The company’s headquarters property is adequate and suitable for its business needs for at least the next two years. The company will determine the timeline for developing additional space at its headquarters location in 2004.
In 2003, as the result of a settlement negotiated with a vendor, pretax results included the recovery of $23 million of the $39 million one-time, pretax charge incurred in 2000.
In 2000, the company recorded a one-time charge of $39 million, pre-tax, to write down previously capitalized costs related to the development of software to process property casualty policies.
In 2000, the company earned $5 million in interest in the first quarter from a $303 million single-premium bank-owned life insurance (BOLI) policy booked at the end of 1999 that was segregated as a Separate Account effective April 1, 2000. Investment income and realized investment gains and losses from separate accounts generally accrue directly to the contract holder and, therefore, are not included in the company’s consolidated financials.
In 1993, results included a credit related to the method of accounting for income taxes to conform with Statement of Accounting Financial Standards No. 109 and a charge related to the effect of 1993 increases in income tax rates on deferred taxes recorded for various prior-year items.
As described in the safe harbor statement below, some factors could affect relationships with its independent agencies and limit opportunities for growth. Management is responsible for monitoring and managing those risk factors. In Item 1, Business, Page 1, and the Results of Operations, Page 22, management covers factors that it believes ensure it can sustain its relationships with independent agencies. In addition, the Management’s Discussion and Analysis reviews other important factors relating to the outlook, including its investing and reserving philosophy.
The following discussion contains certain forward-looking statements that 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:
recession or other economic conditions resulting in lower demand for insurance products
unusually high levels of catastrophe losses due to changes in weather patterns, environmental events or other causes
The significant accounting policies used in the preparation of the financial statements are discussed in Note 1 to the Consolidated Financial Statements, Page 58. In conjunction with that discussion, 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 auditor. 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.
Reserve estimates 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 and estimates of loss expenses associated with processing and settling those claims. Reserves are allocated to various lines of business. For reported claims, management establishes case reserves within the parameters of coverage provided in the policy. For claims incurred but not yet reported, management uses a variety of tools, including actuarial and statistical analysis, to estimate reserves. Loss reserves are reduced by the estimated amount of salvage and subrogation.
At year-end 2003, the total reserve balance, net of reinsurance, was $2.845 billion compared with $2.608 billion at year-end 2002 and $2.352 billion at year-end 2001. See Note 4 to the Consolidated Financial Statements, Page 64, for a reconciliation of property casualty reserve balances with the loss and loss expenses liability on the balance sheet. The increase in reserves in each year reflected the increases in policies and coverage in force, loss development reflecting the trend toward larger average losses and management’s conclusions regarding adequate reserve levels. Management believes that the stability of the company’s business makes its historic data the most important source for establishing adequate reserve levels. Traditionally, management and the outside actuaries have conducted a thorough evaluation in the calendar fourth quarter of the adequacy of reserves as of the end of the third quarter of each year. As a result, the most significant variation in reserves traditionally has been implemented in the fourth quarter. In the quarters following, less detailed but continuous reviews of reserve adequacy are made and any resulting adjustments are reflected in that quarter’s results. In 2004 and beyond, management plans to conduct more extensive analysis of reserve adequacy each quarter.
The company’s outside actuary provides management with an opinion regarding the acceptable range for adequate statutory reserves based on generally accepted actuarial guidelines. Historically, the company has established adequate reserves in the upper half of the actuary’s range. This approach has resulted in recognition of reserve redundancies in each of the past 10 years, which moderated beginning in 2000. Modestly redundant reserves support the company’s business strategy to retain high financial strength ratings and remain a market for agencies’ business in all market conditions.
Slowness to recognize or respond to new or unexpected loss patterns, such as those caused by the risk factors cited in the company’s safe harbor statement, could lead to a rise in reserves, which would lead to a higher loss and loss expense ratio; each percentage point increase in the loss and loss expenses ratio would reduce pre-tax income by $27 million based on 2003 earned premiums.
In the normal course of its business, the company may provide coverage for exposures for which estimates of losses are highly uncertain. Most significant are catastrophic events. Due to the nature of these events, management is unable to predict precisely the frequency or potential cost of catastrophe occurrences. However, in an effort to control such losses, the company does not market property casualty insurance in California, reviews aggregate exposures to huge disasters and monitors its exposure in certain coastal regions. Analysis of a once-in-250-year event affirms the company has catastrophe exposure to:
Fixed-income and equity investments are the company’s 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.
Other-than-temporary impairment in the value of securities is defined by the company as declines in valuation that meet specific criteria established in the asset impairment policy. Such declines often occur in conjunction with events taking place in the overall economy and market, combined with events specific to the industry or operations of the issuing corporation. These specific criteria include a declining trend in market value, the extent of the market value decline and the length of time the value of the security has been depressed, as well as subjective measures such as pending events and issuer liquidity. Generally, these declines in valuation are greater than might be anticipated when viewed in the context of overall economic and market conditions. See Investment Portfolio, Page 44, for information regarding valuation of the invested assets.
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 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.
For property casualty policies, deferred costs are amortized over the terms of the policies. For life policies, acquisition costs are deferred and amortized over the premium-paying period of the policies.
In the three-year period, the after tax impact of realized investment losses was to reduce net income by $27 million, or 17 cents per share, in 2003, by $62 million, or 38 cents, in 2002 and by $17 million, or 10 cents, in 2001. Net realized investment losses were lower in 2003 than 2002 as other-than-temporary impairment charges declined due to the economic and market recovery and as net gains on the sale of securities rose to a higher level. See Investments Results of Operations, Page 38, for additional information on net realized investment gains and losses.
Other considerations - In addition, two items in 2003 that the company considered to be unusual should be taken into consideration when evaluating ongoing business operations:
Uninsured motorist/underinsured motorist reserve release - In the fourth quarter of 2003, the company released $38 million pretax of previously established UM/UIM reserves following the Ohio Supreme Court’s decision to limit its 1999 Scott-Pontzer v. Liberty Mutual decision. That action added $25 million, or 15 cents per share to after tax net income. See Property Casualty Loss and Loss Expense Reserves, Page 25, for additional information regarding UM/UIM reserves.
Book value - Book value reached a record high of $38.69 at year-end 2003 because of the recovery in the financial markets that led to higher market values for equity investments. Year-end 2002 and 2001 book value declined primarily because of fluctuations in market values for the equity investment portfolio.
Property casualty written and earned premium growth in the high single digits.
Earned premiums - Over the past three years, the company has taken advantage of strong insurance industry pricing and leveraged its relationships with independent agencies to obtain higher premiums on new and renewal business. The rate of increase for commercial lines earned premiums slowed in 2003, reflecting changing market conditions, while the rate of increase for personal lines earned premium rose due to higher rates. Total policy count was down 2.2 percent in 2003 after rising 1.7 percent in 2002.
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 and allows it to evaluate the success of its strategies. The estimated industry growth rate was 10.2 percent, 14.9 percent and 8.5 percent in 2003, 2002 and 2001, respectively. The company’s statutory net written premiums on an adjusted basis rose 11.7 percent in 2003, 14.0 percent in 2002 and 13.0 percent in 2001. The company’s 2003 and 2002 statutory net written premiums 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. The company’s 2001 statutory net written premiums were adjusted for the adoption of Codification.
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 as a result of benefits from underwriting efforts. The statutory industry averages are estimated 101.1 percent, 107.4 percent and 115.9 percent for 2003, 2002 and 2001, respectively. On a statutory adjusted basis, the 2003 property casualty 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 and 103.6 percent in 2002 and 2001. The company’s 2002 ratio reflects the written premium adjustment and the 2001 ratio reflects the adoption of Codification. The favorable comparison of this key performance indicator to industry trends highlights the success of the company’s strategies.
The company has been more aggressively identifying and measuring exposures to match coverage amounts and premiums to the risk. Where this matching is not possible, accounts are not being renewed unless there are mitigating factors. Agents agree on the need to carefully select risks and assure pricing adequacy. They appreciate the time the company’s associates invest in creating solutions for their clients while protecting profitability, whether that means working on an individual case or developing modified policy terms and conditions that preserve flexibility, choice and other sales advantages.
In 2003, WinCPP, an online system for commercial lines processing, was expanded to 10 states and now is available for agencies writing more than 70 percent of the company’s total premiums. CMS, a new claims file management system, was deployed in late 2003 to field claims associates in all states. CMS supports the company’s continued comitment to providing exemplary claims service with a personal touch by lifting the administrative burden from the field claims representatives. Through December 31, 2003, capitalized development costs related to CMS totaled $14 million. In 2004, management anticipates investing another $10 million to enhance CMS, providing capabilities for agencies and more comprehensive financial reporting.
The discussion of the commercial lines and personal lines segments provides additional detail regarding these strategies and trends.
As background, the Ohio Supreme Court’s 1999 decision in Scott-Pontzer greatly increased the exposure on commercial auto insurance policies. That ruling extended Ohio businesses’ UM/UIM coverage in force over the past 15 years to their employees when they were not at work and to the employees’ resident family members. It contributed to changes in policy wording for UM/UIM coverage. Additionally, the same court’s 2000 decision in Linko v. Indemnity effectively caused insurers to extend UM/UIM coverage, at the newly increased level of exposure, to every auto insurance policy in Ohio at no additional premium. The two court rulings affected all auto insurers in the state.
Open claim counts for the long-tail asbestos and environmental losses annually ranged from 400 to 600, or less than 1 percent of the total open claim count, in each of the three years.
The 2004 property and casualty reinsurance program encompasses four primary components:
Casualty fourth excess treaty - The company also purchases a casualty reinsurance treaty that provides an additional $25 million in casualty loss protection. This treaty, along with the casualty per occurrence treaty, provides $50 million of protection for workers compensation losses, bad faith losses and “clash coverage” when there is a single occurrence involving multiple Cincinnati Insurance Company policyholders or multiple policies for one insured. The ceded premium is estimated to be $2 million in 2004 compared with $2 million in both 2003 and 2002.
Property catastrophe treaty - To protect against catastrophic events such as wind and hail, hurricanes or earthquakes, the company purchases property catastrophe reinsurance, with a limit up to $400 million. For the 2004 treaty, ceded premiums are estimated to be $25 million, up from $21 million in 2003 and 2002. Part of the increase for 2004 is due to the increase in the limit to $400 million from $300 million effective April 1, 2003 to keep limits in line with increases in exposures due to company growth. The company will retain the first $25 million of losses arising out of a single event and will retain 43 percent of losses from $25 million to $45 million as it did in 2003. The company retains 5 percent of all losses in excess of $45 million, up to $400 million.
Individual risks with limits in excess of $25 million must be handled by a different reinsurance mechanism. Property coverage for individual risks with insured values between $25 million and $50 million are reinsured under an automatic facultative treaty. For those risks with property values exceeding $50 million, the company negotiates the purchase of facultative coverage on an individual certificate basis. For casualty coverage on individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis.
Reinsurance protection for the company’s surety and life insurance businesses are covered under separate treaties with many of the same reinsurers that write the property casualty working treaties.
Late in 2003, competition increased for high-quality accounts, particularly from other regional carriers that may have been less affected by market events in 2001 and 2002. Market conditions now vary substantially between geographic markets, possibly due to differing economic conditions and the presence of different groups of competitors. Rate increases for high-quality accounts are in the low- to mid-single digits. In most markets where the company competes disciplined underwriting generally remains the norm. In certain markets the company has seen some indication of carriers seeking to aggressively price average or below-average accounts. In the company’s opinion, carriers are modifying pricing rather than changing policy terms and conditions. Regional and national carriers continue to target the small accounts market, defined by the company as accounts with premiums under $10,000 annually.
Staying abreast of evolving market conditions is a critical function, accomplished in both an informal and a formal manner. Informally, the field marketing representatives are in constant receipt of market intelligence from the agencies they work with on a daily basis. Formally, the commercial lines product management group completes periodic market surveys to obtain competitive intelligence. This market information helps to determine the top competitors by line of business or specialty program and also determines market
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 2003, commercial new business premiums written directly by agencies rose 6.8 percent to a record $268 million. In 2002, new business premiums rose 14.4 percent to $251 million from $220 million in 2001. The lower 2003 growth rate reflected the slowing of premium increases industrywide.
The company’s standard approach is to write three-year policies, a competitive advantage in the commercial line market. Although the company offers three-year terms, many policies are adjustable at each annual anniversary for the subsequent one-year period, and may be cancelled at any time at the discretion of the policyholder. While writing three-year policies would appear to restrict opportunities to quickly adjust pricing, contract terms provide that the rates for automobile, workers compensation, professional liability and most umbrella liability coverages within multi-year packages may be changed at each of the policy’s annual anniversaries for the next one-year period. The annual rate adjustments could incorporate rate changes approved by state insurance regulatory authorities between the date the policy was written and its annual anniversary date, as well as changes in risk exposures and premium credits or debits relating to loss experience, competition and other underwriting judgment factors. Management estimates that approximately 75 percent of 2003 commercial premium was written on a one-year policy term or was subject to annual rating adjustments.
In 2003, the company resumed writing three-year policies for contractor risks in most states because of these advantages. In 2002, the company temporarily had ceased writing three-year policies for contractors in favor of one-year policies while awaiting state regulatory approval for two significant coverage changes in the company’s general liability and umbrella coverage forms. The changes brought the company’s policy forms in line with industry practices by capping the amount payable during a policy period (usually 12 months) for certain types of liability claims and by clarifying how a policy responds once the insured learns that injury or damage has occurred during a prior policy period. Looking ahead, these changes will help the company better manage liability losses and remain a viable market for agents to place coverage for well managed, reputable contractors. Underwriters carefully monitor new and renewal contractor business, continuing to write one-year policies when competitive or underwriting issues make three-year policies impractical.
Specific actions over the three years that have helped the company achieve these favorable results included:
Risk-category reviews - These studies emphasized underwriting guidelines, such as property age, capacity and loss experience. While the company continues to evaluate each risk on its own merits, these risk category reviews have helped underwriters develop guidelines such as caps on umbrella limits for certain severity-prone risk categories.
General liability task force -This study focused on loss trends by classes of business, severity versus frequency and other metrics for casualty coverages. The objective was to determine why results had not responded to the company’s other actions to improve profitability. The task force completed its analysis in mid-2003. Based on the findings, the company implemented increased underwriting and pricing attention for certain states and territories as well as for general liability classifications that have historically generated unprofitable results.
These actions have helped to address rising loss severity. The significant components of expenses for the commercial lines segment were:
Looking at commercial lines loss data by size, management evaluates new losses and case reserve adjustments greater than $250,000 to track frequency and severity. Analysis of loss data by average size of loss supports management’s belief that the increase in loss severity is not a temporary phenomenon. However, new losses between $250,000 and $1 million and case reserve increases greater than $250,000, declined as a percentage of earned premiums in each of the past two years. New losses greater than $1 million declined as a percentage of earned premium in 2003 after rising 1.0 percentage point in 2002.
Loss expenses incurred - Loss expenses incurred were stable as a percent of earned premium in 2003 and 2002 after rising in 2001 because of higher loss expense reserves.
In total, commercial multi-peril, workers compensation, commercial auto and other liability accounted for 90.5 percent of total commercial lines earned premium in 2003 compared with 90.5 percent in 2002 and 91.5 percent in 2001. Approximately 95 percent of the company’s commercial lines premiums are written for accounts with coverages from more than one business lines. 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. Other factors that have affected results for these lines included:
Commercial multi-peril - As noted above, the company wrote a higher than normal number of one-year policies in 2002 pending regulatory approval for changes in policy terms and conditions. In addition to industrywide slowing in premium growth, this decision affected the 2003 and 2002 growth rates 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, which are included in the other liability line of business.
Workers compensation - Conditions within the workers compensation market improved between 1999 and 2003 as market pricing rose in most states, albeit offset by continued rising trends in loss severity. As indicated by the rapid rise in premium volume of state pools for workers compensation, many carriers chose to exit significant portions of this line of business. While the company remains highly selective about the risks covered, workers compensation is available in packages for commercial lines policyholders, maintaining the company’s competitive position in selected states. Workers compensation has a lower commission ratio than the other commercial business lines.
The workers compensation loss and loss expense ratio has been steady for three years. Overall pricing increases for new and renewed risks and underwriting actions have helped to bring about declining accident year loss ratios over the three-year period. The loss and loss expenses ratio in 2002 reflected the addition of $23 million to IBNR for older accident years, offset by the salvage and subrogation reserve. Higher than expected paid and reported loss development, primarily in accident years 2001 and 2000, accounted for $21 million of the 2002 IBNR change.
Commercial auto - Commercial auto premium growth trends reflected the factors influencing overall commercial lines performance with the primary driver being price increases.
Other liability (commercial umbrella, commercial general liability and most executive risk policies) - Earned premium growth for the other liability line continued at a higher pace in 2003 because of the number of policies written in non-discounted programs and the continuing rise in liability pricing. 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.
During 2004, the company anticipates commercial lines insurance market trends will reflect the industry’s increasing surplus, improving profitability and growing capacity. The company will continue to markets its products to a broad range of business classes, price its products adequately and take a package approach.
On a written premium basis, management anticipates commercial growth of approximately 10 percent if market conditions remain stable. The company expects competition to accelerate for property lines of business due to the historical profitability of this business area and the short-tail exposures associated with it. Conversely, management anticipates somewhat firmer market conditions to continue for casualty lines of business. This is due to profitability challenges and an inflationary legal environment related to these long-tail exposure lines.
Earned premiums - The sources of increasing growth in the past three years were rate increases on new and renewal personal lines business. Agencies and policyholders in the uncertain marketplace are attracted to the company’s fair pricing and long-term approach.
Combined ratio - The combined ratio improved steadily, reflecting the relatively stable loss and loss expense ratio in personal auto and the improving ratio for homeowners due to higher premiums.
Management considers new business measures to be a key indicator of the success of its competitive strategies. In 2003, personal lines new business premiums written directly by agencies declined 9.3 percent to $60 million. In 2002, new business premiums rose 27.2 percent to $66 million from $52 million in 2001. The decline in new business growth in 2003 reflected the company’s emphasis on underwriting personal lines. In addition, recent homeowner rate increases brought pricing more in line with industry averages, potentially diminishing a differentiating factor for more price-sensitive consumers. Further, agencies may be placing less business with the company until the introduction of the personal lines policy processing system in their state.
In the six states in which the company wrote $35 million or more in personal lines agency direct earned premium in 2003, premiums grew 8.3 percent in 2003 and 7.0 percent in 2002. In the remaining 25 states, agency direct earned premiums grew more rapidly, rising 15.9 percent in 2003 and 12.0 percent in 2002. Similar to commercial lines, the stronger growth in the smaller states reflected the opportunities available to the company in less penetrated markets.
While generally seeking to leverage the relationships with the company’s independent agencies, 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 were:
Looking at personal lines loss data by size, management evaluates new losses and case reserve adjustments greater than $250,000 to track frequency and severity. Analysis of loss data by average size of loss supports management’s belief that the increase in loss severity is not a temporary phenomenon. For personal lines, losses greater than $1 million have stabilized on both an absolute dollar basis and as a percentage of earned premium in the past two years after rising from 2001’s level. However, losses between $250,000 and $1 million continue to rise, in line with higher overall loss severity. Case reserve increases greater than $250,000 declined as a percentage of earned premiums in 2003 after rising sharply in 2002. Management remains focused on establishing adequate case reserves at the time a claim is reported.
Loss expenses incurred were stable as a percent of earned premium in 2003 and 2002 after rising in 2001 because of higher loss expense reserves.
Catastrophe losses - Personal lines catastrophe losses, net of reinsurance and before taxes, were $55 million in 2003 compared with $47 million in 2002 and $36 million in 2001.
Underwriting expenses incurred - In 2003 the ratio was reduced by 1.1 percentage points due to the software recovery. Over the three-year period, expenses have declined as a percent of earned premiums because premiums are rising more rapidly than overhead and contingent commissions have been steady. Depreciation of capitalized costs in 2003 was 0.2 percentage points higher than the prior year as significant technological initiatives moved into service.
The planned rate increases and introduction of the Diamond policy processing system into larger states should contribute to earned premium growth in 2004 and beyond. Management believes the loss and loss expense ratio for personal auto could improve slightly over the next year as underwriting efforts continue to enhance profitability.
Homeowner - Earned premiums for homeowners grew 14.0 percent, 10.0 percent and 6.3 percent in 2003, 2002 and 2001, respectively. Catastrophe losses contributed 19.9 percentage points, 20.3 percentage points and 23.5 percentage points to the homeowner loss and loss expense ratio in 2003, 2002 and 2001, respectively. Although the loss and loss expense ratio for the
Rate changes - In 2003, 23 rate increases were effective in 21 of the 25 states in which the company writes homeowners policies. Four of the company’s six largest personal lines states as measured by homeowner premium volume experienced rate increases in the 10 percent to 20 percent range in 2003. Additional rate increases in the 5 percent to 18 percent range have been filed and approved for 2004 in these same states. At the same time, the personal lines underwriters are focusing on insurance-to-value initiatives to verify the company is receiving the correct level of premium for the value of the insured risk. Rate changes are applied to new business and to existing policies as they come up for renewal. Management believes the company’s homeowner rates remain competitive.
Shift to one-year policies - In conjunction with the deployment of the Diamond personal lines policy processing system, the company will begin to write homeowner policies on a one-year basis instead of three-years. One-year policies will allow the company to modify rates, terms and conditions more rapidly when necessary. Homeowner policies were being written on a one-year basis beginning in January 2004 in Indiana and Michigan and February 2004 in Ohio. Other states will shift to one-year policies in advance of the Diamond deployment for each specific state. Diamond will provide greater efficiencies to assist the company and its agencies in processing annual renewals.
The combined impact of these changes in rates and policy terms and conditions is seen as existing three-year policies renew. For example, in Ohio, which accounts for 32.2 percent of the company’s total homeowner earned premium, typical policyholders coming off a three-year term are experiencing approximately a 40 percent increase in total premium for their 2004 renewal policy. This reflects all rate increases, insured value and policy changes that were effective over the three-year policy cycle that is coming to an end. Ohio policies are being renewed on a one-year policy term beginning in early in 2004.
premiums from traditional products, principally term insurance, which contributed 71.7 percent of 2003 revenues
Cincinnati Life continues to introduce new and enhanced products specifically designed for property casualty agencies. The LifeHorizons Whole Life, Universal Life and Disability Income products are well suited for financial, estate and business planning. Approximately 75 percent of the company’s premium volume for these products comes from the property casualty agencies, with the remaining 25 percent from independent life agencies.
In 2002, the life insurance industry was challenged by a number of factors, including the higher-than-historic level of bond defaults, stock market declines that impacted variable annuities and competitive pressures that affected rates for term products. As a result, the industry saw an overall decline in statutory surplus, accelerated write-downs of deferred acquisition costs and lower income. In combination, these factors resulted in ratings downgrades for many life insurance companies during 2002.
During the same period, many large, widely known life insurance companies have transitioned to investor-owned companies from mutual companies. Industry analysts believe these transitions could result in accelerated consolidation in the life insurance industry.
The future presence of larger competitors could have a negative impact on smaller, stand-alone life insurance companies because of their potentially greater efficiency and their ability to be more aggressive in setting prices as rating agencies continue to downgrade the financial strength of numerous companies.
Management believes such 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, especially as other property casualty companies continue to exit the life business.
Over the past several years, the life insurance company has worked to introduce a portfolio of new and enhanced products, primarily under the LifeHorizons name. For example, during 2003, the company introduced a new guaranteed whole life policy and a non-cancelable rider for its disability income product. In 2002, the life company revised the rates for the LifeHorizons term series and introduced a new risk classification system that better matches risk profile and rate. Other recent launches in the LifeHorizons product series included a simplified term policy specifically for clients of the company’s property casualty agencies.
Commissions, general and other business expenses, net of deferred acquisition costs, accounted for 36.4 percent of 2003 expenses
In 2004 the life insurance company will introduce a long-term guaranteed universal life plan to further expand its product portfolio. As the life insurance company seeks to increase penetration of the property casualty agencies, management’s objective is growth in the premium base through the sale of new products, in particular term insurance, which would place more emphasis on growth in statutory gross and net written premiums.
Investment income - Pretax investment income reached a new record of $465 million in 2003, rising 4.7 percent from the prior record in 2002. Growth in investment income over the past two years has been driven by strong cash flow for new investments 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 effect of the weak economy on overall market conditions and the challenge of reinvesting proceeds from called or redeemed bonds at lower prevailing interest rates. Overall, dividends contributed 48.8 percent of pretax investment income in 2003, up from 46.9 percent in 2002 and 45.9 in 2001. The higher contribution was primarily because of lower yields on the fixed-income portfolio and dividend increases from companies in the common stock portfolio. In 2003, 29 of the 51 common stock holdings in the portfolio raised their indicated dividend payout, as did 28 of the 46 in 2002. The 2003 increases should add approximately $16 million to investment income on an annualized basis. Fifth Third, the company’s largest equity holding, contributed 60 percent of the increase and 41.8 percent of total dividend income in 2003.
Lingering weakness in the economy during the first half of 2003 led to the continued write-downs of securities that management deemed had experienced other-than-temporary declines in market value. Of the $80 million in other-than-temporary write-downs in 2003, $69 million occurred in the first six months of the year.
Utility/merchant energy/trading - Valuations throughout the industry were affected by mismanagement of trading operations and accounting irregularities regarding the booking of revenues and the valuation of trading contracts.
The other-than-temporary impairments of airline-related bonds as well as sales of securities reduced the company’s exposure to this industry to approximately $57 million at year-end 2003, down from $140.0 million at year-end 2001.
In 2003, the company recorded $30 million in net realized investment gains compared with $8 million in 2002 and $11 million 2001. The company buys and sells securities on an ongoing basis to help achieve its portfolio objectives. Although the company prefers to hold fixed-income securities until maturity, a decision to sell reflects management’s perception of a change in the underlying fundamentals of the security and preference to allocate those funds to investments that more closely meet the established parameters for long-term stability and growth. Management’s opinion that the security fundamentally no longer meets the company’s investment expectations may reflect a loss of confidence in the issuer’s management, a change in underlying risk factors (such as political risk, regulatory risk, sector risk or credit risk), or a recovery from a previously impaired value.
In 2003, the company recorded $9 million in fair value increases versus $4 million in fair value declines in 2002 and $9 million in fair value increases in 2001 due to the application of Statement of Financial Accounting Standard (SFAS) No. 133, which requires measurement of the fluctuations in the value of the embedded derivative features in selected convertible securities. See Note 1 to the Consolidated Financial Statements, Page 58, for details on the accounting for convertible security embedded options.
The property casualty and life insurance operations’ short-term cash needs primarily consist of paying insurance loss and loss expenses and ongoing operating expenses. Those needs are met through cash flows from insurance premiums and investment income. Although the company has never sold investments to pay claims, the sale of investments would provide an additional source of liquidity, if required.
After satisfying short-term cash requirements, excess cash flows from underwriting and investment activities are used to build the investment portfolio, leading to the potential for increases in future investment income and realized gains. Underwriting generates positive cash flows because cash from premium payments generally is received in advance of cash payments required to settle claims.
The company’s property casualty and life insurance operations generated positive cash flows from underwriting of $472 million, $441 million and $478 million in 2003, 2002 and 2001, respectively. This strong underwriting cash flow was primarily due to growth of premiums in the past three years. In addition, investment income from the insurance operations generated cash flows of $332 million, $316 million and $298 million in 2003, 2002 and 2001, respectively.
As described in Item 1, Regulations, Page 10, and Note 8 to the Consolidated Financial Statements, Page 65, dividends paid to the parent company by its insurance subsidiary are restricted by Ohio regulatory requirements. Further, management intends for all insurance subsidiaries to maintain their superior financial strength ratings, which may constrain their dividend-paying capacity. In 2003, 2002 and 2001, the company’s insurance subsidiary paid dividends of $50 million, $100 million and $100 million, respectively, to the parent company.
Cincinnati Financial has increased the indicated annual cash dividend rate to shareholders for 44 consecutive years and, periodically, the board of directors authorizes stock dividends or splits. In January 2004, the board of directors authorized a 10.0 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.10. In February 2003, the board of directors authorized a 12.4 percent increase in the regular quarterly cash dividend to an indicated annual rate of $1.00. In February 2002, the board authorized a 6.0 percent increase; and in February 2001, a 10.5 percent increase.
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. In 2003, repurchases were made as follows:
Management continues to believe that cash provided by operating activities will continue to be the primary source of funds for the company. Future liquidity could be affected by catastrophe losses in excess of the company’s catastrophe reinsurance treaties, which provide coverage for gross losses up to $400 million. The company has no significant exposure to assumed reinsurance, which accounted for no more than 2.4 percent of earned premiums in each of the last three years and is expected to remain at or near this level in 2004.
Management anticipates its insurance subsidiary will pay dividends of at least $75 million to the parent company in 2004. During 2004, the company will determine the timeline for developing additional space at its headquarters location although management anticipates no extraordinary cash outlays in the next two years.
At December 31, 2003, the investment portfolio made up 80.3 percent of total assets. The remainder consisted primarily of other invested assets (0.5 percent), premium receivables (6.8 percent), reinsurance receivables (4.0 percent), deferred acquisition costs (2.4 percent) and separate accounts (3.0 percent). These percentages have remained relatively constant over the last few years.
Total assets increased 9.8 percent, or $1.387 billion, to $15.509 billion at December 31, 2003. The increase primarily reflected:
$104 million increase in premiums receivables and $29 million increase in deferred policy acquisition costs due to the higher premium volume.
Insurance regulatory and statutory requirements designed to protect policyholders from investment risk influence the company’s investment decisions on an individual insurance company basis. Cash generated from insurance operations is invested almost entirely in five classes of assets evaluated for yield and risk prior to purchase (See Item 1, Investments Segment, Page 7, for a discussion of the five classes of assets).
The company invests 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 (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.
insurance market for all types of aviation and aerospace accounts. Due to the company’s participation in USAIG for policy years 2001 and prior, The Cincinnati Insurance Company was named as the designated insurer for American Airlines’ policy year 2000 business. Recoverables resulting from all American Airlines accidents during that year were recorded on The Cincinnati Insurance Companies’ 2001 financial statements. Management expects to recover 100 percent of the reinsurance recoverables associated with the USAIG participation although it is impossible to estimate the timeframe for recovery due to the complex nature of aviation and aerospace insurance. USAIG has a reinsurance program for its members. Companies participating in the USAIG reinsurance program are all rated A or higher by A.M. Best. Reinsurance recoverables on behalf of unauthorized reinsurers participating in the pool are backed by letters of credit and trust funds from these reinsurers. The company no longer participates in USAIG.
At December 31, 2003, insurance reserves were 47.7 percent of total liabilities. The remainder consisted primarily of unearned premiums (15.5 percent), deferred income tax (20.9 percent) and long- and short-term debt (6.5 percent). These percentages have remained relatively constant over a number of years.
Total liabilities increased 9.2 percent, or $781 million, to $9.305 billion at December 31, 2003 from December 31, 2002. The increase primarily reflected:
$212 million increase in deferred income tax liability to $1.949 billion at December 31, 2003, primarily because of the increase in unrealized gains in the investment portfolio.
The company has two lines of credit totaling $250 million at year-end 2003. There are two financial covenants for the company’s $175 million line of credit. First, consolidated net worth on the last day of each fiscal quarter shall not be less than $5.0 billion or $4.5 billion if such reduction in consolidated net worth is due solely to unrealized losses in the company’s portfolio of debt and equity investments; at year-end 2003, the company’s consolidated net worth was $6.204 billion. Second, the company’s consolidated ratio of indebtedness for borrowed money to net worth, at any time during each fiscal quarter, shall not exceed the ratio of 0.25-to-1.00; as of year-end 2003, the ratio of indebtedness to net worth was 0.10-to-1.00. The company’s $75 million line of credit has no financial covenants. Short-term interest rates will fluctuate. Every 100 basis point increase in short-term rates will increase annual interest expense by $2 million, before-tax, based on the $183 million outstanding on the two lines of credit at year-end 2003.
During 2001, CFC Investment Company entered into an interest-rate swap as a cash hedge of variable interest payments for certain variable-rate debt obligations ($31 million notional amount) to better match fixed rate lease assets with liabilities having a fixed financing rate. Under this interest-rate swap contract, the company agreed to pay a fixed rate of interest for a seven-year period. The contract is considered to be a hedge against changes in the amount of future cash flows associated with the related interest payments. Accordingly, the related unrealized gain or loss on this contract is a component of comprehensive income. The interest swap contract is reflected at fair value in the company’s balance sheet. The unrealized loss at December 31, 2003 and 2002 was $3 million and $4 million, net of tax. The net effect of this transaction was to fix the interest cost on the short-term loan.
Total shareholders’ equity was 40.0 percent and 39.8 percent of total assets at year-end 2003 and 2002.
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 $6.037 billion and $5.509 billion at year-end 2003 and 2002, respectively. It constituted 65.8 percent of total shareholders’ equity at year-end 2003.
Regulatory - the potential for a decrease in market value due to the impact of legislative proposals or changes in the laws or regulations
Economic - the potential for a decrease in value due to changes in general economic factors (recession, inflation, deflation, etc.)
Company-specific risk is the potential for a particular issuer to experience a decline in valuation due to the impact of sector or market risk on the holding or because of issues specific to the firm:
Default - the possibility that an issuer will not make a required payment (interest payment or return of principal) on its debt. Generally this occurs after its financial profile has deteriorated (credit risk) and it no longer has the means to make its payments
The investment committee of the board of directors monitors the investment risk management process primarily through its executive oversight of investment activities. The company takes an active approach to managing market and other investment risks, including the accountabilities and controls over these activities. Actively managing these market risks is integral to the company’s operations and could require a change in the character of future investments purchased or sold or require a shift in the existing asset portfolios to manage exposure to market risk within acceptable ranges. The approach is applied daily by the company’s portfolio managers and analysts to each of the five asset classes in which the company invests.
The final, less significant risk is a small exposure to credit risk for a portion of the tax-exempt portfolio that has support from corporate entities. Examples are bonds insured by corporate bond insurers or bonds with interest payments made by a corporate entity through a municipal conduit/authority. While decisions regarding these investments primarily consider the underlying municipal situation, the existence of third-party insurance reduces risk in the event of default. In circumstances in which the municipality was unable to meet its obligations, risk would be increased if the insuring entity were experiencing financial duress. Because of the company’s diverse exposure and selection of higher-rated entities with strong financial profiles, the company does not believe this is a material concern.
The company is using a dynamic financial planning model developed during 2002 to further incorporate analytical tools in assessing market risks. Management believes the model is improving the company’s ability to measure the impact on bond values resulting from changes in interest rates. Improved measurement of the impact of interest rate changes should allow for improved matching of the company’s assets and liabilities.
Common stocks are subject to a variety of risk factors encompassed under the umbrella of market risk. General economic swings influence the performance of the underlying industries and companies within those industries. A downturn in the economy will have a negative impact on an equity portfolio. Industry- and company-specific risks have the potential to substantially affect the market value of the company’s equity portfolio. The company addresses these risks by maintaining investments in a small group of holdings that management can analyze closely, better understanding their business and the related risk factors.
At December 31, 2003, the company held 15 individual equity positions valued at approximately $100 million or above, see Item 1, Investments Segment, Page 7, for additional details on these holdings. These equity positions accounted for approximately 95 percent of the after-tax net unrealized appreciation of the entire portfolio.
Management believes the company’s equity investment style - centered on companies that pay and increase dividends to shareholders - is an appropriate long-term strategy. While the company’s long-term financial position would be affected by changes in the market valuation of its investments, management believes the company’s strong surplus position and healthy cash flow provides it with a cushion against short-term fluctuations in valuation. The continued payment of cash dividends by the company’s common equities also provides a floor to their valuation. Management is cognizant that a prolonged downturn in the stocks of financial institutions would create the greatest long-term negative effect on the portfolio.
difference was the technology-led nature of the 2003 market rally, a market sector in which the company has virtually no holdings. Financial institution and healthcare and pharmaceutical-related issue indices generated returns more in line with the performance of the company’s portfolio.
Fifth Third’s value in 2003 was affected by uncertainty surrounding a regulatory review announced in late 2002. Some of the uncertainty was removed when Fifth Third entered into a written agreement with the Federal Reserve Bank and the Ohio Department of Commerce in late March 2003. In the agreement, Fifth Third outlined the series of steps its management has been taking to strengthen identified areas. At that time, Fifth Third noted that management is extremely serious about risk management and internal controls and that the company is taking the necessary steps to strengthen procedures to fully cooperate with the regulatory agencies. Fifth Third stated that these efforts, many of which had already begun, will result in Fifth Third emerging from this process as an even stronger company. Fifth Third continues to report results that meet Cincinnati Financial’s investing criteria of increasing sales, earnings and dividends. In addition, Cincinnati Financial management believes Fifth Third has proven management and a favorable outlook.
As a result of the application of the impairment policy, there are just two securities with a combined book value of $70 thousand trading below 70 percent of book value at year-end 2003, compared with 59 securities with a market value of $139 million and a book value of $231 million, or 2.0 percent of total invested assets, at year-end 2002. As discussed in Asset Impairment, Page 19, when evaluating other-than-temporary impairments, management considers the company’s ability to retain a security for a period adequate to recover a substantial portion of their cost. Because of the company’s investment philosophy and strong capitalization, it can hold securities until their scheduled redemption that might otherwise be deemed impaired as management evaluates their potential for recovery based economic, industry or company factors.
The two issues trading below 70 percent of book value at December 31, 2003, had been at that level for 12 months or less. At December 31, 2003, no securities in the company’s portfolio had traded below 70 percent of book value for more than 12 months.
Reflecting the company’s long-term investment philosophy, of the 1,286 securities trading at or above book value, 581, or 45.2 percent, have shown unrealized gains for more than 24 months.
Based on current information, the company anticipates application of its policy will result in other-than-temporary impairment charges less than $5 million in the first quarter of 2004, barring new developments affecting individual companies or industries in the portfolio.
The board of directors has established an audit committee composed of outside directors who are believed to be free from any relationship that could interfere with the exercise of independent judgment as audit committee members.
The audit committee meets periodically with management, the independent auditors and the internal auditors to make inquiries as to the manner in which the responsibilities of each are being discharged and reports thereon to the board of directors. In addition, the audit committee recommends to the board of directors the annual appointment of the independent auditors with whom the audit committee reviews the scope of the audit assignment, adequacy of internal controls and internal audit procedures.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Cincinnati Financial Corporation and subsidiaries at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, 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.
The consolidated financial statements include the accounts of the company and subsidiaries, each of which is wholly owned, and are presented in conformity with accounting principles generally accepted in the United States of America (GAAP). All significant intercompany balances and transactions have been eliminated in consolidation.
Expenses incurred in the issuance of policies are deferred and amortized over the terms of the policies. These expenses vary with and are primarily related to acquiring insurance business, principally agents’ commissions, premium taxes and certain underwriting costs. Anticipated investment income is not considered in determining if a premium deficiency related to insurance contracts exists. Policy premiums are deferred and earned on a pro rata basis over the terms of the policies. The portion of written premiums applicable to the unexpired terms of the policies is recorded as unearned premiums. 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 in each claim and the company’s experience with similar claims. The establishment of appropriate reserves, including reserves for catastrophes, is an inherently uncertain process. Reserve estimates are regularly reviewed and updated, using the most current information available. Any resulting adjustments are reflected in current operations.
Limited-pay products require the policyholder to pay scheduled premiums up front but coverage 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.
Reserves for traditional products are based on expected expenses, mortality, withdrawal rates and investment yields, including provision for adverse deviation. Once these assumptions are established, they generally are maintained throughout the lives of the contracts. Expected mortality is derived primarily from industry experience and withdrawal rates are based on company and industry experience, while investment yield is based on company experience and the economic conditions then in effect.
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 $530 million and $480 million of such reserves at December 31, 2003 and 2002, respectively, are periodically adjusted subject to economic conditions then in effect and subject to contractually guaranteed minimum rates.
Expenses incurred in the issuance of traditional life insurance products, which include whole life and term life insurance contracts, are deferred and amortized as premiums are earned. Expenses incurred in the issuance of interest-sensitive products are deferred and amortized using the gross profit method, adjusted for emerging experience and expected trends.
Billings are based on a fee structure calculated upon the market values of the assets at the end of the period. Revenues are recognized as fees are earned. As of December 31, 2003, CinFin Capital had 53 institutional, corporate and individual clients and $762 million under management, compared with 35 clients and $726 million at December 31, 2002.
The company also assumes some reinsurance from other insurance companies, reinsurers and involuntary state pools. Such assumed reinsurance activity is recorded principally on the basis of reports received from the ceding companies.
Fixed maturities (bonds and notes) and equity securities (common and preferred stocks) are classified as available for sale and are stated at fair values.
The company invests in certain financial instruments that contain embedded options such as convertible debt and convertible preferred stock. 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. 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.
Fair values for investments in equity and fixed-maturity securities (including redeemable preferred stock and assets held in separate accounts) are based on either quoted market prices or data provided by an outside resource that supplies global securities pricing.
Property and equipment is recorded at cost less accumulated depreciation and amortization. The company provides depreciation and amortization based on estimated useful lives using straight-line and accelerated methods. Depreciation and amortization expense recorded in 2003, 2002 and 2001 was $30 million, $22 million and $25 million, respectively. The company reviews property and equipment for impairment whenever events or changes in circumstances, such as significant decreases in market values of assets, changes in legal factors or in the business climate, an accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset, or other such factors indicate that the carrying amount may not be recoverable.
during the application development stage of software development projects. These costs generally consist of certain external, payroll and payroll-related costs. During 2000, the company wrote off $39 million of previously capitalized costs related to the development of next-generation software to process property casualty policies. Management conducted a review of the project, including an assessment by an independent firm, and determined, after several deliverable dates were missed, that the project design would not perform as originally intended. The decision required that the application software under development be abandoned and a new application purchased. As a result of a settlement negotiated with a vendor, third quarter 2003 pretax results included the recovery of $23 million of the $39 million charge. This settlement was included in other operating expenses.
The assets of the separate accounts are carried at fair value. Separate account liabilities primarily represent the contract holders’ claims to the related assets and are carried at the fair value of the assets. In the event that the asset value of contract holders’ accounts is projected below the value guaranteed by the company, a liability is established through a charge to the company’s earnings. Generally, investment income and realized investment gains and losses of the separate accounts accrue directly to the contract holders and, therefore, are not included in the company’s Consolidated Statements of Income; however, each separate account contract includes a negotiated realized gain and loss sharing arrangement with the company. A percentage of each separate account’s realized gain and loss accrues to the company and is transferred from the separate account to the company’s general account and is recognized as revenue or expense. Revenues and expenses for the company related to the separate accounts also consist of contractual fees and mortality, surrender and expense risk charges.
The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” in April 2003 to amend and clarify financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. This statement did not have any effect on the company’s consolidated financial statements.
In May 2003, FASB issued SFAS No. 150 “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer of financial instruments classifies and measures in its statement of financial position certain instruments with characteristics of both liabilities and equity. SFAS No. 150 affects an issuer’s accounting for various types of financial instruments that are required to be accounted for as liabilities. SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003. For all financial instruments entered into prior to May 31, 2003, SFAS 150 is effective at the beginning of the first interim period beginning after June 15, 2003, which for the company begins July 1, 2003. The company does not have any financial instruments outstanding to which the provisions of SFAS No. 150 apply; therefore, the adoption of SFAS No. 150 did not have any impact on the company’s consolidated financial statements.
In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46) “Consolidation of Variable Interest Entities, and Interpretation of ARB No. 51,” which addresses consolidation by business enterprises of variable interest entities (VIEs) either that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or in which the equity investors lack an essential characteristic of a controlling financial interest. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 (Revised Interpretations) resulting in multiple effective dates based on the nature as well as the creation date of the VIE. Management has determined that the adoption of this standard will have no material impact on the consolidated financial statements.
The Accounting Standards Executive Committee 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. Management has determined that this statement will have no effect on the company’s consolidated financial statements.
At December 31, 2003, investments with book value of $65 million and fair value of $69 million were on deposit with various states in compliance with certain regulatory requirements.
The following table provides the unrealized losses and fair values, by investment category and by length of time the individual securities have been in a continuous unrealized loss position, at December 31, 2003:
Activity in the reserve for losses and loss expenses is summarized as follows:
At December 31, 2003 and 2002, the fair value associated with the annuities shown above approximated $412 million and $331 million, respectively.
The company entered an interest-rate swap agreement during 2001, which expires in 2008, to hedge future cash flows (thereby obtaining a fixed interest rate) related to certain variable rate debt obligations ($31 million notional amount). This swap is reflected at fair value in the accompanying balance sheet and the $2 million unrealized loss, net of tax, at December 31, 2003, is a component of comprehensive income; the fair value was $2 million, net of tax, at December 31, 2002. The company does not expect any significant amounts to be reclassified into earnings as a result of interest rate changes in the next 12 months.
million and $429 million, respectively. The company had convertible senior debentures which matured in 2002 and were convertible into shares of common stock at a conversion price of $14.88 per share (or 67.23 shares for each one thousand dollars principal).
CFC’s insurance subsidiary paid cash dividends to the company of $50 million in 2003 and $100 million in both 2002 and 2001. Dividends paid by insurance subsidiaries are restricted by regulatory requirements of the insurance subsidiaries’ domiciliary state. Generally, the maximum dividend that may be paid without prior regulatory approval is limited to the greater of 10 percent of statutory surplus or 100 percent of statutory net income for the prior calendar year, up to the amount of statutory unassigned surplus as of the end of the prior calendar year. Dividends exceeding these limitations may be paid only with approval of the insurance department of the subsidiaries’ domiciliary state. During 2004, the total dividends that may be paid to the company without regulatory approval are approximately $278 million.
The company’s board of directors has authorized the repurchase of outstanding shares. The company has purchased 15.8 million shares at a cost of $520 million between the inception of the share repurchase program in 1996 and December 31, 2003. At December 31, 2003, 5.3 million shares remain authorized for repurchase at any time in the future.
Declared cash dividends per share were $1.00, 89 cents and 84 cents for the years ended December 31, 2003, 2002 and 2001, respectively.
The differences between the statutory federal rates and the company’s effective federal income tax rates are as follows:
The following summarizes the assumptions used to determine net expense for the plan:
The company’s target asset allocations of its pension plan at December 31, 2003, and similarly at December 31, 2002, were 95 percent equity securities and 5 percent fixed maturities and cash.
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 of the company’s insurance subsidiaries 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 $19 million, $17 million and $14 million on premium volume of approximately $132 million, $113 million and $95 million for 2003, 2002 and 2001, respectively.
Various litigation and claims against the company and its subsidiaries are in process and pending resulting from normal insurance and non-insurance activities. Based upon a review of open matters with legal counsel, management believes that the outcomes of normal insurance matters will not have a material effect upon the company’s consolidated financial position or results of operations and the outcomes of non-insurance matters will be covered by external insurance coverage.
Options outstanding and exercisable consisted of the following at December 31, 2003:
The company is organized and operates primarily in two industries, property casualty insurance and life insurance, and has four reportable segments - commercial lines property casualty insurance, personal lines property casualty insurance, life insurance and investment operations - which company management regularly reviews to make decisions about allocating resources to the segments and assessing their performance. Included in the other category below are operations of the parent company, CFC Investment Company and CinFin Capital Management Company (excluding investment activities) and other income of the insurance subsidiaries.
Revenue is primarily from unaffiliated customers. Insurance segments’ revenues are insurance premiums earned; investment operations’ revenue represents net investment income and realized investment gains and losses; and other revenue is primarily finance/lease income and other income of the insurance subsidiaries.
The following table sets forth unaudited quarterly financial data for the years ended December 31, 2003 and 2002: