How strong were Cincinnati Financial's 2004 earnings, and how much came from underlying operations versus one-time items?

Net income rose 56% to a record level, with diluted EPS of $3.44. Underlying underwriting improved substantially, with the property casualty combined ratio falling to 89.8%. However, results also included favorable reserve development of $196 million pretax and $87 million of net realized investment gains, mostly from equity sales. Management noted that the 2004 realized gains added about 36 cents per share after tax. Investors should therefore view part of the earnings jump as non-recurring. Management's 2005 outlook assumes a combined ratio near 91% and says favorable reserve development will contribute less.

What is the main risk from the company's equity portfolio?

Equity securities had a fair value of $7.5 billion against a cost of $1.9 billion, so unrealized appreciation totaled about $5.6 billion pretax, equal to roughly 58% of shareholders' equity after tax. Fifth Third Bancorp alone represented about 46% of the common stock portfolio and about $12.28 of the $37.38 book value per share. Management states that every $1.00 change in Fifth Third's share price changes book value by about 28 cents. A significant decline in financial-sector stocks would reduce book value and shareholders' equity materially.

What is the Investment Company Act issue, and why does it matter to shareholders?

In June 2004 the company applied to the SEC for an exemption, because its holding company's large equity holdings could have made it an unregistered investment company. To address this, it transferred 31.8 million Fifth Third shares to its insurance subsidiary in August 2004. If the SEC were to find the holding company was an unregistered investment company before the transfer, holders of the $420 million 6.9% senior debentures could potentially seek rescission and repayment. The company says it has sufficient assets to repay that debt and believes it was not an investment company. The exemptive order was still pending at the filing date.

What should investors expect for 2005?

Management targets mid-single-digit growth in property casualty written premiums, a combined ratio of about 91% assuming normal catastrophe losses, and pretax investment income growth of 5% to 6%. Commercial lines are expected to run near a 90% combined ratio, and personal lines near 95%. Headwinds include the expensing of stock options under SFAS 123(R) starting in the third quarter of 2005 (about 2 cents per share in lost EPS), higher interest expense from the $375 million 6.125% senior notes issued in November 2004, a $22 million first-quarter reserve charge for a large January loss, and rising reinsurance costs of about $13 million. Industry commercial premiums are expected to decline about 1% in 2005, which suggests growing competitive pressure.

CINF 10-K FY2004 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 14, 2005. Cited figures are marked; the original filing is the authoritative source.

Cincinnati Financial Corporation (CINF) reported a record 2004 in its 10-K, with revenues up 13.6% to $3.614 billion^a and net income up 56.0%, producing diluted EPS of $3.44 versus $2.20 in 2003.

The property casualty combined ratio improved to 89.8% from 94.7%, and book value per share rose slightly to $37.38^b. Results were helped by $196 million of favorable prior-year reserve development, $87 million of net realized gains (mainly from the sale of $356 million in equity holdings), and a strong investment segment, which generated $537 million of pretax income. Investment income reached a record $492 million.

Earnings quality warrants attention: a meaningful share of profit came from reserve releases and realized gains, and the company's book value and equity remain heavily exposed to its concentrated holding in Fifth Third Bancorp, which represented about 46% of the common stock portfolio at market value. The company also disclosed several risk items. It is reviewing whether its holding company falls under the Investment Company Act of 1940, and if it does, $420 million^c of 6.9% senior debentures could theoretically be subject to rescission.

It has also taken steps to lower its ratio of common stock to statutory surplus, moving it to 103.5% from 114.7%, which led to a shift toward fixed-income investments. Management guided to mid-single-digit premium growth and a roughly 91% combined ratio for 2005, while expecting higher interest expense, the adoption of stock option expensing under SFAS 123(R), and a $100 million^d headquarters expansion. Insurer financial strength ratings remained high (A.M.

Best A, Fitch AA, Moody's Aa3, S&P AA-), though S&P carries a negative outlook. For investors, the 2004 results were strong and operationally sound, with pricing discipline in commercial lines and a much improved combined ratio. The main considerations going forward are the sustainability of reserve releases, personal lines profitability (which still posted a 105.0% combined ratio), equity market exposure, and the regulatory and Investment Company Act questions.

02—Key points

Key Highlights

Record 2004 results: revenues rose 13.6% to $3.614 billion, net income rose 56.0%, and diluted EPS reached $3.44, up from $2.20 in 2003.
Property casualty combined ratio improved to 89.8% from 94.7% in 2003, driven by premium growth and $196 million of favorable prior-year reserve development, though this partly flatters results.
Commercial lines combined ratio was 84.1%, while personal lines was 105.0%, with homeowners still unprofitable and management targeting a return to profitability in 2006.
Investment income hit a record $492 million pretax, and realized gains of $87 million were driven primarily by the sale of $356 million of equity holdings.
Equity concentration is high: Fifth Third Bancorp was $3.443 billion, or 46.1% of the common stock portfolio, and equity securities drove most of the $5.6 billion in unrealized gains.
Book value per share rose slightly to $37.38, while return on equity was 9.4%; return on equity based on comprehensive income fell to 4.6% because unrealized gains declined.
Regulatory and capital items: the holding company's Investment Company Act status is under SEC review (affecting $420 million of debentures), the common stock to surplus ratio was reduced to 103.5%, and the board raised the dividend 10.9% (a 15% total annual increase after the stock dividend).

03—Questions

Frequently Asked Questions

How strong were Cincinnati Financial's 2004 earnings, and how much came from underlying operations versus one-time items?
Net income rose 56% to a record level, with diluted EPS of $3.44. Underlying underwriting improved substantially, with the property casualty combined ratio falling to 89.8%. However, results also included favorable reserve development of $196 million pretax and $87 million of net realized investment gains, mostly from equity sales. Management noted that the 2004 realized gains added about 36 cents per share after tax. Investors should therefore view part of the earnings jump as non-recurring. Management's 2005 outlook assumes a combined ratio near 91% and says favorable reserve development will contribute less.
What is the main risk from the company's equity portfolio?
Equity securities had a fair value of $7.5 billion against a cost of $1.9 billion, so unrealized appreciation totaled about $5.6 billion pretax, equal to roughly 58% of shareholders' equity after tax. Fifth Third Bancorp alone represented about 46% of the common stock portfolio and about $12.28 of the $37.38 book value per share. Management states that every $1.00 change in Fifth Third's share price changes book value by about 28 cents. A significant decline in financial-sector stocks would reduce book value and shareholders' equity materially.
What is the Investment Company Act issue, and why does it matter to shareholders?
In June 2004 the company applied to the SEC for an exemption, because its holding company's large equity holdings could have made it an unregistered investment company. To address this, it transferred 31.8 million Fifth Third shares to its insurance subsidiary in August 2004. If the SEC were to find the holding company was an unregistered investment company before the transfer, holders of the $420 million 6.9% senior debentures could potentially seek rescission and repayment. The company says it has sufficient assets to repay that debt and believes it was not an investment company. The exemptive order was still pending at the filing date.
What should investors expect for 2005?
Management targets mid-single-digit growth in property casualty written premiums, a combined ratio of about 91% assuming normal catastrophe losses, and pretax investment income growth of 5% to 6%. Commercial lines are expected to run near a 90% combined ratio, and personal lines near 95%. Headwinds include the expensing of stock options under SFAS 123(R) starting in the third quarter of 2005 (about 2 cents per share in lost EPS), higher interest expense from the $375 million 6.125% senior notes issued in November 2004, a $22 million first-quarter reserve charge for a large January loss, and rising reinsurance costs of about $13 million. Industry commercial premiums are expected to decline about 1% in 2005, which suggests growing competitive pressure.

04—Continue

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