CINCINNATI FINANCIAL CORP 10-Q

Item 3. Quantitative and Qualitative Disclosures About Market Risk Our greatest exposure to market risk is through our investment portfolio. Market risk is the potential for a decrease in securities' fair value resulting from broad yet uncontrollable forces such as: inflation, economic growth or recession, interest rates, world political conditions or other widespread unpredictable events. It is comprised of many individual risks that, when combined, create a macroeconomic impact. Our view of potential risks and our sensitivity to such risks is discussed in our 2020 Annual Report on Form 10-K, Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 118. The fair value of our investment portfolio was $22.795 billion at September 30, 2021, up $1.601 billion from year-end 2020, including a $570 million increase in the fixed-maturity portfolio and a $1.031 billion increase in the equity portfolio. (Dollars in millions) At September 30, 2021 At December 31, 2020 Cost or amortized cost Percent of total Fair value Percent of total Cost or amortized cost Percent of total Fair value Percent of total Taxable fixed maturities $ 8,182 50.7 % $ 8,780 38.5 % $ 7,363 48.3 % $ 8,053 38.0 % Tax-exempt fixed maturities 3,852 23.9 4,128 18.1 3,949 25.9 4,285 20.2 Common equities 3,705 23.0 9,465 41.5 3,640 23.9 8,541 40.3 Nonredeemable preferred equities 391 2.4 422 1.9 287 1.9 315 1.5 Total $ 16,130 100.0 % $ 22,795 100.0 % $ 15,239 100.0 % $ 21,194 100.0 % At September 30, 2021, substantially all of our consolidated investment portfolio, measured at fair value, are classified as Level 1 or Level 2. See Item 1, Note 3, Fair Value Measurements, for additional discussion of our valuation techniques. In addition to our investment portfolio, the total investments amount reported in our condensed consolidated balance sheets includes Other invested assets. Other invested assets included $212 million of private equity investments, $153 million in Lloyd's deposits, $30 million of life policy loans and $23 million of real estate through direct property ownership and development projects in the United States at September 30, 2021. Cincinnati Financial Corporation Third-Quarter 2021 10-Q Page 61 FIXED-MATURITY SECURITIES 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 regular basis, targeting what we believe to be optimal risk-adjusted, after-tax yields. Risk, in this context, includes interest rate, call, reinvestment rate, credit and liquidity risk. We do not make a concerted effort to alter duration on a portfolio basis in response to anticipated movements in interest rates. By regularly investing in the bond market, we build a broad, diversified portfolio that we believe mitigates the impact of adverse economic factors. In the first nine months of 2021, the increase in fair value of our fixed-maturity portfolio reflected net purchases of securities, somewhat offset by a decrease in net unrealized gains, primarily due to an increase in U.S. Treasury yields. At September 30, 2021, our fixed-maturity portfolio with an average rating of A3/A was valued at 107.3% of its amortized cost, compared with 109.1% at December 31, 2020. At September 30, 2021, our investment-grade and noninvestment-grade fixed-maturity securities represented 80.4% and 5.4% of the portfolio, respectively. The remaining 14.2% represented fixed-maturity securities that were not rated by Moody's or S&P Global Ratings. Attributes of the fixed-maturity portfolio include: At September 30, 2021 At December 31, 2020 Weighted average yield-to-amortized cost 4.03 % 4.12 % Weighted average maturity 8.0 yrs 7.5 yrs Effective duration 4.8 yrs 4.5 yrs We discuss maturities of our fixed-maturity portfolio in our 2020 Annual Report on Form 10-K, Item 8, Note 2, Investments, Page 140, and in this quarterly report Item 2, Investments Results. Cincinnati Financial Corporation Third-Quarter 2021 10-Q Page 62 TAXABLE FIXED MATURITIES Our taxable fixed-maturity portfolio, with a fair value of $8.780 billion at September 30, 2021, included: (Dollars in millions) At September 30, 2021 At December 31, 2020 Investment-grade corporate $ 6,805 $ 6,416 States, municipalities and political subdivisions 842 712 Noninvestment-grade corporate 691 479 Commercial mortgage-backed 279 285 United States government 130 120 Foreign government 26 29 Government-sponsored enterprises 7 12 Total $ 8,780 $ 8,053 Our strategy is to buy, and typically hold, fixed-maturity investments to maturity, but we monitor credit profiles and fair value movements when determining holding periods for individual securities. With the exception of United States agency issues that include government-sponsored enterprises, no individual issuer's securities accounted for more than 0.9% of the taxable fixed-maturity portfolio at September 30, 2021. Our investment-grade corporate bonds had an average rating of Baa2 by Moody's or BBB by S&P Global Ratings and represented 77.5% of the taxable fixed-maturity portfolio's fair value at September 30, 2021, compared with 79.7% at year-end 2020. The heaviest concentration in our investment-grade corporate bond portfolio, based on fair value at September 30, 2021, was the financial sector. It represented 41.5% of our investment-grade corporate bond portfolio, compared with 46.2% at year-end 2020. No other sector exceeded 10% of our investment-grade corporate bond portfolio. Our taxable fixed-maturity portfolio at September 30, 2021, included $279 million of commercial mortgage-backed securities with an average rating of Aa1/AA. TAX-EXEMPT FIXED MATURITIES At September 30, 2021, we had $4.128 billion of tax-exempt fixed-maturity securities with an average rating of Aa2/AA by Moody's and S&P Global Ratings. We traditionally have purchased municipal bonds focusing on general obligation and essential services issues, such as water, waste disposal or others. The portfolio is well diversified among approximately 1,700 municipal bond issuers. No single municipal issuer accounted for more than 0.6% of the tax-exempt fixed-maturity portfolio at September 30, 2021. 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 adequately positioned if interest rates were to rise. Although the fair values of our existing holdings may suffer, a higher rate environment would provide the opportunity to invest cash flow in higher-yielding securities, while reducing the likelihood of untimely redemptions of currently callable securities. While higher interest rates would be expected to continue to increase the number of fixed-maturity holdings trading below 100% of amortized cost, we believe lower fixed-maturity security values due solely to interest rate changes would not signal a decline in credit quality. We continue to manage the portfolio with an eye toward both meeting current income needs and managing interest rate risk. Our dynamic financial planning model uses analytical tools to assess market risks. As part of this model, the effective duration of the fixed-maturity portfolio is continually monitored by our investment department to evaluate the theoretical impact of interest rate movements. Cincinnati Financial Corporation Third-Quarter 2021 10-Q Page 63 The table below summarizes the effect of hypothetical changes in interest rates on the fair value of the fixed-maturity portfolio: (Dollars in millions) Effect from interest rate change in basis points -200 -100 - 100 200 At September 30, 2021 $ 14,204 $ 13,540 $ 12,908 $ 12,276 $ 11,637 At December 31, 2020 $ 13,493 $ 12,900 $ 12,338 $ 11,774 $ 11,195 The effective duration of the fixed-maturity portfolio as of September 30, 2021, was 4.8 years, up from 4.5 years at year-end 2020. The above table is a theoretical presentation showing that an instantaneous, parallel shift in the yield curve of 100 basis points could produce an approximately 4.9% change in the fair value of the fixed-maturity portfolio. Generally speaking, the higher a bond is rated, the more directly correlated movements in its fair value are to changes in the general level of interest rates, exclusive of call features. The fair values of average- to lower-rated corporate bonds are additionally influenced by the expansion or contraction of credit spreads. In our dynamic financial planning model, the selected interest rate change of 100 to 200 basis points represents our view 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. EQUITY INVESTMENTS Our equity investments, with a fair value totaling $9.887 billion at September 30, 2021, included $9.465 billion of common stock securities of companies generally with strong indications of paying and growing their dividends. Other criteria we evaluate include increasing sales and earnings, proven management and a favorable outlook. We believe our equity investment style 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. Continued payment of cash dividends by the issuers of our common equity holdings can provide a floor to their valuation. The table below summarizes the effect of hypothetical changes in market prices on fair value of our equity portfolio. (Dollars in millions) Effect from market price change in percent -30% -20% -10% — 10% 20% 30% At September 30, 2021 $ 6,921 $ 7,910 $ 8,898 $ 9,887 $ 10,876 $ 11,864 $ 12,853 At December 31, 2020 $ 6,199 $ 7,085 $ 7,970 $ 8,856 $ 9,742 $ 10,627 $ 11,513 At September 30, 2021, Apple Inc. (Nasdaq:AAPL) was our largest single common stock holding with a fair value of $687 million, or 7.3% of our publicly traded common stock portfolio and 3.0% of the total investment portfolio. Thirty-nine holdings among nine different sectors each had a fair value greater than $100 million. Cincinnati Financial Corporation Third-Quarter 2021 10-Q Page 64 Common Stock Portfolio Industry Sector Distribution Percent of common stock portfolio At September 30, 2021 At December 31, 2020 Cincinnati Financial S&P 500 Industry Weightings Cincinnati Financial S&P 500 Industry Weightings Sector: Information technology 28.9 % 27.6 % 28.3 % 27.6 % Financial 15.6 11.4 14.2 10.4 Healthcare 12.8 13.2 13.3 13.5 Industrials 11.9 8.0 12.3 8.4 Consumer discretionary 8.2 12.4 8.9 12.7 Consumer staples 7.0 5.8 6.7 6.5 Energy 4.4 2.7 3.8 2.3 Materials 4.3 2.5 5.1 2.6 Real estate 2.5 2.6 2.7 2.4 Utilities 2.4 2.5 2.6 2.8 Telecomm services 2.0 11.3 2.1 10.8 Total 100.0 % 100.0 % 100.0 % 100.0 % UNREALIZED INVESTMENT GAINS AND LOSSES At September 30, 2021, unrealized investment gains before taxes for the fixed-maturity portfolio totaled $886 million and unrealized investment losses amounted to $12 million before taxes. The $874 million net unrealized gain position in our fixed-maturity portfolio at September 30, 2021, decreased in the first nine months of 2021, primarily due to an increase in U.S. Treasury yields. The net gain position for our current fixed-maturity holdings will naturally decline over time as individual securities mature. In addition, changes in interest rates can cause rapid, significant changes in fair values of fixed-maturity securities and the net gain position, as discussed in Quantitative and Qualitative Disclosures About Market Risk. For federal income tax purposes, taxes on gains from appreciated investments generally are not due until securities are sold. We believe that the appreciated value of equity securities, compared with the cost of securities that is generally used as a tax basis, is a useful measure to help evaluate how fair value can change over time. On this basis, the net unrealized investment gains at September 30, 2021, consisted of a net gain position in our equity portfolio of $5.791 billion. Events or factors such as economic growth or recession can affect the fair value and unrealized investment gains of our equity securities. The five largest holdings in our common stock portfolio were Apple, Microsoft (Nasdaq:MSFT), BlackRock Inc. (NYSE:BLK), JPMorgan Chase (NYSE:JPM) and Accenture Co. (NYSE:ACN), which had a combined fair value of $2.447 billion. Unrealized Investment Losses We expect the number of fixed-maturity securities trading below amortized cost to fluctuate as interest rates rise or fall and credit spreads expand or contract due to prevailing economic conditions. Further, amortized costs for some securities are revised through write-downs recognized in prior periods. At September 30, 2021, 244 of the 4,285 fixed-maturity securities we owned had fair values below amortized cost, compared with 128 of the 4,128 securities we owned at year-end 2020. The 244 holdings with fair values below amortized cost at September 30, 2021, represented 6.6% of the fair value of our fixed-maturity investment portfolio and $12 million in unrealized losses. • 240 of the 244 holdings had fair value between 90% and 100% of amortized cost at September 30, 2021. These primarily consist of securities whose current valuation is largely the result of interest rate factors. The fair value of these 240 securities was $843 million, and they accounted for $10 million in unrealized losses. • 3 of the 244 fixed-maturity holdings had fair value between 70% and 90% of amortized cost at September 30, 2021. We believe the three fixed-maturity securities will continue to pay interest and ultimately pay principal upon maturity. The issuers of these three securities have strong cash flow to service their debt and meet their Cincinnati Financial Corporation Third-Quarter 2021 10-Q Page 65 contractual obligation to make principal payments. The fair value of these securities was $6 million, and they accounted for $1 million in unrealized losses. • 1 of the 244 fixed-maturity holdings had fair value below 70% of amortized cost at September 30, 2021. We believe this fixed-maturity security will continue to pay interest and ultimately pay principal upon maturity. The fair value of this security was $2 million, and it accounted for $1 million in unrealized losses. The table below reviews fair values and unrealized losses by investment category and by the overall duration of the securities' continuous unrealized loss position. (Dollars in millions) Less than 12 months 12 months or more Total At September 30, 2021 Fair value Unrealized losses Fair value Unrealized losses Fair value Unrealized losses Fixed maturity securities: Corporate $ 647 $ 8 $ 17 $ — $ 664 $ 8 States, municipalities and political subdivisions 154 3 5 1 159 4 Commercial mortgage-backed 7 — 11 — 18 — United States government 6 — — — 6 — Foreign government — — — — — — Government-sponsored enterprises 4 — — — 4 — Total $ 818 $ 11 $ 33 $ 1 $ 851 $ 12 At December 31, 2020 Fixed maturity securities: Corporate $ 330 $ 5 $ 46 $ 2 $ 376 $ 7 States, municipalities and political subdivisions 31 2 2 — 33 2 Commercial mortgage-backed 23 1 6 — 29 1 United States government 12 — — — 12 — Foreign government 10 — — — 10 — Total $ 406 $ 8 $ 54 $ 2 $ 460 $ 10 At September 30, 2021, applying our invested asset impairment policy, we determined that the total of $12 million, for securities in an unrealized loss position in the table above, was not the result of a credit loss. During the third quarter and first nine months of 2021, five securities were written down to fair value through an impairment charge, resulting in $1 million of noncash charges. During the first nine months and full year of 2020, we wrote down 14 securities and recorded $78 million in impairment charges. At December 31, 2020, 128 fixed-maturity securities with a total unrealized loss of $10 million were in an unrealized loss position. Of that total, no fixed-maturity securities had fair values below 70% of amortized cost. Cincinnati Financial Corporation Third-Quarter 2021 10-Q Page 66 The following table summarizes the investment portfolio by severity of decline: (Dollars in millions) Number of issues Amortized cost Fair value Gross unrealized gain (loss) Gross investment income At September 30, 2021 Taxable fixed maturities: Fair valued below 70% of amortized cost 1 $ 3 $ 2 $ (1) $ — Fair valued at 70% to less than 100% of amortized cost 177 764 755 (9) 8 Fair valued at 100% and above of amortized cost 1,862 7,415 8,023 608 237 Investment income on securities sold in current year — — — — 18 Total 2,040 8,182 8,780 598 263 Tax-exempt fixed maturities: Fair valued below 70% of amortized cost — — — — — Fair valued at 70% to less than 100% of amortized cost 66 96 94 (2) 1 Fair valued at 100% and above of amortized cost 2,179 3,756 4,034 278 90 Investment income on securities sold in current year — — — — 2 Total 2,245 3,852 4,128 276 93 Fixed-maturities summary: Fair valued below 70% of amortized cost 1 3 2 (1) — Fair valued at 70% to less than 100% of amortized cost 243 860 849 (11) 9 Fair valued at 100% and above of amortized cost 4,041 11,171 12,057 886 327 Investment income on securities sold in current year — — — — 20 Total 4,285 $ 12,034 $ 12,908 $ 874 $ 356 At December 31, 2020 Fixed-maturities summary: Fair valued below 70% of amortized cost — $ — $ — $ — $ — Fair valued at 70% to less than 100% of amortized cost 128 470 460 (10) 18 Fair valued at 100% and above of amortized cost 4,000 10,842 11,878 1,036 414 Investment income on securities sold in current year — — — — 23 Total 4,128 $ 11,312 $ 12,338 $ 1,026 $ 455 See our 2020 Annual Report on Form 10-K, Item 7, Critical Accounting Estimates, Asset Impairment, Page 61.