Per share data adjusted to reflect all stock splits and dividends prior to December 31, 2005.
Among the factors that influence the consolidated results of operations and financial position of the company, we consider our relationships with independent insurance agents to be the most significant. We seek to be an indispensable partner in each agency’s success. To continue to achieve our performance targets, we must maintain these strong relationships, write a significant portion of each agency’s business and attract new agencies.
We believe consistently applying our long-term strategies rather than taking short-term actions will allow us to address these challenges. We seek to meet our agents’ needs, with an eye toward solutions and approaches that will give us an advantage for five, 10 or even more years. As we appoint new agencies, we are looking to build relationships that will grow as successfully as those we have had for 40 or 50 years.
In 2005, we reported record results, as described in detail in the results of operations.
Realized investment gains and losses are integral to our financial results over the long term. We have substantial discretion in the timing of investment sales and, therefore, the gains or losses that will be recognized in any period. That discretion generally is independent of the insurance underwriting process. Also, applicable accounting standards require us to recognize gains and losses from certain changes in fair values of securities and embedded derivatives without actual realization of those gains and losses. Security sales led to realized gains in 2005 and 2004 while write-downs of impaired assets led to realized losses in 2003.
2005 - Realized investment gains raised net income by $40 million, or 23 cents per share, after tax
The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. Cash dividends declared per share rose 16.1 percent and 14.4 percent in 2005 and 2004.
Invested assets and total assets have been relatively flat over the past two years as strong cash flow has been offset by lower unrealized investment gains. This led to a modest decline in shareholders’ equity and book value in 2005.
Comprehensive income is net income plus the change in net other accumulated comprehensive income. Change in net other accumulated comprehensive income is the year-over-year difference in unrealized gains on investments. In 2005 and 2004, comprehensive income declined because lower unrealized gains more than offset the increase in net income. Unrealized gains were down primarily because of a decline in the market value of our Fifth Third investment.
With net income growing and shareholders’ equity declining, return on equity rose over the past three years. Return on equity based on comprehensive income, however, declined in line with total comprehensive income.
We issued $375 million of long-term debt in 2004, raising total long-term debt to $791 million at year-end 2005 and 2004. Our ratio of long-term debt to capital (long-term debt plus shareholders’ equity) rose in 2004 following the new debt issue and remained stable in 2005.
Our consolidated property casualty insurance underwriting profit rose in 2005 and 2004, and our combined ratio improved each year. (The combined ratio is the percentage of each premium dollar spent on claims plus all expenses - the lower the ratio, the better the performance.) The 2005 improvement reflected lower catastrophe losses, continued strong commercial lines underwriting results, a return to underwriting profitability for personal lines and above-average savings from favorable loss reserve development from prior accident years. The 2004 improvement reflected growth in premiums, in particular more adequate premium per policy, the benefits of other underwriting efforts and above-average savings from favorable loss reserve development from prior accident years.
We also measure a variety of non-financial metrics for our property casualty operations. For example, we monitor our rank within our reporting agency locations. In 2004, we ranked No. 1 or No. 2 by premium volume in 74 percent of the locations that have marketed our products for more than five years. Other measures include subdivision of territories and new agency appointments. In 2005, we subdivided eight field territories, raising the total to 100, and appointed 41 new agency relationships. These new appointments and other changes in agency structures led to a net increase in reporting agency locations of 40 in 2005.
Agent satisfaction with our technology solutions is, and will continue to be, a requirement for maintaining our strong relationships with these agencies. In 2005, we made additional progress in implementing technology solutions that we believe should make it easier for agencies to do business with us. Among other milestones, we deployed our new commercial lines policy processing system to all of our agencies in Ohio for use in processing new and renewal businessowners policies. We also deployed our personal lines policy processing system in two additional states and made important upgrades and enhancements.
Maintaining our strong relationships with our established agencies, writing a significant portion of each agency’s business and attracting new agencies - In 2006, we expect to continue to rank No. 1 or No. 2 by premium volume in at least 74 percent or more of the locations that have marketed our products for more than five years. We expect to subdivide three field territories in 2006 and we are targeting 50 new agency appointments.
In 2006, we expect to make further progress in our efforts to improve service to and communication with our agencies through our expanding portfolio of software. In particular, we will continue to deploy our commercial lines and personal lines quoting and policy processing systems that allow our agencies and our field and headquarters associates to collaborate on new and renewal business more efficiently and give our agencies choice and control. We discuss our technology plans for 2006 in Item 1, Technology Solutions, Page 4.
Our combined ratio estimate for 2006 is 92 percent to 94 percent on either a GAAP or statutory basis compared with 89.2 percent on a GAAP basis in 2005. We believe the most significant difference will be a lower level of savings from favorable loss reserve development from prior accident years. In 2006, we believe that savings is likely to reduce the combined ratio in the range of 2 to 3 percentage points. Higher-than-normal savings, particularly for liability coverages, reduced the 2005 combined ratio by 5.2 percentage points and the 2004 combined ratio by 6.7 percentage points.
We also have raised slightly our estimate of the impact to the 2006 combined ratio from catastrophe losses to the range of 4.0 and 4.5 percentage points from our historic range of 3.0 to 3.5 percentage points. We are taking into account the potential for severe weather, as we’ve seen in the past two years, and the higher retention on our new catastrophe reinsurance treaty. Both the loss and loss expense ratio and underwriting expense ratio trends could affect the combined ratios for our commercial lines and personal lines segments:
Increasing the total return to shareholders through a combination of higher earnings per share, growth in book value and increasing dividends - We do not announce annual targets for earnings per share or book value. Earnings results in 2006 will be tempered by the first quarter adoption of Statement of Financial Accounting Standards (SFAS) No. 123(R) “Share-Based Payments,” which requires expensing the cost of associate options on our income statement. Our estimate of pro forma option expense, as detailed in Item 8, Note 1 to the Consolidated Financial Statements, Page 84, would have reduced earnings per share by 7 cents to 8 cents in each of the past three years.
Over the long-term, we seek to increase earnings per share, book value and dividends at a rate that would allow long-term total return to our shareholders to exceed that of the Standard & Poor’s Composite 1500 Property Casualty Insurance Index. Over the past five years, our total return to shareholders of 40.9 percent matched the return on that Index.
Maintaining financial strength by keeping the ratio of debt to capital below 15 percent and purchasing reinsurance to provide investment flexibility - Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2006. As a result, we believe our debt-to-capital ratio will remain in the range of 11 percent to 12 percent.
The significant accounting policies used in the preparation of the financial statements are discussed in Item 8, Note 1 to the Consolidated Financial Statements, Page 84. In conjunction with that discussion, material implications of uncertainties associated with the methods, assumptions and estimates underlying the company’s critical accounting policies are discussed below. The audit committee of the board of directors reviews the annual financial statements with management and the independent registered public accounting firm. These discussions cover the quality of earnings, review of reserves and accruals, reconsideration of the suitability of accounting principles, review of highly judgmental areas including critical accounting policies, audit adjustments and such other inquiries as may be appropriate.
Changes in medical inflation and mortality rates that affect workers compensation claims
Reporting pattern changes attributable to changes in case reserving practices, particularly with respect to umbrella liability claims
A reserve change of $31 million would have a 1 percentage point effect on the loss and loss expense ratio, based on 2005 earned premiums, a $20 million effect on income and an 11 cent effect on net income per share.
Reserves are established for the total of unpaid loss and loss expenses, including estimates for claims that have been reported, estimates for claims that have been incurred but not yet reported (IBNR) and estimates of loss expenses associated with processing and settling those claims. Reserves are determined for the various lines of business. Loss reserves are reduced by salvage and subrogation reserves.
To establish IBNR reserves on an annual basis, we use a variety of tools, including actuarial and statistical methods. These may include but are not limited to:
While we believe that reported reserves provide for all unpaid loss and loss expense obligations, the estimation processes involve a number of variables and assumptions. We believe this uncertainty is mitigated by the historical stability of our book of business and by our periodic reviews of estimates. As loss experience develops and new information becomes known, the reserves are reviewed and adjusted as appropriate. In this process, we monitor trends in the industry, cost trends, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional exposures to loss. If we determine that reserves established in prior years were not sufficient or were excessive, the change is reflected in current-year results.
Fixed-maturity and equity investments are our largest assets. Certain estimates and assumptions made by management relative to investment portfolio assets are critical. The company’s asset impairment committee continually monitors investments and all other assets for signs of other-than-temporary and/or permanent impairment. Among other signs, the committee monitors 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, uncollectability of all other assets, 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.
The application of our impairment policy resulted in other-than-temporary impairment charges and write-offs of investments that reduced our income before income taxes by $1 million, $6 million and $80 million in 2005, 2004 and 2003, respectively.
Other-than-temporary and permanent impairments are distinct from the ordinary fluctuations seen 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, which may be at maturity. Under the same accounting treatment as market value gains, temporary declines (changes in the fair value of these securities) are reflected on our balance sheet in other comprehensive income, net of tax, and have no impact on reported net income.
We establish reserves for our universal life, deferred annuity and investment contracts equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals.
The key assumptions used in developing the 2005 net pension expense were a 5.75 percent discount rate, an 8.0 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent. The 8.0 percent return on plan assets assumption is based partially on the fact that substantially all of the investments held by the pension plan are common stocks that pay annual dividends. We believe this rate is representative of the expected long-term rate of return on these assets. These assumptions were consistent with the prior year except that the discount rate was reduced by one fourth of one percent due to current market conditions. In 2005, the net pension expense was $13 million. In 2006, we expect a net pension expense of $17 million, primarily as a result of a 0.25 percent reduction in the discount rate and increased service costs.
In addition, the fair value of the plan assets exceeded the accumulated benefit obligation by $8 million at year-end 2005 and $16 million at year-end 2004. The fair value of the plan assets was less than the projected plan benefit obligation by $62 million at year-end 2005 and $41 million at year-end 2004. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. We expect to contribute approximately $10 million to the pension plan in 2006.
We establish 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 track with the change 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.
We issue life contracts, referred to as bank-owned life insurance policies (BOLI). 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.
For our most significant separate account, written in 1999, realized gains and losses are retained in the separate account and are deferred and amortized to the contract holder over a five-year period, subject to certain limitations. Upon termination or maturity of this separate account contract, any unamortized deferred gains and/or losses will revert to the general account. In the event this separate account holder were to exchange the contract for the policy of another carrier, there would be a surrender charge equal to 10 percent of the contract’s account value during the first five years. Beginning in year six, the surrender charge decreases 2 percent a year to 0 percent in year 11. At year-end 2005, net unamortized realized gains amounted to $1 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded, and charged to the general account. Potentially, losses could be material; however, unrealized losses in the separate account portfolio were less than $4 million at year-end 2005.
Information regarding recent accounting pronouncements is provided in Item 8, Note 1 to the Consolidated Financial Statements, Page 84. We have determined that recent accounting pronouncements have not had nor are they expected to have any material impact on our consolidated financial statements.
We measure profit or loss for our 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. We also measure aspects of the performance of our commercial lines
Factors that affected written premiums for property casualty insurance operations included:
Reinsurance reinstatement premiums - To restore affected layers of property catastrophe reinsurance programs, we incurred $8 million and $11 million in reinsurance reinstatement premiums in 2005 and 2004.
2005 - In 2005, we stopped separately reporting on UM/UIM-related reserve actions.
Combined ratio - Our commercial lines combined ratio was very strong in 2005 and 2004 largely due to our programs to obtain more adequate premiums per policy and our underwriting efforts. The 3.3 percentage point increase in the 2005 ratio primarily was due to a rise in the loss and loss expense ratio. The increase reflected a single large loss in 2005 that increased the ratio by 1.1 percentage points and savings from favorable loss reserve development below the 2004 level. We discuss large losses and other factors affecting the combined ratio beginning on Page 42. We discuss the savings from favorable loss reserve development by commercial lines of business on Page 45.
Our commercial lines statutory combined ratio was 87.1 percent in 2005 compared with 83.7 percent in 2004 and 91.6 percent in 2003. By comparison, the estimated industry commercial lines combined ratio was 99.1 percent in 2005, 102.5 percent in 2004 and 100.2 percent in 2003.
As competition in the commercial markets has increased, we have maintained our pricing discipline for both renewal and new business. Our independent agents reported steady pressure on pricing during 2005 and communicated that winning new business and retaining renewals required more pricing flexibility and careful risk selection. With the commercial lines pricing environment growing more competitive, we continue to rely on factors other than price to drive sales. Our agents look for the best insurance program for their clients, not just the best price. They serve policyholders well by presenting our value proposition - customized coverage packages, personal claims service and high financial strength ratings - all wrapped up in a convenient three-year commercial policy. We intend to remain a stable market for our agencies’ best business, and believe that our case-by-case approach gives us a clear advantage. Our field marketing associates and our independent agents work together to select risks and respond appropriately to local pricing trends. Historically, they have proven capable of balancing risk and price to achieve growth in new business over the longer term.
Staying abreast of evolving market conditions is a critical function, accomplished in both an informal and a formal manner. Informally, our field marketing representatives and underwriters are in constant receipt of market intelligence from the agencies with which they work. Formally, our commercial lines product management group and field marketing associates complete periodic market surveys to obtain competitive intelligence. This market information helps to identify the top competitors by line of business or specialty program and also identifies our market strengths and weaknesses. The analysis encompasses pricing, breadth of coverage and underwriting/eligibility issues. In addition to reviewing our competitive position, our product management group and our underwriting audit group review compliance with our underwriting standards as well as the pricing adequacy of our commercial insurance programs and coverages. Further, our research and development department analyzes opportunities and develops new products, new coverage options and improvements to existing insurance products.
We have more aggressively identified and measured exposures to match coverage amounts and premiums to the risk. Where this matching is not possible, accounts are not renewed unless there are mitigating factors. As a result, we experienced no growth in overall commercial lines policy counts from 2003 to 2005. Agents tell us they agree with the need to carefully select risks and assure pricing adequacy. They appreciate the time our associates invest in creating solutions for their clients while protecting profitability, whether that means working on an individual case or developing modified policy terms and conditions that preserve flexibility, choice and other sales advantages.
Over the past three years, we have continued to focus on seeking and maintaining adequate premium per exposure as well as pursuing non-pricing means of enhancing longer-term profitability. These have included identifying the exposures we have for each risk and making sure we offer appropriate coverages, terms and conditions and limits of insurance. We continue to adhere to our underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions, where necessary. In addition, we continue to leverage our strong local presence. Our field marketing representatives have met with every agency to reaffirm agreements on the extent of frontline renewal underwriting to be performed by local agencies. Loss control, machinery and equipment and field claims representatives continue to conduct on-site inspections. Field claims representatives prepare full risk reports on every account reporting a loss above $100,000 or on any risk of concern. Multi-departmental task forces have implemented programs to address concerns for specific areas such as contractor and commercial auto risks. These actions have helped to mitigate rising loss severity.
Loss and loss expenses include both net paid losses and reserve additions for unpaid losses as well as the associated loss expenses. We believe more competitive market conditions were one factor in the 3.3 percentage point rise in the loss and loss expense ratio excluding catastrophes between 2005 and 2004. In addition, 2005 results include a single large loss that was insufficiently covered through our facultative reinsurance programs, which increased the 2005 loss and loss expenses by $24 million, net of reinsurance, or 1.1 percentage points. Savings from favorable loss reserve development was lower in 2005 than 2004, which we discuss by commercial lines of business on Page 45.
Re-underwriting our commercial lines book of business in the early 2000s has had an impact on reserve development patterns because we are seeing lower frequency of losses. The favorable development in 2005 and 2004 was also due to the headquarters claims department’s initiative, begun in 2001. Since 2001, we have been establishing higher initial case reserves on severe injury claims because our experience indicated that juries often ignore significant liability issues in cases involving seriously injured claimants. These higher initial amounts produce case reserves that reflect our full exposure more accurately. But some claims settle before reaching a jury and some juries make awards that are less than the “worst-case” scenario. As a result, some change in our case reserve development patterns allowed us to also reduce IBNR in 2005.
We monitor 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. Our 2005 analysis indicated no significant concentrations other than trends in business lines that we address as part of our ongoing business operations. We also measure new losses and case reserve increases greater than $250,000 to track frequency and severity.
The Cincinnati Insurance Companies do not appoint agencies to actively market property casualty insurance in Louisiana, Mississippi or Texas. Our Hurricane Katrina and Rita losses included losses associated with commercial accounts written by agents in other states to cover locations and vehicles in multiple states, including Louisiana, Mississippi and Texas.
Commercial lines commission expense as a percent of earned premium declined by 0.4 percentage points in 2005 after rising by 1.0 percentage points in 2004. Profit-sharing, or contingent, commissions are calculated on the profitability of an agency’s aggregate book of business, taking into account longer-term profit, with a percentage for prompt payment of premiums and other criteria, and reward our agents’ efforts. These profit-based commissions generally fluctuate with our loss and loss expenses.
Non commission expenses rose to 10.1 percent of earned premium in 2005 from 9.4 percent in 2004 and 7.7 percent in 2003. The three-year rise in the ratio largely was due to unfavorable deferred acquisition cost comparisons resulting from slower premium growth, higher staffing expenses and increased taxes and fees that were partially due to a state guaranty fund refund in 2003. The software recovery discussed in Corporate Financial Highlights, Page 32, reduced the 2003 ratio by 0.8 percentage points.
Policyholder dividend expense was 0.2 percent of earned premium in 2005 compared with 0.5 percent in 2004 and 0.8 percent in 2003.
Over the past three years, results for the business lines within the commercial lines segment have reflected our emphasis on underwriting and obtaining adequate pricing for covered risks, as discussed above.
In 2005 and 2004, commercial multi-peril written premiums rose more rapidly than the total for commercial lines as a higher proportion of liability coverages were written in discounted packages because of competitive pricing pressures. Commercial multi-peril written premiums were lower in 2003 when some liability coverages were moved to nondiscounted policies. Nondiscounted policies are included in our other liability line of business.
2005 - Favorable development lowered the loss and loss expense ratio by 7.7 percentage points. The favorable development largely was due to lower commercial multi-peril exposures because of
prior-year transfers of business to non-discounted policies and to the benefits of changes made in 2002 to our general liability terms and conditions.
2004 - Reserve strengthening added 0.6 percentage points to the loss and loss expense ratio. Additions to reserves for environment claims were offset by favorable development of case reserves for non-environmental claims due to our headquarters claims department’s initiative to establish higher initial case reserves on severe injury claims.
2003 - Reserve strengthening added 2.0 percentage points to the loss and loss expense ratio because we added to our reserves for environmental claims.
In addition, the large loss discussed above added 2.9 percentage points to the 2005 ratio.
Conditions within the workers compensation market remained stable in 2005 and 2004 after improving between 1999 and 2003 as market pricing rose in most states, albeit offset by continued rising trends in loss severity. In 2005, workers compensation written premiums rose more rapidly than our total commercial lines written premiums as this business line appeared to experience less competitive pricing pressures than the overall commercial lines market in the second half of the year. As the commercial lines market has softened, however, insurers have displayed a greater willingness to write more desirable risks, and growth in the premium volume of state pools for workers compensation is declining.
2005 - Reserve strengthening added 13.3 percentage points to the loss and loss expense ratio. The reserve strengthening primarily was due to medical cost inflation and longer estimated payout periods compared with our original projections.
2004 - Reserve strengthening added 4.9 percentage points to the loss and loss expense ratio, which also was due to longer estimated payout periods.
2003 - Reserve strengthening added 4.3 percentage points to the loss and loss expense ratio, which also was due to medical cost inflation.
Written premiums declined 2.4 percent in 2005 after rising 5.5 percent in 2004, below the overall commercial lines growth rate. Commercial auto is one of the package policy components for which we calculate pricing annually. This line tends to be highly sensitive to competitive pressures.
A significant factor in the calendar year-over-year changes has been savings from favorable loss reserve development for prior years.
2004 - Favorable development lowered the loss and loss expense ratio by 10.5 percentage points, including 4.6 percentage points due to the release of UM/UIM reserves. The remainder of the savings largely was due to moderating frequency and severity trends.
Other liability (commercial umbrella, commercial general liability and most executive risk policies) written premiums also grew more rapidly than our total commercial lines written premiums because of the growing number of policies written in non-discounted programs and the continuing rise in liability pricing. The growth
Director and officer coverage accounted for approximately 11 percent of other liability premium in 2005 compared with approximately 13 percent in 2004 and approximately 12 percent in 2003. Our director and officer policies are offered primarily to nonprofit organizations, reducing the risk associated with this line of business. As of December 31, 2005, three of our in-force director and officer policies were for Fortune 500 companies, 38 were for publicly traded companies (excluding banks and savings and loans) and 59 were for banks and savings and loans with more than $500 million in assets.
In large part because this business line also includes umbrella coverages, the calendar year loss and loss expense ratio tends to fluctuate significantly on a year-over-year basis. Our headquarters claims department’s initiative to establish higher initial case reserves on severe injury claims has the greatest effect on this business line:
Prior to Hurricanes Katrina, Rita and Wilma, we anticipated 2006 commercial lines insurance market trends would reflect accelerated competition with pressure on pricing from the industry’s increasing surplus and improving profitability. We are uncertain what the effect of the hurricanes will be on commercial lines pricing going forward. We believe their effect on pricing largely will be limited to coastal markets and business lines directly affected by the storms.
We believe our approach should allow us to maintain most of the positive underlying improvements in profitability that have occurred over the past several years, but we do not believe favorable reserve development will contribute to underwriting profits as much in 2006 as in 2005 and 2004. In addition, underwriting expenses are rising. We discuss our overall outlook for the property casualty insurance operations in Measuring Our Success in 2006 and Beyond, Page 33,.
Premiums - During the past three years, we have been working to address personal lines profitability. Because of our actions, the 2005 personal lines combined ratio was below 100 percent for the first time since 1999. However, as other carriers refined their pricing models , our pricing was less competitive and written premiums declined in 2005 after slowing in 2004. Industry average written premium growth was estimated at 3.5 percent for 2005 and 6.6 percent for 2004. Our earned premium growth has slowed as a result of the written premium trend. Reinsurance reinstatement premiums allocated to personal lines reduced our premium growth by 0.3 and 0.8 percentage points for 2005 and 2004, respectively.
The same factors that reduced policy retention have had an impact on new personal lines business. Personal lines new business premiums written directly by agencies declined 33.9 percent to $32 million in 2005 and declined 19.9 percent to $48 million in 2004.
Between 2000 and 2003, the industry implemented higher homeowner rates and imposed stricter enforcement of underwriting standards. In late 2004, price competition returned as insurers leveraged their higher profitability and stronger financial positions. The marketplace continued to become more competitive throughout 2005.
From mid-2004 to mid-2005, we opted to delay rate changes because we felt it was important to fully commit our programming resources to completing necessary modifications and upgrades to our then-new Diamond policy processing system. During that time period, other carriers began making more aggressive use of segmented pricing models, generating lower rates for higher quality accounts. When some important system modifications were completed in mid-2005, we began filing rate and credit changes to better position our products in the market.
Although our homeowner profitability lagged the industry, our actions resulted in substantial improvement in our personal lines combined ratio over the past three years. Our 2005 statutory combined ratio improved to 94.3 percent while the estimated industry combined ratio deteriorated 2.4 points to 97.3 percent. Moreover, we expect to realize additional profit improvements in 2006 as we continue the conversion to one-year policies written with updated rates, terms and conditions.
In mid-2006, we will introduce a limited program of rate segments incorporating insurance scores into pricing for our personal auto and homeowner products in states using Diamond and make other changes to our credits in states not yet using Diamond. This step should further improve our ability to compete for our agents’ highest quality personal lines accounts. We believe it will increase the opportunity to work with our agents on marketing the advantages of our personal lines products and services to their clients, which would help us resume growing in this business area.
Loss and loss expenses include both net paid losses and reserve additions for unpaid losses as well as the associated loss expenses. The improvement in the loss and loss expense ratio excluding catastrophes over the past three years was due to a 14.4 percentage point improvement in the homeowner ratio excluding catastrophe losses between 2005 and 2003 and a 10.4 percentage point improvement in the personal auto ratio excluding catastrophe losses over the same period. Savings from favorable loss reserve development, including the release of UM/UIM reserves, influenced those improvements. We discuss homeowner and personal auto trends separately beginning on Page 51.
Personal lines catastrophe losses, net of reinsurance and before taxes, were $51 million in 2005 compared with $77 million in 2004 and $55 million in 2003. The following table shows losses incurred, net of reinsurance, and subsequent development, for catastrophe losses in each of the past three years.
The personal auto and homeowner business lines together accounted for 89.2 percent, 89.5 percent and 89.5 percent of total personal lines earned premiums in 2005, 2004 and 2003, respectively. Our intent is to write personal auto and homeowner coverages in personal lines packages that may also include personal umbrella liability, watercraft and other coverages. As a result, we believe that the personal lines segment is best measured and evaluated on a segment basis. We have provided the table above and the discussion below to summarize growth and profitability trends separately for the two primary business lines.
At year-end 2005, approximately 56 percent of all homeowner policies had been converted to a one-year term, up from approximately 27 percent at year-end 2004. We are continuing to renew homeowner policies for three-year terms in nine states until the Diamond roll out is planned for those states. Renewal rates on those three-year policies reflect all rate changes enacted over the past several years. This can cause those policies to renew at a significantly higher cost for the policyholders, even if the price is competitive.
We also assume catastrophe losses as a percent of homeowner earned premium would be in the range of 17 percent. Over the past three years, catastrophe losses have averaged approximately 21 percent of homeowner earned premiums. We believe it will take until 2007 for the full benefit of our pricing and underwriting actions to be reflected in homeowner results.
Industry experts currently anticipate industrywide personal lines written premiums will rise approximately 2.9 percent in 2006, with personal auto premiums expected to rise about 2.5 percent and homeowner premiums expected to rise 4.2 percent.
Competitive rates - We are working on a number of rate setting initiatives to make our personal auto and homeowner rates competitive in all of our territories. We work with our agents to establish rates that are attractive to our agencies’ quality accounts. In mid-2006, we will introduce a limited program of rate segments incorporating insurance scores into rates for our personal auto and homeowner policies to further improve our pricing for our agents’ quality accounts. We believe the opportunity exists to work with our agents to market the advantages of our personal lines products to their clients, which would help us resume growing in this business area.
New agencies - The availability of Diamond should help us increase the number of agencies that offer our personal lines products, which also should contribute to personal lines growth. We currently market both homeowner and personal auto insurance products through 773 of our 1,253 reporting agency locations in 22 of the 32 states in which we market commercial lines insurance. We market homeowner products through 22 locations in three additional states (Maryland, North Carolina and West Virginia.)
Profitability - The life insurance segment reports a small GAAP profit because investment income is included in investment segment results, except investment income credited to contract holders (interest assumed in life insurance policy reserve calculations). Results improved in 2005 and 2004 because operating expenses remained level and mortality experience remained within pricing guidelines as premiums continued to rise.
Premiums from traditional products, principally term insurance, which contributed 71.3 percent
Our life insurance subsidiary reported total statutory written premiums of $205 million in 2005 compared with $193 million in 2004, which included premiums for two general account BOLI policies totaling $10 million, and $143 million in 2003. Written premiums for life insurance operations for all periods include life insurance, annuity and accident and health premiums.
In 2005, our life insurance segment experienced a 2.0 percent rise in applications submitted and a 4.9 percent increase in gross face amounts issued, primarily due to continued strong sales of term insurance marketed through the company’s property casualty agency force.
Over the past several years, we have worked to maintain a portfolio of straightforward and up-to-date products, primarily under the LifeHorizons name. Our product development efforts emphasize death benefit protection and guarantees.
For example, a new term series that includes a return-of-premium feature replaced the existing term portfolio in 2005. Reaction to the new portfolio has been favorable with approximately 25 percent of applications requesting the return-of-premium feature. In 2006, we are introducing a new universal life product that offers a secondary guarantee that keeps the death benefit in force provided a competitive minimum premium requirement is met.
Insurance benefits paid and reserve increases related to traditional life and interest-sensitive products, which accounted for 66.0 percent of 2005 expenses and 64.3 percent of 2004 expenses
We seek to maintain a competitive advantage with respect to benefits paid and reserve increases by consistently achieving better than average claims experience due to skilled underwriting. Commissions paid by
Marketplace and regulatory changes during 2004 have affected the cost and availability of reinsurance for term life insurance issued since the beginning of 2005. We are addressing this situation by retaining no more than a $500,000 exposure, ceding the balance using excess over retention mortality coverage and retaining the policy reserve. Retaining the policy reserve has no direct impact on GAAP results. However, because of the conservative nature of statutory reserving principles, retaining the policy reserve unduly depresses our statutory earnings and requires a large commitment of capital. We anticipate favorable regulatory changes as we discuss in Item 1, Life Insurance Segment, Page 13. We believe we will be able to continue to grow in the term life insurance marketplace while appropriately managing risk, at a cost that allows the life insurance company to achieve its internal performance targets.
Investment income - Pretax investment income reached a new record in 2005, rising 6.9 percent from the prior record in 2004. Growth in investment income over the past two years has been driven by strong cash flow for new investments, higher interest income from the growing fixed-maturity portfolio and increased dividend income from the common stock portfolio.
Realized gains and losses - We reported realized gains in 2005 and 2004 largely due to investment sales. The realized loss in 2003 was due to other-than-temporary impairment charges.
Overall, common stock dividends contributed 43.7 percent of pretax investment income in 2005 compared with 43.9 percent in 2004 and 42.3 percent in 2003. Fifth Third, our largest equity holding, contributed 43.6 percent of total dividend income in 2005. We discuss our Fifth Third investment in Item 7A, Quantitative and Qualitative Disclosures About Market Risk, Page 70. In 2005, 36 of the 49 common stock holdings in the portfolio raised their indicated annual dividend payout, as did 33 of the 51 in 2004 and 29 of 51 in 2003.
Realized investment gains in 2005 and 2004 largely were due to the sale of equity holdings. We buy and sell both fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives.
We sold fixed-maturity investments during the past three years as part of our portfolio management strategies. The majority of these were bonds disposed of due to rating or credit concerns, including several in the airline and auto related industries. Although we prefer to hold fixed-maturity investments until they mature, a decision to sell reflects our 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. Our opinion that a security fundamentally no longer meets our investment parameters 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.
2003 - 31 high-yield corporate bonds written down $39 million and 10 convertible securities written down $26 million. Market value declines in 2003 largely related to events specific to the issuer rather than industry issues, although $58 million of the $80 million write-downs were concentrated in the utility/merchant energy trading, airline and healthcare industries.
Other-than temporary impairment charges from the investment portfolio by industry are summarized as follows:
We believe impairments in 2006 should be limited to securities that have been identified for sale or that have experienced a sharp decline in fair value with little or no warning because of issuer-specific events. All but two securities in the portfolio were trading at or above 70 percent of book value at December 31, 2005. Our asset impairment committee continues to monitor the investment portfolio. The current asset impairment policy is in Critical Accounting Estimates, Asset Impairment, Page 37.
We pursue a strategy of investing some portion of cash flow in tax-advantaged fixed-maturity and equity securities to minimize our overall tax liability and maximize after-tax earnings. Details regarding our effective tax rate are found in Item 8, Note 10 to the Consolidated Financial Statements, Page 93.
Liquidity and capital resources represent the overall financial strength of our company and our ability to generate cash flows to meet the short- and long-term cash requirements of business obligations and growth needs. We seek to maintain prudent levels of liquidity and financial strength for the protection of our policyholders, creditors and shareholders.
Our insurance subsidiary’s primary sources of liquidity are premiums and investment income. Its cash needs primarily consist of paying property casualty and life insurance loss and loss expenses as well as ongoing operating expenses and payments of dividends to the parent company. Although we have never sold investments to pay claims, the sale of investments would provide an additional source of liquidity, if required. After satisfying operating cash requirements, excess cash flows are invested in fixed-maturity and equity securities, leading to the potential for increases in future investment income and unrealized appreciation.
Our insurance subsidiary declared dividends to the parent company of $275 million in 2005, $175 million in 2004 and $50 million in 2003. State of Ohio regulatory requirements restrict the dividends insurance subsidiaries can pay. Generally, the most Ohio-domiciled insurance subsidiaries can pay without prior regulatory approval is 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 Ohio Department of Insurance. During 2006, total dividends that our lead insurance subsidiary can pay to our parent company without regulatory approval are approximately $517 million.
After paying claims and operating expenses, cash flows from underwriting were essentially unchanged in 2005 after rising 21.5 percent in 2004. We discuss our future obligations for claims payments in Contractual Obligations, Page 59, and our future obligations for underwriting expenses in Commissions and Other Underwriting Expenses, Page 60. Based on our outlook for commercial lines, personal lines and life insurance, we believe that cash flows from underwriting could decline in 2006. A lower level of cash flow available for investment could lead to reduced potential for increases in future investment income and capital gains.
Investment income is a primary source of liquidity for both the parent company and insurance subsidiary. The transfer of equity holdings to our insurance subsidiary from the parent company in 2004 increased the amount of investment income generated at the subsidiary level but had no effect on consolidated investment income. As we discuss under Investments Results of Operations, Page 54, investment income rose in each of the past three years, and we expect investment income to grow 6.5 percent to 7.0 percent in 2006.
We generally have substantial discretion in the timing of investment sales and, therefore, the resulting gains or losses that are recognized in any period. That discretion generally is independent of the insurance underwriting process. In 2006, we expect to continue to limit the disposition of investments to those that no longer meet our investment parameters or those that reach maturity or are called by the issuer. The sale of equity investments that no longer meet our investment criteria can provide cash for investment in common stocks that we perceive to have greater potential for capital appreciation and income growth.
At year-end 2005, we had two lines of credit totaling $125 million with no outstanding balance. One line of credit for $75 million was established more than five years ago and has no financial covenants. The second line of credit is an unsecured $50 million line of credit from Fifth Third Bank established in 2005. It is available for general corporate purposes and contains customary financial covenants.
Based on our present capital requirements, we do not anticipate a material increase in debt levels during 2006. As a result, we believe our debt-to-capital ratio will remain in the range of 11 percent to 12 percent.
Our parent company and insurance subsidiary have contractual and other obligations. In addition, one of our primary uses of cash is to enhance shareholder return.
At December 31, 2005, we estimated our future contractual obligations as follows:
While we believe that historical performance of property casualty and life loss payment patterns is a reasonable source for projecting future claims payments, there is inherent uncertainty in this estimate of contractual obligations. We believe that we could meet our obligations under a significant and unexpected change in the timing of these payments because of the liquidity of our invested assets, strong financial position and access to lines of credit.
Our estimate of material commitments for long-term debt was approximately 14.4 percent and our estimate of material commitments for interest on long-term debt was approximately 23.6 percent of the estimated contractual obligations at year-end 2005.
Our estimate of material commitments for obligations due under annuities written by our life insurance subsidiary was approximately 3.5 percent of the estimated contractual obligations at year-end 2005.
The construction of our new office building and parking garage to be situated at our headquarters located in Fairfield is expected to require approximately $83 million over the next three years. The construction project is on schedule and on budget. As of December 31, 2005, construction costs totaled $18 million. We expect construction to be completed by September 2008.
We expect to need approximately $14 million over the next five years for material commitments for computer hardware and software, including maintenance contracts on hardware and other known obligations. We discuss below the non-contractual expenses we anticipate for computer hardware and software in 2006.
In addition to our contractual obligations, our insurance operations use cash for commission and other underwriting expenses.
Many of our operating expenses are not contractual obligations, but reflect the ongoing expenses of our business. Staffing is the largest component of our operating expenses and is expected to rise again in 2006, reflecting the 4.3 percent average annual growth in our associate base over the past three years. Our associate base has grown as we focus on enhancing service to our agencies and staffing additional field territories. Other expenses should rise in line with our growth.
Excess cash flows from underwriting, investment and other corporate activities are invested in fixed-maturity and equity securities on an ongoing basis to help achieve our portfolio objectives. See Item 1, Investments Segment, Page 15, for a discussion of our investment strategy, portfolio allocation and quality. Since the second quarter of 2004, virtually all of our available cash flow has been used to purchase fixed-maturity investments to reduce our property casualty subsidiary’s ratio of common stock to statutory surplus.
Purchases of fixed-maturity securities rose significantly in 2005 and 2004. Due to the allocation of a higher percentage of new investment dollars to fixed-maturity investments, equity securities purchases in 2005 and 2004 were below the level of 2003. Purchases in 2005 included $144 million of nonredeemable preferred stock. We evaluate nonreedemable preferred stocks similar to the evaluation we make for fixed-maturity investments, seeking attractive relative yields.
Dividends to shareholders - Over the past 10 years, the company has paid an average of 42 percent of net income as dividends, with the remaining 58 percent available to reinvest for future growth and for share repurchases. The ability of the company to continue paying cash dividends is subject to factors the board of directors may deem relevant.
Common stock repurchase - Our board believes that stock repurchases can help fulfill our commitment to enhancing shareholder value. Consequently, the board has authorized the repurchase of outstanding shares. Common stock repurchases for treasury have continued at a steady pace over the last several years and occur when we believe that stock prices on the open market are favorable for such repurchases. At a minimum, we would expect the repurchase to offset dilution of option exercises. In 2005, 2004 and 2003, we used $63 million, $66 million and $55 million for share repurchase.
In 2005, the board authorized a 10 million share repurchase program to replace a program authorized in 1999. At year-end 2005, 9.5 million shares remained authorized for repurchase under the 2005 program.
At year-end 2005, the total reserve balance, net of reinsurance, was $3.111 billion, compared with $2.977 billion at year-end 2004 and $2.845 billion at year-end 2003. We provide a reconciliation of the property casualty reserve balances with the loss and loss expense liability on the balance sheet in Item 8, Note 4 to the Consolidated Financial Statements, Page 90. The reserves reflected in the financial statements are management’s best estimate.
The appointed actuary’s range for adequate statutory reserves, net of reinsurance, was $2.921 billion to $3.153 billion for 2005; $2.794 billion to $3.032 billion for 2004; and $2.696 billion to $2.906 billion for 2003. The assumptions used to establish the recommended ranges were consistent with the actuary’s practices. Historically, we have established reserves in the upper half of the actuary’s range, as discussed in Critical Accounting Estimates, Property Casualty Loss and Loss Expense Reserves, Page 35.
We reconcile the beginning and ending balances of our reserve for loss and loss expenses at December 31, 2005, 2004 and 2003, in Item 8, Note 4 to the Consolidated Financial Statements, Page 90. The reconciliation of our year-end 2004 reserve balance to net incurred losses one year later recognizes approximately $160 million in redundant reserves.
Section B shows the cumulative net amount paid with respect to the previously recorded reserve as of the end of each succeeding year. For example, as of December 31, 2005, we had paid $1.053 billion of loss and loss expenses in calendar years 1996 through 2005, for losses that occurred in accident years 1995 and prior. An estimated $130 million of losses remain unpaid as of year-end 2005 (net re-estimated reserves of $1.183 billion less cumulative paid loss and loss expenses of $1.053 billion).
Section D, cumulative net redundancy, represents the aggregate change in the estimates for all years subsequent to the year the reserves were initially established. For example, reserves established at December 31, 1995, had developed a $398 million redundancy over 10 years, net of reinsurance, which has been reflected in income over the 10 years. The effects on income in 2005, 2004 and 2003 of changes in estimates of the reserves for loss and loss expenses for all accident years are shown in the reconciliation below.
Loss and loss expenses incurred for all asbestos and environmental claims were $12 million, or 0.7 percent of total loss and loss expenses in 2005, compared with $41 million, or 2.4 percent in 2004, and $28 million, or 1.6 percent, in 2003. The increase in 2004 was primarily due to mold claims prior to the introduction of the mold exclusion to our policy forms.
The overall favorable development recorded in the commercial lines reserves illustrates the potential for revisions inherent in estimating reserves, especially in long-tail lines such as other liability. With the exception of the UM/UIM reserve releases and other significant changes in assumptions discussed above, commercial lines reserve development over the past three years was consistent with:
For the business lines in the personal lines insurance segment, the following table shows the breakout of gross reserves among case, IBNR and loss expense reserves. Total gross reserves were down slightly from year-end 2004 due to normal claims activity on a lower policy count and lower personal lines catastrophe reserves in 2005 than in 2004.
Gross life policy reserves were $1.343 billion at year-end 2005, compared with $1.194 billion at year-end 2004. We establish reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience adjusted for historical trends in arriving at our assumptions for expected mortality, morbidity and withdrawal rates. We use our own experience and historical trends for setting
A single large loss or an unexpected rise in claims severity or frequency due to a catastrophic event could present us with a liquidity risk. In an effort to control such losses, we forego marketing property casualty insurance in specific geographic areas, monitor our exposure in certain coastal regions, review aggregate exposures to huge disasters and purchase reinsurance. We use the Risk Management Solutions and Applied Insurance Research models to evaluate exposures to a once-in-250-year event in determining appropriate reinsurance coverage programs. In conjunction with these activities, we also continue to evaluate information provided by our reinsurance broker. These various sources explore and analyze credible scientific evidence, including the impact of global climate change, which may affect our exposure under insurance policies.
Reinsurance mitigates the risk of highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. Management’s decisions regarding the appropriate level of property casualty risk retention are affected by various factors, including changes in our underwriting practices, capacity to retain risks and reinsurance market conditions. Reinsurance does not relieve us of our obligation to pay covered claims. The financial strength of our reinsurers is important because our ability to recover for losses covered under one of our reinsurance agreements depends on the financial viability of the reinsurer.
Currently participating on our property and casualty per-occurrence programs are American Reinsurance Company, GE Insurance Solutions, Partner Reinsurance Company of the U.S. and Swiss Reinsurance America Corporation, all of which have A.M. Best insurer financial strength ratings of A (Excellent) or A+ (Superior). Our property catastrophe program is subscribed through a broker by reinsurers from the United States, Bermuda, London and Europe markets.
Primary components of the 2006 property and casualty reinsurance program include:
In mid-2005, we modified our casualty per occurrence treaty for director and officer policies for five Fortune 1000 companies and one financial services company. For three of the six companies, our retention per policy could be as high as $15 million rather than the $4 million for a typical policy; for one of the other companies, our retention per policy could be as high as $14 million; for the other two companies, our retention per policy could be as high as $5 million. We believe the additional risk undertaken with these selected policies remains at an acceptable level based on our financial strength. We arranged for this exception for this small group of companies to maintain business relationships with key agencies and insureds. We intend to review this element of our working treaties on an ongoing basis.
We purchase another casualty excess treaty, which provides an additional $20 million in casualty loss coverage. This treaty also provides catastrophic coverage for workers compensation and extra-contractual liability coverage losses. The ceded premium is estimated to be $1 million for 2006, similar to the premium paid in 2005.
Individual risks with insured values in excess of $25 million as identified in the policy are handled through a different reinsurance mechanism. We reinsure property coverage for individual risks with insured values between $25 million and $50 million under an automatic facultative treaty. For those risks with property values exceeding $50 million, we negotiate the purchase of facultative coverage on an individual certificate basis. For casualty coverage on individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis.
This is our “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Our business is subject to certain risks and uncertainties that may cause actual results to differ materially from those suggested by the forward-looking statements in this report. Some of those risks and uncertainties are discussed in Item 1A, Risk Factors, Page 21. Although we often review or update our forward-looking statements when events warrant, we caution our readers that we undertake no obligation to do so.
Ability to obtain adequate reinsurance on acceptable terms, amount of reinsurance purchased and financial strength of reinsurers
Insurance regulatory actions, legislation or court decisions or legal actions that increase expenses or place us at a disadvantage in the marketplace
Sustained decline in overall stock market values negatively affecting the company’s equity portfolio; in particular a sustained decline in the market value of Fifth Third shares, a significant equity holding
Readers are cautioned that the company undertakes no obligation to review or update the forward-looking statements included herein.
The company’s independent registered public accounting firm has issued an attestation report on our internal control over financial reporting as of December 31, 2005, 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 of America. 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, 2005 and 2004, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2005, 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, 2005, 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, 2005, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
In accordance with GAAP, we have made estimates and assumptions that affect the amounts we report and discuss in the financial statements and accompanying notes. Actual results could differ from our estimates.
Net income per common share is based on the weighted average number of common shares outstanding during each of the respective years. We calculate net income per common share (diluted) assuming the exercise of stock options. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2005, including the 5 percent stock dividend paid April 26, 2005.
We establish reserves to cover the expected cost of claims - or losses - and our expenses related to investigating, processing and resolving claims. Although determining the appropriate amount of reserves including reserves for catastrophe losses is inherently uncertain, we base our decisions on past experience and
The Cincinnati Insurance Companies actively market property casualty insurance policies in 32 states. Our 10 largest states generated 71.1 percent, 72.1 percent and 73.1 percent of total property casualty premiums in 2005, 2004 and 2003, respectively. Ohio, our largest state, accounted for 23.1 percent, 23.7 percent and 24.6 percent of total earned premiums in 2005, 2004 and 2003. Agencies in Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania and Virginia each contributed between 4 percent and 10 percent of premium volume in 2005. No single agency accounted for more than 1.1 percent of the company’s total agency direct earned premiums in 2005.
We offer several types of life and health insurance and we account for each according to the duration of the contract. Short-duration contracts are written to cover claims that arise during a short, fixed term of coverage. We generally have the right to change the amount of premium charged or cancel the coverage at the end of each contract term. Group life insurance is an example. We account for short-duration contracts similarly to property casualty contracts.
Universal life contracts are long-duration contracts for which contractual provisions are not fixed, unlike whole life insurance. Universal life contracts allow policyholders to vary the amount of premium, within limits, without our consent. However we may vary the mortality and expense charges, within limits, and the interest crediting rate used to accumulate policy values. We do not record universal life premiums as revenue. Instead we recognize as revenue the mortality charges, administration charges and surrender charges when received. Some of our universal life contracts assess administration charges in the early years of the contract that are compensation for services we will provide in the later years of the contract. These administration charges are deferred and are recognized over the period when we provide those future services.
We carry the assets of separate account BOLIs at fair value. The liabilities on separate account BOLIs primarily are the contract holders’ claims to the related assets and are carried at the fair value of the assets. If the BOLI asset value is projected below the value we guaranteed, a liability is established by a charge to the company’s earnings.
Investment income consists mainly of interest and dividends. We record interest on an accrual basis and record dividends at the ex-dividend date. We amortize premiums and discounts on fixed-maturity securities using the interest method.
Facts and circumstances sometimes warrant investment write-downs. We record such other-than-temporary declines as realized investment losses.
We base fair value for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) on quoted market prices or on data provided by an outside resource that supplies global securities pricing.
SFAS No. 133 “Accounting for Derivative Financial Instruments and Hedging Activities,” as amended, or any subsequent changes in fair values of these instruments, have not had a significant impact on the accompanying consolidated financial statements. We do not engage in any hedging activities.
SFAS No. 123(R) permits companies to adopt its requirements using either a modified prospective or a modified retrospective method. We currently utilize a standard option-pricing model (binomial option-pricing model) to measure the fair value of stock options granted to associates. Upon the adoption of SFAS No. 123(R), we will use the modified prospective method to measure the fair value of associate stock options.
Subject to a complete review of the requirements of SFAS No. 123(R), based on stock options granted to associates through year-end 2005, we estimate that the adoption of SFAS No. 123(R) will reduce 2006 net income by approximately 8 cents per share.
At December 31, 2005, contractual maturity dates for fixed-maturity and short-term investments were:
At December 31, 2004, 23 fixed-maturity investments with a total unrealized loss of $5 million and one equity security with a total unrealized loss of $1 million had been in that position for 12 months or more. All were trading between 70 percent to less than 100 percent of book value.
Investments in companies that exceed 10 percent of our shareholders’ equity at December 31 include:
In December 2005, we sold 475,000 shares of our holdings of ALLTEL Corporation common stock. On January 24, 2006, we completed the sale of our remaining 12,700,164 shares. The sale contributed $27 million to our 2005 pretax realized gains. The $549 million gain from the sale in 2006 will be recognized in pretax realized investment gains and losses in the first quarter of 2006. After-tax proceeds from the sale totaled approximately $558 million.
We reported total catastrophe losses, net of reinsurance and before taxes, of $127 million for 2005, compared with $148 million for 2004 and $97 million in 2003. Most catastrophe losses are incurred in the calendar year of the event.
We establish the reserves for traditional life insurance policies based on expected expenses, mortality, morbidity, withdrawal rates and investment yields, including a provision for uncertainty. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. We use both our own experience and industry experience, adjusted for historical trends, in arriving at our assumptions for expected mortality, morbidity and withdrawal rates as well as for expected expenses. We base our assumptions for expected investment income on our own experience adjusted for current economic conditions.
We had two lines of credit with commercial banks amounting to $125 million with no outstanding balance at year-end 2005. We had no compensating balance requirement on short-term debt for either 2005 or 2004. We did not use either of these lines of credit in 2005. We had one line of credit with a commercial bank amounting to $75 million with no outstanding balance at year-end 2004.
During 2004, we terminated an interest-rate swap entered into by CFC Investment Company in 2001 as a cash hedge of variable interest payments for certain variable-rate debt obligations. When we paid off the underlying debt, we terminated this agreement at a cost of $2 million, net of tax.
The fair value of our senior debt approximated $870 million at year-end 2005 and approximated $843 million at year-end 2004.
During 2005, we completed the exchange of outstanding 6.125% senior notes due 2034 for up to $375 million aggregate principal amount of newly issued 6.125% series B senior notes due 2034, which are substantially identical to the old 6.125% senior notes except that they have been registered under the Securities Act of 1933, as amended. As of the expiration of the exchange offer, $365 million aggregate principal amount of the outstanding notes had been tendered and accepted for exchange. That transaction had no effect on the company’s financial statements. We also completed our offer to exchange outstanding 6.90% senior debentures due 2028 for up to $420 million aggregate principal amount of newly issued 6.92% senior debentures due 2028. Holders of $392 million aggregate principal amount of the 6.90% senior debentures opted to exchange their bonds for newly issued 6.92% senior debentures.
Our insurance subsidiary declared dividends to the company of $275 million in 2005, $175 million in 2004 and $50 million in 2003. State of Ohio regulatory requirements restrict the dividends insurance subsidiaries can pay. Generally, the most Ohio-domiciled insurance subsidiaries can pay without prior regulatory approval is 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 Ohio Department of Insurance. During 2006, the total dividends that our lead insurance subsidiary may pay to our parent company without regulatory approval will be approximately $517 million.
Our board of directors on August 19, 2005, announced a program to repurchase up to 10 million shares of outstanding stock effective September 1, 2005. The new program replaced a 1999 repurchase authorization. Between September 1, 2005, and December 31, 2005, we purchased 534,000 shares at a cost of $24 million. At year-end 2005, 9.5 million shares remained authorized for repurchase at any time in the future. Repurchase shares are not adjusted for stock dividends.
As of December 31, 2005, 13 million shares of common stock were available for future stock option grants.
Declared cash dividends per share were $1.21, $1.04 and 90 cents for the years ended December 31, 2005, 2004 and 2003, respectively.
Our statements of income include incurred property casualty loss and loss expenses on assumed and ceded business:
Filed tax returns for calendar years 2000 through 2004 are currently open with the Internal Revenue Service. Federal income taxes are not provided for on our life insurance subsidiary’s Policyholder Surplus Account (PSA), which totaled $14 million at December 31, 2005, 2004 and 2003. Prior to 2005, U.S. tax rules provided that tax was due only on amounts distributed from the PSA. Had a distribution from the PSA occurred prior to 2005, tax due would have been approximately $5 million at current federal income tax rates.
The tax liability of a stock life insurance company on distributions made from the PSA was suspended beginning January 1, 2005, by the American Jobs Creation Act of 2004. As a result of this legislation, our life insurance subsidiary has the ability to distribute amounts from its PSA to the parent company prior to December 31, 2006, without incurring federal income tax, thereby permanently eliminating the $5 million tax previously disclosed.
Basic earnings per share are computed based on the weighted average number of shares outstanding. Diluted earnings per share are computed based on the weighted average number of common and dilutive potential common shares outstanding. We have adjusted shares and earnings per share to reflect all stock splits and dividends prior to December 31, 2005.
We sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension plan covering substantially all employees. We do not contribute to the 401(k) plan. Benefits for the defined benefit plan are based on years of credited service and compensation level. Contributions are based on the frozen entry age actuarial cost method. We also maintained a supplemental executive retirement plan, with liabilities of approximately $4 million, at year-end 2005 and 2004. Our pension expense is composed of several components that are determined using the projected unit credit actuarial cost method, and they are based on certain actuarial assumptions.
We use a December 31 measurement date for our plans. The accumulated benefit obligation was $165 million and $142 million at December 31, 2005, and 2004, respectively. The fair value of our stock comprised $29 million (17 percent of total plan assets) at December 31, 2005, and $27 million (17 percent of total plan assets) at December 31, 2004.
We expect to contribute approximately $10 million to our pension plan in 2006.
Here is a summary of the assumptions we use to determine our net expense for the plan:
For 2006, we expect to target 90 percent of our pension plan assets for equity securities and 10 percent for fixed maturities and cash.
Insurance companies use statutory accounting practices (SAP) as prescribed by regulatory authorities. Statutory accounting differs in certain respects from GAAP. The following table reconciles GAAP consolidated net income for the years ended December 31, and shareholders’ equity at December 31, with total statutory net income and capital and surplus:
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. Section 3(b)(2) specifically permits the SEC to exempt entities primarily engaged in business other than that of investing, reinvesting, owning, holding or trading in securities. Cincinnati Financial Corporation alternatively asked the SEC for relief pursuant to Section 6(c) of the Investment Company Act, which would exempt it from all the provisions of the Act because doing so is necessary or appropriate in the public interest, consistent with the protection of investors and consistent with the purposes intended by the Investment Company Act.
Limited opportunities to purchase equity securities that hold the potential for market value appreciation. Historically, the holding company has successfully invested in equity securities that provided both income and capital appreciation, contributing to long-term growth in book value. Constraining our ability to pursue this strategy and invest in equity securities could hamper book value growth over the long term.
If it were determined that the holding company is an unregistered investment company, the holding company might be unable to enforce contracts with third parties, and third parties could seek rescission of transactions with the holding company undertaken during the period that it was an unregistered investment company, subject to equitable considerations set forth in the Investment Company Act. In addition, the holding company could become subject to monetary penalties or injunctive relief, or both, in an action brought by the SEC.
Options outstanding and exercisable consisted of the following at December 31, 2005:
All three insurance segments record revenues from insurance premiums earned. Life insurance segment revenues also include fees from separate account investment management fees.
For commercial lines and personal lines insurance segments, we calculate underwriting income or loss by recording premiums earned minus loss and loss expenses and underwriting expenses incurred.
For the life insurance segment, we determine underwriting income or loss by taking premiums earned and separate account investment management fees, minus contract holder benefits and expenses incurred, plus investment interest credited to contract holders.
Identifiable assets are used by each segment in its operations. We do not report the identifiable assets for the commercial or personal lines segments because we do not use that measure to analyze the segments. We include all fixed-maturity and equity security investment assets, regardless of ownership, in the investment operations segment.