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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------
FORM 10-K
|X| Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended December 31, 2003
or
| | Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to _____________
Commission File Number 0-19289
STATE AUTO FINANCIAL CORPORATION
(exact name of Registrant as specified in its charter)
Ohio 31-1324304
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
518 East Broad Street, Columbus, Ohio 43215-3976
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (614) 464-5000
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Shares, without par value
(Title of class)
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 | |
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. |X|
Indicate by check mark whether the Registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act).
Yes |X| No | |
As of June 30, 2003, the last business day of the Registrant's most
recently completed second fiscal quarter, the aggregate market value (based on
the closing sales price on that date) of the voting stock held by non-affiliates
of the Registrant was $292,274,383.
On March 5, 2004, the Registrant had 39,711,913 Common Shares
outstanding.
10K-a1
DOCUMENTS INCORPORATED BY REFERENCE
1. Portions of the Registrant's Proxy Statement relating to the annual
meeting of shareholders to be held May 28, 2004 (the "2004 Proxy
Statement"), which will be filed within 120 days of December 31, 2003,
are incorporated by reference into Part III of this Form 10-K.
10K-a2
IMPORTANT INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
All statements, other than statements of historical facts, included in
this Form 10-K of State Auto Financial Corporation ("State Auto Financial" or
"STFC") or incorporated herein by reference, including, without limitation,
statements regarding State Auto Financial's future financial position, business
strategy, budgets, projected costs, goals and plans and objectives of management
for future operations, are forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. Forward-looking statements
generally can be identified by the use of forward-looking terminology such as
"may," "will," "expect," "intend," "estimate," "anticipate," "project,"
"believe" or "continue" or the negative thereof or variations thereon or similar
terminology. Forward-looking statements speak only as the date the statements
were made. Although State Auto Financial believes that the expectations
reflected in forward-looking statements have a reasonable basis, it can give no
assurance that these expectations will prove to be correct. Forward-looking
statements are subject to risks and uncertainties that could cause actual events
or results to differ materially from those expressed in or implied by the
statements. For a discussion of the most significant risks and uncertainties
that could cause State Auto Financial's actual results to differ materially from
those projected, see "Forward-Looking Statements; Certain Factors Affecting
Future Results" in Item 7 "Management's Discussion and Analysis of Financial
Condition and Results of Operations." Except to the limited extent required by
applicable law, State Auto Financial undertakes no obligation to update or
revise any forward-looking statements, whether as a result of new information,
future events, or otherwise.
PART I
ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS
State Auto Financial is an insurance holding company formed in 1990
and headquartered in Columbus, Ohio. STFC engages primarily in the property and
casualty insurance business through its wholly-owned subsidiaries, State Auto
Property and Casualty Insurance Company ("State Auto P&C"), Milbank Insurance
Company ("Milbank"), Farmers Casualty Insurance Company ("Farmers"), State Auto
Insurance Company of Ohio ("SA Ohio"), and State Auto National Insurance Company
("SA National"). Farmers owns 100% of the outstanding common shares of the
property-casualty insurer, Mid-Plains Insurance Company ("Mid-Plains").
Approximately 66% of State Auto Financial's outstanding common shares
are owned by State Automobile Mutual Insurance Company ("Mutual"), an Ohio
mutual property and casualty insurance company organized in 1921. Mutual owns
100% of the outstanding common shares of property-casualty insurers, State Auto
Florida Insurance Company ("SA Florida") and State Auto Insurance Company of
Wisconsin ("SA Wisconsin"). Mutual is also the sole owner of Meridian Insurance
Group, Inc. ("MIGI"), an insurance holding company with two wholly-owned
property and casualty insurance subsidiaries: Meridian Security Insurance
Company ("Meridian Security") and Meridian Citizens Security Insurance Company
("Meridian Citizens"). In 2001, Mutual merged with Meridian Mutual Insurance
Company ("Meridian Mutual"), with Mutual continuing as the surviving
corporation, and in a substantially concurrent transaction Mutual acquired the
outstanding shares of MIGI. MIGI is also a party to an affiliation agreement
with the property-casualty insurer, Meridian Citizens Mutual Insurance Company
("Meridian Citizens Mutual"). Meridian Security, Meridian Citizens, and Meridian
Citizens Mutual are hereafter referred to collectively as the "MIGI Insurers,"
and together with MIGI, they are hereafter referred to collectively as the "MIGI
Companies."
Another wholly-owned subsidiary of STFC is Stateco Financial Services,
Inc. ("Stateco"), which provides investment management services to affiliated
insurance companies. STFC also owns Strategic Insurance Software, Inc.
("S.I.S."), a developer and seller of insurance-related software. The limited
liability company, 518 Property Management and Leasing, LLC ("518 PML"), whose
members are State Auto P&C and Stateco, owns and leases real and personal
property to affiliated companies. The results of operations of S.I.S. and 518
PML are not material to the total operations of STFC.
10K-a3
State Auto Financial and its wholly owned subsidiaries, State Auto
P&C, Milbank, Farmers, SA Ohio, SA National, Mid-Plains, Stateco, S.I.S., and
518 PML, are collectively referred to as the "Company."
State Auto P&C has participated in a quota share reinsurance pooling
arrangement with Mutual since 1987 (the "Pooling Arrangement"). The participants
in the Pooling Arrangement currently are State Auto P&C, Mutual, Milbank, SA
Wisconsin, Farmers, SA Ohio, and SA Florida, collectively referred to hereafter
as the "Pooled Companies." State Auto P&C, Milbank, Farmers and SA Ohio are
collectively referred to hereafter as the "STFC Pooled Companies." Effective
January 1, 2003, the pooling percentages were modified as follows: Mutual
(18.3%), State Auto P&C (59%), Milbank (17%), SA Wisconsin (1%), Farmers (3%),
SA Ohio (1%) and becoming party to the agreement on this same date, SA Florida
(0.7%). See "Pooling Arrangement" in the "Narrative Description of Business."
The Pooled Companies, SA National, Mid-Plains and the MIGI Insurers are
collectively referred to as the "State Auto Group."
The insurers in the State Auto Group write a broad line of property
and casualty insurance, including standard personal and commercial automobile;
nonstandard personal automobile; homeowners; commercial multi-peril; workers'
compensation; general liability and fire insurance through approximately 22,400
independent insurance agents associated with approximately 3,400 agencies in 26
states and the District of Columbia. The State Auto Group's insurance products
are marketed primarily in the central and eastern parts of the United States,
excluding New York, New Jersey and the New England States.
(b) FINANCIAL INFORMATION ABOUT SEGMENTS
The Company currently operates in three insurance segments. Prior to
2003, it operated in four segments: the State Auto standard insurance segment,
consisting of the business operations of the STFC Pooled Companies; the State
Auto nonstandard segment, consisting of the business operations of SA National
and Mid-Plains; the Meridian standard segment, consisting of the standard
insurance business of the former Meridian Mutual, and the Meridian nonstandard
segment, consisting of the nonstandard business of the former Meridian Mutual.
Effective January 1, 2003, the Meridian nonstandard segment is included in the
State Auto nonstandard segment as the results of this segment no longer meet the
quantitative thresholds for separate presentation as a reportable segment.
Financial information about all these segments is set forth in Note 15 to the
Company's Consolidated Financial Statements, included in Item 8 "Financial
Statements and Supplementary Data." Additional information regarding the
Company's insurance and non-insurance segments is provided in "Narrative
Description of Business."
(c) NARRATIVE DESCRIPTION OF BUSINESS
PROPERTY AND CASUALTY INSURANCE
POOLING ARRANGEMENT
The Pooled Companies are parties to an intercompany Pooling
Arrangement under the Reinsurance Pooling Agreement Amended and Restated as of
January 1, 2000, as amended by the First, Second, Third and Fourth Amendments
(the "2000 Pooling Agreement"). The Pooling Arrangement covers all the property
and casualty insurance written by the parties, except voluntary assumed
reinsurance written by Mutual and catastrophe inter-company reinsurance written
by State Auto P&C. Under the terms of the Pooling Arrangement, each of the STFC
Pooled Companies, SA Wisconsin and SA Florida cede premiums, losses and expenses
on all of their business to Mutual; in turn, Mutual cedes to each of the Pooled
Subsidiaries, SA Wisconsin and SA Florida a specified portion of premiums,
losses and expenses and Mutual retains the balance (Mutual, SA Wisconsin and SA
Florida are hereafter collectively referred to as the "Mutual Pooled
Companies.").
10K-a4
The following table sets forth a chronology of the participants and
their participation percentage changes that have occurred in the Pooling
Arrangement since it became effective on January 1, 1987:
State SA
Year *** Mutual Auto P&C Milbank Wisconsin Farmers SA Ohio SA Florida
- -------------- ------ -------- ------- --------- ------- ------- ----------
1987-1991 80% 20% N/A N/A N/A N/A N/A
1992-1994 70 30 N/A N/A N/A N/A N/A
1995-1997 55 35 10* N/A N/A N/A N/A
1998 52 37 10** 1 N/A N/A N/A
1999 49 37 10 1 3 N/A N/A
2000-9/30/2001 46 39 10 1 3 1 N/A
10/1/2001-2002 19 59 17 1 3 1 N/A
2003 18.3 59 17 1 3 1 0.7
* At this time Milbank was a wholly owned subsidiary of Mutual.
** In July 1998 Milbank became a wholly owned subsidiary of STFC.
*** Time period is for the year ended December 31, unless otherwise noted.
_______________________
The following table sets forth a summary of the Pooling Arrangement
participant percentages of STFC and Mutual, aggregating their respective
wholly-owned subsidiaries:
Year*** STFC Pooled Companies Mutual Pooled Companies
- ------------------- --------------------- -----------------------
1987-1991 20% 80%
1992-1994 30 70
1995-1997 35 65
1/1/1998-6/30/1998 37 63
7/1/1998-12/31/1998 47 53
1999 50 50
2000 - 9/30/2001 53 47
10/1/2001-2003 80 20
*** Time period is for the year ended December 31, unless otherwise noted.
_______________________
With the June 2001 merger of Meridian Mutual into Mutual, all
insurance business written by Meridian Mutual legally became the business of
Mutual and was included in the Pooling Arrangement effective July 1, 2001. The
former Meridian Mutual business has been monitored as a segment separate from
the State Auto standard business. Over time, the Meridian segment has decreased
and will disappear as this segment is integrated over to the State Auto systems
platform. Indeed, after representing approximately 20% of the Pooled Companies'
earned premium in 2001, 15% in 2002 and 9% in 2003, the Meridian Standard
segment will be included in the State Auto Standard segment beginning with
January 1, 2004. Likewise, the Meridian Nonstandard segment has been included in
the State Auto Nonstandard segment beginning January 1, 2003, due to the
integration efforts of management and the fact the Meridian Nonstandard segment
no longer meets the quantitative thresholds for segment reporting. Both 2002 and
2001 have been revised to reflect this change. See "Reportable Segments" in
"Narrative Description of Business."
Prior to 2001, the pooling percentages were reviewed by management at
least annually, and more often if deemed appropriate by management or the Board
of Directors of each company, to determine whether any adjustments should be
made. As a result of the changes made to the pooling percentages in 2001, it is
not management's current intention to recommend an adjustment to the Pooled
Subsidiaries aggregate participation percentage in the foreseeable future. Under
revised procedures, management of each of the Pooled Companies would make
recommendations to a standing independent committee of the Board of each of
Mutual and STFC. These independent committees would review and evaluate such
factors as they deem relevant and recommend any appropriate pooling change to
the Boards of both Mutual and STFC. See "Management Agreement" in the "Narrative
Description of Business." The Pooling Arrangement is terminable by any party on
90 days' notice or by mutual agreement of the parties. None of the Pooled
Companies currently intends to terminate the Pooling Arrangement.
10K-a5
Under the terms of the Pooling Arrangement, all premiums, incurred
losses, loss expenses and other underwriting expenses are prorated among the
companies party to the agreement on the basis of their participation in the
pool. By spreading the underwriting risk among each of the participants, the
Pooling Arrangement is designed to produce more uniform and stable underwriting
results for each of the Pooled Companies than any one company would experience
individually. One effect of the Pooling Arrangement is to provide each
participant with an identical mix of pooled property and casualty insurance
business on a net basis.
The 2000 Pooling Agreement contains a provision excluding catastrophic
losses and loss adjustment expenses incurred by the parties in the amount of
$100 million in excess of $120 million, as well as the premium for such
exposures. State Auto P&C reinsures each insurer in the State Auto Group for
this layer of reinsurance under a Catastrophe Assumption Agreement. See
"Reinsurance" in the "Narrative Description of Business."
The direct business of the MIGI Insurers is not included in the
Pooling Arrangement and to that extent is not included in the insurance
operations of the Company. If State Auto P&C were required to pay catastrophe
losses of the MIGI Insurers under the above referenced Catastrophe Assumption
Agreement, those losses would impact the Company's results.
NON-STANDARD AUTO INSURANCE
The Company writes non-standard auto insurance through SA National.
See "Marketing" in "Narrative Description of Business." This business is not
part of the Pooling Arrangement. See also "Reportable Segments" in "Narrative
Description of Business."
MANAGEMENT AGREEMENT
State Auto P&C's employees provide all organizational, operational and
management functions for all insurance affiliates within the State Auto Group
through management and cost sharing agreements. For the performance of its
services under two of the management agreements, State Auto P&C is paid a
quarterly management and operations services fee based on formulas outlined in
the agreements, to the extent specified performance standards are achieved.
Under the 2000 Midwest Management Agreement among State Auto P&C, Mutual and SA
Wisconsin, SA Wisconsin pays 0.75% of direct written premium for management and
operation services performed by employees of State Auto P&C. Under the
Management Services Agreement dated July 1, 2002, among State Auto P&C, MIGI and
the MIGI Insurers (the "MIGI Management Agreement"), each of the MIGI Companies
pays State Auto P&C a management fee of 10% of all State Auto P&C's
employee-related costs in exchange for the services of those employees, in
addition to reimbursing State Auto P&C for the actual costs of such services.
Mutual provides facilities for all the insurance affiliates under management or
cost sharing agreements.
While there had been in place a fee under a management agreement
between State Auto P&C and Mutual (the "2000 Management Agreement"), as a result
of the resolution of a disagreement with the Ohio Department of Insurance, the
fee aspect of that agreement was terminated, effective October 1, 2001, and that
arrangement continues as a pure cost sharing arrangement. As a result of the
loss of the service fee under the 2000 Management Agreement, substantially all
of State Auto P&C's insurance operations management fee was eliminated effective
October 1, 2001. Consequently, beginning with the first quarter 2002, the
management and operations services segment was included in the "other" category
for segment reporting as the results of this segment no longer met the
quantitative thresholds for separate presentation as a reportable segment.
Each of the affiliated management and cost sharing agreements, except
the MIGI Management Agreement, has a ten-year term and automatically renews for
an additional ten-year period unless sooner terminated in accordance with its
terms. If the 2000 Management Agreement is terminated for any reason, the
Company would have to locate facilities to continue its operations, although the
Company does not anticipate such termination.
10K-a6
REPORTABLE SEGMENTS
See Note 15, Reportable Segments in the Company's Consolidated
Financial Statements and Item 7 "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
MARKETING
In its 26 states of operation, the State Auto Group markets its
products through approximately 22,400 insurance agents associated with
approximately 3,400 independent insurance agencies. None of the companies in the
State Auto Group has any contracts with managing general agencies.
SA National markets nonstandard products in 21 states exclusively
through the Company's network of independent agents. Mid-Plains writes
nonstandard auto insurance in Iowa and Kansas through the agency network of
Farmers in those states. The Mid-Plains business is processed on SA National's
system, but SA National began in October 2003 to write all Mid-Plains renewals
and all new nonstandard business in Iowa and Kansas. See "Nonstandard Auto
Insurance" in the "Narrative Description of Business."
Because independent insurance agents significantly influence which
insurance company their customers select, management views the Company's
independent insurance agents as its primary customers. Management strongly
supports the independent agency system and believes that maintenance of a strong
agency system is essential for the Company's present and future success. As
such, the Company continually develops programs and procedures to enhance agency
relationships, including the following: regular travel by senior management and
branch office staff to meet with agents, in person, in their home states;
training opportunities; travel incentives; and an agent stock purchase plan.
The Company actively helps its agencies develop professional sales
skills within their staff. The training programs include both products and sales
training in concentrated programs in the Company's home office. Further, the
training programs include disciplined follow-up and coaching for an extended
time.
The Company has made continuing efforts to use technology to make it
easier for its agents to do business with the Company. The Company offers
internet-based rating of certain products. In addition the Company provides its
agents with the opportunity to maintain policyholder records electronically,
avoiding the expense of preparing and storing paper records. Software developed
by S.I.S. also enhances the ability of the Company and its agents to take
advantage of electronic data submission. The Company believes that, since agents
and their customers realize better service and efficiencies through automation,
they value their relationship with the Company. Automation can make it easier
for the agent to do business with the Company, which attracts prospective agents
and enhances the existing agencies' relationship with the Company.
The Company shares the cost of approved advertising with selected
agencies. The Company provides agents with certain travel and cash incentives if
they achieve certain sales and underwriting profit levels. Further, the Company
recognizes its very top agencies as Inner Circle Agencies. Inner Circle Agencies
are rewarded with additional trip and financial incentives, including additional
profit sharing bonus and additional contributions to their Inner Circle Agent
Stock Purchase Plan, a part of the Agent Stock Purchase Plan described below.
To strengthen agency commitment to producing profitable business and
further develop its agency relationships, the Company's Agent Stock Purchase
Plan offers its agents the opportunity to use commission income to purchase the
Company's stock. The Company's transfer agent administers the plan using
commission dollars assigned by the agents to purchase shares on the open market
through a broker. The Company also makes available to certain top performing
agents the opportunity to vest grants of options in the Company's common shares
(without par value) provided the participants meet performance targets described
in the Agent Stock Option Plan.
10K-a7
The Company receives premiums on products marketed in Alabama,
Arkansas, District of Columbia, Florida, Georgia, Illinois, Indiana, Iowa,
Kansas, Kentucky, Maryland, Michigan, Minnesota, Mississippi, Missouri, North
Carolina, North Dakota, Ohio, Oklahoma, Pennsylvania, South Carolina, South
Dakota, Tennessee, Utah, Virginia, West Virginia and Wisconsin. During 2003, the
seven states that contributed the greatest percentage of the Company's direct
premiums written were: Ohio (18.6%), Kentucky (11.9%), Tennessee (6.7%),
Minnesota (6.4%), Indiana (5.3%), Pennsylvania (5.1%), and South Carolina
(4.1%).
CLAIMS
Insurance claims on policies written by the Company are usually
investigated and settled by staff claims adjusters. The Company's claims
division emphasizes timely investigation of claims, settlement of meritorious
claims for equitable amounts, maintenance of adequate reserves for claims, and
control of external claims adjustment expenses. Achievement of these goals
supports the Company's marketing efforts by providing agents and policyholders
with prompt and effective service.
Claim settlement authority levels are established for each adjuster,
supervisor and manager based on his or her level of expertise and experience.
The claims division is responsible for reviewing the claim, obtaining necessary
documentation and establishing loss and expense reserves of certain claims.
Generally, property or casualty claims estimated to reach $100,000 or above are
sent to the home office to be supervised by claims division specialists.
Branches with small volumes of large claims report claims to the home office at
a lower dollar threshold. In territories in which there is not sufficient volume
to justify having full-time adjusters, the Company uses independent appraisers
and adjusters to evaluate and settle claims under the supervision of claims
division personnel.
The Company attempts to minimize claims costs by settling as many
claims as possible through its internal claims staff and, if possible, by
settling disputes regarding automobile physical damage and property insurance
claims (first party claims) through arbitration. In addition, selected agents
have authority to settle small first party claims, which improves claims
service.
Claim representatives use third party, proprietary bodily injury
evaluation software to help them value bodily injury claims, except for the most
severe injury cases. This software continues to be a valuable tool for the
Company. The Claims Contact Centers allow the Company to improve claims
efficiency and economy by concentrating the handling of smaller, less complex
claims in a centralized environment. The Company provides 24 hour, seven days a
week claim service through associates in the Claims Contact Centers, which are
located in Des Moines, Iowa and Columbus, Ohio.
RESERVES
Loss reserves are management's best estimates at a given point in time
of what the Company expects to pay to claimants, based on facts, circumstances
and historical trends then known. During the loss settlement period, additional
facts regarding individual claims may become known, and consequently it often
becomes necessary to refine and adjust the estimates of liability. The Company's
results of operations and financial condition could be impacted, perhaps
significantly, in the future if the ultimate payments required to settle claims
vary from the liability currently recorded.
The Company maintains reserves for the eventual payment of losses and
loss expenses for both reported claims and incurred claims that have not yet
been reported. Loss expense reserves are intended to cover the ultimate costs of
settling all losses, including investigation, litigation and in-house claims
processing costs from such losses.
Reserves for reported losses are initially established on either a
case-by-case or formula basis depending on the type and circumstances of the
loss. The case-by-case reserve amounts are determined based on the Company's
reserving practices, which take into account the type of risk, the circumstances
surrounding each claim and policy provisions relating to types of loss. The
formula reserves are based on historical paid loss data for similar claims with
provisions for trend changes caused by inflation. Loss and loss expense reserves
for incurred claims that have not yet been reported are estimated based on many
10K-a8
variables including historical and statistical information, inflation, legal
developments, storm loss estimates, and economic conditions. Case and formula
basis loss reserves are reviewed on a regular basis. As new data becomes
available, estimates are updated resulting in adjustments to loss reserves.
Generally, reported losses initially reserved on a formula basis which have not
settled after six months, are case reserved at that time. Although management
uses many resources to calculate reserves, there is no precise method for
determining the ultimate liability. The Company does not discount loss reserves
for financial statement purposes. Additional information regarding the Company's
reserves is included in Item 7 "Management's Discussion and Analysis" in the
Losses and Loss Expenses Payable section included therein.
Mutual has guaranteed the adequacy of State Auto P&C's loss and loss
expense reserves as of December 31, 1990. Pursuant to the guarantee, Mutual has
agreed to reimburse State Auto P&C for any losses and loss expenses in excess of
State Auto P&C's December 31, 1990 reserves ($65.5 million) that may develop
from claims that have occurred on or prior to that date. This guarantee ensures
that any deficiency in the reserves of State Auto P&C as of December 31, 1990,
under the Pooling Arrangement percentages effective on December 31, 1990 will be
reimbursed by Mutual. As of December 31, 2003, there has been no adverse
development of these reserves. In the event Mutual becomes financially impaired,
and subject to regulatory restrictions, it may be unable to make any such
reimbursement.
10K-a9
The following table presents one-year development information on
changes in the reserve for loss and loss expenses of the Company for the three
years ended December 31, 2003:
Year Ended December 31
----------------------------
2003 2002 2001
-------- ------- -------
(in thousands)
Beginning of Year:
Loss and loss expenses payable $600,958 523,860 244,583
Less: Reinsurance recoverable on losses and loss
expenses payable(1) 8,825 13,919 7,930
-------- ------- -------
Net losses and loss expenses payable(2) 592,133 509,941 236,653
Provision for losses and loss expenses occurring:
Current year 653,010 641,060 366,348
Prior years(3) (1,787) 12,414 60,726
-------- ------- -------
Total 651,223 653,474 427,074
Loss and loss expense payments for claims occurring
during:
Current year 370,731 349,733 240,508
Prior years 243,842 221,549 144,862
-------- ------- -------
Total 614,573 572,282 385,370
Impact of the addition of the former Meridian Mutual
business to the Pooling Arrangement, effective 7/1/01 -- -- 75,575
Impact of pooling change effective 10/1/01 -- -- 156,009
-------- ------- -------
End of Year:
Net losses and loss expenses payable(4) 628,783 592,133 509,941
Add: Reinsurance recoverable on losses and loss
expenses payable(5) 14,236 8,825 13,919
-------- ------- -------
Losses and loss expenses payable $643,019 600,958 523,860
======== ======= =======
(1) Includes amounts due from affiliates of $4,286, $8,867, and $2,111,
respectively.
(2) Includes net amounts assumed from affiliates of $303,959, $280,011 and
$10,126, respectively.
(3) This line item shows increases (decreases) in the current calendar year in
the provision for losses and loss expenses attributable to claims occurring
in prior years. The decrease of $1.8 million in 2003 and the increase of
$12.4 million in 2002 for claims occurring in prior years is well within
normal expectations for reserve development and claim settlement
uncertainty. The increase of $60,726 in 2001 for claims occurring in prior
years is primarily the result of reserve strengthening on the former
Meridian Mutual business in order to bring these claim reserves in line
with historic State Auto adequacy levels as well as ongoing analysis of
recent loss development trends.
(4) Includes amounts due from affiliates of $5,706, $4,286, and $8,867,
respectively.
(5) Includes net amounts assumed from affiliates of $303,894, $303,959, and
$280,011, respectively.
- ----------
The following table sets forth the development of reserves for losses
and loss expenses from 1993 through 2003 for the Company. "Net liability for
losses and loss expenses payable" sets forth the estimated liability for unpaid
losses and loss expenses recorded at the balance sheet date, net of reinsurance
recoverables, for each of the indicated years. This liability represents the
estimated amount of losses and loss expenses for claims arising in the current
and all prior years that are unpaid at the balance sheet date, including losses
incurred but not reported to the Company.
10K-a10
The lower portion of the table shows the re-estimated amounts of the
previously reported reserve based on experience as of the end of each succeeding
year. The estimate is increased or decreased as more information becomes known
about the claims incurred.
The upper section of the table shows the cumulative amounts paid with
respect to the previously reported reserve as of the end of each succeeding
year. For example, through December 31, 2003, the Company had paid 70.6% of the
currently estimated losses and loss expenses that had been incurred, but not
paid, as of December 31, 2003.
The amounts on the "cumulative redundancy (deficiency)" line represent
the aggregate change in the estimates over all prior years. For example, the
1993 reserve has developed a $14.9 million redundancy through December 31, 2003.
That amount has been included in operations over the ten years and did not have
a significant effect on income of any one year. The effects on income caused by
changes in estimates of the reserves for losses and loss expenses for the most
recent three years are shown in the foregoing three-year loss development table.
In evaluating the information in the table, it should be noted that
each amount includes the effects of all changes in amounts for prior periods.
For example, the amount of the redundancy related to losses settled in 1996, but
incurred in 1993, will be included in the cumulative redundancy amount for years
1993, 1994 and 1995. The table does not present accident or policy year
development data, which readers may be more accustomed to analyzing. Conditions
and trends that have affected the 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.
In 1995, 1998, 1999, 2000 and 2001, the Pooling Arrangement was
amended to increase the Company's share of premiums, losses and expenses. An
amount of assets equal to the increase in net liabilities was transferred to the
Company from Mutual in 1995, 1998, 1999, 2000 and 2001 in conjunction with each
year's respective pooling change. The amount of the assets transferred from
Mutual in 1995, 1998, 1999, 2000 and 2001 has been netted against and has
reduced the cumulative amounts paid for years prior to 1995, 1998, 1999, 2000
and 2001, respectively.
[See table on following page.]
10K-a11
State Auto Financial Corp.
Years Ended December 31
-----------------------------------------------------------------
1993 1994 1995 1996 1997 1998
-------- -------- -------- -------- --------- ---------
(dollars in thousands)
Net liability for losses and loss expenses
payable $123,337 $126,743 $206,327 $199,480 $ 194,155 $ 205,034
Paid (cumulative) as of:
One year later 42.2% 1.5% 38.2% 39.4% 32.7% 35.4%
Two years later 41.3% 29.1% 55.4% 54.1% 54.6% 61.6%
Three years later 55.6% 44.5% 63.3% 65.0% 70.1% 62.1%
Four years later 64.5% 51.0% 67.7% 73.2% 69.2% 78.8%
Five years later 67.2% 54.6% 71.9% 69.8% 77.1% 86.3%
Six years later 69.0% 58.8% 67.1% 74.6% 81.8%
Seven years later 72.1% 52.3% 69.3% 77.1%
Eight years later 67.0% 54.4% 67.2%
Nine years later 68.4% 57.2%
Ten years later 70.6%
Net liability re-estimate as of:
One year later 93.7% 87.4% 87.0% 91.3% 93.0% 96.6%
Two years later 90.0% 77.1% 86.4% 87.3% 92.0% 96.7%
Three years later 85.0% 77.0% 83.2% 86.7% 91.9% 111.9%
Four years later 86.3% 72.9% 81.6% 87.0% 102.0% 111.5%
Five years later 82.8% 70.9% 81.3% 92.6% 101.4% 115.6%
Six years later 81.6% 70.0% 83.6% 92.9% 106.1%
Seven years later 80.8% 72.6% 83.7% 96.1%
Eight years later 83.6% 72.8% 82.5%
Nine years later 83.8% 77.7%
Ten years later 87.9%
Cumulative redundancy (deficiency) $ 14,955 $ 28,273 $ 36,069 $ 7,703 ($11,779) ($32,003)
Cumulative redundancy (deficiency) 12.1% 22.3% 17.5% 3.9% -6.1% -15.6%
Gross* liability - end of year $245,929 $277,783 $412,553 $410,658 $ 402,718 $ 414,268
Reinsurance recoverable $122,591 $151,040 $206,226 $211,178 $ 208,563 $ 209,234
Net liability - end of year $123,337 $126,743 $206,327 $199,480 $ 194,155 $ 205,034
Gross liability re-estimated - latest 103.5% 96.0% 84.6% 95.0% 101.0% 109.4%
Reinsurance recoverable re-estimated - latest 119.1% 111.3% 86.8% 94.0% 96.3% 103.4%
Net liability re-estimated - latest 87.9% 77.7% 82.5% 96.1% 106.1% 115.6%
Years Ended December 31
--------------------------------------------------------
1999 2000 2001 2002 2003
--------- --------- --------- --------- --------
(dollars in thousands)
Net liability for losses and loss expenses
payable $ 221,682 $ 236,657 $ 509,941 $592,132 $628,783
Paid (cumulative) as of:
One year later 41.8% 5.9% 43.4% 41.2% --
Two years later 43.0% 52.7% 65.3%
Three years later 71.9% 79.9%
Four years later 86.9%
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Net liability re-estimate as of:
One year later 97.5% 125.7% 102.4% 99.7% --
Two years later 119.1% 129.1% 105.1%
Three years later 120.3% 133.1%
Four years later 123.2%
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Cumulative redundancy (deficiency) ($51,335) ($78,270) ($25,867) $ 1,787 --
Cumulative redundancy (deficiency) -23.2% -33.1% -5.1% 0.3% --
Gross* liability - end of year $ 438,748 $ 457,202 $ 743,710 $862,428 $933,998
Reinsurance recoverable $ 217,065 $ 220,544 $ 233,769 $270,295 $305,215
Net liability - end of year $ 221,682 $ 236,657 $ 509,941 $592,133 $628,783
Gross liability re-estimated - latest 111.5% 118.0% 103.7% 98.7% --
Reinsurance recoverable re-estimated - latest 99.5% 101.9% 100.5% 96.6% --
Net liability re-estimated - latest 123.2% 133.1% 105.1% 99.7% --
* Gross liability includes: Direct & assumed losses & loss expenses payable.
As the Pooling Arrangement provides for the right of offset, the Company has
reported losses and loss expenses payable ceded to Mutual as assets only in
situations when when net amounts ceded to Mutual exceed that assumed. The
following table provides a reconciliation of the reinsurance recoverable to the
amount reported in the Company's consolidated financial statements at each
balance sheet date:
Years Ended December 31
-----------------------------------------------------------------
1993 1994 1995 1996 1997 1998
-------- -------- -------- -------- --------- ---------
Reinsurance recoverable $122,591 $151,040 $206,226 $211,178 $208,563 $209,234
Amount netted against assumed from Mutual $115,945 $142,680 $193,367 $194,839 $187,506 $196,818
Net reinsurance recoverable $ 6,646 $ 8,360 $ 12,859 $ 16,339 $ 21,057 $ 12,416
Years Ended December 31
-----------------------------------------------------------------
1999 2000 2001 2002 2003
-------- -------- -------- -------- ---------
Reinsurance recoverable $217,065 $220,544 $233,770 $270,295 $305,215
Amount netted against assumed from Mutual $206,258 $212,614 $219,851 $261,470 $290,979
Net reinsurance recoverable $ 10,807 $ 7,930 $ 13,919 $ 8,825 $ 14,236
10K-a12
The following table is a reconciliation as of each December 31 of
losses and loss expenses payable, computed under generally accepted accounting
principles ("GAAP"), to losses and loss expenses payable, computed under
statutory accounting principles used by insurance companies for reporting to
state insurance regulators ("STAT"):
2003 2002 2001
-------- ------- -------
(in thousands)
GAAP losses and loss expenses payable $643,019 600,958 523,860
Less: ceded reinsurance recoverable on losses
and loss expenses payable 14,236 8,825 13,919
-------- ------- -------
Net losses and loss expenses payable 628,783 592,133 509,941
Add: salvage and subrogation recoverable(1) -- 27,093 26,216
-------- ------- -------
STAT losses and loss expenses $628,783 619,226 536,157
======== ======= =======
(1) Effective January 1, 2003, the loss reserving process for statutory
reporting began anticipating salvage and subrogation recoverable.
- ----------
REINSURANCE
Members of the State Auto Group follow the customary industry practice
of reinsuring a portion of their exposures and paying to the reinsurers a
portion of the premiums received. Insurance is ceded principally to reduce net
liability on individual risks or for individual loss occurrences, including
catastrophic losses. Although reinsurance does not legally discharge the
individual members of the State Auto Group from primary liability for the full
amount of limits applicable under their policies, it does make the assuming
reinsurer liable to the extent of the reinsurance ceded.
Each member of the State Auto Group is party to working reinsurance
treaties for property, casualty and workers compensation lines with several
reinsurers arranged through a reinsurance broker. Under the property per risk
excess of loss treaty, each member is responsible for the first $2.0 million of
each defined loss, and the reinsurers are responsible for 100% of the excess
over $2.0 million up to $10 million of defined loss, depending upon the nature
of the injury or damage. The rates for this reinsurance are negotiated annually.
The terms of the casualty excess of loss program provide that each
company in the State Auto Group is responsible for the first $2.0 million of a
covered loss. The reinsurers are responsible for 100% of the excess over $2.0
million up to $5.0 million of covered loss. Also, certain unusual claim
situations involving bodily injury liability, property damage, uninsured
motorists and personal injury protection are covered by an arrangement that
provides for $10.0 million of coverage in excess of a $5.0 million retention for
each loss occurrence. This layer of reinsurance sits above the $3.0 million
excess of $2.0 million arrangement. The rates for this reinsurance are
negotiated annually.
The terms of the workers compensation excess of loss program provide
that each company in the State Auto Group is responsible for the first $2.0
million of covered loss. The reinsurers are responsible for 100% of the excess
over $2.0 million up to $10.0 million of covered loss. Net retentions under this
contract may be submitted to the casualty excess of loss program, subject to a
limit of $2 million per loss occurrence. The rates for this reinsurance are
negotiated annually.
In addition, the State Auto Group has secured other reinsurance to
limit the net cost of large loss events for certain types of coverage. Included
are umbrella liability losses which are reinsured up to a limit of $10.0 million
above a maximum $600,000 retention. The State Auto Group also makes use of
facultative reinsurance for unique risk situations and participates in
involuntary pools and associations in certain states.
10K-a13
The State Auto Group participates in an intercompany catastrophe
reinsurance program. Under this program, the members of the State Auto Group, on
a combined basis, retain the first $40.0 million of catastrophe losses that
affect at least two individual risks. For catastrophe losses incurred by the
State Auto Group up to $80.0 million, in excess of $40.0 million, traditional
reinsurance coverage is provided with a co-participation of 5%. For catastrophe
losses incurred by the State Auto Group up to $100.0 million, in excess of
$120.0 million, in exchange for a premium paid by each reinsured company, State
Auto P&C acts as the catastrophe reinsurer for the State Auto Group under the
terms of an intercompany catastrophe reinsurance agreement. There have been no
losses assumed under this agreement.
To provide funding if the State Auto Group was to incur catastrophe
losses in excess of $120.0 million, State Auto Financial has continued a
structured contingent financing transaction with a financial institution and a
syndicate of other lenders (the "Lenders") to provide up to $100.0 million for
reinsurance purposes. In the event of such a loss, this arrangement provides
that State Auto Financial would sell redeemable preferred shares to SAF Funding
Corporation, a special purpose company ("SPC"), which would borrow the money
necessary for such purchase from the Lenders. State Auto Financial would then
contribute to State Auto P&C the funds received from the sale of its preferred
shares, thereby preserving the statutory surplus of State Auto P&C. State Auto
P&C would use the contributed capital to pay its direct catastrophe losses and
losses assumed under the intercompany catastrophe reinsurance agreement. State
Auto Financial is obligated to repay SPC (which would repay the Lenders) by
redeeming the preferred shares over a five-year period. In the event of a
default by State Auto Financial, the obligation to repay SPC has been secured by
a Put Agreement among State Auto Financial, Mutual and the Lenders, under which
Mutual would be obligated to either purchase the preferred shares from SPC or
repay SPC for the loan(s) outstanding. This funding arrangement, if exercised,
would have the impact of adding up to $100.0 million of additional debt to the
Company while providing needed cash to pay claims, while at the same time
preserving the investment portfolio of the Company in the short term.
SA National has a reinsurance agreement with Mutual pursuant to which
Mutual assumes up to $4,950,000 of each liability loss occurrence in excess of
SA National's $50,000 of retention; and up to $450,000 of each catastrophe loss
occurrence in excess of SA National's $50,000 of retention. Mutual further
provides SA National with an 8.5% quota share within the $50,000 retention on
liability coverages, and a 20% quota share on physical damage coverages.
Mid-Plains also has a reinsurance agreement with Mutual pursuant to which Mutual
assumes up to $450,000 of each liability loss occurrence in excess of
Mid-Plains' $50,000 of retention.
For the period October 1, 2001 through December 31, 2003, Mutual
entered into a Stop Loss Reinsurance Arrangement (the "Stop Loss") with the STFC
Pooled Companies. Under the Stop Loss, Mutual agreed to participate in the
Pooling Arrangement's quarterly underwriting losses and gains, in the manner
described. If the Pooling Arrangement's loss and LAE ratio (the "Pool loss and
LAE ratio") was between 70.75% and 80.00% (after the application of all
available reinsurance), Mutual reinsured the STFC Pooled Companies 27% of the
Pooling Arrangement's losses in excess of a Pool loss and LAE ratio of 70.75% up
to 80.00%. The STFC Pooled Companies were responsible for their share of the
Pooling Arrangement's losses over the 80.00% threshold. Also, Mutual had the
right to participate in the profits of the Pooling Arrangement. Mutual assumed
27% of the Pooling Arrangement's underwriting profits attributable to a Pool
loss and LAE ratio less than 69.25%, but more than 59.99%. The Stop Loss expired
at December 31, 2003.
See discussion regarding the federal Terrorism Risk Insurance Act of
2002 ("Terrorism Act") at Regulation section and Item 7 "Management's Discussion
and Analysis" in the Other External Factors section included therein.
REGULATION
Most states, including all the domiciliary states of the State Auto
Group, have enacted legislation that regulates insurance holding company
systems. Each insurance company in the holding company system is required to
register with the insurance supervisory agency of its state of domicile and
furnish information concerning the operations of companies within the holding
company system that may materially affect the operations, management or
financial condition of the insurers within the system.
10K-a14
Pursuant to these laws, the respective insurance departments may examine any
members of the State Auto Group, at any time, require disclosure of material
transactions involving insurer members of the holding company system, and
require prior notice and an opportunity to disapprove of certain "extraordinary"
transactions, including, but not limited to, extraordinary dividends to
shareholders. Pursuant to these laws, all transactions within the holding
company system affecting any members of the State Auto Group must be fair and
equitable. In addition, approval of the applicable Insurance Commissioner is
required prior to the consummation of transactions affecting the control of an
insurer. The insurance laws of all the domiciliary states of the State Auto
Group provide that no person may acquire direct or indirect control of a
domestic insurer without obtaining the prior written approval of the state
insurance commissioner for such acquisition.
In addition to being regulated by the insurance department of its
state of domicile, each insurance company is subject to supervision and
regulation in the states in which it transacts business. Such supervision and
regulation relate to numerous aspects of an insurance company's business
operations and financial condition. The primary purpose of such supervision and
regulation is to ensure financial stability of insurance companies for the
protection of policyholders. The laws of the various states establish insurance
departments with broad regulatory powers relative to 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. 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. In addition, 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 policy terminations, restrictions on agency terminations
and laws requiring companies to accept any applicant for automobile insurance.
These laws may adversely affect the ability of the insurers in the State Auto
Group to earn a profit on their underwriting operations.
Insurance companies are required to file detailed annual reports with
the supervisory agencies in each of the states in which they do business, and
their business and accounts are subject to examination by such agencies at any
time.
There can be no assurance that such regulatory requirements will not
become more stringent in the future and have an adverse effect on the operations
of the State Auto Group.
Dividends. STFC's insurance subsidiaries generally are restricted by
the insurance laws of their respective states of domicile as to the amount of
dividends they may pay to STFC without the prior approval of the respective
state regulatory authorities. Generally, the maximum dividend that may be paid
by an insurance subsidiary during any year without prior regulatory approval is
limited to the greater of a stated percentage of that subsidiary's statutory
surplus as of a certain date, or adjusted net income of the subsidiary, for the
preceding year. Pursuant to these rules, a total of $52.7 million is available
for payment to State Auto Financial as a dividend from State Auto P&C, Milbank,
Farmers, SA Ohio and SA National during 2004 without prior approval from their
domiciliary state insurance departments, under current law.
Rate and Related Regulation. In general, the Company is not aware of
the adoption of any adverse legislation or regulation by any state where the
Company did business during 2003 which would present material obstacles to the
Company's overall business. However, several states where the Company does
business have passed or are considering more strict regulation of the use of
credit scoring in rating and/or risk selection in personal lines of business.
Similarly, several states are considering restricting insurers' rights to use
loss history information maintained in various data bases by insurance support
organizations. These tools help the Company price its products more fairly and
enhance its ability to compete for business that it believes will be profitable.
Such regulations would limit the ability of the Company, as well as the ability
of all other insurance carriers operating in any affected jurisdiction, to take
advantage of these tools.
In an attempt to make capital and surplus requirements more accurately
reflect the underwriting risk of different lines of insurance as well as
investment risks that attend insurers' operations, the National
10K-a15
Association of Insurance Commissioners ("NAIC") annually tests insurers'
risk-based capital requirements. As of December 31, 2003, each insurer
affiliated with the Company surpassed all standards tested by the formula
applying risk-based capital requirements.
The property and casualty insurance industry is also affected by court
decisions. Premium rates are actuarially determined to enable an insurance
company to generate an underwriting profit. These rates contemplate a certain
level of risk. The courts may modify, in a number of ways, the level of risk
which insurers had expected to assume including eliminating exclusions,
expanding the terms of the contract, multiplying limits of coverage, creating
rights for policyholders not intended to be included in the contract and
interpreting applicable statutes expansively to create obligations on insurers
not originally considered when the statute was passed. Courts have also undone
legal reforms passed by legislatures, which reforms were intended to reduce a
litigant's rights of action or amounts recoverable and so reduce the costs borne
by the insurance mechanism. These court decisions can adversely affect an
insurer's profitability. They also create pressure on rates charged for
coverages adversely affected, and this can cause a legislative response
resulting in rate suppression that can adversely affect an insurer.
The Terrorism Act requires the federal government and the insurance
industry to share in insured losses up to $100 billion per year resulting from
future terrorist attacks within the United States. Under the Terrorism Act,
commercial property and casualty insurers must offer their commercial
policyholders coverage against certified acts of terrorism, but the
policyholders may choose to reject this coverage. If the policyholder rejects
coverage for certified acts of terrorism, the Company intends, subject to the
approval of the state regulators, to cover only such acts of terrorism that are
not certified acts under the Terrorism Act and that do not arise out of nuclear,
biological or chemical agents.
The impact of Sarbanes Oxley Act of 2002 on the Company and its
corporate governance is continuing to be felt, as the Securities and Exchange
Commission (the "SEC") implements regulatory changes to meet the obligations
imposed on it by the Congress. Certain deadlines have been extended by the SEC
which may mitigate the cost of compliance to a limited extent. In addition to
complying with SEC and Congressional mandates, STFC also has to comply with new
listing standards set forth in the Marketplace Rules of The NASDAQ Stock Market,
Inc. ("NASDAQ") recently approved by SEC, which will contribute to an increase
in expenses.
INVESTMENTS
The Company's investment portfolio is managed to provide growth of
statutory surplus in order to facilitate increased premium writings over the
long term while maintaining the ability to service current insurance operations.
The primary objectives are to generate income, preserve capital and maintain
liquidity. The Company's investment portfolio is managed separately from that of
Mutual and its subsidiaries, and investment results are not shared by each of
the Pooled Companies through the Pooling Arrangement. Stateco performs
investment management services for the Company and Mutual and its subsidiaries,
although investment policies implemented by Stateco continue to be set for each
company through the Investment Committee of its Board of Directors.
The Company's decision to make a specific investment is influenced
primarily by the following factors: (a) investment risks; (b) general market
conditions; (c) relative valuations of investment vehicles; (d) general market
interest rates; (e) the Company's liquidity requirements at any given time; and
(f) the Company's current federal income tax position and relative spread
between after tax yields on tax-exempt and taxable fixed income investments. The
Company has investment policy guidelines with respect to purchasing fixed income
investments which preclude investments in bonds that are rated below investment
grade by a recognized rating service. The maximum investment in any single note
or bond is limited to 5.0% of assets, other than obligations of the U.S.
government or government agencies, for which there is no limit. Investments in
equity securities are selected based on their potential for appreciation as well
as ability to continue paying dividends. See discussion regarding Market Risk
included in Part II - Item 7 "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
10K-a16
Strategies as to specific investments can change depending on the
Company's current federal tax position, market interest rates and general market
conditions. The Company's fixed maturity investments are classified as available
for sale and carried at fair market value, according to the Statement of
Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain
Investments in Debt and Equity Securities." Fixed maturities classified as
available for sale, totaled $1,421.4 million and $1,216.7 million at December
31, 2003 and December 31, 2002, respectively.
At December 31, 2003 and 2002, respectively, the Company's equity
portfolio is classified as available for sale and carried at fair market value
that totaled $139.3 million and $53.7 million, respectively.
The table below provides information about the quality and the scope
of the Company's fixed maturity portfolio as of December 31, 2003:
Fair Market Value
(in thousands) % of Portfolio Quality* Amortized Cost Fair Market Value
----------------- -------- -------------- -----------------
Investment Grade -
Corporates and Municipals 58.2% AA+ $ 775,105 $ 827,715
U.S. Governments 2.2% AAA $ 29,156 $ 30,848
U.S. Government Agencies 39.6% AAA $ 555,316 $ 562,849
----- ---------- ----------
100.0% $1,359,577 $1,421,412
===== ========== ==========
*As rated by Moody's Investors Service
- ----------
The following table sets forth the Company's investment results for
the periods indicated:
Year ended December 31
-----------------------------------
(in thousands) 2003 2002 2001
---------- ---------- ---------
Average Invested Assets (1) $1,391,884 $1,210,641 $870,864
Net Investment Income (2) $ 64,625 $ 59,691 $ 47,375
Average Yield 4.6% 4.9% 5.4%
(1) Average of the aggregate invested assets at the beginning and end of each
period, including interim quarter ends. Invested assets include fixed
maturities at amortized cost, equity securities at cost, other invested
assets at cost and cash equivalents.
(2) Net investment income is net of investment expenses and does not include
realized or unrealized investment gains or losses or provision for income
taxes.
- ----------
For additional discussion regarding the Company's investments, see
Item 7 "Management's Discussion and Analysis of Financial Condition and Results
of Operations."
COMPETITION
The property and casualty insurance industry is highly competitive.
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. See "Marketing" in the
"Narrative Description of Business." The Company competes through underwriting
criteria, appropriate pricing, quality service to the policyholder and the
agent, and a fully developed agency relations program.
10K-a17
EMPLOYEES
As of March 5, 2004, the Company had 2,060 employees. Employees of the
Company are not covered by any collective bargaining agreement. Management of
the Company considers its relationship with its employees to be excellent.
AVAILABLE INFORMATION
STFC's internet website address is www.stfc.com. Through this internet
website (found under the "SEC Filings" link), STFC makes available, free of
charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current
Reports on Form 8-K, and all amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the
"Exchange Act"), as soon as reasonably practicable after STFC electronically
files such material with the SEC. Also available on its website is information
pertaining to the Company's corporate governance, including amended and restated
charters of each board of directors standing committee, amended and restated
corporate governance guidelines and the Company's Amended and Restated Code of
Business Conduct. For a free copy of the Form 10-K, write to Terrence L.
Bowshier, Vice President, State Auto Financial Corporation, 518 East Broad
Street, Columbus, Ohio 43215.
Any of the materials the Company files with the SEC may also be read
and copied at the SEC's Public Reference Room at 450 Fifth Street, NW,
Washington, DC 20549. Information on the operation of the SEC's Public Reference
Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a
website that contains reports, proxy and information statements, and other
information regarding issuers that file electronically with the SEC at
http://www.sec.gov.
TENDER OFFER BY MINORITY SHAREHOLDER
On August 20, 2003, Gregory M. Shepard, who owns approximately 5.1% of
STFC's outstanding common shares, and his wholly owned corporation filed a
Schedule TO with the SEC relating to a proposed tender offer to purchase 8.0
million of STFC's outstanding common shares at a price of $32.00 per share,
subject to certain conditions (the "Shepard tender offer"). The Shepard tender
offer was commenced on September 11, 2003, has been extended three times and
currently is scheduled to expire at 5:00 p.m., New York City time, on April 9,
2004, unless further extended by Mr. Shepard. On September 1, 2003, STFC's Board
of Directors and a special committee of its independent directors were informed
that State Auto Mutual's Board of Directors, based on the unanimous
recommendation of a special committee of its independent directors, had
unanimously determined to: (1) oppose and reject the Shepard tender offer
because it is not in the best interests of State Auto Mutual, its policyholders
and its other constituencies; (2) decline and refuse to turn over control of
State Auto Mutual and its affiliates, including STFC, to Mr. Shepard because the
transfer of such control would not be in the best interests of State Auto
Mutual, its policyholders, and its other constituencies; (3) decline and refuse
to provide financing to Mr. Shepard or his company (Mr. Shepard and his company
intend to have State Auto Mutual borrow at least $256 million through the
issuance of surplus notes to finance the Shepard tender offer); and (4) vote
State Auto Mutual's common shares of STFC against approval of the Shepard tender
offer if submitted to a vote of STFC's shareholders. On September 1, 2003,
STFC's Board of Directors and a special committee of its independent directors
met and each unanimously determined that the Shepard tender offer was impossible
to complete because certain essential conditions of the tender offer could not
be met and that the Shepard tender offer is illusory. STFC's Board of Directors
has unanimously recommended to STFC's shareholders that they reject the Shepard
tender offer and not tender their shares to Mr. Shepard or his company pursuant
to the Shepard tender offer. The foregoing discussion of the Shepard tender
offer is not intended to be complete. For complete information concerning the
Shepard tender offer and its terms and conditions, persons should read the
Schedule TO, as amended, filed by Mr. Shepard and his company with the SEC,
which is available at no charge on the SEC's website at http://www.sec.gov.
Persons may also obtain at no charge the STFC Board's recommendation statement
on Schedule 14D-9, as amended, at the SEC's website described above. The
information contained in the Schedule TO and the information contained in the
Schedule 14D-9 are not a part of this Form 10-K.
10K-a18
EXECUTIVE OFFICERS OF THE REGISTRANT
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company Age(1) During the Past Five Years of the Company Since (2)
- ----------------------------- ------ -------------------------- ------------------------
Robert H. Moone, 60 Chairman of the Board of STFC and 1991
Chairman, President and Mutual, 1/1/01 to present; Chief
Chief Executive Officer Executive Officer of STFC and Mutual,
5/99 to present; President of STFC and
Mutual, 5/96 to present; Executive Vice
President, 11/93 to 5/96 and prior
thereto Vice President of STFC and
Mutual
Mark A. Blackburn, 52 Senior Vice President of STFC and 1999
Senior Vice President Mutual, 3/01 to present; Vice President
of STFC and Mutual, 8/99 to 3/01;
Executive Vice President of Grange
Mutual Casualty Insurance Company, 4/96
to 4/99; and for more than five years
prior thereto, Vice President of
General Reinsurance Corporation
Steven J. Johnston, 44 Senior Vice President of STFC and 1994
Senior Vice President, Mutual, 8/99 to present; Treasurer and
Treasurer and Chief Chief Financial Officer of STFC and
Financial Officer Mutual, 4/97 to present; Vice President
of STFC and Mutual, 5/95 to 8/99
John R. Lowther, 53 Senior Vice President of STFC and 1991
Senior Vice President, Mutual, 3/01 to present; Secretary and
Secretary and General Counsel of STFC, 5/91 to
General Counsel present and of Mutual 8/89 to present;
Vice President of STFC, 5/91 to 3/01
and of Mutual 8/89 to 3/01
Terrence L. Bowshier, 51 Vice President of STFC and Mutual, 5/91 1991
Vice President to present
James E. Duemey, 57 Vice President and Investment Officer 1991
Vice President of STFC and Mutual, 5/91 to present
and Investment Officer
William D. Hansen, 37 Vice President of Mutual, 3/00 to 2000
Vice President present; Vice President of STFC, 5/00
to present; Assistant Vice President of
Mutual, 5/95 to 3/00
Steven R. Hazelbaker, 48 Vice President of Mutual, 6/01 to 2001
Vice President present; Vice President of STFC, 6/01
to present; CFO and Treasurer of MIGI
and Meridian Mutual, 1994 to 6/01; Vice
President of MIGI and Meridian Mutual,
1995 to 6/01
Noreen W. Johnson, 55 Vice President of STFC and Mutual, 3/98 1998
Vice President to present; Assistant Vice President of
Mutual, 3/97 to 3/98; employee of
Mutual since 9/92
Robert A. Lett, 64 Vice President of STFC, 3/98 to 1994
Vice President present; Vice President of Mutual, 2/88
to present
John B. Melvin, 54 Vice President of STFC, 3/98 to 1994
Vice President present; Vice President of Mutual,
11/93 to present; and prior thereto an
officer of Mutual
Cathy B. Miley, (3) 54 Vice President of STFC, 3/98 to 1995
Vice President present; Vice President of Mutual, 3/95
to present; Assistant Secretary of
Mutual, 8/92 to 3/95
10K-a19
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company Age(1) During the Past Five Years of the Company Since (2)
- ----------------------------- ------ -------------------------- ------------------------
Richard L. Miley, (3) 49 Vice President of STFC, 3/98 to 1995
Vice President present; Vice President of Mutual, 5/95
to present; Assistant Vice President of
Mutual, 8/87 to 5/95
Paul E. Nordman 46 Vice President of Mutual, 3/04 to 2004
Vice President present; Vice President of STFC, 3/04
to present; Assistant Vice President of
Mutual 7/95 to 3/04
John M. Petrucci, 45 Vice President of Mutual, 3/00 to 2000
Vice President present; Vice President of STFC, 5/00
to present; employee of Mutual since
9/96
Cynthia A. Powell, 43 Vice President of Mutual, 3/00 to 2000
Vice President present; Assistant Vice President, 8/96
to 3/00; Vice President of STFC, 5/00
to present; Assistant Vice President of
STFC, 4/97 to 5/00; employee of Mutual
since 6/90
(1) Age is as of March 15, 2004.
(2) Each of the foregoing officers has been designated by the Company's Board
of Directors as an executive officer for purposes of Section 16 of the
Securities Exchange Act of 1934.
(3) Richard L. Miley and Cathy B. Miley are husband and wife.
ITEM 2. PROPERTIES
The Company shares its operating facilities with Mutual pursuant to
the terms of the 2000 Management Agreement. The Company's corporate headquarters
are located in Columbus, Ohio, in buildings owned by Mutual that contain
approximately 280,000 square feet of office space. The Company and Mutual also
own or lease other office facilities in numerous locations throughout the State
Auto Group's geographical areas of operation.
ITEM 3. LEGAL PROCEEDINGS
INSURANCE BUSINESS
The Company is a party to a number of lawsuits arising in the ordinary
course of its insurance business. Management of the Company believes that the
ultimate resolution of these lawsuits will not, individually or in the
aggregate, have a material, adverse effect on the financial condition of the
Company.
MINORITY SHAREHOLDER LITIGATION--OHIO
On June 30, 2003, STFC and Mutual filed a complaint against Gregory M.
Shepard, who owns approximately 5.1% of STFC's outstanding common shares, in the
United States District Court, Southern District of Ohio, Eastern Division,
seeking injunctive relief on a variety of claims, including enjoining Mr.
Shepard from making material misrepresentations and omissions in his Schedule
13D filings with the SEC and from violating federal securities laws. The factual
basis for this suit related to a series of press releases and Schedule 13D
filings made by Mr. Shepard regarding proposals or purported offers to purchase
certain amounts of STFC's common shares and to take control of STFC and Mutual.
On August 25, 2003, STFC and Mutual amended their original complaint against Mr.
Shepard to seek injunctive relief on additional claims, including enjoining Mr.
Shepard from making material misrepresentations and omissions in connection with
the Shepard tender offer and from illegally tipping persons with material,
nonpublic information concerning the Shepard tender offer. On October 16, 2003,
STFC and Mutual
10K-a20
dismissed, without prejudice, this action against Mr. Shepard in light of the
United States District Court's dismissal of Mr. Shepard's lawsuit against STFC,
Mutual, and their respective directors, discussed in the following paragraph.
On August 21, 2003, one day after Mr. Shepard and his company filed a
Schedule TO with the SEC (see "Tender Offer by Minority Shareholder" in Item 1
"Business"), they filed a complaint against STFC, Mutual, and their respective
directors in the United States District Court, Southern District of Ohio,
Eastern Division, seeking (1) declaratory relief that STFC's directors and
Mutual and its directors violated their respective fiduciary duties to Mr.
Shepard, his company, and STFC's minority shareholders in their consideration of
Mr. Shepard's prior proposals and were likely to engage in breaches of their
respective fiduciary duties in their consideration of the proposed Shepard
tender offer (which tender offer was not commenced until September 11, 2003) and
(2) injunctive relief to enjoin STFC, Mutual, and their respective directors and
employees from taking actions which would have the effect of impeding or
interfering with the Shepard tender offer. On October 15, 2003, the United
States District Court dismissed this action against STFC, Mutual, and their
respective directors based on a finding that the District Court lacked subject
matter jurisdiction.
On October 16, 2003, STFC, Mutual, and their respective directors
filed a complaint against Mr. Shepard and his company in the Common Pleas Court
of Franklin County, Ohio, seeking (1) declaratory relief that neither STFC,
Mutual, nor their respective directors and officers owed or violated any
fiduciary duties to Mr. Shepard, his company, or STFC's minority shareholders in
responding to the Shepard tender offer; (2) declaratory relief that neither STFC
nor its directors and officers have an obligation to call a meeting of
shareholders under Ohio's Control Share Acquisition statute with respect to the
Shepard tender offer; and (3) compensatory damages in favor of STFC and Mutual
from Mr. Shepard and his company for knowingly making misrepresentations in
connection with their control bid in violation of Ohio's control bid statute. On
December 19, 2003, Mr. Shepard and his company filed an answer and counterclaim
against STFC, Mutual, and their respective directors. Their counterclaim seeks
(1) a declaratory judgment requiring STFC to call a meeting of shareholders
under Ohio's Control Share Acquisition statue with respect to the Shepard tender
offer; and (2) injunctive relief to enjoin STFC, Mutual, and their respective
directors and employees from taking actions that would have the effect of
impeding or interfering with the Shepard tender offer. On December 22, 2003,
STFC and Mutual filed a motion to expedite the trial on the declaratory judgment
action. That motion was granted and the trial court has entered an order fixing
a trial date in this action for early June of 2004. As of March 5, 2004, the
case is currently in its discovery phase.
MINORITY SHAREHOLDER LITIGATION--INDIANA
On July 27, 2001, Mr. Shepard and American Union Insurance
Company("AUIC"), an Illinois insurance company owned by Mr. Shepard and his
brother, Tracy Shepard, filed a complaint against STFC, Mutual, MIGI, and MIGI's
former directors in the United States District Court for the Southern District
of Indiana. The factual basis for this suit arises from the circumstances
surrounding the merger of MIGI with and into a wholly owned subsidiary of Mutual
(the "Merger"), which was effective June 1, 2001. In their complaint, Mr.
Shepard and AUIC allege claims of (1) breach of fiduciary duty against the
former MIGI directors for entering into the Merger; (2) breach of contract
against STFC and Mutual with respect to a confidentiality agreement, dated
September 29, 2000, between STFC and AUIC; and (3) tortious interference against
MIGI and one of its former directors with respect to such confidentiality
agreement. On December 3, 2003, the Court granted the request of Mr. Shepard and
AUIC to voluntarily dismiss the claims of breach of fiduciary duty and tortious
interference. Thus, the only remaining claim in this suit is for breach of the
confidentiality agreement against STFC and Mutual. Mr. Shepard and AUIC are
seeking yet-to-be-disclosed compensatory damages in this suit. As of March 5,
2004, the suit continues in its discovery phase.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
10K-a21
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS
STOCK TRADING
Common shares are traded in the Nasdaq National Market System under
the symbol STFC. As of March 5, 2004, there were 902 shareholders of record of
the Company's common shares.
MARKET PRICE RANGE, COMMON STOCK(1)
Initial Public Offering -- June 28, 1991, $2.25(1). The high and low
sale prices for each quarterly period for the past two years as reported by
Nasdaq are:
2003 HIGH LOW DIVIDEND
---- ---- --- --------
First Quarter $17.75 $14.96 $ 0.035
Second Quarter $24.24 $16.59 $ 0.035
Third Quarter $26.60 $21.45 $ 0.040
Fourth Quarter $26.90 $22.50 $ 0.040
2002
----
First Quarter $17.25 $13.70 $0.0325
Second Quarter $17.02 $14.33 $0.0325
Third Quarter $16.82 $14.50 $0.0350
Fourth Quarter $16.78 $12.67 $0.0350
(1) Adjusted for stock splits.
Additionally, see Liquidity and Capital Resources section of
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included in Item 7 of this Form 10-K Annual Report for a discussion
of regulatory restrictions on the payment of dividends by the Company's
insurance subsidiaries.
ITEM 6. SELECTED FINANCIAL DATA
The Selected Consolidated Financial Data is as follows:
10K-a22
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
- --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31
------------------------------------------------------------------------------------
2003 2002 2001* 2000* 1999* 1998* 1997 1996 1995* 1994
-------- ------- ------- ----- ----- ----- ----- ----- ----- -----
STATEMENT OF INCOME DATA -
GAAP BASIS: (dollars and shares in millions, except per share data)
Earned premiums $ 960.6 896.6 555.2 398.0 392.0 356.2 320.1 304.5 296.4 225.3
Net investment income $ 64.6 59.7 47.4 38.9 34.3 32.5 31.1 29.9 28.5 22.2
Total revenues $1,041.7 967.5 623.3 462.8 440.9 402.1 363.0 345.1 333.5 254.4
Net income $ 63.6 37.0 20.6 47.7 42.8 37.5 41.0 26.4 29.9 15.8
Earned premium growth 7.1% 61.5 39.5 1.5 10.1 11.3 5.1 2.7 31.6 16.4
Return on average invested assets (1) 4.6% 4.9 5.4 5.5 5.4 5.7 6.2 6.4 6.4 6.4
BALANCE SHEET DATA -
GAAP BASIS:
Total investments $1,570.3 1,272.3 1,138.7 750.9 627.3 580.0 526.4 499.3 479.9 350.6
Total assets $1,836.7 1,593.0 1,367.5 898.1 759.9 717.5 664.4 605.4 579.2 487.3
Total notes payable $ 161.2 75.5 45.5 45.5 45.5 -- -- -- -- --
Total stockholders' equity $ 542.3 463.8 400.2 386.1 317.7 340.8 297.3 247.6 225.8 175.9
Common shares outstanding 39.6 39.0 38.9 38.6 38.3 42.0 41.8 41.4 41.2 40.9
Return on average equity (2) 12.6% 8.6 5.2 13.6 13.0 11.8 15.0 11.0 14.9 9.0
Debt to stockholders' equity 29.7% 16.3 11.4 11.8 14.3 -- -- -- -- --
PER COMMON SHARE DATA -
GAAP BASIS:
Basic EPS(3)(4) $ 1.62 0.95 0.53 1.24 1.05 0.89 0.99 0.64 0.73 0.39
Diluted EPS (3)(4) $ 1.58 0.93 0.52 1.21 1.03 0.87 0.97 0.63 0.72 0.39
Cash dividends per share(3) $ 0.15 0.14 0.13 0.12 0.11 0.10 0.09 0.08 0.07 0.06
Book value per share(3) $ 13.71 11.89 10.28 10.01 8.29 8.11 7.11 5.98 5.48 4.29
Common Share Price
High $ 26.90 17.25 17.80 18.00 13.88 20.00 16.25 9.25 8.75 5.00
Low $ 14.96 12.67 12.30 7.13 8.88 11.44 8.13 6.50 4.58 4.17
Close at December 31 $ 23.34 15.50 16.24 17.88 9.13 12.38 16.13 9.00 8.67 4.75
Close price to basic EPS 14.41x 16.32 30.64 14.41 8.70 13.91 16.29 14.06 11.88 12.18
Close price to book 1.70x 1.30 1.58 1.79 1.10 1.53 2.27 1.51 1.58 1.11
GAAP RATIOS: (5)
Loss and LAE ratio 67.8 72.9 76.9 68.4 67.5 68.0 65.1 72.3 68.3 74.9
Expense ratio 30.4 29.5 30.1 30.0 28.5 29.3 29.5 28.2 29.5 28.4
Combined ratio 98.2 102.4 107.0 98.4 96.0 97.3 94.6 100.5 97.8 103.3
STATUTORY RATIOS: (5)
Loss and LAE ratio 67.9 73.1 77.4 68.5 67.4 68.4 65.2 72.7 68.6 74.5
Expense ratio 30.7 29.2 27.8 27.0 29.5 29.4 28.9 27.3 31.0 28.2
Combined ratio 98.6 102.3 105.2 95.5 96.9 97.8 94.1 100.0 99.6 102.7
Industry combined ratio(6) 101.1 107.4 115.9 110.4 108.1 106.0 101.6 105.8 106.4 108.4
Net premiums written to surplus(7) 1.9x 2.6 1.8 1.3 1.5 1.6 1.7 1.9 2.1 1.8
(1) Invested assets include investments and cash equivalents.
(2) Net income less preferred share dividends, if any, divided by average
common stockholders' equity.
(3) Earnings per share (EPS) adjusted for 1998 2-for-1 and 1996 3-for-2 common
stock split effected in the form of a stock dividend.
(4) The earnings per share amounts prior to 1998 have been restated as required
to comply with SFAS No. 128.
(5) GAAP ratios are computed using earned premiums for both the loss and LAE
ratio and the expense ratio, and include the effect of eliminations in
consolidation. The statutory expense ratio is computed using net written
premiums. The Company uses the statutory combined ratio to compare its
results to the industry statutory combined ratio as there is no industry
GAAP combined ratio available.
(6) The industry combined ratios are from A.M. Best. The 2003 industry combined
ratio is preliminary.
(7) The Company uses the statutory net premiums written to surplus ratio as
there is no comparable GAAP measure. This ratio, also called the leverage
ratio, measures the Company's statutory surplus available to absorb losses.
* Reflects change in Pooling Arrangement, effective October 1, 2001, January
1, 2000, 1999, 1998 and 1995.
SCFD-1
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
- --------------------------------------------------------------------------------
OVERVIEW
State Auto Financial Corporation ("State Auto Financial" or "STFC")
and its wholly owned subsidiaries are collectively referred to herein as the
"Company." The Company is a member of the State Auto Group, (defined below),
that writes personal and commercial insurance through approximately 22,400
independent insurance agents associated with approximately 3,400 agencies in 26
states and the District of Columbia. The State Auto Group operates primarily in
the central and eastern United States, excluding New York, New Jersey, and the
New England states. State Auto Financial is a majority-owned subsidiary of State
Automobile Mutual Insurance Company ("Mutual"), an Ohio domiciled property and
casualty insurer and member of the State Auto Group. Mutual is one of only 15
companies in the United States that has received A.M. Best's A+ or higher rating
every year since 1954.
State Auto Financial provides personal and commercial insurance to the
standard insurance market through the following principal wholly owned insurance
subsidiaries, collectively referred to as the "STFC Pooled Companies":
- State Auto Property and Casualty Insurance Company ("State Auto P&C")
- Milbank Insurance Company ("Milbank")
- Farmers Casualty Insurance Company ("Farmers") and
- State Auto Insurance Company of Ohio ("SA Ohio").
The STFC Pooled Companies' principal lines of business include:
- Personal and commercial automobile
- Homeowners
- Commercial multi-peril
- Workers' compensation
- General liability
- Fire
State Auto Financial also provides personal automobile insurance to
the nonstandard insurance market through the following principal wholly owned
insurance subsidiaries:
- State Auto National Insurance Company ("SA National") and
- Mid-Plains Insurance Company ("Mid-Plains").
The companies below are collectively referred to as the "Affiliates."
Collectively, the Company and the Affiliates make up the "State Auto Group."
Mutual and its wholly owned subsidiaries:
- State Auto Insurance Company of Wisconsin ("SA Wisconsin"),
- State Auto Florida Insurance Company ("SA Florida")
- Meridian Insurance Group, Inc. ("MIGI") and its wholly owned
subsidiaries:
- Meridian Security Insurance Company ("Meridian
Security")
- Meridian Citizens Security Insurance Company ("Meridian
Citizens")
- Through an affiliation agreement with MIGI:
- Meridian Citizens Mutual Insurance Company
("Meridian Citizens Mutual").
Meridian Security, Meridian Citizens and Meridian Citizens Mutual are
collectively referred to herein as the "Meridian Insurers."
The STFC Pooled Companies participate in a quota share reinsurance
pooling arrangement (the "Pooling Arrangement") with Mutual, SA Wisconsin and SA
Florida (collectively the "Mutual Pooled Companies"). The Pooling Arrangement
provides that the STFC Pooled Companies and the Mutual Pooled Companies cede to
Mutual all of their insurance business and assume from Mutual an amount equal to
their respective participation percentages as outlined in the Pooling
Arrangement.
MD&A 1
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
The following table sets forth a chronology of the participant and
participant percentage changes that have occurred in the Pooling Arrangement
since January 1, 2001:
Pooled Companies
----------------------------------------------------------------------------------
STFC Pooled Companies Mutual Pooled Companies
------------------------------------------- ------------------------------------
State SA Sub SA SA Sub
Year * Auto P&C Milbank Farmers Ohio Total Mutual Wisconsin Florida Total
------ -------- ------- ------- ---- ----- ------ --------- ------- -----
1/1/2001-
9/30/2001 39 10 3 1 53 46 1 N/A 47
10/1/2001-2002 59 17 3 1 80 19 1 N/A 20
1/1/2003-2003 59 17 3 1 80 18.3 1 0.7 20
* Time period is for the year ended December 31, unless otherwise noted.
- ----------------
On January 1, 2003, the Pooling Arrangement was amended to add SA
Florida as a participant, but the Company's aggregate pooling participation
percentage remained at 80%. Since SA Florida did not commence insurance
operations until after January 1, 2003, there was no impact on the Company's
books at January 1, 2003 relating to the foregoing Pooling Arrangement
amendment.
State Auto P&C provides employees to the Company and the Affiliates.
This is contractually provided for under the following management and/or cost
sharing agreements: 1) the "2000 Management Agreement" effective January 1,
2000, to which State Auto P&C, Mutual, SA National, Milbank, and SA Ohio are
parties. After October 1, 2001, the 2000 Management Agreement became a pure cost
sharing agreement, but prior thereto, this agreement provided for a management
fee based on surplus which was paid by each managed company to State Auto P&C ;
2) the "Midwest Management Agreement" effective January 1, 2000 to which State
Auto P&C, Mutual and SA Wisconsin are parties. This agreement provides for a
management fee based on a percentage of direct written premiums collected by the
Company for the services State Auto P&C provides; 3) the "MIGI Management
Agreement," effective July 1, 2002, to which State Auto P&C, Meridian Security,
Meridian Citizens, and Meridian Citizens Mutual are parties. This agreement
provides for a management fee equal to a percentage of the allocable employee
expenses attributable to the operations of these companies paid to the Company
for the services State Auto P&C provides. Each of the foregoing management or
cost sharing agreements also apportions among the parties the actual costs of
the services provided. Effective January 1, 2002, all employees of MIGI 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 State
Auto P&C.
Wholly owned non-insurance subsidiaries (direct and indirect) of State
Auto Financial include:
- Stateco Financial Services, Inc. ("Stateco")
- Strategic Insurance Software, Inc. ("S.I.S.")
- 518 Property Management and Leasing, LLC ("518 PML")
Stateco provides investment management services to the Company and
Affiliates, which comprises the Company's investment management services
segment. S.I.S. develops and sells software for the processing of insurance
transactions, database management systems for insurance agents and electronic
interfacing of information between insurance companies and agents. S.I.S. sells
its services and products to the Affiliates and their agents, and S.I.S. also
markets similar services and products to nonaffiliated insurers and their
agencies. 518 PML is engaged in the business of owning and leasing real and
personal property to the Affiliates. The members of 518 PML are State Auto P&C
and Stateco. The results of operations of S.I.S. and 518 PML are not material to
the total operations of the Company.
SIGNIFICANT TRANSACTIONS SUMMARY
The following is a summary of significant transactions that occurred
during 2001 through 2003 that will assist in the discussion of the Company's
current period financial results:
Effective June 1, 2001, Mutual merged with Meridian Mutual Insurance
Company ("Meridian Mutual"), with Mutual continuing as the surviving
corporation, and acquired MIGI. Effective July 1, 2001, the insurance business
of the former
MD&A 2
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
Meridian Mutual became part of the Pooling Arrangement and the STFC Pooled
Companies assumed 53% of the Meridian Mutual business on this same date.
Concurrent with this transaction, the STFC Pooled Companies received cash of
$6.4 million and fixed maturities totaling $109.7 million, which related to the
additional net insurance liabilities assumed by the STFC Pooled Companies on
July 1, 2001. The business of the former Meridian Mutual includes both standard
and nonstandard personal lines and standard commercial lines. The principal
lines of business include standard personal and commercial automobile,
nonstandard personal automobile, homeowners, commercial multi-peril, workers'
compensation, general liability and fire insurance.
As the former Meridian Mutual standard and nonstandard business was
written and processed through the Meridian underwriting and claims system
platform, management monitored this business as a separate segment from the
State Auto standard and nonstandard business. Monitoring of these segments
separately was necessary in order to facilitate the integration of the business
as these new policies and renewals were converted to the State Auto systems
platform through which State Auto contract forms, pricing, underwriting, and
claims philosophies were fully implemented. With the addition of the former
Meridian Mutual business to the Pooling Arrangement in 2001, the Company renamed
the two insurance segments that existed prior to 2001 to be the "State Auto
standard segment" and the "State Auto nonstandard segment" and the former
Meridian Mutual business to be the "Meridian standard segment" and the "Meridian
nonstandard segment." Due to the integration efforts by management, along with
the Meridian nonstandard segment no longer meeting the quantitative thresholds
for segment reporting, beginning with the first quarter of 2003, this segment's
business was included in the State Auto nonstandard segment. The 2002 and 2001
disclosures have been revised to reflect this change. Likewise, the Meridian
standard business, beginning with the first quarter of 2004, will be included in
the State Auto standard segment.
Effective October 1, 2001, the 2000 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 this income, substantially all of State Auto P&C's management services income
was eliminated at that time. Consequently, beginning with the first quarter
2002, the "management and operations services" segment is included in the "all
other" category for segment reporting, as the results of this segment no longer
meet the quantitative thresholds for separate presentation as a reportable
segment. See "Reportable Segments" included herein and footnote 15 regarding the
Company's operating segments in the consolidated financial statements of the
Company.
The Pooling Arrangement was amended, effective October 1, 2001, such
that the STFC Pooled Companies' aggregate participation was increased from 53%
to 80%. In conjunction with this change in pool participation, the STFC Pooled
Companies 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 STFC Pooled Companies on October 1, 2001.
For the period October 1, 2001 through December 31, 2003, Mutual
entered into a stop loss reinsurance arrangement (the "Stop Loss") with the STFC
Pooled Companies. Under the Stop Loss, Mutual 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") was between 70.75% and
80.00% (after the application of all available reinsurance), Mutual reinsured
the STFC Pooled Companies 27% of the Pooling Arrangement's losses in excess of a
Pool loss and LAE ratio of 70.75% up to 80.00%. The STFC Pooled Companies were
responsible for their share of the Pooling Arrangement's losses over the 80.00%
threshold. Also, Mutual had the right to participate in the profits of the
Pooling Arrangement. Mutual assumed 27% of the Pooling Arrangement's
underwriting profits attributable to Pool loss and LAE ratios less than 69.25%,
but more than 59.99%. The Stop Loss arrangement expired at December 31, 2003.
On May 22, 2003, STFC Capital Trust I, State Auto Financial's Delaware
business trust subsidiary ("Capital Trust"), issued $15.0 million liquidation
amount of its capital securities to a third party. In connection with the
Capital Trust's issuance of the capital securities and the related purchase by
State Auto Financial of all of the Capital Trust's common securities
(liquidation amount of $464,000), State Auto Financial issued to the Capital
Trust $15.5 million aggregate principal amount of Floating Rate Junior
Subordinated Debt Securities due 2033. On November 13, 2003 State Auto Financial
issued $100.0 million unsecured 6.25% senior notes. State Auto Financial used
the proceeds from these debt instruments to contribute additional paid in
capital to its insurance subsidiaries as follows: $39.0 million to State Auto
P&C, $30.0 million to SA National and $15.0 million to Milbank. Milbank used the
$15.0 million additional paid in capital contribution to repay its $15.0 million
surplus note with Meridian Security. State Auto Financial also used these
proceeds to repay $15.0 million of its bank debt and invested the remaining
amount in fixed maturity and equity securities.
MD&A 3
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
CRITICAL ACCOUNTING POLICIES
The Company's significant accounting policies are more fully described
in note 1 to the Company's consolidated financial statements. In preparing the
consolidated financial statements, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities as of the
date of the balance sheet, revenues and expenses for the period then ended and
the financial entries in the accompanying notes to the financial statements.
Such estimates and assumptions could change in the future, as more information
becomes known which could impact the amounts reported and disclosed therein.
Losses and loss expenses payable are management's best estimates at a
given point in time of what the Company expects to pay claimants, based on known
facts, circumstances and historical trends. Reserves for reported losses are
established on either a case-by-case or formula basis depending on the type and
circumstances of the loss. The case-by-case reserve amounts are determined based
on the Company's reserving practices, which take into account the type of risk,
the circumstances surrounding each claim and policy provisions relating to types
of loss. The formula reserves are based on historical data for similar claims
with provision for trend changes caused by inflation. Loss and loss expense
reserves for incurred claims that have not yet been reported are estimated based
on many variables including historical and statistical information, inflation,
legal developments, storm loss estimates, and economic conditions. Case and
formula basis loss reserves are reviewed on a regular basis and as new data
becomes available, estimates are updated resulting in adjustments to loss
reserves. Generally, reported losses initially reserved on a formula basis and
not settled after six months, are case reserved at that time. Although
management uses many resources to calculate reserves, there is no method for
determining the exact ultimate liability.
Acquisition costs, consisting of commissions, premium taxes, and
certain underwriting expenses relating to the production of property and
casualty business, are deferred and amortized ratably over the contract period.
The method followed for computing the acquisition costs limits the amount of
such deferred costs to their estimated realizable value. In determining
estimated realizable value, the computation gives effect to the premium to be
earned, losses and loss expenses to be incurred, and certain other costs
expected to be incurred as premium is earned. These amounts are based on
estimates, and accordingly, the actual realizable value may vary from the
estimated realizable value.
Pension and postretirement benefit obligations are long term in nature
and require significant management judgment in estimating the factors used to
determine these amounts. Management, along with its defined benefit consulting
actuary, reviews these factors, including the discount rate and expected long
term rate of return on plan assets among other factors. Because these
obligations are based upon significant management estimates which could change
given available information, the ultimate benefit obligation could be different
than the amount estimated.
Fixed maturity and equity security investments are classified as
available for sale and carried at fair value. The net unrealized holding gains
or losses, net of applicable deferred taxes, are shown as a separate component
of stockholders' equity as "accumulated other comprehensive income," and as such
are not included in the determination of net income. Investment income is
recognized when earned, and capital gains and losses are recognized when
investments are sold.
The Company regularly monitors its investment portfolio for declines
in value that are other than temporary, an assessment that requires significant
management judgment. Among the factors management considers are the nature of
the investment, severity and length of decline in fair value, events impacting
the issuer, and overall market conditions. When a security in the Company's
investment portfolio has been determined to have a decline in fair value that is
other than temporary, the Company adjusts the cost basis of the security to fair
value. This results in a charge to earnings as a realized loss, which is not
changed for subsequent recoveries in fair value. Future increases or decreases
in fair value, if not other than temporary, are included in other comprehensive
income.
As part of the Company's management of its exposure to fluctuations in
interest rates, the Company entered into interest rate swap agreements in
connection with the issuance of its $100.0 million 6.25% senior notes. The
interest rate swap agreements are the only derivative contracts to which the
Company is party and are accounted for in accordance with Statement of Financial
Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging
Activities, as amended. This Statement requires all derivatives to be recorded
at fair value on the consolidated balance sheet.
MD&A 4
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
At the time a derivative contract is entered into, the Company
formally documents and designates the derivative as either a hedge of the fair
value of a recognized asset or liability (fair value hedge) or a hedge of a
forecasted transaction or the variability of cash flows to be received or paid
related to a recognized asset or liability (cash flow hedge). The Company does
not have any derivative contracts hedging foreign currencies or derivative
contracts held for speculative purposes. The Company formally assesses, both at
the hedge's inception and on an ongoing basis, whether the derivatives used for
hedging transactions are highly effective in offsetting changes in fair values
or cash flows of hedged items. When it is determined that a derivative is not
highly effective as a hedge or that it has ceased to be a highly effective
hedge, the Company discontinues hedge accounting prospectively.
Changes in fair value of derivatives designated as cash flow hedges,
to the extent effective, are recorded in net unrealized gains/losses on
derivatives, a separate component of accumulated other comprehensive income.
Amounts are reclassified to earnings from accumulated other comprehensive income
when the underlying hedged item impacts earnings. Changes in fair value of
derivatives designated as fair value hedges are recorded currently in earnings
which are offset to the extent the derivative was affected by changes in fair
value of the hedged item.
See a discussion of other factors that may have an impact on
management's best estimates at "Impact of Significant External Factors" included
herein.
RESULTS OF OPERATIONS
SUMMARY
The following table summarizes for the years ended December 31, 2003,
2002 and 2001 certain key performance indicators used to manage the operations
of the Company:
December 31
------------------------------
(dollars in thousands) 2003 2002 2001
GAAP Basis: ---------- ------- -------
- -----------
Total revenue $1,041,696 967,479 623,272
Net income $ 63,622 36,995 20,615
Stockholders' equity $ 542,291 463,769 400,193
Loss and LAE ratio * 67.8 72.9 76.9
Expense ratio * 30.4 29.5 30.1
Combined ratio 98.2 102.4 107.0
Catastrophe loss and LAE points* 6.8 5.6 4.4
Premium earned growth 7.1% 61.5 39.5
Investment yield 4.6% 4.9 5.4
Statutory Basis:
- ----------------
Net premiums written to surplus** 1.9x 2.6 1.8
* defined below
** The Company uses the statutory net premiums written to surplus ratio
because there is no comparable GAAP measure. This ratio, also called the
leverage ratio, measures the Company's statutory surplus available to
absorb losses.
- -----------------------
During 2003, the Company attained record level net income while also
incurring record level catastrophe losses. The combined ratio improvements are
the direct result of management's obtaining adequate cost based rates across all
lines of business, re-underwriting the former Meridian Mutual business applying
State Auto underwriting guidelines along with terminating unprofitable Meridian
programs. Management of the Company continues to focus on growing premiums
without compromising profitability. The Company's investment yield has declined
consistent with the decrease in long term interest rates. The Company invests
for yield while maintaining a conservative approach for principal preservation.
During 2003, the Company debt issuance, net of debt repayments, was $85.5
million. The net proceeds of debt were used by State Auto Financial to
contribute additional paid in capital to certain of its insurance subsidiaries
to strengthen the statutory surplus
MD&A 5
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
position for support of continued premium growth and for general corporate
purposes. See below for additional discussion of the Company's operations.
2003 COMPARED TO 2002
Net income before federal income taxes for the Company increased $45.5
million (120.0%) to $83.3 million in 2003 from 2002. The most significant
factors contributing to this increase were an improvement in the Company's loss
experience from 2002 along with growth in earned premium. The Company's GAAP
loss and LAE ratio (defined below) reflected a 5.1 point improvement in 2003
from 2002, despite the largest catastrophe loss event in Company history
occurring in May 2003. While all insurance segments reflected an improvement in
underwriting results from 2002, the most significant improvement was within the
Meridian standard segment.
Consolidated earned premiums increased $64.0 million (7.1%) to $960.6
million in 2003 from 2002. This increase was primarily the result of premium
rate increases across all lines of business (see earned premium table below).
The State Auto standard segment contributed a 14.0% increase to consolidated
earned premiums in 2003 from 2002, while the State Auto non-standard segment
contributed a 1.0% increase to consolidated earned premiums in the same period.
Contributing also to the State Auto standard segment's increase was the
migration of the Meridian standard segment's policies to the State Auto systems
platform. These increases in earned premiums were partly offset by two factors:
declines in the Meridian standard segment and an increase in premiums ceded to
Mutual under the Stop Loss. The Meridian standard segment declined 6.7 points in
2003 from 2002. Contributing to this segment's decrease are the following:
re-underwriting the policies migrating on renewal to the State Auto systems
platform, as well as the non-renewal of policies due to significant rate
increases and underwriting action taken that management believed were necessary
to improve the underwriting performance of the Meridian book of business. The
integration also includes the migration of Indiana business to affiliate
companies outside the Pooled Companies. During the years 2003 and 2002, the STFC
Pooled Companies ceded a total of $12.8 million and $1.4 million, respectively,
in earned premiums to Mutual in accordance with the Stop Loss arrangement. The
effect of the increased premiums ceded reduced consolidated earned premium by
1.2% in 2003 from 2002 (premiums ceded were 1.4% and 0.2% of consolidated earned
premium for the years 2003 and 2002, respectively). The Stop Loss arrangement
ended on December 31, 2003 and was not renewed. See the Stop Loss discussion
below regarding loss and loss adjustment expense cession.
The following table summarizes the consolidated earned premiums by
segment and by line of business for the years ended December 31, 2003 and 2002:
December 31, 2003 December 31, 2002
---------------------------------------------- --------------------------------------------
State State
(dollars in thousands) Auto (1) Meridian (1) Total % of Total Auto(1) Meridian(1) Total % of Total
-------- ------------ ----- ---------- ------- ----------- ----- ----------
Standard
Auto - personal $337,548 28,374 365,922 38 281,373 56,908 338,281 38
Auto - commercial 84,541 15,130 99,671 10 74,764 22,304 97,068 11
Homeowners 134,001 14,593 148,594 16 112,351 21,159 133,510 15
Commercial multi-peril 60,819 18,405 79,224 8 50,306 25,942 76,248 8
Workers' compensation 24,141 8,458 32,599 3 23,236 16,081 39,317 4
Fire and allied lines 65,850 806 66,656 7 57,310 1,095 58,405 7
Other & products liability 54,882 1,326 56,208 6 49,233 1,834 51,067 6
Miscellaneous personal
& commercial 26,571 2,856 29,427 3 24,602 4,542 29,144 3
Total Standard 788,353 89,948 878,301 91 673,175 149,865 823,040 92
Nonstandard Auto (2) $ 82,267 -- 82,267 9 73,555 -- 73,555 8
------- --- ------- ---
Grand Total -- -- 960,568 100 -- -- 896,595 100
======= === ======= ===
(1) State Auto standard segment and Meridian standard segment, respectively
(2) State Auto nonstandard segment
- ------------------------------
MD&A 6
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
As reflected in the table above, earned premiums increased from year
to year across almost all lines of business, with the exception of workers'
compensation. Overall the composition of the Company's book of business did not
change significantly from year to year, with the standard auto - personal line
continuing to be the Company's most significant line of business.
In the past 18-24 months, the Company took necessary and in some cases
significant rate increases, particularly within the Meridian book, in almost all
lines of business. The Company expects to be able to implement smaller rate
increases in 2004 than it had implemented during 2001 and 2003. This is expected
to affect earned premium growth in the years following the implementation of
these increases. In fact, within the last year, the industry has been
experiencing a leveling of rate increases and in some cases certain lines have
experienced modest rate decreases. Management continues to emphasize that it
will not compromise profitability for top line growth and will continue to focus
on maintaining its underwriting consistency through all industry cycles.
Net investment income increased $4.9 million (8.3%) to $64.6 million
in 2003 from 2002. This increase was the result of an increase in invested
assets generated by cash flow provided from operations and financing, partly
offset by a decline in the investment yield. Total cost of invested assets at
December 31, 2003 and 2002 was $1,529.7 million and $1,302.0 million,
respectively. Invested assets are comprised of total investments and cash
equivalents. Reflecting a decline in the interest rate environment, the
annualized investment yields based on average invested assets at cost decreased
to 4.6% in 2003 from 4.9% in 2002. The Company manages its investment portfolio
to maximize after tax profits. With the Company's improving loss experience
throughout 2003, management began allocating a higher proportion of new monies
to tax exempt securities in the fourth quarter of 2003. This reallocation of new
monies is expected to result in lower pre-tax investment yields but higher after
tax investment income than if the Company continued with the portfolio
allocation of 2003. See further discussion regarding investments at the
"Liquidity and Capital Resources," "Investments" and "Market Risk" sections,
included herein.
Consolidated losses and loss adjustment expenses, as a percentage of
earned premiums (the "GAAP loss and LAE ratio"), were 67.8% and 72.9% for the
years 2003 and 2002, respectively. See the Stop Loss discussion above regarding
earned premiums cessions. For the years 2003 and 2002, the STFC Pooled Companies
ceded a total of $5.6 million and $8.8 million, respectively, in losses and loss
adjustment expenses to Mutual in accordance with the Stop Loss arrangement. The
net effect of the earned premium and losses and loss adjustment expenses
cessions under the Stop Loss increased the GAAP loss and LAE ratio by 0.3 points
in 2003 and decreased the GAAP loss and LAE ratio by 0.9 points in 2002.
For the years 2003 and 2002, catastrophe claims contributed 6.8 and
5.6 points, respectively, to the consolidated GAAP loss and LAE ratio.
Catastrophe losses discussed herein are as designated by Insurance Services
Office's Property Claim Services ("PCS") unit, a nationally recognized industry
service. PCS defines catastrophes as events resulting in $25.0 million or more
in insured losses industry wide and affecting significant numbers of insureds
and insurers. High winds, tornadoes, hail, lightning and resulting fires caused
damage in 17 of the Company's 26 operating states between May 2 and May 11, 2003
("CAT 88"). Claims resulting from CAT 88 totaled $39.6 million or 4.1 GAAP loss
and LAE points for the year 2003. In terms of dollars, Cat 88 is the largest
catastrophe loss event in State Auto history. The second most costly catastrophe
loss event occurred in the second quarter of 2002, from a widespread series of
storms that included a tornado in the community of La Plata, Maryland ("CAT
61"). Claims resulting from CAT 61 totaled $27.5 million or 3.1 GAAP loss and
LAE points for the year 2002. As discussed below, each of the Company's
insurance operating segments was impacted by these catastrophe losses.
MD&A 7
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
The following table summarizes the consolidated GAAP loss and LAE
ratio by line of business for the years ended December 31, 2003 and 2002,
respectively. The Standard results reflect the combined State Auto and Meridian
standard segments:
(improve)
Consolidated 2003 2002 deteriorate
- ------------ ---- ---- -----------
Standard
Auto - personal 66.6 68.8 (2.2)
Auto - commercial 53.3 66.5 (13.2)
Homeowners 75.0 85.1 (10.1)
Commercial multi-peril 80.6 89.9 (9.3)
Workers' compensation 93.0 83.7 9.3
Fire and allied lines 60.8 58.9 1.9
Other & products liability 67.6 77.7 (10.1)
Miscellaneous personal
& commercial 28.3 35.5 (7.2)
Total Standard 67.1 72.5 (5.4)
Nonstandard Auto 75.6 77.8 (2.2)
Consolidated 67.8 72.9 (5.1)
As noted in the above table, all lines of business contributed to the
5.1 GAAP loss and LAE improvement in 2003 from 2002, except for workers'
compensation and fire and allied lines which combined represent 10% of total
earned premiums in 2003. Company management monitors all lines of business
paying particular attention to auto - personal, homeowners and workers'
compensation due to the significance these lines have on the profitability of
the Company. The auto - personal line continues to be the most significant line
of business and therefore has the greatest influence on net income. The
homeowners line of business is the Company's second largest (see earned premium
table above). The loss experience in this line was adversely affected in the
last two years by the increased severity of storms; however, due to management's
efforts, its GAAP loss and LAE ratio improved by 10.1 points in 2003 from 2002.
Workers' compensation continues to be the Company's most volatile line of
business due to the risks insured. Workers' compensation results have been
volatile both for the Company and the industry and can have a significant
adverse impact on earnings. The Company manages this exposure with conservative
underwriting and rate levels that are based on National Council of Compensation
Insurance loss costs. As a result of management's conservative approach,
workers' compensation represents 3% of total earned premium. Management
continually monitors these lines in an effort to obtain adequate cost based
rates and write the risks that it believes are more likely to produce an
underwriting profit for the Company.
The following table summarizes the State Auto standard segment GAAP
loss and LAE ratio by line of business for the years ended December 31, 2003 and
2002, respectively:
(improve)
State Auto Standard 2003 2002 deteriorate
- ------------------- ----- ---- -----------
Auto - personal 66.2 67.5 (1.3)
Auto - commercial 54.0 63.5 (9.5)
Homeowners 76.5 81.1 (4.6)
Commercial multi-peril 69.7 80.9 (11.2)
Workers' compensation 100.9 84.4 16.5
Fire and allied lines 60.7 58.8 1.9
Other & products liability 64.4 78.8 (14.4)
Miscellaneous personal
& commercial 26.5 30.0 (3.5)
Total State Auto Standard 66.1 69.4 (3.3)
MD&A 8
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
The State Auto standard segment's GAAP loss and LAE ratio improved 3.3
points in 2003 from 2002, despite being impacted by the record level catastrophe
losses described above. For the years 2003 and 2002, catastrophe losses
represent 7.3 and 5.7 points, respectively, of which Cat 88 accounted for 4.4
points of the 2003 total catastrophe points and Cat 61 accounted for 3.1 points
of the 2002 total catastrophe points. Absent the impact of catastrophe losses,
this segment's GAAP loss and LAE ratio improved 4.9 points in 2003 from 2002.
This improvement reflects the Company's continual emphasis on strict
underwriting, which includes taking necessary and appropriate rate increases
across most lines of business.
The State Auto nonstandard segment's GAAP loss and LAE ratio improved
2.2 points in 2003 to 75.6 from 77.8 in 2002 (see the Consolidated GAAP loss and
LAE ratio table above, nonstandard auto line). The 2003 and 2002 catastrophe
losses represent 1.4 points and 0.8 point, respectively, of the foregoing GAAP
loss and LAE ratio. Absent the impact of catastrophe losses, this segment's GAAP
loss and LAE ratio improved 2.8 points in 2003 from 2002. This improvement was
primarily driven by significant underwriting action and rate level improvement
on the former Meridian nonstandard segment private passenger auto book of
business. Management implemented corrective rate increases on the business that
continued to renew on the Meridian systems platform. In addition, all new
nonstandard private passenger auto business produced by the former Meridian
Mutual agents is now written through the SA National system platform utilizing a
more appropriate rating structure as well as credit scoring (as permitted by
local law) and "point-of-sale" underwriting tools. Management continually
monitors this segment's underwriting performance, as it is typically a more
volatile line of business than the standard segment, paying particular attention
to rate adequacy and risk selection in states and agencies with unusually high
premium written growth. Kentucky, this segment's largest state of operation, had
experienced significant written premium growth over the last year, but with
unacceptable underwriting results. The Company has terminated or suspended
eleven fast growing, but extremely unprofitable, nonstandard auto oriented
agencies in Kentucky. While this action adversely affected this segment's
premium growth, it is expected to improve long term underwriting results.
The following table summarizes the Meridian standard segment GAAP loss
and LAE ratio by line of business for the years ended December 31, 2003 and
2002, respectively:
(improve)
Meridian Standard 2003 2002 deteriorate
- ----------------- ----- ----- -----------
Auto - personal 71.9 75.1 (3.2)
Auto - commercial 49.3 76.5 (27.2)
Homeowners 61.2 106.5 (45.3)
Commercial multi-peril 116.6 107.5 9.1
Workers' compensation 70.5 82.7 (12.2)
Fire and allied lines 74.3 60.8 13.5
Other & products liability 199.3 50.0 149.3
Miscellaneous personal
& commercial 44.6 65.4 (20.8)
Total Meridian Standard 76.4 85.9 (9.5)
The Meridian standard segment's GAAP loss and LAE ratio improved 9.5
points in 2003 from 2002, despite also being impacted by the catastrophe losses
described above. For 2003 and 2002, catastrophe losses represent 7.6 and 7.0
points, respectively, of which Cat 88 accounted for 4.5 points and Cat 61 4.0
points of the 2003 and 2002 total catastrophe points, respectively. Absent the
impact of catastrophe losses, this segment's GAAP loss and LAE ratio improved
10.1 points in 2003 from 2002.
During the year 2003 this segment continued to improve from 2002
despite experiencing several large commercial multi-peril and other liability
losses. Note that the "other and products liability" line is approximately 1.5%
of this segment's 2003 book of business - see earned premium table above. These
continued improvements are a direct result of management's efforts that began in
2001 to obtain adequate cost based rates, re-underwrite the business applying
the State Auto underwriting guidelines and terminate unprofitable programs. The
Meridian integration is proceeding according to plan. The business written on
the historic Meridian platform is being systematically renewed on the State Auto
platform. Management is striving to retain the risks that it believes have the
greatest profit potential for the Company. Due to the integration efforts by
management, along with this segment no longer meeting the quantitative
thresholds for separate
MD&A 9
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
segment reporting, beginning with the first quarter of 2004, the Meridian
standard business will be included in the State Auto standard segment.
Acquisition and operating expenses, as a percentage of earned premiums
(the "GAAP expense ratio"), were 30.4% and 29.5% for the years 2003 and 2002,
respectively. One factor contributing to the 0.9 point increase is the Company
cession of earned premium under the Stop Loss, which was $12.8 million and $1.4
million in 2003 and 2002, respectively. These earned premium cessions under the
Stop Loss increased the Company's GAAP expense ratio by 0.4 point and less than
0.1 point for the years 2003 and 2002, respectively. The Stop Loss agreement
terminated December 31, 2003 and was not renewed. Certain significant variable
expenses that are tied directly to the Company's insurance operation's
profitability also contributed to the increased GAAP expense ratio. These are
the Company's profit sharing plans, the Quality Performance Bonus ("QPB") that
covers substantially all employees and the Quality Performance Agreement or
contingent commission agreement ("QPA") which is available to substantially all
the Company's agents. QPA was 1.6 points and 1.2 points within the GAAP expense
ratio in 2003 and 2002, respectively. QPB was 0.8 point and 0.2 point within the
GAAP expense ratio in 2003 and 2002, respectively. Excluding the Stop Loss, QPA
and QPB effects, the GAAP expense ratio would have been 27.6% and 28.0% for the
years 2003 and 2002, respectively. Management reviews the QPB plan and the QPA
annually to determine the appropriateness of each bonus' formula. Any increase
in the expense ratio is difficult to accept, but the fact is, that the increase
seen this year is largely the result of the Company's profitable underwriting
operations, as discussed above. Notwithstanding these directly profit driven
expense increases, expense control has been and remains one of the critical
elements of the Company's success, and the importance of this is regularly
communicated to all employees.
Interest expense increased $1.3 million (55.9%) to $3.6 million in
2003 from 2002. This increase was the result of the additional net $85.5 million
of debt obtained as of December 31, 2003 from December 31, 2002 (see discussion
included in Liquidity and Capital Resources), partly offset by a decline in the
interest rate on the $45.5 million line of credit with Mutual.
Other expense, as a percentage of earned premiums, was 1.2% and 1.1%
for the years 2003 and 2002, respectively. The increase in 2003 other expense is
primarily attributable to the legal and other related costs incurred by the
Company related to the tender offer initiated by Gregory M. Shepard and his
wholly owned company, and other proposals from Mr. Shepard that preceded the
tender offer. See Part I, Item 3. Legal Proceedings included within this Form
10-K.
The effective tax expense rate for the years 2003 and 2002 were 23.8%
and 2.1%, respectively. Improvement in the Company's 2003 underwriting results
along with an increase in net realized gains on investments and the gradual
shift in increasing the fixed maturity portfolio from tax-exempt to taxable
securities from 2002 contributed to the tax expense rate increase. Management
believes the existing level of pre-tax earnings is sufficient to generate future
taxable income to realize the deferred tax assets.
2002 COMPARED TO 2001
Net income for the Company increased by $16.4 million (79.5%) in 2002.
Contributing to this increase was a 4.6 point improvement in the Company's GAAP
combined ratio and, as more fully described above, changes made to the Company's
participation in the Pooling Arrangement in the second half of 2001.
Additionally, net investment income increased due to the Pooling Arrangement
changes in 2001, which was offset by a decrease in the Company's management and
operations service income.
Consolidated earned premiums increased by $341.4 million (61.5%) in
2002. This increase was the result of the addition of the former Meridian Mutual
business to the Pooling Arrangement, effective July 1, 2001, a change in the
Pooled Subsidiaries' aggregate pooling participation percentage from 53% to 80%,
effective October 1, 2001 and total net internal growth of 16.3%. The addition
of the former Meridian Mutual business and the pooling change increased
consolidated earned premiums 45.2%. The internal growth of the State Auto
standard segment's earned premiums increased consolidated earned premiums 15.1%.
This increase was driven by growth in commercial lines of business due to a
combination of rate changes as well as increased policy counts. Personal lines
of business continued to experience sales increases over prior year due to
changes in the marketplace that permitted rate increases, as well as the
expansion of the new personal lines sales specialist position that contributed
to increased policy counts. The internal growth of the State Auto nonstandard
segment earned premiums increased consolidated earned premiums 5.4% due to a
combination of rate changes and increased policy counts.
MD&A 10
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
The internal decline of the Meridian standard and nonstandard segments
decreased consolidated earned premiums 4.2%. This decrease was expected, given
the corrective actions taken by management in both these segments, which actions
included appropriate and necessary rate increases in almost every line of
business. Additionally, one of the more significant actions taken within the
Meridian standard segment was the discontinuance in late 2000 of the Group
Advantage(R) Program which had generated substantial underwriting losses for
Meridian Mutual. The last Group Advantage(R) policy on the books terminated
January 2003. Regarding the Meridian nonstandard segment, in addition to taking
significant corrective rate action, beginning in late 2001, the Company
implemented an integration plan to write all new nonstandard auto business
produced by the former Meridian Mutual agents through the State Auto nonstandard
segment, specifically through National on the National system platform utilizing
a more appropriate rating structure as well as credit scoring (as permitted by
local law) and "point-of-sale" underwriting tools. The order of integration had
been prioritized such that the states with the most need for profit improvement
migrated to National first. All Meridian nonstandard auto new business is now
being written through the State Auto nonstandard segment. The business that
remains within the Meridian nonstandard segment is expected to decrease given
this segment's historically low retention rate as well as the Company's
continuing to take appropriate rate increases. Fourth quarter 2002 earned
premiums for the Meridian nonstandard segment comprised 0.5% of total
consolidated earned premiums versus 1.8% in the same 2001 period. Consequently,
beginning with the first quarter 2003, the Meridian nonstandard auto business
was included in the State Auto nonstandard segment category.
Net investment income increased by $12.3 million (26.0%) in 2002.
Contributing to the increase over the previous year was an increase in invested
assets due to a transfer of $354.6 million in cash and fixed maturity securities
from Mutual to the Pooled Subsidiaries in the second half of 2001. This transfer
was made in conjunction with the changes made to the Pooled Subsidiaries
participation in the Pooling Arrangement, as more fully described above. Total
cost of invested assets at December 31, 2002 and 2001, was $1,303.0 million and
$1,150.3 million, respectively. Reflecting a decline in the interest rate
environment, the investment yields, based on cash equivalents, fixed and equity
securities at cost were 4.9% and 5.4% for the annual periods ending 2002 and
2001, respectively. See further discussion regarding investments at the
"Liquidity and Capital Resources," "Investments" and "Market Risk" sections,
included herein.
Management services income, including investment management fees,
decreased by $12.9 million (83.1%) in 2002. This decrease was attributable to
the termination of the fee element of the 2000 Management Agreement. The service
fee under the 2000 Management Agreement paid by Mutual in 2001 was $12.5
million.
Consolidated losses and loss adjustment expenses, as a percentage of
earned premiums (the "GAAP loss and LAE ratio"), were 72.9% and 76.9% for the
years 2002 and 2001, respectively. Comparison of the overall results of 2002
with those of 2001 was affected by the addition of the former Meridian Mutual
business to the Pooling Arrangement. Since the former Meridian Mutual business
was added to the Pooling Arrangement effective July 1, 2001, it negatively
impacted the loss results of the Company only in the second half of 2001.
However, in 2002 the results of the former Meridian Mutual business were
included in and negatively impacted the results of the Pooling Arrangement for
the entire year. Comparison of the overall results of 2002 with those of 2001 is
also affected by the reserve strengthening that occurred during the second half
of 2001 with respect to the Meridian segments. While the Meridian standard
business continues to produce loss results poorer than the State Auto book of
business (see table of GAAP loss and LAE ratios operating segments below),
management believes there has been improvement in the performance of the
Meridian segments due to the continuing efforts to improve pricing and risk
selection applicable to these segments during 2002.
During the quarters ended September 30, 2002 and June 30, 2002, the
Pooled Companies produced a Pool loss and LAE ratio under the Stop Loss
(described above) that exceeded the 70.75% threshold, thereby recovering from
Mutual $2.4 million and $6.4 million in losses, respectively (total of $8.8
million for the year ended December 31, 2002). In the quarters ended December
31, 2002 and March 31, 2002, the Pooled Companies' Pool loss and LAE ratio was
less than 69.25%, but more than 59.99%, thereby ceding to Mutual, under the Stop
Loss $1.0 million and $0.4 million in earned premiums, respectively (total of
$1.4 million for the year ended December 31, 2002). The cession activity through
the Stop Loss had the effect of lowering the GAAP loss and LAE ratio by 0.9 and
1.1 points in 2002 and 2001, respectively.
The year 2002 was the worst catastrophe year in the history of the
Company on a dollar loss basis and third worst in terms of GAAP loss and LAE
ratio points. During the second quarter of 2002, a series of tornadoes and
hailstorms went through several of the Company's operating states, including an
F4 tornado in La Plata, Maryland. This storm was the largest single catastrophe
event for the Company in 2002, accounting for 3.1 GAAP loss and LAE ratio
points. Overall, catastrophe losses in 2002 were 1.2 GAAP loss and LAE ratio
points higher than in 2001.
MD&A 11
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
For discussion purposes, the following table provides comparative GAAP
loss and LAE ratios for the Company's insurance operating segments for the 2002
and 2001 periods, respectively, except for the Meridian segments for 2001, which
is for the six month period ended December 31, 2001:
GAAP Loss and LAE Ratio 2002 2001
- ----------------------- ---- -----
State Auto standard segment 69.4 65.9
State Auto nonstandard segment 77.8 91.4
Meridian standard segment 85.9 139.3
Total GAAP Loss and LAE Ratio 72.9 76.9
The State Auto standard segment GAAP loss and LAE ratio increased in
2002 to 69.4 from 65.9 in 2001. Catastrophe losses represented 5.7 points of
this segment's loss results for 2002 compared to 4.4 points for 2001. With the
significant increase in new business policy count came an increase in claim
submissions. While general inflation has been relatively modest for the past
several years, price inflation on goods and services for which insurance pays,
such as medical care and repairs to automobiles and buildings, exceeded the rate
of overall inflation and adversely impacted the GAAP loss and LAE ratio. The
Company has reacted to this inflationary trend by filing more aggressive,
cost-based, rate increases. Also contributing to the current year deterioration
in the GAAP loss and LAE ratio were restrictions on the use of credit scoring in
some states where the Company does business. To the extent these limitations
result in higher loss ratios, the actuarial rate indications will increase
resulting in larger rate increases being sought. The Company is also reviewing
its credit scoring models to ensure that the premium rate derived from the model
continues to accurately reflect the loss experience associated with each
particular credit score range.
Representing approximately 42% of this segment's business, personal
automobile has over the last five years yielded loss results better than
industry average, and in fact, has produced combined ratios of less than 100.0%.
While the current year results are expected again to better industry average,
this line of business did experience deterioration in its current year loss
ratio, specifically within the auto liability and no fault lines, which
management believes is due at least in part to increasing rates of inflation
applicable to the health care sector of the U.S. economy and an increased volume
of new business, as noted above. Adverse loss results on workers' compensation,
commercial multi peril and other liability lines of business, which collectively
represents approximately 18.2% of this segment's business, also contributed to
the current year loss result increase. The Company is taking substantial and
necessary rate increases in rate per exposure across these lines of 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
particularly conservative posture on pricing in this line.
The State Auto nonstandard segment, which now includes the former
Meridian nonstandard segment, GAAP loss and LAE ratio improved in 2002 to 77.8
from 91.4 in 2001. This segment was significantly impacted by the former
Meridian nonstandard segment case reserve strengthening that occurred during the
second half of 2001. Also largely contributing to the current year loss results
improvement were the substantial policy rate increases the Company implemented
in 2001 and 2002 in the former Meridian nonstandard segment. This segment
experienced more volatility in 2002, especially in those states experiencing
substantial premium growth due to policy count increases. As described above,
contributing to this growth has been the addition of National's product to
agents who wrote the former Meridian Mutual's nonstandard auto business. While
nonstandard automobile tends to be a more volatile line of business than
standard automobile, management continually monitors this segment's premium rate
adequacy. Management has been paying particular attention to the adequacy of
these rates in these growth states, as well as risks written in certain
agencies, and is reacting accordingly by increasing rates and working with those
agencies regarding risk selection.
The Meridian standard segment GAAP loss and LAE ratio for 2002 was
85.9 compared to 139.3 for the six month period ended December 31, 2001.
Comparison of the overall results of 2002 with those of 2001 is affected by the
reserve strengthening that occurred during the second half of 2001 within this
segment. Catastrophe losses represent approximately 7.0 points of this segment's
loss results for both the 2002 and 2001 periods. While the Meridian standard
business continues to produce loss results worse than the State Auto book of
business, management believes there has been improvement in this segment due to
the necessary and continued efforts that began in 2001, e.g. seeking adequate
cost-based rates, re-underwriting commercial renewals to be certain that risks
written are within the State Auto underwriting guidelines and discontinuing the
Group Advantage(R) Program.
MD&A 12
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
Acquisition and operating expenses, as a percentage of earned premiums
(the "GAAP expense ratio"), were 29.5% and 30.1% for the years 2002 and 2001,
respectively. Management continually focuses its attention on improving its GAAP
expense ratio, which is especially critical during a period of substantial top
line growth.
Interest expense relates to the $45.5 million line of credit agreement
the Company entered into with Mutual in 1999 and the $15.0 million surplus note
agreement entered into with an affiliate on September 30, 2002. See additional
discussion in the "Liquidity and Capital Resources" section included herein.
The 2002 underwriting improvement, coupled with net investment income
being largely comprised of tax-exempt income, produced an effective tax expense
rate in 2002 of 2.1% versus an effective tax benefit of 15% in 2001. For
additional clarification, see the reconciliation between actual federal income
taxes and the amount computed at the statutory rate as detailed in footnote 8 in
the notes to the Company's consolidated financial statements.
REPORTABLE SEGMENTS
At December 31, 2003, the Company's reportable segments are: State
Auto standard insurance, State Auto nonstandard insurance, Meridian standard
insurance, and investment management services. Due to the integration efforts by
management, along with this segment no longer meeting the quantitative
thresholds for segment reporting within the Meridian nonstandard business,
beginning with the first quarter of 2003, the Meridian nonstandard business was
included in the State Auto nonstandard segment. The 2002 and 2001 disclosures
have been revised to reflect this change. Likewise, the Meridian standard
business, beginning with the first quarter of 2004, will be included in the
State Auto standard segment. The profits (losses) of these segments are
monitored by management on an unconsolidated basis, as reflected in footnote 15,
Reportable Segments, in the Company's consolidated financial statements and
therefore do not reflect adjustments for transactions with other segments or
realized gains or losses on sales of investments.
The following table reflects segment profit (loss) for the years ended
2003, 2002, and 2001, respectively:
(in thousands) 2003 2002 2001
------- ------- -------
State Auto standard insurance $57,323 37,537 45,664
State Auto nonstandard insurance 6,632 4,075 (4,555)
Meridian standard insurance 3,489 (15,376) (44,397)
Investment management services 7,424 6,402 5,965
All other 2,224 1,916 16,326
------- ------- -------
Total segment profit $77,092 34,554 19,003
======= ======= =======
The increase in the Company's 2003 profits within the State Auto
standard and nonstandard insurance segments is primarily due to an improvement
in these segments' current year loss experience as discussed at "2003 Compared
to 2002" in "Results of Operations." The improved loss experience in 2003 in
these segments reflects the Company's continual emphasis on strict underwriting,
which includes taking necessary and appropriate rate increases. The decrease in
the Company's 2002 profit within the State Auto standard insurance segment is
primarily due to an increase in this segment's loss experience as discussed at
"2002 Compared to 2001" in "Results of Operations." For the State Auto
nonstandard insurance segment in 2002, increased earned premium growth, as well
as an increase in the net investment income, despite deterioration in its loss
results, contributed positively to this segment's profit. As discussed above,
management continually monitors these segments' premium rate adequacy and seeks
adequate cost-based rates.
The Company's 2003 profit within the Meridian standard insurance
segment is due to an improvement in this segment's current year loss experience
as discussed at "2003 Compared to 2002" in "Results of Operations." The improved
loss experience in 2003 in this segment is evidence of the Company's successful
integration efforts that began in 2001 to obtain adequate cost based rates,
re-underwrite the business within State Auto underwriting guidelines and
terminate unprofitable programs. Comparison of the Meridian standard segment
profit (loss) results of 2002 with that of 2001 was affected by the reserve
strengthening that occurred during the second half of 2001.
The increase in segment profit of the investment management segment in
2003, 2002 and 2001 was the result of this segment providing its services to the
Meridian Insurers beginning June 1, 2001 and the continued investment portfolio
fair
MD&A 13
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
value growth of the State Auto Group. This segment's revenue is based on the
average fair value of the portfolio of the companies managed. During these
years, the investment management segment profit increased as managed invested
assets increased.
The increase in segment profit of the 2003 all other category is due
to an increase in the State Auto P&C management fee earned from management
agreements that are described at "Overview." The management fee increased
because of the increase in direct written premiums collected under the Midwest
Management Agreement and the increase of allocable employee expenses under the
MIGI Management Agreement. Beginning with the first quarter of 2002, the former
management and operations services segment is now included in the all other
category for segment reporting as the results of this segment no longer meet the
quantitative thresholds for separate presentation as a reportable segment. All
other segment profits, including management and operations services, decreased
in 2002 and 2001. The termination of the service fee under the 2000 Management
Agreement was due to the resolution of the disagreement between the Company and
Ohio Department of Insurance regarding the service fee paid by Mutual to the
Company in 2001. See discussion at "significant transactions" and "2002 Compared
to 2001" in "Results of Operations." For additional information on the Company's
reportable segments, see footnote 15 on "Reportable Segments" in the Company's
consolidated financial statements.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity refers to the ability of the Company to generate adequate
amounts of cash to meet its needs for both long and short-term cash obligations
as they come due. The Company's significant sources of cash are premiums,
investment income, sales of investments and the maturity of fixed maturity
investments. The Company continually monitors its investment and reinsurance
programs to ensure they are appropriately structured to enable the insurance
subsidiaries to meet anticipated short and long-term cash requirements without
the need to sell investments to meet fluctuations in claim payments.
Overall net cash provided by operating activities was $138.0 million
in 2003, $126.6 million in 2002 and $63.5 million in 2001. The increase in 2003
is attributable to improved underwriting cash flow, partly offset by an increase
in cash paid on estimated federal income taxes and a cash contribution to the
Companies defined benefit pension plan (the "Plan") (see discussion below). The
increase in 2002 is largely attributable to the prior year changes to the Pooled
Subsidiaries participation in the Pooling Arrangement. In the second half of
2001, the Pooled Subsidiaries received cash of $8.6 million and fixed maturities
of $346 million from Mutual as a result of adding the Meridian Mutual business
to the Pooling Arrangement and changing the pooling participation percentage of
the Pooled Subsidiaries from 53% to 80%. Over the last three years, operating
cash flows have been sufficient to meet the operating needs of the Company while
providing increased opportunities for investment.
During 2003, as permitted by IRS Regulations, the Company contributed
$4.6 million in cash to the Company's Plan on behalf of its employees. This is
the first year since 1997 that management has been permitted under applicable
rules to make a tax deductible contribution to the Plan. During the years when
the Company was permitted to make plan contributions, it was the practice of
management to contribute the maximum possible as permitted under IRS
Regulations. This historic practice faired well for the Company in the past
several years, as many companies with defined benefit plans experienced
additional minimum liability recognition. In 2004 it is expected the Company
will be impacted for the first time in years by a net periodic cost within the
Plan of approximately $1.5 million. While management acknowledges that the net
periodic benefit the Company recognized in recent years has not been at the
levels it experienced in the late 1990s through 2002, it has not impacted the
profitability of the Company. As the Company continues to be permitted to make
contributions, it is management's intent to make the maximum contribution to the
Plan for the benefit of its employees. For 2004, it is estimated that the
maximum Plan contribution will again be approximately $4.0 million.
Total net cash used in investing activities was $280.2 million during
2003, $85.6 million during 2002 and $55.3 million in 2001. The 2003 cash used in
investing activities reflects the increase in cash flow provided by improved
operating activities and the increase in cash flow provided by financing
activities discussed below. The 2002 and 2001 years' investing activity was
reflective of the cash flow generated from operations discussed above. During
2002 the Company experienced fluctuating activity within its fixed maturity
portfolio. Call activity in 2002 continued in response to the declines in the
interest rate environment. While the Company continued to focus its attention on
improving the loss results of the Meridian book of business, which has put
upward pressure on the Company's overall loss experience in recent years, the
Company increased
MD&A 14
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
its sale activity of its fixed maturities in an effort to increase its taxable
position in its investment portfolio. Monies generated from the call and sale
activity have been reinvested at lower yielding rates.
Overall net cash provided by financing activities was $86.2 million in
2003, $25.0 million in 2002 and $0.5 million in 2001. Net cash provided by
financing activities increased during 2003 and 2002 primarily due to net
proceeds from issuance of debt (see discussion below), partly offset by payments
of dividends and to re-purchase Company common shares.
Mutual, whose ownership in State Auto Financial is approximately 66%,
has waived its right to receipt of the dividends declared by State Auto
Financial since 1994 in an effort to enhance the statutory surplus of the
insurance subsidiaries of State Auto Financial for use in support of
underwriting operations which in turn is expected to increase the statutory
surplus of Mutual. In years before 2002, prior to the declaration of each
dividend by State Auto Financial, Mutual's directors reviewed the facts and
circumstances then present in deciding whether to waive such dividend. Beginning
in 2002, the issue of the waiver of Mutual's dividend on its shares of State
Auto Financial was referred to the standing Independent Committee of the Board
of Directors of Mutual (the "Standing Independent Committee"). It met and
determined that it would review dividend waiver decisions on an annual basis.
For the years 2002 and 2003, the Standing Independent Committee decided to waive
Mutual's dividends that might be declared by the Board of Directors of State
Auto Financial in order to take better advantage of the investment opportunity
State Auto Financial represents for Mutual. At March 8, 2004, the Standing
Independent Committee had not made a determination regarding whether or not it
will waive Mutual's right to receipt of State Auto Financial dividends for 2004.
The timing for this determination has been moved from March to August to
coincide with the timing of the historical dividend increase date. At a board
meeting on March 5, 2004, the Board of Directors of Mutual extended the dividend
waiver decision made by the Standing Independent Committee in March of 2003 to
apply to dividends that may be declared in March and May of 2004. The Standing
Independent Committee intends to complete its analysis of the dividend waiver
for the period of August 2004 to August 2005 prior to the board meeting in
August of 2004.
Impacting cash provided by financing activities during 2003, 2002 and
2001 was State Auto Financial's Board of Directors' approving plans to
repurchase shares of its common stock from the public. In March 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
December 31, 2003. During 2003 and 2002, the Company repurchased 45,000 and
393,000 shares from the public for a total of $729,000 and $6.3 million,
respectively. Impacting cash used in financing activities during 2001 was a 2000
stock repurchase plan approved to purchase up to 1.0 million of State Auto
Financial's common stock from the public ending December 31, 2001 (the "2000
Repurchase Plan"). In 2001, the Company repurchased approximately 25,000 shares
from the public for a total of $388,000.
In conjunction with a 1999 Repurchase Plan, State Auto Financial
entered into a line of credit agreement with Mutual for $45.5 million. The
interest rate is adjustable annually on each January 1 to reflect adjustments in
the then current prime lending rate less 1.75 points, as well as State Auto
Financial's current financial position. The interest rate was 2.5%, 3.0% and
7.75% for 2003, 2002 and 2001, respectively. Beginning January 1, 2004, the
interest rate on this credit agreement is 2.25%. Principal is due upon demand,
with final payment to be received on or prior to December 31, 2005.
On May 22, 2003, STFC Capital Trust I, State Auto Financial's Delaware
business trust subsidiary, issued $15.0 million liquidation amount of its
capital securities to a third party. In connection with the Capital Trust's
issuance of the capital securities and the related purchase by State Auto
Financial of all of the Capital Trust's common securities (liquidation amount of
$464,000) (the Capital Trust's capital and common securities are hereafter
referred to as the "Trust Securities"), State Auto Financial issued to the
Capital Trust $15.5 million aggregate principal amount of Floating Rate Junior
Subordinated Debt Securities due 2033 (the "Subordinated Debentures"). The sole
assets of the Capital Trust are the Subordinated Debentures and any interest
accrued thereon. Interest on the Trust Securities is payable quarterly at a rate
equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly (5.34% for
the period August 24, 2003 through November 23, 2003, adjusted to 4.63% for the
period November 24, 2003 through February 23, 2004). Prior to May 2008, the
interest rate may not exceed 12.5% per annum. The interest rate and interest
payment dates on the Subordinated Debentures are the same as the interest rate
and interest payment dates on the Trust Securities. In January 2003, the FASB
issued FIN 46, Consolidation of Variable Interest Entities, effective for
reporting periods beginning after June 15, 2003. As a result of the Company's
adopting FIN 46 effective July 1, 2003, the financial statements of the Capital
Trust are no longer consolidated within the accompanying financial statements of
the Company. See additional discussion below included in New Accounting
Standards.
MD&A 15
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
The Trust Securities are mandatorily redeemable on May 23, 2033, and
may be redeemed at any time on and after May 23, 2008, at 100% of the principal
amount thereof plus unpaid interest. The Trust Securities may be redeemed in
whole, but not in part, at any time within 90 days following the occurrence of a
"Tax Event" or "Investment Company Event" (as defined in the declaration of
trust) (a) if such Tax Event or Investment Company Event occurs on or after May
23, 2008, at a redemption price equal to 100% of the principal amount thereof
plus unpaid interest, and (b) if such Tax Event or Investment Company Event
occurs prior to May 23, 2008, at a redemption price equal to the greater of 100%
of the principal amount thereof plus accrued interest and a "make-whole" amount.
The Subordinated Debentures are subject to these same redemption terms. The
obligations under the Subordinated Debentures and related agreements, taken
together, constitute a full and unconditional guarantee of payments due on the
Trust Securities.
State Auto Financial has the right, at any time, to defer payments of
interest on the Subordinated Debentures for up to 20 consecutive quarterly
payment periods. Consequently, distributions on the Trust Securities would be
deferred (though such distributions would continue to accrue with interest since
interest would accrue on the Subordinated Debentures during any such extended
interest payment period). In no case may the deferral of payments and
distributions extend beyond the stated maturity dates of the respective
securities. During such deferments, State Auto Financial may not declare or pay
any dividends on, or purchase any of, its capital stock, make any principal or
interest payments on debt securities that rank in all respects equally with or
subordinated to the Subordinated Debentures, or make any payment under
guarantees that rank in all respects equally with or subordinated to State Auto
Financial's guaranty of the Trust Securities.
The Subordinated Debentures are unsecured and subordinated to all of
the Company's existing and future senior indebtedness. As sponsor of the Capital
Trust, State Auto Financial incurred security issuance cost related to the Trust
Preferred Capital Securities and Subordinated Debentures of $535,000. In July
2003, State Auto Financial used the proceeds from the Subordinated Debentures to
make a $15.0 million cash capital contribution to SA National (see discussion
below).
On November 13, 2003, State Auto Financial issued $100.0 million
unsecured senior notes bearing interest fixed at 6.25% due November 15, 2013.
Interest on the notes is payable May 15 and November 15 of each year beginning
May 15, 2004. The notes are general unsecured obligations ranking senior to all
existing and future subordinated indebtedness and equal with all existing and
future senior indebtedness. The notes are not guaranteed by any of the State
Auto Financial subsidiaries and thereby are effectively subordinated to all
State Auto Financial subsidiaries' existing and future indebtedness. State Auto
Financial may redeem the notes in whole at anytime or in part from time to time
at State Auto Financial's option, on at least 30 but not more than 60 days'
prior written notice, at a redemption price equal to the greater of the
principal amount of such notes being redeemed on the redemption date or the make
whole amount, based on U.S. Treasury rates as defined by the note, plus in each
case, accrued and unpaid interest, if any, on the notes to the redemption date.
The notes issued contain certain covenants as defined in the notes, which among
other things, limit State Auto Financial and its subsidiaries' ability to issue
indebtedness secured by the capital stock of certain State Auto Financial
subsidiaries and sell the capital stock of certain State Auto Financial
subsidiaries. The notes also contain a covenant that requires State Auto
Financial to take certain actions in the event it engages in mergers,
consolidations or sales of all or substantially all of the assets and prohibits
it from engaging in such transaction if State Auto Financial is in default under
the notes. State Auto Financial incurred approximately $1.5 million in issuance
cost related to the senior notes.
On October 1, 2003 State Auto Financial entered into an interest rate
swap contract for a notional amount of $25.0 million as a hedge on the ten year
treasury rate in connection with the forecasted issuance of the senior notes.
The swap contract was designated as a cash flow hedge and settled on November 6,
2003, the pricing date of the senior notes, with the Company receiving $811,000.
The gain has been recorded in accumulated other comprehensive income and is
being accreted into interest expense as the underlying interest expense is
recognized for the senior notes.
On November 6, 2003 State Auto Financial entered into an interest rate
swap contract for a notional amount of $50.0 million, receiving semiannual
payments at a fixed rate of 6.25% and making semiannual payments at a variable
rate equal to six month LIBOR plus 1.25 percent with LIBOR to be determined the
last day of each interest reset period (total 2.47% at December 31, 2003). The
swap contract was designated as a fair value hedge to protect against changes in
fair value of the senior notes. At December 31, 2003 the fair market value of
the fixed to floating interest rate swap was $485,000 of which $229,000 related
to net accrued interest to be received and reduced reported interest expense in
the period.
MD&A 16
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
State Auto Financial used the senior notes proceeds to contribute
additional paid in capital to its subsidiaries as follows: $39.0 million to
State Auto P&C, $15.0 million to National (in addition to the $15.0 million
contributed from the Trust Securities mentioned above) and $15.0 million to
Milbank. See further discussion below regarding the leverage ratio. State Auto
Financial also used the senior notes proceeds to repay $15.0 million of bank
debt. See further discussion below regarding bank debt. State Auto Financial
retained the balance for general corporate purposes and has since invested these
funds in fixed maturities and common stocks.
Milbank used the $15.0 million additional paid in capital contribution
from State Auto Financial to repay its surplus note. On September 30, 2002,
Milbank had entered into a $15.0 million surplus contribution note with Meridian
Security. Subject to the condition described below and other terms of the note,
the maturity date was September 30, 2012. The interest rate was equal to the
U.S. Treasury ten-year note yield at September 30, 2002 plus 100 basis points
(4.59%) and was adjustable October 1, 2007, to the then current U.S. Treasury
ten-year note yield plus 100 basis points for the remaining term of the note.
Interest was accrued, but all payments of principal or interest may be made only
with the prior written approval of the South Dakota Director of Insurance,
Milbank's domiciliary state. Upon receipt of written approval by the South
Dakota Director of Insurance, Milbank repaid its surplus note, including
interest, in December 2003.
As discussed above, State Auto Financial used proceeds from the senior
notes to repay its $15.0 million bank debt in December 2003. On December 23,
2002, State Auto Financial entered into a 364 day $15.0 million term loan note
agreement with a bank. Interest adjusted quarterly and accrued based on LIBOR
plus 75 basis points (2.15% at December 31, 2002).
The Company has generated substantial earned premium growth which has
required capital resources. Earned premiums through the State Auto Pool
increased significantly beginning in July 2001 with the addition of the former
Meridian Mutual business. Also increasing earned premiums significantly was the
October 1, 2001 pooling change from 53% to 80%. During the years 2003, 2002 and
2001 earned premiums increased, 7.1%, 61.5% and 39.5%, respectively, from the
preceding year. At December 31, 2003 and 2002, all of the Company's insurance
subsidiaries were in compliance with statutory requirements relating to capital
adequacy.
The National Association of Insurance Commissioners ("NAIC") utilizes
a collection of analytical tools designed to assist state insurance departments
with an integrated approach to screening and analyzing the financial condition
of insurance companies operating in their respective states. One such set of
analytical tools is 12 key financial ratios that have come to be known in the
insurance industry as the "IRIS" ratios. IRIS ratios are derived from financial
statements prepared on a statutory accounting basis, which are accounting
practices prescribed or permitted by the insurance department with regulatory
authority over the Company's insurance subsidiaries. A "defined range" of
results for each ratio has been established by the NAIC for solvency monitoring.
While management utilizes each of these IRIS ratios in monitoring its operating
performance on a statutory accounting basis, the net written premium to
statutory surplus ratio (the "leverage ratio") is monitored to ensure that each
of the Company's insurance subsidiaries continues to operate within the "defined
range" of 3.0 to 1.0. The higher the leverage ratio, the more risk a company
bears in relation to statutory surplus available to absorb losses. In
considering this range, management also considers the distribution of net
premiums between property and liability lines of business. A company with a
larger portion of net premiums from liability lines should generally maintain a
lower leverage ratio.
In the case of SA National and Mid-Plains, both nonstandard auto
insurers that write lines of business that are generally short tail in nature
and with generally lower amounts of coverage applicable, there is relatively
less loss exposure to the premium than is generally the case with other lines of
business that are written for higher limits and for which losses develop over
long periods of time, such as workers' compensation or other liability. In sum,
a higher premium to surplus ratio with a non standard auto insurer is not
necessarily indicative of dangerous financial conditions as might be the case
with another type insurer.
MD&A 17
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
The statutory leverage ratios for the Company at December 31, 2003 and
2002 are as follows:
December 31
-----------
Statutory Leverage Ratios(1) 2003 2002
- ---------------------------- ---- ----
(to 1)
State Auto P&C 1.9 2.6
Milbank 2.0 2.4
Farmers and subsidiary Mid-Plains 1.8 2.3
SA Ohio 1.7 1.8
SA National 1.5 4.4
Weighted Average 1.9 2.6
(1) The Company uses the statutory leverage ratio as there is no comparable
GAAP measure. This ratio measures the company's statutory surplus available
to absorb losses.
These improvements are due to a combination of the capital
contributions made by State Auto Financial (State Auto P&C $39.0 million and SA
National $30.0 million) from proceeds of the debt securities issued in 2003,
improvement in the underwriting operations for the year 2003 of each company, as
well as effective January 1, 2003, the reserving process for statutory reporting
began anticipating salvage and subrogation recoverable for each company. Under
generally accepted accounting principles, the reserving process has historically
anticipated salvage and subrogation recoverable. Management believes these
leverage ratios at December 31, 2003 indicate the financial strength of the
Company and its position to support future premium growth.
On March 5, 2004, the Board of Directors of State Auto Financial
declared a quarterly cash dividend of $0.04 per common share, payable on March
31, 2004, to shareholders of record on March 19, 2004. This is the 51st
consecutive cash dividend declared by State Auto Financial's Board since State
Auto Financial had its initial public offering of common stock on June 28, 1991.
State Auto Financial has increased cash dividends to shareholders for twelve
consecutive years.
The maximum amount of dividends that may be paid to State Auto
Financial during 2004 by its insurance subsidiaries without prior approval under
current law is limited to $52.7 million. The Company is required to notify the
insurance subsidiaries' respective State Insurance Commissioner within five
business days after declaration of all such dividends and at least ten days
prior to payment. Additionally, the domiciliary Commissioner of each insurer
subsidiary has the authority to limit a dividend when the Commissioner
determines, based on factors set forth in the law, that an insurer's surplus is
not reasonable in relation to the insurer's outstanding liabilities and adequate
to its financial needs. Such restrictions are not expected to limit the capacity
of State Auto Financial to meet its cash obligations.
OTHER DISCLOSURES
REINSURANCE ARRANGEMENTS
The State Auto Group companies are participants in a catastrophe
reinsurance program. The amount retained by the State Auto Group is $40.0
million for each occurrence. For up to $80.0 million in losses, excess of $40.0
million, traditional reinsurance coverage is provided.
State Auto P&C assumes catastrophe reinsurance from the State Auto
Group, in exchange for a premium paid by each reinsured company, in the amount
of $100.0 million excess of $120.0 million to reduce their loss exposure per
catastrophe. This layer of $100.0 million in excess of $120.0 million has been
excluded from the Pooling Arrangement. There have been no losses assumed under
this agreement.
To provide funding if the State Auto Group was to incur catastrophe
losses in excess of $120.0 million, State Auto Financial has continued a
structured contingent financing transaction with a financial institution and a
syndicate of other lenders (the "Lenders") to provide up to $100.0 million for
reinsurance purposes. In the event of such a loss, this arrangement provides
that State Auto Financial would sell redeemable preferred shares to SAF Funding
Corporation, a special purpose company ("SPC"), which would borrow the money
necessary for such purchase from the Lenders. State Auto Financial would then
contribute to State Auto P&C the funds received from the sale of its preferred
shares, thereby
MD&A 18
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
preserving the statutory surplus of State Auto P&C. State Auto P&C would use the
contributed capital to pay its direct catastrophe losses and losses assumed
under the catastrophe reinsurance agreement. State Auto Financial is obligated
to repay SPC (which would repay the Lenders) by redeeming the preferred shares
over a five-year period. In the event of a default by State Auto Financial, the
obligation to repay SPC has been secured by a Put Agreement among State Auto
Financial, Mutual and the Lenders, under which Mutual would be obligated to
either purchase the preferred shares from the SPC or repay the SPC for the
loan(s) outstanding. This funding arrangement, if exercised, would have the
impact of adding up to $100.0 million in additional debt to the Company while
providing needed cash to pay claims, while at the same time preserving the
investment portfolio of the Company in the short term.
State Auto P&C's December 31, 1990 liability for losses and loss
expenses of $65.5 million has been guaranteed by Mutual. Pursuant to the
guaranty agreement, all ultimate adverse development of the December 31, 1990
liability, if any, is to be reimbursed by Mutual to State Auto P&C in
conformance with pooling percentages in place at that time. As of December 31,
2003, there has been no adverse development of the liability.
INVESTMENTS
Stateco performs investment management services, which comprises the
investment management services segment, on behalf of the Company and Mutual and
its subsidiaries. The Investment Committee of each insurer's Board of Directors
sets investment policies to be followed by Stateco.
The primary investment objectives of the Company are to generate
income, preserve capital and maintain adequate liquidity for the payment of
claims. Fixed maturity securities are categorized as available for sale and are
carried at fair value. At December 31, 2003, the Company had no fixed maturity
investments rated below investment grade, nor any mortgage loans.
The following table provides information regarding the quality
distribution of the Company's fixed maturity portfolio at December 31, 2003:
Percentage Quality(1)
---------- ----------
Corporate and Municipal Bonds 58.2 AA+
U.S. Governments 2.2 AAA
U.S. Government Agencies 39.6 AAA
-----
Total 100.0
=====
(1) As rated by Moody's Investors Service
- --------------------------------
Despite the volatility in the equity market during 2003, the Company
continued its direction of moderately increasing its equity portfolio
investments to enhance growth of statutory surplus over the long term. Gains and
losses on the sale of equity securities are computed using the first-in,
first-out method. The Company's current investment strategy does not rely on the
use of derivative financial instruments.
At December 31, 2003 all investments in fixed maturity and equity
securities were held as available for sale and therefore are carried at fair
value. Other invested assets are comprised of limited liability partnership and
other investments that are carried at fair value. The unrealized holding gains
or losses, net of applicable deferred taxes, are shown as a separate component
of stockholders' equity as "accumulated other comprehensive income" and as such
are not included in the determination of net income. Effective December 31,
2002, the Company transferred all of its investments previously classified as
held to maturity to the available for sale category to align the investment
portfolio with management's investment policy. For fixed maturities classified
as held to maturity, unrealized holding gains or losses were not reflected in
the accompanying consolidated financial statements; rather they were carried at
amortized cost. Upon transfer of the held to maturity investments to available
for sale at December 31, 2002, the held to maturity investments' amortized cost,
fair value and net unrealized gain were $19.1 million, $20.4 million and $1.3
million, respectively. Other comprehensive income of $0.8 million, net of $0.5
million deferred taxes, was recognized upon transfer.
MD&A 19
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
The following table provides the composition of the Company's
investment portfolio at December 31, 2003 and 2002, respectively:
(dollars in thousands) 2003 2002
------------------ -----------------
Fair value
Fixed maturities $1,421,412 90.5% 1,216,698 95.6%
Equity securities 139,257 8.9% 53,710 4.2%
Other invested assets 9,643 0.6% 1,908 0.2%
---------- ----- --------- -----
Total investments $1,570,312 100.0% 1,272,316 100.0%
========== ===== ========= =====
The Company regularly monitors its investment portfolio for declines
in value that are other than temporary, an assessment which requires significant
management judgment regarding the evidence known. Such judgments could change in
the future as more information becomes known which could negatively impact the
amounts reported herein. Among the factors that management considers are the
nature of the investment, severity and length of decline in fair value, events
impacting the issuer, and overall market conditions. When a security in the
Company's investment portfolio has been determined to have a decline in fair
value that is other than temporary, the Company adjusts the cost basis of the
security to fair value. This results in a charge to earnings as a realized loss,
which is not changed for subsequent recoveries in fair value. Future increases
or decreases in fair value, if not other than temporary, are included in other
comprehensive income.
During 2003 the Company recognized realized losses of $289,000 related
to other than temporary impairments. The Company reviewed its investments at
December 31, 2003, and determined no additional other than temporary impairment
exists in the gross unrealized holding losses, as provided in the table below,
due to the evidence that exists indicating temporary impairment. At December 31,
2003, there were no investments reflected in the table below with an unrealized
holding loss that had a fair value significantly below cost continually for more
than one year. There are no individually material securities with an unrealized
holding loss at December 31, 2003.
The following table provides detailed information on the Company's
investment portfolio for its gross unrealized gains and losses, adjusted for
investments with other than temporary impairment at December 31, 2003:
(dollars in thousands) Gross Gain Gross Loss
Cost or unrealized number unrealized number
December 31, 2003 amortized holding of holding of
Investment Category cost gains positions losses positions Fair value
---------- ---------- --------- ---------- --------- ----------
Fixed Maturities
U.S. Treasury securities &
obligations $ 366,513 7,984 98 1,801 24 372,696
States & political subdivisions 676,468 46,485 333 596 17 722,357
Corporate securities 98,637 6,807 44 86 2 105,358
Mortgage-backed securities of U.S.
Gov. Agencies 217,959 4,726 58 1,684 24 221,001
---------- ------ --- ----- --- ---------
Total fixed maturities 1,359,577 66,002 533 4,167 67 1,421,412
---------- ------ --- ----- --- ---------
Equity Securities
Technologies 10,270 2,346 7 -- -- 12,616
Pharmaceuticals 17,692 2,095 7 661 3 19,126
Financial services 36,086 5,166 18 323 5 40,929
Manufacturing & other 56,977 10,176 36 567 8 66,586
---------- ------ --- ----- --- ---------
Total equity securities 121,025 19,783 68 1,551 16 139,257
---------- ------ --- ----- --- ---------
Other invested assets 9,485 164 1 6 1 9,643
---------- ------ --- ----- --- ---------
Total $1,490,087 85,949 602 5,724 84 1,570,312
========== ====== === ===== === =========
MD&A 20
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
The amortized cost and fair value of fixed maturities at December 31,
2003, by contractual maturity, are summarized as follows:
Amortized Fair
(in thousands) Cost Value
---------- ---------
Due in 1 year or less $ 3,796 3,966
Due after 1 year through 5 years 44,395 47,213
Due after 5 years through 10 years 326,563 341,483
Due after 10 years 771,941 812,961
---------- ---------
Subtotal 1,146,695 1,205,623
Mortgage-backed securities 212,882 215,789
---------- ---------
Total $1,359,577 1,421,412
========== =========
Expected maturities may differ from contractual maturities as the
issuers may have the right to call or prepay the obligations with or without
call or prepayment penalties.
Included in the 2003 realized losses of equity securities below, was
$289,000 recognized related to other than temporary impairment on four equity
positions, of which all four equity positions were held at December 31, 2003.
Included in the 2002 realized losses of equity securities below, was $2.2
million ($329,000 on equity securities sold and $1.9 million on equity
securities held at December 31, 2002) recognized related to other than temporary
impairment on five equity positions. The decline in the amount of other than
temporary impairments from 2002 reflects the stock market recovery in 2003 and
the Company's conservative investment strategy to invest for return while
managing its principal loss risk. There were no individually material equity
securities for which the Company recognized other than temporary impairments in
2003 and 2002. There was no other than temporary impairment of fixed maturities
for 2003 and 2002. The individual circumstances impacting the other than
temporary impairments recognized in 2003 and 2002 did not impact other
investments.
The securities sold during 2003 and 2002, were sold to either
recognize the gain available, to dispose of the security because of the
Company's opportunity to invest in securities with greater potential return
considering capital preservation, or to reposition the taxable/tax-exempt fixed
maturity position of the Company.
Realized gains and losses are summarized as follows:
(in thousands) Realized Fair Value at
For the year ended December 31, 2003 Gains/Losses Sale
------------ -------------
Realized gains:
Fixed maturities $12,147 261,079
Equity securities 723 2,758
------- -------
Total realized gains 12,870 263,837
------- -------
Realized losses:
Fixed maturities 278 14,267
Equity securities 1,969 3,375
------- -------
Total realized losses 2,247 17,642
------- -------
Net realized gains on investments $10,623 281,479
======= =======
MD&A 21
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
MARKET RISK
INVESTMENTS
At December 31, 2003 total investments at fair value comprise
approximately 86% of the Company's total assets. Of the total investments, 90%
are invested in fixed maturities, 9% in equity securities, 1% in other invested
assets. Cash and cash equivalents represent approximately 2% of the Company's
total assets at December 31, 2003.
The Company's decision to make a specific investment is influenced
primarily by the following factors: (a) investment risks; (b) general market
conditions; (c) relative valuations of investment vehicles; (d) general market
interest rates; (e) the Company's liquidity requirements at any given time; and
(f) the Company's current federal income tax position and relative spread
between after tax yields on tax-exempt and taxable fixed income investments.
The fixed maturity portfolio is managed in a laddered-maturity style
and considers business mix and liability payout patterns to ensure adequate cash
flow to meet claims as they are presented. At December 31, 2003, the Company's
fixed maturity portfolio had an average maturity of 9.5 years. For the insurance
subsidiaries, the maximum investment in any single note or bond is limited to
5.0% of statutory assets, other than obligations of the U.S. government or
government agencies, for which there is no limit. As indicated in the table
above, the fixed maturity portfolio is of high quality with all holdings in
either Government obligations, municipal, or corporate obligations. The Company
does not intend to change its investment policy on the quality of its fixed
maturity investments. Investments in equity securities are selected based on
their potential for appreciation as well as ability to continue paying
dividends. Additional information regarding the composition of investments,
along with maturity schedules regarding investments in fixed maturities at
December 31, 2003, is presented in tabular form above.
The Company's primary market risk exposures are to changes in market
prices for equity securities and changes in interest rates and credit ratings
for fixed maturity securities. Related to the Company's investment portfolio,
the Company has no exposure to foreign currency exchange rate risk nor does it
rely on the use of derivative financial instruments. To provide the Company
greater flexibility in order to manage its market risk exposures, the Company
categorizes its fixed maturities as available for sale. Also, the Company does
not maintain a trading portfolio.
The Company's total investments at fair value grew approximately 23%
during 2003 to $1,570.3 million at December 31, 2003 from $1,272.3 million at
December 31, 2002. This growth was generated primarily from cash flow provided
by operations and financing, and an increase in the unrealized gains on equity
securities partly offset by a decrease in the unrealized gain on fixed maturity
securities.
The equity markets increased in 2003 after declining during 2002 and
2001, the first two year decline since the 1973 and 1974 bear markets. The
Company's equity portfolio net unrealized gain increased $20.3 million to $18.2
million net unrealized gain at December 31, 2003 from a net unrealized loss
position of $2.1 million at December 31, 2002.
During 2003 the fixed maturity fair values decreased as the interest
rate environment fluctuated. The Company's fixed maturity portfolio net
unrealized gain decreased $5.6 million to $61.8 million net unrealized gain at
December 31, 2003 from $67.4 million net unrealized gain at December 31, 2002.
The following table provides information about the Company's fixed
maturity investments used for purposes other than trading that are sensitive to
changes in interest rates. The table presents principal cash flows from
maturities, anticipated calls and estimated prepayments, or pay downs from
holdings in asset backed securities. The table also presents the average
interest rate for each period presented.
MD&A 22
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
PRINCIPAL AMOUNT MATURING IN:
(dollars in thousands)
2004 2005 2006 2007 2008 Thereafter Total Fair Value
------ ----- ------ ----- ------ ---------- --------- ----------
Fixed interest
rate securities $9,409 5,155 12,528 6,360 19,953 1,284,620 1,338,025 $1,421,412
Average
Interest rate 7.22% 8.51 6.95 6.75 5.43 5.72%
NOTES PAYABLE AND HEDGE
At December 31, 2003, the Company's notes payable and hedge are summarized as
follows:
December 31, 2003
-----------------------------
Carrying Fair Interest
(dollars in thousands) Value Value Rate
-------- ------- --------
Senior notes due 2013: issued $100,000, November 2003
with fixed interest $100,256 100,512 6.25%
Subordinated debentures due 2033: issued $15,464, May
2003 with variable interest adjusting quarterly 15,464 15,464 5.37%
Affiliate note payable due on demand prior to December
31, 2005: issued $45,500, June 1999 with variable
interest adjusting annually 45,500 45,500 2.50%
-------- -------
Total Notes Payable $161,220 161,476 --
======== =======
Hedge due 2013: notional amount issued $50,000, November
2003, swaps fixed interest for variable interest
adjusting quarterly (asset) $ 485 485 2.47%
Related to the Company's notes payable and fair value hedge, the
Company's primary market risk exposure is to the change in interest rates and
its credit rating. Based upon the notes payable cost at December 31, 2003,
including the effect of the hedge, the Company has $110.9 million notes payable
with variable interest and $50.0 million notes payable with interest fixed at
6.25%, which equates to approximately 69% variable interest debt and 31% fixed
interest debt. The Company's decision to obtain fixed versus variable interest
rate debt is influenced primarily by the following factors: (a) current market
interest rates (b) anticipated future market interest rates (c) availability of
fixed versus variable interest instruments and (d) its currently existing notes
payable fixed and variable interest rate position. As noted above, the Company's
notes payable mature staggered over the next 30 years due $45.5 million in 2005,
$100.0 million in 2013 and $15.5 million in 2033.
LOSSES AND LOSS EXPENSES PAYABLE
The Company's management conducts periodic reviews of loss development
reports and makes judgments in determining the reserves for ultimate losses and
loss expenses payable. Several factors are considered by management in
estimating ultimate liabilities including consistency in relative case reserve
adequacy, consistency in claims settlement practices, recent legal developments,
historical data, actuarial projections, accounting projections, exposure growth,
current business conditions, catastrophe developments, late reported claims,
entry errors, and other reasonableness tests.
Management's best estimate ("MBE") for SA National, Mid-Plains and the
STFC Pooled Companies share of the Pooled Companies loss and allocated loss
adjustment expense reserve ("Loss and ALAE Reserve") at December 31, 2003, is
$654 million compared with an actuarial point estimate of $647 million that is
within a projected range of $617 million to $678 million. The actuarial point
estimate and MBE are not materially different. These values presented are on a
direct basis, gross of salvage and subrogation recoverable, and before
reinsurance, except for the STFC Pooled Companies participation in the
inter-company Pooling Arrangement. Therefore these values cannot be compared to
other loss and loss
MD&A 23
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
expenses payable tables included elsewhere within the Company's Form 10-K.
Ranges provide a quantification of the variability in the reserve projections,
while the point estimates establish a mean, or expected value for the ultimate
reserve. The MBE of loss reserves considers the actuary's point estimate, or
expected value, to be a reasonable and appropriate position within the range.
The following table provides a reconciliation of MBE of the Company's direct
Loss and ALAE Reserve to the Company's net loss and loss expenses payable at
December 31, 2003. The STFC Pooled Companies net additional share of
transactions assumed from Mutual through the Pooling Arrangement for the year
2003 has been reflected in the table below as Assumed by STFC Pooled Companies:
For the year 2003 and at December 31, 2003
- ------------------------------------------
Direct Loss and ALAE Reserve (1): (in thousands)
STFC Pooled Companies, National and Mid-Plains $332,903
Assumed by STFC Pooled Companies 321,378
--------
Total direct loss and ALAE reserve 654,281
--------
Direct unallocated loss adjustment expense ("ULAE") (1):
STFC Pooled Companies, National and Mid-Plains 19,435
Assumed by STFC Pooled Companies 18,224
--------
Total direct ULAE 37,659
--------
Direct salvage and subrogation recoverable:
STFC Pooled Companies, National and Mid-Plains (16,671)
Assumed by STFC Pooled Companies (10,115)
--------
Total direct salvage and subrogation recoverable (26,786)
--------
Reinsurance recoverable (14,236)
Assumed reinsurance 3,457
Reinsurance assumed by STFC Pooled Companies (25,592)
--------
Total losses and loss expenses payable, net of reinsurance
recoverable on losses and loss expenses payable of $14,236 $628,783
========
(1) ALAE are those costs that can be related to a specific claim, which may
include attorney fees, external claims adjusters, and investigation costs, among
others. ULAE are those costs incurred in settling claims, such as in-house
processing costs, for which no identification can be made to specific claims.
ALAE and ULAE comprise the loss expense portion of the total loss and loss
expenses payable.
- ----------
The risks and uncertainties inherent in the estimates include, but are
not limited to, actual settlement experience being different from historical
data and trends, changes in business and economic conditions, court decisions
creating unanticipated liabilities, ongoing interpretation of policy provisions
by the courts, inconsistent decisions in lawsuits regarding coverage and
additional information discovered before settlement of claims. The Company's
results of operations and financial condition could be impacted, perhaps
significantly, in the future if the ultimate payments required to settle claims
vary from the liability currently recorded.
In the preceding paragraphs the Company has offered a description of
certain factors management considers in estimating the ultimate liability for
losses and loss expenses. With respect to the auto line of business, which
represents almost half of the Company's total reserves, perhaps the most
significant external variable is legal developments. As discussed in "Impact of
Significant External Factors" below, court decisions have a significant impact
on the property and casualty insurance industry. Some of these decisions have a
more prospective effect as, for example, when contract provisions relating to
third party coverages are construed in ways not anticipated by the Company.
Other court decisions may have more of a retroactive effect which may be seen
more clearly in the auto insurance line. Auto insurance tends to be a line of
business more regulated by statutes; consequently, the courts tend to have more
of an opportunity to construe and apply those statutes to existing contracts.
Uninsured motorists and underinsured motorists (collectively "UM") are statutory
coverages in almost every state where the Company does business. When courts of
appeal construe UM statutes adversely to the Company and the industry, the
effect of that decision is typically retroactive, because, legally speaking,
when the court interprets a statute it is as though the statute was always
construed in the manner that the court determined. This retroactive effect is
exacerbated in UM cases (and other first party coverage cases) because the
statute of limitations applicable to UM claims and other first party coverages
can be as long as 15 years. Claims that had been closed or not even presented,
going
MD&A 24
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
back as long as fifteen years, can be re-born by an adverse court decision. The
Company considers the impact of adverse court decisions of which it has become
aware when it sets ultimate loss and LAE reserves for auto insurance as well as
other lines to the extent those lines may be retroactively affected by such
matters.
The effect of court decisions is also apparent in the commercial lines
of coverages such as commercial multi-peril and other liability and products
liability. Courts can expand coverage or void exclusions which can increase the
Company's exposure to claims. Some of these third party claims may still be
brought within the statute of limitations applicable to such third party claims
and expose the Company to some retroactive liabilities. These liabilities are
sought to be addressed by the ultimate loss and LAE reserve that is the
Company's estimate of loss and loss expenses payable.
It is not feasible to quantify the impact of judicial decisions by the
courts that may have retroactive effect because the Company cannot foresee,
among the range of issues that are litigated every day in courts in each state
in which the Company does business, which cases will be decided adversely and
how such decisions will actually apply to the Company.
The following table presents the loss and loss expenses payable by
major line of business at December 31, 2003 and 2002, respectively:
%
(dollars in thousands) 2003 2002 Change
-------- ------- ------
Automobile - personal standard $185,441 181,778 2.0%
Automobile - personal nonstandard 37,818 35,270 7.2
Automobile - commercial 80,739 72,800 10.9
Homeowners and farmowners 39,463 45,850 (13.9)
Commercial multi-peril 89,209 77,018 15.8
Workers compensation 81,696 77,801 5.0
Fire and allied lines 14,338 14,416 (0.5)
Other liability and products liability 95,720 80,539 18.8
Miscellaneous personal & commercial lines 4,359 6,661 (34.6)
-------- -------
Total losses and loss expenses payable,
net of reinsurance recoverable on
losses and loss expenses payable of
$14,236 and $8,825, respectively $628,783 592,133 6.2%
======== =======
Total net losses and loss expenses payable increased 6.2% at December
31, 2003 from 2002 which is consistent with the total earned premium increase of
7.1% during 2003 from 2002. Specifically, 2002 was a growth year for both
written premium, along with exposure count, within the commercial lines of
business. With this increased growth, the Company experienced more loss activity
in 2003 which resulted in commensurate reserve growth throughout 2003. The
current year development of the prior years' ultimate liability does not reflect
any changes in the Company's fundamental claims reserving practices.
A tabular presentation of the current year $1.8 million development
broken down by accident year is shown below derived from the Company's 2002 and
2003, 10 year loss development tables, as presented in the Reserves section of
the Company's Form 10-K, "Narrative Description of Business" section. The
development is measured in dollars and as a percentage of the total December 31,
2003 net loss and loss expense payable:
MD&A 25
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
Current year Percentage of
development 12/31/2003
of ultimate liability total net loss and
Accident redundancy loss expenses
year (deficiency) payable
-------------- --------------------- ------------------
(dollars in thousands)
1993 and prior $(4,978) (0.84)%
1994 (1,189) (0.20)
1995 8,547 1.44
1996 (8,873) (1.50)
1997 (2,502) (0.42)
1998 621 0.10
1999 1,986 0.34
2000 (2,979) (0.50)
2001 (4,086) (0.69)
2002 15,240 2.57
------- -----
Total $ 1,787 0.30%
======= =====
In management's opinion, the 0.30% current year development, given the
breakdown by accident year, is well within normal expectations for reserve
development and claim settlement uncertainty.
CONTRACTUAL OBLIGATIONS
At December 31, 2003, the Company had the following contractual
obligations:
Less More
than 1 1-3 3-5 than 5
At December 31, 2003 Total year years years years
- -------------------- -------- ------ ------ ----- -------
(in thousands)
Senior notes due 2013: issued $100,000, November 2003
with fixed interest $100,000 -- -- -- 100,000
Subordinated debentures due 2033: issued $15,464, May
2003 with variable interest adjusting quarterly 15,464 -- -- -- 15,464
Affiliate note payable due on demand prior to December
31, 2005: issued $45,500, June 1999 with variable
interest adjusting annually 45,500 -- 45,500 -- --
-------- ------ -------
Total Notes Payable $161,220 -- 45,500 -- 115,464
======== ====== =======
Lease and other purchase obligations are allocated to the Company
through the Pooling Arrangement.
NEW ACCOUNTING STANDARDS
In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS
Statement No. 123 Accounting for Stock-Based Compensation. This Statement
provides alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based compensation. In addition, this
Statement requires more prominent disclosures in both the 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 Statement and will adopt a
transition method at the time when the FASB issues final guidance that is
required to be adopted.
In January 2003, the FASB issued Interpretation No. 46, Consolidation
of Variable Interest Entities ("FIN 46"), which requires the consolidation of
certain entities considered to be variable interest entities ("VIEs"). An entity
is considered to be
MD&A 26
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
a VIE when it has equity investors who lack the characteristics of having a
controlling financial interest, or its capital is insufficient to permit it to
finance its activities without additional subordinated financial support.
Consolidation of a VIE by an investor is required when it is determined that the
investor will absorb a majority of the VIE's expected losses if they occur,
receive a majority of the entity's expected residual returns if they occur, or
both. As a result of the Company adopting FIN 46, effective July 1, 2003, the
financial operations of STFC Capital Trust I, the Company's Delaware business
trust subsidiary (see "Liquidity and Capital Resource" above), are no longer
consolidated within the accompanying financial statements of the Company. The
net impact of the adoption of FIN 46, effective July 1, 2003, was a
reclassification adjustment to eliminate the Capital Trust's capital securities
of $15.0 million from notes payable and include State Auto Financial's
investment of $464,000 in the common securities of Capital Trust in other
invested assets and include $15.5 million principal amount of Floating Rate
Junior Subordinated Debt Securities issued to the Capital Trust in notes
payable.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with the Characteristics of Both Liabilities and Equity,
effective for reporting periods after July 1, 2003. This Statement establishes
standards for classifying and measuring as liabilities certain financial
instruments that embody obligations of the issuer and have characteristics of
both liabilities and equity. The Company adopted this statement effective July
1, 2003 with no significant impact to the consolidated financial statements.
IMPACT OF SIGNIFICANT EXTERNAL FACTORS
Inflation can have a significant impact on property and casualty
insurers because premium rates are established before the amount of losses and
loss expenses are known. When establishing rates, the Company attempts to
anticipate increases from inflation subject to the limitations of modeling
economic variables. General inflation, as measured by the CPI, has been
relatively modest over the last several years; however, price inflation on the
goods and services purchased by insurance companies in settling claims has been
steadily increasing. In particular, repair costs for homes, autos, and
commercial buildings, and medical care costs, have risen disproportionately over
the last few years. The Company continues to adjust its pricing projections as
loss cost trends change in order to ensure premiums keep pace with inflation in
all lines of business.
The Company considers inflation when estimating liabilities for losses
and loss expenses, particularly for claims having a long period between
occurrence and settlement. The liabilities for losses and loss expenses are
management's best estimates of the ultimate net cost of underlying claims and
expenses and are not discounted for the time value of money. In times of high
inflation, the normally higher yields on investment income may partially offset
potentially higher claims and expenses.
The Company is also affected by court decisions. Premium rates are
actuarially determined to enable an insurance company to generate an
underwriting profit. These rates contemplate a certain level of risk. The courts
may modify, in a number of ways, the level of risk which insurers had expected
to assume including eliminating exclusions, multiplying limits of coverage,
creating rights for policyholders not intended to be included in the contract
and interpreting applicable statutes expansively to create obligations on
insurers not originally considered when the statute was passed. Courts have also
undone legal reforms passed by legislatures, which reforms were intended to
reduce a litigant's rights of action or amounts recoverable and so reduce the
costs borne by the insurance mechanism. These court decisions can adversely
affect an insurer's profitability. They also create pressure on rates charged
for coverages adversely affected and this can cause a legislative response
resulting in rate suppression that can adversely affect an insurer. The Company
may also be adversely affected by regulatory actions on matters within the
jurisdiction of the various insurance departments where the Company does
business or has entities domiciled.
After credit scoring, the industry's use of which has been limited to
varying extents by certain states' laws, the next most predictive underwriting
report available to insurers is previous loss information. Third party vendors
obtain loss information from insurers based on the insured, the vehicle and/or
the property location. As insurers write new business the database is accessed
to analyze any loss experience of the insured, vehicle and/or property location.
Many times insurer's premium rates will be adjusted to reflect the loss
experience accessed from these databases. In some cases the overall
acceptability of the insured's application in the standard market may be
determined by these reports. During 2002 and 2003, use of this loss information
database product by the insurance industry as a predictive underwriting tool has
been challenged by several west coast states and most recently in a few of the
Company's states of operation. While it is too soon to determine states'
reaction to the utilization of these database systems, any restrictive
regulation of the full use of these
MD&A 27
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
underwriting reports could have an adverse impact on the Company as it has
utilized these database systems for several years as an underwriting tool. Since
such regulation is applicable to all companies writing business which utilize
these reports, the Company does not expect to suffer a competitive disadvantage.
The impact of Sarbanes Oxley Act of 2002 is continuing to be felt, as
the Securities and Exchange Commission ("SEC") implements regulatory changes to
meet the obligations imposed on it by Congress. Certain deadlines have been
extended by the SEC which may mitigate the cost of compliance to a limited
extent. In addition to complying with the SEC and Congressional mandates, State
Auto Financial also has to comply with new listing standards of the National
Association of Securities Dealers ("NASD") recently approved by the SEC, which
will contribute to an increase in expenses.
The Terrorism Risk Insurance Act of 2002 (the "Terrorism Act")
established a temporary federal program that provides for a system of shared
public and private compensation for insured losses resulting from acts of
terrorism committed by or on behalf of a foreign interest. In order for a loss
to be covered under the Terrorism Act, it must be the result of an event that is
certified as an act of terrorism by the U.S. Secretary of Treasury ("subject
losses"). In the case of a war declared by Congress, only workers' compensation
losses are covered by the Terrorism Act. The Terrorism Insurance Program (the
"Program") generally requires that all commercial property casualty insurers
licensed in the U.S. participate in the Program. The amount of compensation paid
to participating insurers under the Program is 90% of subject losses, after an
insurer deductible, subject to an annual cap that limits the amount of subject
losses to $100 billion aggregate per program year. The Company's deductible
under this federal Program is approximately $22.3 million for 2004, subject to
final rules to be established by the U.S. Treasury. Under the Terrorism Act,
commercial property and casualty insurers must offer their commercial
policyholders coverage against certified acts of terrorism, but the
policyholders may choose to reject this coverage. If the policyholder rejects
coverage for certified acts of terrorism, the Company intends, subject to the
approval of the state regulators, to cover only such acts of terrorism that are
not certified acts under the Terrorism Act and that do not arise out of nuclear,
biological or chemical agents.
TRENDS AND UNCERTAINTIES
Company management has identified certain trends and uncertainties
that have the potential to significantly affect the Company and the property and
casualty insurance industry:
- Increasing price competition
- Declining investment rate of return
- Volatile investment market
- Increasing frequency and severity of storm losses, including
catastrophes
- Increasing health care cost
- Increasing consolidation of the property and casualty insurance
industry
- Changing product distribution channels
- New and changing insurance risks such as asbestos, mold, silica and
acts of terrorism
- Business continuity planning
Company management considers these trends and uncertainties, and
others, in the management of the Company operations. Increasing price
competition can have the effect of decreasing the rate of growth of earned
premiums, if not decreasing earned premiums, as the Company's underwriting
philosophy does not permit risk selection at a price below which management
believes is adequate. The declining investment rate of return can decrease the
rate of growth of, investment income as well as decrease, investment income and
net income, as the Company invests for an adequate return with a focus on
principal preservation risk. The volatile investment market and related
investment valuation can affect the insurers' statutory surplus as the fair
value of investments fluctuate. The increasing frequency and severity of storm
losses and increasing health care costs can have the effect of increasing losses
and decreasing operating profits. Management considers these trends and
uncertainties in the writing and pricing of policies. Because of the Company's
growth and planned greater geographic dispersion of risk, the loss ratio point
impact of recent catastrophes has not been as severe as catastrophe losses
several years ago that had fewer loss dollars associated with them. There
continues to be consolidation within the property and casualty insurance
industry which can increase competition by creating insurance companies with
more resources and capital. As demonstrated over the years, the Company has
acquired and successfully integrated insurance companies in the past and
considers acquisition opportunities as they arise. The Company believes
acquisitions
MD&A 28
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
will be an important part of its growth strategies. Company management also
monitors the changing product distribution channels, along with its changing
relationships with agencies and consolidation occurring within the agency
distribution system itself. The Company remains committed to cultivating strong
relationships with its agencies and to selling insurance products through the
independent agency system. The Company considers the expanding scope of
insurance risks, such as asbestos, mold, silica and acts of terrorism, in its
pricing, writing of policies and drafting policy forms. The Company established
a business continuity plan to ensure the continuation of core business
operations in the event that normal business operations could not be performed.
Management will continue to assess the business continuity plan to ensure it
meets the Company's changing core business operations needs. Overall, the
Company considers one of its key strengths to be its core values which are to
(i) fairly price and ethically sell useful insurance products; (ii) treat every
transaction with absolute honesty and integrity; (iii) extend dignity and
respect to everyone; (iv) encourage innovation; and (v) fully utilize every
person's talents. These core values, which reflect the "tone at the top," serve
the interests of all the Company's constituencies.
As discussed above, there was particular emphasis throughout 2003,
2002 and 2001 on improving the former Meridian Mutual book of business. The
Company believes its underwriting and pricing discipline, as well as its
commitment to delivering its products as effectively and efficiently as
possible, have been key factors in the Company's underwriting results over the
last several years. The Company remains active in the personal and commercial
markets, developing new products to enhance its product portfolio; appointing
new agents in its operating territories; and refining its pricing levels for the
markets and lines of business the Company believes offer the most profit
potential.
FORWARD-LOOKING STATEMENTS; CERTAIN FACTORS AFFECTING FUTURE RESULTS
Statements contained in this Form 10-K 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.
- The Company maintains loss reserves to cover its estimated
ultimate unpaid liability for losses and loss expenses with
respect to reported and unreported claims incurred as of the end
of each accounting period. Reserves do not represent an exact
calculation of liability, but instead represent estimates,
generally using actuarial projection techniques at a given
accounting date. The Company refines reserve estimates in a
regular ongoing process as historical loss experience develops
and additional claims are reported and settled. The Company
records adjustments to reserves in the results of operations for
the periods in which the estimates are changed. Because
establishing reserves is an inherently uncertain process
involving estimates, currently established reserves may not be
adequate. If the Company concludes that estimates are incorrect
and reserves are inadequate, the Company is obligated to increase
its reserves. An increase in reserves results in an increase in
losses and a reduction in the Company's net income for the period
in which the deficiency in reserves is identified. Accordingly,
an increase in reserves could have a material adverse effect on
the Company's results of operations, liquidity, and financial
condition.
- The Company's insurance operations expose it to claims arising
out of catastrophic events. The Company has experienced, and will
in the future experience, catastrophe losses that may cause
substantial volatility in the Company's financial results for any
fiscal quarter or year and could materially reduce the Company's
profitability or harm the Company's financial condition.
Catastrophes can be caused by various natural events, including
hurricanes, hailstorms, windstorms, earthquakes, explosions,
severe winter weather, and fires, none of which are within the
Company's control. The extent of losses from a catastrophe is a
function of both the total amount of insured exposure in the area
affected by the event and the severity of the event. The
geographic distribution of the Company's business subjects it to
catastrophe exposure from hailstorms and earthquakes in the
Midwest as well as catastrophe exposure from hurricanes in
Florida and the Gulf Coast, southern coastal states, and
Mid-Atlantic regions. Catastrophe losses can vary widely and
could significantly exceed the Company's recent historic results.
The frequency and severity of catastrophes are inherently
unpredictable.
MD&A 29
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
- The Company uses reinsurance to help manage its exposure to
insurance risks. The availability and cost of reinsurance are
subject to prevailing market conditions, both in terms of price
and available capacity, which can affect the Company's business
volume and profitability. Although the reinsurer is liable to the
Company to the extent of the ceded reinsurance, the Company
remains liable as the direct insurer on all risks reinsured. As a
result, ceded reinsurance arrangements do not eliminate the
Company's obligation to pay claims. The Company is subject to
credit risk with respect to the Company's ability to recover
amounts due from reinsurers. Reinsurance may not be adequate to
protect the Company against losses and may not be available to
the Company in the future at commercially reasonable rates. In
addition, the magnitude of losses in the reinsurance industry
resulting from catastrophes may adversely affect the financial
strength of certain reinsurers, which may result in the Company's
inability to collect or recover reinsurance.
- Insurance companies are subject to financial strength ratings
produced by external rating agencies. Higher ratings generally
indicate financial stability and a strong ability to pay claims.
Ratings are assigned by rating agencies to insurers based upon
factors that they believe are relevant to policyholders. Ratings
are important to maintaining public confidence in the Company and
in its ability to market its products. A downgrade in the
Company's financial strength ratings could, among other things,
negatively affect the Company's ability to sell certain insurance
products, the Company's relationships with agents, new sales, and
the Company's ability to compete.
- The Company markets its insurance products through independent,
non-exclusive insurance agents, whereas some of the Company's
competitors sell their insurance products through insurance
agents who sell products exclusively for one insurance company.
If the Company is unsuccessful in attracting and retaining
productive agents to sell the Company's insurance products, the
Company's sales and results of operations could be adversely
affected. The agents that market and sell the Company's products
also sell the Company's competitors' products. These agents may
recommend the Company's competitors' products over the Company's
products or may stop selling the Company's products altogether.
Additionally, the Company competes with the Company's competitors
for productive agents, primarily on the basis of the Company's
financial position, support services and compensation and product
features.
- Mutual and the Company have acquired other insurance companies
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.
- 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.
MD&A 30
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS, CONTINUED
- --------------------------------------------------------------------------------
- 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.
- The property and casualty insurance industry is highly
competitive. While prices have generally increased in some lines,
the rate of increase has moderated and competition continues to
be intense. The Company competes with numerous insurance
companies, many of which are substantially larger and have
considerably greater financial resources. 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
Form 10-K.
- The Company is subject to numerous other factors which affects
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 and unexpected challenges to the control of the Company
by Mutual.
ITEM 7(A). QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
"Qualitative and Quantitative Disclosures About Market Risk" is
included in Item 7 "Management's Discussion and Analysis of Financial Condition
and Results of Operations" under Market Risk.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements, including the Notes to
Consolidated Financial Statements and the Report of Independent Auditors are as
follows:
MD&A 31
Report of Independent Auditors
The Board of Directors and Stockholders
State Auto Financial Corporation
We have audited the accompanying consolidated balance sheets of State Auto
Financial Corporation and subsidiaries as of December 31, 2003 and 2002, and the
related consolidated statements of income, stockholders' equity and cash flows
for each of the three years in the period ended December 31, 2003. Our audits
also included the financial statement schedules listed in the Index at
Item 15(a)(2). These financial statements and schedules are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements and schedules based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States. 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, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of State Auto
Financial Corporation and subsidiaries at December 31, 2003 and 2002, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2003, in conformity with accounting
principles generally accepted in the United States. Also, in our opinion, the
related financial statement schedules, when considered in relation to the basic
financial statements taken as a whole, present fairly in all material respects
the information set forth therein.
/s/ Ernst & Young LLP
Columbus, Ohio
February 20, 2004
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------------------------------------------------
(in thousands, except per share amount) DECEMBER 31
----------------------
2003 2002
---------- ---------
ASSETS
Fixed maturities, available for sale, at fair value (amortized cost $1,359,577
and $1,149,334, respectively) ................................................................ $1,421,412 1,216,698
Equity securities, available for sale, at fair value (cost $121,025 and $55,837, respectively)... 139,257 53,710
Other invested assets, at fair value (amortized cost $9,485 and $1,857, respectively) ........... 9,643 1,908
---------- ---------
Total investments ............................................................................... 1,570,312 1,272,316
Cash and cash equivalents ....................................................................... 40,005 96,048
Deferred policy acquisition costs ............................................................... 87,099 77,886
Accrued investment income and other assets ...................................................... 52,436 50,788
Due from affiliate .............................................................................. -- 14,210
Net prepaid pension expense ..................................................................... 51,415 46,690
Reinsurance recoverable on losses and loss expenses payable (affiliate $5,706
and $4,286, respectively) .................................................................... 14,236 8,825
Prepaid reinsurance premiums (affiliate $3,906 and $3,997, respectively) ........................ 8,434 7,695
Current federal income taxes .................................................................... 238 --
Deferred federal income taxes ................................................................... -- 5,796
Property and equipment, at cost, net of accumulated depreciation of $4,448
and $3,915, respectively ..................................................................... 12,492 12,741
---------- ---------
Total assets .................................................................................... $1,836,667 1,592,995
========== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable (affiliate $303,894 and $303,960, respectively) ................ $ 643,019 600,958
Unearned premiums (affiliate $121,335 and $133,130, respectively) ............................... 404,341 377,990
Notes payable (affiliates $60,964 and $60,500, respectively) .................................... 161,220 75,500
Postretirement benefit liabilities .............................................................. 74,250 66,763
Current federal income taxes .................................................................... -- 745
Deferred federal income taxes ................................................................... 2,008 --
Other liabilities ............................................................................... 8,619 7,270
Due to affiliates ............................................................................... 919 --
---------- ---------
Total liabilities ............................................................................... 1,294,376 1,129,226
---------- ---------
Stockholders' equity:
Class A Preferred stock (nonvoting), without par value. Authorized 2,500 shares;
none issued ............................................................................... -- --
Class B Preferred stock, without par value. Authorized 2,500 shares;
none issued ............................................................................... -- --
Common stock, without par value. Authorized 100,000 shares; 44,164
and 43,525 shares issued, respectively, at stated value of $2.50 per share ................ 110,410 108,815
Less 4,605 and 4,524 treasury shares, respectively, at cost .................................. (55,762) (54,249)
Additional paid-in capital ................................................................... 56,653 50,354
Accumulated other comprehensive income ....................................................... 52,992 42,512
Retained earnings ............................................................................ 377,998 316,337
---------- ---------
Total stockholders' equity ...................................................................... 542,291 463,769
---------- ---------
Total liabilities and stockholders' equity ...................................................... $1,836,667 1,592,995
========== =========
See accompanying notes to consolidated financial statements.
AR-1
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF INCOME
- ------------------------------------------------------------------------------------------------------------
(in thousands, except per share amounts) YEAR ENDED DECEMBER 31
------------------------------
2003 2002 2001
---------- ------- -------
Earned premiums (ceded to affiliate $603,820, $506,777 and $432,168,
respectively) ......................................................... $ 960,568 896,595 555,207
Net investment income .................................................... 64,625 59,691 47,375
Net realized gains on investments ........................................ 10,623 5,909 1,962
Other income (affiliates $3,733, $3,240 and $17,036, respectively) ....... 5,880 5,284 18,728
---------- ------- -------
Total revenues ........................................................... 1,041,696 967,479 623,272
---------- ------- -------
Losses and loss expenses (ceded to affiliate $387,643, $368,819 and
$303,931, respectively) ............................................... 651,223 653,474 427,074
Acquisition and operating expenses ....................................... 291,823 264,348 167,207
Interest expense (affiliates $2,756, $2,333 and $2,275, respectively) .... 3,637 2,333 2,275
Other expenses ........................................................... 11,736 9,534 8,740
---------- ------- -------
Total expenses ........................................................... 958,419 929,689 605,296
---------- ------- -------
Income before federal income taxes ....................................... 83,277 37,790 17,976
---------- ------- -------
Federal income tax expense (benefit):
Current ............................................................... 17,061 8,155 7,699
Deferred .............................................................. 2,594 (7,360) (10,338)
---------- ------- -------
Total federal income taxes ............................................... 19,655 795 (2,639)
---------- ------- -------
Net income ............................................................... $ 63,622 36,995 20,615
========== ======= =======
Earnings per common share:
Basic ................................................................. $ 1.62 0.95 0.53
---------- ------- -------
Diluted ............................................................... $ 1.58 0.93 0.52
---------- ------- -------
Dividends paid per common share .......................................... $ 0.15 0.14 0.13
---------- ------- -------
See accompanying notes to consolidated financial statements.
AR-2
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
- -------------------------------------------------------------------------------------------------------------------------
(in thousands) ACCUMULATED
ADDITIONAL OTHER
COMMON COMMON TREASURY TREASURY PAID-IN COMPREHENSIVE RETAINED
SHARES STOCK SHARES STOCK CAPITAL INCOME EARNINGS TOTAL
------ -------- -------- -------- ---------- ------------- -------- --------
BALANCE-DECEMBER 31, 2000 42,626 $106,564 4,071 ($47,038) $44,208 $20,317 $262,008 $386,059
------ -------- ----- -------- ------- ------- -------- --------
Net income 20,615 20,615
Unrealized gains on
investments, net of tax (8,287) (8,287)
and reclassification
adjustment
--------
Comprehensive income 12,328
--------
Issuance of common stock 419 1,049 1,604 2,653
Tax benefit from stock
options exercised 1,140 1,140
Treasury shares acquired
on stock option exercises 12 (187) (187)
Treasury shares acquired
under repurchase program 25 (388) (388)
Stock options granted 154 154
Cash dividends paid (1,566) (1,566)
------ -------- ----- -------- ------- ------- -------- --------
BALANCE-DECEMBER 31, 2001 43,045 $107,613 4,108 ($47,613) $47,106 $12,030 $281,057 $400,193
====== ======== ===== ======== ======= ======= ======== ========
Net income 36,995 36,995
Unrealized gains on
investments, net of tax 30,482 30,482
and reclassification
adjustment
--------
Comprehensive income 67,477
--------
Issuance of common stock 480 1,202 2,173 3,375
Tax benefit from stock
options exercised 910 910
Treasury shares acquired
on stock option exercises 23 (375) (375)
Treasury shares acquired
under repurchase program 393 (6,261) (6,261)
Stock options granted 165 165
Cash dividends paid (1,715) (1,715)
------ -------- ----- -------- ------- ------- -------- --------
BALANCE-DECEMBER 31, 2002 43,525 $108,815 4,524 ($54,249) $50,354 $42,512 $316,337 $463,769
====== ======== ===== ======== ======= ======= ======== ========
Net income 63,622 63,622
Unrealized gains on
investments, net of tax 9,676 9,676
and reclassification
adjustment
Unrealized gain on 804 804
derivative used in cash
flow hedge
--------
Comprehensive income 74,102
--------
Issuance of common stock 639 1,595 3,863 5,458
Tax benefit from stock
options exercised 2,130 2,130
Treasury shares acquired
on stock option exercises 36 (784) (784)
Treasury shares acquired
under repurchase program 45 (729) (729)
Stock options granted 306 306
Cash dividends paid (1,961) (1,961)
------ -------- ----- -------- ------- ------- -------- --------
BALANCE-DECEMBER 31, 2003 44,164 $110,410 4,605 ($55,762) $56,653 $52,992 $377,998 $542,291
====== ======== ===== ======== ======= ======= ======== ========
See accompanying notes to consolidated financial statements.
AR-3
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF CASH FLOWS
- -------------------------------------------------------------------------------------------------------------------
(in thousands) YEAR ENDED DECEMBER 31
-------------------------------
2003 2002 2001
--------- -------- --------
Cash flows from operating activities:
Net income ..................................................................... $ 63,622 36,995 20,615
Adjustments to reconcile net income to net cash provided by Operating
activities:
Depreciation and amortization, net ....................................... 8,836 5,616 3,036
Net realized gains on investments ........................................ (10,623) (5,909) (1,962)
Changes in operating assets and liabilities:
Deferred policy acquisition costs ..................................... (9,213) (10,798) (4,735)
Accrued investment income and other assets ............................ 92 (10,054) (16,671)
Net prepaid pension expense ........................................... (4,725) (3,346) (5,606)
Postretirement benefit liabilities .................................... 7,487 9,526 1,396
Reinsurance recoverable on losses and loss expenses payable and
prepaid reinsurance premiums ....................................... (6,150) 2,353 (7,943)
Other liabilities and due to/from affiliates, net ..................... 16,478 (18,149) 11,273
Losses and loss expenses payable ...................................... 42,061 77,097 47,693
Unearned premiums ..................................................... 26,351 48,494 21,919
Federal income taxes .................................................. 3,743 (5,205) (14,139)
Cash provided from adding the former Meridian Mutual Insurance Company
business to the reinsurance pool, effective 7/1/01 .......................... -- -- 6,380
Cash provided from the change in the reinsurance pool participation
percentage 10/1/01 .......................................................... -- -- 2,197
--------- -------- --------
Net cash provided by operating activities ...................................... 137,959 126,620 63,453
--------- -------- --------
Cash flows from investing activities:
Purchase of fixed maturities - available for sale ........................... (566,067) (507,626) (246,269)
Purchase of equity securities - available for sale ......................... (72,568) (22,130) (16,437)
Purchase of other invested assets ........................................... (7,618) (1,857) --
Maturities, calls and pay downs of fixed maturities - held to maturity ...... -- 8,238 11,612
Maturities, calls and pay downs of fixed maturities - available for sale .... 84,895 61,509 38,552
Sale of fixed maturities - available for sale ............................... 275,346 363,594 149,043
Sale of equity securities - available for sale .............................. 6,133 12,716 9,301
Net additions of property and equipment ..................................... (311) (56) (1,056)
--------- -------- --------
Net cash used in investing activities .......................................... (280,190) (85,612) (55,254)
--------- -------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock ...................................... 4,674 3,000 2,466
Payments to acquire treasury shares ......................................... (729) (6,261) (388)
Payment of dividends ........................................................ (1,961) (1,715) (1,566)
Proceeds from issuance of debt .............................................. 115,464 30,000 --
Debt issuance costs ......................................................... (2,071) -- --
Payment of debt ............................................................. (30,000) -- --
Cash flow hedge derivative settlement ....................................... 811 -- --
--------- -------- --------
Net cash provided by financing activities ...................................... 86,188 25,024 512
--------- -------- --------
Net increase (decrease) in cash and cash equivalents ........................... (56,043) 66,032 8,711
--------- -------- --------
Cash and cash equivalents at beginning of year ................................. 96,048 30,016 21,305
--------- -------- --------
Cash and cash equivalents at end of year ....................................... $ 40,005 96,048 30,016
========= ======== ========
See accompanying notes to consolidated financial statements.
AR-4
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include State Auto Financial
Corporation (State Auto Financial) and its wholly-owned subsidiaries:
- State Auto Property and Casualty Insurance Company (State Auto P&C), a
South Carolina corporation
- Milbank Insurance Company (Milbank), a South Dakota corporation
- Farmers Casualty Insurance Company (Farmers), an Iowa corporation
- State Auto Insurance Company of Ohio (SA Ohio), an Ohio corporation
- State Auto National Insurance Company (SA National), an Ohio
corporation
- Stateco Financial Services, Inc. (Stateco), an Ohio corporation
- Strategic Insurance Software, Inc. (S.I.S.), an Ohio corporation.
Mid-Plains Insurance Company (Mid-Plains), an Iowa corporation, is a
wholly-owned subsidiary of Farmers. The financial statements also include the
operations and financial position of 518 Property Management and Leasing, LLC
(518 PML), whose members are State Auto P&C and Stateco.
State Auto Financial, an Ohio corporation, is a majority-owned subsidiary
of State Automobile Mutual Insurance Company (Mutual), an Ohio corporation.
State Auto Financial and subsidiaries are referred to herein as the "Companies"
or the "Company." All significant intercompany balances and transactions have
been eliminated in consolidation.
(b) DESCRIPTION OF BUSINESS
The Company, through State Auto P&C, Milbank, Farmers and SA Ohio, provides
standard personal and commercial insurance to its policyholders. The Company's
principal lines of business include personal and commercial automobile,
homeowners, commercial multi-peril, workers' compensation, general liability and
fire insurance. SA National and Mid-Plains provide nonstandard automobile
insurance. State Auto P&C, Milbank, Farmers, SA Ohio, SA National, and
Mid-Plains operate primarily in the central and eastern United States, excluding
New York, New Jersey, and the New England states, through an independent
insurance agency system. State Auto P&C, Milbank, Farmers, SA Ohio, SA National
and Mid-Plains are chartered and licensed as property and casualty insurers in
the states of South Carolina, South Dakota, Iowa, Ohio (SA Ohio and SA National)
and Iowa, respectively, and are licensed in various other states. As such, they
are subject to the regulations of the applicable Departments of Insurance of
their respective states of domicile (the Departments) and the regulations of
each state in which they operate. These property and casualty insurance
companies undergo periodic financial examination by the Departments and
insurance regulatory agencies of the states that choose to participate.
Through State Auto P&C, the Company provides management and operation
services under management agreements for all insurance and non-insurance
affiliates.
Through Stateco, the Company provides investment management services to
affiliated companies.
The Company, through S.I.S., develops and sells software for the processing
of insurance transactions, database management for insurance agents and
electronic interfacing of information between insurance companies and agencies.
S.I.S. sells services and products to affiliated companies and their agents and
markets similar services and products to nonaffiliated insurers and their
agencies.
518 PML, an Ohio limited liability company, was formed to engage in the
business of owning and leasing real and personal property to the Company's
affiliates.
(c) BASIS OF PRESENTATION
The consolidated financial statements have been prepared in conformity with
accounting principles generally accepted in the United States, which vary in
certain respects from statutory accounting practices followed by State Auto P&C,
Milbank, Farmers, SA Ohio, SA National and Mid-Plains that are prescribed or
permitted by the Departments.
In preparing the consolidated financial statements, management is required
to make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the balance sheet, revenues and expenses for the
period then ended and the accompanying notes to the financial statements. Such
estimates and assumptions could change in the future as more information becomes
known which could impact the amounts reported and disclosed herein.
AR-5
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
Material estimates that are particularly susceptible to significant change
in the near term relate to the determination of losses and loss expenses
payable. In connection with the determination of this estimate, management uses
historical data and current business conditions to formulate estimates including
assumptions related to the ultimate cost to settle claims.
These estimates by their nature are subject to uncertainties for various
reasons. The Company's results of operations and financial condition could be
impacted in the future should the ultimate payments required to settle claims
vary from the amount of the liability currently provided.
(d) INVESTMENTS
At December 31, 2003 and 2002 all investments in fixed maturity and equity
securities are held as available for sale and therefore are carried at fair
value. Other invested assets are comprised of limited liability partnership and
other investments that are carried at fair value. The unrealized holding gains
or losses, net of applicable deferred taxes, are shown as a separate component
of stockholders' equity as "accumulated other comprehensive income" and as such
are not included in the determination of net income. Effective December 31,
2002, the Company transferred all of its investments previously classified as
held to maturity to the available for sale category to align the investment
portfolio with management's investment policy. For fixed maturities classified
as held to maturity, unrealized holding gains or losses were not reflected in
the accompanying consolidated financial statements, rather they were carried at
amortized cost. Upon transfer of the held to maturity investments to available
for sale at December 31, 2002, the held to maturity investments' amortized cost,
fair value and net unrealized gain were $19.1 million, $20.4 million and $1.3
million, respectively. Other comprehensive income of $828,000 net of deferred
taxes of $446,000 was recognized upon transfer. Gains and losses on the sale of
investments are computed using the first-in, first-out method. The Company
regularly monitors its investments that have fair value less than the carrying
amount for signs of other than temporary impairment. Among the factors that
management considers are market conditions, the amount, timing and length of
decline in fair value, and events impacting the issuer. When other than
temporary impairment is recognized, the investment cost is written down to fair
value and a realized loss is recorded. The cost is not adjusted for any
subsequent recovery in fair value. For 2003 and 2002, included in net realized
gain on investments was $289,000 and $2.2 million, respectively, of realized
losses recognized due to other than temporary impairments.
(e) CASH EQUIVALENTS
The Company considers all highly liquid debt instruments with a maturity of
three months or less to be cash equivalents.
(f) DEFERRED POLICY ACQUISITION COSTS
Acquisition costs, consisting of commissions, premium taxes, and certain
underwriting expenses related to the production of property and casualty
business, are deferred and amortized ratably over the contract period. The
method followed in computing deferred policy acquisition costs limits the amount
of such deferred costs to their estimated realizable value. In determining
estimated realizable value, the computation gives effect to the premium to be
earned, losses and loss expenses to be incurred, and certain other costs
expected to be incurred as premium is earned, without credit for anticipated
investment income. These amounts are based on estimates and accordingly, the
actual realizable value may vary from the estimated realizable value. Net
deferred policy acquisition costs were:
YEAR ENDED DECEMBER 31
----------------------------
2003 2002 2001
-------- ------- -------
(in thousands)
Balance, beginning of year....................... $ 77,886 67,087 32,458
Acquisition costs deferred....................... 253,455 235,139 143,651
Amortized to expense............................. 244,242 224,340 109,022
-------- ------- -------
Balance, end of year............................. $ 87,099 77,886 67,087
======== ======= =======
AR-6
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
(g) FEDERAL INCOME TAXES
The Company files a consolidated federal income tax return, and pursuant to
an agreement, each entity within the consolidated group pays its share of
federal income taxes based on separate return calculations.
Income taxes are accounted for using the liability method. Using this
method, deferred tax assets and liabilities are determined based on differences
between financial reporting and tax bases of assets and liabilities and are
measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse.
(h) LOSSES AND LOSS EXPENSES PAYABLE
Losses and loss expenses payable are based on formula and case-basis
estimates for reported claims, and on estimates, based on experience and
perceived trends, for unreported claims and loss expenses. The liability for
unpaid losses and loss expenses, net of estimated salvage and subrogation
recoverable of $26.8 million and $27.1 million at December 31, 2003 and 2002,
respectively, has been established to cover the estimated ultimate cost of
insured losses. The amounts are necessarily based on estimates of future rates
of inflation and other factors, and accordingly there can be no assurance that
the ultimate liability will not vary from such estimates. The estimates are
continually reviewed and adjusted as necessary; such adjustments are included in
current operations (see note 4). Salvage and subrogation recoverables are
estimated using historical experience. As such, losses and loss expenses payable
represent management's best estimate of the ultimate liability related to
reported and unreported claims.
(i) OTHER COMPREHENSIVE INCOME
Comprehensive income is defined as all changes in an enterprise's equity
during a period other than those resulting from investments by owners and
distributions to owners. Comprehensive income includes net income and other
comprehensive income. Other comprehensive income includes all other non-owner
related changes to equity and represents net unrealized gains and losses on
available-for-sale fixed maturities, equity securities, other invested assets,
and derivative instruments.
Separate presentation of the accumulated balance of other comprehensive
income within the equity section of the statement of financial position is also
required. The Company has presented the required displays of total comprehensive
income and its components, within the "Consolidated Statements of Stockholders'
Equity." See additional disclosures at note 14.
(j) DERIVATIVES
As part of the Company's management of its exposure to fluctuations in
interest rates, during 2003 the Company entered into interest rate swap
agreements in connection with the issuance of its $100 million 6.25% senior
notes. The interest rate swap agreements are the only derivative contracts to
which the Company is party and are accounted for in accordance with Statement of
Financial Accounting Standard No. 133, Accounting for Derivative Instruments and
Hedging Activities, as amended. This Statement requires all derivatives to be
recorded at fair value on the consolidated balance sheet.
At the time a derivative contract is entered into, the Company formally
documents and designates the derivative as either a hedge of the fair value of a
recognized asset or liability (fair value hedge) or a hedge of a forecasted
transaction or the variability of cash flows to be received or paid related to a
recognized asset or liability (cash flow hedge). The Company does not have any
derivative contracts hedging foreign currencies or derivative contracts held for
speculative purposes. The Company formally assesses, both at the hedge's
inception and on an ongoing basis, whether the derivatives used for hedging
transactions are highly effective in offsetting changes in fair values or cash
flows of hedged items. When it is determined that a derivative is not highly
effective as a hedge or that it has ceased to be a highly effective hedge, the
Company discontinues hedge accounting prospectively.
Changes in fair value of derivatives designated as cash flow hedges, to the
extent effective, are recorded in net unrealized gains/losses on derivatives, a
separate component of accumulated other comprehensive income. Amounts are
reclassified to earnings from accumulated other comprehensive income when the
underlying hedged item impacts earnings. Changes in fair value of derivatives
designated as fair value hedges are recorded currently in earnings to the extent
the derivative was effective in offsetting changes in fair value of the hedged
item.
(k) PREMIUM REVENUES
Premiums are recognized as earned using the monthly pro rata method over
the contract period.
(l) NEW ACCOUNTING STANDARDS
In December 2002, the FASB issued SFAS Statement No. 148, Accounting for
Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS
Statement No. 123 Accounting for Stock-Based Compensation. This Statement
AR-7
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
provides alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based compensation. In addition, this
Statement requires more prominent disclosures in both the 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 Statement and will adopt a
transition method at the time when a consistent fair value measurement and
recognition provision is determined by the FASB and is required to be adopted.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities ("FIN 46"), which requires the consolidation of
certain entities considered to be variable interest entities ("VIEs"). An entity
is considered to be a VIE when it has equity investors who lack the
characteristics of having a controlling financial interest, or its capital is
insufficient to permit it to finance its activities without additional
subordinated financial support. Consolidation of a VIE by an investor is
required when it is determined that the investor will absorb a majority of the
VIE's expected losses if they occur, receive a majority of the entity's expected
residual returns if they occur, or both. As a result of the Company adopting FIN
46, effective July 1, 2003, the financial operations of STFC Capital Trust I,
(the "Capital Trust") the Company's Delaware business trust subsidiary
(described in Note 7 below), are no longer consolidated within the accompanying
financial statements of the Company. The net impact of the adoption of FIN 46,
effective July 1, 2003, was a reclassification adjustment to eliminate the
Capital Trust's capital securities of $15.0 million from notes payable and
include State Auto Financial's investment of $464,000 in the common securities
of Capital Trust in other invested assets and $15.5 million principal amount of
Floating Rate Junior Subordinated Debt Securities issued to the Capital Trust in
notes payable.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with the Characteristics of Both Liabilities and Equity, effective
for reporting periods after July 1, 2003. This Statement establishes standards
for classifying and measuring as liabilities certain financial instruments that
embody obligations of the issuer and have characteristics of both liabilities
and equity. The Company adopted this statement effective July 1, 2003 with no
significant impact to the consolidated financial statements.
(m) RECLASSIFICATIONS
Certain items in the 2002 and 2001 consolidated financial statements have
been reclassified to conform to the 2003 presentation.
(2) INVESTMENTS
Realized and unrealized gains and losses are summarized as follows:
YEAR ENDED DECEMBER 31
--------------------------
2003 2002 2001
------- ------- ------
(in thousands)
Realized gains:
Fixed maturities available for sale ................................... $12,147 12,661 3,072
Equity securities ..................................................... 723 2,047 2,258
------- ------- ------
Total realized gains ..................................................... 12,870 14,708 5,330
------- ------- ------
Realized losses:
Fixed maturities available for sale ................................... 278 2,814 114
Equity securities ..................................................... 1,969 5,985 3,254
------- ------- ------
Total realized losses .................................................... 2,247 8,799 3,368
------- ------- ------
Net realized gains on investments ........................................ $10,623 5,909 1,962
======= ======= ======
Increase (decrease) in unrealized holding gains - Equity securities ...... $20,359 (11,611) (4,608)
Increase (decrease) in unrealized holding gains - Fixed
maturities available for sale at fair value ........................... (5,529) 58,491 (8,134)
Increase in unrealized holding gains - Other invested assets ............. 107 51 --
Change in deferred unrealized gain ....................................... (53) (35) (7)
Deferred federal income taxes thereon .................................... (5,208) (16,414) 4,462
------- ------- ------
Unrealized gains on investments, net of tax reclassification adjustment... 9,676 30,482 (8,287)
------- ------- ------
Derivative used in cash flow hedge ....................................... 804 -- --
------- ------- ------
Increase (decrease) in net unrealized holding gains or losses ............ $10,480 30,482 (8,287)
======= ======= ======
AR-8
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
See footnote 1(e) regarding investments. The Company's investments are
summarized as follows:
COST OR GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST HOLDING GAINS HOLDING LOSSES VALUE
---------- ------------- -------------- ---------
(in thousands)
AVAILABLE FOR SALE AT DECEMBER 31, 2003:
U.S. Treasury securities and obligations of U.S.
government agencies ...................................... $ 366,513 7,984 1,801 372,696
Obligations of states and political subdivisions ............ 676,468 46,485 596 722,357
Corporate securities ........................................ 98,637 6,807 86 105,358
U.S. government agencies mortgage-backed securities ......... 217,959 4,726 1,684 221,001
---------- ------ ----- ---------
Total fixed maturities ................................... 1,359,577 66,002 4,167 1,421,412
Equity securities ........................................... 121,025 19,783 1,551 139,257
Other invested assets ....................................... 9,485 164 6 9,643
---------- ------ ----- ---------
Total ....................................................... $1,490,087 85,949 5,724 1,570,312
========== ====== ===== =========
AVAILABLE FOR SALE AT DECEMBER 31, 2002:
U.S Treasury securities and obligations of U.S. government
agencies ................................................. $ 214,809 11,016 132 225,693
Obligations of states and political subdivisions ............ 696,191 41,574 444 737,321
Corporate securities ........................................ 128,631 10,453 72 139,012
U.S. government agencies mortgage backed securities ......... 109,703 4,969 -- 114,672
---------- ------ ----- ---------
Total fixed maturities ................................... 1,149,334 68,012 648 1,216,698
Equity securities ........................................... 55,837 6,148 8,275 53,710
Other invested assets ....................................... 1,857 51 -- 1,908
---------- ------ ----- ---------
Total ....................................................... $1,207,028 74,211 8,923 1,272,316
========== ====== ===== =========
Deferred federal income taxes on the net unrealized holding gain for
available for sale investments was $28.1 million and $22.9 million at December
31, 2003 and 2002, respectively.
The following table shows the Company's investments gross unrealized losses
and fair value, aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss position, at
December 31, 2003:
LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL
--------------------------------- ----------------------------- ------------------------------
Number Number Number
DESCRIPTION OF Unrealized of Fair Unrealized of Fair Unrealized of
SECURITIES Fair Value Losses Positions Value Losses Positions Value Losses Positions
- -------------------------- ---------- ---------- --------- ------ ---------- --------- ------- ---------- ---------
(in thousands, except number of positions)
U.S. Treasury securities and obligations of U.S.
government agencies $ 83,359 1,801 24 -- -- -- 83,359 1,801 24
Obligations of states and
political subdivisions ...... 33,940 596 17 -- -- -- 33,940 596 17
Corporate securities 6,466 86 2 -- -- -- 6,466 86 2
U.S. government agencies
mortgage backed securities .. 111,663 1,684 24 -- -- -- 111,663 1,684 24
-------- ----- -- ------ ----- --- ------- ----- --
Total fixed maturities $235,428 4,167 67 -- -- -- 235,428 4,167 67
Equity securities .............. 12,595 281 8 10,368 1,270 8 22,963 1,551 16
-------- ----- -- ------ ----- --- ------- ----- --
Total temporarily
impaired securities ......... $248,023 4,448 75 10,368 1,270 8 258,391 5,718 83
======== ===== == ====== ===== === ======= ===== ==
AR-9
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
Management concluded that none of the above unrealized losses are other
than temporary. The process to support this conclusion requires management to
make material estimates. See footnote 1(c) regarding material estimates.
Management believes the above fixed maturity and equity securities unrealized
losses are not other than temporary as the Company has the ability and intent to
hold the investments for a period of time sufficient for a forecasted market
price recovery up to or beyond the cost of the investment. Also, in management's
opinion, evidence indicating the cost of the investment is recoverable within a
reasonable period of time outweighs evidence to the contrary in considering the
severity and duration of the impairment in relation to the forecasted market
price recovery.
The amortized cost and fair value of fixed maturities at December 31, 2003,
by contractual maturity, are summarized as follows:
DECEMBER 31, 2003
AVAILABLE FOR SALE
----------------------
AMORTIZED FAIR
COST VALUE
---------- ---------
(in thousands)
Due in 1 year or less.................................. $ 3,796 3,966
Due after 1 year through 5 years....................... 44,395 47,213
Due after 5 years through 10 years..................... 326,563 341,483
Due after 10 years..................................... 771,941 812,961
Mortgage-backed securities............................. 212,882 215,789
---------- ---------
Total $1,359,577 1,421,412
========== =========
Expected maturities may differ from contractual maturities because the
issuers may have the right to call or prepay the obligations with or without
call or prepayment penalties. Fixed maturities with carrying values of
approximately $49.4 million and $45.3 million were on deposit with regulators as
required by law or specific escrow agreement at December 31, 2003 and 2002,
respectively. Components of net investment income are summarized as follows:
YEAR ENDED DECEMBER 31
-------------------------
2003 2002 2001
------- ------ ------
(in thousands)
Fixed maturities.................................... $62,363 58,225 41,262
Equity securities................................... 1,686 1,146 996
Cash and cash equivalents, and other................ 1,707 1,204 5,756
------- ------ ------
Investment income................................... 65,756 60,575 48,014
------- ------ ------
Investment expenses................................. 1,131 884 639
------- ------ ------
Net investment income............................... $64,625 59,691 47,375
======= ====== ======
The Company's current investment strategy does not rely on the use of
derivative financial instruments. See note 3 for additional fair value
disclosures.
(3) FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in
estimating its fair value disclosures for financial instruments:
INVESTMENT SECURITIES: Fair values for investments in fixed maturities are
based on quoted market prices, where available. For fixed maturities not
actively traded, fair values are estimated using values obtained from
independent pricing services. The fair values for equity securities are
based on quoted market prices. The fair value of other invested assets is
based on equity or cash flow, as applicable. The investment securities fair
value adjustments are recorded in the consolidated financial statements.
AR-10
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS: The carrying amounts reported in the balance
sheets for these instruments approximate their fair value, because of their
short-term nature.
NOTES PAYABLE AND INTEREST SWAP: The Mutual note and Trust Preferred note
(each as defined below) carrying amounts reported in the consolidated
balance sheets for these instruments approximate their fair value as the
interest rates adjust annually and quarterly, respectively. The $100.0
million, 6.25% senior notes have a fair value at December 31, 2003 of
$100.5 million. The financial statements reflect a $256,000 fair value
adjustment to the 6.25% senior notes which pertains to the hedged principal
amount of $50.0 million. The interest rate swap has a $485,000 ($256,000
related to debt and $229,000 related to accrued interest) fair value at
December 31, 2003. The financial statements reflect the fair value
adjustments related to the interest rate swap.
DECEMBER 31, 2003 DECEMBER 31, 2002
----------------------- ----------------------
CARRYING CARRYING
VALUE FAIR VALUE VALUE FAIR VALUE
---------- ---------- --------- ----------
(in thousands)
Fixed Maturities............ $1,421,412 1,421,412 1,216,698 1,216,698
Equity Securities........... 139,257 139,257 53,710 53,710
Other Invested Assets....... 9,643 9,643 1,908 1,908
Cash and Cash Equivalents... 40,005 40,005 96,048 96,048
Notes Payable............... 161,220 161,476 75,500 75,500
Fair Value Hedge............ $ 485 485 -- --
(4) LOSSES AND LOSS EXPENSES PAYABLE
Activity in the liability for losses and loss expenses is summarized as
follows:
YEAR ENDED DECEMBER 31
----------------------------
2003 2002 2001
-------- ------- -------
(in thousands)
Losses and loss expenses payable, at beginning of year................. $600,958 523,860 244,583
Less: reinsurance recoverable on losses and loss expenses payable...... 8,825 13,919 7,930
-------- ------- -------
Net balance at beginning of year....................................... 592,133 509,941 236,653
-------- ------- -------
Incurred related to:
Current year........................................................ 653,010 641,060 366,348
Prior years......................................................... (1,787) 12,414 60,726
-------- ------- -------
Total incurred......................................................... 651,223 653,474 427,074
-------- ------- -------
Paid related to:
Current year........................................................ 370,731 349,733 240,508
Prior years......................................................... 243,842 221,549 144,862
-------- ------- -------
Total paid............................................................. 614,573 571,282 385,370
-------- ------- -------
Impact of adding the former Meridian Mutual Insurance Company to the
Pooling Arrangement, effective July 1, 2001 (note 6)................ -- -- 75,575
Impact of pooling change, October 1, 2001 (note 6)..................... -- -- 156,009
-------- ------- -------
Net balance at end of year............................................. 628,783 592,133 509,941
Plus: reinsurance recoverable on losses and loss expenses payable...... 14,236 8,825 13,919
-------- ------- -------
Losses and loss expenses payable, at end of year (affiliate
$303,893, $303,960 and $280,011, respectively....................... $643,019 600,958 523,860
======== ======= =======
AR-11
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
The decrease of $1.8 million in 2003 and the increase of $12.4 million in
2002, for claims occurring in prior years is well within normal expectations for
reserve development and claim settlement uncertainty. The increase of $60.7
million in 2001 for claims occurring in prior years is primarily the result of
reserve strengthening on the former Meridian Mutual business in order to bring
these claim reserves in line with historic State Auto adequacy levels as well as
ongoing analysis of recent loss development trends.
(5) REINSURANCE
In the ordinary course of business, the Company assumes and cedes
reinsurance with other insurers and reinsurers and is a member in various pools
and associations. See Note 6(a) for discussion of reinsurance with affiliates.
The voluntary arrangements provide greater diversification of business and limit
the maximum net loss potential arising from large risks and catastrophes. Most
of the ceded reinsurance is effected under reinsurance contracts known as
treaties; some is by negotiation on individual risks. Although the ceding of
reinsurance does not discharge the original insurer from its primary liability
to its policyholder, the insurance company that assumes the coverage assumes the
related liability.
Amounts recoverable from reinsurers are estimated in a manner consistent
with the claim liability associated with the reinsured business. The
recoverability of these assets depends on the reinsurers' ability to perform
under the reinsurance agreements. The Company evaluates and monitors the
financial condition and concentrations of credit risk associated with its
reinsurers under voluntary reinsurance arrangements to minimize its exposure to
significant losses from reinsurer insolvencies. The Company has reported ceded
losses and loss expenses payable and prepaid reinsurance premiums with other
insurers and reinsurers as assets. All reinsurance contracts provide
indemnification against loss or liability relating to insurance risk and have
been accounted for as reinsurance.
Prior to the reinsurance transaction with Mutual under the Pooling
Arrangement, as discussed in note 6(a), the effect of the Company's reinsurance
on its balance sheets and income statements, is as follows:
DECEMBER 31
------------------
2003 2002
-------- -------
(in thousands)
Losses and loss expenses payable:
Direct................................................. $335,667 293,720
Assumed................................................ 3,458 3,278
Ceded.................................................. (8,529) (4,540)
-------- -------
Net losses and loss expenses payable................ $330,596 292,458
======== =======
Unearned premiums:
Direct................................................. $281,725 243,811
Assumed................................................ 1,281 1,049
Ceded.................................................. (4,528) (3,699)
-------- -------
Net unearned premiums............................... $278,478 241,161
======== =======
AR-12
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31
----------------------------
2003 2002 2001
-------- ------- -------
(in thousands)
Written premiums:
Direct..................................... $717,937 631,342 501,250
Assumed.................................... 5,125 3,876 4,196
Ceded...................................... (13,470) (12,203) (9,152)
-------- ------- -------
Net written premiums.................... $709,592 623,015 496,294
======== ======= =======
Earned premiums:
Direct..................................... $679,868 577,803 472,766
Assumed.................................... 4,893 3,934 4,304
Ceded...................................... (12,751) (11,260) (8,335)
-------- ------- -------
Net earned premiums..................... $672,010 570,477 468,735
======== ======= =======
Losses and loss expenses incurred:
Direct..................................... $447,246 413,359 328,363
Assumed.................................... 3,302 2,383 3,054
Ceded...................................... (6,498) (1,945) (1,550)
-------- ------- -------
Net losses and loss expenses incurred... $444,050 412,382 329,867
======== ======= =======
(6) TRANSACTIONS WITH AFFILIATES
(a) REINSURANCE
State Auto P&C, Milbank, Farmers, SA Ohio (the "STFC Pooled Companies"), SA
Wisconsin and beginning January 1, 2003, SA Florida, participate in a quota
share reinsurance pooling arrangement (the Pooling Arrangement) with Mutual
whereby the STFC Pooled Companies, SA Wisconsin and SA Florida cede to Mutual
all of their insurance business and assume from Mutual an amount equal to their
respective participation percentages in the Pooling Arrangement. All premiums,
losses and loss expenses and underwriting expenses are allocated among the
participants on the basis of each company's participation percentage in the
Pooling Arrangement. The Pooling Arrangement provides indemnification against
loss or liability relating to insurance risk and has been accounted for as
reinsurance.
Effective January 1, 2003, the Pooling Arrangement was amended, adding SA
Florida as a participant. At December 31, 2002, SA Florida had not commenced
insurance operations, consequently, there was no impact on the Company's
financial statements at January 1, 2003 relating to the Pooling Arrangement
amendment. The STFC Pooled Companies share of the Pool remained at 80% during
the years 2003 and 2002.
In 2000, Mutual entered into an agreement with Meridian Mutual Insurance
Company (Meridian Mutual), an Indiana domiciled property and casualty insurance
company, pursuant to which Meridian Mutual would be merged with and into Mutual,
with Mutual continuing as the surviving corporation. The effective date of the
merger transaction was June 1, 2001. With the merging of Meridian Mutual into
Mutual, all insurance business that had been written by Meridian Mutual became,
legally, Mutual business. For the period June 1, 2001 through June 30, 2001, the
insurance business formerly known as the Meridian Mutual business prior to the
June 1 merger transaction was excluded from the Pooling Arrangement. Effective
July 1, 2001, the insurance business of the former Meridian Mutual became part
of the Pooling Arrangement, and the STFC Pooled Companies assumed 53% of the
former Meridian Mutual business on this same date. Concurrently, with this
transaction, the STFC Pooled Companies received cash of $6.4 million and fixed
maturities totaling $109.7 million from Mutual which related to the additional
net insurance liabilities assumed by the STFC Pooled Companies on July 1, 2001.
As part of the resolution of the disagreement with the Ohio Department of
Insurance (ODI) regarding the recognition of the service fee revenue paid by
Mutual to State Auto P&C (see note 6(d)), the STFC Pooled Companies aggregate
participation in the Pooling Arrangement was increased to 80%, effective October
1, 2001. In conjunction with this change in pool participation, the STFC Pooled
Companies received cash of $2.2 million and fixed maturities totaling $236.3
million from Mutual, which related to the additional net insurance liabilities
assumed on October 1, 2001. All parties that participate in the Pooling
Arrangement have an A. M. Best rating of A+ (Superior).
AR-13
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
The Pooling Arrangement does not relieve each individual pooled subsidiary
of its primary liability as the originating insurer, consequently, there is a
concentration of credit risk arising from business ceded to Mutual. As the
Pooling Arrangement provides for the right of offset, the Company has reported
losses and loss expenses payable and prepaid reinsurance premiums to Mutual as
assets only in situations when net amounts ceded to Mutual exceed that assumed.
The following provides a summary of the reinsurance transactions on the
Company's balance sheets and income statements for the Pooling Arrangement
between the STFC Pooled Companies and Mutual:
DECEMBER 31
--------------------
2003 2002
--------- --------
(in thousands)
Losses and loss expenses payable:
Ceded................................................ $(290,979) (261,470)
Assumed.............................................. 594,872 565,430
--------- --------
Net assumed....................................... $303,893 303,960
========= ========
Unearned premiums:
Ceded................................................ $(250,308) (212,077)
Assumed.............................................. 371,643 345,207
--------- --------
Net assumed....................................... $121,335 133,130
========= ========
YEAR ENDED DECEMBER 31
-------------------------------
2003 2002 2001
--------- -------- --------
(in thousands)
Written premiums:
Ceded..................................... $(616,571) (534,377) (448,331)
Assumed................................... 917,051 864,830 529,253
--------- -------- --------
Earned premiums:
Ceded..................................... $(578,186) (495,036) (426,880)
Assumed................................... 889,532 829,981 515,619
--------- -------- --------
Losses and loss expenses incurred:
Ceded..................................... $(372,810) (353,602) (298,755)
Assumed................................... 594,816 609,910 406,138
--------- -------- --------
Effective with the June 1, 2001 merger transaction of Meridian Mutual into
Mutual, Mutual also acquired all of the outstanding shares of Meridian Insurance
Group, Inc. (MIGI), an Indiana domiciled insurance holding company. MIGI's
wholly-owned insurance subsidiaries are Meridian Security Insurance Company
(Meridian Security), an Indiana domiciled property and casualty insurer, and
Meridian Citizens Security Insurance Company, an Indiana domiciled property and
casualty insurer. MIGI is also party to an affiliation agreement with Meridian
Citizens Mutual Insurance Company, an Indiana domiciled property and casualty
insurer. Collectively, the MIGI insurer subsidiaries and affiliate are hereafter
collectively referred to as the "Meridian Insurers." The STFC Pooled Companies,
SA National, Mid-Plains, Mutual, SA Wisconsin, SA Florida and the Meridian
Insurers are collectively referred to as the "State Auto Group."
State Auto P&C assumes catastrophe reinsurance from the State Auto Group in
the amount of $100 million excess of $120 million in exchange for a premium paid
by each reinsured company. Under this agreement, the Company has assumed from
Mutual and its affiliates premiums written and earned of $2.8 million, $2.9
million and $3.0 million for 2003, 2002 and 2001, respectively. There have been
no losses assumed under this agreement. The catastrophe reinsurance program with
State Auto P&C has been excluded from the Pooling Arrangement.
To protect against a catastrophe loss event in which the State Auto Group
would incur catastrophe losses in excess of $120 million, State Auto Financial
entered into a structured contingent financing transaction with a financial
institution and a syndicate of other lenders (the Lender) to provide up to $100
million for reinsurance purposes. In the event of such a loss, this arrangement
provides that State Auto Financial would sell redeemable preferred shares to SAF
Funding Corporation, a special purpose company (SPC), which would borrow the
money necessary for such purchase from the Lenders. This
AR-14
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
arrangement with the Lenders, SPC and State Auto Financial is a financing
arrangement, whereby State Auto Financial would receive cash funding in the
event of a catastrophe event as described above. State Auto Financial would then
contribute to State Auto P&C the funds received from the sale of its preferred
shares. State Auto P&C would use the contributed capital proceeds to pay its
direct catastrophe losses and losses assumed under the catastrophe reinsurance
agreement. State Auto Financial is obligated to repay SPC by redeeming the
preferred shares over a five-year period. In the event of a default by State
Auto Financial, the obligation to repay SPC has been secured by a Put Agreement
among State Auto Financial, Mutual and the Lenders, under which Mutual would be
obligated to either purchase the preferred shares from the SPC or repay the SPC
for the loan(s) outstanding.
For the period October 1, 2001 through December 31, 2003, Mutual entered
into a stop loss reinsurance arrangement (Stop Loss) with the STFC Pooled
Companies. Under the Stop Loss, Mutual have agreed to participate in the Pooling
Arrangement's quarterly underwriting losses and gains in the manner described.
If the Pooling Arrangement's statutory loss and loss adjustment expense ratio
(loss ratio) was between 70.75% and 80% (after the application of all available
reinsurance), Mutual reinsured the STFC Pooled Companies 27% of the Pooling
Arrangement's losses in excess of a loss ratio of 70.75% up to 80.00%. The STFC
Pooled Companies were responsible for their share of the Pooling Arrangement's
losses over the 80% threshold. Also, Mutual had the right to participate in the
profits of the Pooling Arrangement. Mutual assumed 27% of the Pooling
Arrangement's underwriting profits attributable to loss ratios less than 69.25%,
but more than 59.99%. During 2003, 2002 and 2001, the STFC Pooled Companies
ceded to Mutual, $5.6 million, $8.8 million and $6.2 million in losses,
respectively, and $12.8 million, $1.4 million and $0, respectively, in premiums
under the Stop Loss. The Stop Loss ceased at December 31, 2003.
SA National and Mid-Plains each have ceding reinsurance agreements with
Mutual that include excess of loss and quota share coverages. Through Mutual's
participation in the Pooling Arrangement, the effects of these agreements with
SA National and Mid-Plains are indirectly subject to the Pooling Arrangement
between Mutual and the STFC Pooled Companies.
The following provides a summary of the ceding reinsurance transactions on
the Company's balance sheets and income statement for the reinsurance agreements
between SA National and Mutual and Mid-Plains and Mutual:
2003 2002
------ -----
(in thousands)
Losses and loss expenses payable .............................. $5,707 4,285
Unearned premiums ............................................. $3,906 3,996
2003 2002 2001
------- ------ -----
(in thousands)
Written premiums .................................... $12,850 12,097 6,295
Earned premiums ..................................... $12,831 10,299 5,288
Losses and loss expenses incurred ................... $ 9,209 7,862 3,999
(b) INTERCOMPANY BALANCES
Pursuant to the Pooling Arrangement, Mutual is responsible for the
collection of premiums and payment of losses, loss expenses and underwriting
expenses of the STFC Pooled Companies. Unpaid balances are reflected in due to
or due from affiliates in the accompanying consolidated balance sheets.
Settlements of the intercompany account are made quarterly. No interest is paid
on this account. All premium balance receivables and reinsurance recoverable on
paid losses from unaffiliated reinsurers are carried by Mutual. The Company had
off-balance-sheet credit risk of approximately $201 million and $167 million
related to premium balances due to Mutual from agents and insureds at December
31, 2003 and 2002, respectively, which is collateralized by the unearned premium
from the respective policies.
(c) NOTES PAYABLE
In 1999 State Auto Financial entered into a line of credit agreement with
Mutual for $45.5 million in conjunction with its stock repurchase program.
Principal payment is due on demand by December 31, 2005. The interest rate is
adjustable annually at January 1 to reflect adjustments in the then current
prime lending rate less 1.75% as well as State Auto Financial's current
financial position. Interest rate for the years 2003, 2002 and 2001 was 2.50%,
3.00% and 7.75%, respectively. Interest rate for the year 2004 is 2.25%.
AR-15
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
Upon receipt of the written approval of the South Dakota Director of
Insurance, in the fourth quarter of 2003 Milbank repaid the $15.0 million
surplus contribution note to Meridian Security that was entered into on
September 30, 2002. Subject to the condition described below and the other terms
of the note, the maturity date was September 30, 2012. The interest rate was
equal to the U.S. Treasury ten-year note yield at September 30, 2002 plus 100
basis points (total 4.59%) and was adjustable October 1, 2007 to the then
current U.S. Treasury ten-year note yield plus 100 basis points for the
remaining term of the note. Interest was accrued, but all payments of principal
or interest could be made only with the prior written approval of the South
Dakota Director of Insurance.
Total affiliates interest expense was $2.8 million, $2.3 million and $2.3
million in 2003, 2002 and 2001, respectively. Total interest expense paid to
affiliates was $2.8 million, $2.2 million and 2.3 million in 2003, 2002 and
2001, respectively. See discussion of notes payable (non-affiliate) and hedges
at Note 7.
(d) MANAGEMENT SERVICES
Stateco provides Mutual and its affiliates investment management services.
Investment management income is recognized quarterly based on a percentage of
the average fair value of investable assets and the equity portfolio performance
of each company managed. Revenue related to these services amounted to $2.2
million, $2.1 million and $3.0 million in 2003, 2002 and 2001, respectively, and
is included in other income (affiliates).
State Auto P&C provides management and operation services to Mutual and its
insurance affiliates. Revenue relating to these services amounted to $1.1
million, $553,000 and $12.6 million in 2003, 2002 and 2001, respectively. During
early 2001, the ODI requested that Mutual file an analysis with the ODI on a
quarterly basis, starting with the quarter beginning January 1, 2001, that
justified the apportionment of the management and operation services fee paid by
Mutual to State Auto P&C under the accounting guidance outlined in Statement of
Statutory Accounting Principles No. 70 - Allocation of Expenses. The Company
believed its accounting for such service fee was consistent with all statutory
accounting principles. On October 24, 2001, the Board of Directors of the
Company and Mutual and special committees thereof approved a resolution of the
disagreement between the Company and the ODI regarding the service fee paid by
Mutual to State Auto P&C. The disagreement with ODI was resolved, and ODI
expressly did not take issue with Mutual's payment of the service fee to State
Auto P&C for the nine-month period ending September 30, 2001 which amounted to
$12.5 million, pre-tax, nor with Mutual's accounting for the service fee for
this same time period. The ODI also approved regulatory filings, effective
October 1, 2001, implementing a revised management agreement, changing the STFC
Pooled Companies pooling participation percentages and implementing a stop loss
reinsurance arrangement. See note 6(a) regarding the change in the STFC Pooled
Companies pooling participation percentages and the implementation of a stop
loss reinsurance arrangement.
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. The management
agreement continues to allocate costs and apportion those costs among the
parties to the agreement in accordance with terms outlined therein. As a result
of the loss of the management and operations services income under this
management agreement, a substantial portion of State Auto P&C's services income
has been eliminated, effective October 1, 2001.
(e) OTHER TRANSACTIONS
State Auto P&C's December 31, 1990 liability for losses and loss expenses
of $65.5 million has been guaranteed by Mutual. Pursuant to the guaranty
agreement, all ultimate adverse development of the December 31, 1990 liability,
if any, is to be reimbursed by Mutual to State Auto P&C in conformance with
pooling percentages in place at that time. As of December 31, 2003, there has
been no adverse development of the liability.
(7) NOTES PAYABLE AND DERIVATIVES
On May 22, 2003, STFC Capital Trust I, State Auto Financial's Delaware
business trust subsidiary (the "Capital Trust"), issued $15.0 million
liquidation amount of its capital securities to a third party. In connection
with the Capital Trust's issuance of the capital securities and the related
purchase by State Auto Financial of all of the Capital Trust's common securities
(liquidation amount of $464,000 included in other invested assets) (the Capital
Trust's capital and common securities are hereafter referred to as the "Trust
Securities"), State Auto Financial issued to the Capital Trust $15.5 million
aggregate principal amount of Floating Rate Junior Subordinated Debt Securities
due 2033 (the "Subordinated Debentures"). The sole assets of the Capital Trust
are the Subordinated Debentures and any interest accrued thereon. Interest on
the Trust Securities is payable quarterly at a rate equal to the three-month
LIBOR rate plus 4.20%, adjusted quarterly (total 5.37% at December 31, 2003).
Prior to May 2008, the interest rate may not exceed 12.5% per annum. The
interest rate and interest payment dates on the Subordinated Debentures are the
same as the interest rate and interest payment dates on the Trust
AR-16
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
Securities. In January 2003, the FASB issued FIN 46, Consolidation of Variable
Interest Entities, effective for reporting periods beginning after June 15,
2003. As a result of the Company adopting FIN 46 effective July 1, 2003, the
financial statements of the Capital Trust are no longer consolidated within the
accompanying financial statements of the Company. See additional discussion of
new accounting standards at note 1(l).
The Trust Securities are mandatorily redeemable on May 23, 2033, and may be
redeemed at any time on and after May 23, 2008, at 100% of the principal amount
thereof plus unpaid interest. The Trust Securities may be redeemed in whole, but
not in part, at any time within 90 days following the occurrence of a "Tax
Event" or "Investment Company Event" (as defined in the declaration of trust)
(a) if such Tax Event or Investment Company Event occurs on or after May 23,
2008, at a redemption price equal to 100% of the principal amount thereof plus
unpaid interest, and (b) if such Tax Event or Investment Company Event occurs
prior to May 23, 2008, at a redemption price equal to the greater of 100% of the
principal amount thereof plus accrued interest and a "make-whole" amount. The
Subordinated Debentures are subject to these same redemption terms. The
obligations under the Subordinated Debentures and related agreements, taken
together, constitute a full and unconditional guarantee of payments due on the
Trust Securities.
State Auto Financial has the right, at any time, to defer payments of
interest on the Subordinated Debentures for up to 20 consecutive quarterly
payment periods. Consequently, distributions on the Trust Securities would be
deferred (though such distributions would continue to accrue with interest since
interest would accrue on the Subordinated Debentures during any such extended
interest payment period). In no case may the deferral of payments and
distributions extend beyond the stated maturity dates of the respective
securities. During such deferments, State Auto Financial may not declare or pay
any dividends on, or purchase any of, its capital stock, make any principal or
interest payments on debt securities that rank in all respects equally with or
subordinated to the Subordinated Debentures, or make any payment under
guarantees that rank in all respects equally with or subordinated to State Auto
Financial's guaranty of the Trust Securities.
The Subordinated Debentures are unsecured and subordinated to all of the
Company's existing and future senior indebtedness. As sponsor of the Capital
Trust, State Auto Financial incurred security issuance costs related to the
Trust Preferred Capital Securities and Subordinated Debentures of $535,000,
which is recorded in other assets and is being amortized into interest expense
($13,000 for 2003) as the underlying interest expense is recognized on the Trust
Securities.
On November 13, 2003 State Auto Financial issued $100 million unsecured
senior notes (Senior Notes) bearing interest fixed at 6.25% due November 15,
2013. Interest on the Senior Notes is payable May 15 and November 15 of each
year beginning May 15, 2004. The Senior Notes are general unsecured obligations
ranking senior to all existing and future subordinated indebtedness and equal
with all existing and future senior indebtedness. The Senior Notes are not
guaranteed by any of the Company subsidiaries and thereby are effectively
subordinated to all Company subsidiaries existing and future indebtedness. State
Auto Financial may redeem the Senior Notes in whole at anytime or in part from
time to time at State Auto Financial's option, on at least 30 but not more than
60 days' prior written notice, at a redemption price equal to the greater of the
principal amount of such notes being redeemed on the redemption date or the make
whole amount, based on U.S. Treasury rates as defined by the Senior Notes, plus
in each case, accrued and unpaid interest, if any, on the Senior Notes to the
redemption date. The Senior Notes issued contain certain covenants as defined in
the notes, which among other things, limit State Auto Financial and its
subsidiaries ability to issue indebtedness secured by the capital stock of
certain State Auto Financial subsidiaries and sell the capital stock of certain
State Auto Financial subsidiaries. The Senior Notes also contain a covenant that
requires State Auto Financial to take certain actions in the event it engages in
mergers, consolidations or sales of all or substantially all of the assets and
prohibits from engaging in such transaction if State Auto Financial is in
default under the Senior Notes. State Auto Financial incurred $1.5 million in
issuance costs related to the Senior Notes, which is recorded in other assets
and is being amortized into interest expense ($14,000 for 2003) as the
underlying interest expense is recognized on the Trust Securities.
On October 1, 2003 State Auto Financial entered into an interest rate swap
contract for a notional amount of $25.0 million as a hedge on the ten year
treasury rate in connection with the forecasted issuance of the Senior Notes.
The swap contract was designated as a cash flow hedge and settled on November 6,
2003, the pricing date of the Senior Notes, with the Company receiving $811,000.
The gain has been recorded in accumulated other comprehensive income and is
being accreted as an offset to interest expense ($7,000 in 2003) as the
underlying interest expense is recognized for the Senior Notes. Management
estimates $61,000 will be accreted as an offset to interest expense in 2004.
On November 6, 2003 State Auto Financial entered into an interest rate swap
contract for a notional amount of $50.0 million receiving semiannual payments at
a fixed rate of 6.25% and making semiannual payments at a variable rate equal to
six month LIBOR plus 1.25 percent with LIBOR to be determined the last day of
each interest reset period (total 2.47% at December 31, 2003). The swap contract
was designated as a fair value hedge to protect against changes in fair value of
the Senior Notes. Recorded in other assets at December 31, 2003, the fair market
value of the fixed to floating interest rate
AR-17
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
swap was $485,000 of which $229,000 related to net accrued interest to be
received and reduce reported interest expense in the period. The amount of hedge
ineffectiveness was not material.
On December 21, 2003, State Auto Financial repaid the $15.0 million term
loan note to the bank that it entered into on December 21, 2002. Interest
adjusted quarterly and accrued at LIBOR plus 0.75 points (2.15% at December 31,
2002) and was payable quarterly. This note agreement had various covenants
including financial ratio covenants.
Total cash paid for interest was $3.1 million, $2.2 million and $2.3
million in 2003, 2002 and 2001. See discussion of affiliate notes payable at
note 6 (c). Notes payable at December 31, 2003 and 2002 consisted of the
following:
DECEMBER 31, 2003 DECEMBER 31, 2002
----------------------------- ----------------------------
CARRYING FAIR INTEREST CARRYING MARKET INTEREST
VALUE VALUE RATE VALUE VALUE RATE
------------------------------------------------------------
(in thousands, except interest rates)
Senior notes due 2013: issued $100,000, November
2003 with fixed interest .................... $100,256 100,512 6.25% -- -- --
Subordinated debentures due 2033: issued
$15,464, May 2003 with variable interest .... 15,464 15,464 5.37% -- -- --
Affiliate note payable due on demand prior to
December 31, 2005: issued $45,500, June 1999
with variable interest ...................... 45,500 45,500 2.50% 45,500 45,500 3.00
Affiliate surplus note: issued $15,000,
September 2002 with variable interest ....... -- -- -- 15,000 15,000 4.59
Note payable to bank: issued $15,000, December
2002 with variable interest ................. -- -- -- 15,000 15,000 2.15
-------- ------- ------ ------
Total Notes Payable ......................... $161,220 161,476 75,500 75,500
======== ======= ====== ======
(8) FEDERAL INCOME TAXES
A reconciliation between actual federal income tax expense (benefit) and
the amount computed at the indicated statutory rate is as follows:
YEAR ENDED DECEMBER 31
--------------------------------------------
2003 2002 2001
AMOUNT % AMOUNT % AMOUNT %
------- --- ------- --- ------ ---
(in thousands)
Amount at statutory rate .............................. $29,147 35 13,227 35 6,291 35
Tax-free interest and dividends received deduction .... (9,744) (12) (11,888) (32) (8,925) (50)
Other, net ............................................ 252 1 (544) (1) (5) --
------- --- ------- --- ------ ---
Effective tax and rate ................................ $19,655 24 795 2 (2,639) (15)
======= === ======= === ====== ===
AR-18
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and deferred tax liabilities are presented
below:
DECEMBER 31
----------------
2003 2002
------- ------
(in thousands)
Deferred tax assets:
Unearned premiums not deductible ......................... $27,734 25,927
Losses and loss expenses payable discounting ............. 21,983 21,626
Postretirement benefit liabilities ....................... 18,295 16,438
Other .................................................... 5,925 5,658
Alternative minimum tax credit ........................... 217 3,439
------- ------
Total deferred tax assets ............................. 74,154 73,088
------- ------
Deferred tax liabilities:
Deferral of policy acquisition costs ..................... 30,485 27,260
Net prepaid pension expense .............................. 16,917 15,583
Unrealized holding gain on investments ................... 28,101 22,891
Other .................................................... 659 1,558
------- ------
Total deferred tax liabilities ........................ 76,162 67,292
------- ------
Net deferred tax asset (liability) .................... $(2,008) 5,796
======= ======
The Company is required to establish a valuation allowance for any portion
of the deferred tax asset that management believes will not be realized. In the
opinion of management, it is more likely than not that the Company will realize
the benefit of the deferred tax assets and, therefore, no such valuation
allowance has been established.
Federal income taxes paid during 2003, 2002 and 2001 were $15.9 million,
$6.0 million and $11.5 million, respectively.
(9) PENSION AND POSTRETIREMENT BENEFIT PLANS
The Company provides a pension benefit plan for its eligible employees.
Substantially all Company employees become eligible to participate the year
after becoming 20 years of age and vest with 5 years of credited service or
attain age 65.
The Company's policy is to fund pension costs in accordance with the
requirements of the Employee Retirement Income Security Act of 1974. Benefits
are determined by applying factors specified in the plan to a participant's
defined average annual compensation.
Effective January 1, 2002, employees of 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 pension plan benefit liabilities
were transferred from MIGI to the Company.
In addition to the pension benefit plan, the Company provides a
postretirement benefit plan including certain health care and life insurance
benefits for its eligible retired employees. Substantially all of the Company's
employees may become eligible for these postretirement benefits if they retire
between age 55 and 65 with 15 years or more of service or if they retire at age
65 or later with 5 years or more of service.
The Company did not adjust its liability for postretirement benefits
obligation in consideration of the potential impact of the Medicare Prescription
Drug, Improvement and Modernization Act of 2003, since guidance is not final.
The Company used September 30, 2003, 2002 and 2001, respectively, to
determine the pension and postretirement benefit measurements. Information
regarding the Company's pension and postretirement benefit plans change in
benefit obligation, plan assets and funded status are as follows:
AR-19
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
PENSION POSTRETIREMENT
------------------ ------------------
DECEMBER 31
---------------------------------------
2003 2002 2003 2002
-------- ------- -------- -------
(in thousands)
CHANGE IN BENEFIT OBLIGATION
Benefit obligation at beginning of year ....................... $150,067 97,477 71,199 48,558
Transfer in benefit obligation at beginning
of year due to employee transfer ........................... -- 31,440 -- 8,235
Service cost .................................................. 6,996 5,541 3,206 2,400
Interest cost ................................................. 9,894 9,399 4,713 4,179
Actuarial loss ................................................ 6,477 15,111 2,246 9,336
Contributions ................................................. -- -- (2,224) (1,509)
Benefits paid ................................................. (9,468) (8,901) -- --
-------- ------- -------- -------
Benefit obligation at end of year ............................. $163,966 150,067 79,140 71,199
-------- ------- -------- -------
CHANGE IN PLAN ASSETS
Fair value of plan assets at beginning of year ................ $150,559 136,197 1,896 1,768
Transfer in plan assets at beginning of year due to employee
transfer ................................................... -- 31,320 -- --
Actual gain(loss) return on plan assets ....................... 19,878 (8,057) -- --
Benefits paid ................................................. (9,468) (8,901) -- --
Expected return on plan assets ................................ -- -- 171 150
Gain (loss) on assets ......................................... -- -- (89) (22)
-------- ------- -------- -------
Fair value of plan assets at end of year ...................... $160,969 150,559 $ 1,978 1,896
-------- ------- -------- -------
Funded status ................................................. $ (2,997) 492 (77,161) (69,303)
Unrecognized transition asset ................................. (4,878) (5,511) (31) (34)
Unrecognized prior service cost ............................... 2,675 2,963 4,612 5,073
Unrecognized net loss ......................................... 52,055 48,746 2,444 110
Contribution .................................................. 4,560 -- -- --
-------- ------- -------- -------
Net prepaid (accrued obligation) benefit at end of year ....... $ 51,415 46,690 (70,136) (64,154)
-------- ------- -------- -------
Amounts recognized in the statement of financial position consist of the
following:
SERP (defined below) liability ................................ -- -- (4,114) (2,609)
-------- ------- -------- -------
Net prepaid (accrued obligation)benefit recognized ............ $ 51,415 46,690 (74,250) (66,763)
-------- ------- -------- -------
AR-20
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
Information regarding the Company's pension and postretirement benefit
plans components of net periodic benefit cost and weighted average assumptions
for the years ended December 31, 2003, 2002 and 2001are as follows:
PENSION POSTRETIREMENT
---------------------------- ---------------------
2003 2002 2001 2003 2002 2001
-------- ------- ------- ----- ----- -----
(in thousands)
COMPONENTS OF NET PERIODIC BENEFIT COST
Service cost ............................ $ 6,996 5,541 3,537 3,205 2,400 1,423
Interest cost ........................... 9,895 9,399 6,750 4,713 4,179 3,356
Expected return on plan assets .......... (16,710) (16,724) (14,633) (171) (150) (133)
Amortization of prior service cost ...... 288 280 207 461 (3) (3)
Amortization of transition asset ........ (633) (633) (121) (3) 461 --
Amortization of net gain ................ -- -- (1,346) -- (275) (520)
-------- ------- ------- ----- ----- -----
Net periodic (benefit) cost ............. $ (164) (2,137) (5,606) 8,205 6,612 4,123
======== ======= ======= ===== ===== =====
The Company had no additional minimum liability included in other
comprehensive income for the Pension and Postretirement plans for 2003, 2002 and
2001.
Summarized in the following table are the weighted average assumptions used
to determine the Company benefit obligations for the years ended December 31,
2003 and 2002:
PENSION POSTRETIREMENT
----------- --------------
2003 2002 2003 2002
---- ---- ---- ----
BENEFIT OBLIGATIONS
WEIGHTED-AVERAGE ASSUMPTIONS
Discount rate ................................... 6.5% 6.75% 6.5% 6.75%
Rates of increase in compensation levels ........ 5.0% 5.0% -- --
Summarized in the following table are the weighted average assumptions used to
determine the Company net periodic benefit cost for the years ended December 31,
2003, 2002 and 2001:
PENSION POSTRETIREMENT
------------------ ------------------
2003 2002 2001 2003 2002 2001
---- ---- ---- ---- ---- ----
PERIODIC BENEFIT COST
WEIGHTED-AVERAGE ASSUMPTIONS
Discount rate ................................. 6.75% 7.5% 8.0% 6.75% 7.5% 8.0%
Expected long-term rate of return on assets ... 9.0% 9.0% 9.0% 9.0% 8.5% 8.5%
Rates of increase in compensation levels ...... 5.0% 5.0% 5.0% -- -- --
The Company's defined benefit plan obligations are long-term in nature and
consequently the investment strategies have a long-term time horizon. In
establishing the long term rate of return assumption on plan assets, management,
along with its pension consulting actuary, reviews the historical performance of
the plan assets and the stability in mix of investment portfolio. The expected
inflation rate and expected real rates of return of applicable asset classes are
then determined to assist in setting appropriate assumptions. The relatively
stable investment strategy between fixed maturities and equity securities has
produced a 10 year average rate of return on plan assets through September 30,
2003 of 10.1%.
AR-21
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
The assumed health care cost trend rates used for the years ended December
31, 2003, 2002 and 2001 are as follows:
POSTRETIREMENT
----------------------
YEAR ENDED DECEMBER 31
----------------------
2003 2002 2001
---- ---- ----
ASSUMED HEALTH CARE COST TREND RATES
Health care cost trend rate assumed for the next year......... 9.0% 10.0% 10.0%
Rate to which the cost trend rate is assumed to decline
(the ultimate trend rate).................................. 5.0% 5.0% 5.0%
Year that the rate reaches the ultimate trend rate............ 2008 2008 2007
The assumed health care cost trend rates have a significant effect on the
amounts reported for the postretirement plan. A one percentage point change in
assumed health care cost trend rates would have the following effects:
POSTRETIREMENT
----------------------------
YEAR ENDED DECEMBER 31, 2003
----------------------------
One percentage point change INCREASE (DECREASE)
-------- ----------
(in thousands)
Effect on total service and interest cost.................... $ 1,740 (1,369)
Effect on accumulated postretirement benefit obligation...... 15,370 (12,303)
The Company's pension and postretirement benefit plans weighted average
asset allocations by asset category at the Plans' measurement date of September
30, 2003 and 2002, respectively, are as follows:
PENSION POSTRETIREMENT
------------- --------------
DECEMBER 31
------------------------------
2003 2002 2003 2002
----- ----- ---- ----
ASSET CATEGORY
Equity securities ............................. 61.5% 55.0% -- --
Fixed maturity securities ..................... 38.3 44.9 100% 100%
Cash and cash equivalents ..................... 0.2 0.1 -- --
----- ----- --- ---
Total ...................................... 100.0% 100.0% 100% 100%
===== ===== === ===
The Plan's investment policy objective is to preserve the investment
principal while generating income and appreciation in fair value to meet the
Plans' obligations. The Plans' investment strategy and risk tolerance is
balanced between meeting cash obligation requirements and a long term relatively
high risk tolerance. Since the nature and timing of the Plans' liabilities and
cash requirements are predictable, the liquidity requirements are somewhat
moderate. Therefore at least 75% of the Plans' assets should be in public
marketable securities. Bond investments will normally range from 10 to 20 years
in maturity. Debt instruments, convertible debt and preferred stock are rated
"A" or better by two major rating services. The equity portfolio is comprised
primarily of large capitalization, high quality stocks with a strong earnings
growth and dividends payment history. Total holding of a specific stock cannot
exceed 2% of the outstanding stock. No one equity holding can be greater than 5%
of the total equity portfolio. Total holdings of bonds and stocks of any one
corporation cannot exceed 5% of admitted assets.
AR-22
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
The following table summarizes the Plans' asset allocation exposure range
as a percent of total assets fair market value:
EXPOSURE
INVESTMENT INSTRUMENT RANGE
--------
(0 to %)
Cash and cash equivalents............................................ 10
U.S. governments debt................................................ 100
U.S. government agencies debt........................................ 50
Corporate debt....................................................... 20
Preferred stock...................................................... 10
Common stock......................................................... 70
Convertible securities............................................... 25
Private placement and other.......................................... 6
The Company expects to contribute approximately $4.0 million to its pension
plan in 2004.
All Company and affiliate personnel are employees of State Auto P&C. The
Company through State Auto P&C, provides management and operation services under
management agreements for all insurance and non-insurance affiliates. The
pension net prepaid expense is carried on the financial statements of the
Company, and the annual periodic pension benefit or cost is allocated to
affiliated companies based on allocations pursuant to intercompany management
agreements. The Company's share of the 2003, 2002 and 2001 net periodic benefit
was $164,000, $2.0 million and $4.0 million, respectively.
The postretirement net accrued obligation is also carried on the financial
statements of the Company and the annual periodic postretirement benefit or cost
is allocated to affiliated companies based on allocations pursuant to
intercompany management agreements. The Company's share of the 2003, 2002 and
2001 net periodic cost was $7.0 million, $5.6 million and $3.0 million,
respectively.
Also, the Company has a supplemental executive retirement plan (SERP) for
which the accrued obligation at December 31, 2003 and 2002 was $4.2 million and
$2.6 million, respectively, that is included in the balance sheet postretirement
benefit liabilities amount.
The Company maintains a defined contribution plan that covers substantially
all employees of the Company. The Company matches the first 2% of contributions
of participants' salary at the rate of 75 cents for each dollar contributed.
Participant contributions of 3% to 6% are matched at a rate of 50 cents for each
dollar contributed. The Company's share of the expense under the plan totaled
$2.1 million, $2.0 million and $1.1 million for the years 2003, 2002 and 2001,
respectively.
(10) STOCKHOLDERS' EQUITY
(a) TREASURY SHARES
On March 1, 2002, the State Auto Financial's Board of Directors approved a
plan to repurchase up to 1.0 million shares of common stock from the public over
a period extending to and through December 31, 2003. Through December 31, 2003,
State Auto Financial repurchased 438,023 shares from the public under this plan
of which 45,000 and 393,023 shares were purchased during 2003 and 2002,
respectively. In May 2000, State Auto Financial's Board of Directors approved a
plan to repurchase up to 1.0 million shares of its common stock from the public
over a period ending December 31, 2001. Through December 31, 2001, State Auto
Financial repurchased 50,522 shares from the public. Repurchases during 2003,
2002 and 2001 were funded through dividends from subsidiaries.
(b) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION
State Auto P&C, Milbank, Farmers, SA Ohio and SA National are subject to
regulations and restrictions under which payment of dividends from statutory
earned surplus can be made to State Auto Financial during the year without prior
approval of regulatory authorities. Pursuant to these rules, approximately $52.7
million is available for payment to State Auto Financial in 2004 without prior
approval.
AR-23
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
Reconciliations of statutory capital and surplus and net income (loss), as
determined using statutory accounting practices, to the amounts included in the
accompanying consolidated financial statements are as follows:
DECEMBER 31
-------------------
2003 2002
--------- -------
(in thousands)
Statutory capital and surplus of insurance subsidiaries .... $ 527,148 359,289
Net assets of non-insurance parent and affiliates .......... (120,954) (44,060)
--------- -------
406,194 315,229
Increases (decreases):
Deferred policy acquisition costs ....................... 87,099 77,886
Anticipated salvage and subrogation ..................... -- 27,093
Net prepaid pension expense ............................. 51,415 46,690
Postretirement benefit liability ........................ (24,567) (21,968)
Deferred federal income taxes ........................... (24,112) (36,964)
Fixed maturities at fair value .......................... 41,623 67,281
Surplus note ............................................ 172 (15,000)
Other, net .............................................. 4,467 3,522
--------- -------
Stockholders' equity per accompanying consolidated
financial statements ................................. $ 542,291 463,769
========= =======
YEAR ENDED DECEMBER 31
--------------------------
2003 2002 2001
------- ------ -------
(in thousands)
Statutory net income (loss) of insurance subsidiaries ...... $54,544 17,027 (39,773)
Net income of non-insurance parent and affiliates .......... 1,593 2,461 1,826
------- ------ -------
56,137 19,488 (37,947)
Increases (decreases):
Deferred policy acquisition costs ....................... 9,213 10,776 34,629
Anticipated salvage and subrogation ..................... -- 907 12,813
Net prepaid pension benefit ............................. 164 506 1,131
Postretirement benefit expense .......................... (2,600) (2,260) (1,230)
Deferred federal income taxes ........................... (1,209) 7,671 10,673
Other, net .............................................. 1,917 (93) 546
------- ------ -------
Net income per accompanying consolidated
financial statements ................................. $63,622 36,995 20,615
======= ====== =======
(11) PREFERRED STOCK
State Auto Financial has authorized two classes of preferred stock. For
both classes, upon issuance, the Board of Directors has authority to fix and
determine the significant features of the shares issued, including, among other
things, the dividend rate, redemption price, redemption rights, conversion
features and liquidation price payable in the event of any liquidation,
dissolution, or winding up of the affairs of State Auto Financial. See note 6
(a) regarding State Auto Financial's obligation to issue redeemable preferred
shares to SPC in connection with its catastrophic reinsurance arrangements with
a financial institution.
The Class A preferred stock is not entitled to voting rights until, for any
period, dividends are in arrears in the amount of six or more quarterly
dividends.
AR-24
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
(12) STOCK INCENTIVE PLANS
The Company follows Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" (APB 25) and related Interpretations in
accounting for its employee stock incentive plans using the intrinsic value
method to account for stock-based compensation. Compensation cost charged
against operations in 2003 and 2002 were $0, and $14,000 in 2001 for those
employee stock options granted where the exercise price was less than the market
price of the underlying stock on the date of grant. Had compensation cost for
the Company's plans been determined based on the fair values at the grant dates
consistent with the method of SFAS No. 123, "Accounting for Stock-Based
Compensation," (SFAS No. 123), the Company's pro forma net earnings and net
earnings per share information would have been as follows:
PRO FORMA FAIR VALUE METHOD 2003 2002 2001
------- ------ ------
(in thousands, except
per share amounts)
Net income as reported ................................. $63,622 36,995 20,615
Less pro forma stock compensation expense, net of tax .. (1,736) (1,427) (1,750)
------- ------ ------
Pro forma net income ................................... 61,886 35,568 18,865
======= ====== ======
Pro forma net income per common share
Basic ............................................... $ 1.58 0.91 0.49
------- ------ ------
Diluted ............................................. $ 1.51 0.89 0.48
------- ------ ------
The fair value of options granted to employees and directors in 2003, 2002
and 2001 were estimated at the date of grant using the Black-Scholes
option-pricing model.
The weighted average fair values and related assumptions for options
granted were as follows:
2003 2002 2001
----- ---- ----
Fair value ................... $7.09 6.09 6.79
Expected dividend yield ...... .79% .94% .90%
Risk free interest rate ...... 2.73% 4.20% 4.85%
Expected volatility factor ... .37 .33 .36
Expected life in years ....... 7.2 6.8 6.7
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
The Company has stock option plans for certain directors and key employees.
The Nonemployee Directors' Plan provides each nonemployee director an option to
purchase 4,200 and 1,500 for 2003 and 2002, respectively, shares of common stock
following each annual meeting of the shareholders at an option price equal to
the fair market value at the close of business on the last trading day prior to
the day of the annual meeting. The Company has reserved 300,000 shares of common
stock under this plan. These options are exercisable at issuance to 10 years
from date of grant. The Key Employee's Plan provides that qualified stock
options may be granted at an option price not less than fair market value at
date of grant and that nonqualified stock options may be granted at any price
determined by the options committee of the Board of Directors. The Company has
reserved 5.0 million shares of common stock under this plan. These options are
exercisable at such time or times as may be determined by a committee of the
Company's Board of Directors. Normally, these options are exercisable from 1 to
10 years from date of grant.
The Company has an employee stock purchase plan with a dividend
reinvestment feature, under which employees of the Company may choose at two
different specified time intervals each year to have up to 6% of their annual
base earnings withheld to purchase the Company's common stock. The purchase
price of the stock is 85% of the lower of its beginning-of-interval or
end-of-interval market price. The Company has reserved 2.4 million shares of
common stock under this plan. At December 31, 2003 and 2002, 2.0 million and 1.9
million shares, respectively, have been purchased under this plan.
AR-25
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
The Company has a stock option incentive plan for certain designated
independent insurance agencies that represent the Company and its affiliates.
The Company has reserved 400,000 shares of common stock under this plan. The
plan provides that the options become exercisable on the first day of the
calendar year following the agency's achievement of specific production and
profitability requirements over a period not greater than two calendar years
from date of grant or a portion thereof in the first calendar year in which an
agency commences participation under the plan. Options granted and vested under
this plan have a 10-year term. The Company has accounted for the plan in its
accompanying financial statements at fair value. Expense of $306,000, $165,000
and $140,000 associated with this plan was recognized in 2003, 2002 and 2001,
respectively. The fair value of options granted to agencies was estimated at the
reporting date or vesting date using the Black-Scholes option-pricing model.
2003 2002 2001
------ ---- ----
Fair value ................... $13.37 7.55 8.04
Expected dividend yield ...... .78% .87% .90%
Risk free interest rate ...... 4.07% 4.50% 5.16%
Expected volatility factor ... .36 .36 .34
Expected life in years ....... 8.9 8.1 8.7
A summary of the Company's total stock option activity and related
information for these plans for the years ended December 31, 2003, 2002 and
2001, follows:
2003 2002 2001
------------------------ ------------------------ ------------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE
------- -------------- ------- -------------- ------- --------------
(in thousands, except per share amounts)
Outstanding, beginning
of year................. 2,791 $10.98 2,797 9.58 2,852 8.28
Granted................. 407 18.51 356 16.00 299 16.53
Exercised............... (532) 7.22 (362) 5.11 (315) 4.39
Canceled................ (27) 16.24 -- -- (39) 10.16
----- ----- -----
Outstanding, end of year 2,639 $12.84 2,791 10.98 2,797 9.58
===== ===== =====
A summary of information pertaining to the total options outstanding and
exercisable as of December 31, 2003 follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------- -------------------------
WEIGHTED-AVERAGE
REMAINING WEIGHTED-AVERAGE WEIGHTED-AVERAGE
RANGE OF EXERCISE PRICES NUMBER CONTRACTUAL LIFE EXERCISE PRICE NUMBER EXERCISE PRICE
- ------------------------ ------ ---------------- ---------------- ------ ----------------
(in thousands, except per share amounts)
Less than $5.00......... 12 .4 $ 4.67 12 $ 4.67
$5.01 - $10.00.......... 649 2.1 6.66 648 6.66
Greater than $10.01..... 1,978 7.0 14.92 1,334 13.66
----- -----
2,639 5.8 $12.84 1,994 $11.33
===== =====
AR-26
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
(13) NET EARNINGS PER COMMON SHARE
The following table sets forth the compilation of basic and diluted net
earnings per common share:
YEAR ENDED DECEMBER 31
-------------------------
2003 2002 2001
------- ------ ------
(in thousands, except per
share amounts)
Numerator:
Net earnings for basic and diluted earnings per common share ... $63,622 36,995 20,615
------- ------ ------
Denominator:
Weighted average shares for basic net earnings per common
share ....................................................... 39,255 38,984 38,775
Effect of dilutive stock options ............................... 898 759 906
------- ------ ------
Adjusted weighted average shares for diluted net
earnings per common share ................................... 40,153 39,743 39,681
------- ------ ------
Basic net earnings per common share ............................... $ 1.62 0.95 0.53
------- ------ ------
Diluted net earnings per common share ............................. $ 1.58 0.93 0.52
------- ------ ------
The following options to purchase shares of common stock were not included in
the computation of diluted earnings per share because the exercise price of the
options was greater than the average market price:
YEAR ENDED DECEMBER 31
----------------------
2003 2002 2001
---- ---- ----
(in thousands)
Number of options...................... None 911 562
---- --- ---
(14) OTHER COMPREHENSIVE INCOME
The related federal income tax effects of each component of other
comprehensive income (loss) are as follows:
YEAR ENDED DECEMBER 31, 2003
---------------------------------------
BEFORE-TAX TAX (EXPENSE) NET-OF-TAX
AMOUNT OR BENEFIT AMOUNT
---------- ------------- ----------
(in thousands)
Net unrealized holding gains on securities:
Unrealized holding gains arising during the year ............... $25,507 (8,926) 16,581
Reclassification adjustments for gains realized in net income .. 10,623 (3,718) 6,905
------- ------ ------
Net unrealized holding gains ................................... 14,884 (5,208) 9,676
------- ------ ------
Derivative used in cash flow hedge ................................ 804 -- 804
------- ------ ------
Other comprehensive income ........................................ $15,688 (5,208) 10,480
======= ====== ======
AR-27
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2002
---------------------------------------
BEFORE-TAX TAX (EXPENSE) NET-OF-TAX
AMOUNT OR BENEFIT AMOUNT
---------- ------------- ----------
(in thousands)
Net unrealized holding gains on securities:
Unrealized holding gains arising during the year ............... $52,805 (18,482) 34,323
Reclassification adjustments for gains realized in net income .. 5,909 (2,068) 3,841
------- ------- ------
Net unrealized holding gains ................................... 46,896 (16,414) 30,482
------- ------- ------
Other comprehensive income ........................................ $46,896 (16,414) 30,482
======= ======= ======
YEAR ENDED DECEMBER 31, 2001
---------------------------------------
BEFORE-TAX TAX (EXPENSE) NET-OF-TAX
AMOUNT OR BENEFIT AMOUNT
---------- ------------- ----------
(in thousands)
Net unrealized holding losses on securities:
Unrealized holding losses arising during the year .............. $(10,787) 3,775 (7,012)
Reclassification adjustments for gains realized in net income .. 1,962 (687) 1,275
-------- ----- ------
Net unrealized holding losses .................................. (12,749) 4,462 (8,287)
-------- ----- ------
Other comprehensive loss .......................................... $(12,749) 4,462 (8,287)
======== ===== ======
(15) REPORTABLE SEGMENTS
At December 31, 2003, the Company has four reportable segments: State Auto
standard insurance, State Auto nonstandard insurance, Meridian standard
insurance and investment management services. The reportable segments are
business units managed separately because of the differences in products or
service they offer, type of customer they serve or because of management
considerations. The State Auto standard, State Auto nonstandard and the Meridian
standard insurance segments operate primarily in the central and eastern United
States, excluding New York, New Jersey, and the New England states, through an
independent insurance agency system.
The State Auto standard insurance segment provides personal and commercial
insurance to its policyholders. Its principal lines of business include personal
and commercial automobile, homeowners, commercial multi-peril, workers'
compensation, general liability and fire insurance. The State Auto nonstandard
insurance segment provides personal automobile insurance to policyholders that
are typically rejected or canceled by standard insurance carriers because of
poor loss experience or a history of late payment of premiums.
Effective July 1, 2001, with the STFC Pooled Companies assumption of the
former Meridian Mutual business through the Pooling Arrangement, as more fully
described in note 6(a), the Company established the Meridian standard and
Meridian nonstandard insurance segments. While these Meridian segments offer
similar products and services and operate in the same geographical locations
within the United States as the State Auto segments, they differ within their
operating measures, more specifically within their loss and profitability
results. Monitoring the performance of the Meridian segments allows management
to review the results of its integration efforts of these segments while this
business continues to be processed through the Meridian systems platform. Due to
the integration efforts by management, along with this segment no longer meeting
the quantitative thresholds for segment reporting within the Meridian
nonstandard business, beginning with the first quarter of 2003, the Meridian
nonstandard business was included in the State Auto nonstandard segment. The
2002 and 2001 disclosures have been revised to reflect this change. Likewise,
the Meridian standard business, beginning with the first quarter of 2004, will
be included in the State Auto standard segment.
The investment management services segment manages the investment
portfolios of affiliated insurance companies.
The Company evaluates performance of its reportable segments and allocates
resources thereon based on profit or loss from operations, excluding net
realized gains on investments on the Company's investment portfolio, before
federal income taxes. The Company monitors its assets for the insurance segments
on a legal entity basis, which for the STFC Pooled Companies includes assets of
two of the three reportable insurance segments (State Auto standard insurance
and Meridian standard insurance). The accounting policies of the reportable
segments are the same as those described in the summary of significant
accounting policies.
Revenue from segments in the other category is attributable to three other
operating segments of the Company, which individually are not material:
management and operations services segment, an insurance software development
and resale segment, and a property management and leasing segment.
AR-28
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
The following provides financial information regarding the Company's
reportable segments. The 2001 financial information for the Meridian standard
segment reflects the business assumed by the STFC Pooled Companies, beginning
July 1, 2001:
YEAR ENDED DECEMBER 31
------------------------------
2003 2002 2001
---------- ------- -------
(in thousands)
REVENUES FROM EXTERNAL CUSTOMERS:
State Auto standard insurance ....................... $ 840,312 720,278 485,059
State Auto nonstandard insurance .................... 85,768 76,618 44,037
Meridian standard insurance ......................... 98,731 159,060 72,825
Investment management services ...................... 2,547 2,469 3,466
All other ........................................... 3,570 3,120 15,773
---------- ------- -------
Total revenues from external customers ................. 1,030,928 961,545 621,160
Intersegment revenues:
State Auto standard insurance ....................... 160 120 128
Investment management services ...................... 5,891 5,019 3,553
All other ........................................... 1,868 2,141 5,506
---------- ------- -------
Total intersegment revenues ............................ 7,919 7,280 9,187
---------- ------- -------
Total revenue .......................................... 1,038,847 968,825 630,347
---------- ------- -------
Reconciling items:
Intersegment revenues ............................... (7,919) (7,280) (9,187)
Corporate revenues .................................. 145 25 150
Net realized gains on investment .................... 10,623 5,909 1,962
---------- ------- -------
Total consolidated revenues ............................ $1,041,696 967,479 623,272
========== ======= =======
SEGMENT PROFIT (LOSS):
State Auto standard insurance ....................... $ 57,323 37,537 45,664
State Auto nonstandard insurance .................... 6,632 4,075 (4,555)
Meridian standard insurance ......................... 3,489 (15,376) (44,397)
Investment management services ...................... 7,424 6,402 5,965
All other ........................................... 2,224 1,916 16,326
---------- ------- -------
Total segment profit ................................... 77,092 34,554 19,003
Reconciling items:
Corporate expenses .................................. (4,438) (2,673) (2,989)
Net realized gains on investments ................... 10,623 5,909 1,962
---------- ------- -------
Total consolidated income before federal income taxes .. $ 83,277 37,790 17,976
========== ======= =======
NET INVESTMENT INCOME:
State Auto standard insurance ....................... $ 46,486 42,223 37,230
State Auto nonstandard insurance .................... 3,091 2,759 2,335
Meridian standard insurance ......................... 8,783 9,322 3,595
Investment management services ...................... 94 125 318
All other ........................................... 143 180 193
---------- ------- -------
Total net investment income ............................ 58,597 54,609 43,671
Reconciling items:
Corporate net investment income ..................... 145 25 150
Reclassification adjustments in consolidation ....... 5,883 5,057 3,554
---------- ------- -------
Total consolidated net investment income ............... $ 64,625 59,691 47,375
========== ======= =======
AR-29
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
DECEMBER 31
----------------------
2003 2002
---------- ---------
(in thousands)
SEGMENT ASSETS:
Standard insurance ............................. $1,962,533 1,468,482
Nonstandard insurance .......................... 140,803 98,886
Investment management services ................. 4,637 4,744
All other ...................................... 16,330 12,539
---------- ---------
Total segment assets ........................... 2,124,303 1,584,651
Reconciling items:
Corporate assets ............................... 22,045 833
Reclassification adjustments in consolidation .. (309,681) 7,511
---------- ---------
Total consolidated assets ......................... $1,836,667 1,592,995
========== =========
Revenues from external customers include the following products and services:
YEAR ENDED DECEMBER 31
------------------------------
2003 2002 2001
---------- ------- -------
Earned premiums (in thousands) State Auto standard insurance:
Automobile - Personal ........................................ $ 337,548 281,373 191,600
Automobile - Commercial ...................................... 84,541 74,764 45,801
Homeowners and farmowners .................................... 134,001 112,350 77,105
Commercial multi-peril ....................................... 60,819 50,305 31,215
Workers' compensation ........................................ 24,141 23,236 15,365
Fire and allied .............................................. 65,850 57,310 36,031
Other liability and products liability ....................... 54,882 49,233 21,875
Other lines .................................................. 26,571 24,604 25,304
---------- ------- -------
Total State Auto standard insurance earned premiums ............. 788,353 673,175 444,296
Total State Auto nonstandard insurance earned premiums .......... 82,267 73,555 41,757
---------- ------- -------
Meridian standard insurance:
Automobile - Personal ........................................ 28,374 56,908 26,153
Automobile - Commercial ...................................... 15,130 22,304 10,248
Homeowners and farmowners .................................... 14,593 21,159 9,536
Commercial multi-peril ....................................... 18,405 25,942 11,381
Workers' compensation ........................................ 8,458 16,081 8,660
Fire and allied .............................................. 806 1,095 499
Other liability and products liability ....................... 1,326 1,834 519
Other lines .................................................. 2,856 4,542 2,157
---------- ------- -------
Total Meridian standard insurance earned premiums ............... 89,948 149,865 69,154
---------- ------- -------
Total earned premiums ........................................... 960,568 896,595 555,207
Investment management services .................................. 2,227 2,469 2,965
Net investment income ........................................... 64,480 59,666 47,225
Other income .................................................... 3,653 2,815 15,763
---------- ------- -------
Total revenues from external customers .......................... $1,030,928 961,545 621,160
========== ======= =======
The standard insurance segments participate in a reinsurance pooling
agreement with other standard insurance affiliates. For discussion regarding
this arrangement and these segments' contribution to the pool and participation
in the pool, see note 6. Revenues from external customers are derived entirely
within the United States. Also, all long-lived assets are located within the
United States.
AR-30
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a
majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
- --------------------------------------------------------------------------------
(16) QUARTERLY FINANCIAL DATA (UNAUDITED)
2003
---------------------------------------------------
FOR THREE MONTHS ENDED
---------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
--------- -------- ------------- ------------
(in thousands, except per share amounts)
Total revenues ............................. $253,353 263,160 265,110 260,073
Income before federal income taxes ......... 28,563 8,910 20,804 25,000
Net income ................................. 21,064 8,301 15,580 18,677
Net earnings per common share
Basic ................................... 0.54 0.21 0.40 0.47
Diluted ................................. 0.53 0.21 0.38 0.46
-------- ------- ------- -------
2002
---------------------------------------------------
FOR THREE MONTHS ENDED
---------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
--------- -------- ------------- ------------
(in thousands, except per share amounts)
Total revenues ............................. $229,959 236,223 246,962 254,335
Income (loss) before federal income taxes .. 17,301 (6,751) 5,128 22,112
Net income (loss) .......................... 13,165 (1,385) 5,885 19,330
Net earnings (loss) per common share
Basic ................................... 0.34 (0.04) 0.15 0.50
Diluted ................................. 0.33 (0.04) 0.15 0.49
-------- ------- ------- -------
(17) CONTINGENCIES
The Company's insurance subsidiaries are involved in litigation and may
become involved in potential litigation arising in the ordinary course of
business. Additionally, the insurance subsidiaries may be impacted by adverse
regulatory actions and adverse court decisions where insurance coverages are
expanded beyond the scope originally contemplated in the policies at December
31, 2003. In the opinion of management, the effects, if any, of such litigation
and published court decisions are not expected to be material to the
consolidated financial statements.
AR-31
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A. CONTROLS AND PROCEDURES
(a) The Company carried out an evaluation, under the supervision and with
the participation of the Company's management, including the Company's Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of the Company's disclosure controls and procedures (as
defined in Exchange Act Rule 13a-15(e)). Based upon that evaluation, the
Company's Chief Executive Officer and Chief Financial Officer concluded that, as
of the end of the period covered by this report, the Company's disclosure
controls and procedures were effective in timely alerting them to material
information relating to the Company (including its consolidated subsidiaries)
required to be included in the Company's periodic filings with the Securities
and Exchange Commission.
(b) There has been no change in the Company's internal control over
financial reporting that occurred during the Company's most recent fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, the Company's internal control over financial reporting.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information regarding directors of the Company required by Items 401(a) and
(d)-(f) of Regulation S-K will be found under the caption "Proposal One:
Election of Directors" in the 2004 Proxy Statement, which information is
incorporated herein by reference. Information regarding executive officers of
the Company required by Items 401(b) and (d)-(f) of Regulation S-K is found
under the caption "Executive Officers of the Registrant" at the end of Item 1 of
this Form 10-K, which information is also incorporated by reference into this
Item 10.
The Company has a separately-designated standing Audit Committee
established in accordance with Section 3(a)(58)(A) of the Exchange Act. As of
March 5, 2004, the members of the Audit Committee were Richard K. Smith, David
J. D'Antoni and William J. Lhota. Mr. Smith is Chairman of the Audit Committee.
The Company's Board of Directors has determined that Mr. Smith is an "audit
committee financial expert," as that term is defined in Item 401(h)(2) of
Regulation S-K, and "independent," as that term is defined in Rule 10A-3 of the
Exchange Act.
Information regarding compliance with Section 16(a) of the Exchange Act
required by Item 405 of Regulation S-K will be found under the caption "Section
16(a) Beneficial Ownership Reporting Compliance" in the 2004 Proxy Statement,
which information is incorporated herein by reference.
The Company has adopted procedures by which shareholders may recommend
individuals for membership to the Company's Board of Directors (the "Board"). It
is the policy of the Company's Nominating and Governance Committee (the
"Nominating Committee") to consider and evaluate candidates recommended by
shareholders for membership on the Board in the same manner as all other
candidates for nomination to the Board who are not incumbent directors. If a
shareholder desires to recommend an individual for Board membership, then that
shareholder must provide a written notice to the Secretary of the Company at 518
East Broad Street, Columbus, Ohio 43215 (the "Recommendation Notice"). For a
recommendation to be considered by the Nominating Committee, the Recommendation
Notice must contain, at a minimum, the following: the name and address, as they
appear on the Company's books, and telephone number of the shareholder making
the recommendation, including information on the number of shares owned; and if
such person is not a shareholder of record or if such shares are owned by an
entity, reasonable evidence of such person's ownership of such shares or such
person's authority to act on behalf of such entity; the full legal name, address
and telephone number of the individual being recommended, together with a
reasonably detailed description of the background, experience and qualifications
of that individual; a written acknowledgement by the individual being
10K-b1
recommended that he or she has consented to that recommendation and consents to
the Company's undertaking of an investigation into that individual's background,
experience and qualifications in the event that the Nominating Committee desires
to do so; the disclosure of any relationship of the individual being recommended
with the Company or any of its subsidiaries or affiliates, whether direct or
indirect; and, if known to the shareholder, any material interest of such
shareholder or individual being recommended in any proposals or other business
to be presented at the Company's next annual meeting of shareholders (or a
statement to the effect that no material interest is known to such shareholder).
The Company's Board of Directors has adopted a code of ethics that applies
to the Company's principal executive officer, principal financial officer,
principal accounting officer, controller, and persons performing similar
functions. This code of ethics has been posted on the Company's website at
http://www.stfc.com under "Corporate Governance." Any amendment (other than any
technical, administrative or other non-substantive amendment) to, or waiver
from, a provision of this code will be posted on the Company's website described
above within five business days following its occurrence.
ITEM 11. EXECUTIVE COMPENSATION
Information regarding executive compensation required by Item 402 of
Regulation S-K will be found under the captions "Compensation of Directors,"
"Compensation of Executive Officers," "Compensation Committee Interlocks and
Insider Participation," "Compensation Committee Report," and "Performance Graph"
in the 2004 Proxy Statement, which information is incorporated herein by
reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
Information regarding security ownership of certain beneficial owners and
management required by Item 403 of Regulation S-K will be found under the
caption "Proposal One: Election of Directors" and "Principal Holders of Voting
Securities" in the 2004 Proxy Statement, which information is incorporated
herein by reference.
Information regarding equity compensation plan information required by Item
201(d) of Regulation S-K is as follows:
EQUITY COMPENSATION PLAN INFORMATION AT DECEMBER 31, 2003
Number of Securities
Number of Securities Weighted-Average Remaining Available
to be Issued upon Exercise Exercise Price of for Future Issuance under
Plan Category of Outstanding Options Outstanding Options Equity Compensation Plans
- ------------- -------------------------- ------------------- -------------------------
Equity Compensation Plans Approved by
Security Holders .................... 2,548,398 $12.81 4,708,500(1)
Equity Compensation Plans not Approved
by Security Holders ................. 90,147 $13.86 273,202(2)
--------- ------ ---------
Total .................................. 2,638,545 4,981,702
========= =========
(1) Includes 4,081,200 Common Shares available for issuance under the Company's
2000 Stock Option Plan, 252,300 Common Shares available for issuance under
the Company's 2000 Directors Stock Option Plan, and 375,000 Common Shares
available for issuance under the Company's 1991 Employee Stock Purchase and
Dividend Reinvestment Plan.
(2) This is the number of Common Shares available for issuance under the 1998
State Auto Agent's Stock Option Plan.
- ----------
10K-b2
1998 STATE AUTO AGENT'S STOCK OPTION PLAN
The Company's Board of Directors adopted the 1998 State Auto Agent's Stock
Option Plan (the "Agent's Option Plan") to encourage selected independent
insurance agencies that represent the Company and its affiliates (the "State
Auto Agents") to acquire or increase and retain a financial interest in the
Company in order to strengthen the mutuality of interests between the State Auto
Agents and the Company's shareholders. The Agent's Option Plan is administered
by a plan administration committee consisting of at least three members
appointed by the Company's Board of Directors. The Agent's Option Plan will
terminate in May 2008, unless terminated earlier by the Company's Board of
Directors.
Under the Agent's Option Plan, State Auto Agents who become participants
are offered nonqualified stock options to purchase Common Shares of the Company.
The number of options granted to a participant is based on the formula set forth
in the Agent's Option Plan and in each participant's participation agreement.
The exercise price of options granted under the Agent's Option Plan is equal to
the last reported sale price of the Common Shares on the Nasdaq National Market
on the day of the grant. The options granted become exercisable on the first day
of the calendar year following the participant's achievement of specific
production and profitability requirements. Generally, the participant has up to
two calendar years to achieve these performance targets and vest the options.
Subject to certain restrictions, participants may exercise options that become
vested. Each option has a term of ten years. If an option is not fully exercised
by its expiration date, it will terminate to the extent not previously
exercised.
If a participant's agency agreement terminates, or if the participant fails
to meet its performance criteria as set forth in its participation agreement and
in the Agent's Option Plan, or the participant fails to pay any amounts due
under its agency agreement on time, the option granted to such participant, to
the extent not vested, will terminate. In addition, if a participant terminates
its relationship with the Company or its affiliates, the participant will not be
eligible to receive awards of options after the date of such termination, and
any outstanding but unexercised awards will terminate as described in the
preceding sentence.
The Common Shares subject to the Agent's Option Plan have been registered
under the Securities Act of 1933, as amended. Therefore, these Common Shares are
freely tradeable once acquired upon the exercise of the options, unless such
Common Shares are acquired by a participant who is considered an "affiliate" of
the Company.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding certain relationships and related transactions
required by Item 404 of Regulation S-K will be found under the caption "Certain
Transactions" in the 2004 Proxy Statement, which information is incorporated
herein by reference.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information regarding principal accounting fees and services required by
Item 9(a) of Schedule 14A will be found under the caption "Independent Public
Accountants" in the 2004 Proxy Statement, which information is incorporated
herein by reference.
10K-b3
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) LISTING OF FINANCIAL STATEMENTS
The following consolidated financial statements of the Company, are
filed as part of this Form 10-K Report and are included in Item 8:
Report of Independent Auditors
Consolidated Balance Sheets as of
December 31, 2003 and 2002
Consolidated Statements of Income for
each of the three years in the
period ended December 31, 2003
Consolidated Statements of Stockholders'
Equity for each of the three years in the
period ended December 31, 2003
Consolidated Statements of Cash Flows for each of the three years in
the period ended December 31, 2003
Notes to Consolidated Financial Statements
(a)(2) LISTING OF FINANCIAL STATEMENT SCHEDULES
The following financial statement schedules of the Company for the
years 2003, 2002, and 2001, are included in Item 14(d), following the
signatures, and should be read in conjunction with the consolidated
financial statements contained in this Form 10-K Annual Report.
Schedule Number Schedule
--------------- --------
I. Summary of Investments - Other Than
Investments in Related Parties
II. Condensed Financial Information of Registrant
III. Supplementary Insurance Information
IV. Reinsurance
All other schedules are omitted because they are not applicable or the
required information is included in the consolidated financial statements
or notes thereto.
10K-b4
(a)(3) LISTING OF EXHIBITS
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- ---------------------------------------------
3.01 State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No. 33-40643
Articles of Incorporation on Form S-1 (see Exhibit 3(a) therein)
3.02 State Auto Financial Corporation's Amendment to the 1933 Act Registration Statement No. 33-89400
Amended and Restated Articles of Incorporation on Form S-8 (see Exhibit 4(b) therein)
3.03 State Auto Financial Corporation Certificate of Amendment Form 10-K Annual Report for the year ended
to the Amended and Restated Articles of Incorporation as December 31, 1998 (see Exhibit 3(A)(3)
of June 2, 1998 therein)
3.04 State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No. 33-40643
Code of Regulations on Form S-1 (see Exhibit 3(b) therein)
4.01 State Auto Financial Corporation's Amended and Restated Form 10-K Annual Report for the year ended
Articles of Incorporation, and Articles 1, 3, 5 and 9 of December 31, 1992 (see Exhibit 3(A) and 3(B)
the Company's Amended and Restated Code of Regulations therein)
10.01 Guaranty Agreement between State Automobile Mutual 1933 Act Registration Statement No. 33-40643
Insurance Company and State Auto Property and Casualty on Form S-1 (see Exhibit 10 (d)therein)
Insurance Company dated as of May 16, 1991
10.02 Form of Indemnification Agreement between State Auto 1933 Act Registration Statement No. 33-40643
Financial Corporation and each of its directors on Form S-1 (see Exhibit 10 (e) therein)
10.03* State Auto 1991 Quality Performance Bonus Plan 1933 Act Registration Statement No. 33-40643
on Form S-1 (see Exhibit 10 (f) therein)
10.04* 1991 Stock Option Plan 1933 Act Registration Statement No. 33-40643
on Form S-1 (see Exhibit 10 (h) therein)
10.05* Amendment Number 1 to the 1991 Stock Option Plan 1933 Act Registration Statement No. 33-89400
on Form S-8 (see Exhibit 4 (a) therein)
10.06* 1991 Directors' Stock Option Plan 1933 Act Registration Statement No. 33-40643
on Form S-1 (see Exhibit 10 (i) therein)
10.07 License Agreement between State Automobile Mutual 1933 Act Registration Statement No. 33-40643
Insurance Company and Policy Management Systems on Form S-1 (see Exhibit 10 (k) therein)
Corporation dated December 28, 1984
10.08 Investment Management Agreement between Stateco Financial Form 10-K Annual Report for the year ended
Services, Inc. and State Automobile Mutual Insurance December 31, 1992 (see Exhibit 10 (N) therein)
Company, effective April 1, 1993
10.09* State Auto Insurance Companies Directors' Deferred Form 10-K Annual Report for year ended
Compensation Plan December 31, 1995 (see Exhibit 10(S) therein)
10.10* State Auto Insurance Companies Amended and Restated Registration Statement on Form S-8, File No.
Non-Qualified Incentive Deferred Compensation Plan 333-56338 (see Exhibit 4(e) therein)
10.11* Amendment Number 2 to the 1991 Stock Option Plan Form 10-K Annual Report for the year ended
December 31, 1996 (see Exhibit 10(DD) therein)
10.12* Amendment Number 1 to the 1991 Directors' Stock Option Form 10-K Annual Report for the year ended
Plan December 31, 1996 (see Exhibit 10(EE) therei
10.13 Amended and Restated SERP of State Auto Mutual effective Form 10-K Annual Report for the year ended
as of January 1, 1994 December 31, 1997 (see Exhibit 10(HH) therein)
10K-b5
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- ---------------------------------------------
10.14 Credit Agreement dated as of June 1, 1999 between State Form 10-Q for the period ended June 30, 1999
Auto Financial Corporation and State Automobile Mutual (see Exhibit 10(LL) therein)
Insurance Company
10.15 Reinsurance Pooling Agreement amended and restated as of Form 10-K Annual Report for the year ended
January 1, 2000 by and among State Automobile Mutual December 31, 1999 (see Exhibit 10(W) therein)
Insurance Company, State Auto Property and Casualty
Insurance Company, Milbank Insurance Company, Midwest
Security Insurance Company (n/k/a State Auto Insurance
Company of Wisconsin), Farmers Casualty Insurance Company
and State Auto Insurance Company (n/k/a State Auto
Insurance Company of Ohio)
10.16 Management and Operations Agreement as of January 1, 2000 Form 10-K Annual Report for the year ended
among State Automobile Mutual Insurance Company, State December 31, 1999 (see Exhibit 10(X) therein)
Auto Financial Corporation, State Auto Property and
Casualty Insurance Company, State Auto National Insurance
Company, Milbank Insurance Company, State Auto Insurance
Company (n/k/a State Auto Insurance Company of Ohio),
Stateco Financial Services, Inc., Strategic Insurance
Software, Inc., 518 Property Management and Leasing, LLC
10.17 Property Catastrophe Overlying Excess of Loss Reinsurance Form 10-K Annual Report for the year ended
contract issued to State Automobile Mutual Insurance December 31, 1999 (see Exhibit 10(Y) therein)
Company, State Auto National Insurance Company, Milbank
Insurance Company, Midwest Security Insurance Company
(n/k/a State Auto Insurance Company of Wisconsin),
Farmers Casualty Insurance Company, Mid-Plains Insurance
Company by State Auto Property and Casualty Insurance
Company
10.18 First Amendment to the Management and Operations Form 10-K Annual Report for the year ended
Agreement effective January 1, 2000 among State December 31, 1999 (see Exhibit 10(Z) therein)
Automobile Mutual Insurance Company, State Auto Financial
Corporation, State Auto Property and Casualty Insurance
Company, State Auto National Insurance Company, Milbank
Insurance Company, State Auto Insurance Company (n/k/a
State Auto Insurance Company of Ohio), Stateco Financial
Services, Inc., Strategic Insurance Software, Inc. and
518 Property Management and Leasing, LLC
10.19 First Amendment to the June 1, 1999 Credit Agreement Form 10-K Annual Report for the year ended
dated November 1, 1999 between State Auto Financial December 31, 1999 (see Exhibit 10(AA) therein)
Corporation and State Automobile Mutual Insurance Company
10.20 Second amendment to the June 1, 1999 Credit Agreement Form 10-Q for the period ended March 31, 2000
dated December 1, 1999 between State Auto Financial (see Exhibit 10(BB) therein)
Corporation and State Automobile Mutual Insurance Company
10.21* Form of Executive Agreement between State Auto Financial Form 10-K Annual Report for the year ended
Corporation and certain executive officers December 31, 2000 (see Exhibit 10(CC) therein)
10.22 First Amendment to the Reinsurance Pooling Agreement Form 10-K Annual Report for the year ended
Amended and Restated as of January 1, 2000 by and among December 31, 2000 (see Exhibit 10(DD) therein)
State Auto Property and Casualty Insurance Company, State
Automobile Mutual Insurance Company, Milbank Insurance
Company, Midwest Security Insurance Company (n/k/a State
Auto Insurance Company of Wisconsin), Farmers Casualty
Insurance Company and State Auto Insurance Company (n/k/a
State Auto Insurance Company of Ohio)
10K-b6
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- ---------------------------------------------
10.23 Addendum No. 1 of the Property Catastrophe Overlying Form 10-K Annual Report for the year ended
Excess of Loss Reinsurance Contract by and among State December 31, 2000 (see Exhibit 10(EE) therein)
Auto Property and Casualty Insurance Company, State
Automobile Mutual Insurance Company, State Auto National
Insurance Company, Milbank Insurance Company, Midwest
Security Insurance Company (n/k/a State Auto Insurance
Company of Wisconsin), Farmers Casualty Insurance
Company, Mid-Plains Insurance Company and State Auto
Insurance Company (n/k/a State Auto Insurance Company of
Ohio) dated November 17, 2000
10.24* 2000 Stock Option Plan Definitive Proxy Statement on Form DEF 14A,
File No. 000-19289, for Annual Meeting of
Shareholders held on May 26, 2000 (see
Appendix A therein)
10.25* 2000 Directors Stock Option Plan Definitive Proxy Statement on Form DEF 14A,
File No. 000-19289, for Annual Meeting of
Shareholders held on May 26, 2000 (see
Appendix B therein)
10.26* First Amendment to 2000 Directors Stock Option Plan Form 10-Q for the period ended March 31, 2001
(see Exhibit 10(HH) therein)
10.27* Second Amendment to the Reinsurance Pooling Agreement Form 10-Q for the period ended June 30, 2001
Amended and Restated as of January 1, 2000, by the State (see Exhibit 10(II) therein)
Automobile Mutual Insurance Company, State Auto Property
and Casualty Insurance Company, Milbank Insurance
Company, Midwest Security Insurance Company (n/k/a State
Auto Insurance Company of Wisconsin), Farmers Casualty
Insurance Company and State Auto Insurance Company (n/k/a
State Auto Insurance Company of Ohio)
10.28* Second Amendment to 1991 Directors Stock Option Plan Form 10-Q for the period ended September 30,
2001 (see Exhibit 10(JJ) therein)
10.29* Second Amendment to 2000 Directors Stock Option Plan Form 10-Q for the period ended September 30,
2001 (see Exhibit 10(KK) therein)
10.30* Third Amendment to 2000 Directors Stock Option Plan Form 10-K Annual Report for the year ended
December 31, 2001 (see Exhibit 10(EE) therein
10.31 Third Amendment to State Auto Reinsurance Pooling Form 10-K Annual Report for the year ended
Agreement, Amended and Restated as of January 1, 2000 December 31, 2001 (see Exhibit 10(FF) therein
10.32 Stop Loss Reinsurance Agreement dated October 1, 2001 Form 10-K Annual Report for the year ended
among inter alia Mutual and State Auto P&C December 31, 2001 (see Exhibit 10(GG) therei
10.33 Amendment No. 2 to the Management and Operations Form 10-K Annual Report for the year ende
Agreement dated January 1, 2000 among, inter alia, Mutual December 31, 2001 (see Exhibit 10(HH therein)
and State Auto P&C
10.34 Amendment No. 3 to Management and Operations Agreement Form 10-Q for the period ended June 30, 2002
effective January 1, 2002, among State Automobile Mutual (see Exhibit 10(LL) therein)
Insurance Company, State Auto Financial Corporation,
State Auto Property and Casualty Insurance Company, State
Auto National Insurance Company, Milbank Insurance
Company, State Auto Insurance Company, Stateco Financial
Services, Inc., Strategic Insurance Software, Inc., and
518 Property Management and Leasing, LLC
10.35 Management Services Agreement as of July 1, 2002 by and Form 10-Q for the period ended September 30,
among State Auto Property and Casualty Insurance Company, 2002 (see Exhibit 10(NN) therein)
Meridian Insurance Group, Inc., Meridian Security
Insurance Company, Meridian Citizens Mutual Insurance
Company and Meridian Citizens Security Insurance Company
10K-b7
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- ---------------------------------------------
10.36 Cost Sharing Agreement among State Auto Property and Form 10K Annual Report for year ended 12-31-0
Casualty Insurance Company, State Automobile Mutual (see Exhibit 10(OO) therein)
Insurance Company, and State Auto Florida Insurance
Company effective January 1, 2003
10.37 Fourth Amendment to State Auto Reinsurance Pooling Form 10K Annual Report for year ended 12-31-0
Agreement, Amended and Restated as of January 1, 2000 (see Exhibit 10(TT) therein)
10.38* Fourth Amendment to 2000 Directors Stock Option Plan Form 10K Annual Report for year ended 12-31-0
(see Exhibit 10(UU) therein)
10.39 Employment Agreement dated as of May 22, 2003, between Form 10-Q for the period ending June 30, 2003
State Auto Financial Corporation and Robert H. Moone (see 10(WW) therein)
10.40 Amended and Restated Declaration of Trust of STFC Capital Form 10-Q for the period ending June 30, 2003
Trust I, dated as of May 22, 2003 (see 10(XX) therein)
10.41 Indenture dated as of May 22, 2003, for Floating Rate Form 10-Q for the period ending June 30, 2003
Junior Subordinated Debt Securities Due 2033 (see 10(YY) therein)
10.42 Amendment No. 3 to 1991 Stock Option Plan Effective Form 10-Q for the period ending September 30,
January 1, 2001 2003 (see 10.01) therein)
10.43 Amendment No. 1 to 2000 Stock Option Plan Effective Form 10-Q for the period ending September 30,
January 1, 2001 2003 (see 10.02) therein
10.44 Addendum No. 1 to Property Catastrophe Overlying Excess Form 10-Q for the period ending September 30,
of Loss Reinsurance Contract effective November 16, 2001 2003 (see 10.03) therein
10.45 Property Catastrophe Overlying Excess of Loss Reinsurance Form 10-Q for the period ending September 30,
Contract effective July 1, 2002 2003 (see 10.04) therein
10.46 Property Catastrophe Overlying Excess of Loss Reinsurance Included herein
Contract effective as of 7/1/03
10.47 Credit Agreement Among SAF Funding Corporation, The Form 8-K Current Report filed on December 16,
Lenders and KeyBank National Association dated November 2003 (see Exhibit 10.01 therein)
12, 2003
10.48 Put Agreement among State Automobile Mutual Insurance Form 8-K Current Report filed on December 16,
Company, State Auto Financial Corporation and KeyBank 2003 (see Exhibit 10.02 therein)
National Association dated November 12, 2003
10.49 Standby Purchase Agreement between State Auto Financial Form 8-K Current Report filed on December 16,
Corporation and SAF Funding Corporation dated November 2003 (see Exhibit 10.03 therein)
12, 2003
10.50 Indenture dated as of November 13, 2003, among State Auto Securities Act Registration Statement on Form
Financial Corporation, as Issuer, and Fifth Third Bank as S-4 (File No. 333-111507)(see Exhibit 4.01
Trustee therein)
10.51 Form of 6 1/4% Senior Note due 2013 (Exchange Note) Securities Act Registration Statement on Form
S-4 (File No. 333-111507)(see Exhibit 4.02
therein)
10.52 Amended and Restated Declaration of Trust of STFC Capital Securities Act Registration Statement on Form
Trust I, dated as of May 22, 2003 S-4 (File No. 333-111507)(see Exhibit 10.40
therein)
21.01 List of Subsidiaries of State Auto Financial Corporation Included herein
23.01 Consent of Independent Auditors Included herein
24.01 Powers of Attorney - William J. Lhota, Urlin G. Harris, Form 10-Q for the period ended June 30, 1997
Jr., Paul W. Huesman, and David J. D'Antoni (see Exhibit 24(C) therein)
10K-b8
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- ---------------------------------------------
24.02 Power of Attorney - John R. Lowther Form 10-Q for the period ended March 31, 1998
(see Exhibit 24(D) therein)
24.03 Power of Attorney - Robert H. Moone Form 10-K Annual Report for the year ended
December 31, 1998 (see Exhibit 24(E) therein)
24.04 Power of Attorney - Richard K. Smith Form 10-K Annual Report for the year ended
December 31, 2000 (See Exhibit 24(D) therein)
24.05 Power of Attorney - S. Elaine Roberts Form 10-K Annual Report for the year ended
December 31, 2002 (See Exhibit 24(F) therein)
24.06 Power of Attorney - Paul S. Williams Included herein
31.01 CEO certification required by Section 302 of Included herein
Sarbanes-Oxley Act of 2002
31.02 CFO certification required by Section 302 of Included herein
Sarbanes-Oxley Act of 2002
32.01 CEO certification required by Section 906 of Included herein
Sarbanes-Oxley Act of 2002
32.02 CFO certification required by Section 906 of Included herein
Sarbanes-Oxley Act of 2002
- --------
*Constitutes either a management contract or a compensatory plan or
arrangement required to be filed as an Exhibit
(b) REPORTS ON FORM 8-K
On each of October 16, 2003, November 5, 2003, and December 16, 2003, the
Company filed a Form 8-K under Item 5.
(c) EXHIBITS
The exhibits have been submitted as a separate section of this report
following the financial statement schedules.
(d) FINANCIAL STATEMENT SCHEDULES
The financial statement schedules have been submitted as a separate section
of this report following the signatures and certifications.
10K-b9
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.
STATE AUTO FINANCIAL CORPORATION
Dated: March 12, 2004 /s/ Robert H. Moone
-----------------------------------------------
Robert H. Moone
Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
Name Title Date
---- ----- ----
/s/Robert H. Moone Chairman, President and March 12, 2004
- ---------------------- Chief Executive Officer
Robert H. Moone (principal executive officer)
/s/Steven J. Johnston Chief Financial Officer, March 12, 2004
- ---------------------- Senior Vice President, and Treasurer
Steven J. Johnston (principal financial officer)
/s/ Cynthia A. Powell Vice President and Controller March 12, 2004
- ---------------------- (principal accounting officer)
Cynthia A. Powell
David J. D'Antoni* Director March 12, 2004
- ----------------------
David J. D'Antoni
Urlin G. Harris, Jr.* Director March 12, 2004
- ----------------------
Urlin G. Harris, Jr.
Paul W. Huesman* Director March 12, 2004
- ----------------------
Paul W. Huesman
William J. Lhota* Director March 12, 2004
- ----------------------
William J. Lhota
John R. Lowther* Director March 12, 2004
- ----------------------
John R. Lowther
S. Elaine Roberts* Director March 12, 2004
- ----------------------
S. Elaine Roberts
Richard K. Smith* Director March 12, 2004
- ----------------------
10K-b10
Richard K. Smith
Paul S. Williams* Director March 12, 2004
- ----------------------
Paul S. Williams
*Steven J. Johnston by signing his name hereto, does sign this document on
behalf of the person indicated above pursuant to a Power of Attorney duly
executed by such person.
/s/Steven J. Johnston March 12, 2004
- ----------------------
Steven J. Johnston
Attorney in Fact
10K-b11
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN
INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 2003
Column A Column B Column C Column D
- -------------------------------------------- ---------- ---------- -------------
Amount at
Available for Sale which shown
in the
Type of Investments Cost (1) Value balance sheet
- -------------------------------------------- ---------- ---------- -------------
(in thousands)
Fixed maturities:
Bonds:
United States Government and
government agencies and authorities $ 584,472 $ 593,697 $ 593,697
States, municipalities and
political subdivisions 676,468 722,357 722,357
Public utilities 4,917 5,616 5,616
All other corporate bonds 93,720 99,742 99,742
---------- ---------- ----------
Total fixed maturities 1,359,577 1,421,412 1,421,412
---------- ---------- ----------
Equity securities:
Common stocks:
Public utilities 3,368 3,800 3,800
Banks, trust and insurance companies 33,591 38,253 38,253
Industrial and all other 84,066 97,204 97,204
---------- ---------- ----------
Total equity securities 121,025 139,257 139,257
---------- ---------- ----------
Other long-term investments 9,485 xxxxxx 9,643
---------- ----------
Total investments $1,490,087 xxxxxx $1,570,312
========== ==========
(1) Original cost of equity securities and, as to fixed maturities, original
cost reduced by repayments and adjusted for amortization of premiums or accrual
of discounts.
Sch 1
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONDENSED BALANCE SHEETS
December 31
-------------------
2003 2002
--------- -------
(in thousands)
ASSETS
Fixed maturities, available for sale, at fair value $ 9,698 --
Equity securities, available for sale, at fair value 6,278 --
Investments in common stock of subsidiaries (equity method) 678,575 519,893
Other Invested Assets, at fair value 1,075 --
Cash and cash equivalents 2,191 93
Real estate 371 389
Other assets 2,803 740
Federal income tax 4,519 3,744
--------- -------
Total assets $ 705,510 524,859
========= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Notes payable (affiliates $60,964 and $45,500, respectively) $ 161,220 60,500
Due to affiliates 423 173
Accrued expenses 1,576 417
--------- -------
Total liabilities 163,219 61,090
STOCKHOLDERS' EQUITY
Class A Preferred stock (nonvoting), without par value.
Authorized 2,500 shares; none issued
Class B Preferred stock, without par value
Authorized 2,500 shares; none issued -- --
Common stock, without par value. Authorized
100,000 shares, respectively; issued -- --
44,164 and 43,525 shares
issued and outstanding, respectively, at stated value of
$2.50 per share 110,410 108,814
Less 4,605 and 4,524 treasury shares, respectively, at cost (55,762) (54,249)
Additional paid-in capital 56,653 50,354
Accumulated other comprehensive income 52,992 42,535
Retained earnings 377,998 316,315
--------- -------
Total stockholders' equity 542,291 463,769
--------- -------
Total liabilities and stockholders' equity $ 705,510 524,859
========= =======
Sch 2
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONTINUED
CONDENSED STATEMENTS OF INCOME
Year ended December 31
-------------------------
2003 2002 2001
------- ------ ------
(in thousands)
Investment income $ 145 25 150
Rental income 37 37 38
Net realized loss on investments (16) -- --
------- ------ ------
Total revenue 166 62 188
------- ------ ------
Interest expense (affiliate $1,593, $2,161 and
$2,275, respectively) 2,991 2,161 2,275
Total operating expenses 3,018 1,653 1,889
------- ------ ------
Loss before federal income taxes (5,843) (3,752) (3,976)
Federal income tax benefit (1,540) (1,313) (1,383)
------- ------ ------
Net loss before equity in undistributed net
earnings of subsidiaries (4,303) (2,439) (2,593)
Equity in undistributed net earnings of subsidiaries 67,947 39,457 23,208
------- ------ ------
Net Income $63,644 37,018 20,615
======= ====== ======
Sch 3
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONTINUED
CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31
----------------------------
2003 2002 2001
-------- ------- -------
(in thousands)
Cash flows from operating activities:
Net income $ 63,644 37,018 20,615
Adjustments to reconcile net income to net cash
used in operating activities:
Depreciation and amortization, net 874 183 157
Net realized loss on investments 16 -- --
Equity in undistributed earnings of subsidiaries (67,947) (39,457) (23,208)
Changes in operating assets and liabilities:
Change in accrued expenses and due to affiliates 1,409 (751) 788
Change in other assets (292) 148 (328)
Change in federal income taxes 1,217 74 178
-------- ------- -------
Net cash used in operating activities (1,079) (2,785) (1,798)
-------- ------- -------
Cash flows from investing activities:
Capitalization of subsidiary (84,000) (21,514) (9,001)
Dividends received from subsidiaries 2,650 12,364 11,701
Purchase fixed maturities (9,580) -- --
Purchase equity securities (5,985) -- --
Purchase other invested assets (1,097) -- --
-------- ------- -------
Net cash provided by (used in) investing activities (98,012) (9,150) 2,700
-------- ------- -------
Cash flows from financing activities:
Proceeds from issuance of debt to bank 115,464 15,000 --
Debt issuance costs (2,071) -- --
Net proceeds from sale of common stock 4,675 2,999 2,466
Payments to acquire treasury stock (729) (6,261) (388)
Cash flow hedge derivative settlement 811 -- --
Repayment of debt (15,000) -- --
Payment of dividends (1,961) (1,715) (1,566)
-------- ------- -------
Net cash provided by financing activities 101,189 10,023 512
-------- ------- -------
Net increase (decrease) in cash and invested cash 2,098 (1,912) 1,414
-------- ------- -------
Cash and cash equivalents at beginning of year 93 2,005 591
-------- ------- -------
-------- ------- -------
Cash and cash equivalents at end of year $ 2,191 93 2,005
======== ======= =======
Supplemental Disclosures:
Cash received for federal income taxes $ 2,750 1,386 1,561
-------- ------- -------
Cash paid for interest $ 2,331 2,161 2,275
-------- ------- -------
Sch 4
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(in thousands)
Column A Column B Column C Column D Column E Column F
- ------------------------------------------- ----------- ----------------- -------- ------------ --------
Deferred Future policy Other policy
policy benefits, losses, claims and
acquisition claims and Unearned benefits Premium
Segment cost loss expenses premiums payable revenue
- ------------------------------------------- ----------- ----------------- -------- ------------ --------
Year ended December 31, 2003
State Auto standard insurance segment $80,478 $460,312 $361,704 -- $788,353
State Auto nonstandard insurance segment 4,535 43,632 28,231 -- 82,267
Meridian standard insurance segment 2,086 139,075 14,406 -- 89,948
------- -------- -------- --- --------
Total 87,099 643,019 404,341 -- 960,568
======= ======== ======== === ========
Year ended December 31, 2002
State Auto standard insurance segment $65,374 $402,217 $299,115 -- $673,175
State Auto nonstandard insurance segment 4,305 39,555 25,865 -- 73,555
Meridian standard insurance segment 8,207 159,186 53,010 -- 149,865
------- -------- -------- --- --------
Total 77,886 600,958 377,990 -- 896,595
======= ======== ======== === ========
Year ended December 31, 2001
State Auto standard insurance segment $54,129 $344,746 $244,421 -- $444,296
State Auto nonstandard insurance segment 2,595 33,460 19,613 -- 41,757
Meridian standard insurance segment 10,363 145,654 65,461 -- 69,154
------- -------- -------- --- --------
Total 67,087 523,860 329,495 -- 555,207
======= ======== ======== === ========
Column G Column H Column I Column J Column K
---------- ---------------- ------------ ------------ --------
Amortization
Benefits,claims, of deferred
Net losses and policy Other
investment settlement acquisition operating Premiums
income (1) expenses costs expenses (1) written
---------- ---------------- ------------ ------------ --------
Year ended December 31, 2003
State Auto standard insurance segment $46,486 $520,674 $217,223 $34,742 $854,701
State Auto nonstandard insurance segment 3,091 62,203 11,631 3,060 80,418
Meridian standard insurance segment 8,783 68,346 15,387 9,780 52,146
Investment management services 94 -- -- -- --
All other 143 -- -- -- --
Corporate 145 -- -- -- --
Reclassification adjustments in consolidation 5,883 -- -- -- --
------- -------- -------- ------- --------
Total 64,625 651,223 244,241 47,582 987,265
======= ======== ======== ======= ========
Year ended December 31, 2002
State Auto standard insurance segment $42,223 $467,263 $178,761 $28,187 $722,599
State Auto nonstandard insurance segment 2,759 58,139 10,601 1,830 82,301
Meridian standard insurance segment 9,322 128,072 34,978 9,991 137,944
Investment management services 125 -- -- -- --
All other 180 -- -- -- --
Corporate 25 -- -- -- --
Reclassification adjustments in consolidation 5,057 -- -- -- --
------- -------- -------- ------- --------
Total 59,691 653,474 224,340 40,008 942,844
======= ======== ======== ======= ========
Year ended December 31, 2001
State Auto standard insurance segment $37,230 $292,917 $ 96,127 $42,597 $462,931
State Auto nonstandard insurance segment 2,335 38,178 6,344 3,279 46,484
Meridian standard insurance segment 3,595 95,979 6,551 12,309 64,526
Investment management services 318 -- -- -- --
All other 193 -- -- -- --
Corporate 150 -- -- -- --
Reclassification adjustments in consolidation 3,554 -- -- -- --
------- -------- -------- ------- --------
Total 47,375 427,074 109,022 58,185 573,941
======= ======== ======== ======= ========
(1) Net investment income and other operating expenses are allocated to
segments on a legal entity basis.
Sch 5
STATE AUTO FINANCIAL CORPORATION
SCHEDULE IV - REINSURANCE
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(in thousands, except percentages)
Column A Column B Column C Column D Column E Column F
- ------------------------------------ ------------ ------------------------ ------------------------ ---------- ----------
Ceded to Assumed from Percentage
------------------------ ------------------------ of amount
Outside Affiliated Outside Affiliated assumed
Gross Amount Companies Companies(1) Companies Companies(1) Net Amount to net(2)
------------ --------- ------------ --------- ------------ ---------- ----------
Year ended December 31, 2003
property-casualty earned premiums $679,868 $12,751 $603,823 $4,893 $892,381 $960,568 0.5%
Year ended December 31, 2002
property-casualty earned premiums $577,803 $11,260 $506,777 $3,934 $832,895 $896,595 0.4%
Year ended December 31, 2001
property-casualty earned premiums $472,766 $ 8,335 $432,168 $4,304 $518,640 $555,207 0.8%
- ----------
(1) These columns include the effect of intercompany pooling.
(2) Calculated as earned premiums assumed from outside companies to net amount.
Sch 6
ITEM 15(C)
EXHIBIT INDEX
(a)(3) LISTING OF EXHIBITS
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- ---------------------------------------------
3.01 State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No. 33-40643
Articles of Incorporation on Form S-1 (see Exhibit 3(a) therein)
3.02 State Auto Financial Corporation's Amendment to the 1933 Act Registration Statement No. 33-89400
Amended and Restated Articles of Incorporation on Form S-8 (see Exhibit 4(b) therein)
3.03 State Auto Financial Corporation Certificate of Amendment Form 10-K Annual Report for the year ended
to the Amended and Restated Articles of Incorporation as December 31, 1998 (see Exhibit 3(A)(3)
of June 2, 1998 therein)
3.04 State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No. 33-40643
Code of Regulations on Form S-1 (see Exhibit 3(b) therein)
4.01 State Auto Financial Corporation's Amended and Restated Form 10-K Annual Report for the year ended
Articles of Incorporation, and Articles 1, 3, 5 and 9 of December 31, 1992 (see Exhibit 3(A) and 3(B)
the Company's Amended and Restated Code of Regulations therein)
10.01 Guaranty Agreement between State Automobile Mutual 1933 Act Registration Statement No. 33-40643
Insurance Company and State Auto Property and Casualty on Form S-1 (see Exhibit 10 (d) therein)
Insurance Company dated as of May 16, 1991
10.02 Form of Indemnification Agreement between State Auto 1933 Act Registration Statement No. 33-40643
Financial Corporation and each of its directors on Form S-1 (see Exhibit 10 (e) therein)
10.03* State Auto 1991 Quality Performance Bonus Plan 1933 Act Registration Statement No. 33-40643
on Form S-1 (see Exhibit 10 (f) therein)
10.04* 1991 Stock Option Plan 1933 Act Registration Statement No. 33-40643
on Form S-1 (see Exhibit 10 (h) therein)
1933 Act Registration Statement No. 33-89400
10.05* Amendment Number 1 to the 1991 Stock Option Plan on Form S-8 (see Exhibit 4 (a) therein)
1933 Act Registration Statement No. 33-40643
10.06* 1991 Directors' Stock Option Plan on Form S-1 (see Exhibit 10 (i) therein)
10.07 License Agreement between State Automobile Mutual 1933 Act Registration Statement No. 33-40643
Insurance Company and Policy Management Systems on Form S-1 (see Exhibit 10 (k) therein)
Corporation dated December 28, 1984
10.08 Investment Management Agreement between Stateco Financial Form 10-K Annual Report for the year ended
Services, Inc. and State Automobile Mutual Insurance December 31, 1992 (see Exhibit 10 (N)
Company, effective April 1, 1993 therein)
10.09* State Auto Insurance Companies Directors' Deferred Form 10-K Annual Report for year ended
Compensation Plan December 31, 1995 (see Exhibit 10(S)
therein)
10.10* State Auto Insurance Companies Amended and Restated Registration Statement on Form S-8, File No.
Non-Qualified Incentive Deferred Compensation Plan 333-56338 (see Exhibit 4(e) therein)
10.11* Amendment Number 2 to the 1991 Stock Option Plan Form 10-K Annual Report for the year ended
December 31, 1996 (see Exhibit 10(DD)
therein)
10.12* Amendment Number 1 to the 1991 Directors' Stock Option Form 10-K Annual Report for the year ended
Plan December 31, 1996 (see Exhibit 10(EE)
therein)
10.13 Amended and Restated SERP of State Auto Mutual effective Form 10-K Annual Report for the year ended
as of January 1, 1994 December 31, 1997 (see Exhibit 10(HH)
therein)
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- ---------------------------------------------
10.14 Credit Agreement dated as of June 1, 1999 between State Form 10-Q for the period ended June 30, 1999
Auto Financial Corporation and State Automobile Mutual (see Exhibit 10(LL) therein)
Insurance Company
10.15 Reinsurance Pooling Agreement amended and restated as of Form 10-K Annual Report for the year ended
January 1, 2000 by and among State Automobile Mutual December 31, 1999 (see Exhibit 10(W) therein)
Insurance Company, State Auto Property and Casualty
Insurance Company, Milbank Insurance Company, Midwest
Security Insurance Company (n/k/a State Auto Insurance
Company of Wisconsin), Farmers Casualty Insurance Company
and State Auto Insurance Company (n/k/a State Auto
Insurance Company of Ohio)
10.16 Management and Operations Agreement as of January 1, 2000 Form 10-K Annual Report for the year ended
among State Automobile Mutual Insurance Company, State December 31, 1999 (see Exhibit 10(X) therein)
Auto Financial Corporation, State Auto Property and
Casualty Insurance Company, State Auto National Insurance
Company, Milbank Insurance Company, State Auto Insurance
Company (n/k/a State Auto Insurance Company of Ohio),
Stateco Financial Services, Inc., Strategic Insurance
Software, Inc., 518 Property Management and Leasing, LLC
10.17 Property Catastrophe Overlying Excess of Loss Reinsurance Form 10-K Annual Report for the year ended
contract issued to State Automobile Mutual Insurance December 31, 1999 (see Exhibit 10(Y) therein)
Company, State Auto National Insurance Company, Milbank
Insurance Company, Midwest Security Insurance Company
(n/k/a State Auto Insurance Company of Wisconsin),
Farmers Casualty Insurance Company, Mid-Plains Insurance
Company by State Auto Property and Casualty Insurance
Company
10.18 First Amendment to the Management and Operations Form 10-K Annual Report for the year ended
Agreement effective January 1, 2000 among State December 31, 1999 (see Exhibit 10(Z) therein)
Automobile Mutual Insurance Company, State Auto Financial
Corporation, State Auto Property and Casualty Insurance
Company, State Auto National Insurance Company, Milbank
Insurance Company, State Auto Insurance Company (n/k/a
State Auto Insurance Company of Ohio), Stateco Financial
Services, Inc., Strategic Insurance Software, Inc. and
518 Property Management and Leasing, LLC
10.19 First Amendment to the June 1, 1999 Credit Agreement Form 10-K Annual Report for the year ended
dated November 1, 1999 between State Auto Financial December 31, 1999 (see Exhibit 10(AA)
Corporation and State Automobile Mutual Insurance Company therein)
10.20 Second amendment to the June 1, 1999 Credit Agreement Form 10-Q for the period ended March 31, 2000
dated December 1, 1999 between State Auto Financial (see Exhibit 10(BB) therein)
Corporation and State Automobile Mutual Insurance Company
10.21* Form of Executive Agreement between State Auto Financial Form 10-K Annual Report for the year ended
Corporation and certain executive officers December 31, 2000 (see Exhibit 10(CC)
therein)
10.22 First Amendment to the Reinsurance Pooling Agreement Form 10-K Annual Report for the year ended
Amended and Restated as of January 1, 2000 by and among December 31, 2000 (see Exhibit 10(DD)
State Auto Property and Casualty Insurance Company, State therein)
Automobile Mutual Insurance Company, Milbank Insurance
Company, Midwest Security Insurance Company (n/k/a State
Auto Insurance Company of Wisconsin), Farmers Casualty
Insurance Company and State Auto Insurance Company (n/k/a
State Auto Insurance Company of Ohio)
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- --------------------------------------------
10.23 Addendum No. 1 of the Property Catastrophe Overlying Form 10-K Annual Report for the year ended
Excess of Loss Reinsurance Contract by and among State December 31, 2000 (see Exhibit 10(EE)
Auto Property and Casualty Insurance Company, State therein)
Automobile Mutual Insurance Company, State Auto National
Insurance Company, Milbank Insurance Company, Midwest
Security Insurance Company (n/k/a State Auto Insurance
Company of Wisconsin), Farmers Casualty Insurance
Company, Mid-Plains Insurance Company and State Auto
Insurance Company (n/k/a State Auto Insurance Company of
Ohio) dated November 17, 2000
10.24* 2000 Stock Option Plan Definitive Proxy Statement on Form DEF 14A,
File No. 000-19289, for Annual Meeting of
Shareholders held on May 26, 2000 (see
Appendix A therein)
10.25* 2000 Directors Stock Option Plan Definitive Proxy Statement on Form DEF 14A,
File No. 000-19289, for Annual Meeting of
Shareholders held on May 26, 2000 (see
Appendix B therein)
10.26* First Amendment to 2000 Directors Stock Option Plan Form 10-Q for the period ended March 31, 2001
(see Exhibit 10(HH) therein)
10.27* Second Amendment to the Reinsurance Pooling Agreement Form 10-Q for the period ended June 30, 2001
Amended and Restated as of January 1, 2000, by the State (see Exhibit 10(II) therein)
Automobile Mutual Insurance Company, State Auto Property
and Casualty Insurance Company, Milbank Insurance
Company, Midwest Security Insurance Company (n/k/a State
Auto Insurance Company of Wisconsin), Farmers Casualty
Insurance Company and State Auto Insurance Company (n/k/a
State Auto Insurance Company of Ohio)
10.28* Second Amendment to 1991 Directors Stock Option Plan Form 10-Q for the period ended September 30,
2001 (see Exhibit 10(JJ) therein)
10.29* Second Amendment to 2000 Directors Stock Option Plan Form 10-Q for the period ended September 30,
2001 (see Exhibit 10(KK) therein)
10.30* Third Amendment to 2000 Directors Stock Option Plan Form 10-K Annual Report for the year ended
December 31, 2001 (see Exhibit 10(EE)
therein)
10.31 Third Amendment to State Auto Reinsurance Pooling Form 10-K Annual Report for the year ended
Agreement, Amended and Restated as of January 1, 2000 December 31, 2001 (see Exhibit 10(FF)
therein)
10.32 Stop Loss Reinsurance Agreement dated October 1, 2001 Form 10-K Annual Report for the year ended
among inter alia Mutual and State Auto P&C December 31, 2001 (see Exhibit 10(GG)
therein)
10.33 Amendment No. 2 to the Management and Operations Form 10-K Annual Report for the year ended
Agreement dated January 1, 2000 among, inter alia, Mutual December 31, 2001 (see Exhibit 10(HH)
and State Auto P&C therein)
10.34 Amendment No. 3 to Management and Operations Agreement Form 10-Q for the period ended June 30, 2002
effective January 1, 2002, among State Automobile Mutual (see Exhibit 10(LL) therein)
Insurance Company, State Auto Financial Corporation,
State Auto Property and Casualty Insurance Company, State
Auto National Insurance Company, Milbank Insurance
Company, State Auto Insurance Company, Stateco Financial
Services, Inc., Strategic Insurance Software, Inc., and
518 Property Management and Leasing, LLC
10.35 Management Services Agreement as of July 1, 2002 by and Form 10-Q for the period ended September 30,
among State Auto Property and Casualty Insurance Company, 2002 (see Exhibit 10(NN) therein)
Meridian Insurance Group, Inc., Meridian Security
Insurance Company, Meridian Citizens Mutual Insurance
Company and Meridian Citizens Security Insurance Company
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- --------------------------------------------
10.36 Cost Sharing Agreement among State Auto Property and Form 10K Annual Report for year ended
Casualty Insurance Company, State Automobile Mutual 12-31-02 (see Exhibit 10(OO) therein)
Insurance Company, and State Auto Florida Insurance
Company effective January 1, 2003
10.37 Fourth Amendment to State Auto Reinsurance Pooling Form 10K Annual Report for year ended
Agreement, Amended and Restated as of January 1, 2000 12-31-02 (see Exhibit 10(TT) therein)
10.38* Fourth Amendment to 2000 Directors Stock Option Plan Form 10K Annual Report for year ended
12-31-02 (see Exhibit 10(UU) therein)
10.39 Employment Agreement dated as of May 22, 2003, between Form 10-Q for the period ending June 30,
State Auto Financial Corporation and Robert H. Moone 2003 (see 10(WW) therein)
10.40 Amended and Restated Declaration of Trust of STFC Capital Form 10-Q for the period ending June 30,
Trust I, dated as of May 22, 2003 2003 (see 10(XX) therein)
10.41 Indenture dated as of May 22, 2003, for Floating Rate Form 10-Q for the period ending June 30,
Junior Subordinated Debt Securities Due 2033 2003 (see 10(YY) therein)
10.42 Amendment No. 3 to 1991 Stock Option Plan Effective Form 10-Q for the period ending September
January 1, 2001 30, 2003 (see 10.01) therein)
10.43 Amendment No. 1 to 2000 Stock Option Plan Effective Form 10-Q for the period ending September
January 1, 2001 30, 2003 (see 10.02) therein
10.44 Addendum No. 1 to Property Catastrophe Overlying Excess Form 10-Q for the period ending September
of Loss Reinsurance Contract effective November 16, 2001 30, 2003 (see 10.03) therein
10.45 Property Catastrophe Overlying Excess of Loss Reinsurance Form 10-Q for the period ending September
Contract effective July 1, 2002 30, 2003 (see 10.04) therein
10.46 Property Catastrophe Overlying Excess of Loss Reinsurance Included herein
Contract effective as of 7/1/03
10.47 Credit Agreement Among SAF Funding Corporation The Form 8-K Current Report filed on December
Lenders and KeyBank National Association dated November 16, 2003 (see Exhibit 10.01 therein)
12, 2003
10.48 Put Agreement among State Automobile Mutual Insurance Form 8-K Current Report filed on December
Company, State Auto Financial Corporation and Key Bank 16, 2003 (see Exhibit 10.02 therein)
National Association dated November 12, 2003
10.49 Standby Purchase Agreement between State Auto Financial Form 8-K Current Report filed on December
Corporation and SAF Funding Corporation dated November 16, 2003 (see Exhibit 10.03 therein)
12, 2003
10.50 Indenture dated as of November 13, 2003, among State Auto Securities Act Registration Statement on
Financial Corporation, as Issuer, and Fifth Third Bank as Form S-4 (File No. 333-111507)(see Exhibit
Trustee 4.01 therein)
10.51 Form of 6 1/4% Senior Note due 2013 (Exchange Note) Securities Act Registration Statement on
Form S-4 (File No. 333-111507)(see Exhibit
4.02 therein)
10.52 Amended and Restated Declaration of Trust of STFC Capital Seurities Act Registration Statement on
Trust I, dated as of May 22, 2003 Form S-4 (File No. 333-111507)(see Exhibit
10.40 therein)
21.01 List of Subsidiaries of State Auto Financial Corporation Included herein
23.01 Consent of Independent Auditors Included herein
24.01 Powers of Attorney - William J. Lhota, Urlin G. Harris, Form 10-Q for the period ended June 30, 1997
Jr., Paul W. Huesman, and David J. D'Antoni (see Exhibit 24(C) therein)
If incorporated by reference document with
Exhibit No. Description of Exhibit which Exhibit was previously filed with SEC
- ----------- ---------------------- --------------------------------------------
24.02 Power of Attorney - John R. Lowther Form 10-Q for the period ended March 31,
1998 (see Exhibit 24(D) therein)
24.03 Power of Attorney - Robert H. Moone Form 10-K Annual Report for the year ended
December 31, 1998 (see Exhibit 24(E)
therein)
24.04 Power of Attorney - Richard K. Smith Form 10-K Annual Report for the year ended
December 31, 2000 (See Exhibit 24(D)
therein)
24.05 Power of Attorney - S. Elaine Roberts Form 10-K Annual Report for the year ended
December 31, 2002 (See Exhibit 24(F)
therein)
24.06 Power of Attorney - Paul S. Williams Included herein
31.01 CEO certification required by Section 302 of Included herein
Sarbanes-Oxley Act of 2002
31.02 CFO certification required by Section 302 of Included herein
Sarbanes-Oxley Act of 2002
32.01 CEO certification required by Section 906 of Included herein
Sarbanes-Oxley Act of 2002
32.02 CFO certification required by Section 906 of Included herein
Sarbanes-Oxley Act of 2002
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*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit