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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 September 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 November 1, 2004 was
39,983,060.
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 NINE MONTH PERIODS ENDED
SEPTEMBER 30, 2004
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed consolidated balance sheets - September 30, 2004 and
December 31, 2003
Condensed consolidated statements of income - Three months
ended September 30, 2004 and 2003
Condensed consolidated statements of income - Nine months
ended September 30, 2004 and 2003
Condensed consolidated statements of cash flows - Nine months
ended September 30, 2004 and 2003
Notes to condensed consolidated financial statements -
September 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)
September 30 December 31
2004 2003
------------ -----------
(unaudited) (see note 1)
ASSETS
Fixed maturities, available for sale, at fair value (amortized cost $1,401.5
and $1,359.6, respectively) ......................................................... $1,458.3 1,421.4
Equity securities, available for sale, at fair value (cost $159.9 and $121.0, respectively) 178.2 139.3
Other invested assets, at fair value (cost $9.6 and $9.5, respectively) ................... 9.7 9.6
-------- --------
Total investments ......................................................................... 1,646.2 1,570.3
Cash and cash equivalents ................................................................. 49.4 40.0
Deferred policy acquisition costs ......................................................... 98.9 87.1
Accrued investment income and other assets ................................................ 51.3 52.5
Due from affiliate ........................................................................ 41.2 -
Net prepaid pension expense ............................................................... 55.3 51.4
Reinsurance recoverable on losses and loss expenses payable (affiliate $6.2
and $5.7, respectively) ............................................................... 29.0 14.2
Prepaid reinsurance premiums (affiliate $3.6 and $3.9, respectively) ...................... 8.9 8.4
Current federal income taxes .............................................................. 11.6 0.2
Property and equipment, at cost, net of accumulated depreciation of $5.0
and $4.4, respectively ................................................................ 13.3 12.5
-------- --------
Total assets .............................................................................. $2,005.1 1,836.6
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable (affiliate $294.1 and $303.9, respectively) .............. $ 709.7 643.0
Unearned premiums (affiliate $120.3 and $121.3, respectively) ............................. 428.1 404.3
Notes payable (affiliates $61.0) .......................................................... 164.6 161.2
Postretirement benefit liabilities ........................................................ 79.2 74.3
Other liabilities ......................................................................... 7.3 8.6
Deferred federal income taxes ............................................................. 0.3 2.0
Due to affiliates ......................................................................... - 0.9
-------- --------
Total liabilities ......................................................................... 1,389.2 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 ............. 111.5 110.4
Less 4.6 treasury shares, at cost ..................................................... (56.4) (55.8)
Additional paid-in capital ............................................................ 62.8 56.7
Accumulated other comprehensive income ................................................ 49.7 53.0
Retained earnings ..................................................................... 448.3 378.0
-------- --------
Total stockholders' equity ................................................................ 615.9 542.3
-------- --------
Total liabilities and stockholders' equity ................................................ $2,005.1 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
September 30
2004 2003
---- ----
Earned premiums (ceded to affiliate $166.7 and $151.0, respectively) ................ $ 253.6 246.1
Net investment income ............................................................... 18.0 16.0
Net realized gains on investments ................................................... 0.2 1.5
Other income (affiliates $1.0 and $0.9, respectively) ............................... 1.4 1.5
-------- --------
Total revenues ...................................................................... 273.2 265.1
-------- --------
Losses and loss expenses (ceded to affiliate $140.8 and $103.3, respectively) ....... 189.4 171.0
Acquisition and operating expenses .................................................. 77.0 69.2
Interest expense (affiliates $0.5 and $0.7, respectively) ........................... 1.8 0.8
Other expenses, net ................................................................. 2.4 3.3
-------- --------
Total expenses ...................................................................... 270.6 244.3
-------- --------
Income before federal income taxes .................................................. 2.6 20.8
Federal income tax (benefit) expense ................................................ (2.4) 5.2
-------- --------
Net income .......................................................................... $ 5.0 15.6
======== ========
Earnings per common share:
Basic ........................................................................... $ 0.12 0.40
-------- --------
Diluted ......................................................................... $ 0.12 0.38
-------- --------
Dividends paid per common share ..................................................... $ 0.045 0.040
-------- --------
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)
Nine months ended
September 30
2004 2003
---- ----
Earned premiums (ceded to affiliate $489.5 and $441.2, respectively) ................ $ 754.7 720.1
Net investment income ............................................................... 53.3 47.6
Net realized gains on investments ................................................... 6.9 9.6
Other income (affiliates $3.0 and $2.8, respectively) ............................... 4.5 4.3
-------- --------
Total revenues ...................................................................... 819.4 781.6
-------- --------
Losses and loss expenses (ceded to affiliate $322.8 and $301.3, respectively) ....... 483.1 503.3
Acquisition and operating expenses .................................................. 225.6 209.1
Interest expense (affiliates $1.4 and $2.1, respectively) ........................... 5.3 2.3
Other expenses, net ................................................................. 7.6 8.6
-------- --------
Total expenses ...................................................................... 721.6 723.3
-------- --------
Income before federal income taxes .................................................. 97.8 58.3
Federal income tax expense .......................................................... 25.8 13.3
-------- --------
Net income .......................................................................... $ 72.0 45.0
======== ========
Earnings per common share:
Basic ........................................................................... $ 1.81 1.15
-------- --------
Diluted ......................................................................... $ 1.77 1.12
-------- --------
Dividends paid per common share ..................................................... $ 0.125 0.11
-------- --------
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)
(unaudited)
Nine months ended
September 30
2004 2003
---- ----
Cash flows from operating activities:
Net income ................................................................ $ 72.0 45.0
Adjustments to reconcile net income to net cash provided
by Operating activities:
Depreciation, amortization and other, net ........................ 6.7 6.2
Net realized gains on investments ................................ (6.9) (9.6)
Changes in operating assets and liabilities:
Deferred policy acquisition costs ........................... (11.8) (7.9)
Accrued investment income and other assets .................. 0.9 (2.2)
Net prepaid pension expense ................................. (3.9) (0.1)
Postretirement benefit liabilities .......................... 4.9 5.4
Reinsurance recoverable on losses and loss expenses
payable and prepaid reinsurance premiums .................. (15.3) (5.9)
Other liabilities and due to/from affiliates, net ........... (43.4) (7.2)
Losses and loss expenses payable ............................ 66.7 44.5
Unearned premiums ........................................... 23.8 33.5
Federal income taxes ........................................ (9.3) 1.4
------ ------
Net cash provided by operating activities ................................. 84.4 103.1
------ ------
Cash flows from investing activities:
Purchase of fixed maturities ......................................... (365.8) (436.0)
Purchase of equity securities ........................................ (46.8) (43.8)
Purchase of other invested assets .................................... (0.2) (7.0)
Maturities, calls and pay downs of fixed maturities .................. 68.3 65.8
Sale of fixed maturities ............................................. 254.5 230.2
Sale of equity securities ............................................ 9.8 4.9
Net additions of property and equipment .............................. (1.1) (0.4)
------ ------
Net cash used in investing activities ..................................... (81.3) (186.3)
------ ------
Cash flows from financing activities:
Proceeds from issuance of common stock ............................... 4.2 2.5
Payment of dividends ................................................. (1.7) (1.4)
Proceeds from terminating fair value hedge derivatives ............... 3.8 -
Proceeds from issuance of debt ....................................... - 15.5
Debt issuance costs .................................................. - (0.6)
Payments to acquire treasury shares .................................. - (0.7)
------ ------
Net cash provided by financing activities ................................. 6.3 15.3
------ ------
Net increase (decrease) in cash and cash equivalents ...................... 9.4 (67.9)
Cash and cash equivalents at beginning of period .......................... 40.0 96.1
------ ------
Cash and cash equivalents at end of period ................................ $ 49.4 28.2
====== ======
Supplemental disclosures:
Federal income taxes paid .......................................... $ 35.1 12.0
------ ------
Interest paid (affiliates $1.4 and $1.8, respectively) ............. $ 4.6 2.1
------ ------
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)
September 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 the Company, all adjustments (consisting of
normal, recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three and nine month periods ended
September 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, State Auto Financial terminated its interest rate swap
contract entered into on November 6, 2003 and received proceeds of $2.9 million.
The interest rate swap contract was designated as a fair value hedge to protect
against changes in fair value of the Company's ten year $100.0 million Senior
Notes issued in November 2003. Of the $2.9 million received, $2.3 million
settled future net swap payments and was deferred in notes payable and will be
amortized as an offset to interest expense over the life of the Senior Notes.
The remaining $0.6 million related to net swap payments from inception to
termination and was recorded as an offset to 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. The swap contract was designated as a fair value
hedge to protect against changes in fair value of the Senior Notes. During
August 2004, State Auto Financial terminated the interest rate swap contract
entered into on May 6, 2004 and received proceeds of $1.8 million. Of the $1.8
million received, $1.5 million settled future net swap payments and was deferred
in notes payable and will be amortized as an offset to interest expense over the
life of the Senior Notes. The remaining $0.3 million related to net swap
payments from inception to termination and was recorded as an offset to interest
expense.
3. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted
earnings per common share:
Three months ended Nine months ended
September 30 September 30
------------ ------------
(in millions, except per share amounts) 2004 2003 2004 2003
-------- -------- -------- --------
Numerator:
Net income for basic and diluted earnings per share $ 5.0 15.6 $ 72.0 45.0
======== ======== ======== ========
Denominator:
Basic weighted average shares outstanding ......... 40.0 39.3 39.8 39.2
Effect of dilutive stock options .................. 0.9 1.0 0.9 0.8
-------- -------- -------- --------
Diluted weighted average shares outstanding ....... 40.9 40.3 40.7 40.0
======== ======== ======== ========
Basic earnings per share ............................ $ 0.12 0.40 $ 1.81 1.15
======== ======== ======== ========
Diluted earnings per share .......................... $ 0.12 0.38 $ 1.77 1.12
======== ======== ======== ========
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 Nine months ended
September 30 September 30
------------ ------------
(in millions) 2004 2003 2004 2003
---- ---- ---- ----
Number of options 0.4 - 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 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 Nine months ended
September 30 September 30
------------------- -------------------
(in millions, except per share amounts) 2004 2003 2004 2003
---- ---- ---- ----
Net income, as reported .................................................... $ 5.0 15.6 $ 72.0 45.0
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) (1.9) (1.3)
------ ---- ------ -----
Pro forma net income ....................................................... $ 4.3 15.1 $ 70.1 43.7
====== ==== ====== =====
Earnings per share:
Basic--as reported ....................................................... $ 0.12 0.40 $ 1.81 1.15
====== ==== ====== =====
Basic--pro forma ......................................................... $ 0.11 0.38 $ 1.76 1.11
====== ==== ====== =====
Diluted--as reported ..................................................... $ 0.12 0.38 $ 1.77 1.12
====== ==== ====== =====
Diluted--pro forma ....................................................... $ 0.10 0.37 $ 1.69 1.07
====== ==== ====== =====
There were no options granted during the three month periods ended
September 30, 2004 and 2003. There were 0.5 and 0.4 million options granted to
employees and non-employee directors during the nine month periods ended
September 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 nine months
ended
September 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 the Company'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, 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 non-qualified 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 expense, reflected in net
income, was $0.1 million for both three month periods ended September 30, 2004
and 2003, and was $0.4 million and $0.2 million for the nine month periods ended
September 30, 2004 and 2003, respectively.
There were no options granted to non-employees during the three month
periods ended September 30, 2004 and 2003, respectively. There were 31,000 and
35,000 options granted to non-employees during the nine month periods ended
September 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 nine months
ended
September 30
------------
2004 2003
---- ----
Fair value $16.57 14.79
Dividend yield 0.76% 0.80%
Risk free interest rate 4.12% 3.75%
Expected volatility factor 36.6% 36.4%
Expected life in years 8.8 9.1
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 non-qualified 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 nine month periods ended September 30,
2004 and 2003 is as follows:
Three months ended Nine months ended
September 30 September 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 2.7 $16.15 2.9 12.50 2.6 $12.84 2.8 10.98
Granted - - - - 0.5 30.33 0.4 18.71
Exercised nil 11.43 (0.1) 10.83 (0.4) 9.61 (0.4) 6.63
Cancelled nil 24.25 nil 16.24 nil 24.25 nil 16.24
--- --- --- ---
Outstanding, end of period 2.7 $16.21 2.8 12.53 2.7 $16.21 2.8 12.53
=== === === ===
A summary of information pertaining to all options outstanding and
exercisable at September 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 1.5 $ 6.87 0.4 $ 6.87
$10.01 - $20.00 1.8 6.3 14.97 1.5 14.29
Greater than $20.01 0.5 9.6 30.32 nil 29.40
--- --- ----- --- -----
Total 2.7 6.1 $16.21 1.9 $12.92
=== === ====== === ======
On October 13, 2004, the Financial Accounting Standards Board concluded
that Statement 123R, Share-Based Payment, which would require all companies to
measure compensation cost for all share-based payments (including employee stock
options) at fair value, would be effective for interim or annual periods
beginning after June 15, 2005. Retroactive application of the requirements of
Statement 123 (not Statement 123R) to the beginning of the fiscal year that
includes the effective date would be permitted, but not required.
5. COMPREHENSIVE INCOME
The components of accumulated other comprehensive income, net of related
tax, included in stockholders' equity at September 30, 2004 and 2003, include
unrealized holding gains (losses), net of tax. The components of comprehensive
income, net of related tax, are as follows:
10
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Condensed Consolidated Financial Statements, Continued (unaudited)
Three months ended Nine months ended
September 30 September 30
------------ ------------
(in millions) 2004 2003 2004 2003
---- ---- ---- ----
Net income $ 5.0 15.6 $72.0 45.0
Unrealized holding gain (loss), net of tax 23.9 (13.8) (3.3) 5.4
----- ----- ----- ----
Comprehensive income $28.9 1.8 $68.7 50.4
===== ===== ===== ====
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 Nine months ended
September 30 September 30
----------------------- -----------------------
(in millions) 2004 2003 2004 2003
------ ------ ------ ------
Premiums earned:
Assumed from other insurers and reinsurers $ 1.8 1.2 $ 4.7 3.6
Assumed under State Auto Pool and
other affiliate arrangements 236.0 225.8 698.9 664.4
Ceded to other insurers and reinsurers (4.0) (3.5) (11.4) (9.4)
Ceded under State Auto Pool
and other affiliate arrangements (166.7) (151.0) (489.5) (441.2)
------ ------ ------ ------
Net assumed premiums earned $ 67.1 72.5 $202.7 217.4
====== ====== ====== ======
Losses and loss expenses incurred:
Assumed from other insurers and reinsurers $ 1.3 0.8 $ 3.9 2.4
Assumed under State Auto Pool and
other affiliate arrangements 173.0 155.4 441.5 461.7
Ceded to other insurers and reinsurers (13.8) (1.0) (17.7) (5.5)
Ceded under State Auto Pool
and other affiliate arrangements (140.8) (103.3) (322.8) (301.3)
------ ------ ------ ------
Net assumed losses and loss expenses incurred $ 19.7 51.9 $104.9 157.3
====== ====== ====== ======
7. PENSION AND POSTRETIREMENT BENEFIT PLANS
The following table provides components of net periodic cost (benefit) for
the Company's pension and postretirement benefit plans:
Pension Postretirement Pension Postretirement
------- -------------- ------- --------------
(in millions) Three months ended September 30 Nine months ended September 30
2004 2003 2004 2003 2004 2003 2004 2003
---- ---- ---- ----- ----- ----- ----- -----
Service cost $ 2.0 1.8 $ 0.9 0.8 $ 6.0 5.2 $ 2.7 2.4
Interest cost 2.6 2.4 1.3 1.1 7.8 7.4 3.9 3.5
Expected return on plan assets (4.2) (4.1) (0.1) (0.1) (12.6) (12.5) (0.3) (0.2)
Amortization of prior service cost 0.1 - 0.1 0.1 0.3 0.2 0.3 0.3
Amortization of transition asset (0.2) (0.1) - - (0.6) (0.5) - -
Amortization of net loss 0.1 - - - 0.3 - - -
----- ---- ----- ----- ----- ----- ----- -----
Net periodic cost (benefit) $ 0.4 - $ 2.2 1.9 $ 1.2 (0.2) $ 6.6 6.0
===== ==== ===== ===== ===== ===== ===== =====
During September 2004, the Company contributed $5.0 million to its pension
plan.
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
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)
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 September 30, 2004, the Company has three reportable segments: State
Auto standard insurance, State Auto nonstandard insurance and investment
management services. From third quarter 2001 through December 31, 2003, the
Company maintained separate segments for the former Meridian Mutual Insurance
Company business (standard and nonstandard 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 Nine months ended
(in millions) September 30 September 30
------------ ------------
2004 2003 2004 2003
---- ---- ---- ----
Revenues from external customers:
State Auto standard insurance $ 252.6 240.5 $ 748.0 702.5
State Auto nonstandard insurance 18.6 21.5 59.1 65.0
Investment management services 0.8 0.7 2.2 1.9
All other 0.8 0.9 2.6 2.6
-------- -------- -------- --------
Total revenues from external customers $ 272.8 263.6 $ 811.9 772.0
======== ======== ======== ========
Intersegment revenues:
State Auto standard insurance $ - - $ 0.1 0.1
Investment management services 1.6 1.5 4.9 4.3
All other 0.4 0.5 1.3 1.4
-------- -------- -------- --------
Total intersegment revenues $ 2.0 2.0 $ 6.3 5.8
======== ======== ======== ========
Segment profit:
State Auto standard insurance $ (0.3) 16.7 $ 83.4 40.2
State Auto nonstandard insurance 2.3 1.4 6.1 4.3
Investment management services 2.2 1.9 6.4 5.5
All other - 0.7 0.7 1.8
-------- -------- -------- --------
Total segment profit $ 4.2 20.7 $ 96.6 51.8
Reconciling items:
Corporate expenses $ (1.8) (1.4) $ (5.7) (3.1)
Net realized gains 0.2 1.5 6.9 9.6
-------- -------- -------- --------
Total consolidated income before
federal income taxes $ 2.6 20.8 $ 97.8 58.3
======== ======== ======== ========
Segment assets:
Standard insurance $1,928.0 1,576.4
Nonstandard insurance 141.0 129.2
Investment management services 5.3 5.9
All other 16.1 15.7
-------- --------
Total segment assets $2,090.4 1,727.2
======== ========
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 -
9/30/2004 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 State Auto
Mutual. This amendment did not change the STFC Pooled Companies' Pool
percentages.
Results of Operations
The following table summarizes for the three and nine month periods ended
September 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 Nine Months Ended
------------------ -----------------
(dollars in millions) September 30 September 30
------------ ------------
GAAP Basis: 2004 2003 2004 2003
----------- ---- ---- ---- ----
Total revenue $273.2 265.1 $819.4 781.6
Net income $ 5.0 15.6 $ 72.0 45.0
Stockholders' equity $615.9 515.9 $615.9 515.9
Loss and LAE ratio * 74.7% 69.5% 64.0% 69.9%
Expense ratio * 30.4% 28.1% 29.9% 29.0%
Combined ratio 105.1% 97.6% 93.9% 98.9%
Catastrophe loss and LAE points* 22.7 6.9 9.7 8.9
Earned premium growth 3.0% 7.0% 4.8% 8.4%
Investment yield 4.5% 4.6% 4.5% 4.7%
Twelve Months Ended
September 30
------------
Statutory Basis: 2004 2003
- ---------------- ---- ----
Net premiums written to surplus** 1.7 2.2
* 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 nine month periods ended September 30, 2004, the
Company generated net income of $5.0 million and $72.0 million compared to $15.6
million and $45.0 million for the same 2003 periods, respectively. Net income
before federal income taxes for the Company decreased $18.2 million to $2.6
million and increased $39.5 million to $97.8 million for the three and nine
month periods ended September 30, 2004, respectively, from the same periods in
2003. For the three month period ended September 30, 2004, income before taxes
was negatively impacted by $57.6 million of catastrophe losses, the largest
amount of catastrophe losses in one quarter in the Company's history. For the
nine month period ended September 30, 2004, income before taxes increased as the
direct result of the Company's efforts in continuing to obtain adequate cost
based rates across most lines of business, partly offset by worse catastrophe
loss experience. As discussed in more detail below, the Company's challenge is
to grow premiums without compromising profitability as industry-wide price
competition appears to be increasing. During the three and nine months ended
September 30, 2004, catastrophe losses totaled $57.6 million and $72.9 million
compared to $16.9 million and $64.3 million in the same 2003 periods,
respectively. The Company's investment yield declined slightly, 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 $7.5 million to $253.6 million
(3.0%) and $34.6 million to $754.7 million (4.8%) for the three month and nine
month periods ended September 30, 2004, respectively from the same periods in
2003. The Company's standard segment contributed a 4.2% and 5.0% increase to
consolidated earned premiums for the three and nine month periods ended
September 30, 2004 from the 2003 periods, while the non-standard segment
generated a 1.3% and 1.0% decrease from the same 2003 periods. The 2003
consolidated earned premiums were affected by the Stop Loss (as defined below).
The STFC Pooled Companies ceded $0.2 million and $5.7 million in earned premiums
to State Auto Mutual under a stop loss reinsurance arrangement (the "Stop Loss")
during the three and nine month periods ended September 30, 2003, which reduced
the Company's earned premiums for these periods 0.1% and 0.8%, respectively. The
Stop Loss reinsurance agreement expired December 31, 2003 and was not renewed.
Earned premiums within the standard segment increased $10.6 million to
$236.1 million (4.7%) and $41.6 million to $699.0 (6.3%) for the three month and
nine month periods ended September 30, 2004, respectively, from the same periods
in 2003. The Company has implemented smaller rate increases in 2004 compared to
2003 and 2002 due to increasing price competition and improved underwriting
results, which has slowed earned premium growth. Additionally, this segment has
also experienced a recent slowdown in new and renewal business indicating an
increased competitive pricing environment.
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 within the nonstandard segment decreased $3.1 million to
$17.5 million (-15.0%) and $7.0 million to $55.7 million (-11.2%) for the three
month and nine month periods ended September 30, 2004, respectively from the
same periods in 2003. The nonstandard automobile industry is highly price
sensitive, which can have an adverse impact on renewal business as well as new
premium growth. The Company continues to take cost based rate increases;
however, some nonstandard insurers have taken rate decreases within the last
year. This intense price competition, along with the Company's termination or
suspension during 2003, of certain fast growing, but unprofitable agencies, has
resulted in a decrease in new and renewal business, which in turn has negatively
impacted the Company's earned premiums.
While the Company continues to emphasize that it will not compromise
underwriting profitability for top line growth, it believes that it can
implement periodic rate increases in most states and remain an attractive market
to its independent agency partners by stressing the strengths it brings to the
market place, such as stability, financial soundness, prompt and fair claims
service, and technology which makes it easier for the agent to do business with
State Auto. The Company's new internet-based upload system for personal lines
business, NetXpress, is one example of new, user friendly, technology. Recent
statistics indicate that approximately 66% of new personal lines business
applications and 54% of change requests in those lines are delivered and
processed electronically.
Net investment income increased $2.0 million to $18.0 million and
increased $5.7 million to $53.3 million for the three and nine month periods
ended September 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 September 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 September 30, 2004 and 2003 was $1,617.9 million and
$1,424.2 million, respectively. Reflecting a decline in the interest rate
environment, the annualized investment yields based on average invested assets
at cost decreased to 4.5% from 4.6% and to 4.5% from 4.7% for the three and nine
month periods ended September 30, 2004, respectively, 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" or "loss ratio points"), were
74.7% and 69.5% for the three month periods ended September 30, 2004 and 2003,
respectively, and 64.0% and 69.9% for the nine month periods ended September 30,
2004 and 2003, respectively. During the three and nine months ended September
30, 2004, catastrophe losses totaled $57.6 million (22.7 loss ratio points) and
$72.9 million (9.7 loss ratio points), respectively, compared to $16.9 million
(6.9 loss ratio points) and $64.3 million (8.9 loss ratio points) in the same
2003 periods, respectively. During the three months ended September 30, 2004
hurricanes Charley, Frances, Jeanne and Ivan contributed $47.2 million in
catastrophe losses, or 18.6 loss ratio points (6.3 loss ratio points for the
nine months ended September 30, 2004). 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 consolidated losses and loss adjustments expense during the
three and nine month periods ended September 30, 2004 was the December 31, 2003
termination of the Stop Loss. The STFC Pooled Companies ceded $5.6 million in
loss and loss adjustment expenses to State Auto Mutual under the Stop Loss
during the nine month period ended September 30, 2003. This Stop Loss cession
reduced the GAAP loss and LAE ratio for the nine months ended September 30, 2003
0.9 loss ratio point. See Stop Loss discussion above regarding earned premium
cessions during 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 nine month periods ended September 30, 2004 and 2003, respectively:
Three months ended Nine months ended
September 30 September 30
------------ ------------
Change Change
2004 2003 inc (dec) 2004 2003 inc (dec)
---- ---- --------- ---- ---- ---------
State Auto standard segment 74.9% 68.9 6.0 63.3% 69.3 (6.0)
State Auto nonstandard segment 71.4% 76.1 (4.7) 72.7% 76.8 (4.1)
Total GAAP Loss and LAE Ratio 74.7% 69.5 5.2 64.0% 69.9 (5.9)
15
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Management's Discussion and Analysis of Financial Condition and Results of
Operation, Continued
The State Auto standard segment's GAAP loss and LAE ratio deteriorated 6.0
loss ratio points and improved 6.0 loss ratio points for the three and nine
month periods ended September 30, 2004, respectively, from the same 2003
periods. Catastrophe losses represented 24.4 and 7.5 loss ratio points, and 10.4
and 9.6 loss ratio points of this segment's GAAP loss and LAE ratio for the
three month and nine month periods ended September 30, 2004 and 2003,
respectively. The Company monitors all lines of business paying particular
attention to auto - personal, homeowners and workers' compensation due to the
impact 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 8.0 loss
ratio points to 56.9 and 56.5 for both the three month and nine month periods
ended September 30, 2004, respectively, from the same 2003 periods. Both
improvements are the result of the Company's continual efforts to obtain
adequate rates and monitor underwriting results. Homeowners is the Company's
second largest line of business. Its GAAP loss and LAE ratio deteriorated 31.4
loss ratio points to 125.9 and improved 6.6 loss ratio points to 83.1 for the
three month and nine month periods ended September 30, 2004, respectively from
the same 2003 periods. This line of business was adversely affected by weather
related catastrophe losses. Excluding catastrophe losses, this line of
business's core results improved from the prior year. 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 improved 21.6 loss ratio
points to 77.2 and 3.7 loss ratio points to 72.8 for the three month and nine
month periods ended September 30, 2004, respectively, from the same 2003
periods. 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.
Workers' compensation represents approximately 3% of total earned premium.
The State Auto nonstandard segment's GAAP loss and LAE ratio improved 4.7
and 4.1 loss ratio points for the three and nine month periods ended September
30, 2004, respectively, from the same 2003 periods. Catastrophe losses
represented 0.7 and 0.3 loss ratio point, and 0.5 and 1.7 loss ratio points of
this segment's GAAP loss and LAE ratio for the three and nine month periods
ended September 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. The Company 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.
Acquisition and operating expenses, as a percentage of earned premiums
(the "GAAP expense ratio" or "expense ratio points"), were 30.4% and 28.1% for
the three months ended September 30, 2004 and 2003, respectively, and 29.9% and
29.0% for the nine month periods ended September 30, 2004 and 2003,
respectively. As noted above during the three months and nine months ended
September 30, 2003 the Company ceded to State Auto Mutual $0.2 million and $5.7
million in earned premiums under the Stop Loss which increased the expense ratio
for those periods less than 0.1 and 0.2 expense ratio points, respectively.
Incentive based compensation to employees and agents are significant
variable expenses tied directly to the State Auto Group's insurance operation's
profitability and contributed to the increased GAAP expense ratio for the three
and nine month periods ended September 30, 2004 over the same periods in 2003.
The incentive profit based compensation plans include a Quality Performance
Bonus ("QPB") Plan that covers substantially all employees and a Quality
Performance Agreement ("QPA") available to all the Company's independent agents.
QPB is earned quarterly and is based on the quarterly underwriting profit of the
State Auto Group. Despite the improvement in the core loss experience in 2004
over the same 2003 periods, as described above, the impact of the current
quarter's catastrophe losses resulted in the Company's employees not earning a
QPB in the third quarter. For the three and nine months ending September 30,
2004, QPB accounted for zero and 0.9 expense ratio points of the GAAP expense
ratio, respectively, as compared to 0.1 and 0.3 expense ratio points for the
same 2003 time periods.
In addition to the Independent Agency Agreement that authorizes an
independent agent to represent the Company and bind business on the Company's
behalf, the Company makes available, the QPA, which is paid annually in the year
after it is earned. This separate contract obligates the Company to share a
portion of the underwriting profit generated by the independent agency's book of
business. While there is a provision in the contract that causes the percentage
of the profit sharing to vary based on overall written premium, there is no
bonus earned in the absence of underwriting profit. As discussed above, the
Company experienced significant losses as a result of third quarter hurricane
activity in the southeastern United States. Despite these catastrophic losses,
the remaining geographic operating regions of the Company continued to generate
profitable results into the third quarter, exceeding 2003 profit levels. Based
on this continued improvement, the Company increased its expected QPA accrual
through September 30, 2004. For the three
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
and nine months ending September 30, 2004, QPA accounted for 2.4 and 1.8 expense
ratio points, respectively, as compared to 0.8 and 1.2 expense ratio points for
the same 2003 time periods.
Interest expense increased $1.0 million to $1.8 million and $3.0 million
to $5.3 million for the three and nine month periods ended September 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 nine
months of 2003. Interest expense for the three and nine month periods ended
September 30, 2004 was reduced by $0.4 million and $0.9 million due to the
Company's interest rate swap contracts, as more fully described in "Liquidity
and Capital Resources." See "Liquidity and Capital Resources" for further
discussion of the fair value hedge derivative settlements.
The consolidated effective federal income tax expense/(benefit) rate for
the three and nine month periods ended September 30, 2004 was (93.6)% and 26.3%
as compared to a consolidated effective tax expense rate of 25.1% and 22.9% for
the same 2003 periods, respectively. The consolidated effective tax rate differs
from the statutory tax rate of 35% principally due to tax-exempt investment
income. Consequently, due to the amount of tax-exempt interest earned, the net
investment income effective tax rate approximates 20%, while the remaining rate,
primarily on underwriting income (loss) approximates 35%. The third quarter 2004
federal income tax benefit of $2.4 million was due to the pre-tax loss from
underwriting operations, which does not include net investment income. This
underwriting loss was offset by net investment income but, due to the lower
effective tax rate on net investment income as discussed above, a net tax loss
remained for the three months ending September 30, 2004.
Liquidity and Capital Resources
Liquidity refers to the ability of the Company to generate adequate
amounts of cash to meet its payment needs for both long and short-term cash
obligations as they come due. The Company's significant sources of cash are
premiums, investment income, sales of investments and the maturity of fixed
maturity securities. 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 September 30, 2004 and December 31, 2003, the Company had $49.4 million
and $40.0 million, respectively, of cash and cash equivalents. At September 30,
2004 and December 31, 2003, the Company had $1,646.2 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 nine months ended September 30, 2004, net cash provided by
operating activities was $84.4 million versus $103.1 million for the same 2003
period. The current year decrease is primarily due to increased payments of
$25.6 million made over the same 2003 period on federal income taxes and
interest on outstanding debt. Additionally, the Company made a $5.0 million cash
contribution to the Company's pension plan in the current quarter, whereas the
2003 cash contribution of $4.6 million was made in the fourth quarter of 2003.
For the nine months ended September 30, 2004, net cash used in investing
activities was $81.3 million versus $186.3 million for the same 2003 period. The
decreased net investing activities during 2004 was the result of the Company
having a smaller amount of cash and cash equivalents available to invest at the
beginning of 2004 versus 2003 ($40.0 million in 2004 compared to $96.1 million
in 2003), along with the current year decline in cash provided by operating
activities, as described above.
For the nine months ended September 30, 2004, net cash provided by
financing activities was $6.3 million versus $15.3 million for the same 2003
period. The decreased net financing activity during 2004 was due to the absence
of $14.9 million in net proceeds the Company received in 2003 from the issuance
of debt. Positively impacting cash flows from financing activities during 2004
was the Company's termination of two separate fair value hedge transactions,
described below, for a cash settlement of $3.8 million on future net swap
payments. Additionally, net proceeds from the issuance of Company common stock
on option exercises increased over the same 2003 time period by $1.7 million.
During March 2004, State Auto Financial terminated its interest rate swap
contract entered into on November 6, 2003 and received proceeds of $2.9 million.
The interest rate swap contract was designated as a fair value hedge to protect
against changes in fair value of the Company's ten year $100.0 million Senior
Notes issued in November 2003. Of the $2.9 million received, $2.3 million
settled future net swap payments and was deferred in notes payable and will be
amortized as an offset to interest expense over the life of the Senior Notes.
The remaining $0.6 million related to net swap payments from inception to
termination and was recorded as an offset to interest expense. The Company
classifies
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
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. The swap contract was designated as a fair value
hedge to protect against changes in fair value of the Senior Notes. During
August 2004, State Auto Financial terminated the interest rate swap contract
entered into on May 6, 2004 and received proceeds of $1.8 million. Of the $1.8
million received, $1.5 million settled future net swap payments and was deferred
in notes payable and will be amortized as an offset to interest expense over the
life of the Senior Notes. The remaining $0.3 million related to net swap
payments from inception to termination and was recorded as an offset to interest
expense.
In 1999 State Auto Financial entered into a line of credit agreement with
State Auto Mutual for $45.5 million in conjunction with its stock repurchase
program in effect at that time. 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 year
2004 is 2.25% and was 2.50% in 2003.
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 (5.99% as of
September 30, 2004). Prior to May 2008, the interest rate may not exceed 12.5%
per annum. The Trust Securities are mandatorily redeemable on May 23, 2033, and
may be redeemed at any time on and after May 23, 2008, at 100% of the principal
amount thereof plus unpaid interest. The obligations under the Subordinated
Debentures and related agreements, taken together, constitute a full and
unconditional guarantee of payments due on the Trust Securities. The
Subordinated Debentures are unsecured and subordinated to all of the Company's
existing and future senior indebtedness.
State Auto Financial has issued $100.0 million unsecured Senior Notes
bearing interest fixed at 6.25% due November 15, 2013. The notes are general
unsecured obligations ranking senior to all existing and future subordinated
indebtedness and equal with all existing and future senior indebtedness. The
notes are not guaranteed by any of the State Auto Financial subsidiaries and
thereby are effectively subordinated to all State Auto Financial subsidiaries'
indebtedness.
During the three and nine month periods ended September 30, 2004, a total
of 2,000 and 25,000 shares were acquired as a result of stock swap option
exercises at a total cost of $0.1 million and $0.7 million, respectively. During
the three and nine month periods ended September 30, 2003, a total of 8,000 and
24,000 shares were acquired as a result of stock swap option exercises at a
total cost of $0.2 million and $0.5 million, respectively. During the nine
months ended September 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 10-K for
further discussion of these arrangements.
At September 30, 2004, all of the Company's insurance subsidiaries were in
compliance with statutory requirements relating to capital adequacy. The Company
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 2.2 to 1.0 for the
twelve month periods ended September 30, 2004 and 2003, respectively.
On August 7, 2004, the Board of Directors of State Auto Financial declared
a quarterly cash dividend of $0.045 per share payable on September 30, 2004, to
shareholders of record at the close of business on September 15, 2004. This
dividend represented a 12.5% increase from the previous annual rate and was the
13th straight annual dividend increase declared by State Auto Financial. This
was also the 53rd consecutive quarterly cash dividend declared by the Company's
board since State Auto Financial had its initial public offering of common stock
on June 28, 1991.
State Auto Mutual, whose ownership in State Auto Financial is
approximately 66%, has waived its right to receipt of the dividends declared by
State Auto Financial since 1994 in an effort to enhance the statutory surplus of
the insurance subsidiaries of State Auto Financial for use in underwriting
operations which in turn is expected to increase the statutory
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
surplus of State Auto Mutual. The Standing Independent Committee of the Board of
Directors of State Auto Mutual ("Standing Independent Committee") met in August
2004 and voted to waive State Auto Mutual's dividends that might be declared by
the Board of Directors of State Auto Financial, for the period from August 1,
2004 to July 31, 2005, in order to take better advantage of the investment
opportunity State Auto Financial represents for State Auto Mutual. The Standing
Independent Committee will continue to monitor relevant conditions, including
but not limited to financial conditions. If in the good faith exercise of the
Standing Independent Committee's business judgment such conditions change in a
materially adverse way from those in place currently, it retains the right to
revoke its recommendation to waive such dividends as to a particular dividend
otherwise payable by State Auto Financial on its common shares, provided that
any such revocation shall be effected prior to the declaration of a quarterly
dividend by State Auto Financial.
Other Disclosures
Investments
At September 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:
September 30 December 31 Average
2004 2003 Rating*
---- ---- -------
Corporate and Municipal Bonds 61.7% 58.2 Aa+
U.S. Government 2.2% 2.2 Aaa
U.S. Government Agencies 36.1% 39.6 Aaa
----- -----
Total 100.0% 100.0
===== =====
* As rated by Moody's Investors Service
During the three and nine month periods ended September 30, 2004, the
Company made $17.9 and $46.8 million in purchases of equity securities to
enhance growth of statutory surplus over the long term. The Company's investment
strategy does not rely on the use of derivative financial instruments.
At September 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 September 30, 2004 and December 31, 2003:
September 30, 2004 December 31, 2003
(dollars in millions) ------------------ -----------------
Fixed maturities, at fair value $1,458.3 88.6% 1,421.4 90.5%
Equity securities, at fair value 178.2 10.8% 139.3 8.9%
Other invested assets, at fair value 9.7 0.6% 9.6 0.6%
-------- ------ ------- -----
Total investments $1,646.2 100.0% 1,570.3 100.0%
======== ===== ======= =====
The Company regularly monitors its investment portfolio for declines in
value that are other than temporary, an assessment which requires significant
judgment. Among the factors that the Company 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 forecasted
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 September 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
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
the amounts reported herein. At September 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 September
30, 2004. The following table provides the Company's investment portfolio gross
unrealized gains and losses at September 30, 2004:
Gross Number Gross Number
Cost or unrealized of unrealized of
amortized holding gain holding loss Fair
cost gains positions losses positions Value
---- ----- --------- ------ --------- -----
(dollars in millions)
Investment Category
Fixed Maturities
U.S. Treasury securities $ 335.1 $ 6.5 92 $0.9 30 $ 340.7
States & political subdivisions 821.3 45.0 370 1.6 59 864.7
Corporate securities 33.2 2.7 23 - - 35.9
Mortgage-backed securities of U.S.
Gov. Agencies 211.9 6.3 44 1.2 18 217.0
-------- ----- --- ---- --- --------
Total fixed maturities 1,401.5 60.5 529 3.7 107 1,458.3
Equity Securities
Consumer 22.9 3.6 11 0.6 2 25.9
Technologies 16.3 1.4 8 0.2 1 17.5
Pharmaceuticals 17.2 1.2 4 0.6 5 17.8
Financial services 39.3 4.7 16 1.3 5 42.7
Manufacturing & other 64.2 10.6 32 0.5 6 74.3
-------- ----- --- ---- --- --------
Total equity securities 159.9 21.5 71 3.2 19 178.2
Other invested assets 9.6 0.1 1 - - 9.7
-------- ----- --- ---- --- --------
Total investments $1,571.0 $82.1 601 $6.9 126 $1,646.2
======== ===== === ==== === ========
The amortized cost and fair value of fixed maturities at September 30,
2004, by contractual maturity, is as follows:
Amortized Fair
(in millions) Cost Value
---- -----
Due in 1 year or less $ 2.0 $ 2.1
Due after 1 year through 5 years 44.1 45.8
Due after 5 years through 10 years 219.5 229.7
Due after 10 years 924.0 963.7
-------- --------
Subtotal 1,189.6 1,241.3
Mortgage-backed securities 211.9 217.0
-------- --------
Total $1,401.5 $1,458.3
======== ========
Expected maturities may differ from contractual maturities as the issuers
may have the right to call or prepay the obligations with or without call or
prepayment penalties.
Included in realized losses of equity securities below, was no recognized
loss related to other than temporary impairment for the three and nine month
periods ended September 30, 2004. Included in realized losses of equity
securities below was $35,000 and $289,000 recognized related to other than
temporary impairment on one and four equity positions for the three and nine
month periods ended September 30, 2003, respectively. There were no other than
temporary impairments of fixed maturity securities for the three and nine month
periods ended September 30, 2004 and 2003.
The securities sold during the three and nine month periods ended
September 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 nine months ended September 30, 2004 are summarized as
follows:
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
Three months ended Nine months ended
(in millions) September 30, 2004 September 30, 2004
------------------ ------------------
Realized Fair Value Realized Fair Value
Gains/Losses at Sale Gains/Losses at Sale
------------ ------- ------------ -------
Realized gains:
Fixed maturities $1.0 $38.5 $6.8 $200.8
Equity securities 0.8 2.9 2.5 7.5
---- ----- ---- ------
Total realized gains 1.8 41.4 9.3 208.3
Realized losses:
Fixed maturities 0.9 26.0 1.7 53.7
Equity securities 0.7 2.1 0.7 2.3
---- ----- ---- ------
Total realized losses 1.6 28.1 2.4 56.0
---- ----- ---- ------
Grand total $0.2 $13.3 $6.9 $152.3
==== ===== ==== ======
Losses and Loss Expenses Payable
The following table presents losses and loss expenses payable by major
line of business:
September 30 December 31 Percent
2004 2003 Change
(dollars in millions) ---- ---- ------
Automobile - personal (standard) $182.2 185.5 (1.8)%
Automobile - personal (nonstandard) 38.1 37.8 0.8
Automobile - commercial 76.3 80.7 (5.4)
Homeowners 65.1 39.5 64.8
Commercial multi-peril 94.3 89.2 5.7
Workers' compensation 81.4 81.7 (0.4)
Fire and allied lines 26.5 14.3 85.3
Other/products liability 111.7 95.7 16.7
Miscellaneous personal/commercial lines 5.1 4.4 15.9
------ ----- ----
Total losses and loss expenses payable, net of
reinsurance recoverable on losses and loss expenses
payable of $29.0 and $14.2, respectively $680.7 628.8 8.3%
====== ===== ====
Total net losses and loss expenses payable increased 8.3% from December
31, 2003 to September 30, 2004. Homeowners, commercial multi-peril and fire and
allied loss and loss expenses payable increased as these lines were
significantly impacted in the current quarter by the hurricane catastrophe
losses described above. Other/products liability increased due to higher loss
severity, including several significant umbrella claims. Overall, the Company
does not believe there was a significant change in the total book of business at
September 30, 2004 compared to December 31, 2003.
The Company 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 the Company in estimating
ultimate liabilities including consistency in relative case reserve adequacy,
consistency in claims settlement practices, recent legal developments,
historical data, actuarial projections, accounting projections, exposure growth,
current business conditions, catastrophe developments, late reported claims, and
other reasonableness tests.
The risks and uncertainties inherent in the estimates include, but are not
limited to, actual settlement experience different from historical data, trends,
changes in business and economic conditions, court decisions creating
unanticipated liabilities, ongoing interpretation of policy provisions by the
courts, inconsistent decisions in lawsuits regarding coverage and additional
information discovered before settlement of claims. The Company's results of
operations and financial condition could be impacted, perhaps significantly, in
the future if the ultimate payments required to settle claims vary from the
liability currently recorded. To provide a measure of sensitivity of pre-tax
income to changes in reserve
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
estimates, for every 1% change in the ultimate development of the September 30,
2004 total losses and loss expenses payable, the effect on pre-tax income would
be $6.8 million.
New Accounting Standard
On October 13, 2004, the Financial Accounting Standards Board concluded
that Statement 123R, Share-Based Payment, which would require all companies to
measure compensation cost for all share-based payments (including employee stock
options) at fair value, would be effective for interim or annual periods
beginning after June 15, 2005. Retroactive application of the requirements of
Statement 123 (not Statement 123R) to the beginning of the fiscal year that
includes the effective date would be permitted, but not required. 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 the Company may be "forward-looking" within
the meaning of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements are subject to certain risks and uncertainties that
could cause the Company's actual results to differ materially from those
projected. Forward-looking statements may be identified, preceded by, followed
by, or otherwise include, without limitation, words such as "plans," "believes,"
"expects," "anticipates," "intends," "estimates," or similar expressions. The
following factors, among others, in some cases have affected and in the future
could affect the Company's actual financial performance.
- The Company maintains loss reserves to cover its estimated ultimate
unpaid liability for losses and loss expenses with respect to reported and
unreported claims incurred as of the end of each accounting period.
Reserves do not represent an exact calculation of liability, but instead
represent estimates, generally using actuarial projection techniques at a
given accounting date. The Company refines reserve estimates in a regular
ongoing process as historical loss experience develops and additional
claims are reported and settled. The Company records adjustments to
reserves in the results of operations for the periods in which the
estimates are changed. Because establishing reserves is an inherently
uncertain process involving estimates, currently established reserves may
not be adequate. If the Company concludes that estimates are incorrect and
reserves are inadequate, the Company is obligated to increase its
reserves. An increase in reserves results in an increase in losses and a
reduction in the Company's net income for the period in which the
deficiency in reserves is identified. Accordingly, an increase in reserves
could have a material adverse effect on the Company's results of
operations, liquidity, and financial condition.
- The Company's insurance operations expose it to claims arising out of
catastrophic events. The Company has experienced, and will in the future
experience, catastrophe losses that may cause substantial volatility in
the Company's financial results for any fiscal quarter or year and could
materially reduce the Company's profitability or harm the Company's
financial condition. Catastrophes can be caused by various natural events,
including hurricanes, hailstorms, windstorms, earthquakes, explosions,
severe winter weather, and fires, none of which are within the Company's
control. The extent of losses from a catastrophe is a function of both the
total amount of insured exposure in the area affected by the event and the
severity of the event. The geographic distribution of the Company's
business subjects it to catastrophe exposure from hailstorms and
earthquakes in the Midwest as well as catastrophe exposure from hurricanes
in Florida and the Gulf Coast, southern coastal states, and Mid-Atlantic
regions. Catastrophe losses can vary widely and could significantly exceed
the Company's recent historic results. The frequency and severity of
catastrophes are inherently unpredictable.
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
- 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. If
the Company's financial strength ratings were downgraded, that 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 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
23
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
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. 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, shortages of technical and professional employees, unexpected
challenges to the control of the Company by State Auto Mutual and new,
unanticipated regulatory developments, including but not limited to
matters initiated by government officials who are not insurance department
personnel.
24
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 - There are no material developments to the legal
proceedings discussed in Part II, Item 1, of the Form 10Q for the quarterly
period ended June 30, 2004.
Item 2. Changes in Securities and Use of Proceeds
Issuer Purchases of Equity Securities
Total Number of Maximum Number (or
Shares Purchased Approximate Dollar
as Part of Value) of Shares
Total Number Publicly that May Yet Be
of Shares Announced Purchased under
Purchased * (in Average Price Plans or the Plans or
Period whole numbers) Paid Per Share Programs Programs
- ------ -------------- -------------- -------- --------
07/01/04 thru 07/31/04 - - - -
08/01/04 thru 08/31/04 1,552 30.41 - -
09/01/04 thru 09/30/04 - - - -
-----
Total 1,552 $30.41 - -
=====
* 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 - None
Item 5. Other Information - None
25
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Item 6. Exhibits
Exhibit
No. Description of Exhibits
--- -----------------------
31.1 CEO certification required by Section 302 of Sarbanes Oxley Act of 2002
31.2 CFO certification required by Section 302 of Sarbanes Oxley Act of 2002
32.1 CEO certification required by Section 906 of Sarbanes Oxley Act of 2002
32.2 CFO certification required by Section 906 of Sarbanes Oxley Act of 2002
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: November 3, 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
-- -----------------------
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