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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
- --------------------------------------------------------------------------------
FORM 10-Q
- --------------------------------------------------------------------------------
[x] Quarterly Report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
for the quarterly period ended June 30, 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 August 2, 2004 was
39,954,404.
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 AND SIX MONTH PERIODS ENDED
JUNE 30, 2004
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed consolidated balance sheets - June 30, 2004 and
December 31, 2003
Condensed consolidated statements of income - Three months
ended June 30, 2004 and 2003
Condensed consolidated statements of income - Six months ended
June 30, 2004 and 2003
Condensed consolidated statements of cash flows - Six months
ended June 30, 2004 and 2003
Notes to condensed consolidated financial statements - June
30, 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)
June 30 December 31
2004 2003
---- ----
(unaudited) (see note 1)
ASSETS
Fixed maturities, available for sale, at fair value (amortized cost $1,370.0
and $1,359.6, respectively) ......................................................... $1,387.4 1,421.4
Equity securities, available for sale, at fair value (cost $146.9 and $121.0, respectively) 167.8 139.3
Other invested assets, at fair value (cost $9.7 and $9.5, respectively) ................... 9.8 9.6
-------- -------
Total investments ......................................................................... 1,565.0 1,570.3
Cash and cash equivalents ................................................................. 27.1 40.0
Deferred policy acquisition costs ......................................................... 95.7 87.1
Accrued investment income and other assets ................................................ 60.5 52.5
Due from affiliate ........................................................................ 61.7 -
Net prepaid pension expense ............................................................... 50.7 51.4
Reinsurance recoverable on losses and loss expenses payable (affiliate $6.1
and $5.7, respectively) ............................................................... 16.4 14.2
Prepaid reinsurance premiums (affiliate $3.7 and $3.9, respectively) ...................... 8.8 8.4
Current federal income taxes .............................................................. 1.4 0.2
Deferred federal income taxes ............................................................. 11.5 -
Property and equipment, at cost, net of accumulated depreciation of $4.8
and $4.4, respectively ................................................................ 12.9 12.5
-------- -------
Total assets .............................................................................. $1,911.7 1,836.6
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable (affiliate $292.1 and $303.9, respectively) .............. $ 654.4 643.0
Unearned premiums (affiliate $120.3 and $121.3, respectively) ............................. 418.6 404.3
Notes payable (affiliates $61.0) .......................................................... 163.2 161.2
Postretirement benefit liabilities ........................................................ 77.6 74.3
Other liabilities ......................................................................... 11.1 8.6
Deferred federal income taxes ............................................................. - 2.0
Due to affiliates ......................................................................... - 0.9
-------- -------
Total liabilities ......................................................................... 1,324.9 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; 44.6
and 44.2 shares issued, respectively, at stated value of $2.50 per share ............. 111.4 110.4
Less 4.6 treasury shares, at cost ..................................................... (56.4) (55.8)
Additional paid-in capital ............................................................ 62.0 56.7
Accumulated other comprehensive income ................................................ 25.8 53.0
Retained earnings ..................................................................... 444.0 378.0
-------- -------
Total stockholders' equity ................................................................ 586.8 542.3
-------- -------
Total liabilities and stockholders' equity ................................................ $1,911.7 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
June 30
2004 2003
---- ----
Earned premiums (ceded to affiliate $166.8 and $145.0, respectively) ....... $ 252.4 241.7
Net investment income ...................................................... 17.8 15.8
Net realized gains on investments .......................................... 1.3 4.2
Other income (affiliates $1.1 and $0.9, respectively) ...................... 1.6 1.5
------------ ------------
Total revenues ............................................................. 273.1 263.2
------------ ------------
Losses and loss expenses (ceded to affiliate $93.7 and $114.7, respectively) 146.0 182.8
Acquisition and operating expenses ......................................... 73.5 68.2
Interest expense (affiliates $0.5 and $0.7, respectively) .................. 1.8 0.8
Other expenses, net ........................................................ 2.6 2.5
------------ ------------
Total expenses ............................................................. 223.9 254.3
------------ ------------
Income before federal income taxes ......................................... 49.2 8.9
Federal income tax expense ................................................. 14.6 0.6
------------ ------------
Net income ................................................................. $ 34.6 8.3
============ ============
Earnings per common share:
Basic .................................................................. $ 0.87 0.21
------------ ------------
Diluted ................................................................ $ 0.85 0.21
------------ ------------
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 INCOME
(in millions, except per share amounts)
(unaudited)
Six months ended
June 30
2004 2003
---- ----
Earned premiums (ceded to affiliate $322.8 and $290.2, respectively) ........ $ 501.1 474.1
Net investment income ....................................................... 35.3 31.5
Net realized gains on investments ........................................... 6.7 8.0
Other income (affiliates $2.0 and $1.8, respectively) ....................... 3.1 2.9
---------- ---------
Total revenues .............................................................. 546.2 516.5
---------- ---------
Losses and loss expenses (ceded to affiliate $182.0 and $198.0, respectively) 293.7 332.3
Acquisition and operating expenses .......................................... 148.6 139.9
Interest expense (affiliates $0.9 and $1.3, respectively) ................... 3.5 1.5
Other expenses, net ......................................................... 5.2 5.3
---------- ---------
Total expenses .............................................................. 451.0 479.0
---------- ---------
Income before federal income taxes .......................................... 95.2 37.5
Federal income tax expense .................................................. 28.2 8.1
---------- ---------
Net income .................................................................. $ 67.0 29.4
========== =========
Earnings per common share:
Basic ................................................................... $ 1.69 0.75
---------- ---------
Diluted ................................................................. $ 1.65 0.74
---------- ---------
Dividends paid per common share ............................................. $ 0.08 0.07
---------- ---------
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)
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions) Six months ended
(unaudited) June 30
2004 2003
---- ----
Cash flows from operating activities:
Net income ...................................................... $ 67.0 29.4
Adjustments to reconcile net income to net cash provided by
Operating activities:
Depreciation, amortization and other, net .............. 4.7 3.7
Net realized gains on investments ...................... (6.7) (8.0)
Changes in operating assets and liabilities:
Deferred policy acquisition costs ................. (8.6) (4.3)
Accrued investment income and other assets ........ (8.2) -
Net prepaid pension expense ....................... 0.7 (0.1)
Postretirement benefit liabilities ................ 3.3 3.3
Reinsurance recoverable on losses and loss expenses
payable and prepaid reinsurance premiums ........ (2.6) (10.1)
Other liabilities and due to/from affiliates, net . (60.1) (14.1)
Losses and loss expenses payable .................. 11.4 38.8
Unearned premiums ................................. 14.3 17.6
Federal income taxes .............................. 1.5 (3.9)
-------- --------
Net cash provided by operating activities ....................... 16.7 52.3
-------- --------
Cash flows from investing activities:
Purchase of fixed maturities ............................... (246.0) (302.8)
Purchase of equity securities .............................. (28.9) (29.9)
Purchase of other invested assets .......................... (0.1) (6.4)
Maturities, calls and pay downs of fixed maturities ........ 46.1 36.0
Sale of fixed maturities ................................... 190.1 178.5
Sale of equity securities .................................. 4.8 1.2
Net additions of property and equipment .................... (0.6) (0.1)
-------- --------
Net cash used in investing activities ........................... (34.6) (123.5)
-------- --------
Cash flows from financing activities:
Proceeds from issuance of common stock ..................... 3.7 2.1
Payment of dividends ....................................... (1.0) (0.9)
Fair value hedge derivative settlement ..................... 2.3 -
Proceeds from issuance of debt ............................. - 15.0
Debt issuance costs ........................................ - (0.5)
Payments to acquire treasury shares ........................ - (0.7)
-------- --------
Net cash provided by financing activities ....................... 5.0 15.0
-------- --------
Net decrease in cash and cash equivalents ....................... (12.9) (56.2)
-------- --------
Cash and cash equivalents at beginning of period ................ 40.0 96.0
-------- --------
Cash and cash equivalents at end of period ...................... $ 27.1 39.8
======== ========
Supplemental disclosures:
Federal income taxes paid ................................ $ 26.4 12.0
-------- --------
Interest paid (affiliates $0.9 and $1.3, respectively) ... $ 4.1 1.5
-------- --------
See accompanying notes to condensed consolidated financial statements.
6
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements, (unaudited)
June 30, 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 and six month periods ended June 30,
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. DERIVATIVES
During March 2004, the Company settled its fair value hedge derivative
entered into on November 6, 2003 for a $2.9 million gain. Of the $2.9 million
received, $2.3 million was deferred 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.
On May 6, 2004 State Auto Financial entered into an interest rate swap
contract for a notional amount of $50.0 million, receiving semi-annual payments
at a fixed rate of 6.25% and making semi-annual payments at a variable rate
equal to the six month LIBOR plus 0.94% with LIBOR to be determined the last day
of each interest reset period (total 1.94% at June 30, 2004). The swap contract
was designated as a fair value hedge to protect against changes in fair value of
the Senior Notes. At June 30, 2004 the fair market value of the fixed to
floating interest rate swap was $0.2 million of which substanially all related
to net accrued interest to be received and thus reduced reported interest
expense in the period.
3. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted
earnings per common share:
Three months ended Six months ended
June 30 June 30
(in millions, except per share amounts) 2004 2003 2004 2003
---- ---- ---- ----
Numerator:
Net income for basic and diluted earnings per share $ 34.6 8.3 67.0 29.4
========== ========== ========== ==========
Denominator:
Basic weighted average shares outstanding 39.8 39.2 39.7 39.2
Effect of dilutive stock options 1.0 0.8 1.0 0.7
---------- ---------- ---------- ----------
Diluted weighted average shares outstanding 40.8 40.0 40.7 39.9
========== ========== ========== ==========
Basic earnings per share $ 0.87 0.21 1.69 0.75
========== ========== ========== ==========
Diluted earnings per share $ 0.85 0.21 1.65 0.74
========== ========== ========== ==========
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)
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 Six months ended
June 30 June 30
------- -------
(in millions) 2004 2003 2004 2003
---- ----- ---- ----
Number of options 0.4 - 0.9 0.4
===== ===== ===== =====
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 Six months ended
June 30 June 30
(in millions, except per share amounts) 2004 2003 2004 2003
-------- -------- -------- --------
Net income, as reported $ 34.6 8.3 67.0 29.4
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 (0.7) (0.5) (1.1) (0.9)
-------- -------- -------- --------
Pro forma net income $ 33.9 7.8 65.9 28.5
======== ======== ======== ========
Earnings per share:
Basic -- as reported $ 0.87 0.21 1.69 0.75
======== ======== ======== ========
Basic -- pro forma $ 0.85 0.20 1.66 0.73
======== ======== ======== ========
Diluted -- as reported $ 0.85 0.21 1.65 0.74
======== ======== ======== ========
Diluted -- pro forma $ 0.81 0.19 1.59 0.70
======== ======== ======== ========
There were 0.4 million options granted to employees and non-employee
directors during the three and six month periods ended June 30, 2004 and 2003,
respectively. The fair value of options granted was estimated at the date of
grant using the Black-Scholes option pricing model. The weighted average fair
value and related assumptions are as follows:
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)
Three and six
months ended
June 30
2004 2003
---- ----
Fair value $13.73 7.57
Dividend yield 0.76% 0.80%
Risk free interest rate 4.36% 2.89%
Expected volatility factor 35.7% 37.6%
Expected life in years 8.3 7.8
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 non-employee 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 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 0.3 million
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 $0.2 million and
$0.1million, and $0.3 million and $0.1 million for the three month and six month
periods ended June 30, 2004 and 2003, respectively, was reflected in net income.
There were 0.1 million and less than 0.1 million options granted to
non-employees during the three and six month periods ended June 30, 2004 and
2003, respectively. 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 and six
months ended
June 30
2004 2003
---- ----
Fair value $18.06 12.41
Dividend yield 0.77% 0.82%
Risk free interest rate 4.62% 3.45%
Expected volatility factor 36.2% 36.9%
Expected life in years 9.3 9.2
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)
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 0.4 million 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 and six month periods ended June 30, 2004 and
2003 is as follows:
Three months ended Six months ended
June 30 June 30
2004 2003 2004 2003
---- ---- ---- ----
Weighted Weighted Weighted Weighted
Number Average Number Average Number Average Number Average
Of Exercise of Exercise Of Exercise Of Exercise
(number of options in millions) Options Price Options Price Options Price Options Price
------- ------- ------- ------- ------- ------- ------- -----
Outstanding, beginning of
period 2.5 $ 13.22 2.6 11.53 2.6 $ 12.84 2.8 10.98
Granted 0.4 30.84 0.4 18.74 0.4 30.33 0.4 18.71
Exercised (0.2) 9.62 (0.1) 9.41 (0.3) 9.41 (0.3) 5.67
------ ------- ------- -------
Outstanding, end of period 2.7 $ 16.15 2.9 12.50 2.7 $ 16.15 2.9 12.50
====== ======= ======= =======
A summary of information pertaining to all options outstanding and
exercisable at June 30, 2004 is as follows:
Options Outstanding Options Exercisable
------------------- -------------------
Weighted
Average Weighted Weighted
(number of options in Remaining Average Average
millions) Contractual Exercise Exercise
Range of Exercise Prices Number Life Price Number Price
- ------------------------ ------ ---- ----- ------ -----
$5.01 - $10.00 0.4 1.7 $ 6.88 0.4 $ 6.88
$10.01 - $20.00 1.8 6.5 14.96 1.6 14.30
Greater than $20.01 0.5 9.8 30.33 - -
--- --- ------ --- ------
Total 2.7 6.3 $16.15 2.0 $12.89
=== === ====== === ======
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 stock options as compensation expense beginning
in 2005.
5. COMPREHENSIVE INCOME
The components of accumulated other comprehensive income, net of
related tax, included in stockholders' equity at June 30, 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 Six months ended
June 30 June 30
(in millions) 2004 2003 2004 2003
----- ---- ----- ----
Net income $34.6 8.3 $67.0 29.4
Unrealized holding gain (loss), net of tax (37.2) 20.6 (27.2) 19.2
----- ---- ----- ----
Comprehensive income (loss) $(2.6) 28.9 $39.8 48.6
===== ==== ===== ====
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)
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 Six months ended
June 30 June 30
------- -------
(in millions) 2004 2003 2004 2003
---- ---- ---- ----
Premiums earned:
Assumed from other insurers and reinsurers $ 1.5 1.2 $ 2.9 2.5
Assumed under State Auto Pool and other
affiliate arrangements 234.1 220.9 462.9 438.6
Ceded to other insurers and reinsurers 0.6 3.0 7.4 6.0
Ceded under State Auto Pool and other
affiliate arrangements 166.8 145.0 322.8 290.2
------ ------ ------ ------
Net assumed premiums earned $ 68.2 74.1 $135.6 144.9
====== ====== ====== ======
Losses and loss expenses incurred:
Assumed from other insurers and reinsurers $ 0.7 0.8 $ 2.6 1.5
Assumed under State Auto Pool and other
affiliate arrangements 135.9 172.4 268.5 306.3
Ceded to other insurers and reinsurers (0.9) 4.1 3.9 4.5
Ceded under State Auto Pool and other
affiliate arrangements 93.7 114.7 182.0 198.0
------ ------ ------ ------
Net assumed losses and loss expenses incurred $ 43.8 54.4 $ 85.2 105.3
====== ====== ====== ======
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 Pension Postretirement
------- -------------- ------- --------------
(in millions) Three months ended June 30 Six months ended June 30
2004 2003 2004 2003 2004 2003 2004 2003
---- ---- ---- ---- ---- ---- ---- ----
Service cost $2.0 1.7 $0.9 0.8 $4.0 3.4 $1.8 1.6
Interest cost 2.6 2.5 1.3 1.2 5.2 5.0 2.6 2.4
Expected return on plan assets (4.2) (4.2) (0.1) (0.1) (8.4) (8.4) (0.2) (0.2)
Amortization of prior service cost 0.1 0.1 0.1 0.1 0.2 0.2 0.2 0.2
Amortization of transition asset (0.2) (0.2) - - (0.4) (0.4) - -
Amortization of net loss 0.1 - - - 0.2 - - -
---- ----- ---- --- ---- ----- ---- ----
Net periodic cost (benefit) $0.4 (0.1) $2.2 2.0 $0.8 (0.2) $4.4 4.0
==== ===== ==== === ==== ===== ==== ====
The Company presently anticipates contributing $5.0 million to its pension plan
in 2004. No contribution had been made as of June 30, 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 June 30, 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
11
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements, Continued (unaudited)
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 Six months ended
June 30 June 30
(in millions) 2004 2003 2004 2003
---- ---- ---- ----
Revenues from external customers:
State Auto standard insurance ..... $ 249.9 235.5 $ 495.4 461.9
State Auto nonstandard insurance .. 20.1 22.0 40.5 43.6
Investment management services .... 0.7 0.6 1.4 1.2
All other ......................... 0.9 0.8 1.8 1.7
---------- ---------- ---------- ----------
Total revenues from external customers $ 271.6 258.9 $ 539.1 508.4
========== ========== ========== ==========
Intersegment revenues:
State Auto standard insurance ..... $ - - $ 0.1 0.1
Investment management services .... 1.6 1.4 3.3 2.8
All other ......................... 0.5 0.5 0.9 0.9
---------- ---------- ---------- ----------
Total intersegment revenues .......... $ 2.1 1.9 $ 4.3 3.8
========== ========== ========== ==========
Segment profit:
State Auto standard insurance ..... $ 44.8 2.1 $ 83.8 23.5
State Auto nonstandard insurance .. 2.7 1.0 3.7 3.0
Investment management services .... 2.1 1.9 4.2 3.5
All other ......................... 0.2 0.6 0.7 1.1
---------- ---------- ---------- ----------
Total segment profit ................. $ 49.8 5.6 $ 92.4 31.1
Reconciling items:
Corporate expenses ................ $ (1.9) (0.9) $ (3.9) (1.6)
Net realized gains ................ 1.3 4.2 6.7 8.0
---------- ---------- ---------- ----------
Total consolidated income before
federal income taxes ............. $ 49.2 8.9 $ 95.2 37.5
========== ========== ========== ==========
Segment assets:
Standard insurance ................ $ 1,833.8 1,546.3
Nonstandard insurance ............. 137.4 110.2
Investment management services .... 4.6 4.6
All other ......................... 15.7 15.3
---------- ----------
Total segment assets ................. $ 1,991.5 1,676.4
========== ==========
12
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 SA Sub SA SA Sub
Period Auto P&C Milbank Farmers Ohio Total Mutual Wisconsin Florida Total
------ -------- ------- ------- ---- ----- ------ --------- -------- -----
1/1/2003 -
6/30/2004 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." Effective July 1, 2004 the State Auto Group amended the Pooling
Arrangement to exclude certain new middle market business written by Mutual.
This amendment did not change the STFC Pooled Companies' Pool percentages.
Results of Operations
The following table summarizes for the three and six month periods ended June
30, 2004 and 2003 certain key performance indicators used to manage the
operations of the Company:
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
Three Months Ended Six Months Ended
(dollars in millions) June 30 June 30
GAAP Basis: 2004 2003 2004 2003
----------- ---- ---- ---- ----
Total revenue $273.1 263.2 546.2 516.5
Net income $ 34.6 8.3 67.0 29.4
Stockholders' equity $586.8 513.8 586.8 513.8
Loss and LAE ratio * 57.9% 75.6% 58.6% 70.1%
Expense ratio * 29.1% 28.2% 29.7% 29.5%
Combined ratio 87.0% 103.8% 88.3% 99.6%
Catastrophe loss and LAE points* 5.1 17.1 3.1 10.0
Earned premium growth 4.4% 9.2% 5.7% 9.2%
Investment yield 4.6% 4.7% 4.6% 4.7%
Twelve Months Ended
June 30
Statutory Basis: 2004 2003
- ---------------- ---- ----
Net premiums written to surplus** 1.7 2.3
* Defined below.
** 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 a company's statutory surplus available to absorb losses.
During the three and six month periods ended June 30, 2004, the Company
generated net income of $34.6 million and $67.0 million compared to $8.3 million
and $29.4 million for the same 2003 periods, respectively. Net income before
federal income taxes for the Company increased $40.3 million to $49.2 million
and $57.7 million to $95.2 million for the three and six month periods ended
June 30, 2004, respectively, from the same periods in 2003. The 2004 amounts
were primarily the result of an improved combined ratio along with record level
total revenue. The Company's GAAP combined ratio reflected a 16.8 point and 11.3
point improvement for the three month and six month periods ended June 30, 2004,
respectively, from the same periods in 2003. The periods' improved combined
ratios were the direct result of management's efforts in continuing to obtain
adequate cost based rates across most lines of business, re-underwriting the
former Meridian Mutual business applying State Auto underwriting guidelines,
controlling operating expenses and a significant decrease in catastrophe losses.
During the three and six months ended June 30, 2004, catastrophe losses totaled
$12.9 million and $15.3 million compared to $41.2 million and $47.4 million in
the same 2003 periods, respectively. Management continues to focus on growing
premiums without compromising profitability as industry-wide price competition
increases. 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.
Consolidated earned premiums increased $10.7 million to $252.4 million and
$27.0 million to $501.1 million for the three month and six month periods ended
June 30, 2004, respectively, from the same periods in 2003. These increases were
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 and
six month periods ended June 30, 2004 from the same period in 2003, while the
State Auto non-standard segment generated a 1.0% and 0.8% decrease from the same
period in 2003. The non-standard decrease was primarily the result of the
Company terminating or suspending in during 2003 certain fast growing, but very
unprofitable agencies in Kentucky, implementing necessary rate increases and the
impact of industry-wide increased price competition. While these actions
affected this segment's premium growth, they are expected to improve long term
underwriting results. Also impacting the consolidated earned premiums increase
during the six month period ended June 30, 2004 was the December 31, 2003
termination of the Stop Loss (as defined below). 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 termination of the Stop Loss had the effect of contributing a 1.1% increase
in
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
earned premiums for the six months ended June 30, 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 4.4% from 9.2% and 5.7% from 9.2% for the
three and six month periods ended June 30, 2004, respectively, from the same
periods in 2003. In the past two years, the Company took necessary rate
increases in almost all lines of business, but particularly within the former
Meridian book 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 certain lines. While management continues to emphasize that
it will not compromise profitability for top line growth, it continues to pursue
opportunities in the way it processes business with its agency partners. Of all
the reasons our agency partners personnel list for placing business with a
company, "ease of doing business" is listed as number one. The Company's new
internet-based upload system for personal lines business, NetXpress, is designed
to fulfill that need. Recent statistics indicate that approximately 60% of new
personal lines business applications and 47% of change requests in those lines
are communicated and processed electronically.
Net investment income increased $2.0 million to $17.8 million and
increased $3.8 million to $35.3 million for the three and six month periods
ended June 30, 2004, respectively, from the same periods in 2003. These
increases were the result of an increase in invested assets generated by cash
flow provided from operations and financing since June 30, 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 June 30, 2004 and 2003 was $1,553.5 million and $1,359.0
million, respectively. Reflecting a decline in the interest rate environment,
the annualized investment yields based on invested assets at cost decreased to
4.6% from 4.7% for the three and six month periods ended June 30, 2004 from the
same 2003 periods. 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 57.9% and 75.6% for the
three month periods ended June 30, 2004 and 2003, respectively, and 58.6% and
70.1% for the six month periods ended June 30, 2004 and 2003, respectively.
During the three and six months ended June 30, 2004, catastrophe losses totaled
$12.9 million (5.1 GAAP loss and LAE points) and $15.3 million (3.1 GAAP loss
and LAE points) from $41.2 million (17.1 GAAP loss and LAE points) and $47.4
million (10.0 GAAP loss and LAE points) in the same 2003 periods, respectively.
Contributing to the three months ended June 30, 2003 catastrophe losses was CAT
88 totaling $39.4 million or 16.3 GAAP loss and LAE points, the largest
catastrophe loss event in Company history. 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.
Also impacting the consolidated losses and loss adjustment expense
decrease during the three and six month periods ended June 30, 2004 was the
December 31, 2003 termination of the Stop Loss. The STFC Pooled Companies ceded
$5.6 million in loss and loss expenses to State Auto Mutual under the Stop Loss
during the second quarter of 2003. This Stop Loss cession reduced the GAAP loss
and LAE ratio for the three and six month periods ended June 30, 2003 2.3% and
1.2%, respectively. The Stop Loss reinsurance agreement expired December 31,
2003 and was not renewed. See the Stop Loss discussion above regarding earned
premiums cessions for the six month period ended June 30, 2003.
For discussion purposes, the following table provides comparative GAAP
loss and LAE ratios for the Company's insurance operating segments for the three
and six month periods ended June 30, 2004 and 2003, respectively:
Three months ended Six months ended
June 30 June 30
Change Change
2004 2003 inc (dec) 2004 2003 inc (dec)
---- ---- --------- ---- ---- ---------
State Auto standard segment 57.0% 75.5 (18.5) 57.4 69.5 (12.1)
State Auto nonstandard segment 68.3% 77.4 (9.1) 73.2 77.2 (4.0)
Total GAAP Loss and LAE Ratio 57.9% 75.6 (17.7) 58.6 70.1 (11.5)
The State Auto standard segment's GAAP loss and LAE ratio improved 18.5
and 12.1 points for the three and six month periods ended June 30, 2004,
respectively, from the same 2003 periods. This improvement reflected the
Company's continual emphasis on responsible underwriting, which includes taking
necessary and appropriate rate
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
increases across most lines of business. Catastrophe losses represented 5.5 and
3.3, and 18.6 and 13.1 points of this segment's GAAP loss and LAE ratio for the
three month and six month periods ended June 30, 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 9.4
points to 55.0 and 8.1 points to 56.2 for the three month and six month periods
ended June 30, 2004, respectively, from the same 2003 periods. These
improvements are the result of management's continual efforts to obtain adequate
rates and monitor underwriting results. Homeowners is the Company's second
largest line of business. In 2003 its loss experience was adversely affected by
the increased frequency and severity of storm losses. With the improved
catastrophe level in the current year 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 37.1 points to 68.6 and 26.0 points to 61.2 for the three month and six
month periods ended June 30, 2004, respectively from the same 2003 periods.
Workers' compensation continues to be the Company's most volatile line of
business due to the potential loss severity. Its GAAP loss and LAE ratio
increased 17.8 points to 77.3 and 4.3 points to 70.4 for the three month and six
month periods ended June 30, 2004, respectively, from the same 2003 periods due
to the severity of claims reported and reserve development. 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
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 decreased 9.1
points and 4.0 points for the three and six month periods ended June 30, 2004,
respectively, from the same 2003 periods. Catastrophe losses represented 0.9 and
0.5 points, and 3.8 and 2.3 points of this segment's GAAP loss and LAE ratio for
the three and six month periods ended June 30, 2004 and 2003, respectively. The
nonstandard automobile segment typically is a more volatile line of business in
terms of higher loss frequency 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 2002. However, the Company
terminated or suspended certain fast growing, but very unprofitable, agencies in
Kentucky during 2003. While this action adversely affected this segment's
premium growth, it is expected to improve long term underwriting results. See
discussion within premium earned regarding management's response taken.
Acquisition and operating expenses, as a percentage of earned premiums
(the "GAAP expense ratio"), were 29.1% and 28.2% for the three months ended June
30, 2004 and 2003, respectively, and 29.7% and 29.5% for the six month periods
ended June 30, 2004 and 2003, respectively. Incentive based compensation to
agents and employees, significant variable expenses tied directly to the
Company's insurance operation's profitability, contributed to the increased GAAP
expense ratio for the three and six month periods ended June 30, 2004 over the
same periods during 2003. The incentive based compensation includes 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 1.5 points and 1.6 points, and 1.2 points (both
2003 periods) of the GAAP expense ratio for the three and six month periods
ended June 30, 2004 and 2003, respectively. QPB was 1.3 points and 1.4 points,
and none and 0.5 point of the GAAP expense ratio for the three and six month
periods ended June 30, 2004 and 2003, respectively. Effective April 1, 2004, the
QPB Plan was amended to include a written premium growth requirement along with
the previously existing profitability requirement. The profitability calculation
was also amended to be calculated on a quarterly basis. 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 to $1.8 million and $2.0
million to $3.5 million for the three and six month periods ended June 30, 2004,
respectively, from the same periods in 2003. The increase was the result of the
additional $85.5 million of debt, net of repayments, obtained in the last six
months of 2003. The interest expense for the six month period ended June 30,
2004 was partly reduced by a $0.6 million offset related to the fair value hedge
derivative settlement during May 2004. See "Liquidity and Capital Resources" for
further discussion of the fair value hedge derivative settlement.
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
The effective federal income tax expense rate for the three and six month
periods ended June 30, 2004 was 29.6% as compared to an effective tax expense
rate of 6.8% and 21.6% for the same 2003 periods, respectively. Improvement in
the Company's 2004 underwriting results from the same 2003 periods contributed
to the rate increase. The net investment income effective tax rate approximates
20%, while the remaining rate, primarily underwriting income (loss) approximates
35%.
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, the maturity of fixed
maturity investments and, to a lesser extent, proceeds from borrowings. 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 June 30, 2004 and December 31, 2003, the Company had $27.1 million and
$40.0 million, respectively, of cash and cash equivalents. At June 30, 2004 and
December 31, 2003, the Company had $1,565.0 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 six months ended June 30, 2004, net cash provided by operating
activities decreased to $16.7 million from $52.3 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 affiliate receivable/payable, loss and loss expenses payable
and federal income taxes paid, which more than offset an increased net income.
For the six months ended June 30, 2004, net cash used in investing activities
decreased to $34.6 million from $123.5 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. Also contributing to the decrease was the decline in cash
provided from operating activities in 2004. For the six months ended June 30,
2004, net cash provided by financing activities decreased to $5.0 million from
$15.0 million in the same period in 2003 primarily due to the 2003 proceeds from
debt issuance.
During March 2004 the Company settled its fair value hedge derivative that
was entered into in November 6, 2003 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.
On May 6, 2004 State Auto Financial entered into an interest rate swap
contract for a notional amount of $50.0 million, receiving semi-annual payments
at a fixed rate of 6.25% and making semi-annual payments at a variable rate
equal to the six month LIBOR plus 0.94% with LIBOR to be determined the last day
of each interest reset period (total 1.94% at June 30, 2004). The swap contract
was designated as a fair value hedge to protect against changes in fair value of
the Senior Notes. At June 30, 2004 the fair market value of the fixed to
floating interest rate swap was $0.2 million of which substanially all related
to net accrued interest to be received and reduced reported interest expense in
the period.
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 but no later than 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.
On May 23, 2003 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) (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 May 23, 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 (5.51% as of June
30, 2004). Prior to May 2008, the interest rate may not exceed 12.5% per annum.
The Trust Securities are mandatorily redeemable
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
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'
indebtedness.
During the three and six month periods ended June 30, 2004, a total of
12,000 and 23,000 shares were acquired as a result of stock swap option
exercises at a total cost of $0.3 million and $0.6 million, respectively. During
the three and six month periods ended June 30, 2003, a total of 10,000 and
16,000 shares were acquired as a result of stock swap option exercises at a
total cost of $0.2 million and $0.3 million, respectively. During the six months
ended June 30, 2003, 45,000 shares were repurchased for a total of $0.7 million
as part of the stock repurchase program which ended December 31, 2003.
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 June 30, 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's statutory
net written premium to surplus ratio was 1.7 to 1.0 and 2.3 to 1.0 for the
twelve month periods ended June 30, 2004 and 2003, respectively.
Other Disclosures
Investments
At June 30, 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:
June 30 December 31 Average
2004 2003 Rating*
---- ---- -------
Corporate and Municipal Bonds 59.5% 58.2 Aa+
U.S. Government 2.2% 2.2 Aaa
U.S. Government Agencies 38.3% 39.6 Aaa
----- -----
Total 100.0% 100.0
===== =====
* As rated by Moody's Investors Service
During the three and six month periods ended June 30, 2004, the Company
increased its investment in equity securities by $9.2 million and $28.9 million,
respectively, 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 June 30, 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 June 30, 2004 and December 31, 2003:
(dollars in millions) June 30, 2004 December 31, 2003
------------- -----------------
Fixed maturities, at fair value $1,387.4 88.7% 1,421.4 90.5%
Equity securities, at fair value 167.8 10.7% 139.3 8.9%
Other invested assets, at fair value 9.8 0.6% 9.6 0.6%
-------- ----- ------- -----
Total investments $1,565.0 100.0% 1,570.3 100.0%
======== ===== ======= =====
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
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, events
impacting the issuer, and the Company's intent and ability to hold the security
to forcasted recovery or maturity. 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 June 30, 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 June 30, 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 June 30, 2004. The following table provides the Company's investment
portfolio gross unrealized gains and losses at June 30, 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 $ 335.5 $ 3.2 56 $ 5.7 70 $ 333.0
States & political subdivisions 774.0 26.1 285 8.3 116 791.8
Corporate securities 41.2 2.2 27 -- 2 43.4
Mortgage-backed securities of U.S
Gov. Agencies 219.3 4.1 49 4.2 38 219.2
-------- -------- -------- -------- -------- --------
Total fixed maturities 1,370.0 35.6 417 18.2 226 1,387.4
Equity Securities
Consumer 20.1 4.7 13 -- -- 24.8
Technologies 15.2 2.2 15 0.3 2 17.1
Pharmaceuticals 19.5 2.3 7 0.8 3 21.0
Financial services 42.1 4.8 15 0.8 7 46.1
Manufacturing & other 50.0 9.1 32 0.3 3 58.8
-------- -------- -------- -------- -------- --------
Total equity securities 146.9 23.1 82 2.2 15 167.8
-------- -------- -------- -------- -------- --------
Other invested assets 9.7 0.1 1 -- -- 9.8
-------- -------- -------- -------- -------- --------
Total investments $1,526.6 $ 58.8 500 $ 20.4 241 $1,565.0
======== ======== ======== ======== ======== ========
The amortized cost and fair value of fixed maturities at June 30, 2004, by
contractual maturity, is as follows:
Amortized Fair
(in millions) Cost Value
---- -----
Due in 1 year or less $ 3.0 $ 3.1
Due after 1 year through 5 years 35.2 36.7
Due after 5 years through 10 years 234.5 240.4
Due after 10 years 878.0 888.0
-------- --------
Subtotal 1,150.7 1,168.2
Mortgage-backed securities 219.3 219.2
-------- --------
Total $1,370.0 $1,387.4
======== ========
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.
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
Included in realized losses of equity securities below, was no recognized
loss related to other than temporary impairment for the three and six month
peroids ended June 30, 2004 and 2003, respectively. There were no other than
temporary impairments of fixed maturity securities for the three and six month
periods ended June 30, 2004 and 2003.
The securities sold during the three and six month periods ended June 30,
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 six months ended June 30, 2004 are summarized as follows:
Three months ended Six months ended
(in millions) June 30, 2004 June 30, 2004
Realized Fair Value Realized Fair Value
Gains/Losses at Sale Gains/Losses at Sale
------------ ------- ------------ -------
Realized gains:
Fixed maturities $ 0.9 $ 25.7 $ 5.8 $ 162.3
Equity securities 1.2 2.7 1.7 4.6
-------- -------- -------- --------
Total realized gains 2.1 28.4 7.5 166.9
Realized losses:
Fixed maturities 0.8 21.5 0.8 27.8
Equity securities 0.0 0.1 0.0 0.2
-------- -------- -------- --------
Total realized losses 0.8 21.6 0.8 28.0
-------- -------- -------- --------
Net realized gains on investments $ 1.3 $ 6.8 $ 6.7 $ 138.9
======== ======== ======== ========
Losses and Loss Expenses Payable
The following table presents losses and loss expenses payable by major
line of business:
June 30 December 31 Percent
(dollars in millions) 2004 2003 Change
---- ----- ------
Automobile - personal (standard) $182.8 185.5 (1.4)%
Automobile - personal (nonstandard) 38.3 37.8 1.3
Automobile - commercial 79.1 80.7 (2.0)
Homeowners 44.6 39.5 13.0
Commercial multi-peril 85.6 89.2 (4.0)
Workers' compensation 80.4 81.7 (1.6)
Fire and allied lines 13.3 14.3 (7.5)
Other/products liability 109.0 95.7 13.9
Miscellaneous personal/commercial lines 4.9 4.4 11.8
------ ------ ------
Total losses and loss expenses payable, net of
reinsurance recoverable on losses and loss expenses
payable of $16.4 and $14.2, respectively $638.0 628.8 1.5%
====== ====== ======
Total net losses and loss expenses payable increased 1.5% from December
31, 2003 to June 30, 2004. Homeowners loss and loss expenses payable increased
primarily due to weather related storm loss claims that occurred in the current
quarter. Other/products liability increased due to higher loss severity,
including several significant umbrella claims. Overall, management does not
believe there was a significant change in the total book of business at June 30,
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.
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
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 June 30, 2004 total losses and loss expenses payable, the
effect on pre-tax income would be $6.4 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 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
21
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
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 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
22
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
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.
23
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
As previously reported, on October 16, 2003, State Auto Financial
Corporation ("State Auto Financial"), State Automobile Mutual Insurance Company
("State Auto Mutual"), and their respective directors filed a complaint against
Gregory M. Shepard and his company in the Common Pleas Court of Franklin County,
Ohio (the "Court"), seeking (1) declaratory relief that neither State Auto
Financial, State Auto Mutual, nor their respective directors and officers
violated any fiduciary duties to Mr. Shepard, his company, or State Auto
Financial's minority shareholders in responding to a tender offer commenced by
Mr. Shepard and his company for State Auto Financial's common shares (the
"Shepard 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 law. Also as previously reported, on December 19, 2003, Mr. Shepard and his
company filed a counterclaim against State Auto Financial, State Auto Mutual,
and their respective directors seeking (1) a declaratory judgment requiring
State Auto Financial to call a meeting of shareholders under Ohio's Control
Share Acquisition statute 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. Mr. Shepard and his company announced the termination of the Shepard
tender offer on May 10, 2004.
On May 13, 2004, the Court entered an order (1) dismissing with prejudice
all counterclaims of Mr. Shepard and his company against State Auto Financial,
State Auto Mutual, and their respective directors, and (2) dismissing without
prejudice all claims for declaratory relief against Mr. Shepard and his company.
The only remaining claim before the Court in this action is for compensatory
damages brought by State Auto Financial and State Auto Mutual against Mr.
Shepard and his company for knowingly making misrepresentations in connection
with their control bid in violation of Ohio law. The trial of this remaining
claim is currently scheduled for January 24, 2005.
24
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
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 provided to State Auto Financial and State Auto Mutual
by Mr. Shepard's counsel in April 2004. As of July 31, 2004, the suit continues
in its discovery phase, with a trial currently expected to occur in late 2004 or
early 2005. On June 1, 2004, the State Auto defendants filed a motion for
summary judgment, which the court has not yet decided.
Item 2. Changes in Securities and Use of Proceeds
Issuer Purchases of Equity Securities
Maximum
Number (or
Total Number of Approximate
Shares Dollar Value) of
Purchased as Shares that May
Total Number Part of Publicly Yet Be
of Shares Announced Purchased
Purchased * (in Average Price Plans or under the Plans
Period whole numbers) Paid Per Share Programs or Programs
------ -------------- -------------- -------- -----------
04/01/04 thru 04/30/04 - - - -
05/01/04 thru 05/31/04 10,837 $29.84 - -
06/01/04 thru 06/30/04 427 30.84 - -
------
Total 11,264 $29.88 - -
======
* All shares repurchased were acquired as a result of stock swap option
exercises.
- ------------------
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders
The annual meeting of shareholders of State Auto Financial Corporation was
held on May 28, 2004. The total shares represented at the meeting were
34,106,548 common shares. This constituted 85.6% of the Company's 39,851,750
common shares outstanding. At the meeting, the shareholders voted on the
following proposals:
1. The election of John R. Lowther, Robert H. Moone and Paul W. Huesman as
Class I Directors, each to hold office until the 2007 annual meeting of
shareholders and until a successor is elected and qualified, with each director
nominee receiving the votes indicated:
25
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NUMBER OF VOTES
---------------
FOR WITHHELD
--- --------
John R. Lowther 33,989,574 33,183
Robert H. Moone 33,990,471 32,285
Paul W. Huesman 33,985,891 36,865
On the basis of this vote, each of John R. Lowther, Robert H. Moone and
Paul W. Huesman were elected as Class I Directors to serve until the 2007 annual
meeting and until his successor is elected and qualified.
2. A proposal to ratify the selection of Ernst & Young LLP as the Company's
independent public accountants for 2004.
For the Proposal Opposed to the Proposal Abstain
- ---------------- ----------------------- -------
34,059,753 32,244 14,550
On the basis of this vote, the proposal to ratify the selection of Ernst &
Young LLP as the Company's independent public accountants for 2004 was adopted
by the shareholders.
Item 5. Other Information - None
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits
Exhibit
No. Description of Exhibits
--- -----------------------
10.53 State Auto Insurance Companies Quality Performance Bonus Plan amended and restated as of
April 1, 2004
10.54 State Auto Insurance Companies Quality Performance Bonus Plan 2004 Addendum effective
April 1, 2004
10.55 State Auto Insurance Companies Pooling Agreement Amendment Number 5 effective July 1,
2004
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
On May 13, 2004 the Company filed a Form 8-K regarding legal proceedings.
26
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
STATE AUTO FINANCIAL CORPORATION
Date: August 4, 2004 /s/ Steven J. Johnston
------------------------------------
Steven J. Johnston
Treasurer and Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
27
Exhibit
No. Description of Exhibits
--- -----------------------
10.53 State Auto Insurance Companies Quality Performance Bonus Plan amended and restated as of
April 1, 2004
10.54 State Auto Insurance Companies Quality Performance Bonus Plan 2004 Addendum effective
April 1, 2004
10.55 State Auto Insurance Companies Pooling Agreement Amendment Number 5 effective July 1,
2004
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
28