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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
- --------------------------------------------------------------------------------
FORM 10-Q
- --------------------------------------------------------------------------------
[x] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
for the quarterly period ended March 31, 2004
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
State of Incorporation: Ohio
I.R.S. Employer I.D. No.: 31-1324304
Address of Principal Executive Offices: 518 East Broad Street, Columbus,
OH 43215-3976
Telephone: 614-464-5000
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 whether the Registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's
classes of common stock as of the latest practicable date:
Common shares, without par value, outstanding on May 3, 2004 was
39,729,875.
1
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
INDEX TO FORM 10-Q QUARTERLY REPORT FOR THE THREE MONTH PERIOD ENDED MARCH 31,
2004
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed consolidated balance sheets - March 31, 2004 and
December 31, 2003
Condensed consolidated statements of income - Three months
ended March 31, 2004 and 2003
Condensed consolidated statements of cash flows - Three months
ended March 31, 2004 and 2003
Notes to condensed consolidated financial statements -
March 31, 2004
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 3. Quantitative and Qualitative Disclosure of Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
2
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED BALANCE SHEETS
(in millions, except per share amount)
March 31 December 31
2004 2003
-------- -----------
(unaudited) (see note 1)
ASSETS
Fixed maturities, available for sale, at fair value (amortized cost $1,374.2
and $1,359.6, respectively) .............................................................. $1,449.9 1,421.4
Equity securities, available for sale, at fair value (cost $139.6 and $121.0, respectively) .... 159.4 139.3
Other invested assets, at fair value (cost $9.5) ............................................... 9.7 9.6
-------- --------
Total investments .............................................................................. 1,619.0 1,570.3
Cash and cash equivalents ...................................................................... 52.0 40.0
Deferred policy acquisition costs .............................................................. 91.1 87.1
Accrued investment income and other assets ..................................................... 53.6 52.5
Due from affiliate ............................................................................. 25.2 -
Net prepaid pension expense .................................................................... 51.0 51.4
Reinsurance recoverable on losses and loss expenses payable (affiliate $5.5
and $5.7, respectively) .................................................................... 15.6 14.2
Prepaid reinsurance premiums (affiliate $4.3 and $3.9, respectively) ........................... 9.0 8.4
Current federal income taxes ................................................................... - 0.2
Property and equipment, at cost, net of accumulated depreciation of $4.7
and $4.4, respectively ..................................................................... 12.4 12.5
-------- --------
Total assets ................................................................................... $1,928.9 1,836.6
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable (affiliate $297.0 and $303.9, respectively) ................... $ 648.3 643.0
Unearned premiums (affiliate $118.2 and $121.3, respectively) .................................. 408.8 404.3
Notes payable (affiliates $61.0) ............................................................... 163.3 161.2
Postretirement benefit liabilities ............................................................. 75.9 74.3
Current federal income taxes ................................................................... 12.8 -
Deferred federal income taxes .................................................................. 7.2 2.0
Other liabilities .............................................................................. 26.3 8.6
Due to affiliates .............................................................................. - 0.9
-------- --------
Total liabilities .............................................................................. 1,342.6 1,294.3
-------- --------
Stockholders' equity:
Class A Preferred stock (nonvoting), without par value. Authorized 2.5 shares;
none issued ............................................................................... - -
Class B Preferred stock, without par value. Authorized 2.5 shares; none issued ............ - -
Common stock, without par value. Authorized 100.0 shares; 44.3
and 44.2 shares issued, respectively, at stated value of $2.50 per share .................. 110.8 110.4
Less 4.6 treasury shares, at cost .......................................................... (56.0) (55.8)
Additional paid-in capital ................................................................. 58.6 56.7
Accumulated other comprehensive income ..................................................... 63.0 53.0
Retained earnings .......................................................................... 409.9 378.0
-------- --------
Total stockholders' equity ..................................................................... 586.3 542.3
-------- --------
Total liabilities and stockholders' equity ..................................................... $1,928.9 1,836.6
======== ========
See accompanying notes to condensed consolidated financial statements.
3
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in millions, except per share amounts)
(unaudited)
Three months ended
March 31
2004 2003
-------- -------
Earned premiums (ceded to affiliate $156.0 and $145.2, respectively) ...... $ 248.8 232.4
Net investment income ..................................................... 17.5 15.7
Net realized gains on investments ......................................... 5.4 3.8
Other income (affiliates $0.9) ............................................ 1.4 1.4
-------- --------
Total revenues ............................................................ 273.1 253.3
-------- --------
Losses and loss expenses (ceded to affiliate $88.3 and $83.3, respectively) 147.7 149.6
Acquisition and operating expenses ........................................ 75.1 71.7
Interest expense (affiliates $0.5 and $0.7, respectively) ................. 1.7 0.7
Other expenses ............................................................ 2.6 2.8
-------- --------
Total expenses ............................................................ 227.1 224.8
-------- --------
Income before federal income taxes ........................................ 46.0 28.6
Federal income tax expense ................................................ 13.6 7.5
-------- --------
Net income ................................................................ $ 32.4 21.1
======== ========
Earnings per common share:
Basic ................................................................. $ 0.82 0.54
-------- --------
Diluted ............................................................... $ 0.80 0.53
-------- --------
Dividends paid per common share ........................................... $ 0.040 0.035
-------- --------
See accompanying notes to condensed consolidated financial statements.
4
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
(unaudited)
Three months ended
March 31
2004 2003
------ ------
Cash flows from operating activities:
Net income .......................................................................... $ 32.4 21.1
Adjustments to reconcile net income to net cash provided
by Operating activities:
Depreciation, amortization and other, net .................................. 2.2 1.6
Net realized gains on investments .......................................... (5.4) (3.8)
Changes in operating assets and liabilities:
Deferred policy acquisition costs ..................................... (4.0) (1.3)
Accrued investment income and other assets ............................ (1.2) (1.3)
Net prepaid pension expense ........................................... 0.4 -
Postretirement benefit liabilities .................................... 1.6 1.6
Reinsurance recoverable on losses and loss expenses
payable and prepaid reinsurance premiums ............................ (2.0) (0.4)
Other liabilities and due to/from affiliates, net ..................... (8.4) 7.7
Losses and loss expenses payable ...................................... 5.3 3.5
Unearned premiums ..................................................... 4.5 4.9
Federal income taxes .................................................. 12.8 7.1
------ ------
Net cash provided by operating activities ........................................... 38.9 40.7
------ ------
Cash flows from investing activities:
Purchase of fixed maturities ................................................... (177.6) (185.7)
Purchase of equity securities .................................................. (19.7) (14.8)
Maturities, calls and pay downs of fixed maturities ............................ 22.5 17.5
Sale of fixed maturities ....................................................... 142.9 85.5
Sale of equity securities ...................................................... 1.9 1.2
------ ------
Net cash used in investing activities ............................................... (30.0) (96.3)
------ ------
Cash flows from financing activities:
Proceeds from issuance of common stock ......................................... 1.3 0.8
Payments to acquire treasury shares ............................................ - (0.7)
Payment of dividends ........................................................... (0.5) (0.4)
Fair value hedge derivative settlement ......................................... 2.3 -
------ ------
Net cash provided by (used in) financing activities ................................. 3.1 (0.3)
------ ------
Net increase (decrease) in cash and cash equivalents ................................ 12.0 (55.9)
------ ------
Cash and cash equivalents at beginning of period .................................... 40.0 96.0
------ ------
Cash and cash equivalents at end of period .......................................... $ 52.0 40.1
====== ======
Supplemental disclosures:
Federal income taxes paid .................................................... - 0.4
------ ------
Interest paid (affiliates $0.5 and $0.8, respectively) ....................... $ 0.5 0.9
------ ------
See accompanying notes to condensed consolidated financial statements.
5
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements (unaudited)
March 31,2004
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements
of State Auto Financial Corporation ("State Auto Financial" or the "Company")
have been prepared in accordance with Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes
required by accounting principles generally accepted in the U.S. for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal, recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three month period ended March 31, 2004
are not necessarily indicative of the results that may be expected for the year
ended December 31, 2004. The balance sheet at December 31, 2003 has been derived
from the audited financial statements at that date but does not include all of
the information and footnotes required by accounting principles generally
accepted in the United States for complete financial statements.
For further information, refer to the consolidated financial statements
and footnotes thereto included in the Company's annual report on Form 10-K for
the year ended December 31, 2003 (the "2003 Form 10-K"). Capitalized terms used
herein and not otherwise defined shall have the meaning ascribed to them in the
2003 Form 10-K.
2. DERIVATIVE
During March 2004, the Company settled its fair value hedge derivative
for a total $2.9 million gain. Of the total $2.9 million received, $2.3 million
was recorded in notes payable and will be amortized as an offset to interest
expense over the life of the Company's ten year $100.0 million senior notes
issued in November 2003. The remaining $0.6 million was recorded as an offset to
the current period interest expense. The Company classifies in the statement of
cash flows amounts received from derivative contracts that are accounted for
as hedges of identifiable transactions in the same category as the cash flows
from the items being hedged.
3. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted
earnings per common share:
Three months ended
(in millions, except per share amounts) March 31
2004 2003
------ ------
Numerator:
Net income for basic and diluted earnings per share $ 32.4 21.1
====== ======
Denominator:
Weighted average shares outstanding:
Basic earnings per share 39.6 39.1
Effect of dilutive stock options 0.9 0.6
------ ------
Diluted earnings per share 40.5 39.7
====== ======
Basic earnings per share $ 0.82 0.54
====== ======
Diluted earnings per share $ 0.80 0.53
====== ======
6
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements, Continued (unaudited)
The following number of 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:
Three months ended
(in millions) March 31
2004 2003
---- ----
Number of options - 0.6
=== ===
4. STOCK BASED COMPENSATION
The Company has stock-based employee and non-employee compensation
plans, which are described more fully below. The Company accounts for the
employee and non-employee director plans using the intrinsic value method under
the recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees, and related Interpretations. No stock-based employee
or director compensation cost is reflected in net income, as substantially all
options granted under these plans have an exercise price equal to the market
value of the underlying common stock on the date of grant. The Company accounts
for the remaining non-employee plans using the fair value method under the
recognition and measurement principles of FASB Statement No. 123, Accounting for
Stock-Based Compensation, and related interpretations. Non-employee stock-based
compensation cost is reflected in net income. The following table illustrates
the effect on net income and earnings per share if the Company had applied the
fair value recognition provisions of FASB Statement No. 123, Accounting for
Stock-Based Compensation, to stock-based employee and non-employee director
compensation.
Three months ended
March 31
(in millions, except per share amounts) 2004 2003
------ ------
Net income, as reported $ 32.4 21.1
Deduct: Total stock-based employee and non-
employee director compensation expense
determined under fair value based method for
all awards, net of related tax effects (0.4) (0.3)
------ ------
Pro forma net income $ 32.0 20.8
====== ======
Earnings per share:
Basic--as reported $ 0.82 0.54
====== ======
Basic--pro forma $ 0.81 0.53
====== ======
Diluted--as reported $ 0.80 0.53
====== ======
Diluted--pro forma $ 0.77 0.52
====== ======
There were no options granted to employees and directors during the
three month periods ended March 31, 2004 and 2003. The fair value of options
granted during the calendar year 2003 was estimated at the date of grant using
the Black-Scholes option pricing model. See the 2003 Form 10-K for the weighted
average fair values and related assumptions for options granted during calendar
year 2003.
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 input
of highly subjective assumptions including the expected stock price volatility.
Because the Company's employee and director 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 and director stock options.
The Company has stock option plans for certain key employees, all
Company employees, non-employee directors and certain independent insurance
agencies. The Key Employee's Plan provides that qualified stock options may be
granted at an option price not less than common stock fair market value at date
of grant and that nonqualified stock options may be granted at any price
determined by the Compensation Committee of the Board of Directors. The
7
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements, Continued (unaudited)
Company has reserved 5.0 million shares of common stock under this plan. These
options typically vest over a three year period with one-third vesting at each
anniversary date. Normally, these options are exercisable up to ten years from
the 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.
The Non-employee Directors' Plan provides each non-employee director of
the Company an option to purchase 4,200 shares of common stock following each
annual meeting of the shareholders at an option price equal to the common stock
fair market value at the close of business on the last trading day immediately
prior to the date of the annual meeting. The Company has reserved 300,000 shares
of common stock under this plan. These options vest upon grant and are
exercisable up to 10 years from the date of grant.
The Company accounts for the remaining non-employee plans described
below using the fair value method under the recognition and measurement
principles of FASB Statement No. 123, Accounting for Stock-Based Compensation,
and related interpretations. Non-employee stock-based compensation cost of
$30,000 and $57,000 for the three month periods ended March 31, 2004 and 2003,
respectively, was reflected in net income.
The fair value of non-employee options granted was estimated at the
reporting date or vesting date using the Black-Scholes option-pricing model. The
weighted average fair value and related assumptions are as follows:
Three months ended
March 31
2004 2003
---- ----
Fair value $12.74 7.93
Dividend yield 0.8% 0.9
Risk free interest rate 3.8% 3.8
Expected volatility factor 34.2% 35.3
Expected life in years 9.7 9.3
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 the date of grant or a portion thereof in the first calendar year in which
an agency commences participation under the plan. Options granted under this
plan have a ten year term.
A summary of the Company's stock option activity and related
information for all option plans for the three month periods ended March 31,
2004 and 2003 is as follows:
Three months ended
March 31
2004 2003
---- ----
Weighted Weighted
Number Average Number Average
of Exercise of Exercise
(number of options in millions) Options Price Options Price
------- -------- ------- --------
Outstanding, beginning of year 2.6 $12.84 2.8 $10.98
Granted 0.1 23.34 - -
Exercised (0.2) 9.16 (0.2) 4.65
------ ------
Outstanding, end of period 2.5 $13.22 2.6 $11.53
====== ======
8
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements, Continued (unaudited)
A summary of information pertaining to all options outstanding and
exercisable at March 31, 2004 is as follows:
Options Outstanding Options Exercisable
------------------- -------------------
(number of options in Weighted
millions) Average Weighted Weighted
Remaining Average Average
Contractual Exercise Exercise
Range of Exercise Prices Number Life Price Number Price
- ------------------------ ------ ----------- -------- ------ -------
$5.01 - $10.00 0.6 1.9 6.77 0.6 6.77
$10.01 - $20.00 1.9 6.8 14.98 1.2 13.68
------ ------ ------ ------ ------
Total 2.5 5.7 $13.22 1.8 $11.57
====== ====== ====== ====== ======
On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a
proposal that, if implemented, would require the Company to recognize the fair
value of all stocks options as compensation expense beginning in 2005.
5. OTHER COMPREHENSIVE INCOME
The components of accumulated other comprehensive income, net of
related tax, included in stockholders' equity at March 31, 2004 and 2003 include
unrealized holding gains (losses), net of tax. The components of comprehensive
income, net of related tax, are as follows:
Three months ended
March 31
(in millions) 2004 2003
----- -----
Net income $32.4 21.1
Unrealized holding gain (loss), net of tax 10.0 (1.5)
----- -----
Comprehensive income $42.4 19.6
===== =====
6. REINSURANCE
The following table provides a summary of the Company's reinsurance
transactions with other insurers and reinsurers, as well as reinsurance
transactions with affiliates:
Three months ended
(in millions) March 31
2004 2003
------ ------
Premiums earned:
Assumed from other insurers and reinsurers $ 1.4 1.2
Assumed under State Auto Pool and
other affiliate arrangements 228.8 217.7
Ceded to other insurers and reinsurers 6.8 3.0
Ceded under State Auto Pool
and other affiliate arrangements 156.0 145.2
Losses and loss expenses incurred:
Assumed from other insurers and reinsurers 1.9 0.8
Assumed under State Auto Pool and
other affiliate arrangements 132.6 133.9
Ceded to other insurers and reinsurers 4.8 0.5
Ceded under State Auto Pool
and other affiliate arrangements $ 88.3 83.3
9
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements, Continued (unaudited)
7. PENSION AND POSTRETIREMENT BENEFIT PLANS
The following table provides the Company's components of net periodic cost
(benefit) for the Company's pension and postretirement benefit plans:
Pension Postretirement
------- --------------
(in millions) Three months ended March 31
2004 2003 2004 2003
---- ---- ---- ----
Service cost $2.0 1.7 $0.9 0.8
Interest cost 2.6 2.5 1.3 1.2
Expected return on plan assets (4.2) (4.2) (0.1) (0.1)
Amortization of prior service cost 0.1 0.1 0.1 0.1
Amortization of transition asset (0.2) (0.2) - -
Amortization of net loss 0.1 - - -
---- ---- ---- ---
Net periodic cost (benefit) $0.4 (0.1) $2.2 2.0
==== ==== ==== ===
The Company previously disclosed in the 2003 Form 10-K that it expected
to contribute $4.0 million to its pension plan in 2004. As of March 31, 2004,
this contribution had not been made. The Company presently anticipates
contributing $4.0 million to its pension plan in 2004.
In accordance with FASB Staff Position No. 106-1 Accounting and
Disclosure Requirements Related to the Medicare Prescription Drug, Improvement
and Modernization Act of 2003, 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.
8. SEGMENT INFORMATION
At March 31, 2004, the Company has three reportable segments: State
Auto standard insurance, State Auto nonstandard insurance and investment
management services. As the former Meridian Mutual Insurance Company
("Meridian") standard and nonstandard business was written and processed through
the Meridian underwriting and claims system platform, management monitored that
business as separate segments from the State Auto standard and nonstandard
processed business. Monitoring of those segments separately was necessary in
order to facilitate the integration of the business as it migrated through new
policies and renewals to the State Auto systems platform in which State Auto
policies, pricing, underwriting, and claims philosophies were fully reflected.
Due to the integration efforts that occurred within the former Meridian standard
segment, beginning with the first quarter of 2004, the Meridian standard
business was included in the State Auto standard segment. Likewise, due to the
integration efforts that occurred within the Meridian nonstandard segment,
beginning with the first quarter of 2003, the Meridian nonstandard business was
included in the State Auto nonstandard segment. The segment disclosures for 2003
have been restated to reflect this change. Interim financial data by segment is
as follows:
Three months ended
(in millions) March 31
2004 2003
------ ------
Revenues from external customers:
State Auto standard insurance $245.6 226.5
State Auto nonstandard insurance 20.4 21.6
Investment management services 0.7 0.6
All other 0.8 0.8
------ ------
Total revenues from external customers $267.5 249.5
====== ======
Intersegment revenues:
State Auto standard insurance $ 0.1 0.1
Investment management services 1.6 1.4
All other 0.4 0.4
------ ------
Total intersegment revenues $ 2.1 1.9
====== ======
10
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements, Continued (unaudited)
Three months ended
March 31
2004 2003
-------- --------
Segment profit:
State Auto standard insurance $ 38.9 21.3
State Auto nonstandard insurance 1.1 2.0
Investment management services 2.1 1.7
All other 0.4 0.5
-------- --------
Total segment profit $ 42.5 25.5
Reconciling items:
Corporate expenses $ (1.9) (0.7)
Net realized gains 5.4 3.8
-------- --------
Total consolidated income before
federal income taxes $ 46.0 28.6
======== ========
Segment assets:
Standard insurance $2,019.4 1,499.4
Nonstandard insurance 144.3 107.3
Investment management services 3.5 5.7
All other 16.1 12.8
-------- --------
Total segment assets $2,183.3 1,625.2
======== ========
11
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
In addition to the information discussed below, you are encouraged to
review the Company's Annual Report on Form 10-K for its year ended December 31,
2003 (the "2003 Form 10-K"). The 2003 Form 10-K includes information regarding
the Company not discussed in this Form 10-Q, such as an overview of its
organizational structure and businesses, a summary of its significant
transactions for 2003 and 2002, and information regarding its significant
accounting policies, as well as a discussion regarding its critical accounting
policies. This information will assist in your understanding of the discussion
of the Company's current period financial results.
Overview
State Auto Financial Corporation ("State Auto Financial" and, together
with its subsidiaries, the "Company") operates in two insurance segments: (i)
State Auto Financial's wholly owned insurance subsidiaries 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") engage in the State Auto standard segment
of the Company's operations; and (ii) State Auto National Insurance Company ("SA
National"), a wholly owned subsidiary of the Company, and Mid-Plains Insurance
Company ("Mid-Plains"), a wholly owned subsidiary of Farmers, engage in the
State Auto nonstandard segment of the Company's operations. In addition to these
two insurance segments, the Company previously operated a Meridian standard
insurance segment and a Meridian nonstandard insurance segment, which consisted
of the business of the former Meridian Mutual Insurance Company ("Meridian
Mutual") business assumed by the STFC Pooled Companies (defined below), which
was acquired and merged into State Automobile Mutual Insurance Company ("State
Auto Mutual") in June 2001. Due to the integration efforts that occurred within
the former Meridian segments, beginning with the first quarter of 2003, the
Meridian nonstandard segment was included in the State Auto nonstandard
insurance segment. Likewise, beginning with the first quarter of 2004, the
former Meridian standard segment was included in the State Auto standard
insurance segment. All prior period financial information has been restated to
reflect this segment combination.
An insurance pooling arrangement exists between State Auto P&C,
Milbank, Farmers, and SA Ohio (collectively referred to as the "STFC Pooled
Companies") and State Auto Mutual and its subsidiaries, State Auto Insurance
Company of Wisconsin ("SA Wisconsin") and State Auto Florida Insurance Company
("SA Florida") (collectively referred to as the "Mutual Pooled Companies") and,
together with the STFC Pooled Companies collectively referred to as "Pooled
Companies" or the "State Auto Pool"). Under this pooling arrangement, premiums,
losses and underwriting expenses are shared by the Pooled Companies, with the
STFC Pooled Companies receiving 80% in the aggregate of this underwriting pool
and the Mutual Pooled Companies receiving 20% in the aggregate of this
underwriting pool. The following table sets forth the participants and their
respective percentages of the State Auto Pool:
Pooled Companies
----------------
STFC Pooled Companies Mutual Pooled Companies
--------------------- -----------------------
State Auto SA Sub SA SA Sub
Period P&C Milbank Farmers Ohio Total Mutual Wisconsin Florida Total
------ --- ------- ------- ---- ----- ------ ---------- -------- -----
1/1/2003 -
3/31/2004 59% 17 3 1 80 18.3 1 0.7 20%
The Pooled Companies, SA National, Mid-Plains and State Auto Mutual's
insurance subsidiaries Meridian Security Insurance Company, Meridian Citizens
Security Insurance Company, and Meridian Citizens Mutual Insurance Company a
contractual affiliate of State Auto Mutual's wholly owned subsidiary, Meridian
Insurance Group, Inc., are collectively referred to herein as the "State Auto
Group."
Results of Operations
The following table summarizes for the three month periods ended March
31, 2004 and 2003 certain key performance indicators used to manage the
operations of the Company:
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
Operation, Continued
Three Months Ended
March 31
(dollars in millions)
GAAP Basis: 2004 2003
----------- ------ ------
Total revenue $248.8 232.4
Net income $ 32.4 21.1
Stockholders' equity $586.3 542.3
Loss and LAE ratio * 59.4 64.4
Expense ratio * 30.2 30.8
Combined ratio 89.6 95.2
Catastrophe loss and LAE points* 1.0 2.6
Earned premium growth 7.1% 9.2
Investment yield 4.5% 4.8
Twelve Months Ended
March 31
Statutory Basis: 2004 2003
---------------- ---- ----
Net premiums written to surplus** 1.8x 2.4
* 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 a company's statutory surplus available to absorb losses.
- ---------------------------
During the three months ended March 31, 2004, the Company generated a
record net income of $32.4 million. This achievement was primarily a factor of
record level earned premium of $248.8 million along with a combined ratio of
89.6. This excellent combined ratio was the direct result of management's
obtaining adequate cost based rates across most lines of business,
re-underwriting the former Meridian Mutual business applying State Auto
underwriting guidelines and controlling operating expenses. Management of the
Company continues to focus on growing premiums without compromising
profitability. The Company's investment yield declined consistent with the
decrease in long term interest rates. The Company invests for yield while
maintaining a conservative approach for principal preservation. See below for
additional discussion of the Company's operations.
Net income before federal income taxes for the Company increased $17.4
million (60.8%) to $46.0 million for the three month period ended March 31, 2004
from the same period in 2003. Contributing to this increase was an improvement
in the Company's loss experience from 2003 along with continued growth in earned
premium. The Company's GAAP combined ratio reflected a 5.6 point improvement for
the three month period ended March 31, 2004 from the same period in 2003.
Consolidated earned premiums increased $16.4 million (7.1%) to $248.8
million for the three month period ended March 31, 2004 from the same period in
2003. This increase was primarily the result of premium rate increases across
most lines of business. The overall composition of the Company's book of
business did not change significantly, with the standard auto - personal line
continuing to be the Company's most significant line of business. The State Auto
standard segment contributed a 5.4% increase to consolidated earned premiums for
the three month period ended March 31, 2004 from the same period in 2003, while
the State Auto non-standard segment contributed a 0.7% decrease from the same
period in 2003. The non-standard decrease was primarily the result of the
Company terminating or suspending in the last half of 2003 certain fast growing,
but extremely unprofitable, agencies in Kentucky. While this action adversely
affected this segment's premium growth, it is expected to improve long term
underwriting results. Also impacting the earned premiums increase during the
three month period ended March 31, 2004 was the December 31, 2003 termination of
the Stop Loss (as defined below) since no premiums were required to be ceded to
Mutual as they were in the first quarter of 2003. The STFC Pooled Companies
ceded $5.5 million in earned premiums to State Auto Mutual under a stop loss
reinsurance arrangement (the "Stop Loss") between the companies during the first
quarter of 2003, which reduced the Company's earned premiums for that period.
The absence of a Stop Loss premium cession for the three months ended March 31,
2004 had the effect of contributing a 2.4% increase in earned premiums in 2004,
as compared to the same 2003 period. The Stop Loss reinsurance agreement expired
December 31, 2003 and was not renewed. Earned premium growth slowed to 7.1% from
9.2% for the three month period ended March 31, 2004 from the same period in
2003. In
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
Operation, Continued
the past two years, the Company took necessary rate increases, particularly
within the former Meridian book of business, in almost all lines of business.
The Company anticipates implementing smaller rate increases in 2004 compared to
2003 and 2002, which is expected to affect earned premium growth in the future.
In management's opinion, within the last year the industry has experienced a
slow down in the pace of rate increases and actual rate reductions in a limited
number of certain lines. 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 $1.8 million (11.5%) to $17.5 million
for the three month period ended March 31, 2004 from the same period in 2003.
This increase was primarily the result of an increase in invested assets
generated by cash flow provided from operations and financing since March 31,
2003, partly offset by a decline in the investment yield. Between April 1, 2003
and December 31, 2003, the Company issued debt, net of repayments, of $85.5
million. Total cost of invested assets at March 31, 2004 and 2003 was $1,552.4
million and $1,344.6 million, respectively. Reflecting a decline in the interest
rate environment, the annualized investment yields based on invested assets at
cost decreased to 4.5% from 4.8% for the three month period ended March 31, 2004
from the same 2003 period. 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 59.4% and 64.4% for the
three month periods ended March 31, 2004 and 2003, respectively. See the Stop
Loss discussion above regarding earned premiums cessions for the three month
period ended March 30, 2003. Absent the impact of the Stop Loss, the GAAP loss
and LAE ratio for the three months ended March 31, 2003 was 62.9%. During the
three months ended March 31, 2004 and 2003, catastrophe losses totaled $2.4
million (1.0 GAAP loss and LAE points) and $6.1 million (2.6 GAAP loss and LAE
points), respectively. Catastrophe losses discussed herein have been designated
as such by ISO'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.
For discussion purposes, the following table provides comparative GAAP
loss and LAE ratios for the Company's insurance operating segments for the three
month periods ended March 31, 2004 and 2003, respectively:
Three months ended
March 31
Change
2004 2003 inc (dec)
---- ---- ---------
State Auto standard segment 57.8 63.1 (5.3)
State Auto nonstandard segment 78.1 77.0 1.1
Total GAAP Loss and LAE Ratio 59.4 64.4 (5.0)
The State Auto standard segment's GAAP loss and LAE ratio improved 5.3
points for the three month period ended March 31, 2004 from the same 2003
period. This improvement reflected the Company's continual emphasis on
responsible underwriting, which includes taking necessary and appropriate rate
increases across most lines of business. Catastrophe losses represented 1.0 and
2.8 points of this segment's GAAP loss and LAE ratio for the three months ended
March 31, 2004 and 2003, respectively. 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; its GAAP
loss and LAE ratio improved 3.2 points to 60.9 for the three month period ended
March 31, 2004 from the same 2003 period. Homeowners is the Company's second
largest line of business. Its loss experience can be adversely affected by the
increased frequency and severity of storms. With the minimal impact of
catastrophes in the current quarter, along with a reduction in large loss
frequency and improvement in the core loss ratio due to continued underwriting
due diligence and greater rate adequacy, homeowners' GAAP loss and LAE ratio
improved 14.1 points to 53.6 for the three month period ended March 31, 2004
from the same 2003 period. Workers' compensation continues to be the Company's
most volatile line of business due to the risks insured; its GAAP loss and LAE
ratio improved 8.2 points to 63.9 for the three month period ended March 31,
2004 from the same 2003 period. 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'
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
Operation, Continued
compensation represents approximately 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 State Auto nonstandard segment's GAAP loss and LAE ratio
deteriorated 1.1 points for the three month period ended March 31, 2004 from the
same 2003 period. Catastrophe losses represented 0.1 and 0.8 points of this
segment's GAAP loss and LAE ratio for the three month period ended March 31,
2004 and 2003, respectively. The nonstandard automobile segment typically is a
more volatile line of business than the standard segment. Management continually
monitors this segment's underwriting performance paying particular attention to
rate adequacy and risk selection in states and agencies with unusually high
written premium growth. Kentucky, this segment's largest state of operation,
experienced significant written premium growth during 2003. However, the Company
terminated or suspended certain fast growing, but extremely unprofitable,
agencies in Kentucky during the last half of 2003. While this action adversely
affected this segment's premium growth, it is expected to improve long term
underwriting results.
Acquisition and operating expenses, as a percentage of earned premiums
(the "GAAP expense ratio"), were 30.2% and 30.8% for the three months ended
March 31, 2004 and 2003, respectively. Absent the impact of the first quarter
2003 Stop Loss earned premium cession, the GAAP expense ratio was 30.1% for the
three months ended March 31, 2003. Certain significant variable expenses that
are tied directly to the Company's insurance operation's profitability, such as
bonus and profit sharing plans for employees and agents, contributed to the
increased GAAP expense ratio for the three month period ended March 31, 2004
over the same period during 2003. 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 1.5 points within the GAAP expense ratio for the three months ended March
31, 2004 and 2003, respectively. QPB was 1.5 points and 0.9 point within the
GAAP expense ratio for the three months ended March 31, 2004 and 2003,
respectively. Notwithstanding these profit driven expense increases, expense
control has been and remains one of the critical elements of the Company's
success.
Interest expense increased $1.0 million (142.9%) to $1.7 million for
the three month period ended March 31, 2004 from the same period in 2003. The
increase was the result of the additional $85.5 million of debt, net of
repayments, borrowed between April 1, 2003 and December 31, 2003, partly reduced
by a $0.6 million offset to interest expense related to the fair value hedge
derivative settlement during March 2004. See "Liquidity and Capital Resources"
for further discussion of the fair value hedge derivative settlement.
The effective federal income tax expense rate for the three month
periods ended March 31, 2004 and 2003 were 29.6% and 26.2%, respectively.
Improvement in the Company's 2004 underwriting results, along with an increase
in net realized gains on investments, contributed to the rate increase.
Liquidity and Capital Resources
Liquidity refers to the ability of the Company to generate adequate
amounts of cash to meet its payment 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.
At March 31, 2004 and 2003, the Company had $52.0 million and $40.0
million, respectively, of cash and cash equivalents. At March 31, 2004 and 2003,
the Company had $1,619.0 million and $1,570.3 million, respectively, of total
investments at fair market value. The majority of the Company's fixed maturities
and substantially all the equity securities are traded on public markets.
For the three months ended March 31, 2004, net cash provided by
operating activities decreased to $38.9 million from $40.7 million for the same
2003 period. The decrease in cash flow from operations in 2004 was primarily
attributable to the change in operating assets and liabilities, in particular
amounts related to affiliates and federal income taxes, which slightly more than
offset an increased underwriting profit, investment income and net realized
gains on investments. For the three months ended March 31, 2004, net cash used
in investing activities decreased to $30.0 million from $96.3 million for the
same 2003 period. This decrease in 2004 was due to the Company investing during
the three months ended March 31, 2003 a substantial amount of cash and cash
equivalents that existed at December 31, 2002. For
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
Operation, Continued
the three months ended March 31, 2004, net cash provided by financing activities
increased to $3.1 million from $0.3 million cash used in the same period in 2003
primarily due to the fair value hedge derivative settlement.
During March 2004 the Company settled its fair value hedge derivative
for a total $2.9 million gain. Of the total $2.9 million received, $2.3 million
was recorded in notes payable and will be amortized as an offset to interest
expense over the ten year term of the $100.0 million unsecured senior notes. The
remaining $0.6 million was recorded as an offset to interest expense.
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 2004 and 2003 is 2.25% and
2.50%, respectively.
State Auto Financial's Delaware business trust subsidiary (the "Capital
Trust") has 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 (5.37% as of March 31, 2004). Prior to
May 2008, the interest rate may not exceed 12.5% per annum. 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 obligations under the Subordinated Debentures and related
agreements, taken together, constitute a full and unconditional guarantee of
payments due on the Trust Securities. The Subordinated Debentures are unsecured
and subordinated to all of the Company's existing and future senior
indebtedness.
State Auto Financial has issued $100.0 million unsecured senior notes
bearing interest fixed at 6.25% due November 15, 2013. 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.
During the three month period ended March 31, 2004, a total of 12,042
shares were acquired as a result of stock swap option exercises at a total cost
of $0.2 million. During the three month period ended March 31, 2003, a total of
54,677 shares were repurchased at a total cost of $0.7 million.
The Company has reinsurance arrangements to limit its loss exposure and
contribute to its liquidity and capital resources. See the 2003 Form 10K for
further discussion of these arrangements.
At March 31, 2004, all of the Company's insurance subsidiaries were in
compliance with statutory requirements relating to capital adequacy. Management
believes that the Company has sufficient capital, cash flow and potential
capital resources to meet its cash flow requirements. The Company' net written
premium to surplus ratio was 1.8 to 1.0 and 1.9 to 1.0 for the twelve month
periods ended March 31, 2004 and December 31, 2003, respectively.
Other Disclosures
Investments
At March 31, 2004, the Company had no fixed maturity investments rated
below investment grade. The following table provides information regarding the
quality rating distribution of the Company's fixed maturity portfolio based on
the fair market value:
March 31 December 31 Average
2004 2003 Rating*
-------- ----------- -------
Corporate and Municipal Bonds 58.7% 58.2% Aa+
U.S. Governments 2.3% 2.2% Aaa
U.S. Government Agencies 39.0% 39.6% Aaa
----- -----
Total 100.0% 100.0%
===== =====
- ------------------
* As rated by Moody's Investors Service
16
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
Operation, Continued
During the three month period ended March 31, 2004, the Company
increased its investment in equity securities by $19.7 million to enhance growth
of statutory surplus over the long term. The Company's current investment
strategy does not rely on the use of derivative financial instruments.
At March 31, 2004, all investments in fixed maturity and equity
securities were held as available for sale and therefore were carried at fair
value. Other invested assets are comprised of limited liability partnership
investments, common securities of the Capital Trust (State Auto Financial's
Delaware business trust subsidiary) and trust preferred security 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.
The following table provides the composition of the Company's
investment portfolio at fair market value at March 31, 2004 and December 31,
2003:
(dollars in millions) March 31, 2004 December 31, 2003
------------------- ------------------
Fixed maturities, at fair value $1,449.9 89.6% $1,421.4 90.5%
Equity securities, at fair value 159.4 9.9% 139.3 8.9%
Other invested assets, at fair value 9.7 0.5% 9.6 0.6%
-------- ----- -------- -----
Total investments $1,619.0 100.0% $1,570.3 100.0%
======== ====== ======== ======
The Company regularly monitors its investment portfolio for declines in
value that are other than temporary, an assessment which requires significant
management judgment. 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 a security in the Company's investment portfolio has
a decline in fair value which 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.
The Company reviewed its investments at March 31, 2004, and, based on
the factors described above, determined no other than temporary impairment
existed in the gross unrealized holding losses, as provided in the table below.
This determination could change in the future as more information becomes known
which could negatively impact the amounts reported herein. At March 31, 2004,
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 March 31, 2004. The following table provides the Company's
investment portfolio gross unrealized gains and losses at March 31, 2004:
Gross Gain Gross Loss
Cost or unrealized number unrealized number
amortized holding of holding of Fair
cost gains positions losses positions value
--------- ---------- --------- ---------- --------- --------
(dollars in millions)
Investment Category
Fixed Maturities
U.S. Treasury securities $ 353.9 $ 14.2 118 $ 0.1 6 $ 368.0
States & political subdivisions 747.2 50.7 337 1.8 56 796.2
Corporate securities 50.0 5.4 32 - - 55.4
Mortgage-backed securities of U.S.
Gov. Agencies 223.1 7.8 71 0.7 13 230.3
-------- -------- -------- -------- -------- --------
Total fixed maturities 1,374.2 78.3 558 2.6 75 1,449.9
Equity Securities
Consumer 19.5 4.2 13 - - 23.7
Technologies 14.6 2.0 6 0.2 3 16.4
Pharmaceuticals 19.1 2.1 5 1.1 5 20.1
Financial services 39.4 6.2 17 0.5 5 45.0
Manufacturing & other 47.0 8.0 26 0.8 9 54.2
-------- -------- -------- -------- -------- --------
Total equity securities 139.6 22.5 67 2.6 22 159.4
-------- -------- -------- -------- -------- --------
Other invested assets 9.5 0.2 1 - - 9.7
-------- -------- -------- -------- -------- --------
Total investments $1,523.3 $ 100.9 626 $ 5.2 97 $1,619.0
======== ======== ======== ======== ======== ========
17
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
Operation, Continued
The amortized cost and fair value of fixed maturities at March 31,
2004, by contractual maturity, is as follows:
Amortized Fair
(in millions) Cost Value
-------- --------
Due in 1 year or less $ 3.5 $ 3.7
Due after 1 year through 5 years 36.2 39.0
Due after 5 years through 10 years 259.6 276.1
Due after 10 years 851.8 900.8
-------- --------
Subtotal 1,151.1 1,219.6
Mortgage-backed securities 223.2 230.3
-------- --------
Total $1,374.2 $1,449.9
======== ========
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 realized losses of equity securities below, was no
recognized loss related to other than temporary impairment for the three month
periods ended March 31, 2004 and 2003, respectively. There were no other than
temporary impairments of fixed maturity securities for the three month periods
ended March 31, 2004 and 2003.
The securities sold during the three months ended March 31, 2004, 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 for the three
months ended March 31, 2004 are summarized as follows:
Three months ended
(in millions) March 31, 2004
Realized Fair Value
Gains/Losses at Sale
------------ -------
Realized gains:
Fixed maturities $ 4.9 $136.6
Equity securities 0.6 6.2
------ ------
Total realized gains 5.5 142.8
Realized losses:
Fixed maturities 0.1 6.3
Equity securities - -
------ ------
Total realized losses 0.1 6.3
------ ------
Net realized gains on investments $ 5.4 $136.5
====== ======
18
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
Operation, Continued
Losses and Loss Expenses Payable
The following table presents losses and loss expenses payable by major
line of business:
March 31 December 31 Percent
(dollars in millions) 2004 2003 Change
---- ---- ------
Automobile - personal (standard) $182.1 $185.4 (1.8)%
Automobile - personal (nonstandard) 38.4 37.8 1.6
Automobile - commercial 81.3 80.7 0.7
Homeowners 40.7 39.5 3.1
Commercial multi-peril 87.6 89.2 (1.8)
Workers' compensation 80.3 81.7 (1.7)
Fire and allied lines 14.8 14.3 3.5
Other/products liability 103.4 95.7 8.0
Miscellaneous personal/commercial lines 4.2 4.4 (2.6)
------ ------ ------
Total losses and loss expenses payable, net of
reinsurance recoverable on losses and loss expenses
payable of $15.6 and $14.2, respectively $632.8 $628.8 0.6%
====== ====== ======
Total net losses and loss expenses payable increased 0.6% from December
31, 2003 to March 31, 2004. This increase was consistent with that of a growing
company. Other/products liability increased disproportionately due to several
significant claims. Overall, management does not believe there was a significant
change in the total book of business at March 31, 2004 compared to December 31,
2003.
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, and
other reasonableness tests.
The risks and uncertainties inherent in the estimates include, but are
not limited to, actual settlement experience different from historical data,
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. To provide a measure of sensitivity of pre-tax
income to changes in reserve estimates, for every 1% change in the ultimate
development of the March 31, 2004 total losses and loss expenses payable, the
effect on pre-tax income would be $6.3 million.
New Accounting Standard
On March 31, 2004, the FASB issued a proposal that, if implemented,
would require the Company to recognize the fair value of all stock options as
compensation expense beginning in 2005. Currently the Company accounts for its
employee stock option grants using the intrinsic value method, as permitted by
SFAS No. 123 Accounting for Stock-Based Compensation. The effect of using the
fair value method for all stock option grants has not been determined by
the Company.
Market Risk
With respect to Market Risk, see the discussion regarding this subject
in Management's Discussion and Analysis of Financial Condition and Results of
Operations, included in the 2003 Form 10-K. There have been no material changes
from the information reported regarding Market Risk in the 2003 Form 10-K.
FORWARD-LOOKING STATEMENTS; CERTAIN FACTORS AFFECTING FUTURE RESULTS
Statements contained in this Form 10-Q or any other reports or documents
prepared by the Company or made by management may be "forward-looking" within
the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements are subject to certain risks and uncertainties that
could cause the Company's actual results to differ materially from those
projected. Forward-looking statements may be identified, preceded by, followed
by, or otherwise include, without limitation, words such as "plans," "believes,"
"expects," "anticipates," "intends," "estimates," or similar expressions. The
following factors, among others, in some cases have affected and in the future
could affect the Company's actual financial performance.
- 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
19
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
Operation, Continued
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.
- 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.
- State Auto Mutual and the Company have acquired other
insurance companies and it is anticipated that State Auto 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
20
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
Operation, Continued
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.
- 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 most 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
2003 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 State Auto Mutual.
21
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
The information called for by this item is provided under the caption
"Market Risk" under Item 2 - Management's Discussion and Analysis of Financial
Condition.
ITEM 4. 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 II. OTHER INFORMATION
Item 1. Legal Proceedings
MINORITY SHAREHOLDER LITIGATION--OHIO
On June 30, 2003, State Auto Financial and State Auto Mutual filed a
complaint against Gregory M. Shepard, who owns approximately 5.1% of State Auto
Financial'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 Securities
and Exchange Commission ("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 State Auto Financial's common shares and to take
control of the Company and State Auto Mutual. On August 25, 2003, State Auto
Financial and State Auto 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 tender offer documents filed with the SEC by Mr. Shepard (the "Shepard
tender offer") and from illegally tipping persons with material, nonpublic
information concerning the Shepard tender offer. On October 16, 2003, State Auto
Financial and State Auto Mutual dismissed, without prejudice, this action
against Mr. Shepard in light of the United States District Court's dismissal of
Mr. Shepard's lawsuit against State Auto Financial, State Auto 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, they filed a complaint against State Auto Financial,
State Auto Mutual, and their respective directors in the United States District
Court, Southern District of Ohio, Eastern Division, seeking (1) declaratory
relief that State Auto Financial's directors and State Auto Mutual and its
directors violated their respective fiduciary duties to Mr. Shepard, his
company, and State Auto Financial'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 State Auto Financial, State Auto 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 State
Auto Financial, State Auto Mutual, and their respective directors based on a
finding that the District Court lacked subject matter jurisdiction.
On October 16, 2003, State Auto Financial, State Auto 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 State Auto Financial, State Auto Mutual, nor their
respective directors and officers owed or violated any fiduciary duties to Mr.
Shepard, his company, or State Auto Financial's minority shareholders in
responding to the Shepard
22
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
tender offer; (2) declaratory relief that neither State Auto Financial 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 State Auto Financial and
State Auto 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 State Auto Financial, State Auto Mutual, and
their respective directors. Their counterclaim seeks (1) a declaratory judgment
requiring State Auto Financial to call a meeting of shareholders under Ohio's
Control Share Acquisition statue with respect to the Shepard tender offer; (2)
injunctive relief to enjoin State Auto Financial, State Auto Mutual, and their
respective directors and employees from taking actions that would have the
effect of impeding or interfering with the Shepard tender offer; and 3)
compensatory damages from State Auto Mutual, State Auto Mutual's directors, and
State Auto Financial's directors for the alleged breach of their fiduciary
duties. On December 22, 2003, State Auto Financial and State Auto Mutual filed a
motion to expedite the trial on the declaratory judgment action. As of May 3,
2004, the trial court has set a trial date of June 7, 2004 and the case is
currently in the discovery phase. On April 2, 2004, State Auto Financial, State
Auto Mutual, and the other counter-claim defendants filed a motion for judgment
on the pleadings with respect to the counterclaim filed by Mr. Shepard and his
company. No decision has been rendered on that motion as of May 3, 2004.
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 State Auto Financial, State
Auto Mutual, Meridian Insurance Group, and Meridian Insurance Group'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 Meridian Insurance Group with and into a wholly owned
subsidiary of State Auto Mutual (the "Merger"), which was effective June 1,
2001. In their complaint, Mr. Shepard and AUIC alleged claims of (1) breach of
fiduciary duty against the former Meridian Insurance Group directors for
entering into the Merger; (2) breach of contract against State Auto Financial
and State Auto Mutual with respect to a confidentiality agreement, dated
September 29, 2000, between State Auto Financial and AUIC; and (3) tortious
interference against Meridian Insurance Group 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 State
Auto Financial and State Auto Mutual. Mr. Shepard and AUIC are seeking
compensatory damages in this suit, which they allege exceed $25 million based on
an expert witness' report recently provided to State Auto Financial and State
Auto Mutual by Mr. Shepard's counsel. As of May 3, 2004, the suit continues in
its discovery phase, with a trial currently expected to occur in the fall of
2004.
Item 2. Changes in Securities and Use of Proceeds
Issuer Purchases of Equity Securities
Maximum Number (or
Total Number of Approximate Dollar
Shares Purchased Value) of Shares
Total Number as Part of that May Yet Be
of Shares Publicly Purchased under
Purchased * (in Average Price Announced Plans the Plans or
Period whole numbers) Paid Per Share or Programs Programs
- ------------------------------- --------------- --------------- ---------------- -----------------
01/01/04 thru 01/31/04 10,431 $24.18 - -
02/01/04 thru 02/28/04 1,611 $24.74 - -
03/01/04 thru 03/31/04 - - - -
------
Total 12,042 - -
======
* All shares repurchased were acquired as a result of stock swap option
exercises.
- ---------------------------
23
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders - None
Item 5. Other Information
In the Company's first quarter 2004 earnings press release dated April 27,
2004, the $2.3 million settlement relating to the fair value hedge was accounted
for as accumulated other comprehensive income, a component of equity, resulting
in total shareholders' equity of $588.6 million. After additional analysis of
FASB 133 Accounting for Derivative Instruments and Hedging Activities, the $2.3
million settlement was reclassified as a liability under notes payable,
resulting in total stockholders' equity of $586.3. The reclassification also
changed the shareholders' book value per share from $14.82, as presented in the
earnings release, to $14.76.
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits
Exhibit
No. Description of Exhibits
- ------- -----------------------
31.1 CEO certification required by Section 302 of Sarbanes Oxley Act of 2002
31.2 CFO certification required by Section 302 of Sarbanes Oxley Act of 2002
32.1 CEO certification required by Section 906 of Sarbanes Oxley Act of 2002
32.2 CFO certification required by Section 906 of Sarbanes Oxley Act of 2002
b. Reports on Form 8-K
None
24
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
STATE AUTO FINANCIAL CORPORATION
Date: May 5, 2004 /s/ Steven J. Johnston
---------------------------------------
Steven J. Johnston
Treasurer and Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
25
Exhibit
No. Description of Exhibits
- ------- -----------------------
31.1 CEO certification required by Section 302 of Sarbanes Oxley Act of 2002
31.2 CFO certification required by Section 302 of Sarbanes Oxley Act of 2002
32.1 CEO certification required by Section 906 of Sarbanes Oxley Act of 2002
32.2 CFO certification required by Section 906 of Sarbanes Oxley Act of 2002
26