The Cincinnati Life Insurance Company owns a four-story office building in the Tri-County area of Cincinnati, Ohio. It contains approximately 102,000 rentable square feet. An unaffiliated tenant currently leases 100 percent of the building through January 31, 2005. This property is carried in the financial statements at $3 million as of December 31, 2003, and is classified as Other invested assets.
events that lead to a significant decline in the market value of a particular security and impairment of the asset
The company uses the Risk Management Solutions and Applied Insurance Research models to evaluate exposures and aid 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, that 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 Reinsurance, Page 26, for a discussion of the company’s 2004 reinsurance treaties.
In addition, the fair value of the plan assets exceeded the accumulated benefit obligation by $21 million at December 31, 2003, and by $31 million at December 31, 2002. The fair value of the plan assets was less than the projected plan benefit obligation by $29 million at December 31, 2003, and by $9 million at December 31, 2002. Market conditions and interest rates significantly affect future assets and liabilities of the pension plan. An additional liability may be required in the future, with the potential for a charge to equity to the extent the minimum liability exceeds unrecognized prior service cost upon measurement of plan obligations, which is usually completed by the company at the end of each year.
The company establishes a deferred asset for costs that vary with and are primarily related to acquiring property casualty and life business. These costs are principally agent commissions, premium taxes and certain underwriting costs, which are deferred and amortized into income as premiums are earned. Deferred acquisition costs have grown in line with the growth in premiums. Underlying assumptions are updated periodically to reflect actual experience. Changes in the amounts of timing or estimated future profits could result in adjustments to the accumulated amortization of these costs.
In the company’s most significant separate account written in 1999, realized gains and losses are retained in the separate account and are deferred and amortized to the contract holder over a five-year period, subject to certain limitations. Upon termination or maturity of this separate account contract, any unamortized deferred gains and/or losses will revert to the general account. In the event this separate account holder were to surrender the contract, there would be a surrender charge equal to 10 percent of the contract’s account value during the first five years. Beginning in year 6, the surrender charge decreases 2 percent a year to 0 percent in year 11. At December 31, 2003, net unamortized losses amounted to $2 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded, and charged to the general account. Potentially, losses could be material; however, unrealized losses at December 31, 2003, in the separate account portfolio were less than $1 million.
Combined ratio for the property casualty operations in the range of 95 percent compared with 94.7 percent in 2003, which included a benefit of 0.8 percentage points from the software recovery and 1.4 percentage points from the UM/UIM reserve release. The 2004 target does not include benefits anticipated from additional UM/UIM reserve releases and assumes the combined ratio will include approximately 3.0 to 3.5 percentage points for catastrophe losses.
Property per risk treaty - The primary purpose of the property treaty is to provide excess limits capacity up to $25 million, supplying adequate capacity for the majority of the risks the company writes. The ceded premium is estimated to be $27 million for 2004, compared with $25 million in 2003 and 2002. In 2004, the company is retaining the first $2 million of each loss, and 40 percent of the next $3 million of loss. The $2 million base retention has been in place for many years, and the co-participation is the same percentage as 2003, up from 20 percent in 2002. Losses in excess of $5 million are reinsured at 100 percent up to $25 million.
In the five states in which the company had at least $100 million in agency direct earned premiums in 2003, premiums grew 12.0 percent in 2003 and 16.1 percent in 2002. In the remaining 26 states, agency direct earned premiums grew more rapidly, rising 16.3 percent in 2003 and 9.0 percent in 2002. The stronger growth in the smaller states reflected the opportunities available to the company in less penetrated markets.
Catastrophe losses - Commercial lines catastrophe losses, net of reinsurance and before taxes, were $42 million in 2003, compared with $40 million in 2002 and $28 million in 2001, which included $9 million for losses related to events of September 11, 2001.
By evaluating each risk individually and making decisions regarding rates, the use of three-year policies and other policy terms on a case-by-case basis, even in lines and classes of business that are under pressure, the company believes it can continue to be a preferred market for its agencies and the types of Main Street businesses they serve. This should lead to incremental improvements in its already strong combined ratio.
The personal auto and homeowner business lines together accounted for 89.5 percent, 89.4 percent and 89.0 percent of total personal lines earned premiums in 2003, 2002 and 2001, respectively. The company’s intent is to write personal auto and homeowners coverages in personal lines packages. The company believes that personal lines is best measured and evaluated on a segment basis. For reference, however, the table and discussion below summarizes growth and profitability trends for the personal auto and homeowner business lines.
The accident year loss data provides current estimates of accident year incurred loss and loss expenses for the past five years. Accident year data shows the year in which loss events occurred, regardless of when the losses are actually reported, booked or paid.
As the economy improved in 2003, the level of bond defaults and impairments improved to historic levels. Interest rates earned on new investments remained at historically low levels. Most of the company’s interest-sensitive life and deferred annuity contracts contain guaranteed crediting rates of 3.0 percent to 5.0 percent. The company’s average interest rate earned overall on its investment portfolio, while decreasing in this period, still provides ample margins to allow for maintenance of pricing spreads when determining interest-crediting rates.
Other-than temporary impairment charges by asset class as described in Item 1, Investments Segment, Page 7, are summarized below:
Over the past 10 years, the company has paid an average of 45 percent of net income as dividends, with the remaining 55 percent reinvested for future growth. The ability of the company to continue paying cash dividends is subject to factors the board of directors may deem relevant.
The company held 72.8 million shares of Fifth Third common stock at a cost of $283 million at December 31, 2003. The market value of the company’s Fifth Third position was $4.301 billion at year-end 2003, or 52.7 percent of the company’s total common equity portfolio, compared with $4.261 billion, or 54.0 percent, at year-end 2002. The after-tax unrealized gain represented by the company’s Fifth Third position was $2.612 billion, or 63.8 percent of the company’s total after-tax unrealized gains at year-end 2003, compared with $2.586 billion, or 71.0 percent, at year-end 2002. The Fifth Third position represented $16.28 of the company’s total book value of $38.69 per share at year-end 2003 compared with $16.00 of year-end 2002 book value of $34.65. Every $1.00 change in the market price of Fifth Third’s common stock has approximately a 29-cent impact on Cincinnati Financial’s book value per share. A 20 percent ($11.82) change in the market price of Fifth Third’s common stock, which was $59.10 at year-end 2003, would result in a $860 million change in assets and a $559 million change in after-tax unrealized gains. This would affect shareholders’ equity by 9.0 percent and book value by $3.49 per share.
No provision was made December 31, 2003, 2002 and 2001 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.
The following table sets forth summarized information on the company’s defined benefit pension plan: