CFC Investment Company owns the Fairfield Executive Center, which is located on the northwest corner of its headquarters property in Fairfield, Ohio. This is a four-story office building containing approximately 96,000 square feet. CFC and its subsidiaries occupy approximately 90 percent of the building and unaffiliated tenants occupy approximately 10 percent. The property is carried in the financial statements at $7 million as of December 31, 2004, and is classified as property and equipment, net, for company use.
Unless otherwise noted, estimated industry data are referenced from materials presented on a statutory basis by A.M. Best, a leading insurance industry statistical, analytical and financial strength rating organization. Statutory data for the company is labeled as such; all other company data is presented on a GAAP basis.
The company is built on a foundation of personal relationships with these local independent insurance agents. These agents have an informed, front line perspective that benefits policyholders as well as the company, helping to create profitability and value for shareholders. Local-resident field marketing and other associates live in the communities they serve, working from offices in their homes and providing 24/7 availability. They are assigned directly to agencies, where they are able to provide prompt and personal service, gain firsthand knowledge and be effective decision makers for the company. The company differentiates itself by its commitment to: providing exceptional claims service and field underwriting through locally based associates serving the needs of agents and policyholders; offering competitive products, rates and compensation; and maintaining excellent financial strength ratings. Headquarters associates, including approximately 600 underwriters, are assigned to specific agencies and provide important support to the field staff and agencies.
In addition to property casualty insurance products, the company offers life insurance, leasing and asset management services to help attract and retain high quality independent insurance agencies. This strategy helps diversify revenues and profitability for both the agency and the company and enhances the already strong relationship built by the property casualty operations.
• Achieving above industry average growth in property casualty statutory net written premiums and maintaining industry-leading profitability by leveraging its regional franchise and proven agency-centered business strategy.
• Maintaining financial strength by keeping the ratio of debt to capital low and purchasing reinsurance to protect investment flexibility.
• Increasing the total return to shareholders through a combination of higher earnings per share, growth in book value and increasing dividends. The board of directors is committed to steadily increasing cash dividends and periodically authorizing stock dividends and splits. The board has increased the indicated annual dividend rate for 45 consecutive years, a record the company believes is matched by only 11 other publicly traded corporations.
for property casualty insurers, was significantly better than the estimated industry average. The growth rate of investment income reached its highest level in four years and book value reached a new record, as growth in net income more than offset market fluctuations in the equity portfolio. The company’s financial position continued to strengthen with assets at a record level.
• Increasing business with existing agencies by continuing to provide personal service.
• Resume equity investing. The company remains fully committed to an equity investment focus that management believes is a key to the company’s long-term growth and stability. The company will continue to invest for income and growth, focusing on a total return strategy supported by investments in dividend-paying companies.
This is a “Safe Harbor” statement under the Private Securities Litigation Reform Act of 1995. Certain forward-looking statements contained herein involve potential risks and uncertainties. The company’s future results could differ materially from those discussed. Factors that could cause or contribute to such differences include, but are not limited to:
° Concerns that doing business with the company is too difficult or
• Insurance regulatory actions, legislation or court decisions or legal actions that increase expenses or place us at a disadvantage in the marketplace
• Inaccurate estimates or assumptions used for critical accounting estimates, including loss reserves
• Recession or other economic conditions or regulatory, accounting or tax changes resulting in lower demand for insurance products
• Effect on the insurance industry as a whole, and thus on the company’s business, of the suit brought by the Attorney General of the State of New York against participants in the insurance industry, as well as any increased regulatory oversight that might result from the suit
• Limited flexibility in conducting investment activities if the restrictions imposed by the Investment Company Act of 1940 were to become applicable to the parent company
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 76. 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
• Changes in claim cost trends, including the effects of general economic and tort cost inflation, not reflected in the historical data used to estimate loss reserves
A reserve change of $29 million has a 1 percentage-point effect on the loss and loss expense ratio, based on 2004 earned premiums. Each 1 percentage point change in the loss and loss expense ratio has a $19 million effect on income and an 11 cent per share effect on net income per share, based on 2004 earned premiums.
In 2001, the company began to establish higher initial case reserves on serious liability claims to reflect recent experience indicating the likelihood that juries would ignore significant liability issues in cases involving seriously injured claimants.
The internal actuaries provide a point estimate to summarize their analysis. At year-end 2004 and 2003, IBNR reserves differed from the internal actuarial point estimate by less than 1 percent of the company’s loss and loss expense reserve.
While the company believes that reported reserves provide for all unpaid loss and loss expense obligations, the estimation processes involve a number of variables and assumptions. Management believes this uncertainty is mitigated by the historical stability of the company’s book of business and by its periodic reviews of estimates. As loss experience develops and new information becomes known, the reserve is reviewed and adjusted as appropriate. In this process, the company monitors trends in the industry, relevant court cases, legislative activity and other current events in an effort to ascertain new or additional exposures to loss. If management determines that reserves established in prior years were not sufficient or were excessive, the change is reflected in current-year results.
As part of its internal processes, management utilizes an outside actuary to provide management with an opinion regarding an acceptable range for adequate statutory reserves based on generally accepted actuarial guidelines.
Historically, the company has established adequate reserves that have fallen in the upper half of the outside actuary’s range. This approach has resulted in recognition of reserve redundancies (see Item 1, Property Casualty Loss and Loss Expense Reserves, Development of Loss and Loss Expenses, Page 5, for a 10-year history of reserve development). Modestly redundant reserves support the company’s business strategy to retain high financial strength ratings and remain a market for agencies’ business in all market conditions.
• Earthquakes in the New Madrid fault zone, which lies within the central Mississippi valley, extending from northeast Arkansas through southeast Missouri, western Tennessee and western Kentucky to southern Illinois and southern Indiana
• Tornado, wind and hail in the Midwest, Southeast and mid-Atlantic regions
The company uses 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. Reinsurance mitigates the risk of these highly uncertain exposures and limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure. In conjunction with these activities, the company also continues to explore and analyze credible scientific evidence, including the impact of global climate change, which may affect its exposure under insurance policies. Management’s decisions regarding the appropriate level of property casualty risk retention are affected by various factors, including changes in the company’s underwriting practices, capacity to retain risks and reinsurance market conditions. See Item 1, Reinsurance, Page 6, for a discussion of the company’s 2005 reinsurance treaties.
The application of the company’s impairment policy resulted in other-than-temporary impairment charges and write-offs of investments that reduced the company’s income before income taxes by $6 million, $80 million and $98 million in 2004, 2003 and 2002, 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, or are fixed-income securities that the company intends to hold until maturity. Under the same accounting treatment as market value gains, temporary declines (changes in the fair value of these securities) are reflected on the company’s balance sheet in other comprehensive income, net of tax, and have no impact on reported net income.
The company has a defined benefit pension plan covering substantially all employees. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates and expected return on plan assets, which are updated each year. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions.
The key assumptions used in developing the 2004 net pension expense were a 6.0 percent discount rate, an 8.0 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent, depending on the age of the employee. The 8.0 percent return on plan assets assumption is based on the fact that substantially all of the investments held by the pension plan are common stocks that pay annual dividends. Management believes this rate is representative of the expected long-term rate of return on these assets. These assumptions were consistent with the prior year except that the discount rate was reduced by one half of one percent due to current market conditions. In 2004, the net pension expense was $9 million. In 2005, the company expects a net pension expense of $12 million, primarily as a result of a 0.5 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 $16 million at December 31, 2004, and by $21 million at December 31, 2003. The fair value of the plan assets was less than the projected plan benefit obligation by $41 million at December 31, 2004, and by $29 million at December 31, 2003. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. The company expects to contribute approximately $10 million to its pension plan in 2005.
Another significant estimate relates to the company’s accrual for contingent (profit-sharing) commissions. Management bases the contingent commission accrual estimates on property casualty underwriting results and on supplemental property casualty information. Contingent commissions are paid to agencies using a formula that takes into account overall agency profitability and other factors, such as prompt monthly payment of amounts due to the company. Due to the complexity of the calculation and the variety of factors that can affect contingent commissions for an individual agency, the amount accrued can differ from the actual contingent commissions paid. The contingent commission accrual of $104 million in 2004 contributed 3.5 percentage points to the property casualty combined ratio. If commissions paid were to vary from that amount by 5 percent, it would affect 2005 net income by $3 million, or 2 cents per share, and the combined ratio by approximately 0.2 percentage points.
The company issues 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.
In December 2004, the Financial Accounting Standards Board issued SFAS No. 123(R), which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25. Among other items, SFAS No. 123(R) eliminates the use of APB Opinion No. 25 and the intrinsic value method of accounting and requires companies to recognize the cost of associate services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. The effective date of SFAS No. 123(R) is the first reporting period beginning after June 15, 2005, which is the third quarter of 2005 for the company, although early adoption is allowed.
The company currently expects to adopt SFAS 123(R) effective July 1, 2005; however, the company has not yet determined which of the adoption methods it will use. Subject to a complete review of the requirements of SFAS No. 123(R), based on stock options granted to associates through January 2005, the company expects the adoption of SFAS No. 123(R) on July 1, 2005, will reduce both third quarter and fourth quarter 2005 net income per share by approximately 2 cents per share.
In March 2004, the Financial Accounting Standards Board ratified the consensus reached by the Emerging Issues Task Force in Issue 03-1, “The Meaning of Other-Than-Temporary Impairments and Its Applications to Certain Investments” (EITF 03-1). The EITF reached a consensus on an other-than-temporary impairment model for debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and cost method investments. The basic model developed to evaluate whether an investment within the scope of Issue 03-1 is other-than-temporarily impaired involves a three-step process including: determining whether an investment is impaired (fair value less amortized cost); evaluating whether the impairment is other-than-temporary; and requiring recognition of an impairment equal to the difference between the investment’s cost and fair value.
Highlights of the consolidated results for the past three years include:
Revenues - Revenue growth accelerated over the three-year period on strong property casualty performance, continued growth in investment income and realized gains in 2004 versus realized losses in 2003 and 2002. Earned premium growth slowed over the three years as commercial lines pricing increases continued, but at a lower rate, and personal lines premium growth slowed, primarily due to lower new business levels. The company’s emphasis on common stock holdings with an increasing flow of dividend payments has led to continued growth of investment income. In addition, the company allocated virtually 100 percent of new investment dollars to fixed-income securities during most of 2004, adding to investment income growth.
Net income - Net income rose 56.0 percent in 2004 and 57.0 percent in 2003. In each of the past three years, the company’s total benefits and expenses have grown less rapidly than revenues, as management’s strategies to improve profitability have taken effect. Strong property casualty underwriting profit in 2004 and 2003 led to a higher effective tax rate.
Other considerations - When evaluating ongoing business operations, management takes the following into consideration:
In the three-year period, the after-tax impact of realized investment gains and losses was to raise net income by $60 million, or 36 cents per share, in 2004. Realized investment gains and losses reduced net income by $27 million, or 16 cents, in 2003, and by $62 million, or 36 cents, in 2002. The company reported net realized investment gains in 2004 primarily because of the sale of equity securities. Net realized investment losses were lower in 2003 than 2002 as other-than-temporary impairment charges declined due to the economic and market
• Uninsured motorist/underinsured motorist (UM/UIM) reserve release- Following the Ohio Supreme Court’s late 2003 decision to limit its 1999 Scott-Pontzer v. Liberty Mutual decision, the company released $38 million pretax of previously established UM/UIM reserves, adding $25 million, or 15 cents per share, to net income in 2003.
In 2004, the company reviewed outstanding UM/UIM claims for which litigation was pending. Those claims represented approximately $37 million in previously established case reserves. During the first quarter of 2004, the company filed motions for dismissal in various jurisdictions for specific claims and released an additional $32 million in related case reserves. The reserve releases in 2004 added $21 million, or 12 cents per share, to net income. Following the release of those reserves, the company stopped separately reporting on UM/UIM-related reserve actions. See Property Casualty Reserve Levels, Page 55, for additional information regarding UM/UIM reserves.
Over the long term, management’s objective is to achieve steady growth while performing as an industry profitability leader. Based on its outlook for the insurance and investment markets and its progress in implementing operating strategies, management has established certain performance targets for 2005:
Due to hurricane activity during 2004, management anticipates that there will be assessments for windpools in Florida and other states. The company has received only preliminary information on these potential assessments and at this time believes the potential impact of any assessment would be immaterial.
The following sections review results of operations for the combined property casualty insurance operations and, separately, for each of the company’s four reportable segments (see Commercial Lines Results of Operations, Page 35, Personal Lines Results of Operations, Page 40, Life Insurance Results of Operations, Page 45, and Investments Results of Operations, Page 47).
Management considers statutory net written premium growth to be a key performance indicator, since it can be used to compare the company’s growth to industry performance, allowing the company to evaluate the success of its strategies. The estimated industry growth rate was 4.8 percent, 9.5 percent and 14.7 percent in 2004, 2003 and 2002, respectively. The company’s statutory net written premiums rose 6.5 percent in 2004. The company’s 2004 statutory net written premium growth rate was reduced by 0.4 percentage points due to the reinsurance reinstatement premium. The company’s statutory net written premiums on an adjusted basis rose 11.7 percent in 2003 and 14.0 percent in 2002. The company’s 2003 and 2002 statutory net written premium growth rates were adjusted for the effect of a refinement adopted in 2002 of the company’s estimation process for matching written premiums to policy effective dates.
• Underwriting results and combined ratio - For the third consecutive year, combined property casualty underwriting performance improved on a year-over-year basis as the result of growth in premiums, in particular more adequate premium per policy, and the benefits of other underwriting efforts.
o Higher catastrophe loss ratio in 2004. Total catastrophe losses, net of reinsurance, were $148 million for 2004 compared with $97 million in 2003 and $87 million in 2002. The catastrophe losses contributed 5.1 percentage points to the property casualty combined ratio in 2004 compared with 3.6 percentage points in 2003 and 2002.
o Increase in the underwriting expense ratio. Underwriting expenses have risen more rapidly than premiums due to higher salary expense, largely due to increases in underwriting department staffing, and higher technology-related costs. The software recovery reduced the 2003 underwriting expense ratio by 0.8 percentage points.
On a statutory basis, the 2004 property casualty combined ratio was 89.4 percent, including a 1.1 percentage-point benefit from the UM/UIM reserve release. The 2003 property casualty statutory combined ratio of 95.0 percent before the software recovery, included a 1.4 percentage-point benefit from the UM/UIM reserve release, and compared with 99.6 percent in 2002, before the effect of Codification. The industry average statutory combined ratios are estimated at 97.6 percent, 100.1 percent and 107.4 percent for 2004, 2003 and 2002, respectively. The favorable comparison of this key performance indicator to industry trends highlights the success of the company’s strategies.
In the seven states in which the company had at least $100 million in commercial lines agency direct earned premiums in 2004, premiums were $1.320 billion in 2004. In these states, premiums grew 10.0 percent in 2004. In the remaining 24 states, agency direct earned premiums were $905 million in 2004. In these states, premiums rose 15.2 percent in 2004. The stronger growth rate in the smaller states reflected the opportunities available to the company in less penetrated markets.
Management considers new business measures to be a key indicator of the success of its competitive strategies. Locally based field marketing representatives lead the new business effort, working with agencies to underwrite and price business using personal and direct knowledge of the risk and competitive environment. In 2004, commercial lines new business premiums written directly by agencies rose 5.2 percent to a record $282 million due to strong new business trends in the first half of the year. In 2003, commercial new business premiums rose 6.8 percent to $268 million. In 2002, new business premiums rose 14.4 percent to $251 million. The lower 2004 and 2003 growth rates reflected the company’s pricing discipline. The growth rate in 2004 also reflected the slowing of premium increases industrywide.
In addition to seeking more adequate premium per exposure over the past three years, the company has focused on longer-term efforts to enhance profitability. These have included identifying the exposures the company has for each risk and making sure it offers appropriate coverages, terms and conditions and limits of insurance. The company continues to develop new underwriting guidelines, to re-underwrite books of business with selected agencies and to update policy terms and conditions, where necessary. In addition, the company continues to leverage its strong local presence. 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 have been conducting on-site inspections. Field claims representatives prepare full risk reports on every account reporting a loss above $100,000 or on any risk of concern. 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 address rising loss severity.
Commercial lines catastrophe losses, net of reinsurance and before taxes, were $71 million in 2004 compared with $42 million in 2003 and $40 million in 2002. The following table shows losses incurred, net of reinsurance, and subsequent development, for catastrophe losses in each of the past three years.
Non-commission expenses rose to 9.4 percent of earned premium in 2004 from 7.7 percent in 2003 and 2002. The increase in 2004 reflected higher salary expense and technology-related costs partially offset by continued refinements in the company’s cost allocation processes between commercial lines and personal lines. In 2003 the ratio of underwriting expenses to earned premiums was reduced by 0.8 percentage points due to the software recovery.
Policyholder dividend expense was 0.5 percent of earned premium in 2004 compared with 0.8 percent in 2003 and 0.3 percent in 2002.
In total the commercial multi-peril, workers compensation, commercial auto and other liability lines of business accounted for 90.1 percent of total commercial lines earned premium compared with 90.5 percent in 2003 and 90.5 percent in 2002. Approximately 95 percent of the company’s commercial lines premiums are written as packages, providing accounts with coverages from more than one business line. The company believes that its commercial lines area is best measured and evaluated on a segment basis. For reference, however, the table above and discussion below summarizes growth and profitability trends separately for each of the four primary business lines.
Over the past three years, results for the business lines within the commercial lines segment have reflected the company’s emphasis on underwriting and obtaining adequate pricing for the covered risk, as discussed above. Additional detail regarding reserve development is provided in Property Casualty Reserve Levels, Commercial Lines Segment Reserves, Page 56.
The company wrote a higher than normal number of one-year policies in 2002 pending regulatory approval for changes in policy terms and conditions (see Item 1, Commercial Lines Segment, Page 9, for a discussion of one- and three-year policies). In addition to industrywide slowing in premium growth, this decision decelerated the 2003 growth rate for the company’s commercial multi-peril business line as some liability coverages previously written in premium discounted packages were moved to non-discounted policies in 2003. Many non-discounted policies are included in the company’s other liability line of business.
The loss and loss expense ratio declined steadily over the three-year period. Commercial multi-peril is the company’s single largest business line, and management believes this business line’s loss data are the best indicators of the success of the growth and underwriting actions that have been implemented in the past three years. The 2004 calendar year ratio improved even though catastrophe losses were slightly higher than 2003 and $4 million in
Growth in 2004 was primarily due to higher rates. In 2003 and 2002 the company chose not to renew selected policies where it believed the aggregate terrorism exposure risk was excessive. Any new or renewal policy covering 200 or more employees at any one location received added scrutiny as the company sought to manage risk aggregation. On the basis of new business premiums written directly by agents, new workers compensation premiums increased 18.8 percent in 2004 and 5.9 percent in 2003 after declining 17.4 percent in 2002. Total workers compensation earned premiums were unchanged between 2003 and 2002 as rate increases offset a decline in policy count due to the re-underwriting effort.
In the past several years, the company accelerated efforts to improve commercial auto underwriting and rate levels, making certain that vehicle use was properly classified. As a result of those actions and moderating industry-wide severity and frequency trends, the loss and loss expense ratio for commercial auto improved in each of the past three years. Further, new and revised underwriting guidelines are being used to assure accurate classification and pricing. The UM/UIM reserve releases had their most substantial impact on the commercial auto line, lowering the 2004 loss and loss expense ratio by 4.6 percentage points and the 2003 loss and loss expense ratio by 6.9 percentage points. Including the UM/UIM reserve releases in 2004 and 2003, the 2004 ratio benefited 10.5 percentage points from higher than normal savings due to favorable loss reserve development from prior accident years, the 2003 ratio benefited by 8.8 percentage points and the 2002 ratio benefited by 4.0 percentage points.
Earned premium growth for the other liability line (commercial umbrella, commercial general liability and most executive risk policies) continued at a higher pace in 2004 because of the number of policies written in non-discounted programs and the continuing rise in liability pricing. The other liability policy count has been stable as growth in the number of non-discounted policies has offset declines in other areas, in part due to a change that allowed umbrella coverages to be endorsed to a primary policy rather than be written separately.
The 2004 ratio benefited by 32.5 percentage points due to higher than normal savings due to favorable loss reserve development from prior accident years, including 2.0 percentage points from UM/UIM reserve releases. The 2003 ratio benefited by 23.0 percentage points due to favorable development, including 2.6 percentage points due to UM/UIM reserve releases. The 2002 ratio benefited by 8.8 percentage points from favorable development.
Personal lines is an important component of the company’s overall relationship with many of its agencies and an important component of agency relationships with their clients.
Efforts to improve personal lines profitability have focused on the personal auto and homeowner business lines as discussed below. The significant components of expenses for the personal lines segment are described below.
Management monitors incurred losses by size of loss, business line, risk category, geographic region, agency, field marketing territory and duration of policyholder relationship, addressing concentrations or trends as needed. Analysis indicated no significant concentrations beyond that seen in higher loss ratios for certain business lines, which management believes it has addressed. Management also measures new losses and case reserve adjustments greater than $250,000 to track frequency and severity. For personal lines, losses greater than $1 million and losses between $250,000 and $1 million have stabilized as a percentage of earned premiums. Case reserve increases greater than $250,000 rose as a percentage of earned premiums in 2004 after declining in 2003. Management remains focused on establishing adequate case reserves at the time a claim is reported.
Personal lines catastrophe losses, net of reinsurance and before taxes, were $77 million in 2004 compared with $55 million in 2003 and $47 million in 2002. The following table shows losses incurred, net of reinsurance, and subsequent development, for catastrophe losses in each of the past three years.
Earned premiums for homeowners grew 8.2 percent, 14.0 percent and 10.0 percent in 2004, 2003 and 2002, respectively, primarily because of rate increases that began to take effect in 2002. The loss and loss expense ratio excluding catastrophe losses for the homeowner line declined to 69.3 percent in 2004 from 72.8 percent in 2003 and 78.3 percent in 2002 due to the company’s program to improve homeowner profitability. Catastrophe losses contributed 26.8 percentage points, 19.9 percentage points and 20.3 percentage points to the homeowner loss and loss expense ratio in 2004, 2003 and 2002, respectively. Management continues to seek to improve homeowner results so that this line achieves profitability in 2006. For this measurement, management is presuming commission and underwriting expenses would contribute approximately 29 percentage points to a homeowner combined ratio. The target also assumes that premium growth will lead to catastrophe losses as a percent of homeowner earned premium in the range of 17 percent. However, over the past three years, catastrophe losses have been approximately 22 percent on the same basis.
In mid-2004, the company began modifying its policy terms to change homeowner policy earthquake deductibles to 10 percent from 5 percent in selected Midwestern states, reducing the company’s exposure to a single significant
The three most significant actions taken since 2003 to improve profitability for the homeowner line are summarized below. Management believes that the homeowner line will be profitable in 2006. However, it will take into 2007 for the full benefit of these actions to be reflected in homeowner results.
• Rate changes - In 2004, rate increases in the range of 3.0 percent to 25.8 percent became effective in 22 states. In four of the company’s six largest homeowner states, 2004 increases were in the 8 percent to 18 percent range. Once rate changes become effective, they are applied to new business and to existing policies as they come up for renewal. In 2003, 23 rate increases were effective in 21 of the 25 states in which the company writes homeowners policies.
• Changes in policy terms and conditions - The company has identified specific coverages for updating to increase its control over risk and pricing, including capping replacement cost coverage for most policies and changing the water damage coverages. These changes began to go into effect over the past 24 months as policies have renewed and new business has been written. By the end of 2005, virtually all of the company’s homeowner policies will have the new terms and conditions.
The benefits of changes in rates and policy terms and conditions has been deferred because the company traditionally has written homeowner business on a three-year policy term and approximately one-third of policies come up for renewal each year. For example, in Ohio, which accounted for 32.0 percent of the company’s 2004 total homeowner earned premiums, typical 2005 homeowner renewal policies are experiencing approximately a 40 percent increase in total premium. The increase demonstrates the cumulative effect of rate changes, insured value and policy changes that were effected by the company over the policyholders’ most recent three-year term.
• Policy characteristics - In keeping with industry practices and as noted above, the company’s homeowner policies now include specific charges for optional coverages previously included at no charge, such as water damage coverage. This change can be an advantage for policyholders because it allows them to select the amount of coverage to meet their needs. However, this change also may have diminished a differentiating factor for the company’s products in the marketplace.
• Diamond introduction - The transition to the Diamond system of agencies writing in total almost 60 percent of personal lines volume is a significant accomplishment. However, the company now understands that the agency
learning curve for Diamond may be steeper than anticipated, potentially reducing agency attention to new business efforts. Longer-term, management believes this program could have a substantial positive benefit on premium growth as the technology presents solutions sought by independent agencies.
These factors may affect the personal lines growth rate, however, management believes that they will allow the company to improve the profitability of its homeowner line of business while maintaining personal auto profitability. While primarily focusing on longer-term targets for the homeowner line because of the existing base of three-year policies, management believes the overall personal lines combined ratio will be in the range of 95 percent for 2005 as the company continues to work through the renewal policy cycle and assuming catastrophe losses within normal parameters.
• Revenues - Revenue growth has accelerated over the past three years as the company increased life policy face amounts in force to $44.921 billion at year-end 2004 from $38.492 billion at year-end 2003 and $32.486 billion at year-end 2002.
• Profitability - The life insurance segment reports a small GAAP-based segment 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 2004 and 2003 because operating expenses remained level and mortality experience remained within pricing guidelines as premiums continued to rise.
At the same time, management recognizes that assets under management, capital appreciation and investment income are integral to evaluation of the success of the life insurance segment because of the long duration of life products. For that reason, management also evaluates GAAP data including results for investment activities on life insurance-related assets for The Cincinnati Life Insurance Company subsidiary, which comprises the life insurance segment. Looking at a key performance indicator for Cincinnati Life, GAAP net income grew 74.1 percent in 2004 to $38 million compared with 25.8 percent in 2003 to $22 million. The life insurance portfolio had pretax realized investment gains of $9 million in 2004 compared with $10 million and $11 million of pretax realized investment losses in 2003 and 2002, respectively.
• Premiums from traditional products, principally term insurance, which contributed 71.7 percent
• Separate account investment management fee income, which contributed 2.9 percent
The company’s life insurance subsidiary reported 2004 statutory written life premium of $118 million, which included the sale of two general account BOLI policies totaling $10 million, compared with $102 million in 2003, which included no BOLI sales. Statutory written premiums have been reclassified to exclude annuity deposits not involving life contingencies, which are not recognized as written premium under statutory rules. Annuity sales were $71 million in 2004 compared with $37 million in 2003 and $85 million in 2002. The growth in 2004 annuity sales was attributable to attractive fixed rates and guaranteed income features.
In 2004, the company’s life insurance segment experienced a 3.5 percent rise in applications submitted and a 10.7 percent increase in face amount issued due to continued strong sales of term insurance marketed through the company’s property casualty agency force. Management believes market pressures are mitigated for the life insurance company because of its association with the property casualty operations, its leverage of the property casualty agency franchise and its careful selection of independent agencies. Within this marketplace, Cincinnati Life is able to be competitive and attracts its share of business from the property casualty agencies with which the company has strong relationships.
• Insurance benefits paid and reserve increases, related to traditional life and interest-sensitive products, which accounted for 64.3 percent of 2004 expenses
The life insurance company seeks 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 the life insurance operation are on par with industry averages. During the past three years, the company has invested in imaging and workflow technology. As a result, the efficiency of application processing has improved significantly. During this period, submitted applications have increased at an annualized rate of approximately 6 percent, while staff involved with the underwriting and policy issue has declined 5 percent. This has been accomplished while maintaining the company’s service standards.
Acquisition costs, which vary with and are primarily related to the production of new business, are deferred and recorded as an asset. The company generally limits the expenses capitalized to the lower of the expense assumptions used in pricing or the actual deferrable costs. The deferred acquisition cost is amortized into income in proportion to different measures depending on the policy type. The company regularly reviews and, as appropriate, changes (unlocks) the assumptions used to calculate deferred acquisition costs for universal life contracts. The 2004 unlocking pertained primarily to assumptions regarding asset defaults and mortality. 2004 unlocking assumptions reduced deferred acquisition cost amortization by $4 million and deferred revenue amortization by $1 million.
As the life insurance company seeks to increase penetration of the property casualty agencies, management’s objective is to increase premiums and maintain expenses. Management continues to emphasize the cross-serving opportunities afforded by worksite marketing life insurance products. In 2005, management is exploring additional programs to simplify the worksite marketing sales process for independent property casualty agencies, including enrollment software. Term insurance is the company’s largest life insurance product line. Changes in the marketplace during 2004 have affected the cost and availability of reinsurance for term life insurance for 2005. The company currently is researching alternative reinsurance solutions to help fund the statutory reserve strain on new term business. Management believes it will be able to structure a reinsurance program that provides the life insurance company with the ability to continue to grow in the term life insurance marketplace while appropriately managing risk, at a cost that allows the company to achieve its profit targets.
• Investment income - Pretax investment income reached a new record of $492 million in 2004, rising 5.7 percent from the prior record in 2003. 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-income portfolio and increased dividend income from the common stock portfolio.
The advantages of strong cash flow in the past three years have been somewhat offset by the challenge of investing in a low interest rate environment. The allocation of new investment dollars to fixed-income securities during most of 2004 added to investment income growth. Overall, common stock dividends contributed 48.6 percent of pretax investment income in 2004 compared with 48.8 percent in 2003 and 46.9 percent in 2002. In 2004, 33 of the 51 common stock holdings in the portfolio raised their indicated dividend payout, as did 29 of 51 in 2003 and 28 of the 46 in 2002. The 2004 increases should add approximately $15 million to investment income on an annualized basis. Fifth Third, the company’s largest equity holding, contributed 58.8 percent of the increase and 39.9 percent of total dividend income in 2004.
Over the past three years, net realized investment gains and losses have been made up of other-than-temporary impairment charges, realized investment gains and losses on the sale of securities and changes in the valuation of embedded derivatives within certain convertible securities. These three areas are discussed below:
In 2004, the company recorded $6 million in write-downs of investments that management deemed had experienced an other-than-temporary decline in market value versus $80 million in 2003 and $98 million in 2002. See Critical Accounting Policies and Estimates, Asset Impairment, Page 27, for factors considered by management. These other-than-temporary impairment charges represented 0.1 percent, 0.6 percent and 0.9 percent of total invested assets at year-end 2004, 2003 and 2002, respectively. Also included in other-than-temporary impairments are unrealized losses of holdings that the company has identified for sale but not yet completed a transaction.
The write-down of two airline-related tax-exempt municipal bonds totaling $5 million accounted for the majority of other-than-temporary impairment charges in 2004. The majority of the write-downs in 2003 related to 31 high-yield corporate bonds written down $39 million and 10 convertible securities written down $26 million. Unlike 2002, the market value declines in 2003 were related to company-specific events rather than industry issues.
The impairment of $5 million of airline-related bonds in 2004 was a marked reduction from the prior two years, primarily because of the stabilization or improvement in the market value of previously impaired bonds and the disposition of airline-related securities in previous years. Over the past three years, other-than-temporary impairments of airline-related bonds as well as sales of securities reduced the company’s exposure to this industry to approximately $36 million at year-end 2004, down from $140 million at year-end 2001. The company did not write down any utility/merchant energy/trading securities in 2004 due to a healthier credit climate and the previous disposal of securities. In 2002 and 2003, valuations throughout that industry were affected by mismanagement of trading operations and accounting irregularities regarding the booking of revenues and the valuation of trading contracts. The company did not write down any healthcare securities in 2004. The 2003 healthcare impairment charges related primarily to the sudden default by Healthsouth Corporation and subsequent fraud charges. These securities have since recovered and all coupon payments have been made.
During 2004, the company sold $356 million in equity holdings as part of a program to support the financial strength ratings of its property casualty insurance operations (see Item 1, Financial Strength Ratings, Page 7, for discussion of this program). Holdings to be sold were selected primarily based on the investment committee and management’s belief that these securities would have a lower dividend growth rate over the next several years when compared with other holdings in the portfolio. Management also considered the potential tax effect of any unrealized gains. Partial sales of holdings that were over $100 million in assets at year-end 2003 contributed $311 million. As a result, the company now has 14 holdings over $100 million compared with 15 a year ago. Sales of smaller holdings that the company often uses as trading vehicles or had already targeted for sale contributed the remainder of the $356 million. The company also realized $21 million in gains from the sale of previously impaired securities.
Management believes that it will achieve pretax investment income growth of 5 percent to 6 percent in 2005 as a result of the anticipated growth in dividend income, the potential rise in interest rates, strong cash flow from insurance operations and the higher-than-normal allocation of new cash flow to fixed-income securities. While management does not forecast realized investment gains and losses, it believes that impairment charges in 2005 will be minimal. Every security in the portfolio was trading at or above 75 percent of book value at December 31, 2004. Management believes impairments should be limited to securities marked to market because they have been identified for sale, or those where issuer-specific events cause sharp declines in market value with little or no warning.
The company’s asset impairment committee continues to monitor the investment portfolio. The company also is awaiting the Financial Accounting Standard Board’s final decision regarding EITF 03-1 (see Item 8, Note 1, Recent Accounting Pronouncements, Page 79). Until that decision is announced, the company is unable to estimate the impact of adoption of the standard on its recognition of other-than-temporary impairment losses. The company’s current asset impairment policy is discussed in Critical Accounting Policies and Estimates, Asset Impairment, Page 27. The company believes that the committee’s ongoing reviews help to minimize the effect of changes in interest rates that may negatively change the value of the company’s holdings.
Liquidity is a measure of the company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of business obligations.
Premiums collected have risen over the past three years because of growth in written premiums. Paid losses and related loss expenses accounted for approximately 84 percent, 82 percent and 74 percent of property casualty and life insurance losses and policyholder benefits incurred in 2004, 2003 and 2002, respectively.
• Dividends to shareholders - Over the past 10 years, the company has paid an average of 43 percent of net income as dividends, with the remaining 57 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 - 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.
Common stock repurchases for treasury have continued at a steady pace over the last several years and occur when management believes that stock prices on the open market are favorable for such repurchases. At a minimum, the company would expect the repurchase to offset dilution of option exercises. In 2004, the company repurchased 1,571,800 shares at a total cost of $66 million (see Item 5, Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Page 19 for information regarding the repurchase activity). Shares repurchased under the current board authorization total 13.3 million, at a total cost to the company of $481 million. At December 31, 2004, 3.7 million shares remained authorized for repurchase. Share repurchase amounts are not adjusted for stock dividends.
• Senior notes - On November 1, 2004, the company issued $375 million aggregate principal amount of 6.125% senior notes due 2034, generating net proceeds of $368 million. The company used $183 million of the proceeds to pay off two short-term lines of credit. The remaining proceeds will be used for general corporate purposes and to finance the construction beginning in 2005 of an estimated $100 million office building and parking garage to be situated at the headquarters located in Fairfield.
• $190 million increase in investment portfolio assets as discussed below.
• $57 million increase in reinsurance recoverables primarily due to business growth and record catastrophe losses in 2004. As discussed under Item 1, Reinsurance, Page 6, the company’s working reinsurance treaties are with highly rated and financially strong reinsurers and the company has experienced no collection or aging problems with the property casualty or life reinsurance receivables. See USAIG Pool Participation, Page 54, for a discussion of that reinsurance recoverable.
• $14 million increase in separate accounts primarily due to market appreciation of assets held and reinvestment of income as discussed in Critical Accounting Policies and Estimates, Separate Accounts, Page 29.
While the transfer raised The Cincinnati Insurance Company’s surplus, the action was not a means to accelerate growth or strengthen loss reserves. Rather, it allowed the company to retain the financial flexibility that continues to support its high financial strength ratings. At December 31, 2004, statutory surplus for the property casualty insurance group was $4.191 billion compared with $2.783 billion at December 31, 2003.
Management anticipates continuing the temporary allocation of nearly 100 percent of cash flow available for investment to fixed-income and convertible security purchases until mid-2005. Over the longer term, the company anticipates continuing to invest in equity securities to help achieve its portfolio objectives.
The company’s portfolio investments are primarily in publicly traded fixed-income and equity and equity-linked securities, classified as available for sale in the accompanying financial statements. Valuations of all of the company’s investments are based on either listed prices or data provided by FT Interactive Data, an outside resource that supplies global securities pricing. Changes in the fair value of these securities, based on the listed prices or information from FT Interactive Data, are reported on the company’s balance sheet in other comprehensive income, net of tax. Fixed maturities (fixed-income bonds and notes) and equity and equity-linked securities (common and preferred stocks) are classified as available for sale and recorded at fair value in the financial statements.
market, duration is used to measure the sensitivity of an asset price to movements in yields. See Item 8, Note 2 to the Consolidated Financial Statements, Page 80, for additional information regarding the maturity of the company’s fixed-income portfolio.
At December 31, 2004, insurance reserves were 48.1 percent of total liabilities compared with 47.7 percent at December 31, 2003. At December 31, 2004, the remainder of liabilities consisted primarily of unearned premiums (15.6 percent), deferred income tax (18.6 percent) and long- and short-term debt (8.0 percent).
• $303 million increase in insurance reserves as discussed below. The company does not discount its property casualty reserves.
At year-end 2004, the total reserve balance, net of reinsurance, was $2.977 billion, compared with $2.845 billion at year-end 2003 and $2.608 billion at year-end 2002 (see Item 8, Note 4 to the Consolidated Financial Statements, Page 82, for a reconciliation of property casualty reserve balances with the loss and loss expense liability on the balance sheet). The reserves reflected in the financial statements are management’s most accurate estimation.
As discussed in Commercial Lines Segment Reserves, Page 56, management’s decision to re-underwrite the commercial lines book of business beginning in 2000, including non-renewing certain policyholders due to risk levels, and increasing rates to better reflect exposure levels, has already resulted in improved profitability. Management believes the program is leading to a lower risk profile for the overall commercial lines segment, which should contribute to favorable loss reserve trends.
As discussed in Personal Lines Segment Reserves, Page 58, management is seeking to improve its personal lines segment performance, in particular the homeowner business line, partially by reducing risk exposure through changes in policy terms and conditions. Management does not expect its actions in personal lines to have a material impact on loss reserve trends, largely due to the relatively short-tail nature of homeowner claims.
Beginning in 2002, management’s conclusions regarding reserve levels for all business lines reflected refinement of the manner in which the value of future salvage and subrogation for claims already incurred were estimated.
Net reserves for all asbestos and environmental claims were increased to $135 million in 2004 compared with $105 million in 2003 and $88 million in 2002. Net reserves for all asbestos and environmental claims were 4.5 percent, 3.7 percent and 3.4 percent of total reserves, in 2004, 2003 and 2002, respectively.
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:
The personal lines segment continues to implement rate increases in an effort to restore profitability. Over the past three years, higher-than-normal catastrophe losses have contributed to the personal lines loss and loss expenses.
The following table provides the amounts of net reserve changes made over the past three years by personal line of business and accident year:
• Changes in case reserves based on new information for specific claims or classes of claims
The company currently is working to commence an exchange offer with respect to the 6.125% senior notes issued in 2004 under the registration rights agreement entered into in connection with the offering of these notes. Management believes it will meet the timetable for completion of the exchange offer specified in the registration rights agreement. The interest rate of the notes will increase if the company does not comply with certain obligations under the registration rights agreement.
As of March 4, 2005, the company’s senior debt was rated aa- by A.M. Best Co., A+ by Fitch Ratings, A2 by Moody’s Investors Services and A by Standard & Poor’s Rating Services. During 2004, A.M. Best and Standard & Poor’s changed their credit ratings for the senior debt due to their firms’ respective notching strategies. Notching is a rating organization standard that places an insurer’s credit rating generally two or three levels below its insurer financial strength rating (see Item 1, Financial Strength Ratings, Page 7, for discussion of the company’s insurer financial strength ratings). Notching recognizes that in the event of financial problems, obligations to policyholders would be paid before obligations to creditors. A.M. Best and Standard & Poor’s moved the senior debt credit ratings closer to their standard notching, although Standard & Poor’s commented that CFC’s rating still was one level higher than is typical because of “the large pool of marketable securities at the holding company.”
During 2004, the company paid-off $183 million of short-term debt. At year-end 2004, the company had one line of credit totaling $75 million with no outstanding balance. There are no financial covenants on the line of credit.
currently is working with Messer on design modifications that will be used to determine the final project cost. Construction preparation began in the first quarter of 2005 with completion estimated by September 2008.
Nonetheless, based on cumulative property casualty claims paid over the last ten years, the company anticipates that approximately 34 percent of property casualty reserves will be paid within one year, an additional 36 percent between one and three years, 14 percent between three and five years, and 16 percent in more than five years. While management believes that historical performance of loss payment patterns is a reasonable source for projecting future claims payments, there is inherent uncertainty in this estimate of contractual obligations.
The historic pattern of using premium receipts for the payment of loss and loss expenses has enabled the company to extend slightly the maturities of the investment portfolio beyond the estimated settlement date of the loss reserves. The effective duration to maturity of the company’s fixed-income portfolio was 6.9 years at December 31, 2004. By contrast, at December 31, 2004, the duration of the company’s loss and loss expense reserves was 3.0 years and the duration of all liabilities was 2.7 years. Management believes this difference in duration does not affect the company’s ability to meet its current obligations because cash flow from operations is sufficient to meet these obligations. In addition, the company’s investment strategy has led to substantial unrealized gains from holdings in equity securities. These equity holdings could be liquidated to meet higher than anticipated loss and loss expenses.
Management believes the effect on future liquidity of these items may be offset by:
• Reinsurance - The company’s property catastrophe reinsurance program mitigates the liquidity risk of an unexpected rise in claims severity or frequency due to a catastrophic event. The company’s current catastrophe reinsurance treaties provide coverage for gross losses up to $500 million (see Item 1, Reinsurance, Page 6, for a summary of the company’s reinsurance agreements). Under the terms of the catastrophe reinsurance treaties, the company retains the first $25 million in losses, 40 percent of the next $20 million in losses and 5 percent of losses from $45 million to $500 million, resulting in a maximum cash outlay of $56 million for gross losses up to $500 million. The company’s reinsurance treaties are with highly rated firms with which the company has done business for a number of years. Reinsurance does not relieve the company of its obligation to pay covered claims. The financial strength of the company’s reinsurers is important because the company’s ability to recover for losses under one of the reinsurance agreements depends on the financial viability of the reinsurer.
• Financial strength - As discussed above, the company anticipates that approximately 34 percent of property casualty insurance reserves will be paid within one year, an additional 36 percent between one and three years, 14 percent between three and five years, and 16 percent in more than five years. These timings are based on cumulative property casualty claims paid over the last 10 years. While management believes that historical
• Financial resources - On August 26, 2004, the company announced that Cincinnati Financial Corporation transferred approximately 31.8 million shares of Fifth Third common stock to The Cincinnati Insurance Company, the property casualty insurance subsidiary. This action was related to the company’s June 28, 2004, application to the SEC seeking exemptive relief under the Investment Company Act of 1940. The transfer was authorized by Cincinnati Financial’s board of directors on August 13, 2004, and approved by the Ohio Department of Insurance on August 24, 2004.
The asset transfer resolved the holding company’s current status under the Investment Company Act. See Item 1, Regulation, Page 15, for discussion of the risks associated with the application for exemptive relief.
If it were to be determined that the company was an unregistered investment company before the asset transfer, Cincinnati Financial could be unable to enforce contracts undertaken with third parties during the period that it was an unregistered investment company. Third parties could seek to rescind transactions undertaken with Cincinnati Financial during that period. As a result, it could be determined that holders of Cincinnati Financial’s $420 million aggregate principal amount of 6.9% Senior Debentures due 2028 have a right to rescind such indebtedness, thereby requiring Cincinnati Financial to immediately repay such amounts. However, equitable considerations set forth in the Investment Company Act could support the company’s right to enforce contracts and could limit or prevent third-parties’ ability to rescind a transaction. However, Cincinnati Financial currently has available sufficient assets or could access the capital markets to fund such repayment and believes that its assets are adequate to meet its short- and long-term obligations. In the event the company chose to access the capital markets, current market conditions would dictate the rate on new debt, which could be higher than the 6.9 percent currently paid on the debt.
Total shareholders’ equity was 38.8 percent and 40.0 percent of total assets at year-end 2004 and 2003, respectively.
As a long-term investor, the company has followed a buy-and-hold strategy for more than 40 years. A significant amount of unrealized appreciation on equity investments has been generated as a result of this policy. Unrealized appreciation on equity investments, before deferred income taxes, was $5.553 billion and $6.001 billion at year-end 2004 and 2003, respectively. On an after-tax basis, it constituted 57.8 percent of total shareholders’ equity at year-end 2004.
Unrealized gains in the investment portfolio (accumulated other comprehensive income) from long-term appreciation and investment of cash flows have resulted in year-end 2004 shareholders’ equity of $6.249 billion. Investments at the parent company give management flexibility to support its capitalization policies for the subsidiaries, improve the ability of the insurance companies to write additional premiums and maintain high ratings.
During the years ended December 31, 2004, 2003 and 2002, the company had realized investment gains before taxes of $147 million, $81 million and $58 million offset by realized investment losses of $56 million, $122 million and $152 million, respectively. At December 31, 2004, unrealized investment gains before taxes totaled $5.857 billion and unrealized investment losses in the investment portfolio amounted to $17 million. The unrealized appreciation was primarily due to the company’s holdings in Fifth Third (Nasdaq:FITB) and Alltel Corporation (NYSE:AT) common stock.
The management of the company is responsible for the integrity and objectivity of the financial statements, which are presented on an accrual basis of accounting and include amounts based upon management’s best estimates and judgment. Other financial information in the Annual Report on Form 10-K is consistent in all material respects with that in the financial statements. The accounting system and related internal controls are designed to assure that the books and records reflect the transactions of the company in accordance with established policies and procedures as implemented by qualified personnel.
Deloitte & Touche LLP, the company’s independent registered public accounting firm, has audited the consolidated financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2004, 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.
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 GAAP and that receipts and expenditures of the company are being made only in accordance with authorizations of management and the 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.
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries (the company) as of December 31, 2004 and 2003, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the Index at Item 15(a)2. We also have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting report, that the company maintained effective internal control over financial reporting as of December 31, 2004, based on the criteria established in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements and financial statement schedules, an opinion on management’s assessment, and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audits.
Cincinnati Financial Corporation (company) underwrites insurance through four insurance companies that market through a network of local independent insurance agents. Insurance products include a broad range of business and personal policies, as well as life and disability income insurance and annuities. In addition, the company provides finance/leasing and asset management services through its CFC Investment Company and CinFin Capital Management Company subsidiaries.
Expenses incurred in the issuance of policies are deferred and amortized over the terms of the policies. These expenses vary with and primarily relate 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. Loss and loss expense reserves are based on claims reported prior to the end of the year and estimates of unreported claims net of estimates for salvage and subrogation reserves, based upon facts for 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.
The Cincinnati Insurance Companies market property casualty insurance policies in 31 states. Nine states with at least $100 million in agency earned premium in 2004 generated approximately 69 percent and 70 percent of total property casualty premiums in 2004 and 2003, respectively. Ohio, where the company has 187 independent agencies, accounted for 23.7 percent and 24.6 percent of total earned premiums in 2004 and 2003. Agencies in Georgia, Illinois, Indiana, Michigan, North Carolina, Pennsylvania, Virginia and Wisconsin each contributed between 4 percent and 10 percent of premium volume in 2004 and 2003. No single agency accounted for more than 1.1 percent of the company’s total agency direct earned premiums.
Limited-pay products require the policyholder to pay scheduled premiums up front on coverage that is provided for an extended period. Limited-pay products include single-premium deferred annuities or life insurance policies with a limited premium-paying period. The company defers the amount of premium in excess of the amount necessary to provide for all benefits and expenses and recognizes it over the life of the coverage, using the gross profit method. Universal life products include those that allow policyholders to vary premiums at their discretion or provide benefits or permit charges that are not fixed according to the terms of the policy. Premiums for universal life products are not recognized as revenue when received. The company recognizes cost of insurance charges, administration charges and surrender charges as revenue when earned using the gross profit method.
Reserves for universal life products are equal to the cumulative account balances, which include premium deposits plus credited interest, less charges such as mortality and administration, and withdrawals. Interest rates on approximately $612 million and $530 million of such reserves at December 31, 2004 and 2003, respectively, are periodically adjusted subject to economic conditions then in effect and subject to contractually guaranteed minimum rates.
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 premiums and discounts on fixed-maturity securities.
The company invests in certain financial instruments, such as convertible debt and convertible preferred stock, that contain embedded options. The embedded options are valued and accounted for separately. The company also entered into an interest rate swap agreement as a cash flow hedge during 2001 in order to lock in an interest rate related to certain of its variable rate debt obligations ($31 million notional amount). Statement of Financial Accounting Standards (SFAS) No. 133 “Accounting for Derivative Financial Instruments and Hedging Activities,” as amended, requires changes in the fair value of the company’s derivative financial instruments to be recognized periodically in income or shareholders’ equity (as a component of accumulated other comprehensive income), respectively. During 2004, the interest rate swap was terminated in connection with the repayment of the underlying debt obligation. 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.
The fair values for liabilities under investment-type insurance contracts (annuities) are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued. Fair values for short-term notes payable are estimated using interest rates currently available to the company. Fair values for long-term debentures are based on the quoted market prices for such debentures.
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 exercise of stock options and the conversion of convertible senior debentures, which were issued by the company in 1992 and redeemed through 2002. Shares and earnings per share have been adjusted to reflect all stock splits and dividends prior to December 31, 2004, including the 5 percent stock dividend paid June 14, 2004.
The company has qualified and non-qualified stock option plans under which options are granted to employees at prices that are not less than market price at the date of grant and that are exercisable over 10-year periods. The company applies Accounting Principles Board (APB) Opinion 25 and related interpretations in accounting for these plans. Accordingly, no compensation cost has been recognized for the stock option plans.
SFAS No. 123(R) permits companies to adopt its requirements using either a modified prospective or a modified retrospective method. Under the modified prospective method, the compensation cost is recognized in the financial statements beginning with the effective date, based on the requirements of SFAS No. 123(R) for all share-based payments granted after that date, and based on the requirements of SFAS No. 123 for all unvested awards granted prior to the effective date of SFAS No. 123(R). Under the modified retrospective method, the requirements are the same as under the modified prospective method, but this method also permits companies to restate financial statements of previous periods based on pro forma disclosures made in accordance with SFAS No. 123. The company currently utilizes a standard option-pricing model (binomial option-pricing model) to measure the fair value of stock options granted to associates. While SFAS No. 123(R) permits companies to continue to use such a model, the standard also permits the use of a lattice model. The company has not yet determined which model it will use to measure the fair value of associate stock options upon the adoption of SFAS No. 123(R).
The company currently expects to adopt SFAS 123(R) effective July 1, 2005. However, the company has not yet determined which of the adoption methods it will use. Subject to a complete review of the requirements of SFAS No. 123(R), based on stock options granted to associates through January 2005, the company expects that the adoption of SFAS No. 123(R) on July 1, 2005, will reduce both third-quarter and fourth-quarter 2005 net income per share by approximately 2 cents per share.
In March 2004, the Financial Accounting Standards Board ratified the consensus reached by the Emerging Issues Task Force in Issue 03-1, “The Meaning of Other-Than-Temporary Impairments and Its Applications to Certain Investments” (EITF 03-1). The EITF reached a consensus on an other-than-temporary impairment model for debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and cost method investments. The basic model developed to evaluate whether an investment within the scope of Issue 03-1 is other-than-temporarily impaired involves a three-step process including: 1) determining whether an investment is impaired (fair value less amortized cost); 2) evaluating whether the impairment is other-than-temporary and 3) requiring recognition of an impairment equal to the difference between the investment’s cost and fair value. In September 2004, the FASB issued Staff Position (FSP) No. EITF Issue 03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue No. 03-01.” This FSP delays the effective date of the measurement and recognition guidance contained in paragraphs 10-20 of Issue 03-1 and, as of March 4, 2005, the FASB had not yet issued guidance on the adoption or effective date of FSP No. EITF Issue 03-1-1. The amount of any other-than-temporary impairment that may need to be
recognized in the future will depend on market conditions and management’s intent and ability to hold any such impaired securities.
The Accounting Standards Executive Committee of the AICPA issued Statement of Position 03-1 “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts,” in July 2003 to be effective for the company in the first quarter of 2004. This Statement of Position provides guidance for insurance companies for certain nontraditional long-duration contracts (principally variable annuities with minimum death benefit guarantees) and for separate accounts. This statement had no effect on the company’s consolidated financial statements.
The fair value of the conversion features embedded in convertible securities amounted to a gain of $10 million at December 31, 2004, and a gain of $9 million at December 31, 2003.
At December 31, 2004, contractual maturity dates for investments in fixed-maturity securities were:
At December 31, 2004, investments with book value of $67 million and fair value of $72 million were on deposit with various states in compliance with certain regulatory requirements.
At December 31, 2004, 23 fixed maturity investments with a total unrealized loss of $5 million and one equity securities with a total unrealized loss of $1 million had been in that position for more than 12 months. All were trading between 70 percent to less than 100 percent of book value. These assets presently do not meet the company’s other-than-temporary asset impairment criteria and will not be considered impaired unless they meet such criteria in the future.
At December 31, 2003, 53 fixed maturity investments with a total unrealized loss of $15 million and five equity securities with a total unrealized loss of $4 million had been in that position for more than 12 months. All were trading between 70 percent to less than 100 percent of book value.
Management bases property casualty loss and loss expenses reserve estimates on company experience and information from internal analyses, obtaining additional information from consulting outside actuaries. When reviewing reserves, management analyzes historical data and estimates the effect of various loss development factors.
As a result of changes in estimates of insured events in prior years, the provision for loss and loss expenses decreased by $196 million, $80 million and $45 million in calendar years 2004, 2003 and 2002. These decreases are due in part to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for amounts less than expected.
Total catastrophe losses, net of reinsurance, were $148 million for 2004 compared with $97 million in 2003 and $87 million in 2002. The majority of catastrophe losses are incurred in the calendar year of the event.
The reserve for loss and loss expenses in the accompanying balance sheets also includes $35 million, $29 million and $26 million at December 31, 2004, 2003 and 2002, respectively, for certain life health losses.
At December 31, 2004 and 2003, the fair value associated with the annuities shown above approximated $477 million and $406 million, respectively.
The company entered an interest-rate swap agreement during 2001 to hedge future cash flows (thereby obtaining a fixed interest rate) related to certain variable rate debt obligations ($31 million notional amount), which would have expired in 2008. This agreement was terminated at a cost of $2 million, net of tax, in the fourth quarter of 2004. The swap is reflected at fair value on the accompanying balance sheet at December 31, 2003, and the $2 million unrealized loss, net of tax, at December 31, 2003, is a component of comprehensive income.
The company’s board of directors has authorized the repurchase of outstanding shares. The current repurchase program for 17 million shares was announced on February 6, 1999, replacing a program approved in 1996 and updated in 1998. The company has purchased 13.3 million shares at a cost of $481 million between February 6, 1999, and December 31, 2004. At December 31, 2004, 3.7 million shares remain authorized for repurchase at any time in the future.
As of December 31, 2004, 4 million shares of common stock were available for future stock option grants.
Declared cash dividends per share were $1.09, 95 cents and 85 cents for the years ended December 31, 2004, 2003 and 2002 respectively.
Property casualty premium income in the accompanying statements of income includes approximately $32 million, $56 million and $60 million of earned premiums on assumed business and is net of approximately $175 million, $211 million and $330 million of earned premiums on ceded business for 2004, 2003 and 2002, respectively.
Insurance losses and policyholder benefits in the accompanying statements of income are net of approximately $134 million, $103 million and $95 million of reinsurance recoveries for 2004, 2003 and 2002, respectively. Property casualty premiums and losses consist of the following:
Filed tax returns for calendar years 2000 through 2003 are currently open with the Internal Revenue Service. No provision was made as of December 31, 2004, 2003 and 2002, for federal income taxes on approximately $14 million of the life insurance subsidiary’s retained earnings, since such taxes will become payable only to the extent that such retained earnings are distributed as dividends or exceed limitations prescribed by tax laws. The company does not contemplate any such dividend. If, however, the entire $14 million of retained earnings becomes taxable, at the current federal income tax rates, the tax would be approximately $5 million.
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. Shares and earnings per share have been adjusted to reflect all stock splits and dividends prior to December 31, 2004.
Options to purchase 0.3 million, 2 million and 1 million shares of common stock were outstanding during 2004, 2003 and 2002, respectively, but were not included in the computation of net income per common share (diluted) because the options’ exercise prices were greater than the average market price of the common shares.
The company uses a December 31 measurement date for its plans. The accumulated benefit obligation was $142 million and $117 million at December 31, 2004 and 2003, respectively. The fair value of the company’s stock comprised $27 million (17 percent of total plan assets) at December 31, 2004, and $24 million (18 percent of total plan assets) at December 31, 2003.
The company evaluates and updates pension plan assumptions annually as necessary. The discount rate assumptions for the benefit obligation tracks with and yearly adjustments reflect changes in Moody’s Aa bond yields. The rate of compensation increase assumptions reflect historical calendar year compensation increases.
The company expects to contribute approximately $10 million to its pension plan in 2005.
The company’s pension plan asset allocations by asset category are as follows:
The following benefit payments, which reflected expected future service as appropriate, are expected to be paid:
Statutory accounting practices (SAP) prescribed or permitted for insurance companies by regulatory authorities differ in certain respects from GAAP. The following table reconciles consolidated net income for the years ended December 31, and shareholders’ equity at December 31, as reported herein in conformity with GAAP, with total statutory net income and capital and surplus as reported by the company’s insurance subsidiaries and prepared in accordance with statutory accounting practices prescribed or permitted by insurance regulatory authorities:
The company paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $11 million, $19 million and $17 million on premium volume of approximately $76 million, $132 million and $113 million for 2004, 2003 and 2002, respectively.
On November 15, 2004, Cincinnati Financial Corporation repurchased 1 million shares of Cincinnati Financial’s common stock from Robert C. Schiff, Trustee, Robert C. Schiff Revocable Trust originally dated November 21, 2001. Robert C. Schiff is a founder of the company and retired as director of Cincinnati Financial Corporation in November 2004. The stock was sold to Cincinnati Financial at an aggregate purchase price equal to 99 percent of the product of (a) 1,000,000 multiplied by (b) $43.45, the last reported sale price per share of the common stock on the Nasdaq National Market at the close of trading on November 12, 2004.
Cincinnati Financial Corporation alternatively has asked the SEC for relief pursuant to Section 6(c) of the Investment Company Act that 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. The company simultaneously contacted the SEC’s Division of Investment Management to discuss the status of Cincinnati Financial Corporation under the Investment Company Act. The request for an exemptive order is still pending with the staff of the SEC.
Options outstanding and exercisable consisted of the following at December 31, 2004:
The company operates primarily in two industries, property casualty insurance and life insurance. Company management regularly reviews four reportable segments to make decisions about allocating resources and to assess performance:
• Income before income taxes for the insurance segments is defined as underwriting income (loss).
• Income before income taxes for the investment operations segment is net investment income plus realized investment gains and losses for all fixed maturity and equity security investments of the entire company, less interest credited to contract holders of the life insurance segment.
• Loss before income taxes for the Other category is primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.
The following table sets forth unaudited quarterly financial data for the years ended December 31, 2004 and 2003: