Cincinnati Financial Corporation owns its headquarters building located on 75 acres of land in Fairfield, Ohio. This building contains approximately 615,000 square feet, of which approximately 5 percent is available for future CFC usage. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet (1 percent). The property, including land, is carried in the financial statements at $79 million as of December 31, 2003, and is classified as Property and equipment, net, for company use.
CFC Investment Company owns the Fairfield Executive Center, which is located on the northwest corner of its headquarters property in Fairfield, Ohio. This is a four-story office building containing approximately 96,000 square feet. CFC and its subsidiaries occupy approximately 85 percent of the building; unaffiliated tenants occupy approximately 10 percent; and approximately 5 percent is available for future CFC usage. The property is carried in the financial statements at $8 million as of December 31, 2003, and is classified as Property and equipment, net, for company use.
The following discussion highlights significant factors influencing the consolidated results of operations and financial position of Cincinnati Financial Corporation (CFC). It should be read in conjunction with Item 6, Selected Financial Data, Pages 14 and 15 and Item 8, Consolidated Financial Statements and related Notes, beginning on Page 58.
Among the various factors that influence the consolidated results of operations and financial position of the company, management considers its relationships with independent agencies to be the most significant. To continue to achieve its performance targets, the company must maintain its strong relationships with the select group of agencies with which it does business, write a significant portion of each agency’s business and attract new agencies. The company seeks to be an indispensable partner in each agency’s success. The company measures its accomplishment of this objective based on being the largest or second largest carrier in each agency, either by dollars of premium or number of policies written, depending on the agency’s mix of business.
events or conditions that could weaken or harm the company’s relationships with its independent agencies and limit opportunities for growth, including a downgrade of the company’s financial strength ratings, concerns that doing business with the company is too difficult or perceptions that the company’s level of service is no longer a distinguishing characteristic in the marketplace
sustained decline in overall stock market values negatively affecting the company’s equity portfolio, in particular a sustained decline in market value of Fifth Third Bancorp shares
insurance regulatory actions, legislation or court decisions that increase expenses or place the company at a disadvantage in the marketplace
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 impacting corporate financial reporting and governance. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
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 from those estimates.
The most significant estimates relate to the company’s reserves for property casualty loss and loss expenses. Insurance loss reserves are affected directly by management’s reserving philosophy. Management bases the estimates on company experience and information from internal analysis, and obtains additional information from consulting outside actuaries.
While the company believes that reported reserves make a reasonable provision for all unpaid loss and loss expense obligations, the estimation process involves a number of variables and assumptions. Management believes this uncertainty is mitigated by the historic stability of the company’s book of business and by its continuous review of estimates. As experience develops and new information becomes known, the reserve is adjusted as appropriate. In this process, the company monitors trends in the industry, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional exposures to loss. If management determines that reserves established in prior years were not sufficient or were excessive, the change is reflected in current year results.
The outside actuary’s range for adequate statutory reserves, net of reinsurance, was $2.696 billion to $2.906 billion for 2003; $2.492 billion to $2.674 billion for 2002; and $2.267 billion to $2.429 billion for 2001. The assumptions used to establish the recommended ranges were consistent with prior year practices as described above and in Item 1, Property Casualty Loss and Loss Expense Reserves, Page 3.
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
tornado, wind and hail in the Midwest, Southeast and mid-Atlantic regions
The application of the company’s impairment policy resulted in other-than-temporary impairment charges and write-offs of investments that reduced the company’s income before income taxes by $80 million, $98 million and $45 million in 2003, 2002 and 2001, respectively.
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 are monitored as potentially impaired. The security may be 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. A sudden and severe drop in market value that does not otherwise meet the above criteria is reviewed for possible immediate impairment. Not withstanding the above, the company’s portfolio managers constantly monitor the status of their assigned portfolios for indications of potential problems or issues that may be possible impairment issues. If a significant impairment indicator is noted, the portfolio managers even more closely scrutinize the security.
The key assumptions used in developing the 2003 net pension expense were a 6.5 percent discount rate, an 8.0 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent, depending on the age of the employee. The 8 percent return on assets assumption is based on the fact that substantially all of the investments held by the pension plan are common stocks that pay annual dividends. Management believes 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 half of one percent due to current market conditions. Compared with the prior year, the net pension expense was increased by $4 million. For 2004, the company expects a net pension expense of $8 million, primarily as a result of lower plan assets, lower expected returns and one half of one percent reduction in the interest rate used in converting the lump-sum cash-out form of payment at retirement.
Holding all other assumptions constant, a one half of one percent increase or decrease in the discount rate would have increased or decreased the company’s 2003 net income before income taxes by $1 million. Likewise, a one half of one percent increase or decrease in the expected return on plan assets would have increased or decreased 2003 income before income taxes by $1 million.
The assets of the separate accounts are carried at fair value. Separate account liabilities primarily represent the contract holders’ claims to the related assets and 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 the company’s 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 the company’s 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 the company’s earnings.
See Note 1 to the Consolidated Financial Statements, Page 61, for information regarding recent accounting pronouncements. Management has determined that recent accounting pronouncements have not had nor are they expected to have any material impact on the company’s consolidated financial statements.
The consolidated results of operations reflect the operating results of each of the company’s four segments along with parent company and other non-insurance related activities. The four segments are:
Net income - Net income rose 57.0 percent in 2003 and 23.3 percent in 2002. In each of the past three years, the company’s total benefits and expenses have grown less rapidly than revenues, as management’s strategies to improve profitability have taken effect. Strong property casualty underwriting profit in 2003 led to a higher effective tax rate.
Realized investment gains and losses - A significant factor in the growth rate for net income in any year can be realized investment gains and losses. Management believes it is important to carefully consider the impact of realized investment gains and losses on net income when evaluating the company’s primary business areas: property casualty insurance and life insurance. Management believes the level of realized investment gains and losses for any particular period, while it may be material, may obscure the performance of ongoing underlying business operations in that period. While realized investment gains and losses are integral to the company’s insurance operations over the long term, the determination to recognize gains or losses in any period may be subject to management’s discretion and is independent of the insurance underwriting process. Moreover, under applicable accounting requirements, gains and losses can be recognized from certain changes in market values of securities without actual realization.
Software recovery - In the third quarter of 2003, the company recovered $23 million pretax in a settlement negotiated with a vendor. The recovery added $15 million, or 9 cents per share, to after tax net income. The negotiated settlement related to the $39 million one-time, pretax charge incurred in the third quarter of 2000 to write off previously capitalized software development costs.
