Readers are cautioned that the company undertakes no obligation to review or update the forward-looking statements included in this material.
Commercial accounts were written by the company after the development of coverage forms that exclude cleanup costs. The company’s exposure to risks associated with past production and/or installation of asbestos materials is minimal because the company was primarily a personal lines company when most of the asbestos exposure occurred. The commercial coverage the company did offer was predominantly related to local-market construction activity rather than asbestos manufacturing. Further, over the past two years, the company has revised policy terms, where permitted by state regulation, to limit its exposure to mold and other environmental risks going forward.
FASB issued SFAS No. 148 “Accounting for Stock-Based Compensation - Transition and Disclosure” in December 2002. This pronouncement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The company has adopted the disclosure provisions of this pronouncement and will adopt a transition method at the time when a consistent fair value recognition and measurement provision is determined by FASB (in conjunction with the international accounting standards setters) and is required to be adopted.
Investment income grew at a 4.8 percent compound annual growth rate over the three-year period compared with declines in investment income for the property casualty industry. While low prevailing interest rates and weak market conditions have limited opportunities to expand investment income, the company’s emphasis on equity holdings with a steady flow of dividend payments has added stability to investment income. Growth rates are calculated excluding $5 million in interest earned in 2000 from a $303 million single-premium BOLI policy booked at the end of 1999.
Among other factors, an industry-wide rise in loss severity over the past several years has resulted from escalating legal costs, medical costs and jury verdicts. Management monitors loss data by size of loss, business line, geographic region, agency, field marketing representative and duration of policyholder relationship to determine if there are concentrations or trends that require specific actions. Analysis indicated no significant concentrations beyond that seen in higher loss ratios for certain business lines, which management has addressed.
Commercial multi-peril - The losses and loss expenses ratio excluding catastrophes for commercial multi-peril improved in 2002 after deteriorating slightly in 2001 due to rising loss severity. A number of underwriting and pricing initiatives contributed to the change in the ratio in 2002 including package discount eligibility review, elimination or reduction of discounts, promotion of insurance-to-value levels and the salvage and subrogation reserve in 2002. The overall effect of these actions improved the losses and loss expenses ratio in 2002 by approximately 9.4 percentage points. Additions of $27 million to reserves for older accident years offset the improvement by 4.4 percentage points.
Analysis of loss data by average size of loss supports management’s belief that the industry-wide increase in loss severity is not a temporary phenomenon. Management evaluates the trend in losses and case reserve adjustments greater than $250,000 to track frequency and severity of larger losses and also monitors claim activity, average claim reserves on new claims and reserve development on large claims, as losses are settled or as reserves are increased. Based on the trends of the past three years, management believes that losses between $250,000 and $1 million and reserve increases greater than $250,000 are stable as a percent of earned premiums. Management is monitoring the level of losses greater than $1 million, however, which continue to rise as a percent of earned premiums.
The combined impact of these changes in rates and policy terms and conditions is seen as existing three-year policies renew. For example, in Ohio, which accounts for 32 percent of the company’s total homeowner earned premium, the typical renewal policyholder is experiencing approximately a 30 percent increase in total premium for their next three-year policy term. This reflects all rate increases, insured value and policy changes that were effective over the policyholder’s previous three-year policy cycle. As the company continues to work through the renewal policy cycle, management expects to see quarter-over-quarter improvement in earned premium and losses and loss expenses ratios in 2003 and beyond.
Pre-tax investment income reached a new record of $445 million in 2002, up 5.6 percent from the prior record of $421 million in 2001. Pre-tax investment income grew 2.8 percent in 2001. Growth in investment income over the past two years has been driven by excellent cash flow for new investment and increased dividend income from the common stock portfolio.
The unrealized appreciation is primarily due to the company’s holdings in Fifth Third Bancorp (Nasdaq:FITB) and Alltel Corporation (NYSE:AT) common stock.
As discussed in Significant Accounting Policies on Page 58, when evaluating other-than-temporary impairments, management considers the company’s ability to retain a security for a period adequate to recover a substantial portion of their cost. Because of the company’s investment philosophy and strong capitalization, it can hold securities until their scheduled redemption that might otherwise be deemed impaired. In management’s judgment, the 59 securities trading below 70 percent of book value at year-end 2002 that were not written down do have the potential of recovery based on analysis of economic-, industry- or company-specific factors. Based on its continuous monitoring of potential impairments and if market conditions continue to be adverse, management believes that some or all of the 59 securities being monitored as potentially impaired, or other securities, could meet the criteria for other-than-temporary impairment during the first quarter of 2003. Management believes that the company could record an other-than-temporary impairment charge at March 31, 2003 in the range of $30 million to $50 million, before tax, or 0.3 percent to 0.4 percent of invested assets at December 31, 2002.
Liquidity and capital resources - During the years ended December 31, 2002, 2001 and 2000, the company had realized investment losses amounting to $152 million, $105 million and $118 million, offset by realized investment gains of $58 million, $80 million and $116 million, respectively. At December 31, 2002, there were unrealized investment losses in the investment portfolio amounting to $176 million and unrealized investment gains of $5.770 billion. Given current market conditions, the company could record additional other-than-temporary impairment charges during 2003.
FASB Interpretation 46 “Consolidation of Variable Interest Entities” was issued in January 2993 and is effective at various dates for various requirements. This interpretation addresses consolidation of variable interest entities (formerly known as special purpose entities). Management has determined that this interpretation will have no effect on the company’s consolidated financial statements.
RECLASSIFICATIONS - Certain prior year amounts have been reclassified to conform with current-year classifications, including outstanding loss checks payable, which prior to 2002 were classified as liabilities in the balance sheets, and now, as a result of a new check clearing process with the company’s bank, are included in cash.
The company paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $17 million, $14 million and $14 million on premium volume of approximately $113 million, $95 million and $87 million for 2002, 2001 and 2000, respectively.