UNITED STATESSECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark one)
Commission file number 0-4604
CINCINNATI FINANCIAL CORPORATION
Registrant’s telephone number, including area code: (513) 870-2000
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:$2.00 par, common6.9% Senior Debentures due 2028
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No o
The aggregate market value of voting stock held by nonaffiliates of Cincinnati Financial Corporation was $4,836,296,722 as of February 20, 2003.
As of February 20, 2003, there were 161,075,902 shares of common stock outstanding.
Document Incorporated by Reference
Portions of the definitive Proxy Statement for Cincinnati Financial Corporation’s Annual Meeting of Shareholders to beheld on April 19, 2003 are incorporated by reference into Part III of this Form 10-K.
TABLE OF CONTENTS
CINCINNATI FINANCIAL CORPORATION2002 ANNUAL REPORT ON FORM 10-K
PART I
ITEM 1. BUSINESS
INTRODUCTION
Cincinnati Financial Corporation (CFC), through its subsidiaries, operates in the property casualty and life insurance businesses. Its property casualty operations rank the company as one of the nation’s 20 largest property casualty insurers, based on revenues. Over the past five years, the company’s growth has outpaced that of the industry, with written premiums rising at an average annual rate of 12.2 percent versus the estimated industry average of 6.0 percent. At the same time, the company has sustained its position as one of the most profitable property casualty insurers, with a five-year average statutory combined ratio of 103.0 percent, excluding a one-time charge of $33 million (statutory, before tax) recorded in 2000, compared with the estimated industry average of 109.0 percent. Investment income growth has averaged 5.0 percent over the same period and investment income provides the primary source of profits.
The company’s track record reflects a strong competitive position; an effective and efficient local independent agent distribution system; continued expansion and market penetration in operating territories; and a successful, equity-centered investment strategy.
SEGMENT INFORMATION
The company is organized and operates principally in two industries – property casualty insurance and life insurance.
The company’s four reportable segments are:
Segment information for revenues, income before income taxes, and identifiable assets is included in Note 17 to the Consolidated Financial Statements, Page 71. The company’s segments are defined based upon the components of the company for which financial information is used internally to evaluate performance and determine the allocation of resources.
SUBSIDIARY OVERVIEW
Cincinnati Financial had three subsidiaries at year-end 2002. The lead property casualty insurance subsidiary, The Cincinnati Insurance Company, markets a broad range of commercial and personal insurance policies in 31 states through a select group of 950 independent insurance agencies. Subsidiaries of The Cincinnati Insurance Company are The Cincinnati Casualty Company and The Cincinnati Indemnity Company, which provide the company with flexibility in underwriting, pricing and billing for property casualty insurance; as well as The Cincinnati Life Insurance Company, which markets life, long-term care and disability income policies and annuities through property casualty agencies and independent life agencies. The Cincinnati Insurance Company and its subsidiaries are collectively referred to as The Cincinnati Insurance Companies.
Cincinnati Financial’s other two subsidiaries are CFC Investment Company, which complements the insurance subsidiaries with commercial leasing, financing and real estate services; and, CinFin Capital Management Company, which provides asset management services to institutions, corporations and individuals with $500,000 minimum asset accounts.
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PROPERTY CASUALTY INSURANCE OPERATIONS
STRATEGY
The core strengths of the company’s property casualty insurance operations are its commitment to the independent agent distribution system and the care with which it selects the agencies that represent The Cincinnati Insurance Companies. Its mission places agents at the center of its identity, recognizing that locally based independent agencies have the relationships that lead to profitable business. The company also differentiates itself by providing exceptional claims service, through locally based field claims staff serving the needs of agents and policyholders.
The Cincinnati Insurance Companies, which offer both commercial and personal lines of insurance, continuously strengthen service by providing agents and their clients a strong local presence, unparalleled claim service and competitive products, rates and compensation.
MARKETS AND COMPETITIVE POSITION
The Cincinnati Insurance Companies market property casualty insurance policies in 31 states. In 2002, 98.6 percent of the company’s agencies direct written premium volume was in the 27 states in which the company has had a presence for more than five years. Further, agencies in Ohio contributed 24 percent and Georgia, Illinois, Indiana, Michigan and Pennsylvania each contributed between 5 percent and 10 percent of premium volume in 2002.
The company selects agencies based on their commitment to the same philosophies that distinguish the company in the marketplace: a commitment to doing business person to person; a focus on broad, value-added services; sound balance sheets; and, professional management. The independent agencies representing the company are among the most successful in the country. The agencies with which the company does business averaged approximately $12 million in total annual premium volume for all carriers in 2000, more than two times the approximately $5.5 million national average for 41,000 agencies, based on a Future One 2000 Agency Universe study.
In 2002, each agency representing the company averaged approximately $2.6 million in agency direct written premiums for the company, or 18 percent of the agency’s total volume, up from $2.3 million in 2001 and $2.0 million in 2000. No single agency accounted for more than 1.1 percent of the company’s total agency direct written premiums. The company believes that it can continue to increase its penetration within these agencies that share the company’s philosophy and underwriting approach. Even if the company’s share of these agencies’ business remains unchanged, it expects to be able to continue to grow as the agencies expand.
Factors that distinguish the company in the insurance marketplace include:
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The success of the company’s efforts to distinguish itself in the insurance marketplace is demonstrated by the company’s consistently high rankings in agent and consumer satisfaction surveys. Most recently, the Florida Association of Independent Agents reported that the company had received high marks for its loyalty to agents and claims service. In past years, the company has obtained similar rankings from consumer organizations and Crittenden’s Property/Casualty Ratings. These surveys assess insurers’ accessibility and timely response, premium pricing, efficiency and fairness of claims payments. The National Association of Insurance Commissioners’ (NAIC) Online Consumer Information Source measures the company’s low complaint ratio (www.naic.org) at 0.16 versus the national median of 1.00. NAIC members head state departments of insurance.
TECHNOLOGY-BASED TOOLS
To help solidify relationships with agencies, the company continues to invest in and roll out technology-based tools.
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COMMERCIAL LINES PROPERTY CASUALTY INSURANCE
The commercial lines property casualty insurance segment contributed $1,721 million of Cincinnati Financial’s total revenues and $59 million of income before income taxes in 2002. The company’s commercial lines property casualty companies are licensed in all 50 states, the District of Columbia and Puerto Rico, to serve the needs of policyholders who operate businesses in multiple locations. Substantially all of commercial lines written premiums, however, are for risks located within the 31 states in which the company has agent relationships.
The company’s commercial lines products are marketed through the 950 independent agencies that represent The Cincinnati Insurance Companies. The company’s emphasis is on providing products that agents can market to small- to mid-size businesses in their communities. Approximately 57.5 percent of total premiums are derived from six states: Indiana, Illinois, Michigan, Ohio, Pennsylvania and Virginia. The premium growth rate in these six states over the past three years has exceeded that of overall premiums as the company continues to increase its market penetration in these areas.
Facing rising losses after years of intense price competition, the commercial lines insurance marketplace began to experience a firming of rates in mid-1999. Growing concerns about the economy and rising loss severity, exacerbated by the events of September 11, 2001, led to continued rate increases through year-end 2002. Also in response to the rising loss severity, during this period, some competitors have announced decisions to exit geographic markets or specific lines of business; others have instituted across-the-board price increases. Industry analysts believe the market has experienced a renewed sense of underwriting discipline.
The company responded to these market conditions by continuing to pursue its case-by-case approach to new business and account renewals, seeking to further solidify its relationships with the independent agencies and establish a basis for continued growth. While insisting on adequate premiums for covered exposures, the company has continued to do business the way it always has; on the local level, focusing on each relationship separately. Commercial lines pricing has remained flexible to respond to each risk in partnership with local agencies, who knows their market and their business. The company believes that this approach results in more, high-quality accounts over the long term.
For small- to mid-size commercial customers, the company offers a variety of insurance products. Four business lines – commercial multi-peril, workers compensation, commercial automobile and other liability – account for 90.5 percent of commercial lines earned premiums.
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The remaining 9.5 percent of commercial lines earned premiums in 2002 were derived from a variety of other types of insurance products the company offers to commercial customers.
PERSONAL LINES PROPERTY CASUALTY INSURANCE
The personal lines property casualty insurance segment contributed $670 million of Cincinnati Financial’s total revenues and a $51 million loss before income taxes in 2002. The company markets its full complement of personal lines products in 25 of the 31 states in which it markets commercial lines insurance. Six states – Alabama, Georgia, Illinois, Indiana, Michigan and Ohio – accounted for 72.8 percent of personal lines premiums in 2002.
The company predominantly markets homeowners and personal automobile insurance products through 663 of the 950 independent agencies that represent The Cincinnati Insurance Companies. The 287 agencies that do not market the personal lines products either are located in the six states in which the company does not actively market personal lines insurance or they have decided, in conjunction with company management, that the company’s personal lines products are not appropriate for their agencies at this time.
Already unprofitable due to years of inadequate pricing, industry-wide personal lines insurance saw a dramatic rise in loss ratios in 2001, primarily because the homeowners area experienced an upswing in water damage and mold claims. In response, insurance companies have sought rate increases and added coverage exclusions. A number of carriers have taken dramatic steps such as restricting new business and exiting certain territories. While the personal automobile area has been less volatile in recent years, companies continue to seek rate increases to keep up with increasing claim costs.
Personal automobile accounted for 58 percent of personal lines earned premium in 2002. The company continues to seek and receive approval for appropriate rate increases. The homeowners line accounted for 31 percent of personal lines earned premium in 2002. To return this business line to profitability, the company has focused on pricing and changes in policy terms and conditions. The remaining 11 percent of personal lines earned premium in 2002 was derived from a variety of other types of insurance products the company offers to individuals such as inland marine, watercraft and umbrella. The company offers its personal umbrella product, which accounted for 4 percent of total premiums in 2002, primarily in a package with auto or homeowner coverage. Due to the volatility of the personal umbrella product, the company has experienced rising losses in this area, which it is addressing with rate increases and careful underwriting.
PROPERTY CASUALTY LOSSES AND LOSS EXPENSE RESERVES
The consolidated financial statements include the estimated liability for unpaid losses and loss expenses of the company’s property casualty insurance subsidiaries. The liabilities for losses and loss expenses are determined using case-basis evaluations and statistical projections for estimates of unreported claims and represent estimates of the ultimate net cost of all unpaid losses and loss expenses incurred through December 31 of each year. These estimates are subject to the effect of trends in future claim severity and frequency. These estimates are continually reviewed, and as experience develops and new information becomes known, the liability is adjusted as necessary. Adjustments due to prior year development are reflected in underwriting results in the year in which they are identified.
The company does not discount any of its property casualty liabilities for unpaid losses and loss expenses. A reconciliation of the beginning and ending balances of the company’s liability for losses and loss expenses for 2002, 2001 and 2000 is presented in Note 4 to the Consolidated Financial Statements, see Page 64 The reconciliation of beginning and ending liability balances shows recognition of approximately $45 million in redundant reserves during 2002 related to amounts held in the reserve as of December 31, 2001, for losses and loss expenses in 2001 and prior accident years. This redundancy was due to subsequent reserve estimates that confirm the conservative approach the company uses when establishing adequate reserves. Changes in calendar year 2002 to the 1992 through 1997 accident year reserves were due to adverse developments on umbrella, commercial multi-peril, product liability and workers compensation claims.
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The anticipated effect of inflation is implicitly considered when estimating liabilities for losses and loss expenses. While anticipated price increases due to inflation are considered in estimating the ultimate claim costs, the increase in average severity of claims is caused by a number of factors that vary with the individual type of policy written. Average severity is based on historical trends adjusted for anticipated changes in underwriting standards, policy provisions and general economic trends. These trends are monitored based on actual development and are modified, if necessary.
The principal reason for differences between the property casualty liabilities reported in the accompanying consolidated financial statements (prepared in accordance with accounting principles generally accepted in the United States of America – GAAP) and those same liabilities reported in the annual statements (filed with state insurance departments in accordance with statutory accounting practices – SAP or statutory), relates to the reporting of reinsurance recoverables, which are recognized as receivables for GAAP and as an offset to reserves for SAP.
The table below shows the development of the estimated liability for losses and loss expenses for the years prior to 2002:
The table above presents the development of balance sheet liabilities for 1992 through 2002. The first line of data shows the estimated net liability for unpaid losses and loss expenses recorded at the balance sheet date for each of the indicated years. That liability represents the estimated amount of losses and loss expenses for claims arising in all prior years that are unpaid at the balance sheet date, including losses that had been incurred but not yet reported to the company. The upper portion of the table shows the re-estimated amount of the previously recorded liability based on experience as of the end of each succeeding year. The estimate is increased or decreased as more information becomes known about the frequency and severity of claims.
Net cumulative redundancy represents the aggregate change in the estimates over all prior years. For example, the 1992 liability has developed a $225 million redundancy over 10 years, which has been reflected in income over the 10 years. The effects on income in 2002, 2001 and 2000 of changes in estimates of the liabilities for losses and loss expenses for all accident years are shown in the reconciliation table above.
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The lower portion of the development table shows the cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. For example, as of December 31, 2002, the company had paid $794 million of the currently estimated $913 million of losses and loss expenses that have been incurred as of the end of 1992; thus an estimated $119 million of losses incurred as of the end of 1992 remain unpaid as of year-end 2002.
In evaluating this information, it should be noted that each amount includes the effects of all changes in amounts for prior periods. For example, the amount of deficiency or redundancy related to losses settled in 1997 but incurred in 1992 will be included in the cumulative deficiency or redundancy amount for 1992 and each subsequent year. This table does not present accident or policy year development data, which readers may be more accustomed to analyzing. Conditions and trends that have affected development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future redundancies or deficiencies based on this table.
LIFE INSURANCE OPERATIONS
The life insurance segment contributed $87 million of Cincinnati Financial’s total revenues and a $12 million loss before income taxes in 2002.
Cincinnati Life’s strategic mission complements that of the overall company: to provide products and services that attract and retain high-quality independent agencies. The company primarily focuses on life products that will produce revenue growth through a steady stream of premiums rather than seeking to accumulate assets through the sale of single-premium-type policies.
Cincinnati Life seeks to round and protect accounts in the property casualty agency. At the same time, the life operation looks to increase diversification, revenues and profitability for both the agency and the company. This strategy enhances the already strong relationship built by the combination of the property casualty and life companies.
Cincinnati Life seeks to become the life insurance carrier of choice for the independent agencies that work with the property casualty operations by providing competitive products, underwriting, service and commissions. At year-end 2002, 90 percent of the company’s 950 independent agencies offered Cincinnati Life’s products to their policyholders. Term and worksite insurance products are well suited to cross serving by the company’s property casualty agency force. Agents find that offering worksite marketing to employees of their small commercial accounts provides a benefit to the employees at low cost to the employer. The life company also seeks to develop life business from other independent agencies in a manner that does not conflict with or compete with the property casualty agencies.
The life company offers a full line of whole, term and universal life products, fixed annuities, disability income and long-term care products. Over the past several years, it has worked to introduce a portfolio of new and enhanced products, primarily under the LifeHorizons name. For example, 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. Looking ahead, the life company plans to introduce two new, competitive LifeHorizons guaranteed products – whole life with a single-premium paid-up life rider and long-term guaranteed universal life – and roll out a non-cancelable rider for its disability income insurance product. In 2003, the life operation also will be devoting more internal resources to promotion of its new long-term care insurance product, with a structure targeted at the corporate market.
To augment the enhanced product line, the life operation has staffed a new field marketing position in the western United States to complement the efforts of the 25 life field marketing representatives in other regions of the country.
The life insurance industry was challenged in 2002 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.
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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.
Cincinnati Life believes such pressures are mitigated for the company because of its association with the property casualty operations, its focus on the property casualty distribution system and its careful selection of independent agencies. Within this marketplace, Cincinnati Life is able to be competitive and attract its share of business from the company’s agencies, especially as other property casualty companies continue to exit the life business.
During the past three years, the company has invested in imaging and workflow technology. As a result, the efficiency of application processing has improved significantly. During this period, submitted applications have increased at an annualized rate of approximately 6 percent, while staff involved with the underwriting and policy-issue functions has declined 5 percent. This has been accomplished while maintaining the company’s service standards.
Cincinnati Life is a financially strong and stable life insurance company. During 2002, Cincinnati Life’s statutory surplus increased 7 percent to $408 million from $380 million at year-end 2001. Statutory surplus is one of the key measures of an insurance company’s financial stability. A.M. Best Co. and Standard & Poor’s Ratings Services maintained their ratings for Cincinnati Life in 2002 while Fitch Ratings initiated coverage with an AA (very strong) rating.
INVESTMENT OPERATIONS
By applying a strategy that focuses on the compounding of cash flows over the long term, Cincinnati Financial’s investment operations have contributed to the company’s success in several ways:
While focused on long-term total return, the company maintains liquidity to meet both its immediate and long-range insurance obligations with the purchase and maintenance of medium-risk fixed-maturity and equity securities. The emphasis is on income-producing fixed-maturity and equity securities with the potential for long-term price appreciation. In recent years, the company’s investment strategy has taken into account the trend toward a flatter corporate yield curve and an overall decline in credit quality by purchasing higher-quality corporate bonds with shorter maturities as well as tax-exempt municipal bonds.
REGULATIONS
INSURANCE REGULATORY OVERSIGHT
The company’s subsidiaries primarily are engaged in the property casualty insurance business, and secondarily in the life insurance business, and it is therefore subject to regulation by the State of Ohio, the domiciliary state, as an insurance holding company. All states have enacted legislation that regulates insurance holding company systems such as the company and its insurance subsidiaries. This legislation generally provides that each insurance company in the system is required to register with the department of insurance of its state of domicile and furnish information concerning the operations of companies within the company which may materially affect the operations, management or financial condition of the insurers within the company. All transactions within a holding company affecting insurers must be fair and equitable. Notice to the insurance commissioner is required prior to the consummation of transactions affecting the ownership or control of an insurer and of
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certain material transactions between an insurer and any person or entity in its holding company and, in addition, certain of such transactions cannot be consummated without the commissioner’s prior approval.
The company’s insurance subsidiaries are subject to regulation and supervision in the states in which they do business. In general, such regulation is for the protection of policyholders rather than shareholders. The extent of such regulation varies, but generally has its source in statutes that delegate regulatory, supervisory and administrative powers to a department of insurance. For example, these statutes cover: the standards of solvency which must be met and maintained; the licensing of insurers and their agents; restrictions on insurance policy terminations; unfair trade practices; the nature of and limitations on investments; premium rates; deposits of securities for the benefit of policyholders; approval of policy forms; periodic examinations of the affairs of insurance companies; annual and other reports required to be filed on the financial condition of companies or for other purposes; limitations on dividends to policyholders and shareholders; and, adequacy of provisions for unearned premiums, unpaid losses and loss expenses (both reported and unreported) and other liabilities, among other matters.
Most states have insurance laws requiring insurers to file rates, policy or coverage forms and other information with the state’s regulatory authority. Some states require such rates and/or forms to be approved prior to use while others permit an insurer to begin using rates and/or forms prior to approval by the insurance regulator. Several states exempt such filings and approvals for commercial risks of a certain size. In all states, the insurance regulator has the authority to disapprove a rate after it is filed. Rates proposed for life insurance generally become effective immediately upon filing with a state, even though the same state may require prior rate approval for other types of insurance. Generally, the objectives of the laws governing rate filings are that a rate must be adequate, not excessive and not unfairly discriminatory.
In all states, insurers licensed to transact certain classes of property casualty insurance are required to become members of a guaranty fund. In the event of the insolvency of a licensed insurer writing a class of insurance covered by the fund in the state, members are assessed to pay certain claims against the insolvent insurer. Generally, fund assessments are proportionately based on the members’ market share for the classes of insurance written by the insolvent insurer. In certain states, a portion of these assessments is recovered through premium tax offsets and policyholder surcharges. In 2002, assessments to the company’s insurance subsidiaries amounted to approximately $9 million.
State insurance regulation requires insurers to participate in assigned risk plans, reinsurance facilities and joint underwriting associations, which are mechanisms that generally provide applicants with various basic insurance coverages when they are not available in voluntary markets. Such mechanisms are most commonly instituted for automobile and workers compensation insurance, but many states also mandate participation in FAIR Plans or Windstorm Plans, which provide basic property coverages. Participation is based upon the amount of a company’s voluntary market share in a particular state for the classes of insurance involved. Underwriting results related to these organizations, which tend to be adverse to the company, have been immaterial to the company or its results of operations.
For public reporting, insurance companies prepare financial statements in accordance with GAAP. However, certain data also must be calculated according to statutory accounting rules as defined in the National Association of Insurance Commissioners’ (NAIC) Accounting Practices and Procedures Manual, which may be, and has been, modified by various state insurance departments.
While not a substitute for any GAAP measure of performance, statutory data frequently is used by industry analysts and other recognized reporting sources to facilitate comparisons of the performance of insurance companies. When appropriate, the company makes use of statutory data to analyze trends or make comparisons to industry performance. Estimated industry data is taken from materials published by A.M. Best, a leading insurance industry analytical and rating organization, and presented on a statutory basis. Statutory data for the company is labeled as such; all other data is prepared based on GAAP.
NAIC adopted the Codification of Statutory Accounting Principles (Codification) in March 1998. Codification, which is intended to standardize regulatory accounting and reporting to state insurance regulators, became effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. Ohio required adoption of Codification, with certain modifications, for the preparation of statutory-basis financial statements effective January 1, 2001. Codification is now incorporated into the NAIC Accounting Practices and Procedures Manual. The effects of the company’s adoption of Codification effective January 1, 2001, are discussed below.
NAIC has risk-based capital (RBC) requirements for property casualty and life insurers which serve as an early warning tool for the NAIC and the state regulators to identify companies that may be undercapitalized and may merit further regulatory action.
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The formula prescribes a series of risk measurements to determine a minimum capital amount for an insurance company, based on the profile of the individual company. The ratio of a company’s actual policyholders’ surplus to its minimum capital requirement will determine whether any state regulatory action is required. At December 31, 2002, the company’s insurance subsidiary and each of its subsidiaries had more than sufficient capital to meet the RBC minimum requirements and had excess capacity to write additional premiums in relation to these requirements.
EFFECTS OF CODIFICATION OF STATUTORY ACCOUNTING PRACTICES
The effect of adopting Codification is reported as a cumulative-effect type change in accounting principle for the company’s insurance subsidiaries’ statutory financial statements as of January 1, 2001. This means that the January 1, 2001, balances of the company’s insurance subsidiaries’ statements of admitted assets, liabilities and capital and surplus have been adjusted to the amounts that would have been reported had Codification been in effect since the subsidiaries began operations. Accordingly, there were significant changes to the statutory surplus. For the property casualty companies, the changes were deferred tax assets of $314 million, consisting primarily of taxes on the timing of loss reserves and unearned premiums; deferred tax liabilities of $701 million, comprised mainly of taxes on net unrealized gains; guaranty fund assessments and premium tax liabilities of $11 million; and earned-but-unbilled premium receivables of $6 million, with a resulting decrease in surplus of $392 million. For the life company, the changes were deferred tax liabilities of $62 million, comprised mainly of taxes on net unrealized gains, and a corresponding decrease in surplus.
Additionally, prior to 2001, the company’s property casualty insurance subsidiaries recognized written premiums as they were billed throughout the policy period, which was a previously acceptable method. Beginning on January 1, 2001, these companies began recognizing written premiums on an annualized basis at the effective date of the policy as required by Codification. This method of recognizing written premiums had no effect on statutory income or surplus because earned premiums were unaffected. To account for unbooked premium related to policies with effective dates prior to January 1, 2001, the company recorded a written premium adjustment on January 1, 2001, of $402 million that appeared in the 2001 statutory financial reports submitted to insurance regulatory authorities. Since this adjustment affected written premiums only and was one-time in nature, it has been excluded from comparisons of written premiums between 2002, 2001 and 2000 in this report. Written premiums presented throughout this report for 2000 have been reclassified to conform with the 2001 presentation based on contractual period; information was not readily available to reclassify earlier years’ statutory data.
FEDERAL LEGISLATIVE AND REGULATORY INITIATIVES
Although the federal government and its regulatory agencies generally do not directly regulate the business of insurance, federal initiatives often have an impact on the business in a variety of ways. Some of the current and proposed federal measures that may significantly affect the company’s business are discussed below.
The Terrorism Risk Insurance Act of 2002 (TRIA), signed into law on November 26, 2002, provides a federal backstop for losses related to the writing of the terrorism peril in property casualty insurance policies. Under the TRIA, the company had until February 24, 2003, to notify commercial policyholders about requirements of the law, let them know that the company was required to offer terrorism coverage and let them know how the coverage would be priced.
During December 2002 and January and February 2003, the company distributed more than 400,000 disclosure notices to in-force commercial policyholders. The notices explained the Act and notified them of their coverage. Except for a few select cases, full policy limit coverage has been provided for terrorism for policyholders. The terrorism rating plan, with rates that vary based on geographical and risk-type factors, will go into effect in the near future. The plan will charge all commercial policies a nominal terrorism premium to encourage them to accept coverage while minimizing the company’s administrative costs.
The Gramm-Leach-Bliley Act of 1999 (GLB) permits mergers that combine commercial banks, insurers and securities firms within one holding company group. The impact on the company of the ability of banks to affiliate with insurers is uncertain. Additionally, GLB imposed privacy protections of consumer financial information. GLB requires financial institutions, including the company, to protect the financial information of their policyholders and applicants by requiring them to develop and send a notice of the institution’s privacy practices at the inception of the relationship and annually thereafter. The institutions must also give customers the opportunity to opt out of some information disclosures. Most states have passed similar statutes or regulations, many of which include health as well as financial information in the protections. The company believes it has complied with all relevant statutes of GLB. Further protection of consumer health information is required by regulations promulgated under the Health Insurance Portability and Accountability Act of 1996 (HIPAA). These regulations become effective April 2003 and require health care
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providers such as doctors and hospitals, as well as health and long-term care insurers and health care clearinghouses, to institute physical and procedural safeguards to protect the health records of patients and insureds. Examples of mandated safeguards include requirements that notices of the entity’s privacy practices be sent and that patients and insureds be given the right to access and request amendments to their records. Authorizations are required before a provider, insurer or clearinghouse can use health information for marketing and certain other purposes. Additionally, health plans are required to electronically transmit and receive standardized healthcare information.
While not directly affecting the company’s insurance business, the Sarbanes-Oxley Act of 2002 and regulations promulgated thereunder by the Security and Exchange Commission, apply to the company. Sarbanes-Oxley requires the Securities and Exchange Commission (SEC) to prescribe rules to enhance the accountability of public companies to investors and to enhance its own enforcement powers. Rules promulgated or proposed by the SEC to date relate to: independence of issuers’ audit committees; independence of outside audit firms; requirements of financial experts on audit committees; certification of certain financial reports by the chief executive officer and chief accounting officer of the issuer; requirement of a code of ethics; design and implementation by audit committees of a confidential and anonymous system to receive and handle reports of complaints regarding accounting and internal controls; additional disclosure requirements; and, enhanced civil and criminal penalties, among many others. Additionally, an issuer’s listing exchange may prescribe additional rules to apply to issuers listed on that exchange. The company is monitoring the developments of these rules and is making any necessary adjustments to ensure full compliance.
HISTORY OF CINCINNATI FINANCIAL CORPORATION
INCORPORATION
Cincinnati Financial was incorporated on September 20, 1968, under the laws of the State of Delaware. On April 4, 1992, the shareholders voted to adopt an Agreement of Merger by means of which the reincorporation of the corporation from the State of Delaware to the State of Ohio was accomplished.
SUBSIDIARY DESCRIPTIONS
The Cincinnati Insurance Company (CIC), incorporated in August 1950, is an insurance carrier presently licensed to conduct multiple line underwriting in accordance with Section 3941.02 of the Revised Code of Ohio. This includes the sale of fire, automobile, casualty, bonds and all related forms of property casualty insurance in 50 states, the District of Columbia, and Puerto Rico. CIC is not authorized to write any other forms of insurance. CIC is in a highly competitive industry and competes in varying degrees with a large number of stock and mutual companies.
The Cincinnati Casualty Company (CCC), (formerly the Queen City Indemnity Company), incorporated in 1972 under the laws of Ohio, is engaged in writing workers compensation as well as a limited personal lines book of business on a direct basis. The business of CIC and CCC is conducted separately and there are no plans for combining the business of these companies. CCC reinsures substantially all of its business to CIC.
The Cincinnati Indemnity Company (CID), incorporated in 1988 under the laws of Ohio, is engaged in writing workers compensation, some casualty lines and a small amount of non-standard personal auto coverage. The business of CIC and CID is conducted separately and there are no plans for combining the business of these companies. CID reinsures substantially all of its business to CIC.
The Cincinnati Life Insurance Company (CLIC) was incorporated in 1987 under the laws of Ohio for the purpose of acquiring the business of Inter-Ocean Insurance Company and The Life Insurance Company of Cincinnati. CLIC acquired The Life Insurance Company of Cincinnati and Inter-Ocean Insurance Company on February 1, 1988. CLIC is licensed for the sale of life insurance and accident and health insurance in 49 states and the District of Columbia.
CFC Investment Company (CFC-I), in the business of leasing or financing various items, principally automobiles, trucks, computer equipment, machine tools, construction equipment and office equipment, was incorporated in 1970.
CinFin Capital Management Company (CCM), which offers asset management services to corporations, insurance agencies and companies, institutions, pension plans and high net worth individuals, was incorporated in 1998.
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Cincinnati Financial is the parent and owns 100 percent of The Cincinnati Insurance Company, CFC Investment Company and CinFin Capital Management Company. CIC owns 100 percent of The Cincinnati Casualty Company, The Cincinnati Indemnity Company and The Cincinnati Life Insurance Company.
EMPLOYEES
As of December 31, 2002, Cincinnati Financial employed 3,511 associates.
AVAILABLE INFORMATION
The company’s principal executive offices are located at 6200 S. Gilmore Rd., Fairfield, Ohio 45014-5141, telephone (513) 870-2000. Its Web site address is www.cinfin.com. All of the company’s filings with the SEC are available free of charge through the Investors/Financial Reports page on this Web site, immediately upon filing.
ITEM 2. PROPERTIES
CFC owns its headquarters building located on 75 acres of land in Fairfield, Ohio. This building contains approximately 615,000 square feet. John J. & Thomas R. Schiff & Co. Inc., a related party, occupies approximately 6,750 square feet, and the balance of the building is occupied by CFC and its subsidiaries. The property, including land, is carried in the financial statements at $82 million as of December 31, 2002, and is classified as Property and equipment, net, for company use.
CFC-I owns the Fairfield Executive Center, which is located on the northwest corner of its headquarters property in Fairfield, Ohio. This is a four-story office building containing approximately 96,000 rentable square feet. CFC and its subsidiaries occupy approximately 45 percent of the building; unaffiliated tenants occupy approximately 15 percent of the building; approximately 28 percent of the building is available for future CFC usage; and, approximately 12 percent is available for rent. The property is carried in the financial statements at $8 million as of December 31, 2002, and is classified as Property and equipment, net, for company use.
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.
ITEM 3. LEGAL PROCEEDINGS
The Cincinnati Insurance Company is a defendant in Rochlin et al v. The Cincinnati Insurance Company, a purported class action lawsuit filed in December 2000 in the U.S. District Court for Southern Indiana on behalf of certain female employees in three departments of the company alleging employment-related gender discrimination in promotions and pay. The complaint seeks unspecified monetary damages and injunctive relief. In March 2002, the District Court certified a class but in May 2002 agreed to reconsider its class certification decision. The company denies the allegations of the suit and is vigorously defending this action.
The company is involved in no material litigation other than routine litigation incident to the nature of its insurance business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to security holders during the fourth quarter of 2002.
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PART II
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Cincinnati Financial Corporation had 11,486 direct shareholders of record as of December 31, 2002. Registered owners hold 30 percent of Cincinnati Financial Corporation’s outstanding shares. Many of the company’s independent agent representatives and most of the 3,511 associates of its subsidiaries own the company’s common stock. Common shares are traded under the symbol CINF on the Nasdaq National Market List.
The company’s ability to pay cash dividends may depend on the ability of its subsidiaries to pay dividends to CFC. See Note 8 to the Consolidated Financial Statement for discussion of dividend restrictions at the insurance company subsidiaries.
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ITEM 6. SELECTED FINANCIAL DATA
The selected financial information above allows for a more complete analysis of results of operations and should not be considered a substitute for any GAAP measure of performance.
As more fully discussed in the company’s Form 10-K for 2002, 2001 statutory data for the property casualty subsidiaries reflects the company’s adoption of Codification effective January 1, 2001. Codification of Statutory Accounting Principles required recognition of net written premiums on the basis of the policy contract term rather than the policy billing period. For comparison purposes, a $402 million one-time net written premium adjustment required to conform with Codification was excluded from 2001 data, and 2000 statutory data was reclassified; information was not readily available to reclassify earlier years’ statutory data presented above.
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2000 results include a one-time charge for asset impairment of $39 million, before tax; $25 million, or 16 cents per share, net of tax. The charge affected the statutory expense ratio and combined ratio by 1.7 percentage points and the GAAP expense ratio and combined ratio by 2.1 percentage points.
1993 earnings include a net credit for $14 million, or 8 cents per share, cumulative effect of a change in the method of accounting for income taxes to conform with SFAS No. 109 and a net charge of $9 million, or 5 cents per share, related to the effect of the 1993 increase in income tax rates on deferred taxes recorded for various prior-year terms.
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ITEMS 7 AND 7(A). MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The following discussion highlights significant factors influencing the consolidated results of operations and financial position of Cincinnati Financial Corporation (CFC). It should be read in conjunction with the consolidated financial statements and related notes beginning on Page 52 and the 11-year summary of selected financial information on Pages 14 and 15.
In response to recent legislation and proposed regulations, management reviewed its internal control structure and its disclosure controls and procedures. While management believes the pre-existing disclosure controls and procedures were adequate to enable the company to comply with its disclosure obligations, management implemented minor changes as a result of such review, primarily to formalize and document procedures already in place. The company also established a disclosure committee that consists of certain members of the company’s senior management.
The company’s disclosure controls and procedures are designed to ensure that material information, relating to the company and its subsidiaries, required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the company’s management, including its chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
SAFE HARBOR STATEMENT
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.
Further, the company’s insurance businesses are subject to the effects of changing social, economic and regulatory environments. Public and regulatory initiatives have included efforts to adversely influence and restrict premium rates, restrict the ability to cancel policies, impose underwriting standards and expand overall regulation. The company also is subject to public and regulatory initiatives that can affect the market value for its common stock, such as recent measures impacting corporate financial reporting and governance. The ultimate changes and eventual effects, if any, of these initiatives are uncertain.
Readers are cautioned that the company undertakes no obligation to review or update the forward-looking statements included in this material.
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SIGNIFICANT ACCOUNTING POLICIES
Cincinnati Financial Corporation’s financial statements are prepared using GAAP. These principles require management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates.
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, the following reviews the estimates and assumptions used to develop reported amounts related to the most significant policies. Management discusses the development and selection of these accounting estimates with the audit committee of the board of directors and the audit committee has reviewed the company’s disclosure relating to it in this Management’s Discussion and Analysis.
PROPERTY CASUALTY INSURANCE LOSS RESERVES
As discussed in the Note 4 to the Consolidated Financial Statements, Page 64, management establishes the company’s liabilities for insurance reserves, including adjustments of estimates, based upon company experience and information from internal analysis. Though uncertainty always exists as to the adequacy of established reserves, management believes this uncertainty is mitigated by the historic stability of the company’s book of business. Such reserves are related to various lines of business and will be paid out over future periods. The company monitors trends in the industry, relevant court cases, current legislative activity and other current events in an effort to ascertain new or additional exposures to loss. Insurance loss reserves are affected directly by management’s reserving philosophy.
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.
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 and respond to new or unexpected claim and loss patterns, such as those caused by the risk factors cited in the company’s safe harbor statement, could lead to a rise in incurred but not yet reported (IBNR) reserves. Higher IBNR would lead to a higher losses and loss expenses ratio; each percentage point increase in the losses and loss expenses ratio would reduce pre-tax income by $24 million based on 2002 earned premiums.
The outside actuary’s range for adequate reserves, net of reinsurance, was $2,492 million to $2,674 million for 2002 and $2,267 million to $2,429 million for 2001. The assumptions used to establish the recommended range for 2002 were consistent with prior year practices as described below and in Item 1, Property Casualty Losses and Loss Expense Reserves, Page 5. In addition, the outside actuary undertook additional tests to reflect a change in the initial case reserving procedures by the headquarters claims staff. The decision to establish higher initial case reserves reflected the trend toward rising loss severity, an industry-wide phenomenon.
The total reserve balance, net of reinsurance, at year-end 2002 was $2,608 million compared with $2,352 million at year-end 2001. See Note 4 to the Consolidated Financial Statements, Page 64, for a reconciliation of property casualty reserve balances with the losses and loss expenses liability on the balance sheet. The increase in reserves in each year reflected the increases in policies in force and coverages, loss development deterioration reflecting larger 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 has conducted a thorough evaluation in the fourth quarter of the adequacy of its reserves as of the end of the third quarter of each calendar year. In the quarters following, changes based on that thorough review are implemented in conjunction with the less detailed but continuous review of reserve adequacy. As a result, the most significant variation in reserves is seen in the fourth quarter.
HIGHLY UNCERTAIN EXPOSURES
In the normal course of its business, the company may provide coverage that leads to highly uncertain exposures as summarized below:
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To help mitigate the risk of these highly uncertain exposures, the company maintains reinsurance treaties as described below.
REINSURANCE
The company limits the maximum net loss that can arise from large risks or risks concentrated in areas of exposure by reinsuring these risks (ceding) with other insurers or reinsurers. The company’s property casualty risk retention program is affected by various factors, which include, but are not limited to, the changes in the company’s underwriting practices, the capacity to retain risks and reinsurance market conditions.
The company has property casualty working reinsurance treaties and a property casualty catastrophe reinsurance treaty for 2003 through reinsurers that have written the company’s treaties for more than 10 years.
To protect against single large losses, the company purchases property casualty working reinsurance treaties. For 2003:
For property coverages of individual risks with insured values in excess of $25 million but less than $50 million, the company typically purchases reinsurance (facultative) coverage 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 coverages of individual risks with limits exceeding $25 million, facultative reinsurance coverage is placed on an individual certificate basis.
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To protect against catastrophic events, the company purchases property catastrophe reinsurance. Under the 2003 treaty, ceded premiums are estimated to be $20 million, up from $19 million in 2002 and $13 million in 2001. The company will retain the first $25 million of losses arising out of a single event, as it has done for several years. It will retain 43 percent of losses from $25 million to $45 million as it did in 2002, an increase from 5 percent in 2001. It will retain 5 percent of losses from $45 million to $200 million. In mid-2002, the company expanded the property catastrophe reinsurance program, adding another $100 million layer in excess of $200 million and retaining 50 percent of the losses in this layer. For 2003, the company will reduce its retention of losses between $200 million and $300 million to 5 percent. The company increased its catastrophe coverage because of its increased exposure due to company growth.
The company also has traditionally purchased a reinsurance treaty that provides an additional $25 million in casualty loss protection, notably for workers compensation losses, bad faith losses and “clash coverage” when there is a single occurrence involving multiple insureds or multiple policies for one insured. The company purchases surety reinsurance in a separate contract.
All reinsurance agreements in place in 2003 are similar to those for 2002, with modestly higher retention levels and an estimated incremental cost increase, net of tax, of $4 million, or 2 cents per share. The company has the financial ability to absorb losses at these levels, and the 2003 reinsurance agreement is a means of balancing reinsurance costs and risks.
Management evaluates terrorism exposure based on aggregate exposure to class of risk. As of the November 26, 2002 enactment of the TRIA, only approximately 120 of the company’s commercial lines policies had terrorism exclusions endorsed. Under the 2003 property casualty working treaties, the company’s terrorism reinsurance coverage has limitations in addition to higher retentions. Coverage is more limited for terrorism than for other causes of loss in the event of multiple events during the same calendar year. Under the catastrophe cover, there is no terrorism coverage for nuclear, pollution or contamination events. For other catastrophic terrorism losses, the company has obtained coverage for personal lines and some limited coverage for commercial lines. Due to the company’s focus on small- to medium-sized businesses in smaller markets and the belief that these policyholders are not likely terrorism targets, as well as the availability of reinsurance, the company remains willing to continue to underwrite terrorism losses.
LIFE INSURANCE POLICY RESERVES
Reserves for traditional life insurance policies are based on expected expenses, mortality, withdrawal rates and investment yields, including a 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. 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 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.
DEFERRED ACQUISITION COSTS
The company establishes a deferred asset for costs that vary with and are primarily related to acquiring property casualty and life business, principally agent’s commissions, premium taxes, and certain underwriting costs, which are deferred and amortized into 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. For accident health policies, expenses incurred in the issuance of policies are deferred and amortized in level proportion to gross premiums over the expected lifetime of the contract.
Underlying assumptions are periodically updated to reflect actual experience and changes in the amounts of timing or estimated future profits will results in adjustments in the accumulated amortization of these costs. Management does not believe that future changes in assumptions would have a material affect on the company.
SEPARATE ACCOUNTS
The company issues life contracts with guaranteed minimum returns, referred to as bank-owned life insurance policies (BOLI), the assets and liabilities of which are legally segregated and recorded as assets and liabilities of the separate accounts. Minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders.
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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.
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. 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.
In the company’s most significant separate account, 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 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, decreasing 2 percent a year to 0 percent at year 11. At December 31, 2002, net unamortized losses amounted to $5 million. In accordance with this separate account agreement, the investment assets must meet certain criteria established by banking regulatory authorities to whose jurisdiction the 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, 2002, in the separate account portfolio were $1 million.
INVESTMENTS — VALUATION AND IMPAIRMENT
The company’s largest asset is its investment portfolio; and, therefore, accounting policies relative to the investment portfolio are critical. Most of the company’s investments are made in publicly traded securities. 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, dividend, corporate action and descriptive information to support fund pricing, securities operations, research and portfolio management. FT Interactive Data collects, edits, maintains and delivers data on more than 3.5 million securities, commodities and derivative instruments traded around the world. This data includes daily evaluations for more than 2.5 million active fixed-income issues.
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 securities (common and preferred stocks) are classified as available for sale and recorded at fair value in the financial statements.
The company’s investment committee and asset impairment committee continually monitor investments and other assets for signs of impairment. Among other signs, the committees monitor 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, 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.
Declines in the market value of assets are categorized as follows:
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During 2002, the company recognized $98 million, or 0.9 percent of total invested assets, of other-than-temporary impairment charges, including $16 million from four convertible securities and $82 million from 26 fixed-income securities. During 2001, the company recognized $45 million, or 0.4 percent of total invested assets, of other-than-temporary impairment charges, $8 million from two convertible securities and $37 million from 12 fixed-income securities. Other-than-temporary impairment charges had no influence on 2000 results. Further, $4 million, or less than 0.1 percent of total invested assets, was deemed permanently impaired and written off in 2002 and $18 million, or 0.2 percent of total invested assets, was written off in 2001. See Results of Operation, Page 24, for a detailed discussion.
Based on comparison of market value to book value data as of year-end 2002, 59 securities with a book value of $231 million, or 2.0 percent of total invested assets, were being monitored due to the presence of impairment indicators. Management believes it is unlikely that it would be required to impair the entire value of these securities; however, in those circumstances the impact of impairment on the company’s book value and surplus would be minimal. See Quantitative and Qualitative Disclosures about Market Risk, Page 46, for a detailed discussion of potential other-than-temporary impairment charges.
EMPLOYEE BENEFIT PLAN
The company has a defined benefit pension plan covering substantially all employees. Contributions and pension costs are developed from annual actuarial valuations. These valuations involve key assumptions including discount rates and expected return on plan assets, which are updated each year. Any adjustments to these assumptions are based on considerations of current market conditions. Therefore, changes in the related pension costs or credits may occur in the future due to changes in assumptions. The key assumptions used in developing the 2002 net pension credit were a 6.5 percent discount rate, an 8 percent expected return on plan assets and rates of compensation increases ranging from 5 percent to 7 percent, depending on the age of the employee. The 8 percent return on assets assumption is based on the investments of the portfolio held by the pension plan and that substantially all of the investments are equity securities that pay annual dividends. Management believes this rate is representative of the expected long-term rate of return on these assets. These assumptions were consistent with the prior year except that the discount rate was reduced by half of one percent due to current market conditions. Compared with the prior year, the net pension credit was reduced by $2 million. For 2003, the company expects a net pension expense of $4 million, primarily as a result of lower plan assets and resulting expected returns and a decrease in the interest rate used in converting the lump sum cash out form of payment at retirement by half of one percent. Holding all other
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assumptions constant, a half of one percent increase or decrease in the discount rate would have increased or decreased annual 2002 income before income taxes by $1 million. Likewise, a half of one percent increase or decrease in the expected return on plan assets would have increased or decreased annual 2002 income before income taxes by $800,000.
In addition, the estimated accumulated benefit obligation (ABO) related to the defined benefit pension plan exceeded the fair value of the plan assets at December 31, 2002. This was due primarily to negative returns on the pension funds as a result of the overall decline in the equity markets and a decline in the discount rate used to estimate the pension liability as a result of declining interest rates in the United States. Market conditions and interest rates significantly impact future assets and liabilities of the pension plan. An additional liability might 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.
RECENT ACCOUNTING PRONOUNCEMENTS
The company’s adoption of SFAS No. 142 “Goodwill and Other Intangible Assets,” which requires an impairment-only approach to valuing goodwill and other intangible assets, had no impact on the consolidated financial statements. SFAS No. 143 “Accounting for Asset Retirement Obligations,” which addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs, is not applicable to the company and therefore has no impact on the consolidated financial statements. The company’s adoption of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” which addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of, also had no impact on the consolidated financial statements.
The Financial Accounting Standards Board (FASB) issued SFAS No. 145 “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections” in April 2002, which eliminates inconsistencies in certain lease transactions, includes certain other technical corrections and clarifies language; SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal” was issued in June 2002 and requires that liabilities for costs associated with an exit or disposal activity be recognized and measured at fair value when the liability is incurred; SFAS No. 147 “Acquisitions of Certain Financial Institutions” was issued in October 2002 and relates to the application of the purchase method of accounting and requires those transactions be accounted for in accordance with SFAS No. 141 “Business Combinations” and No. 142 “Goodwill and Other Intangible Assets”; management has determined that these newly issued accounting pronouncements will have no effect on the company’s consolidated financial statements.
FASB issued SFAS No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure” in December 2002. This pronouncement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The company has adopted the disclosure provisions of this pronouncement and will adopt a transition method at the time when a consistent fair value recognition and measurement provision is determined by FASB (in conjunction with the international accounting standards setters) and is required to be adopted.
FASB Interpretation 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” became effective December 15, 2002. This interpretation elaborates on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. Management has determined that this interpretation will have no effect on the company’s consolidated financial statements.
FASB Interpretation 46 “Consolidation of Variable Interest Entities” was issued in January 2003 and is effective at various dates for various requirements. This interpretation addresses consolidation of variable interest entities (formerly known as special purpose entities). Management has determined that this interpretation will have no effect on the company’s consolidated financial statements.
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RESULTS OF OPERATIONS
THREE-YEAR HIGHLIGHTS
Highlights of the company’s financial performance over the past three years include:
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OVERVIEW
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:
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COMMERCIAL LINES
PREMIUM GROWTH
Commercial lines earned premiums rose 18.6 percent in 2002, or 17.6 percent excluding the premium estimate adjustment described above, compared with 17.9 percent in 2001 and 13.2 percent in 2000. Statutory written premiums for commercial lines of insurance grew 22.8 percent in 2002, or 15.8 percent excluding the premium estimate adjustment, compared with the estimated industry average of 17.9 percent. The primary source of growth in the past two years has been firmer pricing on new and renewal commercial business, more then offsetting deliberate decisions to not write or non-renew certain business. In 2001, the company’s commercial lines statutory written premiums grew 16.6 percent compared with an estimated industry average of 8.1 percent.
Commercial lines premium growth in states in which the company has had a presence for more than five years was 16.0 percent in 2002 compared with 22.9 percent in 2001, reflecting the continued opportunities available to the company. Expansion states, where the company has operated for five or fewer years, also were a factor in overall growth, with agency direct premiums of $49 million in 2002 compared with $32 million in 2001 and $14 million in 2000. Over the past five years, the company began marketing commercial lines insurance in Idaho, Montana, upstate New York, North Dakota and Utah.
Growth also has reflected the focus on improving customer service through the creation of smaller marketing territories, permitting local field marketing representatives to devote more time to each independent agent. At year-end 2002, the company had 83 property casualty field territories, up from 74 at the end of 2000. During 2003, the company plans to split and staff another six territories. Smaller territories allow marketing representatives to increase the level of service as well as expand the opportunities to ask for and earn new business.
The company’s standard approach is to write three-year policies, a competitive advantage in the commercial lines market. Exceptions have traditionally included some business new to the agency, aggressively priced policies or policies for which facultative reinsurance has been purchased. Though the company commits to a three-year policy term, policies are annually renewable at the discretion of the policyholder and are cancelable at any time. In 2002, the company wrote a higher-than-normal number of one-year policies while awaiting state regulatory approval for the addition of aggregate limits to the company’s general liability and umbrella coverage forms. These policies would normally have been written on a three-year basis. The changes to the general liability and umbrella coverage limits bring the company in line with industry practices. In 2003, the company expects to resume writing three-year policies at its normal pace because of the competitive advantages.
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While writing three-year policies would appear to restrict opportunities to quickly adjust pricing, annual adjustments are in fact made within multi-year packages to automobile, workers compensation, professional liability and most umbrella liability coverages. Management estimates that approximately 74.5 percent of 2002 commercial premium was subject to annual adjustment or re-pricing. Rates on the remaining 25.5 percent of premium are guaranteed for three years. Multi-year packages are offered at rates that may be slightly higher than single-year or annually-adjusted rates. By reducing annual administrative efforts, multi-year policies reduce the company’s and agency’s expenses and the incentive for the policyholder to shop for a new policy every year. Management believes that the advantages of three-year policies in terms of policyholder retention and reduced administrative costs outweigh the potential disadvantage of these policies in periods of rising rates. In addition, the company began increasing rates in 2000 and is two-thirds through the repricing period for renewals of multi-year policies.
Premium growth in 2002 benefited from double-digit premium increases for most commercial lines of business on relatively constant policy counts. The company is 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. Agents agree on the need to carefully select risks and restore 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.
Based on billed written premiums directly by agencies, in 2002, commercial annualized new business premiums were $251 million compared with $220 million in 2001 and $230 million in 2000. Locally based field marketing representatives, who work with agencies to underwrite and price business based on personal and direct knowledge of the risk and competitive environment, lead the new business effort. Overall growth of new business in 2002 was affected by the company’s decision to selectively reduce workers compensation writings. On the basis of billed written premiums directly, new workers compensation premiums declined 17.4 percent in 2002 and 18.4 percent in 2001, compared with a 55.4 percent increase in 2000.
The company has tightened underwriting of new and renewal business, writing new business on a case-by-case basis and offering one-year policies where competition or reinsurance arrangements makes multi-year policies impractical. Over the past three years, the growth rate for individual business lines within the commercial lines segment has shown the company’s emphasis on obtaining adequate pricing for the covered risk:
In total, commercial multi-peril, workers compensation, commercial auto and other liability accounted for 90.5 percent of total commercial lines earned premium in 2002 versus 91.5 percent in 2001 and 92.7 percent in 2000.
While no immediate effects are anticipated, the company reached certain milestones in 2002 related to Web-based technology projects that make it easier for agents to place business with the company. Agencies and field representatives in four states now are using the company’s new commercial policy quoting systems with six additional states planned for 2003.
PROFITABILITY
The commercial lines combined ratio was 96.6 percent in 2002, an improvement from 101.7 percent in 2001 and 115.2 percent in 2000 (106.8 percent when the UM/UIM reserve is excluded). Catastrophe losses contributed 2.3 percent, 1.9 percent and 1.5 percent to the commercial lines losses and loss expenses and combined ratios in 2002, 2001 and 2000, respectively.
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LOSSES AND LOSS EXPENSES ANALYSIS
The losses and loss expenses ratio for commercial lines was 70.3 percent in 2002, compared with 74.1 percent in 2001 and 84.1 percent in 2000 (75.7 percent when the reserve addition is excluded). Since 2000, improvement in commercial lines profitability has primarily been driven by pricing gains as policy count has been relatively flat over the three-year period. In addition, the company has focused on longer-term efforts to enhance profitability. These have included knowing what exposures it has for each risk and making sure it offers appropriate coverages and limits of insurance at appropriate prices. The company continues to develop new underwriting guidelines, to re-underwrite books of business with selected agencies and to change policy terms and conditions where necessary. In addition, the company continues to leverage its strong local presence. Field marketing representatives have been meeting with every agency to reaffirm agreements on the extent of frontline renewal underwriting to be performed by local agencies. Loss control, machinery and equipment and field claims representatives have been conducting on-site inspections, with field claims representatives preparing full risk reports on every account reporting a loss above $100,000 or on any risk of concern.
Specific actions in 2002 and 2001 have included:
The reserve estimation policies for the company’s property casualty business are described under Significant Accounting Policies (see Page 18). As rate and other actions have begun to contribute to improved overall profitability for commercial lines, the company continually monitors the adequacy of its reserves relative to commercial lines.
Management’s conclusions regarding reserve levels in 2002 reflected refinement of the manner in which the value of future salvage and subrogation for claims already incurred is estimated. Also, management increased reserves for incurred but not yet reported losses because of higher than expected paid and/or reported development in workers compensation, commercial casualty, commercial umbrella and other liability lines for accident years 1999 through 2001. The increased IBNR was due to management’s continuous efforts to achieve its best estimates of the ultimate incurred losses and not due to any specific event or level of claim activity in a particular line. Management monitors claim activity and appropriately modifies amounts added to losses and loss expense reserves via IBNR additions on an ongoing basis. The IBNR increase in 2001 primarily reflected business growth and the company’s analysis of loss trends. The IBNR increase in 2000 primarily reflected the $103 million commercial lines portion of the UM/UIM reserve.
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.
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LINE OF BUSINESS ANALYSIS
Among other factors, an industry-wide rise in loss severity over the past several years has resulted from escalating legal costs, medical costs and jury verdicts. Management monitors loss data by size of loss, business line, geographic region, agency, field marketing representative and duration of policyholder relationship to determine if there are concentrations or trends that require specific actions. Analysis indicated no significant concentrations beyond that seen in higher loss ratios for certain business lines, which management has addressed.
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In addition to the renewed focus on underwriting discussed above, a number of factors have affected profitability in the company’s four largest commercial lines of business:
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COMMERCIAL LINES LOSSES INCURRED ANALYSIS (GAAP)
Analysis of loss data by average size of loss supports management’s belief that the industry-wide increase in loss severity is not a temporary phenomenon. Management evaluates the trend in losses and case reserve adjustments greater than $250,000 to track frequency and severity of larger losses and also monitors claim activity, average claim reserves on new claims and reserve development on large claims, as losses are settled or as reserves are increased. Based on the trends of the past three years, management believes that losses between $250,000 and $1 million and reserve increases greater than $250,000 are stable as a percent of earned premiums. Management is monitoring the level of losses greater than $1 million, however, which continue to rise as a percent of earned premiums.
CATASTROPHE LOSSES
Commercial lines catastrophe losses, net of reinsurance and before taxes, were $40 million in 2002 compared with $28 million in 2001, which included $9 million for losses related to events of September 11, 2001. Reported direct losses accounted for less than fourth-tenths of a percent of the $9 million and arose from the company’s participation in an aircraft insurance pool and other reinsurance agreements. Commercial lines catastrophe losses were $18 million in 2000.
EXPENSES
The expense ratio remained relatively stable over the past three years, excluding the one-time charge to expense software development assets in 2000, as the company maintained its level of investment in staff and in upgrades to technology and facilities. While management expects overall expenses to trend down, the commission expense ratio is expected to rise as workers compensation, which has a low commission rate, becomes a smaller percentage of total premiums.
POLICYHOLDER DIVIDEND EXPENSE
Policyholder dividend expense as a percent of earned premiums declined by 0.8 percentage points in 2002 and 0.3 percentage points in 2001. The improvement in the ratio in 2002 and 2001 reflected the company’s emphasis on pricing for workers compensation as well as its decision to not write or not renew many of these policies. Whenever possible, renewal workers compensation policies are being written by The Cincinnati Casualty Company, which does not offer policyholder dividends.
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USAIG POOL PARTICIPATION
In 2002, Cincinnati Financial, through The Cincinnati Insurance Company, participated in USAIG, a joint underwriting association of individual insurance companies that collectively function as a worldwide insurance market for all types of aviation and aerospace accounts. However, the company ceded its share of the main USAIG pool for policy year 2002, which resulted in a net financial impact equivalent to exiting the pool. Cincinnati Financial’s net participation share in the main USAIG pool was 10 percent for policy years 2001 and 2000.
Due to policy year 2001 rate increases that were booked in 2002, the company recorded a USAIG-related underwriting gain of $10 million for 2002 versus underwriting losses of $3 million and $2 million for 2001 and 2000, respectively. The 2001 underwriting loss included $4 million related to the events of September 11, 2001, and the American Airlines flight 587 accident in Queens, New York, in November 2001.
For participants in the USAIG main pool, each member’s share of premiums, losses, expenses and profits is proportionate to its contracted participation level during the years they participate in the pool. Each member company of USAIG adheres to financial rating, statutory surplus and security agreement requirements. The member companies fund a trust account at a depository bank to meet 100 percent of their respective net liabilities.
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 pool has two governing committees to which each member company may appoint a representative. The general policy committee meets periodically to review, among other things, reinsurance credit exposure, trends in the reinsurance marketplace and to evaluate exceptions to the approved reinsurer list that may arise. The advisory council, which includes all member companies, meets annually.
The managers of USAIG issue policies in the name of one or more of the member companies. All business written in The Cincinnati Insurance Company name is treated in the company’s accounts as direct premium and losses and is then ceded to USAIG. For the years ended December 31, 2002, 2001 and 2000, direct business earned and then ceded was $192 million, $57 million and $39 million, while direct losses and loss expenses incurred and then ceded were $29 million, $314 million and $7 million, respectively. Since The Cincinnati Insurance Company was named as the designated insurer for American Airlines’ policy year 2000 business, the gross losses and recoverables resulting from all American Airlines accidents were recorded on its 2001 financial statements. Management expects to recover 100 percent of the reinsurance recoverables associated with these accidents.
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PERSONAL LINESGROWTH AND PROFITABILITY
Personal lines earned premiums rose 8.1 percent in 2002, compared with 4.0 percent in 2001 and 4.6 percent in 2000. The sources of growth in the past three years were rate increases on new and renewal personal lines business, as well as increased opportunities to write new accounts as agencies and policyholders in the uncertain marketplace are attracted to the company’s fair pricing and long-term approach. Statutory written premiums for personal lines of insurance grew 11.0 percent in 2002, or 9.8 percent excluding the premium estimate adjustment, compared with 5.3 percent in 2001. In each of the past two years, the segment’s written premiums have grown less rapidly than the overall industry averages of 11.2 percent and 9.3 percent, respectively, as the company has focused on underwriting actions as it seeks to return to acceptable levels of profitability.
The personal lines combined ratio was 107.6 percent in 2002, improved from 112.4 percent in 2001 and 108.0 percent in 2000 (106.8 percent excluding the UM/UIM reserve addition). Catastrophe losses contributed 7.1 percent, 5.8 percent and 5.4 percent to the personal losses and loss expenses ratio and the combined ratios in 2002, 2001 and 2000, respectively. The losses and loss expenses ratio for personal lines was 79.7 percent in 2002, compared with 82.9 percent in 2001 and 79.2 percent for 2000 (78.0 percent excluding the UM/UIM reserve addition).
While no short-term effects are anticipated, the company reached certain milestones in 2002 related to Web-based technology projects that will make it easier for agents to place business with the company. During its first six months of operation, Kansas agencies processed 3,700 policies with approximately $3 million of premium using the initial version of the new integrated processing system for six personal lines of business. As the technology is rolled out sequentially to other states over the next several years, management believes the program could have a substantial positive benefit on premium growth and evaluation of the company’s personal lines business. The objectives are to build a single-entry data processing system to streamline policy issue; to speed up processing time to improve cash flow; and to offer direct billing, a feature frequently requested by agents. The total amount capitalized for development of this new software through December 31, 2002 was $15 million.
The reserve estimation policies for the company’s property casualty business are described under Significant Accounting Policies (see Page 18). As rate and other actions have begun to contribute to improved overall profitability for personal lines, the company continually monitors the adequacy of its reserves relative to personal lines.
Management’s conclusions regarding reserve levels in 2002 reflected refinement of the manner in which the value of future salvage and subrogation for claims already incurred is estimated. Also, management increased reserves for incurred but not yet reported losses because of higher than expected paid and/or reported development in the homeowner line for accident years
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1999 through 2001. The increased IBNR was due to management’s continuous efforts to achieve its best estimates of the ultimate incurred losses and not due to any specific event or level of claim activity in a particular line. Management monitors claim activity and appropriately modifies amounts added to losses and loss expenses reserves via IBNR additions on an ongoing basis. The IBNR increase in 2001 primarily reflected business growth and the company’s analysis of loss trends. The IBNR increase in 2000 primarily reflected the $7 million reserve for UM/UIM.
The personal auto and homeowner business lines together accounted for 89.4 percent, 89.0 percent and 88.6 percent of total personal lines earned premiums in 2002, 2001 and 2000, respectively. The following analyzes growth and profitability for these lines separately:
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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 percent of the company’s total homeowner earned premium, the typical renewal policyholder is experiencing approximately a 30 percent increase in total premium for their next three-year policy term. This reflects all rate increases, insured value and policy changes that were effective over the policyholder’s previous three-year policy cycle. As the company continues to work through the renewal policy cycle, management expects to see quarter-over-quarter improvement in earned premium and losses and loss expenses ratios in 2003 and beyond.
PERSONAL LINES LOSSES INCURRED ANALYSIS (GAAP)
Personal lines catastrophe losses, net of reinsurance and before taxes, were $47 million in 2002 compared with $36 million in 2001 and $32 million in 2000.
The expense ratio, excluding the one-time charge to expense software development assets in 2000, remained relatively stable over the past three years, as the company maintained its level of investment in staff and costs associated with upgrading technology and facilities.
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LIFE INSURANCE OPERATIONSOVERVIEW
PREMIUMS
The company’s life insurance subsidiary reported 2002 statutory written premiums of $220 million, including a single $33 million general account BOLI policy, up from $102 million in 2001. In 2000, written premiums were $119 million, including a single $20 million separate account BOLI policy. Excluding BOLI premiums, written premiums rose 81.9 percent in 2002 compared with 3.0 percent in 2001 and 3.8 percent in 2000. Written premiums have been reclassified to exclude annuity deposits not involving life contingencies, which are not recognized as written premium under statutory rules. Total written premiums in 2002 included $85 million of annuities, compared with $10 million in 2001 and $7 million in 2000, as agents continued to market attractive annuity features including guaranteed interest and fixed income.
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.
NET INCOME BEFORE REALIZED INVESTMENT GAINS AND LOSSES
In 2002, net income before realized investment gains and losses was down 16.7 percent from 2001 in part due to increased regulatory and legal costs. In 2001, net income before realized investment gains and losses declined 8.1 percent from the prior year primarily due to higher expenses related to charges for automation and policy audits and incentives. In 2000, net income before realized investment gains and losses rose 14.9 percent, due to growth in investment income, favorable mortality experience, expense control and continued growth.
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INVESTMENT OPERATIONSOVERVIEW
Investment operations affect the company’s results of operation through the inclusion of investment income and realized gains and losses. Investment operations provide the company’s primary source of pre- and after-tax profits.
INVESTMENT INCOME
Pre-tax investment income reached a new record of $445 million in 2002, up 5.6 percent from the prior record of $421 million in 2001. Pre-tax investment income grew 2.8 percent in 2001. Growth in investment income over the past two years has been driven by excellent cash flow for new investment and increased dividend income from the common stock portfolio.
The advantages of the excellent cash flow 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 prevailing interest rates.
In 2002, 28 of the 46 common stocks in the portfolio raised their dividends, which should add approximately $12 million to gross investment earnings on an annualized basis. The 10 largest holdings in the equity portfolio accounted for approximately 90 percent of the increase in indicated annual dividends in 2002.
REALIZED INVESTMENT GAINS AND LOSSES
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.
Over the past three years, realized investment losses have included:
OTHER-THAN-TEMPORARY IMPAIRMENTS
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:
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Other-than-temporary impairment charges by asset class are shown below:
In 2002, the company recorded $8 million, which included $5 million in gains from assets sold in the normal course of the company’s investing activities, compared with $11 million in gains in 2001 and $2 million in losses in 2000. The company’s investment operations buy and sell securities on an ongoing basis to help achieve its portfolio objectives. Securities sold at a loss typically reflected management’s opinion that the security fundamentally no longer meets the company’s investment expectations. This change in expectations forces management to consider deviating from its typical intent to hold to maturity. This may reflect a loss of confidence in 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. The decision to sell reflects management’s perception of a change in the underlying fundamentals of the company and preference to allocate those funds to investments that more closely meet the established parameters for long-term stability and growth. Sales of securities that had previously been impaired or distressed securities totaled $73 million in 2002 versus $66 million in 2001 and $124 million in 2000, with high-yield corporate bonds accounting for 35.7 percent, 42.4 percent and 54.5 percent of these sales in 2002, 2001 and 2000, respectively. As described in other-than-temporary impairments above, issues affecting the airline, telecommunication, utility/merchant energy/trading and cable industries were a primary factor in the decision to sell securities.
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VALUATION OF EMBEDDED DERIVATIVES
In 2002, the company recorded $4 million in fair value declines versus $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.
OTHER
Operations of the parent company, CFC Investment Company and CinFin Capital Management Company, excluding investment activities, and other income of the insurance subsidiaries resulted in $14 million in revenues in 2002, up from $13 million in 2001 and $11 million in 2000. The losses before income taxes of $32 million, $35 million and $36 million recorded in 2002, 2001 and 2000, respectively, were primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.
FEDERAL INCOME TAXES
Investment operations are the company’s primary source of profits. The company pursues a strategy of investing in tax advantaged fixed maturities and equity securities to minimize its overall tax liability and maximize after-tax earnings. The statutory net underwriting losses in each of the past three years served to further reduce the company’s tax expense. The differences in income tax expense and the effective tax rate during the period were primarily the company’s tax-exempt interest and dividends received exclusion. See Note 10 to the Consolidated Financial Statements, Page 66, for detail regarding the company’s effective income tax rate.
Management anticipates that the effective tax rate will approximate 20 percent if the company achieves its performance objectives of an underwriting profit, growth in investment income and more normalized realized investment gains.
Reflecting that strategy, the company’s income tax expense (benefit) was $41 million, $28 million and $(9) million for 2002, 2001 and 2000, respectively, while the effective tax rate was 14.8 percent, 12.7 percent and (8.9) percent for the same periods.
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LIQUIDITY AND CAPITAL RESOURCES
CASH FLOW
Cash flow from operations for each of the last three years was sufficient to meet operating needs of the company, with short-term borrowings utilized for financing activities during 2001 and 2000. Management believes that operating cash flows will continue to be the primary source of funds for the company. Net underwriting cash flows and net investment income have continued to be strong and contributed to cash flow from operations expansion of more than $120 million over 2001 and more than $180 million over 2000. The company uses cash provided by operations as well as cash provided by investment sales or calls primarily to purchase additional fixed-income and equity securities, pay dividends and repurchase stock.
Future liquidity could be affected by catastrophe losses that are in excess of the company’s catastrophe reinsurance treaties, which provide coverage for gross losses up to $300 million. The company has no significant exposure to assumed reinsurance, which accounted for no more than 2.6 percent of earned premiums in each of the last three years and is expected to remain at or near this level in 2003. In 2003, ceded reinsurance agreements will result in higher ceded premiums and higher retention by the company, which will increase incurred losses. The company expects to have minimal, if any, cash requirements related to the pension plan in 2003. However, if asset returns remain at 8 percent per year and the employee population is stable, it is possible that the defined benefit plan may have minimum contribution requirements as early as 2004.
Common stock repurchases for treasury have continued at a steady pace over the last several years and occur whenever management believes that stock prices on the open market are favorable for such repurchases. At December 31, 2002, 6.8 million shares remain authorized for repurchase at any time in the future when market conditions permit.
During 2002, the life insurance company annuity sales, including premiums and deposit-type contract funds, were much higher than normal at $110 million compared with $38 million and $28 million in 2001 and 2000, respectively. The growth in annuity sales was attributable to the fixed rates and guaranteed income features that were attractive in 2002’s economic climate.
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ASSETS
The market value of the company’s investments was $11.257 billion and $11.571 billion at year-end 2002 and 2001, respectively. These investments made up 80.1 percent of the company’s $14.059 billion in assets at year-end 2002 compared with 83.2 percent of the company’s $13.914 billion assets at year-end 2001.
INVESTMENT PORTFOLIO
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 types of assets evaluated prior to purchase based on yield and risk. The company invests primarily in publicly traded securities, classified as available for sale in the accompanying financial statements. The balance sheet reflects changes in the fair value of these securities as other comprehensive income, net of tax.
Within two broad categories, fixed-income securities and equity and convertible securities, the company invests in five classes of assets:
FIXED-INCOME SECURITIES
At year-end 2002 and 2001, investments totaling approximately $3.305 billion and $3.010 billion ($3.220 billion and $3.012 billion at amortized cost) of the company’s $11.257 billion and $11.571 billion investment portfolio related to fixed-income securities. At December 31, 2002, the company’s portfolio of fixed-income securities had a weighted average yield-to-book of 7.4 percent, a weighted average maturity of 10.6 years and a weighted average modified duration of 4.9 years. For the insurance companies’ purposes, strong emphasis has been placed on purchasing current income-producing securities.
By maintaining a well diversified, fixed-income portfolio, the company attempts to mitigate overall credit risk. No individual fixed-income issuer’s securities account for more than 2 percent of the fixed-income portfolio. At year-end 2002, the airline industry comprised approximately $97 million in market value ($119 million amortized cost) distributed among the three types of fixed-income securities. Continued weak performance by the airlines could further impact the value of the company’s holdings within this sector. See Potential Impairments, Page 48 for further discussion.
The energy sector, which encompasses utilities and merchant trading, accounted for $186 million in market value ($197 million amortized book value) of fixed-income assets. Management monitors industry concentrations for developments such as the unregulated operations of certain utilities, which may impact the value of the company’s holdings going forward. See Potential Impairments, Page 48 for further discussion.
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See Note 2 to the Consolidated Financial Statements, Page 62, for information regarding the maturity of the company’s fixed-income portfolio. Credit ratings as of December 31, 2002, for the company investment portfolio, excluding common and preferred stocks and including $4 million in government treasuries and $72 million in convertible debentures, were:
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Equity and Convertible Securities
At year-end 2002 and 2001, investments totaling $7.884 billion and $8.495 billion ($2.375 billion and $2.174 billion at cost) of the company’s $11.257 billion and $11.571 billion investment portfolio related to equity securities.
Additional information regarding the composition of investments, together with maturity data regarding investments in fixed-maturity obligations, is included in the Note 2 to Consolidated Financial Statements, Page 62.
OTHER INVESTED ASSETS
Other invested assets of $68 million, compared with $66 million in 2001, primarily consisted of mortgage loans, policy loans and notes receivable. During 2002, the company sold an office building in downtown Cincinnati for a net gain of $2 million, net of tax. See Item 2, Properties, Page 12, for information regarding the company’s other real estate holdings.
LIABILITIES
At December 31, 2002, total long- and short-term debt was 7.1 percent and insurance reserves were 47.6 percent of total liabilities, with remaining liabilities consisting of unearned premiums, deferred income taxes, declared but unpaid dividends and other liabilities.
DEBT
At December 31, 2002, and December 31, 2001, long-term debt consisted of $420 million and $426 million, respectively, of which $420 million was senior debentures in both years with $6 million in convertible debentures at year-end 2001, which matured in 2002. The senior debenture is not encumbered by rating triggers. The company’s excellent cash flow and strong capital position have allowed it to minimize its reliance on debt financing although the company utilizes a line of credit to fund short-term cash needs.
The company has two lines of credit totaling $250 million at year-end 2002. 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 2002, the company’s consolidated net worth was $5.598 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 2002, the ratio of indebtedness to net worth was 0.11-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 interest expense by $2 million, before-tax, based on the $183 million outstanding on the two lines of credit at year-end 2002.
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
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comprehensive income. The interest swap contract is reflected at fair value in the company’s balance sheet. The unrealized loss at December 31, 2002 was $4 million. The net effect of this transaction was to fix the interest cost on the short-term loan.
The company has no off-balance sheet arrangements.
Following is a summary of the contractual obligations and other commercial commitments:
(In millions)
Credit and Financial Strength Ratings
Insurers are rated on their financial strength and claims-paying ability to provide consumers with comparative information in the insurance industry. Among other factors, the ratings focus on items such as results of operations, capital resources and minimum policyholders’ surplus requirements as well as qualitative analysis.
During 2002, the company’s ratings from Standard & Poor’s, Moody’s and A.M. Best remained unchanged and a new rating from Fitch was initiated at A+ (very strong). In 2001, Standard & Poor’s had changed their rating of the company due to their outlook for the overall insurance industry and the company.
While factors such as the company’s catastrophe exposures, investment philosophy and bias towards incremental change with an eye toward stability instead of quick fixes have the potential to introduce volatility, the ratings agencies have consistently asserted that the company has built appropriate financial strength to manage that volatility and seek higher long-term returns for shareholders.
While management believes its financial position is strong, the rating agencies could decide to change their ratings in the future. The following table summarizes the company’s current debt and financial strength ratings:
DIVIDENDS
Cincinnati Financial has increased cash dividends to shareholders for 42 consecutive years and, periodically, the board of directors authorizes stock dividends or splits. In February 2003, the board of directors authorized a 12.4 percent increase in the regular quarterly 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. Over the past 10 years, the company has paid an average of 40 percent to 45 percent of net income as dividends, with the remaining 55 percent to 60 percent reinvested for future growth. The ability of the company to continue paying cash dividends is subject to factors as the board of directors may deem relevant.
Since 1992, the company’s board also has authorized four stock splits or stock dividends: a three-for-one stock split in 1998; a 5 percent stock dividend in 1996; a 5 percent stock dividend in 1995; and, a three-for-one stock split in 1992. After the most recent stock split in 1998, a shareholder who purchased one Cincinnati Insurance share before 1957 would own 1,947 Cincinnati Financial shares if all shares from accrued stock dividends and splits were held and cash dividends not reinvested.
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COMMON STOCK REPURCHASE
The Cincinnati Financial board believes that stock repurchases can help fulfill the company’s commitment to enhancing shareholder value. Consequently, the company’s board has authorized the repurchase of outstanding shares. At December 31, 2002, 6.8 million shares remained authorized for repurchase at any time in the future. The company has purchased 1.1 million shares at a cost of $42 million, 1.2 million shares at a cost of $46 million and 2.1 million shares at a cost of $67 million during the years ended December 31, 2002, 2001 and 2000, respectively. Shares repurchased total 14.1 million, at a total cost to the company of $465 million, since the inception of the share repurchase program in 1996.
SHAREHOLDERS’ EQUITY
At year-end 2002, total shareholders’ equity was 39.8 percent of total assets.
As a long-term investor, the company has followed a buy-and-hold strategy for more than 40 years. A significant amount of unrealized appreciation on equity investments has been generated as a result of this policy. Unrealized appreciation on equity investments, before deferred income taxes, was $5.509 billion and $6.321 billion at year-end 2002 and 2001, respectively. It constituted 69.9 percent of the equity investment portfolio; and, after deferred income taxes, 65.1 percent of total shareholders’ equity at year-end 2002.
The unrealized appreciation is primarily due to the company’s holdings in Fifth Third Bancorp (Nasdaq:FITB) and Alltel Corporation (NYSE:AT) common stock.
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Quantitative and Qualitative Disclosures about Market Risk
Market risk is the potential for a decrease in value resulting from broad yet uncontrollable forces such as: inflation, economic growth, interest rates, world political conditions or other widespread unpredictable events. It is comprised of many individual risks that, when combined, create a macroeconomic impact. Some of the risks are:
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.
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 investment portfolio managers to each of the five asset classes in which the company invests.
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Risks associated with the five asset classes can be summarized as follows (H – high, A – average, L – low):
Sector risk is the potential for a negative impact on a particular industry due to its sensitivity to factors that make up market risk. General supply/demand factors for an industry will be affected by market risk and will affect companies within that industry to varying degrees.
For investment-grade corporate bonds, the inverse relationship between interest rates and bonds prices would lead to falling bond values during periods of increasing interest rates. Although the potential for a worsening financial structure, and ultimately default, does exist with investment-grade corporate bonds, their higher-quality financial profiles make credit risk less of a concern than for lower-quality investments. The company addresses this risk by consistently investing within a particular maturity range, which has, over the years, provided the portfolio with a laddered maturity schedule less subject to large swings in value due to interest-rate changes. While a single maturity range may see values drop due to general interest-rate levels, other maturity ranges will be less affected by those changes. Additionally, purchases are spread across a wide spectrum of industries and companies, diversifying the company’s holdings and minimizing the impact of specific industries or companies with greater sensitivities to interest-rate fluctuations.
The primary risk related to high-yield corporate bonds is credit risk or the potential for a deteriorating financial structure. A weak financial profile can lead to rating downgrades from the credit rating agencies, which can put further downward pressure on bond prices. This weakening financial picture can lead to an inability to pay corporate obligations and to default. Interest rate risk is less of a factor with high-yield corporate bonds, as valuation is related more directly to underlying operating performance than to general interest rates. This puts more emphasis on results achieved by the issuer rather than general economic trends or statistics within the marketplace. The company addresses this concern by focusing on issuer – and industry-specific financial analysis and ongoing monitoring of holdings within this asset class.
The primary risk related to tax-exempt bonds is interest-rate risk as well as geo-political risk associated with the specific economic environment within the political boundaries of the issuing municipal entity. The company addresses these concerns by focusing on municipalities’ general-obligation debt and on essential-service bonds. Essential-service bonds are key because they derive funds from services provided by the municipality, which are vital to the people living in the area (schools, water service, sewer service, etc.). This enhances the ongoing need (demand) for service and thus provides stability to the financial picture of the issuer. Another risk related to tax-exempt bonds is regulatory risk or the potential for legislative changes that would negate the benefit of owning tax-exempt bonds. The company monitors regulatory activity for situations that may negatively affect current holdings and its ongoing strategy for investing in these securities.
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, for example bonds insured by corporate bond insurers or bonds with interest payment made by a corporate entity through a municipal conduit/authority. While decisions regarding these investments primarily are made based on the underlying municipal situation, the existence of third-party insurance in the event of default reduces risk. 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 focus on higher-rated entities with strong financial profiles, the company does not feel this is a material concern.
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INTEREST RATE SENSITIVITY ANALYSIS
The company recently developed financial planning models to further incorporate analytical tools in assessing market risks. Management believes the models will improve the company’s ability to measure the impact on bond values resulting from changes in interest rates. Improving measurement of the impact of interest-rate changes should allow for improved matching of the company’s assets and liabilities.
Hypothetically, an increase in interest rates (market yields to maturity) of 100 basis points at December 31, 2002, would decrease the fair value of the fixed-income portfolio by $161 million, or to $3.144 billion from $3.305 billion. The interest-rate change selected represents management’s views of a shift in rates that is quite possible over a one-year period. The rates selected should not be considered a prediction of future events as interest rates may be much more volatile in the future. The analysis is not intended to provide a precise forecast of the effect of changes in rates on the company’s results or financial condition, nor does it take into account any actions that might be taken to reduce exposure to such risks.
EQUITY AND CONVERTIBLE SECURITIES
The primary risk related to convertible securities is similar to other corporate fixed-income securities in terms of their sensitivity to interest rates, credit risk and default risk. The better the financial condition of the underlying issuer, the lower the credit risk. However, higher-rated convertible securities are more likely to be sensitive to changes in the general level of interest rates. Alternatively, issuers with a weaker financial profile have a higher potential for default and lower sensitivity to interest rates. For these issuers, operational performance is the most significant factor in valuing the security.
Common stocks are subject to a variety of risk factors encompassed within 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 industry- and company-specific risks by maintaining investments in a small group of holdings that management can analyze closely, better understanding their business and the related risk factors.
While the company’s financial position would be affected by changes in the market valuation of its investments, in 2002, the company’s equity portfolio outperformed the S&P 500 Index, a common benchmark of market performance, losing 7.3 percent versus a decline of 22.1 percent for the Index. Over the past five years, the portfolio performed similarly, with an average annual return of 7.1 percent compared with an average annual decline of 0.6 percent for the S&P 500 Index. While past performance cannot guarantee future returns, management believes the company’s investment style – focused on companies that pay and increase dividends to shareholders – offers some protection in down markets. A prolonged downturn in the stocks of financial institutions would make future comparisons with the S&P 500 Index more difficult.
At December 31, 2002, the company held six individual equity investments that accounted for approximately 90 percent of the after-tax net unrealized appreciation of the entire investment portfolio. The company’s largest equity holding is Fifth Third Bancorp common stock, of which the company held 72.8 million shares at a cost of $283 million at December 31, 2002. The market value of the company’s Fifth Third Bancorp position was $4.261 billion at year-end 2002, or 54.0 percent of its total equity portfolio. The after-tax unrealized gain represented by the company’s Fifth Third Bancorp position was $2.586 billion, or 71.0 percent of the company’s total after-tax unrealized gains at year-end 2002. The Fifth Third Bancorp position represented $16.00 of the company’s total book value of $34.65 per share at year-end 2002. Every $1.00 change in the market price of Fifth Third Bancorp’s common stock has approximately a 29-cent impact on Cincinnati Financial’s book value per share. A 20 percent change in the market price of Fifth Third Bancorp’s common stock, which was $58.55 at year-end 2002, would result in a $852 million change in assets and a $554 million change in after-tax unrealized gains. This would affect shareholders’ equity by 10 percent and book value by $3.43 per share.
POTENTIAL IMPAIRMENTS
Based on an evaluation of the portfolio at year-end 2002, 59 securities trading below 70 percent of book value are being monitored for potential other-than-temporary impairment. These securities had 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. If all securities trading below 70 percent of book value had been written down for an other-than-temporary impairment charge, the company would have recorded an additional $92 million in realized investment losses, before taxes, at December 31, 2002. Of the 59 securities trading below 70 percent of book value at year-end, the unrealized loss associated with the 22 securities trading below book value for less than four quarters amounted to $42 million, before tax. The 37 securities trading below book value for more than four quarters accounted for the remaining $50 million, before tax, of the unrealized loss at December 31, 2002.
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Management’s decision to continue monitoring these 59 securities reflected its application of its asset impairment policy, which evaluates: significant decreases in the market value of the assets; changes in legal factors or in the business climate; or, other such factors indicating whether or not the carrying amount may be recoverable. Objective measures, such as a declining trend in market value, the extent of the market value decline and the length of time in which the value has been depressed, can be outweighed by subjective measures such as impending events and issuer liquidity. Impairment will be evaluated, however, in the event of a declining market value for four consecutive quarters with quarter-end market value below 50 percent of book value or a market value 50 percent below book value for three consecutive quarters.
As discussed in Significant Accounting Policies on Page 58, 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. In management’s judgment, the 59 securities trading below 70 percent of book value at year-end 2002 that were not written down do have the potential of recovery based on analysis of economic-, industry- or company-specific factors. Based on its continuous monitoring of potential impairments and if market conditions continue to be adverse, management believes that some or all of the 59 securities being monitored as potentially impaired, or other securities, could meet the criteria for other-than-temporary impairment during the first quarter of 2003. Management believes that the company could record an other-than-temporary impairment charge at March 31, 2003 in the range of $30 million to $50 million, before tax, or 0.3 percent to 0.4 percent of invested assets at December 31, 2002.
Management deems the risk related to securities trading between 70 percent and 100 percent of book value to be relatively minor and at least partially offset by the earned income potential of these investments. At year-end 2002, impairment to market value of all 214 securities trading in this range would have resulted in only $80 million in additional realized investment losses, before tax. In 2002, securities trading between 70 percent and 100 percent of book value, which represented 7.3 percent of the total market value of the portfolio, generated $63 million, or 14.2 percent, of total earned income.
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The following table summarizes the portfolio at December 31, 2002:
(Dollars in millions)
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Outlook
Management believes the outlook for the company’s results of operation and liquidity and capital resources is positive in 2003 and beyond for a number of reasons:
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Item 8. Financial Statements and Supplementary Data
RESPONSIBILITY FOR FINANCIAL STATEMENTS
The accompanying financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2002 were prepared by management in conformity with accounting principles generally accepted in the United States of America.
The management of the company is responsible for the integrity and objectivity of the financial statements, which are presented on an accrual basis of accounting and include amounts based upon management’s best estimates and judgment. Other financial information in the Annual Report on Form 10-K is consistent with that in the financial statements. The accounting plan and related system of internal controls are designed to assure that the books and records reflect the transactions of the company in accordance with established policies and procedures as implemented by qualified personnel.
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 auditor 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.
Deloitte & Touche LLP, independent auditors, have audited the financial statements of Cincinnati Financial Corporation and subsidiaries for the year ended December 31, 2002, and their report is included herein. The auditors meet with members of the audit committee of the board of directors to discuss the results of their examination and are afforded the opportunity to present their opinions in the absence of management personnel with respect to the adequacy of internal controls and the quality of financial reporting of the company.
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INDEPENDENT AUDITORS’ REPORT
To the Shareholders and Board of Directors of Cincinnati Financial Corporation:
We have audited the accompanying consolidated balance sheets of Cincinnati Financial Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedules listed in the Index at Item 15(a)2. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
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, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, 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.
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CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS
Accompanying notes are an integral part of this statement.
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CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME
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CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
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CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS
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1. Summary of Significant Accounting Policies
NATURE OF OPERATIONS – Cincinnati Financial Corporation (company), through four insurance companies, markets insurance mainly through a network of local independent agents. Insurance products include fire, automobile, casualty, bonds and all related forms of property casualty insurance as well as life insurance, long-term care, disability income policies and annuities. In addition, the company has finance/leasing and asset management operations through the CFC Investment Company and CinFin Capital Management Company subsidiaries.
BASIS OF PRESENTATION – 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. All significant inter-company balances and transactions have been eliminated in consolidation.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
PROPERTY CASUALTY INSURANCE – 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. Losses and loss expense reserves are based on claims reported prior to the end of the year and estimates of unreported claims, 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.
The Cincinnati Insurance Companies market property casualty insurance policies in 31 states. In 2002, 98.6 percent of the company’s agencies’ direct written premium volume was in the 27 states in which the company has had a presence for more than five years. Further, agencies in Ohio contributed 24 percent and Georgia, Illinois, Indiana, Michigan and Pennsylvania each contributed between 5 percent and 10 percent of premium volume in 2002. No single agency accounted for more than 1.1 percent of the company’s total agency direct written premiums.
LIFE INSURANCE – Traditional products require the policyholder to pay scheduled premiums over the life of the coverage. The company recognizes premiums received on traditional products as revenue when due.
Limited-pay products require the policyholder to pay scheduled premiums up front but coverage is provided for an extended period. The company defers the amount of premium in excess of the amount necessary to provide for all benefits and expenses and recognizes it over the life of the coverage using the gross profit method.
Universal life products include those that allow policyholders to vary premiums at their discretion or provide benefits or permit charges that are not fixed according to the terms of the policy. Premiums for universal life products are not recognized as revenue when received. The company recognizes cost of insurance charges, administration charges and surrender charges as revenue when earned using the gross profit method.
Reserves for 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 and withdrawals. Interest rates on approximately $446 million and $344 million of such reserves at December 31, 2002 and 2001, respectively, are periodically adjusted subject to economic conditions then in effect and subject to contractually guaranteed minimum rates.
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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.
ACCIDENT HEALTH INSURANCE – Expenses incurred in the issuance of policies, as noted above in property casualty insurance, are deferred and amortized in level proportion to gross premiums over the expected lifetime of the contract. Policy premium income, unearned premiums and reserves for unpaid losses are accounted for in substantially the same manner as property casualty insurance items discussed above.
LEASE/FINANCE – CFC Investment Company provides auto and equipment direct financing (leases and loans) to commercial and individual clients. Generally, lease contracts transfer ownership of the property to the lessees at the end of the lease terms and contain bargain purchase options. Income is recognized over the financing term using the interest method.
Identified initial direct costs associated with the origination of a lease or loan are capitalized and amortized, using the interest method, over the life of the financing. These costs include, but are not limited to, finder fees, broker fees, filing fees and the cost of credit reports.
ASSET MANAGEMENT – As of December 31, 2002, CinFin Capital had 35 institutional, corporate and individual clients and $726 million under management, compared with 35 clients and $663 million at December 31, 2001. 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.
REINSURANCE – In the normal course of business, the company seeks to reduce losses that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance companies and reinsurers. Reinsurance contracts do not relieve the company from any obligation to policyholders. Although the company historically has not experienced uncollectible reinsurance recoverables, failure of reinsurers to honor their obligations could result in losses to the company. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy.
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.
INVESTMENTS – Fixed maturities (bonds and notes) and equity securities (common and preferred stocks) are classified as available for sale and are stated at fair values.
Unrealized gains and losses on investments, net of taxes, are included in shareholders’ equity in accumulated other comprehensive income. Realized gains and losses on investments are recognized in net income on a specific identification basis.
Investment income consists primarily of interest and dividends. Interest is recognized on an accrual basis and dividends are recorded at the ex-dividend date. The interest method is used for amortizing premium for discounts on fixed-maturity securities.
Other-than-temporary declines in the fair value of investments are recognized in net income as realized investment losses at the time when facts and circumstances indicate such write-downs are warranted.
FAIR VALUE DISCLOSURES – 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.
The fair values for liabilities under investment-type insurance contracts (annuities) are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued. Fair values for short-term notes payable are estimated using interest rates currently available to the company. Fair values for long-term debentures are based on the quoted market prices for such debentures. Fair value of the interest rate swap is determined by a bank.
DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES – The company invests in certain financial instruments that contain embedded options, which are stated at fair value and are attached to the host contracts, such as convertible debt and convertible preferred stock. 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 and its interest rate swap agreement to be recognized periodically in income or shareholders’ equity (as a component of accumulated other
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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.
PROPERTY AND EQUIPMENT – Property and equipment is recorded at cost less accumulated depreciation. The company provides depreciation based on estimated useful lives using straight-line and accelerated methods. Depreciation expense recorded in 2002, 2001 and 2000 was $22 million, $25 million and $18 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.
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.
FEDERAL INCOME TAXES – Deferred income tax liabilities and assets are computed using the tax rates in effect for the time when temporary differences in book and taxable income are estimated to reverse. Deferred income taxes are recognized for numerous temporary differences between the company’s taxable income and book-basis income and other changes in shareholders’ equity. Such temporary differences relate primarily to unrealized gains on investments and differences in the recognition of deferred acquisition costs and insurance reserves. Deferred income taxes associated with unrealized appreciation (except the amounts related to the effect of income tax rate changes) are charged to shareholders’ equity in accumulated other comprehensive income, and deferred taxes associated with other differences are charged to income.
SEPARATE ACCOUNTS – The company issues life contracts with guaranteed minimum returns, referred to as bank-owned life insurance (BOLI) policies, the assets and liabilities of which are legally segregated and recorded as assets and liabilities of the separate accounts. Minimum investment returns and account values are guaranteed by the company and also include death benefits to beneficiaries of the contract holders.
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, is 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.
EARNINGS PER SHARE – Net income per common share is based on the weighted average number of common shares outstanding during each of the respective years. The calculation of net income per common share (diluted) assumes the conversion of convertible senior debentures and the exercise of stock options.
STOCK OPTIONS – The company has primarily qualified stock option plans under which options are granted to employees at prices which are not less than market price at the date of grant and which are exercisable over 10-year periods. The company applies Accounting Principles Board (APB) Opinion 25 and related interpretations in accounting for these plans. Accordingly, no compensation cost has been recognized for the stock option plans.
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Had compensation cost for the company’s stock option plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123 “Accounting for Stock-Based Compensation,” the company’s net income and earnings per share would have been reduced to the pro forma amounts indicated below:
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.
NEW ACCOUNTING PRONOUNCEMENTS – The company’s adoption of SFAS No. 142 “Goodwill and Other Intangible Assets,” which requires an impairment-only approach to valuing goodwill and other intangible assets, had no impact on the consolidated financial statements. SFAS No. 143 “Accounting for Asset Retirement Obligations,” which addresses accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs, is not applicable to the company and therefore has no impact on the consolidated financial statements. The company’s adoption of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” which addresses financial accounting and reporting for the impairment of long-lived assets and for long-lived assets to be disposed of, also had no impact on the consolidated financial statements.
FASB issued SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure” in December 2002. This pronouncement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, it requires more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The company has adopted the disclosure provisions of this pronouncement and will adopt a transition method at the time when a consistent fair value recognition and measurement provision is determined by FASB (in conjunction with the international accounting standards setters) and is required to be adopted.
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FASB Interpretation 46 “Consolidation of Variable Interest Entities” was issued in January 2993 and is effective at various dates for various requirements. This interpretation addresses consolidation of variable interest entities (formerly known as special purpose entities). Management has determined that this interpretation will have no effect on the company’s consolidated financial statements.
RECLASSIFICATIONS – Certain prior year amounts have been reclassified to conform with current-year classifications, including outstanding loss checks payable, which prior to 2002 were classified as liabilities in the balance sheets, and now, as a result of a new check clearing process with the company’s bank, are included in cash.
2. Investments
At December 31, 2002, contractual maturity dates for investments in fixed-maturity securities were:
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Actual maturities may differ from contractual maturities when there exists a right to call or prepay obligations with or without call or prepayment penalties.
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.
The following analyzes cost or amortized cost, gross unrealized gains, gross unrealized losses and fair value for the company’s investments:
The fair value of the conversion features embedded in convertible securities amounted to a loss of $4 million at December 31, 2002 and a gain of $9 million at December 31, 2001.
Investments in companies that exceed 10 percent of the company’s shareholders’ equity include:
3. Deferred Acquisition Costs
Acquisition costs incurred and capitalized during 2002, 2001 and 2000 amounted to $580 million, $481 million and $438 million, respectively. Amortization of deferred acquisition costs was $523 million, $454 million and $405 million for 2002, 2001 and 2000, respectively.
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4. Property Casualty Losses and Loss ExpensesActivity in the reserve for losses and loss expenses is summarized as follows:
As a result of changes in estimates of insured events in prior years, the provision for losses and loss expenses decreased by $45 million, $62 million and $20 million in 2002, 2001 and 2000. These decreases are due in part to the effects of settling reported (case) and unreported (IBNR) reserves established in prior years for less than expected.
The reserve for losses and loss expenses in the accompanying balance sheets also includes $26 million and $22 million at December 31, 2002 and 2001, respectively, for certain life health losses.
5. Life Policy Reserves
Life policy reserves have been calculated using the account value basis for universal life and annuity policies and modifications of the 1975-80 select and ultimate table for traditional policies. Life policy reserves are summarized as follows:
At December 31, 2002 and 2001, the fair value associated with the annuities shown above approximated $331 million and $213 million, respectively.
6. Notes Payable
The company and subsidiaries had no compensating balance requirement on debt for either 2002 or 2001. The company had two lines of credit with commercial banks amounting to $250 million in 2002 (expiring in 2003) and $275 million in 2001, of which $183 million was in use at December 31, 2002 and 2001. Interest rates charged on such borrowings ranged from 1.78 percent to 6.11 percent during 2002, which resulted in an average interest rate of 3.01 percent. At December 31, 2002, the fair value of the notes payable approximated the carrying value and the weighted average interest rate approximated 2.63 percent.
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The company entered an interest-rate swap agreement during 2001, which expires in seven years, 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 unrealized loss, net of tax, at December 31, 2002, of $2 million is a component of comprehensive income; the fair value was not significant at December 31, 2001. 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.
7. Senior Debentures
The company issued $420 million of senior debentures due 2028 in 1998. The convertible senior debentures matured in 2002 and were convertible into shares of common stock at a conversion price of $14.88 per share (67.23 shares for each one thousand dollars principal). At December 31, 2002 and 2001, the fair value of the debentures approximated $429 million and $415 million, respectively.
8. Shareholders’ Equity and Dividend Restrictions
The insurance subsidiaries paid cash dividends to the company of approximately $100 million total, each year in 2002, 2001 and 2000. Dividends paid to the company 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 2003, the total dividends that may be paid to the company without regulatory approval are approximately $234 million.
The company’s board of directors has authorized the repurchase of outstanding shares. The company has purchased 14.1 million shares at a cost of $465 million between the inception of the share repurchase program in 1996 and December 31, 2002. At December 31, 2002, 6.8 million shares remain authorized for repurchase at any time in the future.
Six million shares of common stock were available for future stock option grants, as of December 31, 2002.
Declared cash dividends per share were 89 cents, 84 cents and 76 cents as of December 31, 2002, 2001 and 2000, respectively.
ACCUMULATED OTHER COMPREHENSIVE INCOME – The change in unrealized gains on investments and derivatives included:
Income taxes relate to each component above ratably.
9. Reinsurance
Property casualty premium income in the accompanying statements of income includes approximately $60 million, $38 million and $34 million of earned premiums on assumed business and is net of approximately $330 million, $155 million and $108 million of earned premiums on ceded business for 2002, 2001 and 2000, respectively.
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Written premiums consist of the following:
Insurance losses and policyholder benefits in the accompanying statements of income are net of approximately $96 million, $422 million and $109 million of reinsurance recoveries for 2002, 2001 and 2000, respectively.
10. Federal Income Taxes
Significant components of the company’s net deferred tax liability are as follows:
The provision for federal income taxes is based upon a consolidated income tax return for the company and subsidiaries. Although realization is not assured, management believes it is more likely than not that the deferred tax assets will be realized based on the assumption that certain levels of income will be achieved.
The differences between the statutory federal rates and the company’s effective federal income tax rates are as follows:
No provision was made December 31, 2002, 2001 and 2000 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.
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11. Net Income Per Common Share
Basic earnings per share is computed based on the weighted average number of shares outstanding. Diluted earnings per share is computed based on the weighted average number of common and dilutive potential common shares outstanding.
For the company, dilutive potential common shares consist of outstanding stock options and shares issuable under the matured 5.5 percent convertible senior debentures (debentures). The computations of basic and diluted earnings per share are as follows:
Options to purchase 1 million shares of common stock were outstanding during 2002, 2001 and 2000, respectively, but were not included in the computation of net income per common share (diluted) because the options’ exercise prices were greater than the average market price of the common shares.
12. Pension Plan
The company and subsidiaries sponsor a defined contribution plan (401(k) savings plan) and a defined benefit pension plan covering substantially all employees. Benefits for the defined benefit plan are based on years of credited service and compensation level. Contributions to the plan are based on the frozen entry age actuarial cost method. Pension expense is composed of several components that are determined using the projected unit credit actuarial cost method and based on certain actuarial assumptions.
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The following table sets forth summarized information on the company’s defined benefit pension plan:
The fair value of the company’s stock comprised $22 million of the plan’s assets at December 31, 2002 and 2001.
The following summarizes the assumptions for the plan:
The components of the net periodic benefit cost are as follows:
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13. Statutory Accounting Information
Accounting principles generally accepted in the United States of America differ in certain respects from statutory insurance accounting practices prescribed or permitted for insurance companies by regulatory authorities.
The National Association of Insurance Commissioners adopted the Codification of Statutory Accounting Principles (Codification). Codification, which is intended to standardize regulatory accounting and reporting to state insurance departments, became effective January 1, 2001. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. Ohio, the domiciliary state of the company’s insurance subsidiaries, required adoption of Codification with certain modifications for the preparation of statutory financial statements effective January 1, 2001. 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.
Adopting Codification reduced statutory capital and surplus as of January 1, 2001, by $392 million for the property casualty insurance subsidiaries and $62 million for the life insurance subsidiary.
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14. Transactions with Affiliated Parties
The company paid certain officers and directors, or insurance agencies of which they are shareholders, commissions of approximately $17 million, $14 million and $14 million on premium volume of approximately $113 million, $95 million and $87 million for 2002, 2001 and 2000, respectively.
15. Contingencies
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 non-insurance matters will be covered by external insurance coverage.
16. Stock Options
See Note 1 for a general description of the company’s stock option plans. A summary of options information follows:
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Options outstanding and exercisable consisted of the following at December 31, 2002:
17. Segment Information
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 the parent company, CFC Investment Company and CinFin Capital Management Company operations, 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, asset management fees and other income of the insurance subsidiaries.
Income before income taxes for the insurance segments represents underwriting profit (loss) – premiums earned minus losses and loss expenses incurred or policyholder benefits and other expenses. The commercial lines property casualty segment and the personal lines property casualty segment incurred an impairment charge amounting to $25 million and $14 million, before tax, respectively, for capitalized computer software development costs in 2000. Income before income taxes for the investment operations represents net investment income, plus realized investment gains and losses, less interest credited to contract holders. The investment operations segment incurred other-than-temporary impairment charges related to investments of $98 million in 2002 and $45 million in 2001. Other losses before income taxes of $32 million, $35 million and $36 million recorded in 2002, 2001 and 2000, respectively, were primarily due to interest expense from debt of the parent company and operating expenses of the company’s headquarters.
Identifiable assets by segment are those assets used in the respective segment’s operations. Information regarding identifiable assets is not reported for two reportable segments – commercial lines and personal lines of property casualty insurance – because these amounts are not used by company management for analysis of those segments. All fixed-maturity and equity security investments, regardless of ownership, are included in the investment operations segment.
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Segment information, is summarized in the following table.
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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There were no disagreements on accounting and financial disclosure requirements with accountants within the last 24 months prior to December 31, 2002.
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Part III
Pursuant to Paragraph G(3) of the General Instructions to Form 10-K, portions of the information required by Part III of Form 10-K are incorporated by reference from the company’s Proxy Statement to be filed with the SEC in connection with the 2003 Annual Meeting of Shareholders.
Item 10. Directors and Executive Officers of the Registrant
Item 11. Executive Compensation
Information concerning executive compensation appears in the Proxy Statement under “Compensation of Directors and Executive Officers.” This portion of the Proxy Statement is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information concerning security ownership of certain beneficial owners and management appears in the Proxy Statement under “Principal Shareholders” and “Information Regarding Nominees, Directors and Executive Officers.” These portions of the Proxy Statement are incorporated herein by reference.
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Additional information with respect to options under the company’s equity compensation plans is available in Notes 8 and 16 of the Consolidated Financial Statements, Pages 65 and 70.
Item 13. Certain Relationships and Related Transactions
Information concerning certain relationships and related transactions appears in the Proxy Statement under “Other Transactions” and “Compensation Committee Interlocks and Insider Participation.” These portions of the Proxy Statement are incorporated herein by reference.
Item 14. Controls and Procedures
The company’s disclosure controls and procedures are designed to ensure that material information relating to the company and its subsidiaries required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to the company’s management, including its chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Within the 90 days prior to the date of this annual report, the company carried out an evaluation, under the supervision and with the participation of management, including the chief executive officer and chief financial officer, of the effectiveness of the design and operation of disclosure controls and procedures. Based on that evaluation of these disclosure controls and procedures, the chief executive officer and chief financial officer concluded that Cincinnati Financial Corporation’s disclosure controls and procedures were effective as of the date of such evaluation.
The chief executive officer and chief financial officer also have concluded that there were no significant changes in the company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date that the company completed its evaluation.
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Part IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
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Schedule ISUMMARY OF INVESTMENTS – OTHER THAN INVESTMENTS IN RELATED PARTIES
CINCINNATI FINANCIAL CORPORATION AND SUBSIDIARIES
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Schedule I (CONTINUED)SUMMARY OF INVESTMENTS – OTHER THAN INVESTMENTS IN RELATED PARTIES
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Schedule IICONDENSED FINANCIAL INFORMATION OF REGISTRANT
This condensed financial information should be read in conjunction with the consolidated financial statements and notes included in Part II, Item 8, Page 52.
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Schedule II (CONTINUED)CONDENSED FINANCIAL INFORMATION OF REGISTRANT
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Supplemental disclosure:
A subsidiary transferred land and a building to the company valued at $34 million during 2000. During 2001, the company deemed this transfer a dividend.
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Schedule IIISUPPLEMENTARY INSURANCE INFORMATION
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Schedule III (CONTINUED)SUPPLEMENTARY INSURANCE INFORMATION
Notes to Schedule III:
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Schedule IVREINSURANCE
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Schedule VSUPPLEMENTAL INFORMATION CONCERNING PROPERTY CASUALTY INSURANCE OPERATIONS
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Schedule VISUPPLEMENTAL INFORMATION CONCERNING PROPERTY CASUALTY INSURANCE OPERATIONS
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Schedule VI (CONTINUED)SUPPLEMENTAL INFORMATION CONCERNING PROPERTY CASUALTY INSURANCE OPERATIONS
Note to Schedule VI:
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Signatures
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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Certification of Chief Executive Officer
I, John J. Schiff, Jr., certify that:
Date: March 14, 2003
/S/ John J. Schiff, Jr.,
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Certification of Chief Financial Officer
I, Kenneth W. Stecher, certify that:
/S/ Kenneth W. Stecher
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Index of Exhibits
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