CFC owns its headquarters building located on 75 acres of land in Fairfield, Ohio. This building contains approximately 615,000 square feet. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet, and the balance of the building is occupied by CFC and its subsidiaries. The property, including land, is carried in the financial statements at $82 million as of December 31, 2002, and is classified as Property and equipment, net, for company use.
CFC-I 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 rentable square feet. CFC and its subsidiaries occupy approximately 45 percent of the building; unaffiliated tenants occupy approximately 15 percent of the building; approximately 28 percent of the building is available for future CFC usage; and, approximately 12 percent is available for rent. The property is carried in the financial statements at $8 million as of December 31, 2002, and is classified as Property and equipment, net, for company use.
2000 results include a one-time charge for asset impairment of $39 million, before tax; $25 million, or 16 cents per share, net of tax. The charge affected the statutory expense ratio and combined ratio by 1.7 percentage points and the GAAP expense ratio and combined ratio by 2.1 percentage points.
1993 earnings include a net credit for $14 million, or 8 cents per share, cumulative effect of a change in the method of accounting for income taxes to conform with SFAS No. 109 and a net charge of $9 million, or 5 cents per share, related to the effect of the 1993 increase in income tax rates on deferred taxes recorded for various prior-year terms.
ITEMS 7 AND 7(A). MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The company’s disclosure controls and procedures are designed to ensure that material information, relating to the company and its subsidiaries, required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the company’s management, including its chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Modestly redundant reserves support the company’s business strategy to retain high financial strength ratings and remain a market for agencies’ business in all market conditions. Slowness to recognize and respond to new or unexpected claim and loss patterns, such as those caused by the risk factors cited in the company’s safe harbor statement, could lead to a rise in incurred but not yet reported (IBNR) reserves. Higher IBNR would lead to a higher losses and loss expenses ratio; each percentage point increase in the losses and loss expenses ratio would reduce pre-tax income by $24 million based on 2002 earned premiums.
The total reserve balance, net of reinsurance, at year-end 2002 was $2,608 million compared with $2,352 million at year-end 2001. See Note 4 to the Consolidated Financial Statements, Page 64, for a reconciliation of property casualty reserve balances with the losses and loss expenses liability on the balance sheet. The increase in reserves in each year reflected the increases in policies in force and coverages, loss development deterioration reflecting larger losses and management’s conclusions regarding adequate reserve levels. Management believes that the stability of the company’s business makes its historic data the most important source for establishing adequate reserve levels. Traditionally, management has conducted a thorough evaluation in the fourth quarter of the adequacy of its reserves as of the end of the third quarter of each calendar year. In the quarters following, changes based on that thorough review are implemented in conjunction with the less detailed but continuous review of reserve adequacy. As a result, the most significant variation in reserves is seen in the fourth quarter.
In the normal course of its business, the company may provide coverage that leads to highly uncertain exposures as summarized below:
Environmental and asbestos - Management has reviewed its exposure to environmental risk, including mold, and asbestos risk. Management believes that reserves are adequate at this time and that these coverage areas are immaterial to the company’s financial position due to the types of accounts the company has insured in the past. Factors evaluated to reach those conclusions include:
Catastrophic events - Due to the nature of catastrophic events, management is unable to predict precisely the frequency or potential cost of catastrophe occurrences in the future. However, in an effort to control such losses, the company does not market property casualty insurance in California, reviews aggregate exposures to huge disasters and monitors its exposure in certain coastal regions. Based on analysis of a once-in-250-year event, the company has catastrophe exposure to hurricanes in the Gulf and southeastern coastal regions, earthquakes in the New Madrid fault zone (lies within the central Mississippi Valley, extending from northeast Arkansas, through southeast Missouri, western Tennessee, western Kentucky to southern Illinois) and tornado, wind and hail in the Midwest and Southeast. The company uses the Risk Management Solutions and Applied Insurance Research models to evaluate exposures and aid in determining appropriate reinsurance coverage programs.
The casualty working treaty ceded premiums are estimated to be $55 million, compared with $52 million in 2002 and $32 million in 2001, net of a one-time ceding commission. The company will retain the first $2 million of each casualty loss, as it has for several years. It will retain 60 percent of each loss from $2 million to $4 million, up from 40 percent in 2002 and 20 percent in 2001. Losses in excess of $4 million are reinsured at 100 percent up to $25 million. Terrorism losses at this higher level are reinsured at 80 percent, unchanged from last year, compared with 100 percent in 2001.
For property coverages of individual risks with insured values in excess of $25 million but less than $50 million, the company typically purchases reinsurance (facultative) coverage under an automatic facultative treaty. For those risks with property values exceeding $50 million, the company negotiates the purchase of facultative coverage on an individual certificate basis. For casualty coverages of individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis.
To protect against catastrophic events, the company purchases property catastrophe reinsurance. Under the 2003 treaty, ceded premiums are estimated to be $20 million, up from $19 million in 2002 and $13 million in 2001. The company will retain the first $25 million of losses arising out of a single event, as it has done for several years. It will retain 43 percent of losses from $25 million to $45 million as it did in 2002, an increase from 5 percent in 2001. It will retain 5 percent of losses from $45 million to $200 million. In mid-2002, the company expanded the property catastrophe reinsurance program, adding another $100 million layer in excess of $200 million and retaining 50 percent of the losses in this layer. For 2003, the company will reduce its retention of losses between $200 million and $300 million to 5 percent. The company increased its catastrophe coverage because of its increased exposure due to company growth.
The company also has traditionally purchased a reinsurance treaty that provides an additional $25 million in casualty loss protection, notably for workers compensation losses, bad faith losses and “clash coverage” when there is a single occurrence involving multiple insureds or multiple policies for one insured. The company purchases surety reinsurance in a separate contract.
All reinsurance agreements in place in 2003 are similar to those for 2002, with modestly higher retention levels and an estimated incremental cost increase, net of tax, of $4 million, or 2 cents per share. The company has the financial ability to absorb losses at these levels, and the 2003 reinsurance agreement is a means of balancing reinsurance costs and risks.
Management evaluates terrorism exposure based on aggregate exposure to class of risk. As of the November 26, 2002 enactment of the TRIA, only approximately 120 of the company’s commercial lines policies had terrorism exclusions endorsed. Under the 2003 property casualty working treaties, the company’s terrorism reinsurance coverage has limitations in addition to higher retentions. Coverage is more limited for terrorism than for other causes of loss in the event of multiple events during the same calendar year. Under the catastrophe cover, there is no terrorism coverage for nuclear, pollution or contamination events. For other catastrophic terrorism losses, the company has obtained coverage for personal lines and some limited coverage for commercial lines. Due to the company’s focus on small- to medium-sized businesses in smaller markets and the belief that these policyholders are not likely terrorism targets, as well as the availability of reinsurance, the company remains willing to continue to underwrite terrorism losses.
For property casualty policies, deferred costs are amortized over the terms of the policies. For life policies, acquisition costs are deferred and amortized over the premium-paying period of the policies. For accident health policies, expenses incurred in the issuance of policies are deferred and amortized in level proportion to gross premiums over the expected lifetime of the contract.
In the company’s most significant separate account, realized gains and losses are retained in the separate account and are deferred and amortized to the contract holder over a five-year period, subject to certain limitations. Upon termination or maturity of this separate account contract, any unamortized deferred gains and/or losses revert to the general account. In the event this separate account holder were to surrender the contract, there would be a surrender charge equal to 10 percent of the contract’s account value during the first five years, decreasing 2 percent a year to 0 percent at year 11. At December 31, 2002, net unamortized losses amounted to $5 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by banking regulatory authorities to whose jurisdiction the contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded, and charged to the general account. Potentially, losses could be material; however, unrealized losses at December 31, 2002, in the separate account portfolio were $1 million.
The company’s largest asset is its investment portfolio; and, therefore, accounting policies relative to the investment portfolio are critical. Most of the company’s investments are made in publicly traded securities. Valuations of all of the company’s investments are based on either listed prices or data provided by FT Interactive Data, an outside resource that supplies global securities pricing, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. FT Interactive Data collects, edits, maintains and delivers data on more than 3.5 million securities, commodities and derivative instruments traded around the world. This data includes daily evaluations for more than 2.5 million active fixed-income issues.
Changes in the fair value of these securities, based on the listed prices or information from FT Interactive Data, are reported on the company’s balance sheet in other comprehensive income, net of tax. Fixed maturities (bonds and notes) and equity securities (common and preferred stocks) are classified as available for sale and recorded at fair value in the financial statements.
When evaluating other-than-temporary impairments, management considers the company’s ability to retain a security for a period adequate to recover a significant percentage of cost. Because of the company’s investment philosophy and strong capitalization, it can hold securities that have the potential to recover value until their scheduled redemption, when they might otherwise be deemed impaired. Other-than-temporarily impaired investment assets are evaluated based on their adjusted book value and further written down, if deemed appropriate. The decision to sell or write down an asset with impairment indications reflects, at least in part, management’s opinion that the security no longer meets the company’s investment expectations. In addition, because the company can hold securities trading below book value until maturity and its criteria for determining potential impairments relate to the magnitude of a quarter-end decline in market value or rating, the company monitors the length of time securities in its portfolio are in a continuous loss position only when securities have reached 70 percent of book value. See Quantitative and Qualitative Disclosures about Market Risk, Page 46, for a detailed discussion of continuous loss position information for securities trading below 70 percent of book value at December 31, 2002.
Other-than-temporary declines in the fair value of investments are recognized in net income as realized losses at the time when facts and circumstances indicate such write-downs are warranted.
Write-offs (permanent impairments) - Permanent impairments 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 reflected in realized losses.
The company has a defined benefit pension plan covering substantially all employees. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates and expected return on plan assets, which are updated each year. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions. The key assumptions used in developing the 2002 net pension credit were a 6.5 percent discount rate, an 8 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 investments of the portfolio held by the pension plan and that substantially all of the investments are equity securities 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 half of one percent due to current market conditions. Compared with the prior year, the net pension credit was reduced by $2 million. For 2003, the company expects a net pension expense of $4 million, primarily as a result of lower plan assets and resulting expected returns and a decrease in the interest rate used in converting the lump sum cash out form of payment at retirement by half of one percent. Holding all other
FASB Interpretation 46 “Consolidation of Variable Interest Entities” was issued in January 2003 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.
Highlights of the company’s financial performance over the past three years include:
19.4 percent growth in statutory written premiums (14.0 percent excluding the premium estimate adjustment) in 2002 versus the 14.2 percent industry average. Growth in 2002 included a 17.0 percent increase in new business premiums. The company leveraged its relationships with independent agencies to obtain firmer pricing on new and renewal business.
In November 2002, Standard & Poor’s affirmed its AA- (very strong) ratings with a stable outlook. This rating applies to each insurance subsidiary based on strong competitive position, high business persistency, strong capitalization and excellent financial flexibility. Standard & Poor’s noted these factors are counteracted by the company’s aggressive investment strategies and relatively slow response to significant market changes. In 2001, Standard & Poor’s had changed its rating of the property casualty subsidiaries to AA- (very strong) from AA+ (very strong) in light of their outlook for the overall insurance industry and the company.
In November 2002, Moody’s Investors Service reaffirmed its Aa3 ratings of the property casualty subsidiaries noting key factors including the company’s sound balance sheet, conservative leverage profile and sizable capital base. Moody’s said that offsetting these strengths are the company’s continued struggles with large loss severity trends, but pricing and underwriting initiatives should continue to offset these patterns, which are being closely monitored by the company. Other challenges include the risks inherent in the company’s investment strategy, which is concentrated in a limited number of equities and continued development for front and back-end technology systems that lag companies of comparable size.
Growth also has reflected the focus on improving customer service through the creation of smaller marketing territories, permitting local field marketing representatives to devote more time to each independent agent. At year-end 2002, the company had 83 property casualty field territories, up from 74 at the end of 2000. During 2003, the company plans to split and staff another 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 company’s standard approach is to write three-year policies, a competitive advantage in the commercial lines market. Exceptions have traditionally included some business new to the agency, aggressively priced policies or policies for which facultative reinsurance has been purchased. Though the company commits to a three-year policy term, policies are annually renewable at the discretion of the policyholder and are cancelable at any time. In 2002, the company wrote a higher-than-normal number of one-year policies while awaiting state regulatory approval for the addition of aggregate limits to the company’s general liability and umbrella coverage forms. These policies would normally have been written on a three-year basis. The changes to the general liability and umbrella coverage limits bring the company in line with industry practices. In 2003, the company expects to resume writing three-year policies at its normal pace because of the competitive advantages.
While writing three-year policies would appear to restrict opportunities to quickly adjust pricing, annual adjustments are in fact made within multi-year packages to automobile, workers compensation, professional liability and most umbrella liability coverages. Management estimates that approximately 74.5 percent of 2002 commercial premium was subject to annual adjustment or re-pricing. Rates on the remaining 25.5 percent of premium are guaranteed for three years. Multi-year packages are offered at rates that may be slightly higher than single-year or annually-adjusted 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 retention and reduced administrative costs outweigh the potential disadvantage of these policies in periods of rising rates. In addition, the company began increasing rates in 2000 and is two-thirds through the repricing period for renewals of multi-year policies.
Premium growth in 2002 benefited from double-digit premium increases for most commercial lines of business on relatively constant policy counts. The company is 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. Agents agree on the need to carefully select risks and restore 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.
Based on billed written premiums directly by agencies, in 2002, commercial annualized new business premiums were $251 million compared with $220 million in 2001 and $230 million in 2000. Locally based field marketing representatives, who work with agencies to underwrite and price business based on personal and direct knowledge of the risk and competitive environment, lead the new business effort. Overall growth of new business in 2002 was affected by the company’s decision to selectively reduce workers compensation writings. On the basis of billed written premiums directly, new workers compensation premiums declined 17.4 percent in 2002 and 18.4 percent in 2001, compared with a 55.4 percent increase in 2000.
Commercial multi-peril - Earned premiums grew 13.2 percent, 15.8 percent and 13.5 percent in 2002, 2001 and 2000, respectively. As noted above, the company wrote a higher than normal number of one-year policies in 2002 pending regulatory approval for changes in policy terms and conditions. Commercial multi-peril premium growth slowed as some policies previously written in a premium discounted package were moved to non-discounted package programs, which are included in the other liability line of business. This change reflected firmer pricing within the marketplace.
Workers compensation - Overall growth was 16.7 percent due to price increases in 2002 versus 21.3 percent in 2001 and 12.2 percent in 2000. During 2002, the company selectively reduced its workers compensation writings, although pricing had improved for renewal business because of reduced credits.
Other liability (commercial umbrella, commercial general liability and directors and officers) - Earned premiums grew 27.5 percent in 2002 due to a higher number of policies written in non-discounted programs. Other liability earned premium growth in 2001 was 4.9 percent down from 12.9 percent in 2000.
Contractor task force - A number of initiatives resulted from this review including the development of a supplemental application to better identify exposures; renewing emphasis on agent and underwriter education in the area of effective risk transfer mechanisms, particularly for subcontractors; better managing exposures to apartment or tract housing development; making residential contractors ineligible for monoline umbrella treatment; and, excluding mold and external insulating finishing system (EIFS) exposures, where allowed by state regulations.
Risk-category reviews - These studies emphasized underwriting guidelines, such as property age, capacity and loss experience. While the company continues to evaluate risks on their own merits, these risk category reviews have helped it to develop guidelines such as caps on umbrella limits for certain severity-prone business types.
The reserve estimation policies for the company’s property casualty business are described under Significant Accounting Policies (see Page 18). As rate and other actions have begun to contribute to improved overall profitability for commercial lines, the company continually monitors the adequacy of its reserves relative to commercial lines.
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 umbrella and other liability lines for accident years 1999 through 2001. The increased IBNR was due to management’s continuous efforts to achieve its best estimates of the ultimate incurred losses and not due to any specific event or level of claim activity in a particular line. Management monitors claim activity and appropriately modifies amounts added to losses and loss expense reserves via IBNR additions on an ongoing basis. The IBNR increase in 2001 primarily reflected business growth and the company’s analysis of loss trends. The IBNR increase in 2000 primarily reflected the $103 million commercial lines portion of the UM/UIM reserve.
The following discussion details results for the four largest of the company’s commercial property casualty business lines. The accident year loss data below provides current estimates of accident year incurred losses and loss expenses for each of the past four years.
For 2003, auto base rate changes in the 10 percent to 14 percent range are in the filing stages, which should help the company sustain the losses and loss expenses ratio in its current range.
Policyholder dividend expense as a percent of earned premiums declined by 0.8 percentage points in 2002 and 0.3 percentage points in 2001. The improvement in the ratio in 2002 and 2001 reflected the company’s emphasis on pricing for workers compensation as well as its decision to not write or not renew many of these policies. Whenever possible, renewal workers compensation policies are being written by The Cincinnati Casualty Company, which does not offer policyholder dividends.
Due to policy year 2001 rate increases that were booked in 2002, the company recorded a USAIG-related underwriting gain of $10 million for 2002 versus underwriting losses of $3 million and $2 million for 2001 and 2000, respectively. The 2001 underwriting loss included $4 million related to the events of September 11, 2001, and the American Airlines flight 587 accident in Queens, New York, in November 2001.
For participants in the USAIG main pool, each member’s share of premiums, losses, expenses and profits is proportionate to its contracted participation level during the years they participate in the pool. Each member company of USAIG adheres to financial rating, statutory surplus and security agreement requirements. The member companies fund a trust account at a depository bank to meet 100 percent of their respective net liabilities.
USAIG has a reinsurance program for its members. Companies participating in the USAIG reinsurance program are all rated A or higher by A.M. Best. Reinsurance recoverables on behalf of unauthorized reinsurers participating in the pool are backed by letters of credit and trust funds from these reinsurers. The pool has two governing committees to which each member company may appoint a representative. The general policy committee meets periodically to review, among other things, reinsurance credit exposure, trends in the reinsurance marketplace and to evaluate exceptions to the approved reinsurer list that may arise. The advisory council, which includes all member companies, meets annually.
The managers of USAIG issue policies in the name of one or more of the member companies. All business written in The Cincinnati Insurance Company name is treated in the company’s accounts as direct premium and losses and is then ceded to USAIG. For the years ended December 31, 2002, 2001 and 2000, direct business earned and then ceded was $192 million, $57 million and $39 million, while direct losses and loss expenses incurred and then ceded were $29 million, $314 million and $7 million, respectively. Since The Cincinnati Insurance Company was named as the designated insurer for American Airlines’ policy year 2000 business, the gross losses and recoverables resulting from all American Airlines accidents were recorded on its 2001 financial statements. Management expects to recover 100 percent of the reinsurance recoverables associated with these accidents.
Personal lines earned premiums rose 8.1 percent in 2002, compared with 4.0 percent in 2001 and 4.6 percent in 2000. The sources of growth in the past three years were rate increases on new and renewal personal lines business, as well as increased opportunities to write new accounts as agencies and policyholders in the uncertain marketplace are attracted to the company’s fair pricing and long-term approach. Statutory written premiums for personal lines of insurance grew 11.0 percent in 2002, or 9.8 percent excluding the premium estimate adjustment, compared with 5.3 percent in 2001. In each of the past two years, the segment’s written premiums have grown less rapidly than the overall industry averages of 11.2 percent and 9.3 percent, respectively, as the company has focused on underwriting actions as it seeks to return to acceptable levels of profitability.
The personal lines combined ratio was 107.6 percent in 2002, improved from 112.4 percent in 2001 and 108.0 percent in 2000 (106.8 percent excluding the UM/UIM reserve addition). Catastrophe losses contributed 7.1 percent, 5.8 percent and 5.4 percent to the personal losses and loss expenses ratio and the combined ratios in 2002, 2001 and 2000, respectively. The losses and loss expenses ratio for personal lines was 79.7 percent in 2002, compared with 82.9 percent in 2001 and 79.2 percent for 2000 (78.0 percent excluding the UM/UIM reserve addition).
While no short-term effects are anticipated, the company reached certain milestones in 2002 related to Web-based technology projects that will make it easier for agents to place business with the company. During its first six months of operation, Kansas agencies processed 3,700 policies with approximately $3 million of premium using the initial version of the new integrated processing system for six personal lines of business. As the technology is rolled out sequentially to other states over the next several years, management believes the program could have a substantial positive benefit on premium growth and evaluation of the company’s personal lines business. The objectives are to build a single-entry data processing system to streamline policy issue; to speed up processing time to improve cash flow; and to offer direct billing, a feature frequently requested by agents. The total amount capitalized for development of this new software through December 31, 2002 was $15 million.
The reserve estimation policies for the company’s property casualty business are described under Significant Accounting Policies (see Page 18). As rate and other actions have begun to contribute to improved overall profitability for personal lines, the company continually monitors the adequacy of its reserves relative to personal lines.
The personal auto and homeowner business lines together accounted for 89.4 percent, 89.0 percent and 88.6 percent of total personal lines earned premiums in 2002, 2001 and 2000, respectively. The following analyzes growth and profitability for these lines separately:
Personal auto - Earned premiums for personal auto grew 7.9 percent, 3.8 percent and 2.8 percent in 2002, 2001 and 2000, respectively. The growth was driven by continued market penetration with rates remaining relatively unchanged in 2002. Rate increases from 2.5 percent to 10.0 percent were approved in 20 states in the second half of 2002 and will contribute to earned premium growth in 2003 and beyond.
Homeowner - Earned premiums for homeowners grew 10.0 percent, 6.3 percent and 8.3 percent in 2002, 2001 and 2000, respectively. Catastrophe losses contributed 20.3 percentage points, 23.5 percentage points and 14.8 percentage points to the homeowner losses and loss expenses in 2002, 2001 and 2000, respectively. Although the losses and loss expenses ratio excluding catastrophes for the homeowner line declined to 78.3 in 2002 after rising to 85.4 percent in 2001 from 77.4 for 2000, it remained above the 70.0 percent to 72.0 percent level the company considers acceptable. To improve profitability in the homeowner line, the company has focused on:
Rate changes - In 2002, rate increases were effective in 20 active states, with an average increase of approximately 9 percent and with three active states experiencing more than one rate change during the year. Looking into 2003, the company has already received approval for rate changes in 11 active states. Management anticipates the average increase over current rates will exceed 10 percent over the course of the year. The 2003 rate changes affect several of the company’s largest states as measured by homeowner premium volume. Rate changes are applied to new business
The expense ratio, excluding the one-time charge to expense software development assets in 2000, remained relatively stable over the past three years, as the company maintained its level of investment in staff and costs associated with upgrading technology and facilities.
In 2002, net income before realized investment gains and losses was down 16.7 percent from 2001 in part due to increased regulatory and legal costs. In 2001, net income before realized investment gains and losses declined 8.1 percent from the prior year primarily due to higher expenses related to charges for automation and policy audits and incentives. In 2000, net income before realized investment gains and losses rose 14.9 percent, due to growth in investment income, favorable mortality experience, expense control and continued growth.
Investment operations affect the company’s results of operation through the inclusion of investment income and realized gains and losses. Investment operations provide the company’s primary source of pre- and after-tax profits.
Management chose to not record an other-than-temporary impairment for most of the secured bonds because management believed that much higher potential values based upon underlying asset collateral were not being recognized by the market.
Telecommunication - In 2002, management recorded other-than-temporary impairment charges for two high-yield corporate bonds and one convertible issue following the dramatic decline in industry-wide valuations as a result of overbuilding of infrastructure, corporate mismanagement and accounting fraud. The impact of the Global Crossing and WorldCom bankruptcies filtered down through the entire industry.
Utility/merchant energy/trading - These bonds also can be divided into unsecured notes and those with collateral in the form of pipelines, power facilities and real estate. Valuations throughout the industry were affected by mismanagement of trading operations, which contributed to accounting irregularities regarding the booking of revenue and the valuation of trading contracts.
In 2002, the company recorded $4 million in fair value declines versus $9 million in fair value increases in 2001 due to the application of Statement of Financial Accounting Standard (SFAS) No. 133, which requires measurement of the fluctuations in the value of the embedded derivative features in selected convertible securities. See Note 1 to the Consolidated Financial Statements, Page 58, for details on the accounting for convertible security embedded options.
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. The statutory net underwriting losses in each of the past three years served to further reduce the company’s tax expense. 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.
Reflecting that strategy, the company’s income tax expense (benefit) was $41 million, $28 million and $(9) million for 2002, 2001 and 2000, respectively, while the effective tax rate was 14.8 percent, 12.7 percent and (8.9) percent for the same periods.
Cash flow from operations for each of the last three years was sufficient to meet operating needs of the company, with short-term borrowings utilized for financing activities during 2001 and 2000. Management believes that operating cash flows will continue to be the primary source of funds for the company. Net underwriting cash flows and net investment income have continued to be strong and contributed to cash flow from operations expansion of more than $120 million over 2001 and more than $180 million over 2000. The company uses cash provided by operations as well as cash provided by investment sales or calls primarily to purchase additional fixed-income and equity securities, pay dividends and repurchase stock.
Future liquidity could be affected by catastrophe losses that are in excess of the company’s catastrophe reinsurance treaties, which provide coverage for gross losses up to $300 million. The company has no significant exposure to assumed reinsurance, which accounted for no more than 2.6 percent of earned premiums in each of the last three years and is expected to remain at or near this level in 2003. In 2003, ceded reinsurance agreements will result in higher ceded premiums and higher retention by the company, which will increase incurred losses. The company expects to have minimal, if any, cash requirements related to the pension plan in 2003. However, if asset returns remain at 8 percent per year and the employee population is stable, it is possible that the defined benefit plan may have minimum contribution requirements as early as 2004.
Within two broad categories, fixed-income securities and equity and convertible securities, the company invests in five classes of assets:
By maintaining a well diversified, fixed-income portfolio, the company attempts to mitigate overall credit risk. No individual fixed-income issuer’s securities account for more than 2 percent of the fixed-income portfolio. At year-end 2002, the airline industry comprised approximately $97 million in market value ($119 million amortized cost) distributed among the three types of fixed-income securities. Continued weak performance by the airlines could further impact the value of the company’s holdings within this sector. See Potential Impairments, Page 48 for further discussion.
The energy sector, which encompasses utilities and merchant trading, accounted for $186 million in market value ($197 million amortized book value) of fixed-income assets. Management monitors industry concentrations for developments such as the unregulated operations of certain utilities, which may impact the value of the company’s holdings going forward. See Potential Impairments, Page 48 for further discussion.
Investment-grade corporate bonds - At year-end 2002 and 2001, approximately $1.488 billion and $1.240 billion ($1.394 billion and $1.208 billion at amortized cost) of the investment portfolio related to corporate bonds rated as investment grade. Bonds with a Moody’s rating at or above Baa 3 or a Standard & Poor’s rating at or above BBB- are considered investment grade. A majority of the bonds not rated by Moody’s are investment grade for statutory purposes and are related to small, tax-exempt bond issues. The company seeks to balance current income with potential changes in market value as well as changes in credit risk when determining whether or not to hold these securities to maturity.
High-yield corporate bonds - At year-end 2002 and 2001, approximately $630 million and $652 million ($693 million and $718 million at amortized cost) of the investment portfolio were corporate bonds considered to be high-yield corporate bonds. Bonds with a Moody’s rating below Baa 3 or a Standard & Poor’s rating below BBB- and non-rated bonds are considered high yield. The company’s strong capital position permits it to invest in these securities in addition to investment-grade corporate bonds. While such investments tend to have higher yields, they are inherently more risky and illiquid since the risk of default by the issuer, as indicated by their ratings, is higher. Historically, they have made a positive contribution to investment income and, in general, are less sensitive to interest-rate fluctuations. Similar to investment-grade bonds, the company seeks to balance current income with potential changes in market value as well as changes in credit risk when determining whether or not to hold these securities to maturity. During 2002, the corporate bond market experienced the highest default rates in absolute dollars since 1990-1991. In 2002, the company recorded losses in its non-investment grade bond portfolio due to deteriorating economic conditions and tightening credit standards. The company is taking an aggressive approach, closely monitoring this class and selling or impairing issues that management believes may not be able to recoup lost value. See Potential Impairments, Page 48 for further discussion.
At year-end 2002 and 2001, investments totaling $7.884 billion and $8.495 billion ($2.375 billion and $2.174 billion at cost) of the company’s $11.257 billion and $11.571 billion investment portfolio related to equity securities.
Convertible securities - For more than 30 years, the company has invested in both convertible bonds and convertible preferred stocks. These securities are the primary trading vehicle in the portfolio. Management believes the conversion features enhance the overall value of the security and does not believe that investments in convertible securities pose any significant risk to the company or its portfolio due to their characteristics. As a class, convertible securities tend to be less sensitive to interest-rate changes than fixed-rate securities and less sensitive to market conditions than equity securities.
Additional information regarding the composition of investments, together with maturity data regarding investments in fixed-maturity obligations, is included in the Note 2 to Consolidated Financial Statements, Page 62.
Other invested assets of $68 million, compared with $66 million in 2001, primarily consisted of mortgage loans, policy loans and notes receivable. During 2002, the company sold an office building in downtown Cincinnati for a net gain of $2 million, net of tax. See Item 2, Properties, Page 12, for information regarding the company’s other real estate holdings.
At December 31, 2002, total long- and short-term debt was 7.1 percent and insurance reserves were 47.6 percent of total liabilities, with remaining liabilities consisting of unearned premiums, deferred income taxes, declared but unpaid dividends and other liabilities.
At December 31, 2002, and December 31, 2001, long-term debt consisted of $420 million and $426 million, respectively, of which $420 million was senior debentures in both years with $6 million in convertible debentures at year-end 2001, which matured in 2002. The senior debenture is not encumbered by rating triggers. The company’s excellent cash flow and strong capital position have allowed it to minimize its reliance on debt financing although the company utilizes a line of credit to fund short-term cash needs.
During 2001, CFC Investment Company entered into an interest-rate swap as a cash hedge of variable interest payments for certain variable-rate debt obligations ($31 million notional amount) to better match fixed rate lease assets with liabilities having a fixed financing rate. Under this interest-rate swap contract, the company agreed to pay a fixed rate of interest for a seven-year period. The contract is considered to be a hedge against changes in the amount of future cash flows associated with the related interest payments. Accordingly, the related unrealized gain or loss on this contract is a component of
Following is a summary of the contractual obligations and other commercial commitments:
During 2002, the company’s ratings from Standard & Poor’s, Moody’s and A.M. Best remained unchanged and a new rating from Fitch was initiated at A+ (very strong). In 2001, Standard & Poor’s had changed their rating of the company due to their outlook for the overall insurance industry and the company.
Cincinnati Financial has increased cash dividends to shareholders for 42 consecutive years and, periodically, the board of directors authorizes stock dividends or splits. In February 2003, the board of directors authorized a 12.4 percent increase in the regular quarterly dividend to an indicated annual rate of $1.00. In February 2002, the board authorized a 6.0 percent increase; and in February 2001, a 10.5 percent increase. Over the past 10 years, the company has paid an average of 40 percent to 45 percent of net income as dividends, with the remaining 55 percent to 60 percent reinvested for future growth. The ability of the company to continue paying cash dividends is subject to factors as the board of directors may deem relevant.
Since 1992, the company’s board also has authorized four stock splits or stock dividends: a three-for-one stock split in 1998; a 5 percent stock dividend in 1996; a 5 percent stock dividend in 1995; and, a three-for-one stock split in 1992. After the most recent stock split in 1998, a shareholder who purchased one Cincinnati Insurance share before 1957 would own 1,947 Cincinnati Financial shares if all shares from accrued stock dividends and splits were held and cash dividends not reinvested.
At year-end 2002, total shareholders’ equity was 39.8 percent of total assets.
As a long-term investor, the company has followed a buy-and-hold strategy for more than 40 years. A significant amount of unrealized appreciation on equity investments has been generated as a result of this policy. Unrealized appreciation on equity investments, before deferred income taxes, was $5.509 billion and $6.321 billion at year-end 2002 and 2001, respectively. It constituted 69.9 percent of the equity investment portfolio; and, after deferred income taxes, 65.1 percent of total shareholders’ equity at year-end 2002.
Regulatory risk - the potential for a decrease in market value due to the impact of legislative proposals or changes in the laws or regulations. Over the past two years, the market has reacted to the passage of the Sarbanes-Oxley Act, TRIA, past and pending tax law changes, Social Security reform issues and healthcare legislation issues.
Interest-rate risk - 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. Interest rates have been at 40-year lows, reflecting the overall economic environment. Uncertainty exists regarding future Federal Reserve policy pending a decision regarding Chairman of the Federal Reserve Greenspan’s successor.
Fraud - the potential for a negative impact on an issuer’s performance due to actual or alleged illegal or improper activity of individuals its employs.
The investment committee of the board of directors monitors the investment risk management process primarily through its executive oversight of investment activities. The company takes an active approach to managing market and other investment risks, including the accountabilities and controls over these activities. Actively managing these market risks is integral to the company’s operations and could require a change in the character of future investments purchased or sold or require a shift in the existing asset portfolios to manage exposure to market risk within acceptable ranges. The approach is applied daily by investment portfolio managers to each of the five asset classes in which the company invests.
Risks associated with the five asset classes can be summarized as follows (H - high, A - average, L - low):
The final, less significant risk is a small exposure to credit risk for a portion of the tax-exempt portfolio that has support from corporate entities, for example bonds insured by corporate bond insurers or bonds with interest payment made by a corporate entity through a municipal conduit/authority. While decisions regarding these investments primarily are made based on the underlying municipal situation, the existence of third-party insurance in the event of default reduces risk. In circumstances in which the municipality was unable to meet its obligations, risk would be increased if the insuring entity were experiencing financial duress. Because of the company’s diverse exposure and focus on higher-rated entities with strong financial profiles, the company does not feel this is a material concern.
Hypothetically, an increase in interest rates (market yields to maturity) of 100 basis points at December 31, 2002, would decrease the fair value of the fixed-income portfolio by $161 million, or to $3.144 billion from $3.305 billion. The interest-rate change selected represents management’s views of a shift in rates that is quite possible over a one-year period. The rates selected 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, higher-rated convertible securities are more likely to be sensitive to changes in the general level of interest rates. Alternatively, issuers with a weaker financial profile have a higher potential for default and lower sensitivity to interest rates. For these issuers, operational performance is the most significant factor in valuing the security.
Common stocks are subject to a variety of risk factors encompassed within the umbrella of market risk. General economic swings influence the performance of the underlying industries and companies within those industries. A downturn in the economy will have a negative impact on an equity portfolio. Industry- and company-specific risks have the potential to substantially affect the market value of the company’s equity portfolio. The company addresses industry- and company-specific risks by maintaining investments in a small group of holdings that management can analyze closely, better understanding their business and the related risk factors.
While the company’s financial position would be affected by changes in the market valuation of its investments, in 2002, the company’s equity portfolio outperformed the S&P 500 Index, a common benchmark of market performance, losing 7.3 percent versus a decline of 22.1 percent for the Index. Over the past five years, the portfolio performed similarly, with an average annual return of 7.1 percent compared with an average annual decline of 0.6 percent for the S&P 500 Index. While past performance cannot guarantee future returns, management believes the company’s investment style - focused on companies that pay and increase dividends to shareholders - offers some protection in down markets. A prolonged downturn in the stocks of financial institutions would make future comparisons with the S&P 500 Index more difficult.
At December 31, 2002, the company held six individual equity investments that accounted for approximately 90 percent of the after-tax net unrealized appreciation of the entire investment portfolio. The company’s largest equity holding is Fifth Third Bancorp common stock, of which the company held 72.8 million shares at a cost of $283 million at December 31, 2002. The market value of the company’s Fifth Third Bancorp position was $4.261 billion at year-end 2002, or 54.0 percent of its total equity portfolio. The after-tax unrealized gain represented by the company’s Fifth Third Bancorp position was $2.586 billion, or 71.0 percent of the company’s total after-tax unrealized gains at year-end 2002. The Fifth Third Bancorp position represented $16.00 of the company’s total book value of $34.65 per share at year-end 2002. Every $1.00 change in the market price of Fifth Third Bancorp’s common stock has approximately a 29-cent impact on Cincinnati Financial’s book value per share. A 20 percent change in the market price of Fifth Third Bancorp’s common stock, which was $58.55 at year-end 2002, would result in a $852 million change in assets and a $554 million change in after-tax unrealized gains. This would affect shareholders’ equity by 10 percent and book value by $3.43 per share.
Based on an evaluation of the portfolio at year-end 2002, 59 securities trading below 70 percent of book value are being monitored for potential other-than-temporary impairment. These securities had a market value of $139 million and a book value of $231 million, or 2.0 percent of total invested assets, at year-end 2002. If all securities trading below 70 percent of book value had been written down for an other-than-temporary impairment charge, the company would have recorded an additional $92 million in realized investment losses, before taxes, at December 31, 2002. Of the 59 securities trading below 70 percent of book value at year-end, the unrealized loss associated with the 22 securities trading below book value for less than four quarters amounted to $42 million, before tax. The 37 securities trading below book value for more than four quarters accounted for the remaining $50 million, before tax, of the unrealized loss at December 31, 2002.
Property casualty insurance operations - The company believes that its strategies provide it with important competitive advantages within the overall insurance marketplace. In the past, those advantages have led to above average growth rates and have continued to contribute to profitability measures well ahead of industry measures, despite the industry-wide challenges of rising loss frequency and severity.
Based on the strong performance of the property casualty insurance operations in 2002, with earned premiums rising 15.8 percent and the GAAP combined ratio at 99.7 percent, management believes its strategies to return performance to historic levels will be successful. As a result, the company anticipates strong growth for 2003 and believes that the full-year GAAP combined ratio should be 99.0 percent or below (98.5 percent or below on a statutory basis), presuming catastrophe losses remain in the range of 3 percent of earned premiums and recognizing that 2003 quarterly IBNR amounts may exceed that of 2002. Industry analysts are projecting a 102.1 percent statutory combined ratio for the property casualty insurance industry in 2003.
Investment operations - To address current market conditions, the company is shortening the duration of the fixed-income portfolio and emphasizing higher credit quality investments. Management also will continue to emphasize long-term equity investments in companies with increasing sales, earnings and dividends, strong management teams and favorable outlooks. Pending a significant shift in market conditions, however, management anticipates achieving investment income growth in the range of 4 percent in 2003, ahead of industry averages, although at a lower pace than the company has traditionally achieved.
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 plan and related system of 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.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. 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.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
The Cincinnati Insurance Companies market property casualty insurance policies in 31 states. In 2002, 98.6 percent of the company’s agencies’ direct written premium volume was in the 27 states in which the company has had a presence for more than five years. Further, agencies in Ohio contributed 24 percent and Georgia, Illinois, Indiana, Michigan and Pennsylvania each contributed between 5 percent and 10 percent of premium volume in 2002. No single agency accounted for more than 1.1 percent of the company’s total agency direct written premiums.
LIFE INSURANCE - 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.
Limited-pay products require the policyholder to pay scheduled premiums up front but coverage is provided for an extended period. The company defers the amount of premium in excess of the amount necessary to provide for all benefits and expenses and recognizes it over the life of the coverage using the gross profit method.
Universal life products include those that allow policyholders to vary premiums at their discretion or provide benefits or permit charges that are not fixed according to the terms of the policy. Premiums for universal life products are not recognized as revenue when received. The company recognizes cost of insurance charges, administration charges and surrender charges as revenue when earned using the gross profit method.
ACCIDENT HEALTH INSURANCE - Expenses incurred in the issuance of policies, as noted above in property casualty insurance, are deferred and amortized in level proportion to gross premiums over the expected lifetime of the contract. 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.
LEASE/FINANCE - CFC Investment Company provides auto and equipment direct financing (leases and loans) to commercial and individual clients. Generally, lease contracts transfer ownership of the property to the lessees at the end of the lease terms and contain bargain purchase options. Income is recognized over the financing term using the interest method.
Identified initial direct costs associated with the origination of a lease or loan are capitalized and amortized, using the interest method, over the life of the financing. These costs include, but are not limited to, finder fees, broker fees, filing fees and the cost of credit reports.
REINSURANCE - 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.
INVESTMENTS - Fixed maturities (bonds and notes) and equity securities (common and preferred stocks) are classified as available for sale and are stated at fair values.
DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES - The company invests in certain financial instruments that contain embedded options, which are stated at fair value and are attached to the host contracts, such as convertible debt and convertible preferred stock. The company also entered into an interest rate swap agreement as a cash flow hedge during 2001 in order to lock in an interest rate related to certain of its variable rate debt obligations ($31 million notional amount). Statement of Financial Accounting Standards (SFAS) No. 133 “Accounting for Derivative Financial Instruments and Hedging Activities,” as amended requires changes in the fair value of the company’s derivative financial instruments and its interest rate swap agreement to be recognized periodically in income or shareholders’ equity (as a component of accumulated other
FEDERAL INCOME TAXES - Deferred income tax liabilities and assets are computed using the tax rates in effect for the time when temporary differences in book and taxable income are estimated to reverse. Deferred income taxes are recognized for numerous temporary differences between the company’s taxable income and book-basis income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains on investments and differences in the recognition of deferred acquisition costs and insurance reserves. Deferred income taxes associated with unrealized appreciation (except the amounts related to the effect of income tax rate changes) are charged to shareholders’ equity in accumulated other comprehensive income, and deferred taxes associated with other differences are charged to income.
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. 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. Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holders and, therefore, is 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. A percentage of each separate account’s realized gain and loss accrues to the company and is transferred from the separate account to the company’s general account and is recognized as revenue or expense. Revenues and expenses for the company related to the separate accounts also consist of contractual fees and mortality, surrender and expense risk charges.
STOCK OPTIONS - The company has primarily 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.
Had compensation cost for the company’s stock option plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123 “Accounting for Stock-Based Compensation,” the company’s net income and earnings per share would have been reduced to the pro forma amounts indicated below:
NEW ACCOUNTING PRONOUNCEMENTS - The company’s adoption of SFAS No. 142 “Goodwill and Other Intangible Assets,” which requires an impairment-only approach to valuing goodwill and other intangible assets, had no impact on the consolidated financial statements. SFAS No. 143 “Accounting for Asset Retirement Obligations,” which addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs, is not applicable to the company and therefore has no impact on the consolidated financial statements. The company’s adoption of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” which addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of, also had no impact on the consolidated financial statements.
The Financial Accounting Standards Board (FASB) issued SFAS No. 145 “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections” in April 2002, which eliminates inconsistencies in certain lease transactions, includes certain other technical corrections and clarifies language; SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal” was issued in June 2002 and requires that liabilities for costs associated with an exit or disposal activity be recognized and measured at fair value when the liability is incurred; SFAS No. 147 “Acquisitions of Certain Financial Institutions” was issued in October 2002 and relates to the application of the purchase method of accounting and requires those transactions be accounted for in accordance with SFAS No. 141 “Business Combinations” and No. 142 “Goodwill and Other Intangible Assets”; management has determined that these newly issued accounting pronouncements will have no effect on the company’s consolidated financial statements.
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, it requires 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.
Actual maturities may differ from contractual maturities when there exists a right to call or prepay obligations with or without call or prepayment penalties.
The following analyzes cost or amortized cost, gross unrealized gains, gross unrealized losses and fair value for the company’s investments:
The fair value of the conversion features embedded in convertible securities amounted to a loss of $4 million at December 31, 2002 and a gain of $9 million at December 31, 2001.
Investments in companies that exceed 10 percent of the company’s shareholders’ equity include:
Acquisition costs incurred and capitalized during 2002, 2001 and 2000 amounted to $580 million, $481 million and $438 million, respectively. Amortization of deferred acquisition costs was $523 million, $454 million and $405 million for 2002, 2001 and 2000, respectively.
As a result of changes in estimates of insured events in prior years, the provision for losses and loss expenses decreased by $45 million, $62 million and $20 million in 2002, 2001 and 2000. 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 losses and loss expenses in the accompanying balance sheets also includes $26 million and $22 million at December 31, 2002 and 2001, respectively, for certain life health losses.
Six million shares of common stock were available for future stock option grants, as of December 31, 2002.
ACCUMULATED OTHER COMPREHENSIVE INCOME - The change in unrealized gains on investments and derivatives included:
Insurance losses and policyholder benefits in the accompanying statements of income are net of approximately $96 million, $422 million and $109 million of reinsurance recoveries for 2002, 2001 and 2000, respectively.
No provision was made December 31, 2002, 2001 and 2000 for federal income taxes on approximately $14 million of the life insurance subsidiary’s retained earnings, since such taxes will become payable only to the extent that such retained earnings are distributed as dividends or exceed limitations prescribed by tax laws. The company does not contemplate any such dividend.
For the company, dilutive potential common shares consist of outstanding stock options and shares issuable under the matured 5.5 percent convertible senior debentures (debentures). The computations of basic and diluted earnings per share are as follows:
Options to purchase 1 million shares of common stock were outstanding during 2002, 2001 and 2000, 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 and subsidiaries sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension plan covering substantially all employees. Benefits for the defined benefit plan are based on years of credited service and compensation level. Contributions to the plan are based on the frozen entry age actuarial cost method. Pension expense is composed of several components that are determined using the projected unit credit actuarial cost method and based on certain actuarial assumptions.
The National Association of Insurance Commissioners adopted the Codification of Statutory Accounting Principles (Codification). Codification, which is intended to standardize regulatory accounting and reporting to state insurance departments, became effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. Ohio, the domiciliary state of the company’s insurance subsidiaries, required adoption of Codification with certain modifications for the preparation of statutory financial statements effective January 1, 2001. The following table reconciles consolidated net income for the years ended December 31, and shareholders’ equity at December 31, as reported herein in conformity with GAAP, with total statutory net income and capital and surplus of the company’s insurance subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by insurance regulatory authorities.
The company is organized and operates primarily in two industries, property casualty insurance and life insurance, and has four reportable segments - commercial lines property casualty insurance, personal lines property casualty insurance, life insurance and investment operations - which company management regularly reviews to make decisions about allocating resources to the segments and assessing their performance. Included in the other category below are the parent company, CFC Investment Company and CinFin Capital Management Company operations, excluding investment activities, and other income of the insurance subsidiaries.
Revenue is primarily from unaffiliated customers. Insurance segments’ revenues are insurance premiums earned; investment operations’ revenue represents net investment income and realized investment gains and losses; and other revenue is primarily finance/lease income, asset management fees and other income of the insurance subsidiaries.
Identifiable assets by segment are those assets used in the respective segment’s operations. Information regarding identifiable assets is not reported for two reportable segments - commercial lines and personal lines of property casualty insurance - because these amounts are not used by company management for analysis of those segments. All fixed-maturity and equity security investments, regardless of ownership, are included in the investment operations segment.