Cincinnati Financial Corporation owns its headquarters building located on 100 acres of land in Fairfield, Ohio. This building contains approximately 800,000 total square feet. 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 $76 million as of December 31, 2004, and is classified as property and equipment, net, for company use.
The Cincinnati Life Insurance Company owns a four-story office building in the Tri-County area of Cincinnati, Ohio. It contains approximately 102,000 rentable square feet. An unaffiliated tenant currently leases 100 percent of the building through December 31, 2005. At this time, the company has not been informed that the tenant intends to vacate the property and the tenant has until August 2005 to notify the company of their intent. This property is carried in the financial statements at $3 million as of December 31, 2004, and is classified as other invested assets.
In 2004, the company decided to undertake a building expansion at its headquarters location in Fairfield, Ohio. Preparation for construction of an underground garage and third office tower began in January 2005. The new tower will contain more than 690,000 total square feet, including the garage. It will rise seven stories above three underground parking levels with 700 parking spaces. The construction has an estimated completion date of September 2008. The company believes this expansion will accommodate its business needs for the foreseeable future.
Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2004.
2003 - As the result of a settlement negotiated with a vendor, pretax results included the recovery of $23 million of the $39 million one-time, pretax charge incurred in 2000.
Topics addressed in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Item 7A, Quantitative and Qualitative Disclosures About Market Risk, include:
Cincinnati Financial Corporation is the parent company of the nation’s 25th largest property casualty insurer, based on statutory net written premium volume through the first nine months of 2004. The company marketed property casualty insurance products through a select group of 986 independent insurance agencies in 31 states at year-end 2004.
The company’s strong surplus and asset positions provide security for policyholders while allowing for a successful, equity-centered investment strategy.
By consistently applying long-term strategies rather than taking short-term actions, the company seeks to build shareholder value by:
In 2004, the company reported record results, as described in detail in the results of operations. Statutory net written premium growth outpaced the estimated industry average while the combined ratio, a common measure of profitability
The company currently is pursuing a number of strategies to help it achieve its performance objectives over the next several years:
• Improving ease of doing business and communication with agencies through an expanding portfolio of technology solutions. The company expects to continue to strengthen its relationships with agencies through the introduction and use of technology that is designed to bring agencies greater efficiencies and permit associates to spend more time with people and less with paper.
• Subdividing field marketing territories to further increase the company’s representative’s presence in, and their ability to serve, each agency.
• Appointing additional agencies in markets where the company has identified a need for insurance products and services and an opportunity to capture a greater market share.
Currently, management anticipates pretax investment income growth in 2005 in the range of 5 percent to 6 percent. The investment portfolio is positioned for long-term capital appreciation. Equity and equity-linked securities make up 34.0 percent of the portfolio based on book value and 62.7 percent based on market value at year-end 2004.
• Unusually high levels of catastrophe losses due to changes in weather patterns, environmental events, terrorism incidents or other causes
• Ability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased and financial strength of reinsurers
• Events or conditions that could weaken or harm the company’s relationships with its independent agencies and hamper opportunities to add new agencies, resulting in limitations on the company’s opportunities for growth, such as:
° Perceptions that the company’s level of service, particularly claims service, is no longer a distinguishing characteristic in the marketplace
• Events that reduce the company’s ability to maintain effective internal control over financial reporting under the Sarbanes-Oxley Act of 2002 in the future
• Prolonged low interest rate environment or other factors that limit the company’s ability to generate growth in investment income
The most significant estimates relate to the company’s reserves for property casualty loss and loss expenses. Management believes that the stability of the company’s business makes its historical data the most important source for establishing adequate reserve levels.
Management bases reserve estimates on company experience and information from internal analyses, obtaining additional information from consulting outside actuaries. When reviewing reserves, management analyzes historical data and estimates the effect of various loss development factors. Management believes that the following represent the primary risks to its ability to estimate loss reserves accurately:
• Changes in reinsurance coverage, not reflected in reserving data, that affect the company’s net payments and net case reserves
• Payment and reporting pattern changes attributable to the implementation of a new claims management system
• Absence of cost-effective methods for assessing asbestos and environmental claim liabilities accurately (see Property Casualty Reserve Levels, Asbestos and Environmental Reserves, Page 56, for discussion of related reserve levels and trends)
Any of these factors can cause the company’s ultimate loss experience to be better or worse than reserves held, and the difference could be material. To the extent that reserves are inadequate and strengthened, the amount of such increase is treated as a charge in the period that the deficiency is recognized, raising the loss and loss expense ratio and reducing earnings. To the extent that reserves are redundant and released, the amount of the release is a credit in the period that the redundancy is recognized, reducing the loss and loss expense ratio and increasing earnings.
Management establishes case reserves for claims that have been reported within the parameters of coverage provided in the policy. Individual case reserves greater than $35,000 established by field claims representatives are reviewed by experienced headquarters claims supervisors while case reserves greater than $100,000 are reviewed by headquarters claims managers. The estimates reflect informed judgment and experience of the company’s claims associates based on general insurance reserving practices and their experience with the company. Case reserves are reviewed on a 90-day cycle, or more frequently if specific circumstances require, based on events such as the status of ongoing negotiations.
To establish IBNR reserves on an annual basis, management uses a variety of tools, including actuarial and statistical methods. These may include but are not limited to:
Management conducts its thorough evaluation of the adequacy of reserves as of the end of the third quarter of each year. As a result, the most significant refinements in reserves historically have been implemented in the fourth quarter. Less detailed, periodic reviews of reserve adequacy are made at the other quarter ends. A loss review committee, including internal actuaries and representatives from management of multiple operating departments, is responsible for the quarterly review process.
The outside actuaries conduct a thorough evaluation of the adequacy of reserves as of the end of the third quarter of each year and conduct a supplemental review of full-year data at year-end.
In the normal course of its business, the company may provide coverage for exposures for which estimates of losses are highly uncertain. Most significant are catastrophic events. Due to the nature of these events, management is unable to predict precisely the frequency or potential cost of catastrophe occurrences. However, in an effort to control such losses, the company foregoes marketing property casualty insurance in California, reviews aggregate exposures to huge disasters and monitors its exposure in certain coastal regions. The company has catastrophe exposure to:
Other-than-temporary impairment in the value of securities is defined by the company as declines in valuation that meet specific criteria established in the asset impairment policy. Such declines often occur in conjunction with events taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing corporation. These specific criteria include a declining trend in market value, the extent of the market value decline and the length of time the value of the security has been depressed, as well as subjective measures such as pending events and issuer liquidity. Generally, these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and market conditions. See Investment Portfolio, Page 53, for information regarding valuation of the invested assets.
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. Notwithstanding 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 an impairment indicator is noted, the portfolio managers even more closely scrutinize the security.
When evaluating other-than-temporary impairments, the committee 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. Investment assets that have already been impaired 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. See Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Unrealized Investment Gains and Losses, Page 66, for detailed information regarding securities trading in a continuous loss position at December 31, 2004. 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.
The company establishes a deferred asset for costs that vary with and are primarily related to acquiring property casualty and life business. These costs are principally agent commissions, premium taxes and certain underwriting costs, which are deferred and amortized into income as premiums are earned. Deferred acquisition costs have grown in line with the growth in premiums. Underlying assumptions are updated periodically to reflect actual experience. Changes in the amounts or timing of estimated future profits could result in adjustments to the accumulated amortization of these costs.
For property casualty policies, deferred costs are amortized over the terms of the policies. For life policies, acquisition costs are amortized into income either over the premium-paying period of the policies or the life of the policy, depending on the policy type.
Separate account assets are carried at fair value. Separate account liabilities primarily represent the contract holders’ claims to the related assets and also 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 Item 8, Note 1 to the Consolidated Financial Statements, Page 76, 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.
In September 2004, the FASB issued Staff Position (FSP) No. EITF Issue 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-01.” This FSP delayed the effective date of the measurement and recognition guidance contained in paragraphs 10-20 of Issue 03-1 and, as of February 25, 2005, the FASB had not yet issued guidance on the adoption or effective date of FSP No. EITF Issue 03-1-1. The amount of any other-than-temporary impairment that may need to be recognized in the future will be dependent on market conditions and management’s intent and ability to hold any such impaired securities.
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 activities. The four segments are:
Comprehensive income - Accumulated other comprehensive income, which includes the accumulated unrealized gains on investments, declined by $297 million in 2004, gained $441 million in 2003 and declined $470 million in 2002. See Item 1, Investments Segment, Page 13, for additional information on the investment portfolio and see Shareholders’ Equity, Page 62, for information on unrealized gains and losses. Return on equity improved for the third consecutive year while return on equity based on comprehensive income was 4.6 percent in 2004 compared with 13.8 percent in 2003 and negative 4.0 percent in 2002.
• Realized investment gains and losses - A significant factor in the growth rate of net income in any year can be realized investment gains and losses. Management believes it is important to carefully consider the impact of these 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 2003, the company recovered $23 million pretax from a settlement negotiated with a vendor. The recovery added $15 million, or 9 cents per share, to net income. The negotiated settlement related to the $39 million one-time, pretax charge incurred in 2000 to write off previously capitalized software development costs.
• Option expense - Pro forma option expense as disclosed in a Item 8, Note 1 to the Consolidated Financial Statements, Page 76, would have reduced earnings per share by 7 cents in both 2004 and 2003 and 8 cents in 2002.
• Effects of inflation - Management does not believe that inflation has had a material effect on consolidated results of operations, except to the extent that inflation may affect interest rates and claim costs.
• Property casualty written premium growth in the mid-single digits. The company’s outlook is based on comments from various agencies and production results, market intelligence from the company’s field marketing representatives and account retention trends, as well as staffing of new marketing territories and plans for new agency appointments.
• Combined ratio for the property casualty insurance operations in the range of 91 percent, assuming catastrophe losses are a more normal 3.5 percentage points on the combined ratio. Management anticipates that the commercial lines combined ratio will be in the range of 90 percent and the personal lines combined ratio will be in the range of 95 percent, marking a return to profitability for this segment. The consolidated target also assumes that favorable loss reserve development will be in line with historical levels.
• Investment income growth of 5 percent to 6 percent pretax due in part to the investment of a greater percentage of available cash flow in fixed-income securities during most of 2004 and the first half of 2005.
Management expects the impact of these anticipated strong operating results will be tempered in 2005 by the adoption of option expensing and slightly higher interest expense on long-term debt, which increased modestly with the November 2004 issue of $375 million aggregate principal amount of senior notes due 2034. The company will adopt SFAS No. 123(R), “Share-Based Payment,” which calls for stock option expense to be included as a component of net income, in the third quarter of 2005. Pro forma option expense as disclosed in Item 8, Note 1 to the Consolidated Financial Statements, Page 76, would have reduced earnings per share by 7 cents in both 2004 and 2003 and 8 cents in 2002.
A series of winter storms across the Midwest and Northeast during January 2005 caused approximately $5 million in catastrophe losses for policyholders. As previously announced, management estimates that first-quarter 2005 results will include an initial reserve of $22 million, net of reinsurance, for a single large loss in January that was insufficiently covered through its facultative reinsurance programs. Management’s performance targets for 2005 take these events into account.
As described in Item 8, Note 17 of the Consolidated Financial Statements, Page 89, management measures profit or loss for its property casualty and life segments 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. Underwriting results and segment pretax operating income are not a substitute for net income determined in accordance with GAAP.
Investments held by the parent company and the related investment portfolios for the property casualty and life insurance subsidiaries are managed and reported as the investments segment, separate from the underwriting businesses. Net investment income and net realized investment gains and losses for the company’s investment portfolios are discussed in the investments segment discussion.
• Earned premiums - Over the past three years, strong insurance industry pricing and its relationships with independent agencies have permitted the company to obtain adequate premiums on new and renewal business. The rate of increase for commercial lines earned premiums slowed over the three-year period, reflecting changing market conditions, while the rate of increase for personal lines earned premium reflected higher rates offset by declining new business activity. To restore affected layers of property catastrophe reinsurance programs, the company incurred $11 million in reinsurance reinstatement premiums in 2004, reducing net earned premium growth by 0.4 percentage points.
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. The average net earned premium per territory rose 4.7 percent in 2004 to $33 million, 7.8 percent in 2003 to $32 million and 5.0 percent to $29 million in 2002.
The improvement in the combined ratio was largely driven by a lower loss and loss expense ratio excluding catastrophes. Premium growth has been the most significant factor in the improvement in the loss and loss expense ratio. The 2004 ratio also benefited from higher than normal savings due to favorable loss reserve development from prior accident years as well as UM/UIM reserve releases. The 2003 ratio benefited from UM/UIM reserve releases. Other factors are covered in the commercial lines and personal lines segment discussions below. The loss and loss expense ratio improvement was offset by:
• 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 than offsetting the company’s deliberate decisions not to write or renew certain business and the loss of some smaller accounts due to competition. The reinsurance reinstatement premiums allocated to commercial lines reduced net earned premium growth for 2004 by 0.3 percentage points. During this three-year period, the company has experienced little growth in overall commercial lines policy counts. This has reflected the company’s re-underwriting of the existing book of business and its insistence on obtaining adequate premium for the covered risks.
• Profitability - Since 2002, improvement in commercial lines profitability has primarily been driven by more adequate premiums per policy as well as underwriting actions taken. Results for 2004 also benefited from higher than normal savings due to favorable loss reserve development from prior accident years, including the benefit of the UM/UIM reserve release, which reduced the ratio by 1.5 percentage points (see Property Casualty Reserve Levels, Commercial Lines Segment Reserves, Page 56, for information regarding loss reserve development for the commercial lines segment). The 2003 combined ratio included the benefits of the UM/UIM reserve release and the software recovery, which reduced the ratio by 2.0 percentage points and 0.8 percentage points, respectively.
Loss and loss expenses include both net paid losses and reserve additions for unpaid losses as well as the associated loss expenses. As a result of the underwriting actions noted above, which have led to higher premiums on a relatively stable level of exposure, loss and loss expenses excluding catastrophes declined over the three-year period. A primary reason for the improvement in the ratio between 2004 and 2003 was higher than normal savings due to favorable loss reserve development from prior accident years (see Property Casualty Reserve Levels, Commercial Lines Segment Reserves, Page 56, for information regarding loss reserve development for the commercial lines segment). The favorable development was largely due to the claims department’s initiative, begun in 2001, to establish higher initial case reserves on liability claims in the period when the claim is reported. UM/UIM reserve releases contributed 1.5 percentage points to the loss and loss expense ratio in 2004 and 2.0 percentage points in 2003.
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 believes it has addressed. Management also measures new losses and case reserve adjustments greater than $250,000 to track frequency and severity. New losses greater than $1 million, new losses between $250,000 and $1 million and case reserve increases greater than $250,000, declined as a percentage of earned premiums in each of the past three years.
Commission expense as a percent of earned premium rose by 1.0 percentage points in 2004 and 0.6 percentage points in 2003 as contingent (profit-based) commissions increased because of strong recent results. The company relies on its independent agencies as frontline underwriters who know the businesses and individuals in their communities.
liability reserve strengthening in 2004 offset the improvement by 0.6 percentage points. Higher general liability base rates were effective in most states during 2003. This contributed to further improvement in the loss and loss expense ratio in 2004 and 2003. Reserve strengthening increased the ratio by 2.0 percentage points in 2003 and 1.0 percentage points in 2002.
Conditions within the workers compensation market remained stable in 2004 after improving between 1999 and 2003 as market pricing rose in most states, albeit offset by continued rising trends in loss severity. As indicated by the rapid rise in premium volume of state pools for workers compensation, many carriers chose to exit significant portions of this line of business. While the company remains highly selective about the risks covered, workers compensation is available as part of package policies for commercial lines policyholders, maintaining the company’s competitive position in selected states. Workers compensation has a lower commission ratio and higher breakeven point than the other commercial business lines.
The workers compensation loss and loss expense ratio has been steady for three years. Overall pricing increases for new and renewed risks and underwriting actions have helped stabilize the accident year loss ratio in the mid-70 percent range for the most recent three years compared with the higher level of 2000 and 2001. The loss and loss expense ratio reflected $16 million in reserve strengthening in 2004, primarily due to medical cost trends, $13 million in 2003 and $9 million in 2002.
Commercial auto premium growth trends reflected the factors influencing overall commercial lines performance, with the primary driver being price increases. Commercial auto, one of the commercial lines coverage areas for which the company prices coverage on an annual basis, frequently is one of the first lines to experience pricing pressure because it often represents the largest portion of insurance costs for commercial policyholders.
Director and officer coverage accounted for approximately 13 percent of other liability premium in 2004 and approximately 12 percent in 2003. Director and officer policies are offered primarily to non-profit organizations, reducing the risk associated with this line of business. As of December 31, 2004, only four in-force director and officer policies were for Fortune 500 companies. Forty-two were for publicly traded companies (excluding banks and savings and loans) and 70 were for banks and savings and loans with more than $500 million in assets.
In large part because this business line includes umbrella coverages, the calendar year loss and loss expense ratio tends to fluctuate dramatically on a year-over-year basis. The improvement in the 2004 calendar year loss and loss expense ratio was driven by 2000 through 2003 accident year loss and loss expense ratios 6.5 to 14.7 percentage points below their year-ago levels.
Industry experts currently anticipate industry-wide commercial lines written premiums will decline approximately 1 percent in 2005. The company anticipates commercial lines insurance market trends will reflect accelerated competition in 2005 with pressure on pricing from the industry’s increasing surplus and improving profitability. During the second half of 2004, agents indicated that renewal price increases were running in the low single digits, with variations by geographic region, class of business and size of account. Aggressive pricing is occurring more frequently for higher quality and for larger accounts although disciplined underwriting appears to be the norm. The company will continue to market its products to a broad range of business classes, price its products adequately and take a package approach. The company intends to maintain its underwriting selectively and to manage carefully its rate levels as well as maintain its programs that seek to accurately match exposures with appropriate premium. The creation of new marketing territories and appointment of new agencies over the next several years also could contribute to commercial lines growth. As a result of these factors, management presently anticipates 2005 commercial lines written premium growth in the mid-single digits compared with 7.6 percent in 2004.
The company believes it can continue to be a preferred market for its agencies and the types of Main Street businesses they serve by evaluating each risk individually and making decisions regarding rates, the use of three-year policies and other policy terms on a case-by-case basis, even in lines and classes of business that are under competitive pressure. This should allow the company to maintain the positive underlying improvements in profitability that have occurred over the past several years, but management does not believe favorable reserve development will contribute as much in 2005 as it did in 2004. As a result, management currently is estimating a 2005 commercial lines combined ratio in the range of 90 percent compared with 84.1 percent in 2004.
In the seven states in which the company wrote $35 million or more in personal lines agency direct earned premiums in 2004, premiums were $621 million in 2004. In these states, premiums grew 6.4 percent in 2004. In the 15 states with less than $35 million in premiums in 2004, agency direct earned premiums grew more rapidly, rising 10.7 percent in 2004 to $194 million. Similar to commercial lines, the stronger growth in the smaller states reflected the opportunities available to the company in less penetrated markets.
Personal lines new business premiums written directly by agencies declined 19.9 percent to $48 million in 2004 and 9.3 percent to $60 million in 2003 from a 2002 high of $67 million. The decline in new business in 2004 and 2003 reflected the company’s emphasis on underwriting personal lines and factors specific to the personal auto and homeowner business lines, as discussed below. In addition, agencies may be placing less new business with the company until the introduction of Diamond, the new personal lines policy processing system, in their state. Further, the company now understands that the agency learning curve for Diamond may be steeper than anticipated, potentially reducing agency attention to new business efforts in the initial months after the system is introduced in their state.
Commission expense as a percent of earned premium rose by 0.6 percentage points in 2004 and 0.5 percentage points in 2003 as total contingent (profit-based) commissions rose.
Over the three-year period, non-commission expenses fluctuated as a percent of earned premiums, but rose to a three-year high of 9.3 percent in 2004 due to higher salary expense and high technology-related costs. In 2003 the ratio of underwriting expenses to earned premiums was reduced by 1.1 percentage points due to the software recovery. The fluctuation in the expense ratio was partially due to continued refinements in the company’s cost allocation processes between commercial lines and personal lines.
The personal auto and homeowner business lines together accounted for 89.5 percent, 89.5 percent and 89.4 percent of total personal lines earned premiums in 2004, 2003 and 2002, respectively. The company’s intent is to write personal auto and homeowners coverages in personal lines packages. As a result, management believes that personal lines is best measured and evaluated on a segment basis. For reference, however, the table above and discussion below summarizes growth and profitability trends for the personal auto and homeowner business lines. Information regarding reserve development is provided in Property Casualty Reserve Levels, Personal Lines Segment Reserves, Page 58.
Earned premiums for personal auto grew 5.4 percent, 9.8 percent and 7.9 percent in 2004, 2003 and 2002, respectively. The growth was driven by the effect of rate increases beginning in late 2002. During 2004, rate increases in the range of 1.6 percent to 10.0 percent became effective in 21 states. Once rate changes become effective, they are applied to new business and to existing policies as they come up for renewal. Management believes the company’s personal auto rates generally remain competitive.
Over the last three years, the benefits of personal auto re-underwriting programs and higher pricing have generally served to offset rising loss severity. For selected agencies, the programs reviewed and strengthened underwriting standards, required motor vehicle reports for many insured drivers and developed strategies to increase the company’s penetration of the agency’s personal lines business. The loss and loss expense ratio for personal auto improved to 66.1 percent in 2004 from 71.1 percent in 2003 and 67.6 percent in 2002. The 2002 ratio included a 5.0 percentage-point benefit from the salvage and subrogation reserve.
• Shift to one-year policies - In conjunction with the deployment of Diamond, the personal lines policy processing system, the company has begun to write homeowner policies on a one-year term instead of a three-year term. One-year policies allow the company to modify rates, terms and conditions more promptly, when
In the personal lines marketplace, the company believes agents select Cincinnati for their value-oriented clients who seek to balance value and price and are attracted by Cincinnati’s superior claims service and the benefits of the company’s package approach. However, management is maintaining modest expectations for the personal lines area and anticipates mid-single digit written premium growth in 2005. Industry experts currently anticipate industry-wide personal lines written premiums will rise approximately 4.5 percent in 2005.
• Timing - The company implemented homeowner rate increases in its larger states in late 2003 and early 2004. As a result, the impact of these rate changes will accumulate into 2007, because approximately one-third of the three-year policies written before late 2003 come up for renewal each year.
• Rate levels - The company continues to work with its agents to refine the current rate structure to bring homeowner profitability in line with personal auto results and establish prices that attract agencies’ quality accounts. Management believes homeowner rate increases instituted in the past 24 months generally established pricing above the mid-point of market rates. As a result, current rates in some areas may be at a level that diminishes a differentiating factor for more price-sensitive consumers. In addition, the rate of increase for policies renewing for the first time in three years can be significant, as discussed above, even if the result is a competitive price. In a number of its field territories, management believes rates may be too high and it continues to evaluate independent agent market intelligence for potential refinements to the rate structure.
• Underwriting - Personal lines underwriters are focusing on insurance-to-value initiatives to verify that policyholders are buying the correct level of coverage for the value of the insured risk. In addition, the company is carefully maintaining its underwriting standards to help achieve the return to profitability.
Management believes the new system will ultimately make it easier for agents to place personal auto, homeowners and other personal lines business with the company, while greatly increasing policy-issuance and policy-renewal efficiency and providing direct-bill capabilities. Agents using Diamond chose direct bill for 39 percent of the policies and headquarters policy printing for 72 percent of the policies in 2004, options that generally were not available on the company’s previous system.
Cincinnati Life offers whole, term and universal life products, fixed annuities and disability income products. Revenues in 2004 were derived principally from:
Over the past several years, the life insurance company has worked to introduce a portfolio of new and enhanced products, primarily under the LifeHorizons name. For example, during 2003, the company introduced a new guaranteed whole life policy and a non-cancelable rider for its disability income product.
In 2004, Cincinnati Life continued 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. Management has added a life field marketing representative for the western states and plans to add a representative for the northeastern states in 2005. During 2004, Cincinnati Life added a disability income product to its worksite marketing portfolio.
• Commissions, general and other business expenses, net of deferred acquisition costs, accounted for 35.7 percent of 2004 expenses
Segment profitability depends largely on premium levels, the adequacy of product pricing, underwriting skill and operating efficiencies. Life segment results include only investment interest credited to contract holders (interest assumed in life insurance policy reserve calculations). The remaining investment income is reported in the investment segment results. The life investment portfolio is managed to earn target spreads between earned investment rates on general account assets and rates credited to policyholders. Management considers the amount of assets under management and investment income for the life investment portfolio as key performance indicators for the life insurance segment.
• Realized gains and losses - The company reported realized gains in 2004 compared with realized losses in 2003 and 2002. Realized losses were substantially lower in 2003 than 2002 as fewer other-than-temporary impairment charges were recorded due to the economic and market recovery.
Other-than-temporary impairment charges declined significantly in 2004 due to prior impairments in the portfolio and an improvement in the general financial climate. During the three-year period, almost 90 percent of the write-downs of securities that management deemed had experienced other-than-temporary declines in market value occurred during 2002 and the first half of 2003. During that earlier period, lingering weakness in the economy affected market values. Of the $80 million in other-than-temporary write-downs in 2003, $69 million occurred in the first six months of the year.
Other-than temporary impairment charges from the investment portfolio by asset class (see Item 1, Investments Segment, Page 13, for a description of the five asset classes) are summarized below:
In 2004, the company recorded $87 million in net realized investment gains, primarily due to the sale of equity holdings, compared with $30 million in 2003 and $8 million in 2002. The company buys and sells securities on an ongoing basis to help achieve its portfolio objectives. Although the company prefers to hold fixed-income securities until maturity, a decision to sell reflects management’s perception of a change in the underlying fundamentals of the security and preference to allocate those funds to investments that more closely meet the established parameters for long-term stability and growth. Management’s opinion that a security fundamentally no longer meets the company’s investment expectations may reflect a loss of confidence in the issuer’s management, a change in underlying risk factors (such as political risk, regulatory risk, sector risk or credit risk), or a recovery from a previously impaired value. In 2004 and 2003, the company sold fixed-income securities that it deemed to have limited upside potential.
In 2004, the company recorded $10 million in fair value increases compared with $9 million in fair value increases in 2003 and $4 million in fair value declines in 2002 due to the application of SFAS No. 133, which requires measurement of the fluctuations in the value of the embedded derivative features in selected convertible securities. See Item 8, Note 1 to the Consolidated Financial Statements, Page 76, for details on the accounting for convertible security embedded options.
Other income of the insurance subsidiaries, parent company operations and non-investment operations of CFC Investment Company and CinFin Capital Management Company resulted in $8 million in revenues in 2004 compared with $7 million in 2003 and $14 million in 2002. Losses before income taxes of $37 million in 2004, $38 million and $32 million recorded in 2004, 2003 and 2002, respectively, were primarily due to interest expense from debt of the parent company.
Income tax expense was $216 million in 2004 compared with $106 million in 2003 and $41 million in 2002. The effective tax rate for 2004 was 27.0 percent compared with 22.0 percent in 2003 and 14.8 percent in 2002. In addition to a rise in underwriting profits, the higher tax rate reflected the higher level of capital gains, which are taxed at a 35 percent rate, compared with capital losses in 2003.
The parent company’s cash requirements include general operating expenses, interest payments on its long- and short-term debt, dividends to shareholders and common stock repurchases. The parent company’s primary means of meeting its liquidity requirements are dividends and borrowings from its insurance subsidiary and investment income from its investment portfolio. The company’s access to the capital markets and short-term bank borrowing also provide other potential sources of liquidity.
As described in Item 1, Regulations, Page 15, and Item 8, Note 8 to the Consolidated Financial Statements, Page 83, dividends paid to the parent company by its insurance subsidiary are restricted by Ohio regulatory requirements. Further, management intends for all insurance subsidiaries to maintain their superior financial strength ratings, which may constrain their dividend-paying capacity. In 2004, 2003 and 2002, the company’s insurance subsidiary declared ordinary dividends of $175 million, $50 million and $100 million, respectively, to the parent company. The subsidiary can pay up to $588 million in ordinary dividends to the parent company in 2005 without approval from the Ohio Department of Insurance.
Operating activities are conducted primarily by the property casualty and life insurance companies. Underwriting generates positive cash flows because cash from premium payments generally is received in advance of cash payments required to settle claims. The increase in the positive cash flow from operating activities generated in each of the past three years resulted from the improvement in the results of operations discussed above.
The following table summarizes cash flow of the insurance subsidiary (direct method):
Excess cash flows from underwriting, investment and other corporate activities are invested in fixed-income and equity securities on an ongoing basis to help achieve the company’s portfolio objectives. See Item 1, Investments Segment, Page 13, for a discussion of the company’s investment strategy, portfolio allocation and quality.
Disposition of investments occurs for a number of reasons (See Item 8, Consolidated Statements of Cash Flows, Page 75):
• Sales of fixed maturities investments. Although the company prefers to hold fixed-income securities until maturity, a decision to sell or to reduce a holding reflects management’s perception of a change in the underlying fundamentals of the security and preference to allocate those funds to investments that more closely meet the established parameters for long-term stability and growth. In 2004 and 2003, sales of fixed-income securities rose as the company sold securities that it deemed to have limited upside potential.
• Call or maturity of fixed maturity investments. Calls of U.S. agency paper in 2004 and 2003 were the primary reason for the increase in calls and maturities of fixed maturity investments. The company has purchased U.S. agency paper with higher coupons and shorter call protection features.
• Sales of equity securities investments. Sales of equity securities rose in 2004 due to the sale of $356 million in equity holdings (see Investments Results of Operations, Page 47, for a discussion of equity sales in 2004).
• Purchases of fixed maturities investments. Purchases of fixed-income securities rose significantly in 2004 as the company allocated a higher percentage of new investment dollars to fixed-income investments in the second half of the year and used proceeds from the call of U.S. agency paper to purchase new fixed-income investments (see Item 1, Financial Strength Ratings, Page 7, and Item 1, Investments Segment, Page 13, for discussion of the investment strategy and portfolio allocation.).
In February 2005, the board of directors authorized a 10.9 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.22 per share and also authorized a 5 percent stock dividend payable April 26, 2005. The board indicated that it intended to maintain the new quarterly cash dividend on the higher number of shares outstanding following the stock dividend, resulting in a 15.0 percent increase in the total indicated annual rate.
In January 2004, the board of directors authorized a 10.0 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.10 per share and also authorized a 5 percent stock dividend payable June 15, 2004, maintaining the increased quarterly cash dividend on the new shares. This resulted in a 16.1 percent increase in the total indicated annual rate. In 2003, the indicated annual rate rose 10.8 percent.
Total assets increased 3.9 percent, or $598 million, to $16.107 billion at year-end 2004. The increase primarily reflected:
• $215 million increase in cash due to strong cash flow in 2004.
• $59 million increase in premiums receivables and $28 million increase in deferred policy acquisition costs due to the higher premium volume.
The market value of the company’s investment portfolio was $12.639 billion and $12.449 billion at year-end 2004 and 2003, respectively.
Insurance regulatory and statutory requirements designed to protect policyholders from investment risk influence the company’s investment decisions on an individual insurance company basis. Cash generated from insurance operations is invested almost entirely in five classes of assets evaluated for yield and risk prior to purchase (see Item 1, Investments Segment, Page 13, for a discussion of the five classes of assets). In 2004, the company temporarily changed the allocation of new property casualty portfolio investments to reduce the ratio of common stock to statutory surplus. The property casualty portfolio maintained that ratio below 100 percent throughout the 1990s (see Item 1, Financial Strength Ratings, Page 7, for additional information). The ratio of common stock to statutory surplus for the property casualty insurance group portfolio was 103.5 percent at year-end 2004 compared with 114.7 percent at year-end 2003.
On August 26, 2004, the company announced it transferred approximately 31.8 million shares of Fifth Third common stock to The Cincinnati Insurance Company, Cincinnati Financial Corporation’s insurance subsidiary, from the parent company. This action was related to the June 28, 2004, application to the SEC seeking exemptive relief under the Investment Company Act of 1940 (see Item 1, Regulation, Page 15, for more detail regarding the holding company’s status under the Investment Company Act). The transfer was authorized by Cincinnati Financial’s board of directors on August 13, 2004, and approved by the Ohio Department of Insurance on August 24, 2004.
At December 31, 2004, the company’s portfolio of fixed-income securities had a weighted average yield-to-book of 5.8 percent, a weighted average maturity of 9.4 years and a weighted average modified duration to maturity of 6.9 years. At December 31, 2003, the company’s portfolio of fixed-income securities had a weighted average yield-to-book value of 6.6 percent, a weighted average maturity of 9.5 years and a weighted average modified duration to maturity of 6.7 years. The decline in the yield-to-book was due to lower prevailing interest rates as well as the company’s’ focus on tax-exempt municipal bonds, which have a lower gross yield. The average maturity of the fixed-income portfolio declined slightly because of the company’s focus on the intermediate portion of the yield curve and the purchase of approximately $100 million in short-term bonds to fund estimated construction payments for the headquarters expansion.
The average duration to maturity increased slightly as lower coupon levels offset shorter maturities (see Item 1, Investments Segment, Page 13, for additional discussion of the fixed-income portfolio). Modified duration can be defined as the average maturity of all bond payments, where each payment is weighted by its value. In the fixed-income
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 15.7 percent and 16.1 percent, respectively, of book value and market value of the overall fixed-income portfolio at December 31, 2004, compared with 16.7 percent and 17.1 percent of book value and market value at December 31, 2003. Approximately 85.3 percent of the market value of financials sector holdings were investment-grade corporate bonds at year-end 2004 compared with 82.2 percent at year-end 2003. No other industry accounts for more than 10 percent of the fixed-income portfolio.
Due to the company’s participation in USAIG for policy years 2001 and prior, The Cincinnati Insurance Company was named as the designated insurer for American Airlines’ policy year 2000 business. Reinsurance recoverables resulting from all American Airlines accidents during that year were recorded on The Cincinnati Insurance Companies’ 2001 financial statements. Management expects to recover 100 percent of the reinsurance recoverables associated with the USAIG participation although it is impossible to estimate the timeframe for recovery due to the complex nature of aviation and aerospace insurance. More than 99 percent of the reinsurance recoverables associated with USAIG are backed by securities on deposit. The company no longer participates in new business generated by USAIG and its members.
Total liabilities increased 5.9 percent, or $553 million, to $9.858 billion at December 31, 2004 from $9.305 billion at December 31, 2003. The increase primarily reflected:
Offsetting the increases were a $183 million decline in notes payable and a $115 million decline in deferred income tax liability, primarily reflecting lower unrealized gains in the investment portfolio.
The outside actuary’s range for adequate statutory reserves, net of reinsurance, was $2.794 billion to $3.032 billion for 2004; $2.696 billion to $2.906 billion for 2003; and $2.492 billion to $2.674 billion for 2002. The assumptions used to establish the recommended ranges were consistent with the actuary’s practices. Historically, the company has established reserves in the upper half of the actuary’s range, as discussed in Critical Accounting Policies, Loss and Loss Expense Reserves, Page 25.
In addition to management’s conclusions regarding adequate reserve levels, other factors that have affected reserve levels over the past three years included:
In 2003 and 2004, $70 million in reserves were released following the November 2003 Ohio Supreme Court’s limiting of its 1999 Scott-Pontzer v. Liberty Mutual decision. The reserve releases were primarily made in the commercial auto and other liability business lines. As background, the Ohio Supreme Court’s 1999 decision in Scott-Pontzer greatly increased the exposure on commercial auto insurance policies. That ruling extended Ohio businesses’ uninsured motorist/underinsured motorist coverage in force over the preceding 15 years to their employees when they were not working and to the employees’ resident family members. It contributed to changes in policy wording for UM/UIM coverage. Additionally, the same court’s 2000 decision in Linko v. Indemnity effectively caused insurers to extend UM/UIM coverage, at the newly increased level of exposure, to every auto insurance policy in Ohio at no additional premium. The two court rulings affected all auto insurers in the state. Between 1999 and December 2003, the company had established case and IBNR reserves for past UM/UIM losses on the basis of the 1999 and 2000 decisions. 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.
Following the fourth-quarter 2003 reserve review, reserve levels were modified to reflect management’s assessment that mold claims behaved similar to asbestos and environmental claims, and reserves for these claims should be estimated using similar methods. These changes have been seen predominately in the commercial multi-peril business line. Management expects that mold exclusions added to the company’s commercial policies beginning in 2003 will mitigate this issue after 2006.
Further, beginning in 2003, reserve levels reflected the need to establish higher expense reserves because of the rise in litigation costs due to larger and more complex claims. These changes have been seen predominately in commercial multi-peril and other liability business lines.
Also in 2002, management increased IBNR reserves because of higher than expected paid and/or reported development in workers compensation, commercial multi-peril and other liability business lines for accident years 1999 through 2001.
Management believes that the company’s asbestos and environment reserves, including mold 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.
Commercial accounts generally were written by the company after the development of coverage forms that exclude asbestos cleanup costs. The company believes its exposure to risks associated with past production and/or installation of asbestos materials is minimal because the company was primarily a personal lines company when most of the asbestos exposure occurred. The commercial coverage the company did offer was predominantly related to local-market construction activity rather than asbestos manufacturing. Further, over the past three years, to limit its exposure to mold and other environmental risks going forward, the company has revised policy terms where permitted by state regulation.
For the business lines in the commercial lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves:
As a result of underwriting actions taken since 2000 and a generally favorable insurance marketplace, the commercial lines segment has been able to obtain higher premium per exposure. As a result, profitability has improved due to higher revenue on stable loss and loss expenses.
The following table provides the amounts of net reserve changes made over the past three years by commercial line of business and accident year:
• The initiative, begun in 2001, to establish higher initial case reserves on liability claims in the period in which the claim is reported.
• Differences in the timing of actual settlements compared with the payout patterns assumed in the accident year IBNR reductions
The company regularly reviews its life insurance business to ensure that any deferred acquisition cost associated with the business is recoverable and that its actuarial liabilities (life insurance segment reserves) make sufficient provision for future benefits and related expenses. In 2004, deferred acquisition costs were written-off and reserves were
At December 31, 2004, long-term debt was $791 million compared with $420 million at December 31, 2003.
The company issued $375 million aggregate principal amount of 6.125% senior notes due 2034 on November 1, 2004. The $368 million net proceeds from the offering:
• Paid off $183 million in short-term debt. A portion of the short-term debt was paid prior to the senior note offering using funds borrowed from the property casualty subsidiary. Proceeds from the offering were used to pay-off that inter-company loan in addition to paying off the outstanding balance on the lines of credit.
The company had no off-balance sheet arrangements (defined for purposes of applicable SEC rules) at year-end 2004.
Management anticipates investing approximately $15 million in key technology initiatives in 2005, primarily for its claims management and commercial lines policy processing systems (see Item 1, Property Casualty Insurance Operations, Page 1, for discussion of the technology initiatives underway). Capitalized development costs related to key technology initiatives totaled $14 million in 2004. These activities are conducted at management’s discretion and no material contractual obligations exist for activities planned as part of these projects. In addition, material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations, are expected to require approximately $13 million over the next five years.
At December 31, 2004, the company estimated its future contractual obligations as follows:
Management believes that the insurance subsidiaries maintain sufficient liquidity to pay claims and operating expenses, as well as meet commitments in the event of unforeseen circumstances such as catastrophe losses, reinsurer insolvencies, changes in the timing of claims payments, increases in claims severity, reserve deficiencies or inadequate premium rates. Management believes catastrophic events are the most likely cause of an unexpected rise in claims severity or frequency.
performance of loss payment patterns is a reasonable source for projecting future claims payments, there is inherent uncertainty in this estimate of contractual obligations. Management believes that it could meet its obligations under a significant and unexpected change in the timing of these payments because of the liquidity of the company’s invested assets, strong financial position and access to lines of credit.
The accompanying consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2004, were prepared by management in conformity with accounting principles generally accepted in the United States of America (GAAP).
The board of directors has established an audit committee composed of independent outside directors who are believed to be free from any relationship that could interfere with the exercise of independent judgment as audit committee members.
The audit committee meets periodically with management, the independent registered public accounting firms and the internal auditors to make inquiries as to the manner in which the responsibilities of each are being discharged and reports thereon to the board of directors. In addition, the audit committee recommends to the board of directors the annual appointment of the independent registered public accounting firms with whom the audit committee reviews the scope of the audit assignment, adequacy of internal controls and internal audit procedures.
The company’s management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2004, as required by Section 404 of the Sarbanes Oxley Act of 2002. Management’s assessment is based on the criteria established in the Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and was designed to provide reasonable assurance that the company maintained effective internal control over financial reporting as of December 31, 2004. The assessment led management to conclude that, as of December 31, 2004, the company’s internal control over financial reporting is effective based on those criteria.
The company’s independent registered public accounting firm has issued an attestation report on our internal control over financial reporting as of December 31, 2004, and the company’s management assessment of our internal control over financial reporting. This report appears below.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States. A company’s internal control over financial reporting includes those policies and procedures that: (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the company as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein. Also, in our opinion, management’s assessment that the company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, the company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
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.
Billings are based on a fee structure calculated upon the market values of the assets at the end of the period. Revenues are recognized as fees are earned. As of December 31, 2004, CinFin Capital had 60 institutional, corporate and individual clients and $827 million under management, compared with 53 clients and $762 million at December 31, 2003.
Other-than-temporary declines in the fair value of investments are recognized in net income as realized investment losses at the time when facts and circumstances indicate such write-downs are warranted.
Property and equipment is recorded at cost less accumulated depreciation. The company provides depreciation based on estimated useful lives (ranging from three years to 39 1/2 years) using straight-line and accelerated methods. Depreciation expense recorded in 2004, 2003 and 2002 was $30 million, $31 million and $28 million, respectively. The company reviews property and equipment for impairment whenever events or changes in circumstances, such as significant decreases in market values of assets, changes in legal factors or in the business climate, an accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset, or other such factors indicate that the carrying amount may not be recoverable.
The company capitalizes costs related to computer software developed internally during the application development stage of software development projects. These costs generally consist of certain external, payroll and payroll-related costs. During 2000, the company wrote off $39 million of previously capitalized costs related to the development of next-generation software to process property casualty policies. The write-off was included in other operating expenses in 2000. Management conducted a review of the project, including an assessment by an independent firm, and determined, after several deliverable dates were missed, that the project design would not perform as originally intended. The decision required that the application software under development be abandoned and a new application purchased. As a result of a settlement negotiated with a vendor, 2003 pretax results included the recovery of $23 million of the $39 million charge.
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 company issues life contracts with guaranteed minimum returns, referred to as bank-owned life insurance policies (BOLIs). Based on the specific contract provisions, the assets and liabilities for some BOLIs are legally segregated and recorded as assets and liabilities of the separate accounts. Other BOLIs are included in the general account. For separate account BOLIs, minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders.
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, 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. A percentage of each separate account’s realized gain and loss representing contract fees and assessments 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.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 123(R), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25. Among other items, SFAS No. 123(R) eliminates the use of APB Opinion No. 25 and the intrinsic value method of accounting and requires companies to recognize the cost of associate services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. The effective date of SFAS No. 123(R) is the first reporting period beginning after June 15, 2005, which is the third quarter of 2005 for calendar year companies, although early adoption is allowed.
Certain prior-year amounts have been reclassified to conform with current-year classifications.
The following table provides the unrealized losses and fair values, by investment category and by length of time the individual securities have been in a continuous unrealized loss position:
Acquisition costs incurred and capitalized during 2004, 2003 and 2002 amounted to $657 million, $615 million and $576 million, respectively. Amortization of deferred acquisition costs was $629 million in 2004, including a $3 million adjustment related to unrealized gains on investments, $586 million, including a $13 million adjustment related to unrealized gains on investments, for 2003, and $519 million for 2002, respectively.
Activity in the reserve for loss and loss expenses is summarized as follows:
Following the Ohio Supreme Court’s late 2003 decision to limit its 1999 Scott-Pontzer v. Liberty Mutual decision, the company released $38 million pretax of previously established uninsured/under-insured motorist (UM/UIM) reserves in 2003. In 2004, the company reviewed outstanding UM/UIM claims for which litigation was pending. Those claims represented approximately $37 million in previously established case reserves. During the first quarter of 2004, the company filed motions for dismissal in various jurisdictions for specific claims and released an additional $32 million in related case reserves. Following the release of those reserves, the company stopped separately reporting on UM/UIM related reserve actions.
Life policy reserves have been calculated using the account value basis for universal life and annuity policies and modifications of the 1975-80 select and ultimate table for traditional policies. Life policy reserves are summarized as follows:
The company and subsidiaries had no compensating balance requirement on debt for either 2004 or 2003. The company had two lines of credit with commercial banks amounting to $250 million in 2003, of which $183 million was in use at December 31, 2003. During 2004, the company paid off these two lines of credit. Interest rates charged on borrowings during 2004 ranged from 1.53 percent to 6.19 percent, which resulted in an average interest rate of 2.76 percent. The company had one line of credit with a commercial bank amounting to $75 million with no outstanding balances at year-end 2004.
The company issued $420 million aggregate principal amount of 6.9% senior debentures due 2028 in 1998. The company issued $375 million aggregate principal amount of 6.125% senior notes due 2034 in 2004. At December 31, 2004 and 2003, the fair value of the senior debt approximated $843 million and $458 million, respectively.
CFC’s insurance subsidiary declared dividends to the company of $175 million in 2004, $50 million in 2003, and $100 million in 2002. Dividends paid by insurance subsidiaries are restricted by regulatory requirements of the insurance subsidiaries’ domiciliary state. Generally, the maximum dividend that may be paid without prior regulatory approval is limited to the greater of 10 percent of statutory surplus or 100 percent of statutory net income for the prior calendar year, up to the amount of statutory unassigned surplus as of the end of the prior calendar year. Dividends exceeding these limitations may be paid only with approval of the insurance department of the subsidiary’s domiciliary state. During 2005, the total dividends that may be paid to the company without regulatory approval will be approximately $588 million.
The change in unrealized gains and losses on investments and derivatives included:
Significant components of the company’s net deferred tax liability are as follows:
The provision for federal income taxes is based upon a consolidated income tax return for the company and subsidiaries. As of December 31, 2004, the company has capital loss carry forwards of $56 million that expire in 2008 and 2009. 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.
For the company, dilutive potential common shares consist of outstanding stock options. The computations of basic and diluted earnings per share are as follows:
The company and subsidiaries sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension plan covering substantially all employees. The company does not contribute to the defined contribution plan. 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 components of the net periodic benefit cost are as follows:
The company’s target asset allocation of its pension plan for 2005 is 90 percent equity securities and 10 percent fixed maturities and cash.
Various litigation and claims against the company and its subsidiaries resulting from normal insurance and non-insurance activities are in process and pending. Based upon a review of open matters with legal counsel, management believes that the outcomes of normal insurance matters will not have a material effect upon the company’s consolidated financial position or results of operations and the outcomes of non-insurance matters will be covered by external insurance coverage or will not have a material effect upon the company’s consolidated financial position or results of operations.
On June 28, 2004, Cincinnati Financial Corporation filed an application with the SEC formally requesting an exemption for the holding company under Section 3(b)(2) of the Investment Company Act, which permits the SEC to exempt entities primarily engaged in business other than that of investing, reinvesting, owning, holding or trading in securities.
On August 26, 2004, the company announced that Cincinnati Financial Corporation transferred approximately 31.8 million shares of Fifth Third Bancorp common stock to The Cincinnati Insurance Company to address its status under the Investment Company Act. The 31.8 million shares had a market value of $1.600 billion on August 26, 2004. The transfer was authorized by Cincinnati Financial’s board of directors on August 13, 2004, and approved by the Ohio Department of Insurance on August 24, 2004. After the contribution, the ratio of investment securities held at the holding company level was 36.3 percent of total holding-company-only assets at December 31, 2004.
Registered investment companies are not permitted to operate their business in the manner in which Cincinnati Financial is operated, nor are registered investment companies permitted to have many of the relationships that the parent company has with its affiliated companies. If it were to be determined that the parent company was an unregistered investment company before the transfer of equity securities in August 2004, Cincinnati Financial may be unable to enforce contracts with third parties, and third parties could seek to obtain rescission of transactions with Cincinnati Financial undertaken during the period that it was an unregistered investment company, subject to equitable considerations set forth in the Investment Company Act. As a result, it could be determined that holders of Cincinnati Financial’s $420 million aggregate principal amount of 6.9% Senior Debentures due 2028 have a right to rescind such indebtedness, thereby requiring Cincinnati Financial to immediately repay such amounts. Cincinnati Financial may be unable to refinance such obligations on acceptable terms as a result of its potential status under the Investment Company Act. However, Cincinnati Financial currently has available sufficient assets to fund such repayment and believes that its assets are adequate to meet its short- and long-term obligations.
Operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding investment activities) and other income of the insurance subsidiaries are reported as Other.
• Revenue for all three insurance segments is insurance premiums earned. Life insurance segment revenue also includes fees from separate account investment management fees.
• Investment operations segment revenue is pretax net investment income plus realized investment gains and losses
Income (loss) before income taxes for each segment is based on the nature of that business area’s operations:
o Commercial lines and personal lines insurance segments - underwriting income (loss) is premiums earned minus loss and loss expenses incurred or policyholder benefits and underwriting expenses
o Life insurance segment - underwriting income (loss) is premiums earned and separate account investment management fees, less contract holder benefits incurred and expenses incurred, plus investment interest credited to contract holders
Identifiable assets by segment are those assets used in the respective segment’s operations. Identifiable assets are not separately reported for two reportable segments - commercial lines and personal lines of property casualty insurance - because company management does not use this measure to analyze those segments. All fixed maturity and equity security investment assets, regardless of ownership, are included in the investment operations segment.