
 
           
 
               
Reserves as originally estimated
  $ 231     $ 114  
Reserves re-estimated as of December 31, 2005
    219       111  
 
           
Redundancy/(deficiency)
  $ 12     $ 3  
 
           
Impact on loss and loss expense ratio
    2.7 %     1.0 %
 
               
As of December 31, 2004
               
2003 accident year
  $ (9 )   $ 0  
2002 accident year
    (1 )     1  
2001 accident year
    3       4  
2000 accident year
    3       1  
1999 accident year
    1       0  
1998 accident year
    1       0  
1997 and prior accident years
    1       0  
 
           
Redundancy/(deficiency)
  $ (1 )   $ 6  
 
           
 
               
Reserves as originally estimated
  $ 224     $ 89  
Reserves re-estimated as of December 31, 2004
    225       83  
 
           
Redundancy/(deficiency)
  $ (1 )   $ 6  
 
           
Impact on loss and loss expense ratio
    (0.2 )%     2.2 %
 
               
As of December 31, 2003
               
2002 accident year
  $ (8 )   $ 2  
2001 accident year
    (4 )     5  
2000 accident year
    0       0  
1999 accident year
    2       1  
1998 accident year
    0       0  
1997 accident year
    1       0  
1996 and prior accident years
    0       0  
 
           
Redundancy/(deficiency)
  $ (9 )   $ 8  
 
           
 
               
Reserves as originally estimated
  $ 201     $ 96  
Reserves re-estimated as of December 31, 2003
    210       88  
 
           
Redundancy/(deficiency)
  $ (9 )   $ 8  
 
           
Impact on loss and loss expense ratio
    (2.1 )%     3.1 %
The overall favorable development recorded in the personal lines segment reserves illustrates the potential for revisions inherent in estimating reserves. Personal lines reserve development over the past three years was consistent with:
  Settlements that differed from the established case reserves
  Changes in case reserves based on new information for specific claims or classes of claims
  Differences in the timing of actual settlements compared with the payout patterns assumed in the accident year IBNR reductions
  Recognition of favorable case reserve development
Life Insurance Reserves
Gross life policy reserves were $1.343 billion at year-end 2005, compared with $1.194 billion at year-end 2004. We establish reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting

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our assumptions for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
We establish reserves for our universal life, deferred annuity and investment contracts equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals.
We regularly review our life insurance business to ensure that any deferred acquisition cost associated with the business is recoverable and that our actuarial liabilities (life insurance segment reserves) make sufficient provision for future benefits and related expenses.
2006 Reinsurance Programs
A single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event could present us with a liquidity risk. In an effort to control such losses, we forego marketing property casualty insurance in specific geographic areas, monitor our exposure in certain coastal regions, review aggregate exposures to huge disasters and purchase reinsurance. We use the Risk Management Solutions and Applied Insurance Research models to evaluate exposures to a once-in-250-year event in determining appropriate reinsurance coverage programs. In conjunction with these activities, we also continue to evaluate information provided by our reinsurance broker. These various sources explore and analyze credible scientific evidence, including the impact of global climate change, which may affect our exposure under insurance policies.
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions regarding the appropriate level of property casualty risk retention are affected by various factors, including changes in our underwriting practices, capacity to retain risks and reinsurance market conditions. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover for losses covered under one of our reinsurance agreements depends on the financial viability of the reinsurer.
Currently participating on our property and casualty per-occurrence programs are American Reinsurance Company, GE Insurance Solutions, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of which have A.M. Best insurer financial strength ratings of A (Excellent) or A+ (Superior). Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and Europe markets.
The estimated incremental premium savings is $7 million for the 2006 property casualty reinsurance agreements, without taking into account the reinstatement premium incurred in 2005. The savings primarily is due to higher retention levels and to lower rates for the casualty per occurrence program, which offset higher rates for the property per occurrence and property catastrophe programs.
Primary components of the 2006 property and casualty reinsurance program include:
  Property per risk treaty – The primary purpose of the property treaty is to provide excess limits capacity up to $25 million, supplying adequate capacity for the majority of the risks we write and also includes protection for extra-contractual liability coverage losses. The ceded premium is estimated to be $30 million for 2006, compared with $29 million in 2005 and $27 million in 2004. In 2006, we are retaining the first $4 million of each loss. Losses between $4 million and $25 million are reinsured at 100 percent. The $4 million base retention is new for 2006. Last year, we retained the first $3 million of every property loss. Losses in excess of $3 million were reinsured at 100 percent up to $25 million in 2005.
 
  Casualty per occurrence treaty – The casualty treaty provides excess limits capacity up to $25 million. Similar to the property treaty, this provides sufficient capacity to cover the vast majority of casualty accounts we insure and also includes protection for extra-contractual liability coverage losses. The ceded premium is estimated to be $47 million in 2006, compared with $64 million in 2005 and $61 million in 2004. In 2006, we are changing to a flat $4 million retention. Previously, we retained the first $2 million of each casualty loss, and 60 percent of the next $2 million of loss. Losses in excess of $4 million are reinsured at 100 percent up to $25 million.
 
    In mid-2005, we modified our casualty per occurrence treaty for director and officer policies for five Fortune 1000 companies and one financial services company. For three of the six companies, our retention per policy could be as high as $15 million rather than the $4 million for a typical policy; for one of the other companies, our retention per policy could be as high as $14 million; for the other two companies, our retention per policy could be as high as $5 million. We believe the additional risk undertaken with these selected policies remains at an acceptable level based on our financial strength. We arranged for this exception for this small group of companies to maintain business relationships with key agencies and insureds. We intend to review this element of our working treaties on an ongoing basis.
 
  Casualty excess treaties – We purchase a casualty reinsurance treaty that provides an additional $25 million in protection for certain casualty losses. This treaty, along with the casualty per occurrence treaty, provides a total of $50 million of protection for workers compensation, extra-contractual liability coverage and clash coverage losses, which is used when there is a single occurrence involving multiple

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    policyholders of The Cincinnati Insurance Companies or multiple coverages for one insured. The ceded premium is estimated to be $2 million in 2006 up only slightly from 2005 and 2004.
    We purchase another casualty excess treaty, which provides an additional $20 million in casualty loss coverage. This treaty also provides catastrophic coverage for workers compensation and extra-contractual liability coverage losses. The ceded premium is estimated to be $1 million for 2006, similar to the premium paid in 2005.
  Property catastrophe treaty – To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, we purchase property catastrophe reinsurance, with a limit up to $500 million. For the 2006 treaty, ceded premiums are estimated to be $38 million, up from $29 million in 2005, excluding the reinstatement premium, and $27 million in 2004, excluding the reinstatement premium. The premium increase for 2006 primarily is due to the difficult market conditions brought on in part by the record catastrophe losses experienced by reinsurance companies in 2005. We increased our retention on this program to $45 million and we will retain 5 percent of losses between $45 million and $500 million. In 2005, we retained the first $25 million of losses arising out of a single event, 40 percent of losses from $25 million to $45 million and 5 percent of all losses in excess of $45 million, up to $500 million.
Individual risks with insured values in excess of $25 million as identified in the policy are handled through a different reinsurance mechanism. We reinsure property coverage for individual risks with insured values between $25 million and $50 million under an automatic facultative treaty. For those risks with property values exceeding $50 million, we negotiate the purchase of facultative coverage on an individual certificate basis. For casualty coverage on individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis.
Responding to the challenges presented by terrorism has become a very important issue for the insurance industry over the last three years. Terrorism coverage at various levels has been secured in all of our reinsurance agreements. The broadest coverage for this peril is found in the property and casualty working treaties, which provide coverage for commercial and personal risks. Our property catastrophe treaty provides coverage for personal risks and the majority of its reinsurers provide limited coverage for commercial risks with total insured values of $10 million or less. For insured values between $10 million and $25 million, there also may be coverage in the property working treaty.
Reinsurance protection for the company’s surety business is covered under separate treaties with many of the same reinsurers that write the property casualty working treaties.
Reinsurance protection for our life insurance business is covered under separate treaties with many of the same reinsurers that write the property casualty working treaties. In 2005, we modified our reinsurance protection for our term life insurance business due to changes in the marketplace that affected the cost and availability of reinsurance for term life insurance. We are retaining no more than a $500,000 exposure, ceding the balance using excess over retention mortality coverage, and retaining the policy reserve. Retaining the policy reserve has no direct impact on GAAP results. However, because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of our capital. We also have catastrophe reinsurance coverage on our life insurance operations that reimburses us up to $20 million for covered net losses in excess of $5 million. The treaty contains a reinstatement provision, provided the covered losses were not due to terrorism.
The NAIC has asked for comments on proposals to modify statutory accounting procedures to reduce the negative effect on statutory life insurance income. We expect the NAIC proposals will be adopted. If they are not, we believe we will be able to structure a reinsurance program to provide the life insurance company with the ability to continue to grow in the term life insurance marketplace while appropriately managing risk, at a cost that allows us to achieve our life insurance company profit targets.
Safe Harbor Statement
This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. Some of those risks and uncertainties are discussed in Item 1A, Risk Factors, Page 21. Although we often review or update our forward-looking statements when events warrant, we caution our readers that we undertake no obligation to do so.
Factors that could cause or contribute to such differences include, but are not limited to:
  Unusually high levels of catastrophe losses due to risk concentrations, changes in weather patterns, environmental events, terrorism incidents or other causes
 
  Ability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased and financial strength of reinsurers
 
  Increased frequency and/or severity of claims

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  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:
  o   Downgrade of the company’s financial strength ratings,
 
  o   Concerns that doing business with the company is too difficult or
 
  o   Perceptions that the company’s level of service, particularly claims service, is no longer a distinguishing characteristic in the marketplace
  Increased competition that could result in a significant reduction in the company’s premium growth rate
 
  Underwriting and pricing methods adopted by competitors that could allow them to identify and flexibly price risks, which could decrease our competitive advantages
 
  Insurance regulatory actions, legislation or court decisions or legal actions that increase expenses or place us at a disadvantage in the marketplace
 
  Delays or inadequacies in the development, implementation, performance and benefits of technology projects and enhancements
 
  Inaccurate estimates or assumptions used for critical accounting estimates, including loss reserves
 
  Events that reduce the company’s ability to maintain effective internal control over financial reporting under the Sarbanes-Oxley Act of 2002 in the future
 
  Recession or other economic conditions or regulatory, accounting or tax changes resulting in lower demand for insurance products
 
  Sustained decline in overall stock market values negatively affecting the company’s equity portfolio; in particular a sustained decline in the market value of Fifth Third shares, a significant equity holding
 
  Events that lead to a significant decline in the value of a particular security and impairment of the asset
 
  Prolonged low interest rate environment or other factors that limit the company’s ability to generate growth in investment income
 
  Adverse outcomes from litigation or administrative proceedings
 
  Effect on the insurance industry as a whole, and thus on the company’s business, of the actions undertaken by the Attorney General of the State of New York and other regulators against participants in the insurance industry, as well as any increased regulatory oversight that might result
 
  Investment activities or market value fluctuations that trigger restrictions applicable to the parent company under the Investment Company Act of 1940
Further, the company’s insurance businesses are subject to the effects of changing social, economic and regulatory environments. Public and regulatory initiatives have included efforts to adversely influence and restrict premium rates, restrict the ability to cancel policies, impose underwriting standards and expand overall regulation. The company also is subject to public and regulatory initiatives that can affect the market value for its common stock, such as recent measures affecting corporate financial reporting and governance. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
Readers are cautioned that the company undertakes no obligation to review or update the forward-looking statements included herein.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Introduction
Market risk is the potential for a decrease in securities value resulting from broad yet uncontrollable forces such as: inflation, economic growth, interest rates, world political conditions or other widespread unpredictable events. It is comprised of many individual risks that, when combined, create a macroeconomic impact. The company accepts and manages risks in the investment portfolio as part of the means of achieving portfolio objectives. Some of the risks are:
  Political – the potential for a decrease in market value due to the real or perceived impact of governmental policies or conditions
 
  Regulatory – the potential for a decrease in market value due to the impact of legislative proposals or changes in laws or regulations
 
  Economic – the potential for a decrease in value due to changes in general economic factors (recession, inflation, deflation, etc.)

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  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.
Risks associated with the five asset classes described in Item 1, Investments Segment, Page 15, can be summarized as follows (H – high, A – average, L – low):
                                         
    Taxable   Tax-exempt           Preferred   Short-term
    fixed maturities   fixed maturities   Common equities   equities   investments
 
Political
    A       H       A       A       L  
Regulatory
    A       A       A       A       L  
Economic
    A       A       H       A       L  
Revaluation
    A       A       H       A       L  
Interest rate
    H       H       A       H       L  
Fraud
    A       L       A       A       L  
Credit
    A       L       A       A       L  
Default
    A       L       A       A       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

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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 calls of the higher-yielding U.S. agency paper purchased over the past year. While higher interest rates would be expected to continue to increase the number of fixed-maturity holdings trading below 100 percent of book value, we believe lower fixed-maturity security values due solely to interest rate changes would not signal a decline in credit quality.
A dynamic financial planning model developed during 2002 uses analytical tools to assess market risks. As part of this model, the modified duration of the fixed-maturity portfolio is continually monitored by our investment department to evaluate the theoretical impact of interest rate movements.
We measure modified duration and duration to worst. The table below summarizes the effect of hypothetical changes in interest rates on the fixed-maturity portfolio under both duration scenarios:
                                         
    Fair value   Modified duration   Duration to worst
    of fixed   100 basis   100 basis   100 basis   100 basis
    maturity   point spread   point spread   point spread   point spread
(In millions)   portfolio   decrease   increase   decrease   increase
 
At December 31, 2005
  $ 5,476     $ 5,868     $ 5,084     $ 5,779     $ 5,173  
At December 31, 2004
    5,070       5,445       4,695       5,326       4,814  
The modified duration of our portfolio is currently 7.1 years and the modified duration of the redeemable preferred portfolio is currently 10.4 years. A 100 basis-point movement in interest rates would result in an approximately 7.2 percent change in the market value of the combined portfolios. Generally speaking, the higher a bond’s rating, the more directly correlated movements in its market value will be to changes in the general level of interest rates. Therefore, the municipal bond portfolio is more likely to respond to a changing interest rate scenario. Our U.S. agency paper portfolio, because it generally has very little call protection, has a low duration and would not be expected to be as responsive to rate movements. Lower investment grade and high-yield corporate bond values are driven by credit spreads, as well as their durations, in response to interest rate movements.
In the dynamic financial planning model, the selected interest rate change of 100 basis points represents our views of a shift in rates that is quite possible over a one-year period. The rates modeled should not be considered a prediction of future events as interest rates may be much more volatile in the future. The analysis is not intended to provide a precise forecast of the effect of changes in rates on our results or financial condition, nor does it take into account any actions that we might take to reduce exposure to such risks.
Short-term Investments
Our short-term investments present minimal risk as we generally purchase the highest quality commercial paper.
Equity Investments
Common stocks are subject to a variety of risk factors encompassed under the umbrella of market risk. General economic swings influence the performance of the underlying industries and companies within those industries. A downturn in the economy will have a negative impact on an equity portfolio. Industry- and company-specific risks have the potential to substantially affect the market value of the company’s equity portfolio. We address these risks by maintaining investments in a small group of holdings that we can analyze closely, better understanding their business and the related risk factors.
At December 31, 2005, the company held 14 individual equity positions valued at approximately $100 million or above, see Item 1, Investments Segment, Page 15, for additional details on these holdings. These equity positions accounted for approximately 93.8 percent of the unrealized appreciation of the entire portfolio.

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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 63.4 percent of the total fair value of the common stock portfolio at December 31, 2005. Financials sector investments typically underperform the overall market during periods when interest rates are expected to rise. We historically have seen these types of short-term fluctuations in market value of its holdings as potential buying opportunities but are cognizant that a prolonged downturn in this sector could create a long-term negative effect on the portfolio.
Over the longer term, our objective is for the performance of our equity portfolio to exceed that of the broader market. Over the five years ended December 31, 2005, our compound annual equity portfolio return was a negative 0.8 percent compared with a compound annual total return of 0.5 percent for the Standard & Poor’s 500 Index, a common benchmark of market performance. In 2005, our compound annual equity portfolio was a negative 4.2 percent, compared with a compound annual total return of 4.9 percent for that Index. Our equity portfolio underperformed the market for these periods because of the decline in the market value of our holdings of Fifth Third common stock over the past five years.
The primary risk related to preferred stock is similar to those related to investment grade corporate bonds. Falling interest rates will adversely impact market values due the normal inverse relationship between rates and yields. Credit risk exists due to their subordinate position in the capital structure. We minimize this risk by primarily purchasing investment grade preferred stocks of issuers with a strong history of paying a common stock dividend.
Fifth Third Bancorp Holding
One of our common stock holdings, Fifth Third, accounted for 26.3 percent of our shareholders’ equity at year-end 2005 and dividends earned from our Fifth Third investment were 20.2 percent of our investment income in 2005.
                         
    Years ended December 31,
(In Millions except market price data)   2005   2004   2003
 
Fifth Third Bancorp common stock holding:
                       
Dividends earned
  $ 106     $ 95     $ 82  
Percent of total investment income
    20.2 %     19.4 %     17.7 %
 
                         
    At December 31,        
    2005   2004
         
Shares held
    73       73          
Closing market price of Fifth Third
  $ 37.72     $ 47.30          
Book value of holding
    283       283          
Fair value of holding
    2,745       3,443          
After-tax unrealized gain
    1,600       2,054          
 
                       
Market value as a percent of total equity investments
    38.6 %     45.9 %        
Market value as a percent of invested assets
    21.6       27.2          
Market value as a percent of total shareholders’ equity
    45.1       55.1          
After-tax unrealized gain as a percent of total shareholders’ equity
    26.3       32.9          
Based on 2005 results, a 10 percent change in dividends earned from our Fifth Third holding would result in an $11 million change in pretax investment income and a $9 million change in after-tax earnings.
Every $1.00 change in the market price of Fifth Third’s common stock has approximately a 27 cent impact on our book value per share. A 20 percent change in the market price of Fifth Third’s common stock from its year-end 2005 closing price would result in a $549 million change in assets and a $357 million change in after-tax unrealized gains.
Fifth Third’s market value over the past three years has been impacted by a difficult interest rate environment and the residual effects of a regulatory review that was concluded in early 2004. We believe that they have come out of the process a stronger bank operationally and we believe the management team can execute on the strategy for growth they have defined. During this challenging period for the bank, we have continued to benefit from their superior dividend growth. In September 2005, Fifth Third increased its indicated annual dividend by 8.6 percent, which is expected to contribute an additional $9 million to investment income on an annualized basis.

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Unrealized Investment Gains and Losses
At December 31, 2005, unrealized investment gains before taxes totaled $5.145 billion and unrealized investment losses in the investment portfolio amounted to $78 million.
Unrealized Investment Gains
The unrealized gains at year-end 2005 were primarily due to long-term gains from the company’s holdings in the common stock of Fifth Third (Nasdaq: FITB) and Alltel Corporation (NYSE: AT). Reflecting the company’s long-term investment philosophy, of the 1,082 securities trading at or above book value, 767, or 70.9 percent, have shown unrealized gains for more than 24 months.
Unrealized Investment Losses – Potential Other-than-temporary Impairments
The asset impairment policy evaluates significant decreases in the market value of the assets; changes in legal factors or in the business climate; or other such factors indicating whether or not the carrying amount may be recoverable. A declining trend in market value, the extent of the market value decline and the length of time in which the value has been depressed are objective measures that can be outweighed by subjective measures such as impending events and issuer liquidity. In 2005 and earlier, impairment is evaluated in the event of a declining market value for four consecutive quarters with quarter-end market value below 50 percent of book value, or when a security’s market value is 50 percent below book value for three consecutive quarters. Effective January 1, 2006, impairment may be evaluated in the event a declining market value for four consecutive quarters with quarter-end market value below 70 percent of book value, or when a security’s market value is 70 percent below book value for three consecutive quarters. In addition to applying the impairment policy, the status of the portfolio is constantly monitored by the company’s portfolio managers for indications of potential problems or issues that may be possible impairment issues. If an impairment indicator is noted, the portfolio managers even more closely scrutinize the security. During 2005 and 2004, a total of six securities were written down as other-than-temporarily impaired.
We expect the number of securities trading below 100 percent of book value to fluctuate as interest rates rise or fall. Further, book values for some securities have been revised due to impairment charges recognized during 2003 and 2002. At December 31, 2005, 732 of the 1,814 securities we owned were trading below 100 percent of book value compared with 208 of the 1,593 securities we owned at December 31, 2004. Of the 732 holdings trading below book value at December 31, 2005, 714 were trading between 90 percent and 100 percent of book value.
The 732 holdings trading below book value at December 31, 2005, represented 22.3 percent of invested assets and $78 million in unrealized losses. We deem the risk related to securities trading between 70 percent and 100 percent of book value to be relatively minor and at least partially offset by the earned income potential of these investments.
  714 of these holdings were trading between 90 percent and 100 percent of book value. The value of these securities fluctuates primarily because of changes in interest rates. The fair value of these 714 securities was $2.717 billion at December 31, 2005, and they accounted for $57 million in unrealized losses.
 
  18 of these holdings were trading below 90 percent of book value at December 31, 2005. The fair value of these holdings was $111 million, and they accounted for the remaining $21 million in unrealized losses. These holdings are being monitored for credit- and industry-related risk factors. Of these securities, seven are bonds or convertible preferred stocks of auto industry-related issuers and one is a common stock of a pharmaceutical company. These eight securities account for $69 million of the fair value of holdings trading below 90 percent of book value. The remaining ten are smaller positions in a variety of industries.
Holdings trading below 70 percent of book value are monitored more closely for potential other-than-temporary impairment. At December 31, 2005, two auto-related holdings with a fair value of $8 million were trading below 70 percent of book value. At year-end 2004, no securities were trading below 70 percent of book value.