The purpose of the Management’s Discussion and Analysis is to provide an understanding of Cincinnati Financial Corporation’s (CFC) consolidated results of operations and financial position. It begins with an overview of the company and its outlook, a safe harbor statement that covers factors that could cause results to differ from those anticipated by management and details on the company’s critical accounting policies and estimates. It should be read in conjunction with Item 6, Selected Financial Data, Pages 20 and 21, and the Consolidated Financial Statements and related Notes, beginning on Page 72. Per share amounts have been adjusted for the 5 percent stock dividend paid June 15, 2004; per share data has not been adjusted for the 5 percent stock dividend to be paid on April 26, 2005.
• Pursuing a total return investment strategy that generates both strong investment income growth and capital appreciation.
In 2005, management believes the company will achieve statutory net written premium growth in the mid-single digits and a GAAP combined ratio of 91 percent (equivalent to approximately 91 percent on a statutory basis). A.M. Best estimates that 2005 net written premiums industry-wide may rise by 1 percent and that the 2005 industry statutory combined ratio may be approximately 97.3 percent.
• 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 Bancorp shares, a significant equity holding
• Reporting pattern changes attributable to changes in case reserving practices, particularly with respect to umbrella claims
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:
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.
SFAS No. 123(R) permits companies to adopt its requirements using either a modified prospective or a modified retrospective method. Under the modified prospective method, the compensation cost is recognized in the financial statements beginning with the effective date, based on the requirements of SFAS No. 123(R) for all share-based payments granted after that date, and based on the requirements of SFAS No. 123 for all unvested awards granted prior to the effective date of SFAS No. 123(R). Under the modified retrospective method, the requirements are the same as under the modified prospective method, but this method also permits companies to restate financial statements of previous periods based on pro forma disclosures made is accordance with SFAS No. 123. The company currently utilizes a standard option-pricing model (binomial option-pricing model) to measure the fair value of stock options granted to associates. While SFAS No. 123(R) permits companies to continue to use such a model, the standard also permits the use of a lattice model. The company has not yet determined which model it will use to measure the fair value of associate stock options upon the adoption of SFAS No. 123(R).
recovery and as net gains on the sale of securities rose to a higher level (see Investment Results of Operations, Page 47, for additional information on net realized investment gains and losses, including the equity securities sold during 2004).
The company has been more aggressively identifying and measuring exposures to match coverage amounts and premiums to the risk. Where this matching is not possible, accounts are not being renewed unless there are mitigating factors. Agents tell the company they agree on the need to carefully select risks and assure pricing adequacy. They appreciate the time the company’s 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.
The company’s success has been built on frontline decision-making. The company expects to continue to strengthen its relationships with agencies with technology that brings agencies greater efficiencies while permitting associates to spend more time with people and less with paper.
o Increase in the commission expense ratio. Commission expense rose more rapidly than premiums primarily because of the company’s profit-sharing commission program. 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. In 2004, profit sharing commission expense contributed 3.5 percentage points, reflecting the substantial growth in the underwriting profit to $298 million. In 2003, profit sharing commission expense contributed 2.2 percentage points, reflecting the 2003 underwriting profit of $117 million before the software recovery. In 2002, these commissions contributed 0.9 percentage points to the combined ratio, as the company incurred a small underwriting profit.
• Earned premiums - The primary source of growth in the past three years was rate increases to address premium inadequacy. Rate increases on new and renewal business have offset a decline in policy count in each year. The reinsurance reinstatement premiums allocated to personal lines reduced net earned premium growth for 2004 by 0.8 percentage points.
• Combined ratio - Over the past three years, the combined ratio has reflected an improving loss and loss expense ratio excluding catastrophe losses. In 2004, the improvement in the loss and loss expense ratio was offset by higher catastrophe losses and rising commission and underwriting expenses over the entire period. In 2003, the improvement also reflected a 2.4 percentage-point decline in the underwriting expense ratio, of which 1.1 percentage-points were due to the software cost recovery.
necessary. The company has moved to one-year homeowner policies in Alabama, Florida, Georgia, Illinois, Indiana, Kansas, Kentucky, Michigan, Nebraska, Ohio and Wisconsin. The company plans for homeowner policies written in other states to shift to a one-year term in advance of the Diamond deployment for each specific state. At the end of 2004, management estimates that approximately 27 percent of homeowner policies now have been written on a one-year term.
• New agencies - The appointment of new agencies over the next several years also should contribute to personal lines growth.
• Fee income from interest-sensitive products, principally universal life insurance, which contributed 25.4 percent
The property casualty and life insurance operations’ short-term cash needs primarily consist of paying insurance loss and loss expenses as well as ongoing operating expenses and payments of dividends to the parent company. Historically, those needs have been met through underwriting cash flow and investment income. Although the company has never sold investments to pay claims, the sale of investments would provide an additional source of liquidity, if required. After satisfying short-term cash requirements, excess cash flows from underwriting are invested in fixed-income and equity securities in the insurance subsidiaries, leading to the potential for increases in future investment income and realized gains.
Purchases of investments reflected the company’s historical portfolio allocation strategy through the first quarter of 2004:
At December 31, 2004, the investment portfolio made up 78.5 percent of total assets compared with 80.3 percent at December 31, 2003. At December 31, 2004, the remainder consisted primarily of other invested assets (0.2 percent), premium receivables (6.9 percent), reinsurance receivables (4.2 percent), deferred acquisition costs (2.5 percent) and separate accounts (3.0 percent). These percentages have remained relatively constant over the last few years.
Over the past several years, the company has invested a higher portion of available funds in U.S. agency paper and insured municipal bonds, resulting in a significant rise in the percentage of the portfolio rated A and above based on fair value (market value). The majority of 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, 2004 and 2003, for the company’s fixed income portfolio were:
At December 31, 2004, $260 million, or 38.2 percent, of total reinsurance receivables, compared with $324 million, or 52.3 percent, at December 31, 2003, related to the company’s participation 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. The reinsurance receivable primarily relates to September 11, 2001, events. The decline in 2004 was due to a partial reduction in those loss reserves.
The types of coverages the company offers 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.
Loss and loss expenses incurred for all asbestos and environmental claims were $41 million, or 2.4 percent of total loss and loss expenses in 2004, compared with $28 million, or 1.6 percent, in 2003, and $37 million, or 2.2 percent, in 2002. The increase in 2004 was primarily due to mold claims.
In addition, the company has $420 million aggregate principal amount of 6.9% senior debentures due 2028. Neither note is encumbered by rating triggers. The company has minimized its reliance on debt financing although it utilizes lines of credit to fund short-term cash needs.
Traditional products require the policyholder to pay scheduled premiums over the life of the coverage. The company recognizes premiums received on traditional products as revenue when due.
In determining the pro forma amounts above, the fair value of each option was estimated on the date of grant using the binomial option-pricing model with the following weighted-average assumptions used for grants in 2004, 2003 and 2002, respectively: dividend yield of 2.40 percent, 2.40 percent and 2.52 percent; expected volatility of 25.65 percent, 26.03 percent and 25.90 percent; risk-free interest rates of 4.37 percent, 4.20 percent and 4.26 percent; and expected lives of 10 years for all years. Compensation expense in the pro forma disclosures is not indicative of future amounts as options vest over several years and additional grants generally are made each year. Options granted under the company’s options plans vest over three years.
Investments in companies and industry sectors that exceed 10 percent of the company’s shareholders’ equity include: