The selected financial information above allows for a more complete analysis of results of operations and should not be considered a substitute for any GAAP measure of performance.
As more fully discussed in the company’s Form 10-K for 2002, 2001 statutory data for the property casualty subsidiaries reflects the company’s adoption of Codification effective January 1, 2001. Codification of Statutory Accounting Principles required recognition of net written premiums on the basis of the policy contract term rather than the policy billing period. For comparison purposes, a $402 million one-time net written premium adjustment required to conform with Codification was excluded from 2001 data, and 2000 statutory data was reclassified; information was not readily available to reclassify earlier years’ statutory data presented above.
The following discussion highlights significant factors influencing the consolidated results of operations and financial position of Cincinnati Financial Corporation (CFC). It should be read in conjunction with the consolidated financial statements and related notes beginning on Page 52 and the 11-year summary of selected financial information on Pages 14 and 15.
In response to recent legislation and proposed regulations, management reviewed its internal control structure and its disclosure controls and procedures. While management believes the pre-existing disclosure controls and procedures were adequate to enable the company to comply with its disclosure obligations, management implemented minor changes as a result of such review, primarily to formalize and document procedures already in place. The company also established a disclosure committee that consists of certain members of the company’s senior management.
Cincinnati Financial Corporation’s financial statements are prepared using GAAP. These principles require management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates.
The significant accounting policies used in the preparation of the financial statements are discussed in Note 1 to the Consolidated Financial Statements, Page 58 In conjunction with that discussion, the following reviews the estimates and assumptions used to develop reported amounts related to the most significant policies. Management discusses the development and selection of these accounting estimates with the audit committee of the board of directors and the audit committee has reviewed the company’s disclosure relating to it in this Management’s Discussion and Analysis.
As discussed in the Note 4 to the Consolidated Financial Statements, Page 64, management establishes the company’s liabilities for insurance reserves, including adjustments of estimates, based upon company experience and information from internal analysis. Though uncertainty always exists as to the adequacy of established reserves, management believes this uncertainty is mitigated by the historic stability of the company’s book of business. Such reserves are related to various lines of business and will be paid out over future periods. The company monitors trends in the industry, relevant court cases, current legislative activity and other current events in an effort to ascertain new or additional exposures to loss. Insurance loss reserves are affected directly by management’s reserving philosophy.
The outside actuary’s range for adequate reserves, net of reinsurance, was $2,492 million to $2,674 million for 2002 and $2,267 million to $2,429 million for 2001. The assumptions used to establish the recommended range for 2002 were consistent with prior year practices as described below and in Item 1, Property Casualty Losses and Loss Expense Reserves, Page 5. In addition, the outside actuary undertook additional tests to reflect a change in the initial case reserving procedures by the headquarters claims staff. The decision to establish higher initial case reserves reflected the trend toward rising loss severity, an industry-wide phenomenon.
Open claim counts for the long-tail asbestos and environmental losses ranged from 400 to 600 for all three years, or less than 1 percent of the total open claim count in each of the three years.
Losses and loss expenses incurred for all asbestos and environmental claims were $20 million, or 1.2 percent total losses and loss expenses, in 2002, compared with $7 million, or 0.4 percent, in 2001, and $19 million, or 1.2 percent, in 2000.
Reserves for all asbestos and environmental claims were $71 million, or 2.7 percent of total reserves, in 2002, compared with $63 million, or 2.7 percent, in 2001 and $62 million, or 2.9 percent, in 2000.
To help mitigate the risk of these highly uncertain exposures, the company maintains reinsurance treaties as described below.
The company limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure by reinsuring these risks (ceding) with other insurers or reinsurers. The company’s property casualty risk retention program is affected by various factors, which include, but are not limited to, the changes in the company’s underwriting practices, the capacity to retain risks and reinsurance market conditions.
The company has property casualty working reinsurance treaties and a property casualty catastrophe reinsurance treaty for 2003 through reinsurers that have written the company’s treaties for more than 10 years.
To protect against single large losses, the company purchases property casualty working reinsurance treaties. For 2003:
The property working treaty ceded premiums are estimated to be $24 million compared with $25 million in 2002 and $16 million in 2001, net of a one-time ceding commission. In 2003, the company will retain the first $2 million of each loss, as it has for several years. It will retain 40 percent of the next $3 million of the loss, up from 20 percent in 2002 while there was no retention on that layer in 2001. Losses in excess of $5 million are reinsured at 100 percent up to $25 million. Terrorism losses greater than $5 million are reinsured at 80 percent, unchanged from 2002, compared with 100 percent coverage in 2001.
Reserves for traditional life insurance policies are based on expected expenses, mortality, withdrawal rates and investment yields, including a provision for adverse deviation. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. Expected mortality is derived primarily from industry experience. Withdrawal rates are based on company and industry experience, while investment yield is based on company experience and the economic conditions then in effect.
The company establishes a deferred asset for costs that vary with and are primarily related to acquiring property casualty and life business, principally agent’s commissions, premium taxes, and certain underwriting costs, which are deferred and amortized into income.
Underlying assumptions are periodically updated to reflect actual experience and changes in the amounts of timing or estimated future profits will results in adjustments in the accumulated amortization of these costs. Management does not believe that future changes in assumptions would have a material affect on the company.
The company issues life contracts with guaranteed minimum returns, referred to as bank-owned life insurance policies (BOLI), the assets and liabilities of which are legally segregated and recorded as assets and liabilities of the separate accounts. Minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders.
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.
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. 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.
The company’s investment committee and asset impairment committee continually monitor investments and other assets for signs of impairment. Among other signs, the committees monitor significant decreases in the market value of the assets, changes in legal factors or in the business climate, an accumulation of costs in excess of the amount originally expected to acquire or construct an asset, or other factors such as bankruptcy, deterioration of creditworthiness, failure to pay interest or dividends or signs indicating that the carrying amount may not be recoverable.
Declines in the market value of assets are categorized as follows:
Temporary declines - Temporary declines are ordinary fluctuations in the value of a security when considered in the context of overall economic and market conditions. Securities considered to have a temporary decline would be expected to recover their market value. Similar to market value gains, temporary declines (changes in the fair value of these securities) are reported on the company’s balance sheet in other comprehensive income, net of tax, and have no impact on net income.
Other-than-temporary impairments - Other-than-temporary impairment charges indicate a decline in valuation - often 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 - which meets specific criteria established by the asset impairment committee. These objective measures include a declining trend in market value, the extent of the market value decline and the length of time over which the value 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. Impairment charges are classified as other-than-temporary if, in management’s judgment,
there is little expectation that the value will be recouped in the foreseeable future. A security trading below 70 percent of book value or with a Moody’s Investors Service or Standard & Poor’s credit rating below B3/B- is defined by the company as distressed and monitored as potentially impaired. The security may be written down in the event of a declining market value for four consecutive quarters with quarter-end market value below 50 percent of book value or when a security’s market value is 50 percent below book value for three consecutive quarters. A sudden and severe drop in market value that does not otherwise meet the above criteria is reviewed for possible immediate impairment. Not withstanding the above, the company’s portfolio managers constantly monitor the status of their assigned portfolios for indications of potential problems or issues that may be possible impairment issues. If a significant impairment indicator is noted, the portfolio managers more closely scrutinize the security.
During 2002, the company recognized $98 million, or 0.9 percent of total invested assets, of other-than-temporary impairment charges, including $16 million from four convertible securities and $82 million from 26 fixed-income securities. During 2001, the company recognized $45 million, or 0.4 percent of total invested assets, of other-than-temporary impairment charges, $8 million from two convertible securities and $37 million from 12 fixed-income securities. Other-than-temporary impairment charges had no influence on 2000 results. Further, $4 million, or less than 0.1 percent of total invested assets, was deemed permanently impaired and written off in 2002 and $18 million, or 0.2 percent of total invested assets, was written off in 2001. See Results of Operation, Page 24, for a detailed discussion.
Based on comparison of market value to book value data as of year-end 2002, 59 securities with a book value of $231 million, or 2.0 percent of total invested assets, were being monitored due to the presence of impairment indicators. Management believes it is unlikely that it would be required to impair the entire value of these securities; however, in those circumstances the impact of impairment on the company’s book value and surplus would be minimal. See Quantitative and Qualitative Disclosures about Market Risk, Page 46, for a detailed discussion of potential other-than-temporary impairment charges.
assumptions constant, a half of one percent increase or decrease in the discount rate would have increased or decreased annual 2002 income before income taxes by $1 million. Likewise, a half of one percent increase or decrease in the expected return on plan assets would have increased or decreased annual 2002 income before income taxes by $800,000.
In addition, the estimated accumulated benefit obligation (ABO) related to the defined benefit pension plan exceeded the fair value of the plan assets at December 31, 2002. This was due primarily to negative returns on the pension funds as a result of the overall decline in the equity markets and a decline in the discount rate used to estimate the pension liability as a result of declining interest rates in the United States. Market conditions and interest rates significantly impact future assets and liabilities of the pension plan. An additional liability might be required in the future, with the potential for a charge to equity to the extent the minimum liability exceeds unrecognized prior service cost upon measurement of plan obligations, which is usually completed by the company at the end of each year.
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.
FASB Interpretation 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” became effective December 15, 2002. This interpretation elaborates on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. Management has determined that this interpretation will have no effect on the company’s consolidated financial statements.
Property casualty statutory written premium growth of 19.4 percent in 2002, or 14.0 percent excluding the premium estimate adjustment, and 13.1 percent in 2001 compared with estimated industry growth of 14.2 percent and 8.1 percent in 2002 and 2001, respectively. 2002 property casualty written premiums benefited from a premium estimate adjustment, which added $2 million after tax, or 1 cent per share, to net income. The premium estimate adjustment reflected further refinement of the company’s estimation process for matching written and earned premiums to policy effective dates. It added $117 million to written premiums, $15 million to earned premiums and $3 million to pre-tax GAAP underwriting profits.
Net income rose 23.3 percent in 2002 and 63.3 percent in 2001 after declining 53.5 percent in 2000. To evaluate the success of pricing, rate and underwriting strategies, management evaluates the trend in net income before realized investment gains and losses, which rose 43.2 percent in 2002 and 74.6 percent in 2001 after declining 52.9 percent in 2000. The difference between net income and net income before realized investment gains and losses is the inclusion of realized investment gains and losses, the timing of which the company has some measure of control due to unrealized gains in the portfolio. 2001 growth rates for net income and net income before realized investment gains and losses are calculated excluding a one-time charge of $25 million (after-tax) recorded in 2000 to expense impaired assets related to development of next-generation software to process property casualty policies. For comparison purposes, all data discussed below excludes the charge, unless otherwise indicated.
Book value was $34.65 at year-end 2002, down from $37.07 at year-end 2001 and the all-time high of $37.26 at year-end 2000. Overall between year-end 2002 and year-end 2000, the company’s common stock portfolio outperformed the overall market, declining 3.4 percent compared with a 17.1 percent decline for the Standard & Poor’s (S&P) 500 Index.
98.4 percent statutory combined ratio in 2002, compared with the estimated industry statutory combined ratio of 105.7 percent and improved from a statutory combined ratio of 103.6 percent in 2001 and 109.9 percent in 2000 (103.9 percent excluding the UM/UIM reserve addition). The estimated statutory combined ratio for the industry was 116.0 percent in 2001 and 110.1 percent in 2000. Statutory ratios are used for comparison since GAAP-based industry data is not readily available.
$18 million of statutory underwriting loss in 2002 compared with underwriting losses of $108 million in 2001 and $210 million in 2000. The underwriting results for 2000 included a $110 million pre-tax addition to reserves, net of reinsurance, for an estimate of past UM/UIM losses incurred but not yet reported (IBNR) resulting from two Ohio Supreme Court decisions that affected all insurers in the state.
In May 2002, Fitch announced an initial rating of AA (very strong) with a stable outlook based on the company’s strong financial condition and excellent financial flexibility. Fitch commented that the property casualty operation is defined by strong profitability, which is derived in part by above-average premium growth relative to its peers and strong capitalization at the operating level. The rating also considers the company’s significant investment concentration in common stocks.
In November 2002, A.M. Best affirmed its top A++ (superior) financial strength ratings and stable outlook for the company’s property casualty group and subsidiaries. Best cited the company’s superior capitalization, sustained profitability and benefits from its long-standing independent agency strategy. A.M. Best said these strengths are somewhat offset by the company’s high investment leverage, continued stockholder dividends and modest surplus growth caused by the recent decline in the equity markets and operating returns that are below the company’s historical average.
Commercial lines earned premiums rose 18.6 percent in 2002, or 17.6 percent excluding the premium estimate adjustment described above, compared with 17.9 percent in 2001 and 13.2 percent in 2000. Statutory written premiums for commercial lines of insurance grew 22.8 percent in 2002, or 15.8 percent excluding the premium estimate adjustment, compared with the estimated industry average of 17.9 percent. The primary source of growth in the past two years has been firmer pricing on new and renewal commercial business, more then offsetting deliberate decisions to not write or non-renew certain business. In 2001, the company’s commercial lines statutory written premiums grew 16.6 percent compared with an estimated industry average of 8.1 percent.
Commercial lines premium growth in states in which the company has had a presence for more than five years was 16.0 percent in 2002 compared with 22.9 percent in 2001, reflecting the continued opportunities available to the company. Expansion states, where the company has operated for five or fewer years, also were a factor in overall growth, with agency direct premiums of $49 million in 2002 compared with $32 million in 2001 and $14 million in 2000. Over the past five years, the company began marketing commercial lines insurance in Idaho, Montana, upstate New York, North Dakota and Utah.
The company has tightened underwriting of new and renewal business, writing new business on a case-by-case basis and offering one-year policies where competition or reinsurance arrangements makes multi-year policies impractical. Over the past three years, the growth rate for individual business lines within the commercial lines segment has shown the company’s emphasis on obtaining adequate pricing for the covered risk:
Commercial auto - Earned premiums grew 19.8 percent, 20.9 percent and 15.9 percent in 2002, 2001 and 2000, respectively. The growth rate in commercial auto earned premiums in 2002 was due to price increases as the number of policies remained stable.
In total, commercial multi-peril, workers compensation, commercial auto and other liability accounted for 90.5 percent of total commercial lines earned premium in 2002 versus 91.5 percent in 2001 and 92.7 percent in 2000.
While no immediate effects are anticipated, the company reached certain milestones in 2002 related to Web-based technology projects that make it easier for agents to place business with the company. Agencies and field representatives in four states now are using the company’s new commercial policy quoting systems with six additional states planned for 2003.
The commercial lines combined ratio was 96.6 percent in 2002, an improvement from 101.7 percent in 2001 and 115.2 percent in 2000 (106.8 percent when the UM/UIM reserve is excluded). Catastrophe losses contributed 2.3 percent, 1.9 percent and 1.5 percent to the commercial lines losses and loss expenses and combined ratios in 2002, 2001 and 2000, respectively.
The losses and loss expenses ratio for commercial lines was 70.3 percent in 2002, compared with 74.1 percent in 2001 and 84.1 percent in 2000 (75.7 percent when the reserve addition is excluded). Since 2000, improvement in commercial lines profitability has primarily been driven by pricing gains as policy count has been relatively flat over the three-year period. In addition, the company has focused on longer-term efforts to enhance profitability. These have included knowing what exposures it has for each risk and making sure it offers appropriate coverages and limits of insurance at appropriate prices. The company continues to develop new underwriting guidelines, to re-underwrite books of business with selected agencies and to change policy terms and conditions where necessary. In addition, the company continues to leverage its strong local presence. Field marketing representatives have been meeting with every agency to reaffirm agreements on the extent of frontline renewal underwriting to be performed by local agencies. Loss control, machinery and equipment and field claims representatives have been conducting on-site inspections, with field claims representatives preparing full risk reports on every account reporting a loss above $100,000 or on any risk of concern.
General liability task force - Nearing completion, this study is focusing on loss trends by classes of business, severity versus frequency and other metrics for casualty coverages. The objective is to determine why general liability results have not responded to the company’s other actions to improve profitability. Task force recommendations are expected in the first quarter of 2003.
In addition to the renewed focus on underwriting discussed above, a number of factors have affected profitability in the company’s four largest commercial lines of business:
Further, in 2002 the company rolled out a carefully positioned strategic change to its general liability coverage that revised the handling of policy aggregate limits while maintaining other marketing advantages and bringing the company’s policy forms in line with industry practices. Over the past year, this had the effect of reducing total general liability exposure although the policy count remained relatively unchanged. Looking ahead, this change will help the company better manage contractor-related losses without disrupting the relationships agents have with this important source of business in their communities.
Higher general liability base rates will be effective in most states during first nine months of 2003. This is expected to contribute to further improvement in the losses and loss expenses ratio in 2003.
Commercial auto - The losses and loss expenses ratio for commercial auto improved in 2002 and in 2001. The 2000 losses and loss expenses ratio reflects the $103 million IBNR reserve established for UM/UIM. These improvements reflected pricing changes made over the past two years and underwriting actions that addressed the rise in loss severity that began in 2000. Further, a task force studied loss patterns in this business line and recommended new or revised underwriting guidelines focusing on accurate classification and pricing. As part of the company’s overall emphasis on underwriting, risk information is being more closely scrutinized, generally resulting in higher pricing for renewal policyholders. 2002 performance also benefited from the salvage and subrogation reserve.
Commercial lines catastrophe losses, net of reinsurance and before taxes, were $40 million in 2002 compared with $28 million in 2001, which included $9 million for losses related to events of September 11, 2001. Reported direct losses accounted for less than fourth-tenths of a percent of the $9 million and arose from the company’s participation in an aircraft insurance pool and other reinsurance agreements. Commercial lines catastrophe losses were $18 million in 2000.
The expense ratio remained relatively stable over the past three years, excluding the one-time charge to expense software development assets in 2000, as the company maintained its level of investment in staff and in upgrades to technology and facilities. While management expects overall expenses to trend down, the commission expense ratio is expected to rise as workers compensation, which has a low commission rate, becomes a smaller percentage of total premiums.
In 2002, Cincinnati Financial, through The Cincinnati Insurance Company, participated in USAIG, a joint underwriting association of individual insurance companies that collectively function as a worldwide insurance market for all types of aviation and aerospace accounts. However, the company ceded its share of the main USAIG pool for policy year 2002, which resulted in a net financial impact equivalent to exiting the pool. Cincinnati Financial’s net participation share in the main USAIG pool was 10 percent for policy years 2001 and 2000.
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 the homeowner line 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 expenses 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 $7 million reserve for UM/UIM.
Over the last three years, the benefits of a personal auto re-underwriting program generally served to offset rising loss severity. The re-underwriting program reviewed and strengthened underwriting standards, required motor vehicle reports for many insured drivers and obtained commitments for selected agencies to provide the company with specific premium volume increases. Excluding salvage and subrogation reserve, the losses and loss expenses ratio for personal auto was relatively constant at 71.7 percent in 2002, compared with 69.2 percent in 2001 and 73.3 percent in 2000.
and to existing three-year policies as they come up for renewal. At the same time, the personal lines underwriters are focusing on insurance-to-value initiatives to verify the company is receiving the correct level of premium for the value of the insured risk. Significant earned premium increases are expected over the next three years as policies renew.
Changes in policy terms and conditions - The company has identified specific coverage areas for updating to increase its control over risk and pricing. For example, the company has capped the replacement cost coverage at 125 percent of the amount chosen by the policyholder to insure the home; previously, full replacement coverage without a maximum was standard for the company. For water damage, which represented 21 percent of losses in 2002 and 18 percent of losses in 2001, the company changed its coverage form to let policyholders choose and pay for the level of coverage they need. This endorsement began to roll out in September 2002 in three major personal lines states, Ohio, Michigan and Indiana, which accounted for 50.2 percent of 2002 homeowner earned premium.
Personal lines catastrophe losses, net of reinsurance and before taxes, were $47 million in 2002 compared with $36 million in 2001 and $32 million in 2000.
The company’s life insurance subsidiary reported 2002 statutory written premiums of $220 million, including a single $33 million general account BOLI policy, up from $102 million in 2001. In 2000, written premiums were $119 million, including a single $20 million separate account BOLI policy. Excluding BOLI premiums, written premiums rose 81.9 percent in 2002 compared with 3.0 percent in 2001 and 3.8 percent in 2000. Written premiums have been reclassified to exclude annuity deposits not involving life contingencies, which are not recognized as written premium under statutory rules. Total written premiums in 2002 included $85 million of annuities, compared with $10 million in 2001 and $7 million in 2000, as agents continued to market attractive annuity features including guaranteed interest and fixed income.
The advantages of the excellent cash flow have been somewhat offset by the effect of the weak economy on overall market conditions and the challenge of reinvesting proceeds from called or redeemed bonds at prevailing interest rates.
In 2002, 28 of the 46 common stocks in the portfolio raised their dividends, which should add approximately $12 million to gross investment earnings on an annualized basis. The 10 largest holdings in the equity portfolio accounted for approximately 90 percent of the increase in indicated annual dividends in 2002.
Airline - In 2002, management recorded other-than-temporary impairment charges for all unsecured airline-related bonds due to the overall outlook for that industry, even if they did not otherwise meet the impairment criteria. Secured notes, or those that have aircraft as collateral for the trust certificate, were not impaired except for the two carriers in bankruptcy proceedings (UAL Corporation/United Airlines and US Airways Group, Inc./US Airways). Management chose to record an other-than-temporary impairment for most of the secured notes of these two issuers due to their unique situation.
Cable - Market values in this industry have suffered in the past year in the wake of the Adelphia bankruptcy and subsequent concerns related to industry-wide liquidity.
In 2002, the company recorded $8 million, which included $5 million in gains from assets sold in the normal course of the company’s investing activities, compared with $11 million in gains in 2001 and $2 million in losses in 2000. The company’s investment operations buy and sell securities on an ongoing basis to help achieve its portfolio objectives. Securities sold at a loss typically reflected management’s opinion that the security fundamentally no longer meets the company’s investment expectations. This change in expectations forces management to consider deviating from its typical intent to hold to maturity. This may reflect a loss of confidence in 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. The decision to sell reflects management’s perception of a change in the underlying fundamentals of the company and preference to allocate those funds to investments that more closely meet the established parameters for long-term stability and growth. Sales of securities that had previously been impaired or distressed securities totaled $73 million in 2002 versus $66 million in 2001 and $124 million in 2000, with high-yield corporate bonds accounting for 35.7 percent, 42.4 percent and 54.5 percent of these sales in 2002, 2001 and 2000, respectively. As described in other-than-temporary impairments above, issues affecting the airline, telecommunication, utility/merchant energy/trading and cable industries were a primary factor in the decision to sell securities.
Operations of the parent company, CFC Investment Company and CinFin Capital Management Company, excluding investment activities, and other income of the insurance subsidiaries resulted in $14 million in revenues in 2002, up from $13 million in 2001 and $11 million in 2000. The losses before income taxes of $32 million, $35 million and $36 million recorded in 2002, 2001 and 2000, respectively, were primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.
Management anticipates that the effective tax rate will approximate 20 percent if the company achieves its performance objectives of an underwriting profit, growth in investment income and more normalized realized investment gains.
Common stock repurchases for treasury have continued at a steady pace over the last several years and occur whenever management believes that stock prices on the open market are favorable for such repurchases. At December 31, 2002, 6.8 million shares remain authorized for repurchase at any time in the future when market conditions permit.
During 2002, the life insurance company annuity sales, including premiums and deposit-type contract funds, were much higher than normal at $110 million compared with $38 million and $28 million in 2001 and 2000, respectively. The growth in annuity sales was attributable to the fixed rates and guaranteed income features that were attractive in 2002’s economic climate.
The market value of the company’s investments was $11.257 billion and $11.571 billion at year-end 2002 and 2001, respectively. These investments made up 80.1 percent of the company’s $14.059 billion in assets at year-end 2002 compared with 83.2 percent of the company’s $13.914 billion assets at year-end 2001.
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 types of assets evaluated prior to purchase based on yield and risk. The company invests primarily in publicly traded securities, classified as available for sale in the accompanying financial statements. The balance sheet reflects changes in the fair value of these securities as other comprehensive income, net of tax.
At year-end 2002 and 2001, investments totaling approximately $3.305 billion and $3.010 billion ($3.220 billion and $3.012 billion at amortized cost) of the company’s $11.257 billion and $11.571 billion investment portfolio related to fixed-income securities. At December 31, 2002, the company’s portfolio of fixed-income securities had a weighted average yield-to-book of 7.4 percent, a weighted average maturity of 10.6 years and a weighted average modified duration of 4.9 years. For the insurance companies’ purposes, strong emphasis has been placed on purchasing current income-producing securities.
See Note 2 to the Consolidated Financial Statements, Page 62, for information regarding the maturity of the company’s fixed-income portfolio. Credit ratings as of December 31, 2002, for the company investment portfolio, excluding common and preferred stocks and including $4 million in government treasuries and $72 million in convertible debentures, were:
Tax-exempt municipal bonds - At year-end 2002 and 2001, approximately $1.111 billion and $1.042 billion ($1.055 billion and $1.013 billion at amortized cost) of the investment portfolio were tax-exempt municipal bonds. The company has historically found municipal bonds attractive because earnings on these securities are exempt from federal taxes. Because of alternative minimum tax effects, however, the company uses a blend of tax-exempt and taxable fixed-maturity securities. The company traditionally has purchased municipal bonds focusing on essential services, such as schools, sewer, water or others. While no single municipal issuer accounts for more than 1.5 percent of the tax-exempt municipal bond portfolio, concentrations within individual states can be high. Holdings in the top five states - Indiana, Illinois, Missouri, Ohio and Texas - account for approximately 66 percent of the municipal portfolio.
Common stocks - Investments in common stocks have been made with an emphasis on securities with an annual dividend yield of 1.5 percent to 3.0 percent and a history of dividend increases. The company’s strategy in equity investments is to identify approximately 10 companies in which it can accumulate 5 percent to 10 percent of their common stock. While this emphasis on a small group of equities has resulted in significant concentrations within the portfolio, it also permits the company to closely monitor and often develop relationships with the management of issuing companies, gaining an in-depth understanding of their industry and outlook. As a long-term investor, the company has followed this buy-and-hold strategy for many years, resulting in significant accumulated unrealized appreciation within the equity portfolio.
The company’s portfolio of equity investments had an average dividend yield-to-cost of 9.1 percent at December 31, 2002.
The company has two lines of credit totaling $250 million at year-end 2002. There are two financial covenants for the company’s $175 million line of credit. First, consolidated net worth on the last day of each fiscal quarter shall not be less than $5.0 billion or $4.5 billion if such reduction in consolidated net worth is due solely to unrealized losses in the company’s portfolio of debt and equity investments; at year-end 2002, the company’s consolidated net worth was $5.598 billion. Second, the company’s consolidated ratio of indebtedness for borrowed money to net worth, at any time during each fiscal quarter, shall not exceed the ratio of 0.25-to-1.00; as of year-end 2002, the ratio of indebtedness to net worth was 0.11-to-1.00. The company’s $75 million line of credit has no financial covenants. Short-term interest rates will fluctuate. Every 100 basis point increase in short-term rates will increase interest expense by $2 million, before-tax, based on the $183 million outstanding on the two lines of credit at year-end 2002.
comprehensive income. The interest swap contract is reflected at fair value in the company’s balance sheet. The unrealized loss at December 31, 2002 was $4 million. The net effect of this transaction was to fix the interest cost on the short-term loan.
Insurers are rated on their financial strength and claims-paying ability to provide consumers with comparative information in the insurance industry. Among other factors, the ratings focus on items such as results of operations, capital resources and minimum policyholders’ surplus requirements as well as qualitative analysis.
While factors such as the company’s catastrophe exposures, investment philosophy and bias towards incremental change with an eye toward stability instead of quick fixes have the potential to introduce volatility, the ratings agencies have consistently asserted that the company has built appropriate financial strength to manage that volatility and seek higher long-term returns for shareholders.
While management believes its financial position is strong, the rating agencies could decide to change their ratings in the future. The following table summarizes the company’s current debt and financial strength ratings:
The Cincinnati Financial board believes that stock repurchases can help fulfill the company’s commitment to enhancing shareholder value. Consequently, the company’s board has authorized the repurchase of outstanding shares. At December 31, 2002, 6.8 million shares remained authorized for repurchase at any time in the future. The company has purchased 1.1 million shares at a cost of $42 million, 1.2 million shares at a cost of $46 million and 2.1 million shares at a cost of $67 million during the years ended December 31, 2002, 2001 and 2000, respectively. Shares repurchased total 14.1 million, at a total cost to the company of $465 million, since the inception of the share repurchase program in 1996.
Market risk is the potential for a decrease in value resulting from broad yet uncontrollable forces such as: inflation, economic growth, interest rates, world political conditions or other widespread unpredictable events. It is comprised of many individual risks that, when combined, create a macroeconomic impact. Some of the risks are:
Political risk - the potential for a decrease in market value due to the real or perceived impact of governmental policies or situations. In particular since the events of September 11, 2001, the market has been sensitive to issues related to terrorism, homeland security and related international issues, such as the potential for war.
Economic risk - the potential for a decrease in value due to changes in general economic factors (such as interest rates or a slowdown in the economy). Over the past two years, there have been heightened concerns due to the recession, continued sluggish economy, higher unemployment, low capital spending, weak consumer confidence and state budget deficits.
Company-specific risk is the potential for a particular issuer to experience a decline in valuation due to the impact of sector or market risk on the holding or because of issues specific to the firm.
Credit risk - the potential for deterioration in an issuer’s financial profile due to specific company issues, problems it faces in the course of its operations or industry-related issues.
Default risk - the possibility that an issuer will not make a required payment (interest payment or return of principal) on its debt. Generally this occurs after its financial profile has deteriorated (credit risk) and it no longer has the means to make its payments.
Sector risk is the potential for a negative impact on a particular industry due to its sensitivity to factors that make up market risk. General supply/demand factors for an industry will be affected by market risk and will affect companies within that industry to varying degrees.
For investment-grade corporate bonds, the inverse relationship between interest rates and bonds prices would lead to falling bond values during periods of increasing interest rates. Although the potential for a worsening financial structure, and ultimately default, does exist with investment-grade corporate bonds, their higher-quality financial profiles make credit risk less of a concern than for lower-quality investments. The company addresses this risk by consistently investing within a particular maturity range, which has, over the years, provided the portfolio with a laddered maturity schedule less subject to large swings in value due to interest-rate changes. While a single maturity range may see values drop due to general interest-rate levels, other maturity ranges will be less affected by those changes. Additionally, purchases are spread across a wide spectrum of industries and companies, diversifying the company’s holdings and minimizing the impact of specific industries or companies with greater sensitivities to interest-rate fluctuations.
The primary risk related to high-yield corporate bonds is credit risk or the potential for a deteriorating financial structure. A weak financial profile can lead to rating downgrades from the credit rating agencies, which can put further downward pressure on bond prices. This weakening financial picture can lead to an inability to pay corporate obligations and to default. Interest rate risk is less of a factor with high-yield corporate bonds, as valuation is related more directly to underlying operating performance than to general interest rates. This puts more emphasis on results achieved by the issuer rather than general economic trends or statistics within the marketplace. The company addresses this concern by focusing on issuer - and industry-specific financial analysis and ongoing monitoring of holdings within this asset class.
The primary risk related to tax-exempt bonds is interest-rate risk as well as geo-political risk associated with the specific economic environment within the political boundaries of the issuing municipal entity. The company addresses these concerns by focusing on municipalities’ general-obligation debt and on essential-service bonds. Essential-service bonds are key because they derive funds from services provided by the municipality, which are vital to the people living in the area (schools, water service, sewer service, etc.). This enhances the ongoing need (demand) for service and thus provides stability to the financial picture of the issuer. Another risk related to tax-exempt bonds is regulatory risk or the potential for legislative changes that would negate the benefit of owning tax-exempt bonds. The company monitors regulatory activity for situations that may negatively affect current holdings and its ongoing strategy for investing in these securities.
The company recently developed financial planning models to further incorporate analytical tools in assessing market risks. Management believes the models will improve the company’s ability to measure the impact on bond values resulting from changes in interest rates. Improving measurement of the impact of interest-rate changes should allow for improved matching of the company’s assets and liabilities.
Management’s decision to continue monitoring these 59 securities reflected its application of its asset impairment policy, which evaluates: significant decreases in the market value of the assets; changes in legal factors or in the business climate; or, other such factors indicating whether or not the carrying amount may be recoverable. Objective measures, such as a declining trend in market value, the extent of the market value decline and the length of time in which the value has been depressed, can be outweighed by subjective measures such as impending events and issuer liquidity. Impairment will be evaluated, however, in the event of a declining market value for four consecutive quarters with quarter-end market value below 50 percent of book value or a market value 50 percent below book value for three consecutive quarters.
Management deems the risk related to securities trading between 70 percent and 100 percent of book value to be relatively minor and at least partially offset by the earned income potential of these investments. At year-end 2002, impairment to market value of all 214 securities trading in this range would have resulted in only $80 million in additional realized investment losses, before tax. In 2002, securities trading between 70 percent and 100 percent of book value, which represented 7.3 percent of the total market value of the portfolio, generated $63 million, or 14.2 percent, of total earned income.
Management believes the outlook for the company’s results of operation and liquidity and capital resources is positive in 2003 and beyond for a number of reasons:
The accompanying financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2002 were prepared by management in conformity with accounting principles generally accepted in the United States of America.
The audit committee meets periodically with management, the independent auditors and the internal auditor 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 auditors with whom the audit committee reviews the scope of the audit assignment, adequacy of internal controls and internal audit procedures.
Deloitte & Touche LLP, independent auditors, have audited the financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2002, and their report is included herein. The auditors meet with members of the audit committee of the board of directors to discuss the results of their examination and are afforded the opportunity to present their opinions in the absence of management personnel with respect to the adequacy of internal controls and the quality of financial reporting of the company.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Cincinnati Financial Corporation and subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, 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.
NATURE OF OPERATIONS - Cincinnati Financial Corporation (company), through four insurance companies, markets insurance mainly through a network of local independent agents. Insurance products include fire, automobile, casualty, bonds and all related forms of property casualty insurance as well as life insurance, long-term care, disability income policies and annuities. In addition, the company has finance/leasing and asset management operations through the CFC Investment Company and CinFin Capital Management Company subsidiaries.
BASIS OF PRESENTATION - The consolidated financial statements include the accounts of the company and subsidiaries, each of which is wholly owned, and are presented in conformity with accounting principles generally accepted in the United States of America. All significant inter-company balances and transactions have been eliminated in consolidation.
PROPERTY CASUALTY INSURANCE - Expenses incurred in the issuance of policies are deferred and amortized over the terms of the policies. These expenses vary with and are primarily related to acquiring insurance business, principally agents’ commissions, premium taxes and certain underwriting costs. Anticipated investment income is not considered in determining if a premium deficiency related to insurance contracts exists. Policy premiums are deferred and earned on a pro rata basis over the terms of the policies. The portion of written premiums applicable to the unexpired terms of the policies is recorded as unearned premiums. Losses and loss expense reserves are based on claims reported prior to the end of the year and estimates of unreported claims, based upon facts in each claim and the company’s experience with similar claims. The establishment of appropriate reserves, including reserves for catastrophes, is an inherently uncertain process. Reserve estimates are regularly reviewed and updated, using the most current information available. Any resulting adjustments are reflected in current operations.
Reserves for universal life products are equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals. Interest rates on approximately $446 million and $344 million of such reserves at December 31, 2002 and 2001, respectively, are periodically adjusted subject to economic conditions then in effect and subject to contractually guaranteed minimum rates.
ASSET MANAGEMENT - As of December 31, 2002, CinFin Capital had 35 institutional, corporate and individual clients and $726 million under management, compared with 35 clients and $663 million at December 31, 2001. 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.
Investment income consists primarily of interest and dividends. Interest is recognized on an accrual basis and dividends are recorded at the ex-dividend date. The interest method is used for amortizing premium for discounts on fixed-maturity securities.
FAIR VALUE DISCLOSURES - Fair values for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) are based on either quoted market prices or data provided by an outside resource that supplies global securities pricing.
comprehensive income), respectively. Neither the adoption of SFAS No. 133 nor any subsequent changes in fair values of these instruments have had a significant impact on the accompanying consolidated financial statements.
PROPERTY AND EQUIPMENT - Property and equipment is recorded at cost less accumulated depreciation. The company provides depreciation based on estimated useful lives using straight-line and accelerated methods. Depreciation expense recorded in 2002, 2001 and 2000 was $22 million, $25 million and $18 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.
SEPARATE ACCOUNTS - The company issues life contracts with guaranteed minimum returns, referred to as bank-owned life insurance (BOLI) policies, the assets and liabilities of which are legally segregated and recorded as assets and liabilities of the separate accounts. Minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders.
EARNINGS PER SHARE - Net income per common share is based on the weighted average number of common shares outstanding during each of the respective years. The calculation of net income per common share (diluted) assumes the conversion of convertible senior debentures and the exercise of stock options.
At December 31, 2002, contractual maturity dates for investments in fixed-maturity securities were:
At December 31, 2002 and 2001, the fair value associated with the annuities shown above approximated $331 million and $213 million, respectively.
The company and subsidiaries had no compensating balance requirement on debt for either 2002 or 2001. The company had two lines of credit with commercial banks amounting to $250 million in 2002 (expiring in 2003) and $275 million in 2001, of which $183 million was in use at December 31, 2002 and 2001. Interest rates charged on such borrowings ranged from 1.78 percent to 6.11 percent during 2002, which resulted in an average interest rate of 3.01 percent. At December 31, 2002, the fair value of the notes payable approximated the carrying value and the weighted average interest rate approximated 2.63 percent.
The company entered an interest-rate swap agreement during 2001, which expires in seven years, to hedge future cash flows (thereby obtaining a fixed interest rate) related to certain variable rate debt obligations ($31 million notional amount). This swap is reflected at fair value in the accompanying balance sheet and the unrealized loss, net of tax, at December 31, 2002, of $2 million is a component of comprehensive income; the fair value was not significant at December 31, 2001. The company does not expect any significant amounts to be reclassified into earnings as a result of interest rate changes in the next 12 months.
The company issued $420 million of senior debentures due 2028 in 1998. The convertible senior debentures matured in 2002 and were convertible into shares of common stock at a conversion price of $14.88 per share (67.23 shares for each one thousand dollars principal). At December 31, 2002 and 2001, the fair value of the debentures approximated $429 million and $415 million, respectively.
The insurance subsidiaries paid cash dividends to the company of approximately $100 million total, each year in 2002, 2001 and 2000. Dividends paid to the company 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 subsidiaries’ domiciliary state. During 2003, the total dividends that may be paid to the company without regulatory approval are approximately $234 million.
The company’s board of directors has authorized the repurchase of outstanding shares. The company has purchased 14.1 million shares at a cost of $465 million between the inception of the share repurchase program in 1996 and December 31, 2002. At December 31, 2002, 6.8 million shares remain authorized for repurchase at any time in the future.
Declared cash dividends per share were 89 cents, 84 cents and 76 cents as of December 31, 2002, 2001 and 2000, respectively.
Property casualty premium income in the accompanying statements of income includes approximately $60 million, $38 million and $34 million of earned premiums on assumed business and is net of approximately $330 million, $155 million and $108 million of earned premiums on ceded business for 2002, 2001 and 2000, respectively.
The provision for federal income taxes is based upon a consolidated income tax return for the company and subsidiaries. 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.
Basic earnings per share is computed based on the weighted average number of shares outstanding. Diluted earnings per share is computed based on the weighted average number of common and dilutive potential common shares outstanding.
The fair value of the company’s stock comprised $22 million of the plan’s assets at December 31, 2002 and 2001.
Accounting principles generally accepted in the United States of America differ in certain respects from statutory insurance accounting practices prescribed or permitted for insurance companies by regulatory authorities.
Adopting Codification reduced statutory capital and surplus as of January 1, 2001, by $392 million for the property casualty insurance subsidiaries and $62 million for the life insurance subsidiary.
Various litigation and claims against the company and its subsidiaries are in process and pending resulting from normal insurance and non-insurance activities. 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 non-insurance matters will be covered by external insurance coverage.
Options outstanding and exercisable consisted of the following at December 31, 2002:
Income before income taxes for the insurance segments represents underwriting profit (loss) - premiums earned minus losses and loss expenses incurred or policyholder benefits and other expenses. The commercial lines property casualty segment and the personal lines property casualty segment incurred an impairment charge amounting to $25 million and $14 million, before tax, respectively, for capitalized computer software development costs in 2000. Income before income taxes for the investment operations represents net investment income, plus realized investment gains and losses, less interest credited to contract holders. The investment operations segment incurred other-than-temporary impairment charges related to investments of $98 million in 2002 and $45 million in 2001. Other losses before income taxes of $32 million, $35 million and $36 million recorded in 2002, 2001 and 2000, respectively, were primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.
Note: The sum of the quarterly reported amounts may not equal the full year as each is computed independently