CLIC owns a four-story office building in the Tri-County area of Cincinnati, Ohio containing approximately 102,000 rentable square feet. At the present time, 100 percent of the building is currently being leased by an unaffiliated tenant. This property is carried in the financial statements at $3 million as of December 31, 2002, and is classified as Other invested assets.
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: unusually high levels of catastrophe losses due to changes in weather patterns or other natural or man-made causes; increased frequency and/or severity of claims; environmental events or changes; insurance regulatory actions, legislation or court decisions that increase expenses or place the company at a disadvantage in the marketplace; adverse outcomes from litigation or administrative proceedings; recession or other economic conditions resulting in lower demand for insurance products; sustained decline in overall stock market values negatively affecting the company’s equity portfolio, in particular a sustained decline in market value of Fifth Third Bancorp shares; events as described in Quantitative and Qualitative Disclosures about Market Risk, Page 46, that could lead to a significant decline in the market value of a particular security or sector and impairment of assets; delays in the development, implementation and benefits of technology enhancements; and decreased ability to generate growth in investment income.
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 over the past 10 years, which moderated at year-end 2002 and 2001.
Revenue growth in each of the past three years primarily reflected higher contributions from property casualty earned premiums and investment income.
Within the property casualty insurance market, the company offers both commercial and personal policies through a network of independent agencies. Property casualty insurance operations highlights include:
Commercial auto review - This program identified or fine-tuned underwriting guidelines and procedures, with careful attention to trucking businesses that specialize in transporting goods for others, in some cases on a long-haul basis.
Following two Ohio Supreme Court decisions, in 2000 the company established a $110 million IBNR reserve, net of reinsurance, for past UM/UIM losses incurred but not yet reported. The court rulings affected all auto insurers in the state, and the company’s reserve action was intended to clear the way for long-term performance improvements benefiting shareholders and policyholders. Prior to the establishment of the reserve, the company had incurred losses in 2000 and 1999 of $28 million and $12 million, respectively, related to these claims. In 2001, the company reduced the IBNR reserve by $54 million for claims reported during the year and changes in case reserves. In 2002, the company reduced the IBNR reserve by an additional $30 million for claims reported during the year and changes in case reserves; however, the rate at which new claims are being presented has declined and favorable development on older claims is appearing. Management believes the reserve balance, which stood at $26 million at year-end 2002, is adequate to cover additional claims that may be reported during 2003 and beyond. Management will continue to monitor these claims and revise its estimates of the related ultimate liabilities and reserves accordingly. Management also will continue to monitor cases pending before the Supreme Court in Ohio that could alter the outlook for future UM/UIM claims either positively or negatively.
Workers compensation - The losses and loss expenses ratio in 2002 reflected the addition of $23 million to reserves 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 IBNR change. Calendar year 2002 losses and loss expenses ratio improved slightly over 2001 but overall pricing increases for new and renewed risks have helped to bring about declining accident year loss ratios over the three-year period. At the same time, overall earned premium growth slowed in 2002 as the company chose to non-renew selected accounts. 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, especially in light of the terrorism risk. Recent accident year losses and loss expenses ratio trends reflect the improvement the company has seen due to pricing and underwriting actions.
Other liability - The losses and loss expenses ratio for other liability increased by 18.9 percentage points in 2002 after declining by 22.9 percentage points in 2001. Higher than anticipated accident year 2002 losses for umbrella business resulted in a $19 million increase in IBNR in 2002, which added 6.9 percentage points to the calendar year 2002 losses and loss expenses ratio. In addition, the reserve analysis of certain other liability sublines was refined in 2001. Due to this analysis, which allows more accurate reserve estimation, management determined that other liability reserves could be reduced for 2001. Due to these reserve reductions, calendar year 2001 losses in this line were substantially lower than accident year 2001 losses. Pricing increases taken in 2002 should result in improvement of other liability losses and loss expenses ratio in future years.
New submitted applications increased 16 percent to more than 47,600 on strong sales of ordinary life products. Over the coming months, Cincinnati Life will enhance its disability income policy and introduce two new, competitive LifeHorizons guaranteed products-whole life with a single-pay paid-up life rider and long-term guaranteed universal life.
Realized investment losses, net, before federal taxes were $94 million in 2002 compared with realized investment losses of $25 million in 2001 and $2 million in 2000.
In 2002, the company recorded $98 million in write-downs of securities management deemed had experienced an other-than-temporary decline in market value versus $45 million in 2001. (See Investments - Valuation and Impairment discussion in Significant Accounting Policies on Page 21 for factors considered by management.) There were no other-than-temporary impairment charges recorded in the investment portfolio in 2000. Write-down of the carrying value of distressed airline, telecommunication, utility/merchant energy/trading and cable bonds represented 71.4 percent of 2002 impairment charges:
Revaluation risk - the potential for a decrease in market value due to a change in relative value (change in market multiple) of the market brought on by general economic factors. The technology/telecommunication revaluation of the past two years, combined with other political, regulatory and economic issues, has resulted in lower market price/earnings multiples.
Expenses incurred in the issuance of policies, as noted above in property casualty insurance, are deferred and amortized over the premium paying period of the policies using the gross profit method.
The company capitalizes costs related to computer software developed for internal use 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.
In determining the pro forma amounts above, the fair value of each option was estimated on the date of grant using the binomial option-pricing model with the following weighted-average assumptions used for grants in 2002, 2001 and 2000, respectively: dividend yield of 2.52 percent, 2.20 percent and 2.11 percent; expected volatility of 25.90 percent, 25.54 percent and 24.92 percent; risk-free interest rates of 4.26 percent, 5.54 percent and 5.30 percent; and expected lives of 10 years for all years. Compensation expense in the pro forma disclosures is not indicative of future amounts as options vest over several years and additional grants generally are made each year.
At December 31, 2002, investments with book value of $62 million and fair value of $66 million were on deposit with various states in compliance with certain regulatory requirements.