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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
(X) Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the quarterly period ended June 30, 2002
----------------------------------------------
( ) Transition report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the Transition period from ______________________ to _______________________
State Auto Financial Corporation
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Ohio 31-1324304
- -------------------------------- -------------------------------------
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation)
518 East Broad Street, Columbus, Ohio 43215-3976
- --------------------------------------------------------------------------------
(Address of principal executive offices) (zip code)
(614) 464-5000
- --------------------------------------------------------------------------------
Registrant's telephone number, including area code
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 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.
(X) Yes ( ) No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
Common shares, without par value 38,977,576
- -------------------------------- --------------------------
(CLASS) (OUTSTANDING ON 08/12/02)
INDEX
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed consolidated balance sheets - June 30 , 2002 and
December 31, 2001
Condensed consolidated statements of income - Three months
ended June 30, 2002 and 2001
Condensed consolidated statements of income - Six months ended
June 30, 2002 and 2001
Condensed consolidated statements of cash flows - Six months
ended June 30, 2002 and 2001
Notes to condensed consolidated financial statements -
June 30, 2002
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Item 3. Quantitative and Qualitative Disclosure of Market Risk
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
June 30 December 31
ASSETS 2002 2001
---- ----
(unaudited) (see note 1)
Fixed maturities:
Held for investment, at amortized cost
(fair value $26,053 and $28,672 respectively) $ 24,635 $ 27,406
Available for sale, at fair value
(amortized cost $1,077,596 and $1,042,539, respectively) 1,110,438 1,051,405
Equity securities, at fair value (cost $60,905 and $50,361, respectively) 65,098 59,845
Other invested assets 1,548 -
----------- -----------
Total investments 1,201,719 1,138,656
Cash and cash equivalents 38,446 30,016
Deferred policy acquisition costs 74,054 67,087
Accrued investment income and other assets 39,926 38,908
Due from affiliate 13,621 -
Net prepaid pension expense 45,622 43,344
Reinsurance recoverable on losses and loss expenses payable 14,348 13,919
Prepaid reinsurance premiums 6,663 4,955
Federal income taxes:
Current 4,275 1,549
Deferred 12,447 13,800
Property and equipment 12,986 13,250
Goodwill 2,012 2,012
----------- -----------
Total assets $ 1,466,119 $ 1,367,496
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable $ 564,802 $ 523,860
Unearned premiums 360,756 329,495
Note payable to affiliate 45,500 45,500
Postretirement benefit liabilities 64,500 57,237
Other liabilities 7,416 5,059
Due to affiliates - 6,152
----------- -----------
Total liabilities 1,042,974 967,303
----------- -----------
Commitments and contingencies - -
Stockholders' equity:
Class A Preferred stock (nonvoting), without par value. Authorized 2,500,000
shares; none issued - -
Class B Preferred stock, without par value. Authorized 2,500,000 shares;
none issued - -
Common stock, without par value. Authorized 100,000,000 shares;
43,299,471 and 43,045,320 shares issued, respectively, at stated
value of $2.50 per share 108,249 107,613
Less 4,273,972 and 4,108,230 treasury shares, respectively, at cost (50,311) (47,613)
Additional paid-in capital 49,049 47,106
Accumulated other comprehensive income 24,149 12,030
Retained earnings 292,009 281,057
----------- -----------
Total Stockholders' equity 423,145 400,193
----------- -----------
Total liabilities and stockholders' equity $ 1,466,119 $ 1,367,496
=========== ===========
See accompanying notes to condensed consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Three Months Ended June 30, 2002 and 2001
(dollars in thousands, except per share amounts)
(unaudited)
2002 2001
--------- ---------
Earned premiums $ 221,342 $ 105,316
Net investment income 14,837 10,431
Management services income from affiliates 586 4,964
Net realized gain (loss) on investments (1,156) 1,416
Other income (includes $126 and $493,
respectively, from affiliates) 614 905
--------- ---------
Total revenues 236,223 123,032
--------- ---------
Losses and loss expenses 176,500 77,706
Acquisition and operating expenses 63,956 31,288
Interest expense 540 568
Other expense, net 1,978 1,443
--------- ---------
Total expenses 242,974 111,005
--------- ---------
Income (loss) before federal income taxes (6,751) 12,027
Federal income tax expense (benefit) (5,366) 2,594
--------- ---------
Net income (loss) ($ 1,385) $ 9,433
========= =========
Earnings (loss) per share:
- basic ($ 0.04) $ 0.24
========= =========
- diluted ($ 0.04) $ 0.24
========= =========
Dividends paid per common share $ 0.0325 $ 0.030
========= =========
See accompanying notes to condensed consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Six Months Ended June 30, 2002 and 2001
(dollars in thousands, except per share amounts)
(unaudited)
2002 2001
--------- ---------
Earned premiums $ 434,179 $ 206,877
Net investment income 29,448 20,735
Management services income from affiliate 1,174 9,884
Net realized gain on investments 154 1,817
Other income (includes $260 and $907,
respectively, from affiliates) 1,227 1,720
--------- ---------
Total revenues 466,182 241,033
--------- ---------
Losses and loss expenses 323,740 143,489
Acquisition and operating expenses 126,393 61,887
Interest expense 1,081 1,137
Other expense, net 4,419 3,294
--------- ---------
Total expenses 455,633 209,807
--------- ---------
Income before federal income taxes 10,549 31,226
Federal income tax expense (benefit) (1,230) 7,253
--------- ---------
Net income $ 11,779 $ 23,973
========= =========
Net earnings per share:
- basic $ 0.30 $ 0.61
========= =========
- diluted $ 0.29 $ 0.60
========= =========
Dividends paid per common share $ 0.065 $ 0.060
========= =========
See accompanying notes to condensed consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Six Months Ended June 30, 2002 and 2001
(in thousands)
(unaudited)
2002 2001
---------- ---------
Cash flows from operating activities:
Net income $ 11,779 $ 23,973
Adjustments to reconcile net earnings to net cash provided by operating
activities:
Depreciation and amortization, net 2,421 1,310
Net realized gains on investments (154) (1,817)
Changes in operating assets and liabilities:
Deferred policy acquisition costs (6,967) (2,337)
Accrued investment income and other assets (1,121) (4,012)
Net prepaid pension expense (1,068) (2,500)
Postretirement health care benefits 2,423 326
Other liabilities and due to/from affiliate, net (17,416) (5,321)
Reinsurance receivable and prepaid reinsurance premiums (2,137) (1,044)
Losses and loss expenses payable 40,941 2,544
Unearned premiums 31,261 13,817
Federal income taxes (7,229) (2,447)
--------- ---------
52,733 22,492
Transfer of MIGI employee related net liabilities, effective 1/1/02 3,631 -
--------- ---------
Net cash provided by operating activities 56,364 22,492
--------- ---------
Cash flows from investing activities:
Purchase of fixed maturities - available for sale (230,752) (120,759)
Purchase of equity securities (16,942) (13,872)
Purchase of other invested assets (1,548) -
Maturities, calls and principal reductions of fixed maturities -
held to maturity 2,721 8,733
Maturities, calls and principal reductions of fixed maturities -
available for sale 16,802 22,057
Sale of fixed maturities - available for sale 177,157 73,078
Sale of equity securities 6,337 7,326
Net additions of property and equipment - (382)
--------- ---------
Net cash used in investing activities (46,225) (23,819)
--------- ---------
Cash flows from financing activities:
Net proceeds from sale of common stock 1,541 1,391
Payment of dividends (827) (747)
Payments to acquire treasury shares (2,423) -
--------- ---------
Net cash provided by (used in) financing activities (1,709) 644
--------- ---------
Net increase (decrease) in cash and cash equivalents 8,430 (683)
Cash and cash equivalents at beginning of period 30,016 21,305
--------- ---------
Cash and cash equivalents at end of period $ 38,446 $ 20,622
========= =========
Supplemental disclosures:
Federal income taxes paid $ 6,000 $ 9,700
========= =========
Interest paid $ 1,081 $ 1,137
========= =========
See accompanying notes to condensed consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 2002
(in thousands, except per share amounts)
(unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles in the United States for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three and six month periods ending June
30, 2002 are not necessarily indicative of the results that may be expected for
the year ended December 31, 2002. The balance sheet at December 31, 2001 has
been derived from the audited financial statements at that date but does not
include all of the information and footnotes required by accounting principles
generally accepted in the United States for complete financial statements.
For further information, refer to the consolidated financial statements and
footnotes thereto included in the Registrant Company and Subsidiaries' annual
report on Form 10-K for the year ended December 31, 2001.
In June 2001, the Financial Accounting Standards Board issued statements of
Financial Accounting Standards No. 141, Business Combinations, and No. 142,
Goodwill and Other Intangible Assets, effective for fiscal years beginning after
December 15, 2001. Under the new rules, goodwill is no longer amortized but is
subject to annual impairment tests in accordance with the Statements. Other
intangible assets continue to be amortized over their useful lives. Effective
January 1, 2002, the Company implemented the new rules in accordance with the
statements. As part of the implementation, the Company performed the requisite
transitional impairment tests for goodwill. The adoption of the statements did
not materially impact the Company's financial position or results of operations.
Effective January 1, 2002, employees of the Meridian Insurance Group, Inc.
(MIGI), a subsidiary of the former Meridian Mutual, became employees of State
Auto P&C. In conjunction with this transaction approximately $3.6 million in net
plan benefit liabilities were transferred from MIGI to the Company.
2. COMPREHENSIVE INCOME
The components of comprehensive income, net of related tax, are as follows:
Three months ended Six months ended
June 30 June 30
------- -------
2002 2001 2002 2001
-------- -------- -------- --------
Net income (loss) $ (1,385) $ 9,433 $ 11,779 $ 23,973
Unrealized holding gains, net of tax 14,849 3,784 12,119 4,069
-------- -------- -------- --------
Comprehensive income $ 13,464 $ 13,217 $ 23,898 $ 28,042
======== ======== ======== ========
The components of accumulated other comprehensive income, net of related tax,
included in stockholders' equity at June 30, 2002 and December 31, 2001 include
only unrealized holding gains, net of tax.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
June 30, 2002
(in thousands, except per share amounts)
(unaudited)
3. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted earnings per
common share:
Three months ended Six months ended
June 30 June 30
------- -------
2002 2001 2002 2001
-------- -------- -------- --------
Numerator:
Net income (loss) for basic and diluted
Earnings per share $ (1,385) $ 9,433 $ 11,779 $ 23,973
-------- -------- -------- --------
Denominator:
Weighted average shares for
basic earnings per share 39,007 38,744 38,987 38,682
Effect of dilutive stock options - 917 816 953
Adjusted weighted average shares
for diluted earnings per share 39,007 39,661 39,803 39,635
-------- -------- -------- --------
Basic earnings (loss) per share $ (0.04) $ 0.24 $ 0.30 $ 0.61
-------- -------- -------- --------
Diluted earnings (loss) per share $ (0.04) $ 0.24 $ 0.29 $ 0.60
-------- -------- -------- --------
4. REINSURANCE
The following provides the income statement transactions for ceded reinsurance
with other insurers and reinsurers as well as the ceded reinsurance transaction
for the Pooling Arrangement between the Company's Pooled Subsidiaries and
Mutual:
Three months ended Six months ended
June 30 June 30
------- -------
2002 2001 2002 2001
-------- -------- -------- --------
Premiums earned:
Other insurers and reinsurers $ 5,400 $ 3,149 $ 9,758 $ 6,084
Ceded under pooling arrangement
and stop loss 120,268 104,567 235,839 206,718
Losses and loss expenses incurred:
Other insurers and reinsurers 1,846 1,622 4,307 2,534
Ceded under pooling arrangement
and stop loss $107,171 $ 91,196 $184,178 $151,817
For the three months ended June 30, 2002, the Pooled Subsidiaries ceded to
Mutual $6.4 million in losses and for the six months ended June 30, 2002 $6.4
million in losses and $425,000 in premiums earned.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
June 30, 2002
(in thousands, except per share amounts)
(unaudited)
5. SEGMENT INFORMATION
Effective October 1, 2001, the management agreement between State Auto P&C and
certain affiliate companies, including Mutual, was amended to eliminate the
management and operations service fee charged by State Auto P&C. As a result of
the loss of the management and operations services income under this management
agreement, substantially all of State Auto P&C's services income has been
eliminated. Consequently, beginning with the first quarter 2002, the management
and operations services segment will be included in the other category for
segment reporting as the result of this segment no longer meeting the
quantitative thresholds for separate presentation as a reporting segment. The
segment disclosures for the second quarter of 2001 have been restated to reflect
this change.
Three months ended Six months ended
June 30 June 30
------- -------
2002 2001 2002 2001
----------- ----------- ----------- -----------
Revenues from external customers:
State Auto standard insurance $ 175,629 $ 106,802 $ 344,396 $ 210,653
State Auto nonstandard insurance 16,452 8,818 29,631 16,684
Meridian standard insurance 41,355 - 83,487 -
Meridian nonstandard insurance 2,639 - 5,914 -
Investment management services 643 890 1,315 1,715
All other 656 5,100 1,276 10,146
----------- ----------- ----------- -----------
Total revenues from external customers $ 237,374 $ 121,610 $ 466,019 $ 239,198
=========== =========== =========== ===========
Intersegment revenues:
State Auto standard insurance $ 23 $ 40 $ 47 $ 81
Investment management services 1,217 790 2,397 1,574
All other 552 1,626 1,135 3,240
----------- ----------- ----------- -----------
Total intersegment revenues $ 1,792 $ 2,456 $ 3,579 $ 4,895
=========== =========== =========== ===========
Segment profit (loss):
State Auto standard insurance $ (348) $ 4,475 $ 14,165 $ 16,596
State Auto nonstandard insurance 1,055 184 1,699 774
Meridian standard insurance (8,195) - (8,562) -
Meridian nonstandard insurance 572 - 476 -
Investment management services 1,652 1,428 3,255 2,788
All other 345 5,266 716 10,620
----------- ----------- ----------- -----------
Total segment profit (loss) $ (4,919) $ 11,353 $ 11,749 $ 30,778
Reconciling items:
Corporate expenses $ (676) (742) $ (1,354) (1,369)
Net realized gains (losses) (1,156) 1,416 154 1,817
----------- ----------- ----------- -----------
Total consolidated income before federal income
taxes $ (6,751) $ 12,027 $ 10,549 $ 31,226
=========== =========== =========== ===========
Segment assets:
Standard insurance $ 1,339,503 $ 895,435
Nonstandard insurance 86,408 54,643
Investment management services 8,121 11,510
All other 16,147 16,337
----------- -----------
Total segment assets $ 1,450,179 $ 977,925
=========== ===========
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
June 30, 2002
(in thousands, except per share amounts)
(unaudited)
6. RECLASSIFICATIONS
Certain items in the 2001 condensed consolidated financial statements have been
reclassified to conform to the 2002 presentation.
STATE AUTO FINANCIAL CORPORATION AND SUBISIDIAIRES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For information regarding the Company's significant accounting policies as well
as discussion regarding its critical accounting policies, refer to the
Management's Discussion and Analysis of Financial Condition and Results of
Operations as well as the consolidated financial statements and footnotes
thereto included in the Company and Subsidiaries annual report on Form 10-K for
the year ended December 31, 2001.
Results of Operations
- ---------------------
This discussion pertains to the following companies: State Auto Financial
Corporation (the "Company") and its wholly owned insurance subsidiaries State
Auto Property & Casualty Insurance Company ("State Auto P&C"), Milbank Insurance
Company ("Milbank"), Farmers Casualty Insurance Company ("Farmers Casualty") and
State Auto Insurance Company ("SAIC"); which engage in the State Auto standard
insurance segment of the Company's operations, as well as, beginning July 1,
2001, the Meridian standard and nonstandard insurance segments (defined below).
The Company's State Auto nonstandard segment of operations is conducted through
State Auto National Insurance Company ("State Auto National"), a wholly owned
subsidiary of the Company and Mid-Plains Insurance Company ("Mid-Plains") a
wholly owned subsidiary of Farmers Casualty. State Auto P&C, Milbank, Farmers
Casualty and SAIC are collectively referred to below as the "Pooled
Subsidiaries", while the Pooled Subsidiaries, State Automobile Mutual Insurance
Company ("Mutual") and its wholly owned subsidiary, Midwest Security Insurance
Company are collectively referred to below as the "Pooled Companies" or the
"State Auto Pool".
As more fully described in the Company's December 31, 2001 Form 10-K, following
is a summary of several transactions that occurred in the second half of 2001
that will assist in the discussion of the Company's current period financial
results:
- Effective June 1, 2001, Mutual entered into an agreement with
Meridian Mutual Insurance Company ("Meridian Mutual"),
pursuant to which Meridian Mutual was merged with and into
Mutual, with Mutual continuing as the surviving corporation.
With the merging of Meridian Mutual into Mutual, all insurance
business that had been written by Meridian Mutual became,
legally, Mutual business. Effective July 1, 2001, the
insurance business of the former Meridian Mutual became part
of the Pooling Arrangement and the Pooled Subsidiaries assumed
53% of the Meridian Mutual business on this same date.
Concurrent with this transaction, the Pooled Subsidiaries
received cash of $6.4 million and fixed maturities totaling
$109.7 million, which related to the additional net insurance
liabilities assumed by the Pooled Subsidiaries on July 1,
2001. This former Meridian Mutual business assumed by the
Pooled Subsidiaries comprises the Company's "Meridian
standard" and "Meridian nonstandard" segments.
- On October 24, 2001, the board of directors of the Company and
Mutual and special independent committees thereof approved a
resolution of the disagreement between the Company and the
Ohio Department of Insurance ("ODI") regarding the service fee
paid by Mutual to State Auto P&C under the Mutual Management
Agreement (as defined in the Form 10-K). The disagreement with
ODI was resolved and ODI expressly did not take issue with
Mutual's payment of the service fee for the first three
quarters of 2001, nor with Mutual's accounting for the service
fee in each of those quarters. The ODI also approved
regulatory filings, effective October 1, 2001, which
implemented a revised Mutual Management Agreement, changed the
Pooled Subsidiaries' pooling participation percentage and
implemented an inter-company stop loss reinsurance
arrangement. The following describes these changes, effective
October 1, 2001:
o The Mutual Management Agreement was amended to
eliminate the management and operations services fee
charged by State Auto P&C to participants to the
agreement, including Mutual. As a result of the loss
of the management and operations services income
under the Mutual Management Agreement, substantially
all of State Auto P&C's services income has been
eliminated, effective October 1, 2001.
o The Pooling Arrangement (as defined in the Form 10K)
was amended such that the Pooled Subsidiaries'
aggregate participation was increased from 53% to
80%. In conjunction with this change in pool
participation, the Pooled Subsidiaries received cash
of $2.2 million and fixed maturities totaling $236.3
million from Mutual, which related to the additional
net insurance liabilities assumed by the Pooled
Subsidiaries on October 1, 2001.
o For the period October 1, 2001 through December 31,
2003, Mutual entered into a stop loss reinsurance
arrangement (the "Stop Loss") with the Pooled
Subsidiaries. Under the Stop Loss, Mutual has agreed
to participate in the Pooling Arrangement's
quarterly underwriting losses and gains in the
manner described. If the Pooling Arrangement's
quarterly statutory loss and loss adjustment expense
ratio (the "Pool loss and LAE ratio") is between
70.75% and 80.00% (after the application of all
available reinsurance), Mutual will reinsure the
Pooled Subsidiaries 27% of the Pooling Arrangement's
losses in excess of a Pool loss and LAE ratio of
70.75% up to 80.00%. The Pooled Subsidiaries would
be responsible for their share of the Pooling
Arrangement's losses over the 80.00% threshold.
Also, Mutual will have the right to participate in
the profits of the Pooling Arrangement. Mutual will
assume 27% of the Pooling Arrangement's underwriting
profits attributable to Pool loss and LAE ratios
less than 69.25%, but more than 59.99%.
Effective January 1, 2002, employees of the Meridian Insurance Group, Inc., a
subsidiary of the former Meridian Mutual, became employees of State Auto P&C. In
conjunction with this transaction approximately $3.6 million in net plan benefit
liabilities were transferred from MIGI to the Company.
Income before federal income taxes decreased $18.8 million to a loss of $6.8
million for the three months ended June 30, 2002 and decreased $20.7 million to
income of $10.5 million for the six months ended June 30, 2002, respectively,
from the same 2001 periods. Contributing to these decreases was an increase in
the level of catastrophe storm losses within the standard segment as compared to
the same period in 2001.
Consolidated earned premiums during the quarter ended June 30, 2002, increased
$116.0 million or 110.2% to $221.3 million from the same 2001 period.
Consolidated earned premiums for the six months ended June 30, 2002, increased
$227.3 million or 109.9% to $434.2 million from the same 2001 period.
This increase was principally the result of the addition of the former Meridian
Mutual business to the Pooling Arrangement, effective July 1, 2001, and a change
in the Pooled Subsidiaries' aggregate pooling participation percentage from 53%
to 80%, effective October 1, 2001. These actions increased consolidated earned
premiums 88.1% and 90.4% for the three months and six months ended June 30,
2002, respectively, from the same 2001 time period.
The internal growth of the Company's State Auto standard segment's earned
premiums increased consolidated earned premiums 17.1% and 16.1% for the three
months and six months ended June 30, 2002, respectively, from the 2001 periods.
While this segment continued to experience an increase in production levels in
its commercial lines of business, beginning in late 2001, this segment began
experiencing increased sales in its personal lines of business, largely due to
changes in the market place and to the expansion of the new personal lines sales
specialist position. Production levels within the Company's State Auto
nonstandard segment, due to a combination of rate changes as well as increased
policy counts, continued to increase. This segment's earned premiums increased
consolidated earned premiums 7.2% and 6.2% for the three months and six months
ended June 30, 2002, respectively, from the 2001 periods.
The internal growth of the Meridian standard and nonstandard segments decreased
consolidated earned premiums 0.6% and 1.6%, and 1.6% and 1.2% for the three
months and six months ended June 30, 2002, respectively, from the 2001 periods.
These decreases are not unexpected, given the corrective actions taken in both
these segments that include appropriate rate increases in almost every line of
business. Additionally, as more fully described in the Company's December 31,
2001 Form 10-K and March 31, 2002 Form 10-Q, one of the more significant actions
taken within the Meridian standard segment, was the discontinuance of the Group
Advantage(R) Program. At the end of 2001, there were approximately 800 such
policies in force. At June 30, 2002, there were approximately 24 such policies
in force. Regarding the Meridian nonstandard segment, there is currently an
integration plan in place to
write all new nonstandard auto business produced by the former Meridian agents
through the State Auto nonstandard segment, specifically through National on the
National system platform. Most notably, the National system utilizes credit
scoring and "point-of-sale" underwriting tools. The order of integration has
been prioritized such that the states with most need for profit improvement are
migrating to National first.
Net investment income increased $4.4 million or 42.2% to $14.8 million and $8.7
million or 42.0% to $29.4 million for the three month and six month periods
ending June 30, 2002, respectively, from the same 2001 periods. Investable
assets, at cost, at June 30, 2002 were $1,203.1 million versus $765.2 million at
June 30, 2001. Investable assets increased primarily due to the transfer of cash
and fixed maturity securities from Mutual totaling $354.6 million to the Pooled
Subsidiaries in conjunction with the Pooled Subsidiaries assuming 53% of the
former Meridian Mutual business on July 1, 2001 and the change in the Pooled
Subsidiaries aggregate pooling participation, effective October 1, 2001, from
53% to 80%. Reflecting a decline in the interest rate environment, the
investment yield, based on fixed and equity securities at cost, decreased from
5.5% to 5.0% for both the three month and six month periods ending June 30,
2002, respectively, from the same 2001 periods.
Management services income decreased $4.4 million to $0.6 million and $8.7
million to $1.2 million for the three month and six month periods ending June
30, 2002, respectively, from the same 2001 periods. This decrease, as discussed
above, is largely the result of the resolution of the disagreement between the
Company and ODI regarding the service fee paid by Mutual to State Auto P&C. The
service fee under the 2000 Mutual Management Agreement paid by Mutual for the
three month and six month periods ending June 30, 2001 was approximately $4.2
million and $8.4 million, respectively.
Losses and loss expenses, as a percentage of earned premiums (the "GAAP loss and
LAE ratio"), increased to 79.7% for the three months ended June 30, 2002 from
73.8% for the same 2001 period and for the six months ended June 30, 2002,
increased to 74.6% from 69.4% for the same 2001 period. During the second
quarter of 2002, the Pooled Companies produced a statutory loss and LAE ratio
under the Stop Loss (described above) that exceeded the 80.0% threshold, thereby
recovering the full layer of $6.4 million from Mutual, while in the first
quarter of 2002, the Pooled Companies statutory loss and LAE ratio was less than
69.25%, but more than 59.99%, thereby ceding to Mutual, under the Stop Loss
$425,000 in earned premiums. The cession activity through the Stop Loss had an
effect of lowering the current three and six month GAAP loss and LAE ratios by
2.9 points and 1.4 points, respectively. Absent the impact of the Stop Loss
cession, the increase in the current three-month and six-month period GAAP loss
and LAE ratios was largely the result of the Company experiencing several large
storm losses during the current quarter. The largest storm event impacting the
current quarter was an F5 tornado that went through the community of LaPlata,
Maryland. This same catastrophic event, which occurred April 27 through May 1,
2002, caused losses in an additional 12 of the Company's operating states. This
storm alone totaled $25.5 million and now ranks as the most costly catastrophic
event in State Auto history. Another storm that occurred at the end of the first
quarter of 2002 negatively impacted current quarter results by approximately
$3.0 million. Total storm activity in the second quarter of 2002, was
approximately $29.8 million or 13.5 and 6.9 GAAP loss and LAE ratio points for
the three month and six month periods ending June 30, 2002, respectively. The
GAAP loss and LAE ratios also increased due to adverse development on the
workers compensation line of business as well as the Meridian standard segment's
loss results continuing to be greater than that of State Auto's.
For discussion purposes, the following table provides comparative statutory loss
and loss adjustment expense ratios (the "Statutory Loss and LAE ratio") for the
Company's insurance operating segments for the three and six months ended June
30, 2002 and 2001, respectively:
Three months ended Six months ended
June 30 June 30
------- -------
Statutory Loss and LAE Ratio
2002 2001 2002 2001
---- ---- ---- ----
Segments:
State Auto standard insurance 76.1 73.9 71.1 69.3
State Auto nonstandard insurance 78.9 76.4 79.9 73.9
Meridian standard insurance 96.6 - 86.9 -
Meridian nonstandard insurance 72.9 - 80.3 -
------------- -------------- -------------- ------------
Total Statutory Loss and LAE Ratio 79.9 74.1 74.7 69.6
============= ============== ============== ============
The State Auto standard segment reflected an increase of 2.2 and 1.8 points in
its Statutory Loss and LAE ratio for the three month and six month periods
ending June 30, 2002. The stop loss cession had an effect of lowering this
segment's current three month and six month Statutory Loss and LAE ratio by 3.1
and 1.5 points, respectively. Catastrophe losses represent 13.0 points and 8.0
points of this segment's loss results for three month and six month periods
ended June 30, 2002, respectively, compared to 12.5 points and 7.0 points for
the same periods ended June 30, 2001. Also contributing to the current periods
increase were adverse loss results on workers' compensation, which currently
represents approximately 3.3% of this segment's business. Workers' compensation
continues to be one of the most volatile lines that the Company provides and for
this reason the Company has always maintained a conservative posture on pricing.
The Company is in the process of taking substantial and necessary rate increases
across this entire line of business, along with the Meridian standard segment.
This segment's largest line of business, automobile, also adversely impacted the
Company's quarterly losses. While the loss experience of the commercial auto
segment has improved over the last several years, it remains unprofitable on a
year to date basis. The Company is currently studying this segment for proper
risk classification in some states and pricing adequacy company wide. Management
continues to recognize the significance of personal auto insurance to the
profitability of the Company and is vigilant in its efforts to preserve this by
regularly performing underwriting audits, monitoring rate adequacy, and
endeavoring to fully utilize all available underwriting tools.
The State Auto nonstandard segment reflected an increase of 2.5 points and 6.0
points in its Statutory Loss and LAE ratio for the three month and six month
periods ending June 30, 2002, respectively. Approximately 2.2 points and 1.2
points of these increases for the three month and six month periods,
respectively, is due to the impact of the current period storm losses, as
discussed above. Given the nature of the risks written through this segment,
this segment tends to be more volatile on a quarterly basis than those risks
written through the standard segment. Contributing to the year to date increase,
were several unusually large losses experienced by this segment in the first
quarter of 2002 as compared to the same time period in 2001.
The stop loss cession had an effect of lowering the Meridian standard and
nonstandard segment's Statutory Loss and LAE ratio for the current three month
period by 3.1 points each, and for the six month period 1.4 points and 1.3
points, respectively. Impacting the Statutory Loss and LAE ratios within the
Meridian standard segment were approximately 20.6 points and 14.0 points for the
three month and six month periods ending June 30, 2002, respectively, relating
to the current year storm losses. Absent these storm losses, this segment
continues to produce worse results than the State Auto book, however it has
reflected an improvement for the current three month period, compared to the
same 2001 period. The Meridian nonstandard segment reflected current period
improvements from the same three-month and six month 2001 periods. Largely
contributing to these improvements have been the substantial rate increases the
Company began rolling out in late 2001 as well a decline in this segment's
policy count from the same time period. Despite these improvements, the Company
continues to seek adequate cost-based rates on the entire Meridian book and is
still in the process of re-underwriting much of it to be certain risks written
fall within State Auto guidelines.
Acquisition and operating expenses, as a percentage of earned premiums (the
"expense ratio"), decreased to 28.9% from 29.7% and to 29.1% from 29.9% for the
three months and six months ended June 30, 2002, respectively, from the same
2001 time periods. The decrease in the expense ratio in the current three months
and six months ended June 30, 2002 is primarily due to fixed costs, such as
salaries, depreciation and utilities, comprising a lesser portion of earned
premiums in 2002 than 2001 as a result of the Company's growth in premium
writings that began in the first quarter of 2001.
Interest expense relates to the line of credit agreement the Company entered
into with Mutual during 1999 to assist in the funding of its stock repurchase
program. Based on terms of the agreement, the interest rate adjusts annually. In
2002 the interest rate is 4.75% compared to 5.0% in 2001.
During the three-month and six-month periods ending June 30, 2002, the Company
experienced an underwriting loss on its insurance operations, as described
above. This underwriting loss, coupled with net investment income being largely
comprised of tax-exempt income, produced an effective tax expense (benefit) rate
of (79.5%) and (11.7%) for the three month and six month periods ending June 30,
2002, respectively, compared to 21.6% and 23.2% for the same 2001 periods,
respectively.
Liquidity and Capital Resources
- -------------------------------
Through the six months ended June 30, 2002, net cash provided by operating
activities increased to $56.4 million from $22.5 million in 2001. The increase
in cash flow from operations in 2002 is largely attributable to an increase in
the Company's pool participation percentage, as described above, as well as an
increase in net investment income over the same 2001 time period. Net cash used
in investing activities increased to $46.2 million from $23.8 million in 2001.
This increase is due to the Company investing unallocated cash generated by
operations to long-term investments. Net cash used in investing activities
changed to $1.7 million cash used from $0.6 million cash provided in 2001. This
change was primarily due to cash used to acquire treasury shares under the
Company's stock repurchase plan. On March 1, 2002, the Board of Directors of
State Auto Financial approved a plan to repurchase up to 1.0 million shares of
its common stock from the public over a period extending to and through December
31, 2003. Through June 30, 2002, 149,400 shares were repurchased under this plan
at an average price per share of $16.22 for a total $2,423,420.
At June 30, 2002, funds consisting of cash and cash equivalents were $38.4
million versus $20.6 million at June 30, 2001.
New Accounting Standards
- ------------------------
In June 2001, the Financial Accounting Standards Board issued statements of
Financial Accounting Standards No. 141, Business Combinations, and No. 142,
Goodwill and Other Intangible Assets, effective for fiscal years beginning after
December 15, 2001. Under the new rules, goodwill will no longer be amortized but
will be subject to annual impairment tests in accordance with the Statements.
Other intangible assets will continue to be amortized over their useful lives.
Effective January 1, 2002, the Company implemented the new rules in accordance
with the statements. As part of the implementation, the Company performed the
requisite transitional impairment tests for goodwill. The adoption of the
statements did not materially impact the Company's financial position or results
of operations.
Market Risk
- -----------
With respect to Market Risk, see the discussion regarding this subject in the
Company's December 31, 2001 Management's Discussion and Analysis of Financial
Condition and Results of Operations, included in the December 31, 2001 Form
10-K. There have been no material changes from the information reported
regarding Market Risk in the 2001 Form 10-K.
FORWARD-LOOKING STATEMENTS; CERTAIN FACTORS AFFECTING FUTURE RESULTS
Statements contained in this Form 10-Q or any other reports or documents
prepared by the Company or made by management may be "forward-looking" within
the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements are subject to certain risks and uncertainties that
could cause the Company's actual results to differ materially from those
projected. Forward-looking statements may be identified, preceded by, followed
by, or otherwise include, without limitation, words such as "plans," "believes,"
"expects," "anticipates," "intends," "estimates," or similar expressions. The
following factors, among others, in some cases have affected and in the future
could affect the Company's actual financial performance.
In addition to the acquisition of the Meridian Insurers and Mutual's merger with
Meridian Mutual as discussed above, during the past several years, Mutual and
the Company have acquired other insurance companies, such as Milbank, Farmers
Casualty, and Midwest Security, and it is anticipated that Mutual and the
Company will continue to pursue acquisitions of other insurance companies in the
future. Acquisitions involve numerous risks and uncertainties, including the
following: obtaining necessary regulatory approvals of the acquisition may prove
to be more difficult than anticipated; integrating the acquired business may
prove to be more costly or difficult than anticipated; integrating the acquired
business without material disruption to existing operations may prove to be more
difficult than anticipated; anticipated cost savings may not be fully realized
(or not realized within the anticipated time frame) or additional or unexpected
costs may be incurred; loss results of the Company acquired may be worse than
expected; and retaining key employees of the acquired business may prove to be
more difficult than anticipated. In addition, other companies in the insurance
industry have similar acquisition strategies. There can be no assurance that any
future acquisitions will be successfully integrated into the Company's
operations, that competition for acquisitions will not intensify or that the
Company will be able to complete such acquisitions on acceptable terms and
conditions. In addition, the costs of unsuccessful acquisition efforts may
adversely affect the Company's financial performance.
Other risk factors include, without limitation, the following:
o The Company's financial results are subject to the occurrence
of weather-related and other types of catastrophic events,
none of which are within the Company's control.
o The Company's operations are subject to changes occurring in
the legislative, regulatory and judicial environment. Risks
and uncertainties related to the legislative, regulatory, and
judicial environment include, but are not limited to,
legislative changes at both the state and federal level, state
and federal regulatory rulemaking promulgations and
adjudications that may affect the Company specifically, its
affiliates or the industry generally, class action and other
litigation involving the Company, its affiliates, or the
insurance industry generally and judicial decisions affecting
claims, policy coverages and the general costs of doing
business. Many of these changes are beyond the Company's
control.
o The laws of the various states establish insurance departments
with broad regulatory powers relative to approving
intercompany arrangements, such as management, pooling, and
investment management agreements, granting and revoking
licenses to transact business, regulating trade practices,
licensing agents, approving policy forms, setting reserve
requirements, determining the form and content of required
statutory financial statements, prescribing the types and
amount of investments permitted and requiring minimum levels
of statutory capital and surplus. In addition, although
premium rate regulation varies among states and lines of
insurance, such regulations generally require approval of the
regulatory authority prior to any changes in rates.
Furthermore, all of the states in which the State Auto Group
transacts business have enacted laws which restrict these
companies' underwriting discretion. Examples of these laws
include restrictions on agency terminations and laws requiring
companies to accept any applicant for automobile insurance and
laws regulating underwriting "tools." These laws may adversely
affect the ability of the insurers in the State Auto Group to
earn a profit on their underwriting operations.
o The property and casualty insurance industry is highly
competitive. While prices have generally increased in most
lines, price competition continues. The Company competes with
numerous insurance companies, many of which are substantially
larger and have considerably greater financial resources. In
addition, because the Company's products are marketed
exclusively through independent insurance agencies, most of
which represent more than one company, the Company faces
competition within each agency. The Company competes through
underwriting criteria, appropriate pricing, and quality
service to the policyholder and the agent and through a fully
developed agency relations program. See "Marketing" in the
"Narrative Description of Business" in Item 1 of the Company's
December 31, 2001 Form 10-K.
o The Company is subject to numerous other factors which affect
its operations, including, without limitation, the development
of new insurance products, geographic spread of risk,
fluctuations of securities markets, economic conditions,
technological difficulties and advancements, availability of
labor and materials in storm hit areas, late reported claims,
previously undisclosed damage, utilities and financial
institution disruptions, and shortages of technical and
professional employees.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
- --------------------------------------------------------------
The information called for by this item is provided under the caption "Market
Risk" under Item 2 - Management's Discussion and Analysis of Financial
Condition.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART II. OTHER INFORMATION
Item 1. Legal Proceedings - None
Item 2. Changes in Securities and Use of Proceeds - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders
The annual meeting of shareholders of State Auto Financial Corporation
was held on Thursday, May 23, 2002. The total shares represented at the meeting
were 35,723,332. This constituted 91.64% of the Company's 38,980,255 shares
outstanding. At the meeting, the shareholders voted on one resolution; the
election of William J. Lhota and David J. D'Antoni as Class II Directors, each
to hold office until the 2005 annual meeting of shareholders and until a
successor is elected and qualified, with each director nominee receiving the
votes indicated:
NUMBER OF VOTES
---------------
FOR WITHHELD
--- --------
William J. Lhota 35,673,817.943 49,514.984
David J. D'Antoni 35,672,417.943 50,514.984
On the basis of this vote, William J. Lhota and David J. D'Antoni were
elected as Class II Directors to serve until the 2005 annual meeting and until a
successor is elected and qualified.
Item 5. Other Information - None
INDEX TO EXHIBITS
Item 6. a. Exhibits
Exhibit No. Description of Exhibits
----------- -----------------------
10(LL) Amendment No. 3 to Management and Operations
Agreement effective January 1, 2002
99.1 CEO certification required by Section 906 of
Sarbanes- Oxley Act of 2002
99.2 CFO certification required by Section 906 of
Sarbanes- Oxley Act of 2002
b. Reports on Form 8-K: None
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
STATE AUTO FINANCIAL CORPORATION
Date: AUGUST 14, 2002 /s/ Steven J. Johnston
--------------- -------------------------------------
Steven J. Johnston
Treasurer and Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)