Option expense - In each of the past three years, net income would have been reduced by approximately 6 cents if option expense, calculated using the binomial option-pricing model, was included in operating expenses.
Comprehensive income - Accumulated other comprehensive income, which includes the accumulated unrealized gains on investments and derivatives, grew by $441 million in 2003 after declining $470 million and $43 million in 2002 and 2001. See Item 1, Investments Segment, Page 7, for additional information on the investment portfolio and see Shareholders’ Equity, Page 46, for information on unrealized gains and losses. Return on equity improved for the third consecutive year while return on equity based on comprehensive income rose to 13.8 percent from a negative 4.0 percent in 2002 and 2.5 percent in 2001.
Based on its outlook for the insurance and investment markets, its progress in implementing operating strategies and its results for 2003, management has established certain performance targets for 2004 including:
Investment income growth of 3.5 percent to 4.5 percent compared with 4.7 percent in 2003.
Factors supporting management’s outlook for 2004 and beyond are discussed in the results of operations for each of the four business segments.
As described in Note 17 of the Consolidated Financial Statements, Page 72, management measures segment profit or loss for its property casualty and life businesses 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. Management also measures aspects of the performance of its commercial lines and personal lines segments on a combined property casualty insurance operations basis. For the combined property casualty insurance operations as well as the commercial lines and personal lines segment, statutory accounting data and ratios are key performance indicators that are used for comparison to industry results since GAAP-based industry data is not readily available. Statutory accounting data and ratios also are key performance indicators for The Cincinnati Life Insurance Company, the life insurance subsidiary.
The related investment portfolios for the property casualty and life insurance segments are managed separately from the underwriting businesses, along with investments held by the parent company. Net investment income and net realized investment gains and losses are discussed in the investments segment discussion. Underwriting results and segment pretax operating income are not a substitute for net income determined in accordance with GAAP.
The following sections review results of operations for the combined property casualty insurance operations and, separately, for each of the company’s four reportable segments (see Commercial Lines Results of Operations, Page 27, Personal Lines Results of Operations, Page 32, Life Insurance Results of Operations, Page 36, and Investments Results of Operations, Page 38).
The company achieved strong growth by leveraging the competitive characteristics discussed in Item 1, Property Casualty Insurance Operations, Page 1. It continues to apply its relationship-based strategies, including a case-by-case approach to new business and account renewals. While insisting on adequate premiums for covered exposures, the company continues to do business the way it always has; on the local level, focusing on each relationship separately. Commercial lines pricing remained flexible to respond to each risk in cooperation with local agencies, which are in a position to know their market and their business. The company believes that this approach results in more high-quality accounts over the long term, further solidifies its relationships with independent agencies and establishes a basis for continued growth.
Growth also has reflected the efforts to improve customer service through the creation of smaller marketing territories, permitting local field marketing representatives to devote more time to each independent agency. At year-end 2003, the company had 87 property casualty field territories, up from 76 at the end of 2001. During 2004, the company plans to split and staff another five to six territories. Smaller territories allow marketing representatives to increase the level of service as well as expand the opportunities to ask for and earn new business. The average net earned premium per territory rose 7.8 percent in 2003 to $32 million following a 5.0 percent increase in 2002.
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. CinciLink, the company’s Web site for agencies, enables agencies to obtain information and access the company’s new Web-based systems. The Web site includes content to make it easier for agencies to place business with the company, such as online policy loss information, software updates and a property casualty electronic coverage forms library. The initial rollout of commercial lines and personal lines rating software was achieved through CinciLink.
The largest component of the property casualty segments’ expenses is loss and loss expenses incurred, which includes both paid losses and net reserve additions for unpaid losses as well as expenses related to each. Paid losses and related loss expense accounted for 86.9 percent, 85.3 percent and 89.3 percent of property casualty insurance losses and policyholder benefits incurred in 2003, 2002 and 2001, respectively.
The remaining 13.1 percent, 14.7 percent and 10.7 percent in 2003, 2002 and 2001, respectively, reflected additions to reserves for all unpaid loss and loss expense obligations, including case reserves for reported losses and reserves for incurred but not yet reported losses, offset by released reserves. The reserve estimation policies for the property casualty segments are described in Property Casualty Insurance Loss Reserves, Page 18. The majority of IBNR increases over the past three years have been due to growth in premiums and loss cost inflation as well as management’s continuous efforts to achieve its best estimates of ultimate incurred losses. The assessment is made for each business line within the commercial lines and personal lines segments.
Reserve levels in 2003 also reflected management’s assessment that mold-related reserves should be strengthened and the need to establish higher loss expense reserves because of the rise in litigation costs due to larger and more complex claims. These two 2003 increases were offset by the release of $38 million in UM/UIM reserves following the November 2003 Ohio Supreme Court’s limiting of its 1999 Scott-Pontzer v. Liberty Mutual decision. As the company reviews pending claims in light of the recent court decision, up to an additional $37 million in UM/UIM case reserves may be released in coming quarters.
In the November 2003 decision to limit the Scott-Pontzer decision, the court ruled that an employer’s commercial automobile insurance policy only covers injured employees and only when the accident happens in the course and scope of their employment. Since 1999, the company had established case reserves and IBNR for past UM/UIM losses incurred but not yet reported related to these decisions.
Management’s conclusions regarding reserve levels in 2002 reflected refinement of the manner in which the value of future salvage and subrogation for claims already incurred is estimated. Also, management increased reserves for incurred but not yet reported losses because of higher than expected paid and/or reported development in workers compensation, commercial casualty, commercial and other umbrella lines for accident years 1999 through 2001.
Loss and loss expenses incurred for all asbestos and environmental claims were $13 million, or 0.7 percent of total loss and loss expense in 2003, compared with $20 million, or 1.2 percent, in 2002 and $7 million, or 0.4 percent, in 2001.
Reserves for all asbestos and environmental claims were constant at $71 million in 2003 and 2002, up from $63 million in 2001. Reserves for all asbestos and environmental claims were 2.5 percent, 2.7 percent and 2.7 percent of total reserves, in 2003, 2002 and 2001, respectively.
The company has property casualty working reinsurance treaties for 2004 through reinsurance companies that have written its treaties for more than 15 years. The strong relationships the company has with these reinsurers has allowed the company to negotiate favorable terms and conditions during a difficult time in the market cycle. The property casualty working treaties align the company with three of the most financially sound reinsurance companies in the world. The company also secures property catastrophe coverage and catastrophic casualty protection.
Casualty per occurrence treaty - The casualty treaty provides the company with excess capacity up to $25 million. Similar to the property treaty, this provides sufficient capacity to write the vast majority of casualty accounts the company insures. The ceded premium is estimated to be $60 million in 2004, compared with $55 million in 2003 and $52 million in 2002. In 2004, the company is retaining the first $2 million of each casualty loss, and 60 percent of the next $2 million of loss. This structure is identical to 2003. In 2003, the co-participation rose 40 percent from the 2002 level. Losses in excess of $4 million are reinsured at 100 percent up to $25 million.
Dealing with the challenges presented by terrorism has become a very important issue for the insurance industry over the last two years. Terrorism coverage at various levels has been secured in all of the company’s reinsurance agreements. The broadest coverage for this peril is found in the property and casualty working treaties, which provides coverage for commercial and personal risks. Our property catastrophe treaty provides coverage for personal risks and the majority of our reinsurers provide limited coverage for commercial risks with total insured values of $10 million or less. For insured values between $10 million and $25 million, there also may be coverage in the property working treaty.
All reinsurance agreements in place for 2004 are similar to those for 2003 and 2002. The 2004 estimated incremental cost increase of $7 million, net of tax, is primarily due to the growth in the company’s premium base. The company has the financial ability to absorb losses at the current retention levels, and the 2004 reinsurance agreements are a means of balancing reinsurance costs with an acceptable level of risk.
Earned premiums - The primary source of growth in the past three years has been higher pricing on new and renewal commercial business and insurance-to-value initiatives, more then offsetting the company’s deliberate decisions not to write or renew certain business. The growth rate in 2003 slowed as the rate of premium increases moderated industrywide.
Profitability - Since 2001, improvement in commercial lines profitability has primarily been driven by more adequate premiums per policy, with policy count relatively stable over the three-year period. In addition, careful attention to underwriting has slowed the rate of growth in loss and loss expenses. The 2003 combined ratio included the benefit of the software recovery and UM/UIM reserve release, which reduced the ratio by 0.8 percentage points and 2.0 percentage points, respectively.
From mid-1999 into 2003, the commercial lines marketplace implemented continued rate increases in reaction to concerns about the economy and rising loss severity, exacerbated by the events of September 11, 2001. Also in response to rising loss severity, during that period, some competitors announced decisions to exit geographic markets or specific lines of business; others instituted across-the-board price increases. Industry analysts believed the market was experiencing a renewed awareness of underwriting discipline.
The company has faced and will continue to address these more competitive conditions by seeking to remain a stable market for its agencies’ best business although during this three year period, the company has experienced little or no growth in commercial lines policy count. The slow growth in policy count reflected the company’s re-underwriting of the existing book of business and its insistence on obtaining adequate premium for the covered risks, the combination into a single commercial package unit of coverages formerly provided by stand-alone umbrella policies and increased competition for smaller accounts. Looking ahead, management believes that opportunities to obtain new business and increase policy count will come from its strong relationships with independent agencies, subdivision of territories to enhance service and appointment of up to 150 new agencies over the next several years. Offsetting new appointments will be continued consolidation within the independent agency marketplace and terminations of agency relationships.
strengths and weaknesses for the company. The analysis encompasses pricing, breadth of coverage and underwriting/eligibility issues. In addition to reviewing the company’s competitive position, the product management group performs underwriting audits to assess profitability initiatives. Further, the company’s research and development department analyzes opportunities and develops new products, new coverage options and improvements to existing insurance products.
Multi-year packages are offered at rates that may be slightly higher than annual rates. By reducing annual administrative efforts, multi-year policies reduce the company’s and agency’s expenses and the incentive for the policyholder to shop for a new policy every year. Management believes that the advantages of three-year policies in terms of policyholder convenience, account retention and reduced administrative costs outweigh the potential disadvantage of these policies in periods of rising rates.
Commercial lines software, which is intended to reduce the administrative burden on the company’s associates and bring the agencies greater efficiencies, made further progress in 2003. WinCPP, an online system for commercial lines rating and price quoting was expanded to 10 states from three and was available for agencies writing more than 70 percent of the company’s total premiums. Development of e-CLAS™, a commercial lines policy processing system advanced to the initial field testing stage for the Businessowners Policy, and this product is expected to go to the pilot stage with selected Ohio agencies in late 2004. Through December 31, 2003, capitalized development costs related to e-CLAS totaled $8 million and management anticipates investing another $11 million in 2004.
In addition to seeking more adequate premium per exposure over the past three years, the company has focused on longer-term efforts to enhance profitability. These have included confirming what exposures the company has for each risk and making sure it offers appropriate coverages, terms and conditions and limits of insurance. The company continues to develop new underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions where necessary. In addition, the company continues to leverage its strong local presence. Over the past three years, field marketing representatives 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 have been conducting 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.
Contractor task force - Initiatives resulting from this review included developing a supplemental application to better identify exposures; renewing emphasis on agent and underwriter education in the area of effective risk transfer techniques, particularly for general contractors; better managing exposures to apartment or tract housing development; making residential contractors ineligible for monoline umbrella liability policies; and excluding mold and external insulating finishing system (EIFS) exposures, where allowed by state regulations. Accelerated use of insurance risk reviews by field claims staff helped manage the loss ratio for contractors and similar types of businesses, contributing to the loss ratio improvement for commercial lines.
Commercial auto task force - This review identified or fine-tuned underwriting guidelines and procedures, with careful attention to trucking businesses that specialize in transporting goods for others, in some cases on a long-haul basis.
Losses incurred - Losses incurred includes both net paid losses and reserve additions for unpaid losses. As a result of the underwriting actions noted above, which have led to higher premiums on a relatively stable level of exposure, incurred losses declined to 51.2 percent of earned premiums in 2003, including a 2.0 percentage-point benefit from the UM/UIM reserve release, from 57.8 percent in 2002 and 62.3 percent in 2001. Management monitors 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. Analysis indicated no significant concentrations beyond that seen in higher loss ratios for certain business lines, which management has addressed.
Underwriting expenses incurred - In 2003 the ratio was reduced by 0.8 percentage points due to the software recovery. In 2003, commission expense rose by 1.3 percentage points as total contingent (profit-based) commissions were two times the level of the prior year because of strong recent results. The company relies on its independent agencies as frontline underwriters who know the businesses and individuals in their communities; many agencies are benefiting from their hard work over the past several years. Depreciation of capitalized costs in 2003 was 0.2 percentage points higher than the prior year as significant technological initiatives moved into service. Over the three-year period, non-commission expenses remained steady as a percent of earned premiums.
Policyholder dividends incurred - Policyholder dividend expense as a percent of earned premiums was 0.8 percent in 2003 compared with 0.3 percent in 2002 and 1.1 percentage points in 2001. The rise between 2003 and 2002 reflected increased estimates of workers compensation dividends. The decline between 2002 and 2001 was due to the company’s emphasis on pricing for workers compensation as well as its decision not to write or renew many of these policies.
The loss and loss expenses ratio declined steadily over the three-year period. This is the company’s single largest business line and the loss data are the best indicators of the success of the growth and underwriting actions that have been implemented in the past three years. Higher general liability base rates were effective in most states during 2003. This contributed to further improvement in the loss and loss expenses ratio in 2003. In 2002, underwriting and pricing initiatives also contributed, including package discount eligibility reviews, elimination or reduction of discounts, promotion of insurance-to-value levels and the salvage and subrogation reserve. The overall effect of these actions improved the loss and loss expenses ratio by 3.9 percentage points in 2003 and 7.6 percentage points in 2002. Additions of $27 million to reserves for older accident years offset the improvement by 4.4 percentage points in 2002.
In 2003 and 2002 the company chose not to renew selected policies where the aggregate terrorism exposure risk was excessive. Any new or renewal policy covering 200 or more employees at any one location received added scrutiny as the company sought to manage risk aggregation. On the basis of new business premiums written directly by agents, new workers compensation premiums rose 5.9 percent in 2003 after declining 17.4 percent in 2002 and 18.4 percent in 2001. Total workers compensation earned premiums were unchanged between 2003 and 2002 because of rate increases offset by a decline in policy count due to the re-underwriting effort.
In the past several years, the company accelerated efforts to improve commercial automobile underwriting and rate levels, making certain that vehicle use was properly classified. As a result, the loss and loss expenses ratio for commercial auto improved in each of the past three years. Further, a task force studied loss patterns in this business line and recommended new or revised underwriting guidelines to assure accurate classification and pricing. As part of the company’s overall emphasis on underwriting, risk information is being more closely scrutinized, generally resulting in higher pricing for renewal policyholders. The 2003 UM/UIM reserve release had its most substantial impact on the commercial auto line, lowering the full-year loss and loss expense ratio by 6.9 percentage points. The 2002 ratio benefited by 7.5 percentage points from the salvage and subrogation reserve.
For professional liability coverages, particularly nursing home professional liability, the company narrowed the underwriting criteria and significantly increased rates. Directors and officers coverage accounted for 12 percent of other liability premium in 2003. Director and officer policies are offered primarily to non-profit organizations, reducing the risk associated with this line of business; only 35 in-force director and officer policies as of December 31, 2003, are for publicly traded companies and only nine are for Fortune 1000 companies.
The loss and loss expense ratio for other liability declined by 24.2 percentage points in 2003 due to current accident year results below historic levels and improvements in older accident year results. The 2003 ratio also benefited by 2.6 percentage points due to the UM/UIM reserve release. The ratio increased by 18.9 percentage points in 2002. Higher than anticipated accident year 2002 losses for umbrella business resulted in a $19 million IBNR increase in 2002, adding 6.9 percentage points to the calendar year 2002 ratio.
Already unprofitable due to years of inadequate pricing, industrywide personal lines insurance saw loss ratios further deteriorate in 2001, primarily because the homeowners market experienced an upswing in water damage and mold claims. In response, insurance companies have sought rate increases and added coverage exclusions for the homeowner line. A number of carriers have taken dramatic steps, restricting new business and exiting certain territories. For many insurance companies marketing homeowner products, responses to those issues already are substantially improving their results. While the personal automobile area has been less volatile in recent years, many carriers continued to seek rate increases throughout 2003 to keep up with rising claim costs.
In August 2002, the company introduced Diamond, a Web-based policy processing system for personal lines products, to agencies in Kansas. The single-entry data processing system streamlines policy issue, reduces processing time to improve cash flow and offers direct billing. Longer-term, management believes this program could have a substantial positive benefit on premium growth as the technology presents solutions sought by independent agencies. State-by-state development and rollout will take place over the coming years as the software undergoes upgrades and modifications to accommodate each state’s rules and rates. Agencies in three of the company’s most significant personal lines states -Indiana, Michigan and Ohio - are targeted for deployment in 2004. Through December 31, 2003, capitalized development costs related to the project totaled $25 million. In 2004, management anticipates investing another $10 million.
Personal auto - Earned premiums for personal auto grew 9.8 percent, 7.9 percent and 3.8 percent in 2003, 2002 and 2001, respectively. The growth was driven by continued market penetration and the effect of rate increases beginning in late 2002. Rate increases ranging from 5 percent to 8 percent went into effect in four of the six largest personal lines states in 2003. Additional single-digit increases have been filed and approved for 10 states for 2004, including increases in the range of 4 percent to 6 percent in three of the six largest personal lines states. Management believes the company’s personal auto rates remain competitive.
Over the last three years, the benefits of a personal auto re-underwriting program generally served to offset rising loss severity. The program reviewed and strengthened underwriting standards, required motor vehicle reports for many insured drivers and obtained commitments for selected agencies to provide the company with specific premium volume increases. The loss and loss expense ratio for personal auto was relatively constant at 71.1 percent in 2003, 67.6 percent in 2002 and 70.6 percent in 2001. The 2002 ratio included a 5.0 percentage-point benefit from the salvage and subrogation reserve.
To obtain profitability for the homeowner line, the three most significant actions taken are summarized below:
Changes in policy terms and conditions - Over the past three years, the company has identified specific coverage areas for updating to increase its control over risk and pricing. For most policyholders, the company has capped the guaranteed replacement cost coverage at 125 percent of the amount chosen by the policyholder to insure the home; previously, full replacement coverage without a maximum was standard for the company. For water damage, which represented 22 percent of losses in 2003, 21 percent of losses in 2002 and 19 percent of losses in 2001, the company changed its coverage form to let policyholders choose and pay for the level of coverage they need rather than include broadened coverage with all policies. The guaranteed replacement cost coverage change and water damage endorsement began to roll out in September 2002 in three major personal lines states, Ohio, Michigan and Indiana, which accounted for 49.2 percent of 2003 homeowner earned premium. These changes were approved in all but two of the homeowner states at year-end 2003.
Management is maintaining reasonable growth projections for the personal lines area as the company prepares for the introduction of the new personal lines processing system in the key states of Indiana, Michigan and Ohio in the first half of 2004. The training program for agency representatives in Indiana and Michigan should be completed in the first half of 2004 and in Ohio during the fourth quarter of 2004. After that education effort is complete, the company has identified Alabama, Florida, Georgia, Illinois and Kentucky for the next round of deployment. The new system will make it easier for agents to place personal auto, homeowners and other personal lines business with the company while greatly increasing policy issuance efficiency and providing direct bill capabilities. It currently is in use in the company’s Kansas agencies and is undergoing a series of upgrades and modifications to accommodate each state’s rules and rates. The appointment of new agencies over the next several years also could contribute to personal lines growth.
In addition, management believes that it has in place strategies to improve the profitability of its homeowner line of business while maintaining or slightly improving personal auto profitability. While primarily focusing on longer-term targets for the homeowner line because of the existing base of three-year policies, as the company continues to work through the renewal policy cycle, management expects to see quarter-over-quarter improvement in loss and loss expenses ratios in 2004 and beyond.
Profitability - The life insurance segment reports a GAAP-based segment loss because investment income is included in investment segment results, except investment income credited to contract holders (interest assumed in life insurance policy reserve calculations).
At the same time, management recognizes that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life products. For that reason, management also evaluates GAAP data including results for investment activities on life insurance-related assets for The Cincinnati Life Insurance Company subsidiary, which comprises the life insurance segment. Looking at a key performance indicator for Cincinnati Life, GAAP net income grew 25.8 percent in 2003 to $22 million from $17 million in 2002 and $26 million in 2001. Results improved in 2003 because operating expenses remained level and mortality experience remained within pricing guidelines as premiums continued to rise. The decline in 2002 was due in part to increased regulatory and legal cost. GAAP net income in 2001 exceeded that of both 2003 and 2002 primarily because of higher capital losses in those years.
Cincinnati Life offers a full line of whole, term and universal life products, fixed annuities and disability income products. Revenues are derived principally from:
fee income from interest-sensitive products, principally universal life insurance, which contributed 26.0 percent of 2003 revenue
asset management fee income, generated primarily from separate account assets, which contributed 2.3 percent of 2003 revenue
The company’s life insurance subsidiary reported 2003 statutory written life premium of $102 million, compared with $131 million in 2002, which included the sale of a single $33 million general account bank-owned life insurance policy, and $89 million in 2001. Statutory written premiums have been reclassified to exclude annuity deposits not involving life contingencies, which are not recognized as written premium under statutory rules. New annuity sales were $37 million in 2003 compared with $85 million in 2002 and $10 million in 2001. The growth in 2002 annuity sales was attributable to the fixed rates and guaranteed income features that were attractive in 2002’s economic climate.
While the life insurance industry generally experienced declines during 2003 in applications submitted and face amount issued, the company’s life insurance segment experienced a 5.9 percent rise in applications submitted and a 20.0 percent increase in face amount issued due to continued strong sales of term insurance marketed through the company’s property casualty agency force.
In 2004, Cincinnati Life continues to enhance the LifeHorizons portfolio of products to meet changing needs of both consumers and agencies. Product development centers on mortality-oriented products combined with contract guarantees. Distribution expansion into western and northeastern states is a high priority, and management anticipates adding a life field marketing representative for the northeast in 2004.
Insurance benefits paid and reserve increases, primarily related to traditional life products, which accounted for 63.6 percent of 2003 expenses
The life insurance company maintains a competitive advantage with respect to benefits paid and reserve increases by consistently achieving better than average claims experience due to skilled underwriting. Commissions paid by the life insurance operation are on par with industry averages. During the past three years, the company has invested in imaging and workflow technology. As a result, the efficiency of application processing has improved significantly. During this period, submitted applications have increased at an annualized rate of approximately 6 percent, while staff involved with the underwriting and policy issue has declined 5 percent. This has been accomplished while maintaining the company’s service standards.
The investment segment contributes investment income and realized gains and losses to results of operations. Investments provide the company’s primary source of pretax and after-tax profits.
Realized gains and losses - Realized losses were substantially lower in 2003 than 2002. Due to the economic and market recovery, fewer other-than-temporary impairment charges were recorded in the second half of the year. Offsetting full-year other-than-temporary impairment charges primarily were net gains on the sale of securities. Realized losses rose in 2002 due to higher impairment charges.
Over the past three years, net realized investment losses have been made up of other-than-temporary impairment charges, realized investment gains and losses on the sale of securities and changes in the valuation of embedded derivatives within certain convertible securities. These three areas are discussed below:
In 2003, the company recorded $80 million in write-downs of securities management deemed had experienced an other-than-temporary decline in market value versus $98 million in 2002 and $45 million in 2001. See Asset Impairment, Page 19, for factors considered by management. These other-than-temporary impairment charges represented 0.6 percent, 0.9 percent and 0.4 percent of total invested assets at year-end 2003, 2002 and 2001, respectively. Also included in other-than-temporary impairments are unrealized losses of holdings that the company has identified for sale but not yet completed a transaction.
The majority of the write-downs in 2003 related to 31 high-yield corporate bonds written down $39 million and 10 convertible securities written down $26 million. Unlike the prior year, the market value declines in 2003 were related to company-specific events rather than industry issues. Utility/merchant energy/trading, airline and healthcare bonds represented 72.1 percent of 2003 and 42.9 percent of 2002 impairment charges:
Airline - In 2002, management recorded other-than-temporary impairment charges for all unsecured airline-related bonds due to the overall outlook for that industry, even if they did not otherwise meet the company’s asset impairment criteria. Secured notes, or those that have aircraft as collateral for the trust certificate were not impaired except for two carriers in bankruptcy proceedings (UAL Corporation/United Airlines and US Airways Group, Inc./US Airways). Additional impairments in 2003 were for selected secured bonds that management believed had inferior collateral.
Healthcare - The 2003 healthcare impairment charges related primarily to the sudden default by Healthsouth Corporation and subsequent fraud charges. These securities have since recovered and all coupon payments have been made.
At December 31, 2003, they were trading above their pre-default level.
Management believes that it can achieve investment income growth of 3.5 percent to 4.5 percent in 2004 as a result of the anticipated growth in dividend income, strong cash flow from insurance operations and overall portfolio growth. While management does not forecast realized investment gains and losses, it believes that impairment charges in 2004 will be limited to securities marked to market because they have been identified for sale, or those where issuer-specific events cause sharp declines in market value with little or no warning.
Operations of the parent company, CFC Investment Company and CinFin Capital Management Company, excluding investment activities, and other income of the insurance subsidiaries resulted in $7 million in revenues in 2003, down from $14 million in 2002 and $10 million in 2001. Losses before income taxes of $38 million, $32 million and $37 million recorded in 2003, 2002 and 2001, respectively, were primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.
The company’s income tax expense was $106 million, $41 million and $28 million for 2003, 2002 and 2001, respectively, while the effective tax rate was 22.0 percent, 14.8 percent and 12.7 percent for the same periods. Investment operations are the company’s primary source of profits. The company pursues a strategy of investing in tax-advantaged fixed maturities and equity securities to minimize its overall tax liability and maximize after-tax earnings. A 2003 GAAP net underwriting gain of $140 million increased the company’s tax expense compared with a gain of $7 million in 2002 and a loss of $102 million in 2001. The differences in income tax expense and the effective tax rate during the period were primarily the company’s tax-exempt interest and dividends received exclusion. See Note 10 to the Consolidated Financial Statements, Page 66, for detail regarding the company’s effective income tax rate. Management anticipates that the effective tax rate will be in the 21 percent to 24 percent range if the company continues to achieve its performance objectives of an underwriting profit, growth in investment income and more normalized realized investment gains.
Liquidity is a measure of the company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of business obligations. The company’s primary means of meeting its liquidity requirements are through dividends from its insurance subsidiaries and investment income from its investment portfolio. The parent company’s cash requirements include general operating expenses, interest payments on its debt, dividends to shareholders and common stock repurchases. The company’s lines of credit also provide another potential source of short-term liquidity.
In 2003, 2002 and 2001, the insurance subsidiaries invested $1.398 billion, $843 million and $708 million in fixed-income and equity securities. Those purchases were offset by sales of fixed-income securities totaling $143 million, $64 million and $19 million in 2003, 2002 and 2001, respectively. Calls and maturities of fixed-income securities added $389 million, $219 million and $186 million to cash flow in 2003, 2002 and 2001, respectively. Sales, calls or maturities of equity and equity-linked securities totaled $209 million, $98 million and $187 million in 2003, 2002 and 2001, respectively. See Item 1, Investments Segment, Page 7, for a discussion of the portfolio allocation and quality.
As a result of investment income from its investments and dividends and borrowings from its insurance subsidiary, the parent company met its cash requirements for general operating expenses, interest payments on its long- and short- term debt, dividends to shareholders and common stock repurchase. Investing activities generated $48 million of cash flow in 2003 after using $39 million in 2002 and $34 million in 2001.
In January 2004, the board also authorized a 5 percent stock dividend payable June 15, 2004, to shareholders of record April 30, 2004. This is the 28th stock dividend or split declared over the past 47 years.
Common stock repurchases for treasury have continued at a steady pace over the last several years and occur whenever management believes that stock prices on the open market are favorable for such repurchases. At a minimum, the company would expect to offset dilution of option exercises. Shares repurchased total 15.6 million, at a total cost to the company of $520 million, since the inception of the share repurchase program in 1996. At December 31, 2003, 5.3 million shares remain authorized for repurchase.
$27 million increase in reinsurance recoverables is primarily due business growth and an increase in the recoverable related to the company’s USAIG pool participation. As discussed under Reinsurance, Page 26, the company’s working reinsurance treaties are with highly rated and financially strong reinsurers and the company has experienced no collection or aging problems with the property casualty or life reinsurance receivables. See USAIG Pool Participation, Page 44, for a discussion of that reinsurance recoverable.
$36 million increase in separate accounts primarily due to market appreciation of assets held and reinvestment of income as discussed in Separate Accounts, Page 20.
Offsetting the increases were a $31 million decline in other assets due to the elimination of a prepaid federal tax assets in 2003 and a $21 million decline in cash.
The market value of the company’s investments was $12.527 billion and $11.265 billion at year-end 2003 and 2002, respectively.
At December 31, 2003, the company’s portfolio of fixed-income securities had a weighted average yield-to-book value of 6.5 percent, a weighted average maturity of 10.2 years and a weighted average modified duration of 5.0 years. At December 31, 2002, the company’s portfolio of fixed-income securities had a weighted average yield-to-book of 7.4 percent, a weighted average maturity of 10.6 years and a weighted average modified duration of 4.9 years. The decline in the yield-to-book was due to lower prevailing interest rates and the reinvestment of funds from calls or redemptions at lower rates. Management is attempting to maintain an intermediate portfolio duration to protect against the anticipated rise in interest rates as the economy continues to improve. Duration can be defined as the average maturity of all bond payments, where each payment is weighted by its value. In the fixed-income market, duration is used to measure the sensitivity of an asset price to movements in yields. See Note 2 to the Consolidated Financial Statements, Page 62, for additional information regarding the maturity of the company’s fixed-income portfolio.
Over the past year, 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). Credit ratings as of December 31, 2003 and 2002, for the company’s fixed income portfolio were:
Similar to the equity portfolio, the fixed-income portfolio is concentrated in the financials sector, including banks, brokerage, finance and investment and insurance companies. Management leverages its familiarity with this sector in its fixed-income portfolio. The financials sector represented 15.6 and 15.9 percent of both the book value and market value, respectively, of the overall fixed-income portfolio at December 31, 2003. Approximately 95 of the financials sector holdings are investment-grade corporate bonds. No other industry accounts for more than 10 percent of the fixed-income portfolio.
In 2003, $324 million, or 52.3 percent of total reinsurance receivables, compared with $311 million in 2002, related to the company’s participation in USAIG, a joint underwriting association of individual insurance companies that collectively function as a worldwide
$347 million increase in insurance reserves as discussed in Item 1, Property Casualty Loss and Loss Expense Reserves, Page 3; Property Casualty Insurance Loss Reserves, Page 18; and Life Insurance Policy Reserves, Page 20, as well as Property Casualty Loss and Loss Expense Reserves, Page 25. The company does not discount its property casualty reserves.
The company had no off-balance sheet arrangements at December 31, 2003. Following is a summary of the contractual obligations and other commercial commitments at December 31, 2003:
During the years ended December 31, 2003, 2002 and 2001, the company had realized investment losses before taxes amounting to $122 million, $152 million and $105 million, offset by realized investment gains of $81 million, $58 million and $80 million, respectively. At December 31, 2003, unrealized investment gains before taxes totaled $6.322 billion and unrealized investment losses in the investment portfolio amounted to $29 million. The unrealized appreciation was primarily due to the company’s holdings in Fifth Third (Nasdaq: FITB) and Alltel Corporation (NYSE:AT) common stock.
Political - the potential for a decrease in market value due to the real or perceived impact of governmental policies or conditions
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
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
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 7, can be summarized as follows (H - high, A - average, L - low):
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. The company addresses this risk by consistently investing within a particular maturity range, which has, over the years, provided the portfolio with a laddered maturity schedule 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 the company’s 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. The company addresses this concern by analyzing issuer- and industry-specific financial results and by closely monitoring holdings within this asset class.
Hypothetically, an increase in interest rates (market yields to maturity) of 100 basis points at December 31, 2003, would decrease the fair value of the fixed-income portfolio by approximately 5.0 percent or $195 million, or to $3.730 billion from $3.925 billion. Investment-grade corporate bonds have the greatest sensitivity to interest rate changes. Based on the present duration of the investment-grade corporate bond portfolio, a 100 basis point increase in interest rates would result in a 5.5 percent decline in the fair value of that portion of the portfolio. This would be offset by the callable agency paper, which has higher coupons and, therefore, lower duration effects. The tax-exempt municipal bond portfolio, with a longer average maturity schedule, would be somewhat less sensitive to interest rate increases, while the high-yield corporate bond portfolio would be even less sensitive.
Because of the company’s large surplus, long-term investment horizon and its ability to hold most fixed-income investments until maturity, management believes the company is well positioned for a rise in interest rates. A higher rate environment would provide the opportunity to reinvest cash flow in higher yielding securities. The potential decline in fair values due to an interest rate increase would not signal a decline in credit quality. Management believes that lower values due solely to interest rate changes would not signal the likelihood of additional other-than-temporary impairments.
In the dynamic financial planning model, the selected interest rate change of 100 basis points represents management’s 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 the company’s results or financial condition, nor does it take into account any actions that might be taken to reduce exposure to such risks.
The primary risk related to convertible securities is similar to other corporate fixed-income securities in terms of their sensitivity to interest rates, credit risk and default risk. The better the financial condition of the underlying issuer, the lower the credit risk. However, the pricing of convertible securities is more likely to be driven by the relationship of the underlying common stock price to the strike price of the embedded option. If the underlying stock price is well below the strike price, the convertible security will trade more like a pure fixed-income instrument and be more interest rate sensitive. However, as the underlying stock approaches the option strike price, the convertible will be less interest rate sensitive and more responsive to movements in the stock.
Management monitors securities trading below 70 percent of book value for potential other-than-temporary impairment in line with its asset impairment policy discussed in Asset Impairment, Page 19. The reduction in the number of securities trading below 100 percent of book value at year-end 2003 compared with year-end 2002 reflected the recent emphasis on increasing the credit quality of the bond portfolio, as rated by Standard & Poor’s and Moody’s, as well as the downward shift in the yield curve and compression of the spread with treasury bonds. Further, during 2003 and 2002, 49 and 30 securities, respectively, were written down as other-than-temporarily impaired.
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. 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 a market value 50 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 a significant impairment indicator is noted, the portfolio managers even more closely scrutinize the security.
Management deems 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. At year-end 2003, impairment to market value of all 116 securities trading in this range would have resulted in only $24 million in additional realized investment losses, before tax. These 116 securities, which represented 5.2 percent of the total market value of the portfolio, generated $25 million, or 5.5 percent, of total earned investment income.
For all 116 securities trading at 70 percent to less than 100 percent of book value, 51 securities representing $19 million in unrealized losses had been trading in that range for more than 12 months; seven securities representing less than $1 million in unrealized losses had been trading in that range for more than six to 12 months; and 58 securities representing $5 million in unrealized losses had been trading in that range for six months or less.
Of the total 118 holdings trading below book value at December 31, 2003, three were common stocks and 11 were convertible securities representing total unrealized losses of $7 million. Financials sector securities accounted for $6 million, or 25.4 percent, of the unrealized losses. At year-end, total financials sector securities in the common equity portfolio had a market value of $5.753 billion. The other $18 million in unrealized losses was spread across a variety of industries.
The accompanying financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2003, were prepared by management in conformity with accounting principles generally accepted in the United States of America (GAAP).
The management of the company is responsible for the integrity and objectivity of the financial statements, which are presented on an accrual basis of accounting and include amounts based upon management’s best estimates and judgment. Other financial information in the Annual Report on Form 10-K is consistent with that in the financial statements. The accounting system and related internal controls are designed to assure that the books and records reflect the transactions of the company in accordance with established policies and procedures as implemented by qualified personnel.
Deloitte & Touche LLP, independent auditors, have audited the financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2003, and their report is included herein. The auditors meet with members of the audit committee of the board of directors to discuss the results of their examination and are afforded the opportunity to present their opinions in the absence of management personnel with respect to the adequacy of internal controls and the quality of financial reporting of the company.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedules listed in the Index at Item 15(a)2. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
Cincinnati Financial Corporation (company), through four insurance companies, markets insurance mainly through a network of local independent agents. Insurance products include a broad range of business and personal policies, as well as life and disability income insurance and annuities. In addition, the company has finance/leasing and asset management operations through the CFC Investment Company and CinFin Capital Management Company subsidiaries.
The Cincinnati Insurance Companies market property casualty insurance policies in 31 states. Nine states with at least $100 million in agency earned premium in 2003 generated approximately 70 percent and 71 percent of total property casualty premiums in 2003 and 2002. Ohio, where the company has 187 independent agencies, accounted for 24.6 percent and 25.3 percent of total earned premiums in 2003 and 2002. Agencies in Illinois, Indiana, Michigan and Pennsylvania each contributed between 5 percent and 10 percent of premium volume in 2003 and 2002. No single agency accounted for more than 1.2 percent of the company’s total agency direct earned premiums.
Expenses incurred in the issuance of policies are deferred and amortized in level proportion to earned premiums over the contract term. Policy premium income, unearned premiums and reserves for unpaid losses are accounted for in substantially the same manner as property casualty insurance items discussed above.
In the normal course of business, the company seeks to reduce losses that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance companies and reinsurers. Reinsurance contracts do not relieve the company from any obligation to policyholders. Although the company historically has not experienced uncollectible reinsurance recoverables, failure of reinsurers to honor their obligations could result in losses to the company. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy.
Unrealized gains and losses on investments, net of taxes, are included in shareholders’ equity in accumulated other comprehensive income. Realized gains and losses on investments are recognized in net income on a specific identification basis.
The fair values for liabilities under investment-type insurance contracts (annuities) are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued. Fair values for short-term notes payable are estimated using interest rates currently available to the company. Fair values for long-term debentures are based on the quoted market prices for such debentures. Fair value of the interest rate swap is determined by a bank.
The company issues life contracts with guaranteed minimum returns, referred to as bank-owned life insurance policies, the assets and liabilities of which are legally segregated and recorded as assets and liabilities of the separate accounts. Minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders.
Net income per common share is based on the weighted average number of common shares outstanding during each of the respective years. The calculation of net income per common share (diluted) assumes the conversion of convertible senior debentures and the exercise of stock options.
The company has qualified and non-qualified stock option plans under which options are granted to employees at prices which are not less than market price at the date of grant and which are exercisable over 10-year periods. The company applies Accounting Principles Board (APB) Opinion 25 and related interpretations in accounting for these plans. Accordingly, no compensation cost has been recognized for the stock option plans.
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 2003, 2002 and 2001, respectively: dividend yield of 2.40 percent, 2.52 percent and 2.20 percent; expected volatility of 26.03 percent, 25.90 percent and 25.54 percent; risk-free interest rates of 4.20 percent, 4.26 percent and 5.54 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.
At December 31, 2003, contractual maturity dates for investments in fixed-maturity securities were:
The fair value of the conversion features embedded in convertible securities amounted to a gain of $9 million at December 31, 2003, and a loss of $4 million at December 31, 2002.
At December 31, 2003, 40 fixed maturity investments with a total unrealized loss of $12 million and 11 equity securities with a total unrealized loss of $7 million had been in that position for 12 months or more. All were trading between 70 percent to less than 100 percent of book value. These assets presently do not meet the company’s other-than-temporary asset impairment criteria and will not be impaired unless they do so in the future.
During 2003, lingering weakness in certain sectors of the economy, such as basic manufacturing, led to continued price weakness for related equity securities. These economic factors as well as company-specific problems contributed to the continued price weakness for the fixed maturity securities. In addition, utility/merchant energy/trading and airline bonds that remain in the portfolio continue to trade below book value because of industrywide performance concerns.
Acquisition costs incurred and capitalized during 2003, 2002 and 2001 amounted to $615 million, $576 million and $478 million, respectively. Amortization of deferred acquisition costs was $586 million in 2003, including a $13 million adjustment related to unrealized gains on investments, and $519 million and $451 million for 2002 and 2001, respectively.
As a result of changes in estimates of insured events in prior years, the provision for losses and loss expenses decreased by $80 million, $45 million and $62 million in calendar years 2003, 2002 and 2001. These decreases are due in part to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for less than expected.
The reserve for loss and loss expenses in the accompanying balance sheets also includes $29 million, $26 million and $22 million at December 31, 2003, 2002 and 2001, respectively, for certain life health losses.
The company and subsidiaries had no compensating balance requirement on debt for either 2003 or 2002. The company had two lines of credit with commercial banks amounting to $250 million in 2003 (expiring in 2004) and $250 million in 2002, of which $183 million was in use at December 31, 2003 and 2002. Interest rates charged on such borrowings ranged from 1.56 percent to 8.49 percent during 2003, which resulted in an average interest rate of 2.57 percent. At December 31, 2003, the fair value of the notes payable approximated the carrying value and the weighted average interest rate approximated 2.43 percent.
The company issued $420 million of senior debentures due 2028 in 1998. At December 31, 2003 and 2002, the fair value of the debentures approximated $458
As of December 31, 2003, 5 million shares of common stock were available for future stock option grants.
Property casualty premium income in the accompanying statements of income includes approximately $56 million, $60 million and $38 million of earned premiums on assumed business and is net of approximately $211 million, $330 million and $155 million of earned premiums on ceded business for 2003, 2002 and 2001, respectively.
Insurance losses and policyholder benefits in the accompanying statements of income are net of approximately $103 million, $96 million and $422 million of reinsurance recoveries for 2003, 2002 and 2001, respectively.
The provision for federal income taxes is based upon a consolidated income tax return for the company and subsidiaries. As of December 31, 2003, the company has capital loss carryforwards of $91 million that expire in 2007 and 2008. Although realization is not assured, management believes it is more likely than not that the deferred tax assets will be realized based on the assumption that certain levels of income will be achieved.
Options to purchase 2 million, 1 million and 1 million shares of common stock were outstanding during 2003, 2002 and 2001, respectively, but were not included in the computation of net income per common share (diluted) because the options’ exercise prices were greater than the average market price of the common shares.
The company uses a December 31 measurement date for its plans. The accumulated benefit obligation was $117 million and $93 million at December 31, 2003 and 2002, respectively. The fair value of the company’s stock comprised $24 million (18 percent of total plan assets) at December 31, 2003, and $22 million (18 percent of total plan assets) at December 31, 2002.
The following summarizes the assumptions used to determine the benefit obligation for the plan:
The company expects to contribute $8 million to its pension plan in 2004.
Income before income taxes for the insurance segments represents underwriting profit (loss), which is defined as premiums earned minus loss and loss expenses incurred or policyholder benefits, and underwriting expenses.
Income before income taxes for the investment operations represents net investment income plus realized investment gains and losses, less interest credited to contract holders. Other losses before income taxes of $38 million, $32 million and $37 million recorded in 2003, 2002 and 2001, respectively, were primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.
Note: The sum of the quarterly reported amounts may not equal the full year as each is computed independently.