Management expects that the impact of these anticipated strong operating results will be tempered in 2005 by the adoption of option expensing and slightly higher interest expense on long-term debt, which increased modestly with the November 2004 issue of $375 million aggregate principal amount of senior notes due 2034. The company will adopt Statement of Financial Accounting Standards (SFAS) No. 123 (R), “Share-Based Payment,” which calls for stock option expense to be included as a component of net income, in the third quarter of 2005. Pro forma option expense as disclosed in Item 8, Note 1 to the Consolidated Financial Statements, Page 76, would have reduced earnings per share by 7 cents in both 2004 and 2003 and 8 cents in 2002.
• Delays in the development, implementation, performance and benefits of technology projects and enhancements
• Events that lead to a significant decline in the market value of a particular security and impairment of the asset
• Court decisions that result in unanticipated coverage expansions on past and existing policies
Reserves for the company’s universal life, deferred annuity and investment contracts are equal to the cumulative account balances, which include premium deposits plus credited interest less charges and withdrawals.
Holding all other assumptions constant, a one half of one percent increase or decrease in the discount rate would have increased or decreased the company’s 2004 net income before income taxes by $1 million. Likewise, a one half of one percent increase or decrease in the expected return on plan assets would have increased or decreased 2004 income before income taxes by $1 million.
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 exchange the contract for the policy of another carrier, there would be a surrender charge equal to 10 percent of the contract’s account value during the first five years. Beginning in year six, the surrender charge decreases 2 percent a year to 0 percent in year 11. At December 31, 2004, net unamortized realized losses amounted to $1 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by the regulatory authorities to whose jurisdiction the group contract holder is subject. Therefore, sales of investments may be mandated to maintain compliance with these regulations, possibly requiring gains or losses to be recorded, and charged to the general account. Potentially, losses could be material; however, unrealized losses at December 31, 2004, in the separate account portfolio were less than $1 million.
Book value - Book value was $37.38 at year-end 2004 up slightly from year-end 2003 as higher net income was offset by lower unrealized investment gains.
Factors supporting management’s outlook for 2005 are discussed in the Results of Operations for each of the four business segments.
For the combined property casualty insurance operations as well as the commercial lines and personal lines segments, statutory accounting data and ratios are key performance indicators that are used by management to assess business trends and to make comparisons to industry results, since GAAP-based industry data generally is not readily available. Statutory accounting data and ratios also are key performance indicators for The Cincinnati Life Insurance Company, the life insurance subsidiary.
The growth in earned premium reflected the competitive characteristics discussed in Item 1, Property Casualty Insurance Operations, Page 1, including a case-by-case approach to new business and account renewals. While insisting on adequate premiums for covered exposures, the company continues to do business the way it always has; on the local level, focusing on each relationship separately. Commercial lines pricing remained flexible to respond to each risk in cooperation with local agents, who are in a position to know their market and their business. The company believes that this approach results in more high-quality accounts over the long term, further solidifies its relationships with independent agencies and establishes a basis for continued growth.
The significant components of expenses for the commercial lines segment are described below.
Loss and loss expenses include both net paid losses and reserve additions for unpaid losses as well as the associated loss expenses. For personal lines, loss and loss expenses excluding catastrophes were $522 million in 2004 compared with $524 million in 2003 and $487 million in 2002. Loss and loss expenses for personal lines have reflected the industrywide rise in loss severity over the past several years due to escalating medical costs and home values offset by the benefits of underwriting actions and changes in policy terms and conditions. In addition, the loss and loss expense ratio benefited from higher than normal savings due to favorable loss reserve development from prior accident years (see Property Casualty Reserve Levels, Personal Lines Segment Reserves, Page 58, for information regarding loss reserve development for the personal lines segment).
catastrophic event. See Item 1, Financial Strength Ratings, Page 7, for discussion of the company’s strategy to support the financial strength ratings of its property casualty insurance operations.
The company pursues a strategy of investing some portion of cash flow in tax-advantaged fixed maturities and equity securities to minimize its overall tax liability and maximize after-tax earnings. See Item 8, Note 10 to the Consolidated Financial Statements, Page 84, for detail regarding the company’s effective income tax rate.
• Purchases of equity securities investments. Due to the allocation of a higher percentage of new investment dollars to fixed-income investments, equity securities purchases in 2004 were below the level of 2003 and 2002. Management anticipates resuming equity securities investments in 2005 to help achieve its portfolio objectives.
• $93 million increase in unearned premiums due to higher premium volume.
• Higher than expected medical inflation affecting the workers compensation line
restated for certain second-to-die policies following a period of losses in this line. In calculating the revised liabilities, the assumed investment yield was reduced to reflect current economic conditions and the termination rate was adjusted in line with actual experience and reinsurance ceded was calculated directly for each life insurance product, rather than averaging reinsurance costs over several product areas.
• Will finance the construction of an estimated $100 million office building and parking garage to be situated at the headquarters located in Fairfield beginning in 2005, as announced in August 2004.
During 2004, the company terminated an interest-rate swap entered into by CFC Investment Company in 2001 as a cash hedge of variable interest payments for certain variable-rate debt obligations ($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 was considered to be a hedge against changes in the amount of future cash flows associated with the related interest payments. When the company paid-off the underlying debt, it terminated this agreement at a cost of $2 million, net of tax.
Interest expense on the company’s short- and long-term debt was $38 million (pretax), or 14 cents per share (after tax), in 2004, which excludes interest expense on inter-company debt. Assuming the company had issued the 6.125% senior notes on January 1, 2004, and used the proceeds as indicated, management estimates interest expense would have been $52 million (pretax), or 20 cents per share (after tax), in 2004.
The construction of an office building and parking garage to be situated at the headquarters located in Fairfield is expected to require approximately $100 million over a four-year period. On January 6, 2005, the company entered into a cost-plus contract with Messer Construction Co. for design-build services in connection with the project. The company
Estimated material commitments for net property casualty loss and loss expense reserves represented approximately 55 percent of the estimated contractual obligations as of December 31, 2004. The company directs its staff to settle claims and pay losses as quickly as practical and made $1.621 billion in net claim payments during 2004. As of December 31, 2004, the company had net property casualty reserves of $2.977 billion, reflecting $1.522 billion in unpaid amounts on reported claims (case reserves), $634 million in loss expense reserves and $821 million in estimates of IBNR claims. The specific amounts and timing of obligations related to case reserves and related loss expenses are not set contractually. The amounts and timing of obligations for IBNR claims and related loss expenses are unknown.
Fixed maturities (bonds, notes and redeemable preferred stocks) and equity securities (common and non-redeemable preferred stocks) are classified as available for sale and are stated at fair values.