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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[x] Annual Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 1997
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 (no fee required)
For the transition period from ___________ to _____________
Commission File Number 0-19289
STATE AUTO FINANCIAL CORPORATION
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(exact name of Registrant as specified in its charter)
Ohio 31-1324304
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
518 East Broad Street, Columbus, Ohio 43215-3976
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(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (614) 464-5000
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Shares, without par value
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(Title of class)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
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On March 18, 1998, the aggregate market value (based on the closing
sales price on that date) of the voting stock held by non-affiliates of the
Registrant was $223,002,710.
On March 18, 1998, the Registrant had 18,347,882 Common Shares
outstanding.
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DOCUMENTS INCORPORATED BY REFERENCE
1. Portions of the Registrant's Proxy Statement relating to the annual
meeting of shareholders to be held May 28, 1998, which Proxy Statement
will be filed within 120 days of December 31, 1997, are incorporated by
reference in Part III, Items 10, 11, 12 and 13 of this report.
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PART I
ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS
State Auto Financial Corporation, an Ohio corporation formed April 18,
1990 ("State Auto Financial" or "STFC"), is an insurance holding company
headquartered in Columbus, Ohio, which engages, through its subsidiaries,
primarily in the property and casualty insurance business. State Auto Financial
is approximately 65% owned by State Automobile Mutual Insurance Company, an Ohio
property and casualty insurance company formed in 1921 ("Mutual").
State Auto Financial's principal subsidiary is State Auto Property and
Casualty Insurance Company, a South Carolina corporation formed in 1950 ("State
Auto P&C"). State Auto P&C is a regional insurer engaged primarily in writing
personal and commercial automobile, homeowners, commercial multi-peril, workers'
compensation and fire insurance. State Auto P&C markets its insurance products
through approximately 11,300 independent insurance agents associated with
approximately 2,000 agencies in 24 states. Wisconsin was added as a new
operating territory in 1997. State Auto P&C's products are marketed primarily in
the central and eastern part of the United States, excluding New York, New
Jersey and the New England States.
Another subsidiary of State Auto Financial, Stateco Financial Services,
Inc., an Ohio corporation formed in 1962 ("Stateco"), provides investment
management services to affiliated companies and insurance premium finance
services to customers of State Auto P&C, Mutual and Milbank Insurance Company
("Milbank"), a wholly-owned subsidiary of Mutual.
State Auto P&C, Mutual, Milbank and Midwest Security (defined below)
are collectively referred to hereafter as the ("Pooled Companies"). The Pooled
Companies and National, defined below, are collectively referred to as the
("State Auto Group"). See "Business - Insurance Premium Finance Services" and
"Investment Management Services."
On May 16, 1991, Mutual contributed all of the stock of State Auto P&C,
which it had owned since 1958, and all of the stock of Stateco, which it had
owned since 1962, to State Auto Financial in exchange for all of the outstanding
common shares of State Auto Financial. State Auto P&C and Stateco thereby became
wholly-owned subsidiaries of State Auto Financial and State Auto Financial
continued as a wholly-owned subsidiary of Mutual.
On June 28, 1991, State Auto Financial completed an initial public
offering of 5,490,000 (adjusted to reflect a two-for-one stock split effected in
the form of a stock dividend declared in March 1993, and a three-for-two stock
split effected in the form of a stock dividend declared in May 1996 of its
common shares, which reduced Mutual's ownership interest in State Auto Financial
to approximately 68%.
On October 4, 1991, State Auto Financial formed an Ohio subsidiary,
State Auto National Insurance Company ("National"), which in February 1992 began
writing personal automobile insurance for non-standard risks.
Strategic Insurance Software, Inc. ("SIS") is an Ohio corporation
formed by State Auto Financial on January 12, 1995, which began operations in
July 1995. SIS develops and sells software for the processing of insurance
transactions, management of insurance policy data and electronic interfacing of
insurance policy information between insurance companies and agencies.
SIS is a majority-owned subsidiary of State Auto Financial.
On December 15, 1997, the Articles of Organization of 518 Property
Management and Leasing, LLC ("518 PML") were filed with the Ohio Secretary of
State. 518 PML is an Ohio limited liability company formed to engage in the
business of owning and leasing real and personal property to Mutual and its
affiliates. The members of 518 PML are State Auto P&C and Stateco.
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State Auto Financial and its subsidiaries, State Auto P&C, Stateco,
National, SIS, and 518 PML are collectively referred to as the ("Company").
Effective July 1, 1993, Mutual acquired Milbank, a South Dakota
domiciled property and casualty insurance company. In connection with the
closing of this purchase, on August 20, 1993, Mutual and State Auto Financial
entered into an Option Agreement whereby, subject to the approval of the South
Dakota Insurance Division, State Auto Financial may purchase Milbank from Mutual
at any time over the option term of five years for a price determined pursuant
to a formula set forth in the Option Agreement. On March 6, 1998, State Auto
Financial's Board of Directors approved a resolution affirming STFC's intent to
exercise this option and commenced the steps necessary to effect the transfer of
ownership of Milbank from Mutual to State Auto Financial. Following the closing
of State Auto Financial's acquisition of Milbank, which the parties anticipate
occurring effective July 1, 1998, Milbank will become a wholly-owned subsidiary
of State Auto Financial.
In March 1997, Mutual acquired 100% of the outstanding shares of
Midwest Security Insurance Company ("Midwest Security"), a Wisconsin domiciled
personal lines property and casualty insurer. Pursuant to the terms of the stock
purchase agreement, the transaction was effective as of January 1, 1997. In
connection with this transaction, Mutual and State Auto Financial entered into
an Option Agreement whereby, subject to the approval of the Office of the
Insurance Commissioner of the State of Wisconsin, State Auto Financial may
purchase Midwest Security at any time over the option term of five years at a
price calculated pursuant to a formula set forth in the Option Agreement. With
the acquisition of Midwest Security, the State Auto Group entered its 24th
state.
Since January 1, 1987, State Auto P&C has participated in an
underwriting pooling arrangement with Mutual. Under this arrangement, State Auto
P&C cedes to Mutual all of its property and casualty insurance business and
assumes from Mutual a portion of the combined property and casualty insurance
business of both State Auto P&C and Mutual. From January 1987 through December
1991, State Auto P&C assumed 20% of the combined business. Effective January 1,
1992, State Auto P&C's participation in the pool was increased to 30%. Effective
January 1, 1995, the pooling arrangement was amended to include all of the
property and casualty business of Milbank and the participation percentages were
changed to: Mutual 55%, State Auto P&C 35% and Milbank 10%. Effective July 1,
1996, the pooling arrangement was amended to exclude from the scope of such
arrangements catastrophe losses and premiums attributable thereto in excess of
$120,000,000 up to $220,000,000. See "Reinsurance." Subject to regulatory
approval of the domicilary insurance regulator of each of the pool participants,
pursuant to an Amended and Restated Reinsurance Pooling Agreement dated
effective as of January 1, 1998 Midwest Security has been added to the pooling
arrangement and concurrently the pooling percentages have been adjusted as
follows: Mutual 52%, State Auto P&C 37%, Milbank 10%, and Midwest Security 1%.
See "Pooling Arrangement."
Pursuant to an Amended and Restated Management Agreement and the
Midwest Management Agreement (defined below), State Auto P&C provides executive
management services for Mutual and its insurance subsidiaries. Mutual provides
non-executive employees and facilities for such entities. See "Management
Agreement."
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS.
The Company is of the opinion that all of its operations are within one
industry segment and that no information as to industry segments is required
pursuant to Statement of Financial Accounting Standards ("SFAS") No. 14 or
Regulation S-K. In June 1997, the Financial Accounting Standards Board issued
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information," which is effective for fiscal years beginning after December 15,
1997. SFAS No. 131 changes the way public companies report segment information
in annual financial statements and also requires those companies to report
selected segment information in interim financial reports to shareholders. The
Company has not yet determined the reporting changes required by SFAS No. 131.
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(c) SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM
ACT OF 1995.
Statements contained herein expressing the beliefs of management and
the other statements which are not historical facts contained in this report are
forward looking statements that involve risks and uncertainties. These risks and
uncertainties include but are not limited to: legislative, judicial, and
regulatory changes, the impact of competitive products and pricing, product
development, geographic spread of risk, weather and weather-related events,
other types of catastrophic events, fluctuations of securities markets, economic
conditions, and technological difficulties and advancements.
(d) NARRATIVE DESCRIPTION OF BUSINESS.
PROPERTY AND CASUALTY UNDERWRITING
The Company writes personal and commercial property and casualty
insurance lines, including automobile, homeowners, commercial multi-peril,
workers' compensation, liability, fire and other lines of business. Independent
insurance agencies constitute the Company's sales force.
The following table sets forth for each of the last three fiscal years
the amount of the Company's net premiums earned by line of insurance:
Net Premiums Earned (1)(2)
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Year Ended December 31
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1997 1996 1995
---- ---- ----
(in thousands)
Automobile.............................. $151,886 $141,486 $136,825
Homeowners and farmowners............... 40,689 40,184 40,043
Commercial multi-peril.................. 15,471 14,207 13,297
Workers' compensation................... 9,804 11,572 13,548
Fire and allied lines................... 16,756 15,341 14,200
Other commercial liability.............. 11,950 10,483 8,731
Other personal lines.................... 7,191 6,194 5,101
Other commercial lines.................. 935 878 779
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Total................................. $254,682 $240,345 $232,524
======== ======== ========
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(1) The Company earns premiums ratably over the life of an insurance
policy. Net premiums earned are the portion of net premiums written in
both the year in question and prior years, which are applicable to the
expired period of policies.
(2) This reflects net premiums earned by State Auto P&C, after giving
effect to reinsurance and to the pooling arrangement, plus the net
premiums earned by National, the only other insurance subsidiary of
State Auto Financial.
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As mentioned above, the insurance business of Mutual, State Auto P&C,
Milbank and as of January 1, 1998, (subject to regulatory approval) Midwest
Security is combined through the pooling arrangement giving each company an
identical mix of personal and commercial business as written by all three
insurers. The Pooled Companies products' sales are predominantly personal lines.
However, the Pooled Companies are putting greater emphasis on expanding
penetration into the commercial lines market. Commercial lines are being
introduced in Wisconsin in the second quarter of 1998, approximately one year
after closing on the purchase of Midwest Security.
The insurance business of National, with the exception of amounts
reinsured with Mutual, is not included in the pooling arrangement and,
therefore, remains 100% in the Company. See "Pooling
6
Arrangement." National's products are personal lines auto insurance products
written for non-standard risks, with less restrictive underwriting criteria and
higher rates than those applicable to standard risks.
The Company uses computer-based underwriting procedures for personal
lines business. Under such procedures, applications for such business may be
accepted or rejected based upon established underwriting guidelines.
Applications that do not meet guidelines for automated acceptance are referred
to personal lines specialists who review the applications and assess exposure.
During the underwriting process, risks are also reviewed to determine whether or
not they are acceptable as submitted by the independent agents as preferred,
standard or non-standard risks. Personal lines specialists continue to have
significant responsibility for encouraging the Company's agency force to sell
its personal lines products.
POOLING ARRANGEMENT
Since January 1987, State Auto P&C and Mutual have participated in an
intercompany pooling arrangement. Under the terms of the pooling arrangement,
State Auto P&C ceded all of its insurance business to Mutual. All of Mutual's
property and casualty insurance business was also included in the pooled
business. Mutual then ceded a percentage of the pooled business to State Auto
P&C and retained the balance. From January 1987 through December 31, 1991, State
Auto P&C assumed 20% of the pooled business. Effective January 1, 1992, State
Auto P&C increased its percentage of the pool to 30%. Effective January 1, 1995,
the pooling arrangement was amended to include all of the property and casualty
business of Milbank. Concurrently with the inclusion of Milbank, the
participation percentages were amended as follows: Mutual 55%, State Auto P&C
35% and Milbank 10%. Subject to regulatory approval, effective January 1, 1998,
Midwest Security has been added to the pooling arrangement pursuant to an
Amended and Restated Reinsurance Pooling Agreement dated January 1, 1998 (the
"98 Pooling Agreement") which agreement also amended the participation
percentages as follows: Mutual 52%, State auto P&C 37%, Milbank 10%, and Midwest
Security 1%.
The pooling percentages are reviewed by management at least annually,
and more often if deemed appropriate by management or the Board of Directors of
each company, to determine whether any adjustments should be made. Future
adjustments in the pooling percentages are expected to be based on the
performance of the insurance operations of Mutual, State Auto P&C, Milbank and
Midwest Security, the growth in direct premiums written of each company as it
relates to the pooling percentages, the combined ratio of the pooled business
and the net premiums written of the pooled business in relation to the statutory
capital and surplus of Mutual, State Auto P&C, Milbank, and Midwest Security
respectively, among other factors. Management of each of the Pooled Companies
makes recommendations to a four-member coordinating committee consisting of two
members of Mutual's Board of Directors and two members of State Auto Financial's
Board of Directors. The coordinating committee reviews and evaluates various
factors relevant to the pooling percentages and recommends any appropriate
pooling change to the Boards of both Mutual and State Auto Financial. See
"Management Agreement." The pooling arrangement is terminable by any party on 90
days notice or by mutual agreement of the parties. Neither Mutual, State Auto
P&C, Milbank, nor Midwest Security currently intends to terminate the pooling
arrangement.
The pooling arrangement is designed to produce more uniform and stable
underwriting results for State Auto P&C, Mutual, Milbank and Midwest Security
than any one company would experience individually, by spreading the risk among
each of the participants. Under the terms of the pooling arrangement, all
premiums, incurred losses, loss expenses and other underwriting expenses are
prorated among the companies on the basis of their participation in the pool.
One effect of the pooling arrangement is to give State Auto P&C, Mutual, Milbank
and Midwest Security an identical mix of property and casualty insurance
business on a net basis.
The terms of the pooling arrangement were amended in December 1993 to
clarify that certain liabilities created by FASB 106 (post-retirement health
care benefits liability) and FASB 112 (post employment benefits liability) which
did not exist when the pooling arrangement was initiated are to be carried by
Mutual and not pooled except for those liabilities associated with the transfer
of certain executives to State Auto P&C. See "Management Agreement."
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An Amended and Restated Reinsurance Pooling Agreement was executed to
be effective as of July 1, 1996 as a consequence of a reinsurance transaction
entered into by State Auto P&C. The sole substantive change effected by this
agreement was to exclude from the scope of the pooling arrangement catastrophic
loss claims and loss adjustment expenses insured by State Auto P&C, Mutual and
Milbank in the amount of $100,000,000 in excess of $120,000,000 but less than
$220,000,000 and the premium for such exposures. State Auto P&C has become the
reinsurer for each member of the State Auto Group of property casualty companies
(except Midwest Security) for this layer of reinsurance under a Catastrophe
Assumption Agreement. See "Reinsurance."
The following table sets forth the loss ratios by line of insurance and
the combined ratios for the Company, prepared in accordance with accounting
practices prescribed or permitted by state insurance authorities, for the
periods indicated. The loss ratio is the ratio of incurred losses and associated
expenses to net earned premiums ("loss ratio"). The combined ratio is a
traditional measure of underwriting profitability. The combined ratio is the sum
of (a) the loss ratio; and (b) the ratio of expenses incurred for commissions,
premium taxes, administrative and other underwriting expenses, to net written
premium ("expense ratio"). When the combined ratio is under 100%, underwriting
results are generally considered profitable. Conversely, when the combined ratio
is over 100%, underwriting results are generally considered unprofitable. The
combined ratio does not reflect investment income or federal income taxes. The
Company's operating income depends on income from underwriting operations,
investments and management fees.
Year Ended December 31(1)
-------------------------
1997 1996 1995
---- ---- ----
Loss ratios:
Automobile................................. 65.5% 69.5% 74.1%
Homeowners and Farmowners.................. 71.0% 101.7% 73.1%
Commercial multi-peril..................... 72.5% 70.1% 66.6%
Workers' compensation...................... 64.3% 46.8% 38.6%
Fire and allied lines...................... 58.6% 76.4% 49.4%
Other commercial liability................. 64.9% 56.5% 69.7%
Other personal lines....................... 34.2% 34.9% 32.5%
Other commercial lines..................... 17.0% 11.0% 13.0%
----- ------ -----
Total loss ratio................................ 65.2% 72.6% 68.6%
Expense ratio................................... 27.9% 26.4% 30.1%
===== ====== =====
Combined ratio.................................. 93.1% 99.0% 98.7%
===== ====== =====
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(1) This reflects a combination of the loss ratios of State Auto P&C and
National, after giving effect to reinsurance and the pooling
arrangement as amended effective July 1, 1996.
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NON-STANDARD AUTOMOBILE INSURANCE
In October 1991, State Auto Financial formed National, to write
personal automobile insurance for nonstandard risks. National began writing
insurance in Ohio in February 1992. It began writing in West Virginia in October
1993, Tennessee and Mississippi during August 1994 and Kentucky during March
1995. It entered Arkansas and Georgia in December 1996, Minnesota in February
1997. Later in 1997, it began to do business in Alabama, Illinois and Missouri.
Currently licensed in seven (7) additional states and seeking certificates of
authority in at least three more, National presently anticipates beginning
operations in at least five (5) of these states during 1998. Nonstandard
automobile products provide insurance for private passenger automobile risks
that are typically rejected or canceled by standard market companies because
insureds have poor loss experience or a history of late payments of premium.
Nonstandard products are priced to account for the additional risk and expenses
normally associated with this market.
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MARKETING
The Company entered Wisconsin in 1997, its 24th state of operations. In
its twenty-four states, it markets its products through approximately 11,300
insurance agents associated with approximately 2,000 independent insurance
agencies. Neither the Company, Mutual, Milbank, nor Midwest Security has any
contracts with managing general agencies. National is also marketing its
non-standard products through the Company's existing network of independent
agents in its states of operation.
Because independent insurance agents have significant influence over
which insurance company will be selected to write insurance policies for their
customers, management views the State Auto Group's independent insurance agents
as the primary customers of the Company. Management strongly supports the
independent agency system and believes that maintenance of a strong agency
system is essential for the Company's present and future success. Programs and
procedures have been implemented and are continually being developed to enhance
agency relationships. Senior management and branch office staff regularly travel
to states in which the Company does business to meet with agents. The Company
has instituted training programs which involve both products training and sales
training on how to market insurance products with disciplined follow up and
coaching. The Company is actively involved in promoting single entry
multi-company electronic interface which creates efficiencies for both agencies
and the Company. The use of electronic interface is growing among the Company's
agencies. Several software tools to facilitate this process are available,
including software called Semci Partner(R) developed and marketed by SIS. The
Company and Mutual are actively encouraging their agencies to utilize Semci
Partner(R). Also, the Company provides agents with certain travel and cash
incentives if they achieve certain sales and underwriting profit levels. As a
further incentive, the Company recognizes its very top agencies as Inner Circle
Agents and distinguishes them with various additional trip and financial
incentives including bonus commissions for those Inner Circle Agents who
participate in the agent stock purchase plan described below. Finally, the
Company shares with selected agencies the cost of certain approved advertising.
In an effort to strengthen agency commitment to producing profitable
business and further develop its relationships with its agency force, the
Company has a plan whereby agents can apply a portion of their commission income
towards purchasing stock of the Company on a monthly basis. The plan is
administered by the Company's transfer agent which uses commission dollars
assigned by agents to purchase shares through a broker on a monthly basis. As of
year end 1997, there were 384 agents participating in this agent stock purchase
plan.
Under the Company's agency agreements with independent insurance
agents, each agent is authorized to sell and bind insurance coverages in
accordance with established procedures and to collect and remit premiums. The
authority of agents to bind an insurance company is common practice in the
property and casualty insurance industry. The risk to the Company is minimized
because it has the right to terminate coverage on a risk or policy bound by the
agent. In addition, the Company does not grant binding authority to agents on
risks it considers to present a greater than normal exposure to loss. Each agent
receives a percentage of direct premiums written as a commission and a share of
the underwriting profits generated by insurance placed by them as bonus
compensation subject to certain qualifying conditions as set forth in the agency
agreement.
The Company receives premiums on products marketed in Alabama,
Arkansas, Florida, Georgia, Illinois, Indiana, Kentucky, Maryland, Michigan,
Minnesota, Mississippi, Missouri, North Carolina, North Dakota, Ohio, Oklahoma,
Pennsylvania, South Carolina, South Dakota, Tennessee, Utah, Virginia, West
Virginia and Wisconsin. For the year ended December 31, 1997, the seven states
that contributed the greatest percentage of direct premiums written to the State
Auto Group were Ohio (21.3%), Kentucky (10.4%), Tennessee (8.8%), South Carolina
(5.4%), North Carolina (5.2%), Maryland (5.2%), and Minnesota (4.7%).
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CLAIMS
Insurance claims on policies written by the Company are usually
investigated and settled by staff claims adjusters. The Company's claims policy
emphasizes timely investigation of claims, settlement of meritorious claims for
equitable amounts, maintenance of adequate reserves for claims, and control of
external claims adjustment expenses. This claims policy is designed to support
the Company's marketing efforts by providing agents and policyholders with
prompt service.
Claim settlement authority levels are established for each adjuster,
supervisor and manager based on his or her level of expertise and experience.
Upon receipt, each claim is reviewed and assigned to an adjuster based upon its
type, severity and class of insurance. The claims department is responsible for
reviewing the claim, obtaining necessary documentation and establishing loss and
expense reserves of certain claims. Any property or casualty claims estimated to
reach $100,000 or above are sent to the home office to be supervised by claims
department specialists. In territories in which there is not sufficient volume
to justify having full-time adjusters, the Company uses independent appraisers
and adjusters to evaluate and settle claims under the supervision of claims
department personnel.
The Company attempts to minimize claims costs by using its internal
claims staff to settle as many claims as possible, and, if possible, by settling
disputes regarding automobile physical damage and property insurance claims
(first party claims) through arbitration. In addition, selected agents have
authority to settle small first party claims which improves claims service. The
Company's in-house trial counsel operation created in Cleveland, Ohio in 1993 to
represent insureds in third party claim litigation has achieved its objectives
of reducing the cost of defending claims. A third attorney was added to the
Cleveland Office in 1997 and a fourth is planned for 1998. Presently, the
Company also has a two lawyer in-house trial counsel's office in Baltimore,
Maryland. It has no immediate plans to add in-house trial counsel in any other
territories where it operates.
The third party proprietary software installed in 1996 to assist claims
adjusters in evaluating bodily injury claims, except for the most severe injury
cases, continues to be a valuable tool in assisting adjusters in negotiating
bodily injury settlements more effectively.
INVESTMENT MANAGEMENT SERVICES
Stateco has been providing investment management services since April
1, 1993. These services are provided to all insurance companies affiliated with
the Company or Mutual, including Mutual, Milbank, Midwest Security, State Auto
P&C and National. Stateco has entered into an Investment Management Agreement
with each of these entities, pursuant to which Stateco manages the investment
portfolios of these companies and receives an investment management fee based on
performance and the size of the portfolio managed for each affiliate. Stateco
has presented proposals to other potential clients although Stateco has not yet
reached an agreement to engage in investment management services on behalf of a
non-affiliated company.
INSURANCE PREMIUM FINANCE SERVICES
Through Stateco, the Company provides insurance premium finance
services to certain policyholders of Mutual, State Auto P&C and Milbank.
Premiums for property and casualty insurance are typically payable at the time a
policy is placed in force or renewed. On certain large commercial policies, the
premium cost may be difficult for a policyholder to pay in one sum. Stateco
makes loans to commercial insurance policyholders for the term of an insurance
policy to enable them to pay the insurance premium in installments over the term
of the policy, and retains a contractual right to cancel the insurance policy if
the loan installment is not paid on a timely basis. As of December 31, 1997,
Stateco had a net loan receivable balance from policyholders of these companies
of approximately $728,000.
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INSURANCE SOFTWARE BUSINESS
SIS is developing and selling software used by insurance companies and
agencies to allow more efficient and effective electronic management and
communication of policyholder data from insurers to agents (download) and from
agents to insurers (upload). SIS' principal product, Semci Partner(R), is an
alternative to significantly more costly agency management systems which SIS
believes will be attractive to a substantial segment of independent insurance
agencies. While SIS' principal customer is Mutual, it has sold and continues to
sell Semci Partner(R) directly to agents, including agents who do not
represent the State Auto Group. In addition, in 1997 it introduced a new product
called Partner Plus which includes insurance agency accounting software in
addition to the regular features of Semci Partner(R). SIS' revenue from Semci
Partner(R) and other SIS software sales is not material to the Company at
this time.
PROPERTY LEASING BUSINESS
As noted above, the Company formed 518 PML, an Ohio limited liability
company in December 1997. The initial members of 518 PML are Stateco and State
Auto P&C. Stateco contributed $7,000,000 in cash and a parcel of real property
located in Goodlettsville, Tennessee, while State Auto P&C contributed real
property located in Greer, South Carolina. 518 PML plans to develop an office
building on the real estate in Goodlettsville which it expects to lease to
Mutual for Mutual's Nashville Regional Office facility commencing in the summer
of 1999. 518 PML has leased the Greer property to Mutual to use as its Southern
Regional Office facility. Revenue from 518 PML is not material to the Company at
this time.
MANAGEMENT AGREEMENT
The Company operates and manages its business in conjunction with
Mutual and Milbank under a management agreement which was restructured pursuant
to an Amended and Restated Management Agreement effective April 1, 1994. Under
this agreement, State Auto P&C provides executive management services for
Mutual, Milbank, and National, overseeing the insurance operations of all these
companies all of which are parties to the agreement. State Auto P&C does not
provide investment management services, because these services are provided by
Stateco. See "Investment Management Services." A management fee is paid by
Mutual, Milbank, and National for the services provided by State Auto P&C equal
to 2% of the five year average of annual statutory statement "surplus as regards
policyholders", less valuations for managed subsidiaries, of each managed
company. (State Auto Life Insurance Company ("State Auto Life") paid such a
management fee; however, Mutual sold State Auto Life in July 1997). The Amended
and Restated Management Agreement also imposes a performance standard which
could result in State Auto P&C not being entitled to the fee for a particular
quarter if a managed company's performance does not meet the standard
incorporated in the agreement. Management believes that the amount of the
management fee charged is fair and reasonable. In 1997, the managed companies
paid a management fee of $5,416,000 to State Auto P&C.
In addition to the above-described Amended and Restated Management
Agreement, the Company and Mutual entered into a Management Agreement with
Midwest Security effective as of January 1, 1997 (the "Midwest Management
Agreement"). Mutual is providing clerical and non-executive employees to Midwest
Security. The Company provides executive management services to Midwest Security
in return for a management fee. Under this agreement, the Company's management
fee is based on direct written premium of Midwest Security. The fee set for 1997
was 0.75% of direct written premium of Midwest Security and it includes a
performance standard, as well. In 1997, Midwest Security paid a management fee
of $162,000 to State Auto P&C.
Under the Amended and Restated Management Agreement, Mutual provides
the Company with the facilities, clerical personnel and other non-executive
employees necessary to run its day-to-day operations. All costs incurred by
Mutual with respect to underwriting expenses and loss expenses incurred on
behalf of Mutual, State Auto P&C, Milbank, and from January 1998 forward,
Midwest Security, continue to be shared pro rata between Mutual, State Auto P&C,
Milbank, and Midwest Security through the pooling arrangement. "See Pooling
Arrangement." For companies not participating in the pooling arrangement, like
National, expenses directly attributable to a particular company continue to be
charged
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to that company and expenses of personnel who are not dedicated entirely to work
for a particular company are allocated among the companies based on an estimate
of time devoted by such personnel to each company for which services are
rendered. Mutual also charges rent, which is determined under statutory
accounting principles, to each company which has dedicated space within Mutual's
facilities (currently National and Stateco).
The Amended and Restated Management Agreement and the Midwest
Management Agreement set forth procedures for potential conflicts of interest.
Generally, business opportunities presented to the common officers of the
companies, other than business opportunities that meet certain criteria, must be
presented to a four-member coordinating committee consisting of two directors of
Mutual, who represent the interests of Mutual and its subsidiaries, and two
directors of the Company, who represent the interests of the Company and its
subsidiaries. This committee reviews and evaluates the business opportunity
using such factors as it considers relevant. Based upon such review and
evaluation, this committee then makes recommendations to the respective boards
of directors as to whether or not such business opportunity should be pursued
and if so, by which company. The boards of directors of Mutual and of the
Company and, when appropriate, a subsidiary, must then act on the recommendation
of the committee after considering all other factors they deem relevant.
The Amended and Restated Management Agreement has a ten year term
ending March 31, 2004, and automatically renews for an additional ten year term
unless any of the managed companies terminates its participation, or the
manager, State Auto P&C, terminates the agreement upon not less than two years
advance written notice of nonrenewal. The Midwest Management Agreement also has
a ten year term ending December 31, 2006 and automatically renews for an
additional ten year term unless sooner terminated in accordance with its
provisions. The Amended and Restated Management Agreement may also be terminated
by any of the managed companies upon events constituting a change of control or
potential change of control (as defined in the Amended and Restated Management
Agreement) of the Company, upon agreement between a managed company and State
Auto P&C and, the agreement is terminated automatically with respect to a party
if it is subject to insolvency proceedings. Milbank may terminate its
participation in the Amended and Restated Management Agreement upon 120 days
notice. If the Amended and Restated Management Agreement is terminated for any
reason, the Company would have to locate facilities, personnel and management to
continue its operations.
RESERVES
Loss reserves are estimates at a given point in time of what an insurer
expects to pay to claimants, based on facts, circumstances and historical trends
then known. It can be expected that the ultimate liability will exceed or be
less than such estimates. During the loss settlement period, additional facts
regarding individual claims may become known, and consequently it often becomes
necessary to refine and adjust the estimates of liability.
The Company maintains reserves for the eventual payment of losses and
loss expenses for both reported claims and incurred claims that have not yet
been reported. Loss expense reserves are intended to cover the ultimate costs of
settling all losses, including investigation and litigation costs from such
losses.
Reserves for reported losses are established on either a case-by-case
or formula basis depending on the type and circumstances of the loss. The
case-by-case reserve amounts are determined based on the Company's reserving
practices, which take into account the type of risk, the circumstances
surrounding each claim and policy provisions relating to types of loss. The
formula reserves are based on historical paid loss data for similar claims with
provisions for trend changes caused by inflation. Loss and loss expense reserves
for incurred claims that have not yet been reported are estimated based on many
variables including historical and statistical information, inflation, legal
developments, storm loss estimates, and economic conditions. Loss reserves are
reviewed on a regular basis and as new data becomes available, estimates are
updated resulting in adjustments to loss reserves. Although management uses many
resources to calculate reserves, there is no precise method for determining the
ultimate liability. The Company does not discount loss reserves for financial
statement purposes.
12
Mutual has guaranteed the adequacy of State Auto P&C's loss and loss
expense reserves as of December 31, 1990. Pursuant to the guarantee, Mutual has
agreed to reimburse State Auto P&C for any losses and loss expenses in excess of
State Auto P&C's December 31, 1990 reserves ($65,464,000) that may develop from
claims that have occurred on or prior to that date. This guarantee ensures that
any deficiency in the reserves of State Auto P&C as of December 31, 1990, under
the pooling arrangement percentages effective on December 31, 1990, will be
reimbursed by Mutual. As of December 31, 1997, there has been no adverse
development of these reserves. In the event Mutual becomes financially impaired,
and subject to regulatory restrictions, it may be unable to make any such
reimbursement.
The following table presents one year development information on
changes in the reserve for loss and loss expenses of the Company for the three
years ended December 31, 1997:
Year Ended December 31
-------------------------------------------------
1997 1996 1995
---- ---- ----
(in thousands)
Reserve for losses and loss expenses
at beginning of year(1) $156,184 $161,297 $126,742
-------- -------- --------
Provision for losses and loss
expenses occurring:
Current year 179,295 194,568 171,449
Prior years(2) (13,505) (21,028) (12,536)
-------- -------- --------
Total 165,790 173,540 158,913
-------- -------- --------
Loss and loss expense payments
for claims occurring during:
Current year 107,537 116,983 95,011
Prior years 61,862 61,670 62,248
-------- -------- --------
Total 169,399 178,653 157,259
-------- -------- --------
Impact of pooling change 1/1/95 -- -- 32,901
-------- -------- --------
Reserve for losses and loss expenses
at end of year (1) $152,575 $156,184 $161,297
======== ======== ========
- ---------------
(1) This line item is net of reinsurance receivable on losses and loss
expenses payable of approximately $9,871,000, $9,691,000, and
$9,278,000, for the years 1997, 1996 and 1995, respectively.
(2) This line item shows redundancies in the provision for losses and loss
expenses attributable to prior years in the amounts of approximately
$13,505,000, $21,028,000, and $12,536,000, for the years 1997, 1996 and
1995, respectively. These decreases have resulted primarily from
moderating trends in the frequency and severity of losses and loss
expenses due to lower inflation. This along with fundamental
improvements primarily in the auto liability line of business resulted
in incurred losses and loss expenses developing favorably.
- ----------------
The following table sets forth the development of reserves for losses
and loss expenses from 1987 through 1997 for the Company. "Net liability for
losses and loss expenses payable" sets forth the estimated liability for unpaid
losses and loss expenses recorded at the balance sheet date, net of reinsurance
recoverables, for each of the indicated years. This liability represents the
estimated amount of losses and loss expenses for claims arising in the current
and all prior years that are unpaid at the balance sheet date, including losses
incurred but not reported to the Company.
The lower portion of the table shows the re-estimated amounts of the
previously reported reserve based on experience as of the end of each succeeding
year. The estimate is increased or decreased as more information becomes known
about the claims incurred.
13
The upper section of the table shows the cumulative amounts paid with
respect to the previously reported reserve as of the end of each succeeding
year. For example, through December 31, 1997, the Company had paid 86.5% of the
currently estimated losses and loss expenses that had been incurred, but not
paid, as of December 31, 1988.
The amounts on the "cumulative redundancy (deficiency)" line represent
the aggregate change in the estimates over all prior years. For example, the
1987 reserve has developed a $2,381,000 redundancy over ten years. That amount
has been included in operations over the ten years and did not have a
significant effect on income of any one year. The effects on income caused by
changes in estimates of the reserves for losses and loss expenses for the most
recent three years are shown in the foregoing three-year loss development table.
In evaluating the information in the table, it should be noted that
each amount includes the effects of all changes in amounts for prior periods.
For example, the amount of the redundancy related to losses settled in 1990, but
incurred in 1987, will be included in the cumulative redundancy amount for years
1987, 1988 and 1989. The table does not present accident or policy year
development data, which readers may be more accustomed to analyzing. Conditions
and trends that have affected the development of the liability in the past may
not necessarily occur in the future. Accordingly, it may not be appropriate to
extrapolate future redundancies or deficiencies based on this table.
Participation in the pooling arrangement is reflected beginning in
1987. On January 1, 1987, as a result of the reinsurance pooling arrangement
commencing on that date, State Auto P&C's obligation for unpaid losses and loss
expenses was redefined from its former obligation to 20% of the obligations of
State Auto P&C and Mutual combined. The result of initial pooling increased
State Auto P&C's liability for losses and loss expenses. This is reflected in
the first line of the 1987 column. Effective, January 1, 1992, the pooling
percentage was changed whereby State Auto P&C increased its share in the pooled
losses and loss expenses from 20% to 30%. This increase is reflected in the 1992
column. Effective January 1, 1995, the pooling percentage was again changed
adding Milbank to the pool and increasing State Auto P&C's share in the pooled
losses and loss expenses from 30% to 35%. This increase is reflected in the 1995
column. An amount of assets equal to the increase in net liabilities was
transferred to State Auto P&C from Mutual in 1987, 1992 and 1995 in conjunction
with each year's respective pooling change. The amount of the assets transferred
from Mutual in 1992 and 1995 has been netted against and has reduced the
cumulative amounts paid for years prior to 1992 for the January 1, 1992 pooling
change and for years prior to 1995 for the January 1, 1995 pooling change.
[See table on following page.]
14
State Auto Financial Corp.
Years Ended December 31
-------------------------------------------------------------------------------------------------
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
(Dollars in Thousands)
Net liability for losses
and loss expenses payable $45,771 $51,142 $58,203 $65,464 $71,139 $119,044 $123,337 $126,743 $161,298 $156,184 $152,575
Paid (cumulative)
as of:
One year later 47.8% 47.7% 48.1% 43.3% 12.2% 41.3% 42.2% 23.2% 38.2% 39.6% --
Two years later 68.6% 65.7% 68.8% 46.1% 43.0% 60.9% 52.9% 44.6% 55.5%
Three years later 78.1% 76.0% 70.9% 62.9% 58.7% 67.3% 64.0% 56.6%
Four years later 82.6% 76.1% 79.9% 71.8% 64.4% 73.0% 70.9%
Five years later 81.7% 80.8% 84.4% 75.7% 68.7% 76.0%
Six years later 84.3% 83.0% 85.9% 78.3% 71.5%
Seven years later 85.8% 83.8% 88.0% 80.0%
Eight years later 86.4% 85.4% 89.3%
Nine years later 87.6% 86.5%
Ten years later 88.7%
Net liability re-estimate
as of:
One year later 94.1% 93.7% 98.0% 95.4% 91.2% 92.7% 93.7% 90.1% 87.0% 91.4% --
Two years later 93.2% 91.6% 97.4% 92.1% 87.2% 90.5% 90.8% 82.1% 86.4%
Three years later 92.2% 91.3% 95.9% 89.7% 85.4% 88.2% 86.9% 82.0%
Four years later 92.1% 90.4% 95.4% 88.1% 84.7% 86.6% 87.9%
Five years later 91.2% 90.6% 95.0% 89.3% 83.0% 88.0%
Six years later 91.6% 89.9% 95.9% 88.3% 86.4%
Seven years later 90.8% 91.5% 95.4% 92.1%
Eight years later 93.2% 91.3% 99.0%
Nine years later 93.1% 94.1%
Ten years later 94.8%
Cumulative redundancy
(deficiency) $2,381 $3,006 $590 $5,185 $9,651 $14,256 $14,905 $22,826 $21,900 $13,505 --
Cumulative redundancy
(deficiency) 5.2% 5.9% 1.0% 7.9% 13.6% 12.0% 12.1% 18.0% 13.6% 8.6% --
Gross* liability - end of year $165,875 $162,446
Reinsurance receivable $9,691 $9,871
Net liability - end of year $156,184 $152,575
Gross liability re-estimated - latest 92.8%
Reinsurance receivable re-estimated -latest 116.4%
Net liability re-estimated - latest 91.4%
* Gross liability includes: Direct & assumed losses & loss expenses payable.
15
The following table is a reconciliation as of each December 31 of
losses and loss expenses payable, computed under generally accepted accounting
principles ("GAAP"), to losses and loss expenses payable, computed under
statutory accounting principles used by insurance companies for reporting to
state insurance regulators ("STAT"):
1997 1996 1995
---- ---- ----
(in thousands)
GAAP losses and loss
expenses payable $162,446 $165,875 $170,575
Less: reinsurance receivable
on losses 9,871 9,691 9,278
Add: salvage and subrogation
recoverable 8,487 8,265 7,378
-------- -------- --------
STAT losses and loss
expenses payable $161,062 $164,449 $168,675
======== ======== ========
INVESTMENTS
The Company's investment portfolio is managed to provide growth of
statutory surplus in order to facilitate increased premium writings over the
long term while maintaining the ability to service current insurance operations.
The primary objectives are to generate income, preserve capital and maintain
liquidity. The Company's investment portfolio is managed separately from that of
Mutual and its affiliates and investment results are not shared by Mutual, State
Auto P&C, Milbank, and Midwest Security through the pooling arrangement. The
Company has investment policy guidelines with respect to purchasing fixed income
investments which preclude investments in bonds that are rated below investment
grade by a recognized rating service. The maximum investment in any single note
or bond is limited to 2.0% of assets, other than obligations of the U.S.
government or government agencies, for which there is no limit. The Company's
decision to make a specific investment is influenced primarily by the following
factors: (a) investment risks; (b) general market conditions; (c) relative
valuations of investment vehicles; (d) general market interest rates; (e) the
Company's liquidity requirements at any given time; and (f) the Company's
current federal income tax position and relative spread between after tax yields
on tax-exempt and taxable fixed income investments. The investment management
services on behalf of the Company and Mutual and its subsidiaries are performed
by Stateco, although investment policies to be implemented by Stateco continue
to be set for each company through the Investment Committee of its Board of
Directors. See "Investment Management Services."
Strategies as to specific investments can change depending on the
Company's current federal tax position, market interest rates and general market
conditions. Consequently, pursuant to the Statement of Financial Accounting
Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," adopted effective December 31, 1993, the Company segregates a
portion of its fixed maturity investments for the purpose of providing greater
flexibility in the investment portfolio. Fixed maturities that are purchased
with the intention and ability of holding them until maturity are categorized as
held-to-maturity and carried at amortized cost. Fixed maturities that may be
sold, thereby providing the Company the flexibity noted above, are categorized
as available-for-sale and are carried at fair value. Fixed maturities
available-for-sale totaled $320.3 million and $294.1 million at December 31,
1997 and 1996, respectively.
During 1997, the Company began a program to build an equity portfolio
to enhance growth of surplus over the long term. At December 31, 1997, the
equity portfolio totaled $4.6 million.
16
The table below provides information about the quality of the Company's fixed
maturity portfolio
Bond Portfolio Quality
Investment Grade Corporates 62.1%
and Municipals
U.S. Governments 24.3%
U.S. Government Agencies 13.6%
The following table sets forth the Company's investment results for the periods
indicated:
Year Ended December 31
---------------------------------------------------
1997 1996 1995
---- ---- ----
(Dollars in thousands)
Average invested assets (1) $399,628 $376,280 $348,515
Net investment income (2) $25,078 $23,879 $22,617
Average yield 6.24% 6.35% 6.49%
- --------------
(1) Average of the aggregate invested assets at the beginning and end of
each period. Invested assets include fixed maturities at amortized
cost, equity securities at cost and cash equivalents.
(2) Net investment income is net of investment expenses and does not
include realized or unrealized investment gains or losses or provision
for income taxes.
- --------------
REGULATION
The Company. Most states have enacted legislation that regulates
insurance holding company systems. Ohio, the domiciliary state of Mutual and
National, has adopted legislation regulating the activities of those companies.
South Carolina has adopted legislation regulating the activities of State Auto
P&C as the South Carolina domiciled member of the holding company system, as
have South Dakota and Wisconsin which are the domiciliary regulators of Milbank
and Midwest Security, respectively. Each insurance company in the holding
company system is required to register with the insurance supervisory agency of
its state of domicile and furnish information concerning the operations of
companies within the holding company system that may materially affect the
operations, management or financial condition of the insurers within the system.
Pursuant to these laws, the respective insurance departments may examine Mutual,
State Auto P&C, National, Milbank and Midwest Security at any time, require
disclosure of material transactions involving insurer members of the holding
company system and require prior notice and an opportunity to disapprove of
certain "extraordinary" transactions, including, but not limited to,
extraordinary dividends from State Auto P&C and National to State Auto
Financial. Pursuant to these laws, all transactions within the holding company
system affecting Mutual, State Auto P&C, National, Milbank and Midwest Security
must be fair and equitable. In addition, approval of the applicable Insurance
Commissioner is required prior to the consummation of transactions affecting the
control of an insurer.
South Carolina insurance law provides that no person may acquire direct
or indirect control of State Auto P&C unless it has obtained the prior written
approval of the Chief Insurance Commissioner of South Carolina for such
acquisition. Any purchaser of 10% or more of the outstanding Common Shares would
be presumed to have acquired control of State Auto P&C, unless such presumption
is rebutted. Ohio law has similar provisions in place which would be applicable
to National, as does South Dakota for Milbank and Wisconsin for Midwest
Security.
17
In addition to being regulated by the insurance department of its state
of domicile, each insurance company is subject to supervision and regulation in
the states in which it transacts business, and such supervision and regulation
relate to numerous aspects of an insurance company's business and financial
condition. The primary purpose of such supervision and regulation is to ensure
financial stability of insurance companies for the protection of policyholders.
The laws of the various states establish insurance departments with broad
regulatory powers relative to granting and revoking licenses to transact
business, regulating trade practices, licensing agents, approving policy forms,
setting reserve requirements, determining the form and content of required
statutory financial statements, prescribing the types and amount of investments
permitted and requiring minimum levels of statutory capital and surplus.
Although premium rate regulation varies among states and lines of insurance,
such regulations generally require approval of the regulatory authority prior to
any changes in rates. In addition, all of the states in which State Auto P&C,
Mutual, National, Milbank and Midwest Security transact business have enacted
laws which restrict their underwriting discretion. Examples of these laws
include restrictions on policy terminations, restrictions on agency terminations
and laws requiring companies to accept any applicant for automobile insurance.
These laws adversely affect the ability of the foregoing companies to earn a
profit on their underwriting operations.
Insurance companies are required to file detailed annual reports with
the supervisory agencies in each of the states in which they do business, and
their business and accounts are subject to examination by such agencies at any
time.
There can be no assurance that such regulatory requirements will not
become more stringent in the future and have an adverse effect on the operations
of National or the insurers participating in the pooling arrangement.
Dividends. State Auto P&C and National are subject to regulations and
restrictions under which payment of non-extraordinary dividends from statutory
surplus can be made to State Auto Financial during the year without prior
approval of regulatory authorities.
The National Association of Insurance Commissioners, an association of
the chief insurance regulators from the fifty states, the District of Columbia
and U.S. Territories ("NAIC"), has created a certification process for state
insurance departments in an effort to bolster state regulation of insurers'
solvency. One element of the certification process includes a requirement that a
state has in place a variety of "model" laws and regulations which, in the
NAIC's view, enhance the ability of the state regulators to effectively regulate
insurance company solvency. Both the South Carolina Insurance Department and the
Ohio Insurance Department, the domiciliary regulator for State Auto P&C and
National respectively, have been certified by the NAIC.
Insurers are permitted to pay dividends without prior approval from the
domiciliary insurance department unless the dividend is an "extraordinary
dividend." In South Carolina, an extraordinary dividend is one which, when
considered with all other dividends paid in the last 12 months, is an amount
more than the greater of 10% of the insurer's statutory surplus as regards
policyholders as of the preceding December 31, or the statutory net income not
including net realized capital gains or losses for the previous year ended
December 31. In Ohio, the definition is substantially the same as in South
Carolina except that net income does not exclude net realized capital gains and
losses. Both South Carolina and Ohio require notice of all dividends within five
business days after declaration and at least ten days prior to payment. In
addition, the law in both Ohio and South Carolina gives the Commissioner the
authority to limit a non-extraordinary dividend when the Commissioner
determines, based on factors set forth in the law, that an insurer's surplus as
regards policyholders is not reasonable in relation to the insurer's outstanding
liabilities and adequate to its financial needs, provided the Commissioner acts
within the ten calendar days prior to payment. Pursuant to these rules, $28.9
million is available for payment to State Auto Financial as a dividend from
State Auto P&C and National during 1998 without prior approval under current
law.
Rate and Related Regulation. The Company is not aware of any adverse
legislation or regulation that has been adopted by any state where the Company
did business during 1997 which would present
18
material obstacles to the Company's overall business. On the federal level,
however, there remains the possibility that the Department of Housing and Urban
Development ("HUD") will seek to regulate homeowner underwriting practices under
the authority of the Fair Housing Act. Court decisions in the federal courts
have generally upheld HUD's right to regulate homeowner insurance underwriting
practices. If HUD regulations are promulgated, and these include a disparate
impact standard for the determination of illegal discrimination, such
regulations could present a significant underwriting challenge to the Company.
In an attempt to make capital and surplus requirements more accurately
reflect the underwriting risk of different lines of insurance as well as
investment risks that attend insurers operations, the NAIC created what it calls
risk-based capital requirements. The NAIC imposed on property and casualty
insurers a risk-based capital requirement to be applicable as of year end 1994.
Each insurer affiliated with the Company exceeded all standards tested by the
formula applying risk-based capital requirements as of year-end 1997.
The property and casualty insurance industry is also affected by court
decisions. Premium rates are actuarially determined to enable an insurance
company to generate an underwriting profit. These rates contemplate a certain
level of risk. The courts may modify the level of risk which insurers had
expected to assume in a number of ways, including eliminating exclusions,
multiplying limits of coverage, creating rights for policyholders not intended
to be included in the contract and interpreting applicable statutes expansively
to create obligations on insurers not originally considered when the statute was
passed. Courts have also undone legal reforms passed by legislatures, which
reforms were intended to reduce a litigant's rights of action or amounts
recoverable and so reduce the costs borne by insurance mechanism. These court
decisions can adversely affect an insurer's profitability. They also create
pressure on rates charged for coverages adversely affected and this can cause a
legislative response resulting in rate suppression that can adversely affect an
insurer.
One state with a particularly adverse judicial climate is West
Virginia. For example, this state is one of two in the United States in which
the courts have permitted third party claimants to bring bad faith actions
against the insurers of the tort feasors, based on violations of the state's
Unfair Claim Practice law. This state of the law makes claims handling more
problematic in West Virginia than other jurisdictions in which the State Auto
Group operates.
REINSURANCE
The Company, Mutual, Milbank and Midwest Security follow the customary
industry practice of reinsuring a portion of their exposures and paying to the
reinsurers a portion of the premiums received on all policies. Insurance is
ceded principally to reduce net liability on individual risks or for individual
loss occurrences, including catastrophic losses. Effective January 1, 1998,
reinsurance premiums and reimbursements are allocated between State Auto P&C,
Milbank, Mutual, and Midwest Security according to their relative pooling
percentages. National does not directly participate in the pooling arrangement.
Although reinsurance does not legally discharge State Auto P&C, Mutual,
National, Milbank, or Midwest Security from primary liability for the full
amount of their policies, it does make the assuming reinsurer liable to the
extent of the reinsurance ceded.
Each member of the State Auto Group has separate working reinsurance
treaties for property and casualty lines with several reinsurers arranged
through a reinsurance broker. Under the property excess of loss treaty, each
member of the State Auto Group is responsible for the first $2,000,000 of each
defined loss and the reinsurers are responsible for 100% of the excess over
$2,000,000 up to $10,000,000 of such defined loss, depending upon the nature of
the injury or damage. The rates for this reinsurance are negotiated annually.
The terms of the casualty excess of loss program provide that each
company in the State Auto Group is responsible for the first $2,000,000 of a
covered loss. The reinsurers are responsible for 100% of the loss excess of
$2,000,000 and up to $5,000,000. Also, certain unusual claim situations
involving bodily injury liability, property damage liability, uninsured
motorist, personal injury protection and workers' compensation insurance are
covered by an arrangement which provides for $10,000,000 of coverage
19
above a $5,000,000 retention for each loss occurrence. This layer of reinsurance
sits above the $3,000,000 excess of $2,000,000 arrangement.
In addition, the State Auto Group has secured other reinsurance to
limit the net cost of large loss events for certain types of coverages. Included
are umbrella liability losses which are reinsured up to a limit of $15,000,000
above a maximum $500,000 retention. The companies also make use of the
facultative market for unique risk situations and participate in involuntary
pools and associations in certain states.
Catastrophe reinsurance has been arranged for property business,
including automobile physical damage. Effective July 1, 1997, the Company and
Mutual renewed both the traditional and structured financing pieces of their
reinsurance program, originally placed in July 1996, exactly duplicating last
year's program. State Auto P&C, Mutual, Milbank, and National retain the first
$40 million of each occurrence. Eighty million of traditional reinsurance is
available above the $40 million retention with a co-participation of 5%. In the
event the State Auto Group incurs catastrophe losses in excess of $120.0
million, State Auto Financial has continued its structured contingent financing
transaction with Chase Manhattan Bank ("Chase") to provide up to $100.0 million
to be used to cover such catastrophe losses. Under this arrangement, in the
event of such a loss, State Auto Financial would issue and sell redeemable
preferred shares to SAF Funding Corporation, a special purpose company ("SPC"),
which will borrow the money necessary for such purchase from Chase and a
syndicate of other lenders (the "Lenders"). State Auto Financial will contribute
to State Auto P&C the proceeds from the sale of its preferred shares. State Auto
P&C has assumed catastrophe reinsurance from Mutual, Milbank and National
pursuant to a Catastrophe Assumption Agreement in the amount of $100.0 million
excess of $120.0 million. State Auto P&C will use the contributed capital to pay
its direct catastrophe losses and losses assumed under the Catastrophe
Assumption Agreement. State Auto Financial is obligated to repay SPC (which will
repay the lenders) by redeeming the preferred shares over a six year period.
This layer of $100.0 million in excess of $120.0 million has been excluded from
the pooling arrangement as well by virtue of an Amended and Restated Reinsurance
Pooling Agreement. See "Pooling Arrangement." In addition, State Auto
Financial's obligation to repay SPC has been secured by a Put Agreement among
State Auto Financial, Mutual and the Lenders, under which, in the event of a
default by State Auto Financial as described in the Credit Agreement or in the
Put Agreement, Mutual would be obligated to put either the preferred shares or
the loan(s) outstanding.
National has entered into a reinsurance agreement with Mutual. Pursuant
to the agreement, on an excess of loss basis, Mutual assumes all liability
losses in excess of National's $50,000 retention; on a quota share basis, Mutual
assumes 20% of all liability losses - and premiums - within National's $50,000
retention. The excess of loss coverage is intended to insulate National from
shock losses while the quota share arrangement is intended to slow the drain on
statutory surplus which can normally be expected with a rapid increase in
premium writings. The quota share portion of the agreement may be extended to
physical damage coverages in 1998.
Midwest Security has also entered into reinsurance agreements with
Mutual. Under an umbrella quota share agreement, Mutual reinsures on a per risk
basis, 100% of the first and second $1,000,000 in umbrella coverage written by
Midwest Security. Mutual also has a property catastrophe excess of loss
agreement with Midwest Security under which Mutual is liable for 100% of
$5,000,000 of losses excess a $100,000 retention in three different layers.
Mutual also has written a property casualty multiple line excess of loss
agreement with Midwest Security under which Midwest Security bears the first
$50,000 of each loss (except for $25,000 in case of private passenger auto
physical damage) with Mutual bearing the excess over the retention, subject to a
limit of $500,000 in casualty and $1,000,000 in property. Mutual also wrote for
Midwest Security a second casualty excess of loss agreement for $1.5 million in
excess of $500,000 for liability coverages referenced under the first multiple
line excess of loss agreement. Management believes the premiums charged to
Midwest Security for these reinsurance agreements are comparable to those that
would be charged by a third party reinsurer. The premiums and losses assumed
under these reinsurance agreements are pooled by Mutual pursuant to the pooling
arrangement. These agreements were in effect only until December 31, 1997
because Midwest Security is being included in the pooling arrangement effective
as of January 1, 1998.
20
YEAR 2000
See discussion included in Part II - Item 7 Management's Discussion and
Analysis of Financial Condition and Results of Operations.
COMPETITION
The property and casualty insurance industry is highly competitive.
Price competition has been particularly intense during recent years. This has
been particularly true in regards to commercial lines in 1997. The Company
competes with numerous insurance companies, many of which are substantially
larger and have considerably greater financial resources. In addition, because
the Company's products are marketed exclusively through independent insurance
agencies, most of which represent more than one company, the Company faces
competition within each agency. See "Marketing." 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.
EMPLOYEES
As of March 6, 1998, the Company had 45 employees. See "Management
Agreement." All of the other personnel providing services to State Auto
Financial and its subsidiaries are employed by Mutual and made available under
the terms of the Amended and Restated Management Agreement. See "Management
Agreement." At December 31, 1997, Mutual had approximately 1,300 full-time
employees. Employees of the Company and of Mutual are not covered by any
collective bargaining agreement. Management of Mutual and of the Company
consider their relationship with the employees to be excellent.
EXECUTIVE OFFICERS OF THE REGISTRANT
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company (1)(2) Age During the Past Five Years of the Company Since
- ------------------------------- --- -------------------------- --------------------
Robert L. Bailey, 64 Chairman of the Board of STFC 3/93 to 1991
Chairman of the Board, present; Chief Executive Officer of
and Chief Executive Officer STFC 5/91 to present; President of
STFC, 5/91 to 5/96; Chairman of the
Board of Mutual 3/93 to present; Chief
Executive Officer of Mutual, 5/89 to
present; President of Mutual, 1983 to
5/96;
Robert H. Moone, 54 President and Chief Operating Officer 1991
President and of STFC, 5/96 to present; Executive
Chief Operating Officer Vice President, 11/93 to 5/96 and prior
thereto Vice President of STFC;
President and Chief Operating Officer
of Mutual and National, 5/96 to
present; Executive Vice President,
11/93 to 5/96 and prior thereto,
Senior Vice President of Mutual
Steven J. Johnston, 39 Vice President, Treasurer and Chief 1994
Vice President, Financial Officer of STFC and Mutual
Treasurer and Chief 4/97 to present; Vice President of STFC
Financial Officer and Mutual 5/95 to 4/97; Assistant Vice
President of Mutual 8/92 to 5/95
John R. Lowther, 47 Vice President, Secretary and General 1991
Vice President, Secretary Counsel of STFC, 5/91 to present; Vice
and General Counsel President, Secretary and General
Counsel of Mutual, 8/89 to present;
21
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company (1)(2) Age During the Past Five Years of the Company Since
- ------------------------------- --- -------------------------- --------------------
Michael F. Dodd, 60 Senior Vice President of STFC, 5/91 to 1991
Senior Vice President present; Senior Vice President of
Mutual 2/89 to present
Terrence L. Bowshier, 45 Vice President and Comptroller of STFC 1991
Vice President and and Mutual 5/91 to present;
Comptroller
James E. Duemey, 51 Vice President and Investment Officer 1991
Vice President and of STFC and Mutual 5/91 to present;
Investment Officer
Terrence P. Higerd, 53 Vice President of STFC, 5/91 to 1991
Vice President present; Vice President of Mutual 6/87
to present
Noreen W. Johnson 49 Vice President of STFC and Mutual 3/98 1998
Vice President to present; Assistant Vice President of
Mutual 3/97 to 3/98; employee of Mutual
from 9/92 to 3/97
Robert A. Lett 59 Vice President of STFC 3/98 to present; 1994
Vice President Vice President of Mutual 2/88 to present
John B. Melvin 48 Vice President of STFC 3/98 to present; 1994
Vice President Vice President of Mutual 11/93 to
present; and prior thereto an officer
of Mutual
Cathy B. Miley(3) 48 Vice President of STFC 3/98 to present; 1995
Vice President Vice President of Mutual 3/95 to
present; Assistant Vice President of
Mutual 8/92 to 3/95
Richard L. Miley(3) 44 Vice President of STFC 3/98 to present; 1995
Vice President Vice President of Mutual 5/95 to
present; Assistant Vice President of
Mutual 8/87 to 5/95
Gary L. Huber 56 Vice President of STFC 3/98 to present; 1997
Vice President Vice President of Mutual 5/97 to
present; Chief Operating Officer United
Fire and Casualty Insurance Company,
Des Moines, Iowa for more than five
years prior to his joining Mutual
(1) Except for Mr. Bailey, each of the executive officers is elected by the
respective company's Board of Directors for an indefinite term. Mr. Bailey has
executed an employment agreement effective January 1, 1996, which is for a five
year term.
(2) Each of the foregoing executive officers has been designated by the
Company's Board of Directors as an officer for purposes of Section 16 of the
Securities Exchange Act of 1934.
(3) Cathy B. Miley and Richard L. Miley are husband and wife.
ITEM 2. PROPERTIES
Because the operations of the Company and Mutual are integrated with
one another pursuant to the terms of the Amended and Restated Management
Agreement, the Company and Mutual share their operating facilities. See Item 1,
"Management Agreement." The Company's and Mutual's corporate headquarters are
located in Columbus, Ohio in buildings owned by Mutual that contain
approximately 270,000 square feet of office space. The Company and Mutual also
have regional underwriting and
22
claims office facilities which they share through the Management Agreement.
These facilities include a 53,500 square foot regional office in Greer, South
Carolina, a 6,600 square foot branch office in Cleveland, Ohio owned by Mutual,
and a 29,000 square foot branch office in Cincinnati, Ohio owned by Mutual. In
addition, Mutual currently leases a 22,800 square foot regional office in
Nashville, Tennessee pursuant to a 10-year lease. In the first quarter of 1998,
518 PML acquired land in Goodlettsville, Tennessee on which it is constructing
an office building which the Company expects to become Mutual's Nashville
Regional Office following expiration of the current lease in June 1999. Milbank
owns an office facility in Milbank, South Dakota where Mutual employees provide
services to Milbank agents and policyholders. Midwest Security leases an office
facility in Onalaska, Wisconsin where Mutual employees service Midwest
Security's agents and policyholders. Mutual also leases a number of small
offices throughout its operating area for the claims operations of Mutual and
the Company.
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to a number of lawsuits arising in the ordinary
course of its insurance business. Management of the Company believes that the
ultimate resolution of these lawsuits will not, individually or in the
aggregate, have a material, adverse effect on the financial condition of the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON SHARES AND RELATED SHAREHOLDER
MATTERS
STOCK TRADING
Common shares are traded in the Nasdaq National Market System under the
symbol STFC. As of March 9, 1998, there were 826 shareholders of record of the
Company's common shares.
MARKET PRICE RANGE, COMMON STOCK(1)
Initial Public Offering -- June 28, 1991, $4.50. The high and low sale
prices for each quarterly period for the past two years as reported by Nasdaq
are:
1996 High Low Dividend
---- ---- --- -------
First Quarter $17.50 $14.00 $.037
Second Quarter 16.67 15.00 .037
Third Quarter 16.17 13.00 .04
Fourth Quarter 18.50 13.25 .04
1997
----
First Quarter 19.00 16.75 .040
Second Quarter 23.00 16.75 .040
Third Quarter 23.875 20.25 .045
Fourth Quarter 32.25 23.25 .045
(1)Adjusted for a March 1993 two-for-one and a July 1996
three-for-two common stock split effected in the form of a
stock dividend, respectively.
Additionally, see Liquidity and Capital Resources section of
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included in Item 7 of this Form 10-K Annual Report.
23
ITEM 6. SELECTED FINANCIAL DATA
"Selected Consolidated Financial Data" is as follows:
24
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995* 1994 1993
---- ---- ----- ---- ----
STATEMENTS OF EARNINGS DATA: (Dollars in thousands, except per share data)
Earned premiums $ 254,682 240,345 232,524 175,587 169,610
Net investment income $ 25,078 23,879 22,617 17,756 17,222
Management services income $ 8,705 8,020 7,574 6,078 2,155
Net realized gains on investments $ 543 1,401 1,201 1,506 718
----------------------------------------------------------------
Total revenues $ 289,008 273,645 263,916 200,927 189,705
----------------------------------------------------------------
Earnings before federal income taxes $ 47,084 30,148 35,339 19,105 16,849
----------------------------------------------------------------
Net earnings before cumulative effect of change in
accounting for income taxes $ 33,959 22,602 25,542 14,662 13,646
----------------------------------------------------------------
Net earnings $ 33,959 22,602 25,542 14,662 13,729
----------------------------------------------------------------
Net earnings per common share before cumulative
effect adjustment(1)(2):
Basic $ 1.86 1.25 1.42 .82 .76
----------------------------------------------------------------
Diluted $ 1.82 1.23 1.41 .82 .76
----------------------------------------------------------------
Net earnings per common share(1)(2):
Basic $ 1.86 1.25 1.42 .82 .77
----------------------------------------------------------------
Diluted $ 1.82 1.23 1.41 .82 .77
----------------------------------------------------------------
Cash dividends per common share(1) $ .17 .15 .14 .13 .11
----------------------------------------------------------------
BALANCE SHEET DATA AT YEAR END:
Total investments $ 404,179 384,307 369,847 273,226 273,753
Total assets $ 493,151 453,120 434,496 334,796 320,203
Total stockholders' equity $ 225,479 186,461 168,252 130,186 124,332
Book value per common share(1) $ 12.29 10.28 9.33 7.27 6.99
STATUTORY RATIOS:
Loss ratio 65.2% 72.6 68.6 75.1 73.5
Expense ratio 27.9% 26.4 30.1 25.9 29.1
Combined ratio(3) 93.1% 99.0 98.7 101.0 102.6
Industry combined ratio(4) 101.6% 105.9 106.4 108.5 106.9
Ratio of net premiums written to statutory capital and surplus 1.87 2.08 2.32 1.85 2.02
(1) Adjusted for a July 1996 3-for-2 common stock split effected in the form of a stock dividend.
(2) The net earnings per share amounts prior to 1997 have been restated as required to comply with SFAS No. 128.
(3) Derived from combined statutory financial statements on a pooled basis, including State Auto National.
(4) Preliminary industry information for 1997 from A.M. Best Co.
* Reflects change in pooling arrangement, effective January 1, 1995.
25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
"Management's Discussion and Analysis of Financial Condition and
Results of Operations" is as follows:
26
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
State Auto Financial Corporation (State Auto Financial), through its
principal insurance subsidiary State Auto Property and Casualty Insurance
Company (State Auto P&C), provides personal and commercial insurance primarily
in the central and eastern parts of the United States, excluding New York, New
Jersey, and the New England states. State Auto P&C's principal lines of business
include personal and commercial automobile, homeowners, commercial multi-peril,
workers' compensation, general liability and fire insurance. Another insurance
subsidiary, State Auto National Insurance Company (National), writes personal
automobile insurance for non-standard risks. In 1997 National wrote insurance in
eleven states. State Auto P&C and National's products are marketed through
independent agents.
State Auto P&C provides executive management services to oversee the
insurance operations of all the State Auto Insurance Companies, which include
National and State Automobile Mutual Insurance Company (Mutual), a majority
shareholder of State Auto Financial, and Mutual's wholly-owned subsidiaries,
Milbank Insurance Company (Milbank), Midwest Security Insurance Company (Midwest
Security) (Midwest Security was acquired by Mutual effective January 1, 1997)
and until June 30, 1997, State Auto Life Insurance Company (State Auto Life was
sold by Mutual effective July, 1997). Stateco Financial Services, Inc.
(Stateco), a wholly-owned subsidiary of State Auto Financial, provides
investment management services to affiliated companies and also provides
insurance premium finance services to customers of State Auto P&C, Mutual and
Milbank.
Strategic Insurance Software, Inc. (SIS), a majority owned subsidiary,
develops and sells software for the processing of insurance transactions,
database management for insurance agents and electronic interfacing of
information between insurance companies and agents. SIS sells services and
products to affiliated companies and their agents and markets similar services
and products to nonaffiliated insurers and their agencies. State Auto Financial
and its subsidiaries, State Auto P&C, National, Stateco and SIS are referred to
collectively as the Company.
Since 1987 State Auto P&C has participated in a reinsurance pooling
arrangement (the Arrangement) with Mutual. The Arrangement provides that all
premiums, losses, loss expenses and underwriting expenses of each company be
pooled and then allocated back to each company based on percentages outlined in
the Arrangement. Effective January 1, 1995, the Arrangement was amended to
include all of the property and casualty business of Milbank. Concurrently with
the inclusion of Milbank, the pooling participation percentages were amended to
allocate 35% to State Auto P&C, 55% to Mutual and 10% to Milbank. Effective
January 1, 1998, subject to regulatory approval, the arrangement was amended to
include all of the property and casualty business of Midwest Security.
Concurrently, with the inclusion of Midwest Security, the pooling participation
percentages were amended to allocate 37% to State Auto P&C, 52% to Mutual, 10%
to Milbank and 1% to Midwest Security. The change in the Arrangement did not
affect a prior agreement between State Auto P&C and Mutual whereby Mutual agreed
to reimburse State Auto P&C for the development of any losses or loss expenses
on claims occurring on or prior to December 31, 1990, that is in excess of State
Auto P&C's reserves on that date. As of December 31, 1997, there has been no
adverse development of the liability.
Effective July 1, 1993, Mutual acquired Milbank. In connection with this
purchase, Mutual and State Auto Financial entered into an Option Agreement
granting State Auto Financial the right to acquire Milbank from Mutual within
five years at a price determined by a formula set out in the Option Agreement.
On March 6, 1998, the Board of Directors of State Auto Financial adopted a
resolution authorizing the officers of State Auto Financial to take such steps
as are necessary to effect the exercise of State Auto Financial's option to
acquire Milbank from Mutual. State Auto Financial's acquisition of Milbank is
subject to procedural matters contemplated by the Option Agreement, as approved
by the directors of Mutual and State Auto Financial, being completed and
regulatory approval in Ohio and South Dakota. The proposed effective date of
transfer is third quarter 1998.
State Auto P&C, National, Mutual, Milbank and
27
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
Midwest Security are referred to collectively as the State Auto Insurance
Companies, while State Auto P&C, Mutual and Milbank are referred to as the
Pooled Companies.
1997 Compared to 1996
---------------------
Net earnings for the Company increased 50% over 1996. The Company's statutory
combined ratio decreased to 93.1% in 1997 from 99.0% in 1996, reflecting
improvements in almost all major lines of insurance.
State Auto P&C increased its earned premium approximately 2.9% from the same
1996 period. During the 1997 year, the Pooled Companies' experienced minimal
growth in direct written premiums on its personal lines of business of
approximately 1.0%, while commercial lines reflected an increase of
approximately 8.3% from the same 1996 period. Commercial lines growth decreased
from 1996 levels due primarily to a substantial reduction in workers'
compensation loss costs as promulgated by the National Council on Compensation
Insurance that began approximately one year ago. As a result of these lower loss
costs, workers' compensation direct written premiums decreased approximately
6.6% from 1996. The workers' compensation line of business represents
approximately 12% of the Pooled Companies' commercial business. National's
earned premium increased 56.8% from the same 1996 period. Contributing to this
increase was National's entry into the states of Arkansas and Georgia in
December 1996, Minnesota in February 1997 and in the later half of 1997,
Alabama, Illinois and Missouri. Currently licensed in six additional states and
seeking certificates of authority in at least three others, National anticipates
beginning operations in at least six of these states during 1998. Total earned
premiums for the Company increased $14.3 million or 6.0% to $254.7 million.
Net investment income increased $1.2 million or 5.0% to $25.1 million. An
increase in invested assets over the same 1996 period contributed to this
increase. Total cost of invested assets at December 31, 1997 was $391.1 million
compared to $377.0 million at December 31, 1996. During the last half of 1997,
the Company began a program to build an equity portfolio to enhance growth of
statutory surplus over the long term. At December 31, 1997, the equity portfolio
totaled $4.6 million. The investment yield, based on fixed and equity securities
at cost, decreased to 6.2% from 6.4% in 1996.
Management services income, which includes income generated from investment
and executive management services provided by Stateco and State Auto P&C,
respectively increased $0.7 million or 8.5% to $8.7 million.
Losses and loss expenses, as a percentage of earned premiums, decreased to
65.1% from 72.2% in 1996. The decrease in this ratio is due to a reduction in
the level of catastrophe losses experienced by the Company as compared to the
same period in 1996 and continuing improvement in the Company's core
underwriting operations. Homeowners' line of business, which comprises
approximately 16.0% of the Company's earned premiums, reflected a substantial
improvement in its statutory loss ratio of 71.0%, down from 101.7% in 1996.
Additionally, automobile, the Company's largest line of business (approximately
60% of the Company's earned premiums), also reflected an improvement in its
statutory loss ratio of 65.5%, down from 69.5% in 1996.
Acquisition and operating expenses, as a percentage of earned premiums,
increased to 29.1% from 28.1% in 1996. The increase in this percentage is due to
the amortization of software expenses, the Quality Performance Bonus (the Bonus)
and the amount of bonus compensation earned by the Company's agents. Beginning
with the first quarter of 1997, the State Auto Insurance Companies began
amortizing costs associated with the development of its claims and billing
processing system that began a little over two years ago. The amortization
period of these costs will be approximately three years. Additionally, there was
an increase over the same periods in 1996 of the Bonus earned by nearly all
permanent employees. Performance is measured quarterly and the Bonus is earned
if the State Auto Insurance Companies' quarterly direct statutory combined ratio
is better than predetermined targets set at the beginning of each fiscal year.
A Bonus has been
28
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
paid in each of the 1997 quarterly periods. Also contributing to this increase
was an increase over 1996 of the amount of bonus compensation earned by the
Company's agents. Each agent shares in the underwriting profits generated by
insurance placed by them. Thus, the improvement in the underwriting operations
of the Company is shared with the agents who produced the profitable business.
Currently, approximately 20% of the Company's policy transactions are now sent
electronically from the agent to the Company, thereby enhancing the efficiency
of the Company's operations and which is expected to have a long-term positive
impact on the Company's expenses.
Decrease in other expenses of $0.6 million to $1.9 million is primarily due
to the State Auto Insurance Companies changing the catastrophe portion of its
reinsurance program beginning July 1, 1996, that prior to this period was
accounted for as deposit reinsurance (See Liquidity and Capital Resources).
Expenses associated with the catastrophe portion of the program accounted for as
deposit reinsurance were included in Other Expenses.
Federal income taxes increased $5.6 million to $13.1 million. This increase
is due to the increase in taxable income as a result of the improvement in
insurance operations in 1997 compared to the same period in 1996. The tax
benefit from tax exempt securities for 1997 remained comparable to the 1996
level. See footnote (7) to consolidated financial statements of State Auto
Financial Corporation and Subsidiaries.
1996 Compared to 1995
---------------------
Net earnings for the Company decreased 11.5% due primarily to numerous
storm-related catastrophe claims in the first three quarters of the year.
Despite these significant losses, the Company was able to produce a statutory
combined ratio of 99.0% bettering industry results for the year of 105.9%.
Earned premiums increased $7.8 million or 3.4% to $240.3 million. Direct
written premiums for commercial business increased approximately 10.9% from the
same 1995 period. Except for National, the Company's personal lines experienced
no growth in 1996. Contributing to the results in personal lines, was the
introduction of the PRIME of LIFE personal auto and homeowners plan beginning on
a state-by-state basis in late 1995 (the Plan). The Plan focuses on the 50 and
older segment of the personal lines market, a group that has generally produced
more favorable underwriting and retention results for the industry than any
other segment of the personal lines market. The Plan offers a combination of
auto and homeowners discounts and enhances coverages. As a consequence of moving
existing eligible policyholders to the Plan and reflecting the actuarially
justified discounts, along with conservative underwriting and newer agency
appointments of more commercial lines oriented agencies, personal lines written
premium was flat. The Company remains committed to profitable premium growth as
it is continually reviewing current strategies and developing new programs in
both commercial and personal lines sales. Positively contributing to both
commercial and personal lines sales in 1996, was the Company's entry into its
23rd state of operation, Oklahoma. National, which began operations in the
non-standard personal auto market in 1992, recorded an increase in its direct
written premiums of approximately 43%. During the fourth quarter of 1996,
National began writing business in Arkansas and Georgia and wrote its first
policy in the state of Minnesota in February of 1997 bringing the total number
of its operating states to eight. It began operations in three additional states
during 1997.
Net investment income increased $1.3 million or 5.6% to $23.9 million. An
increase in invested assets over the same 1995 period contributed to this
increase. Total amortized cost of invested assets at December 31, 1996 was
$377.0 million compared to $355.4 million at December 31, 1995. The investment
yield decreased to 6.4% from 6.5% in 1995.
Management services income, which includes income generated from investment
and executive management services provided by Stateco and State Auto P&C,
respectively, increased $0.4 million or 5.9% to $8.0 million.
Losses and loss expenses, as a percentage of earned premiums, increased to
72.2% from 68.3% in
29
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
1995. During 1996, the Company experienced several significant weather related
catastrophes. Severe winter weather in January and February, tornado and
hailstorms in the Louisville, Kentucky area in May and storm losses in Raleigh,
North Carolina resulting from Hurricane Fran moving inland in September,
increased losses and loss expenses by approximately $16.0 million. The impact of
these storms increased this loss and loss expense ratio 6.7 points. Despite
these significant losses, the Company continued to record improvements in its
underlying book of business. Automobile, the Company's largest line of business,
showed an improvement in its statutory loss ratio of 69.5%, down from 74.1% in
1995.
Acquisition and operating expenses, as a percentage of earned premiums,
decreased to 28.1% from 29.0% in 1995. The decrease in the ratio for 1996 is due
primarily to the decrease in the amount of Quality Performance Bonus earned by
nearly all permanent employees of the State Auto Companies in 1996 compared to
the same periods in 1995.
Federal income taxes decreased $2.3 million to $7.5 million. This decrease is
reflective of the lower taxable income experienced by the Company in the current
year. The effective tax rate decreased to 25% from 28% in 1995.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity refers to the ability of a company to generate adequate amounts of
cash to meet its needs for both long and short-term cash obligations as they
come due. The Company's significant sources of cash are premiums, investment
income and investments as they mature. The Company continually monitors its
investment and reinsurance programs to ensure they are appropriately structured
to enable the insurance subsidiaries to meet anticipated and unanticipated short
and long-term cash requirements without the need to sell fixed income
investments to meet fluctuations in claim payments.
Net cash provided by operating activities increased to $24.9 million from
$22.4 million in the same 1996 period. Net cash used in investing activities
decreased to $15.3 million from $21.2 million from the same 1996 period. Net
cash provided by financing activities increased to $1.4 million from $0.4
million in the same 1996 period. As of December 31, 1997, funds consisting of
cash and cash equivalents for general operations were $23.9 million compared to
$12.9 million at December 31, 1996. No long-term fixed maturies were required to
be sold to meet financial obligations in 1997.
Effective July 1, 1996, the State Auto Insurance Companies negotiated a
change in their catastrophe reinsurance program. The amount retained by the
State Auto Insurance Companies is $40.0 million for each occurrence, an increase
of $20.0 million over the prior program. For up to $80.0 million in losses,
excess of $40.0 million, traditional reinsurance coverage is provided. To
provide funding if the State Auto Insurance Companies were to incur catastrophe
losses in excess of $120.0 million, State Auto Financial entered into a
structured contingent financing transaction with Chase Manhattan Bank (Chase) to
provide up to $100.0 million for reinsurance purposes. Under this arrangement,
in the event of such a loss, State Auto Financial would sell redeemable
preferred shares to SAF Funding Corporation, a special purpose company (SPC),
which will borrow the money necessary for such purchase from Chase and a
syndicate of other lenders. State Auto Financial will contribute to State Auto
P&C the proceeds from the sale of its preferred shares. State Auto P&C has
assumed catastrophe reinsurance from Mutual, Milbank and National pursuant to a
catastrophe reinsurance agreement in the amount of $100.0 million excess of
$120.0 million. State Auto P&C will use the contributed capital to pay its
direct catastrophe losses and losses assumed under the catastrophe reinsurance
agreement. State Auto Financial is obligated to repay SPC (which will repay the
lenders) by redeeming the preferred shares over a six year period. This layer of
$100.0 million in excess of $120.0 has been excluded from the pooling agreement
as well by virtue of an Amended and Restated Reinsurance Pooling Agreement.
In addition, State Auto Financial's obligation to repay SPC has been secured
by a Put Agreement among State Auto Financial, Mutual and the Lenders, under
which, in the event of a default by State Auto Financial as described in the
Credit Agreement or in
30
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
the Put Agreement, Mutual would be obligated to put either the preferred shares
or the loan(s) outstanding.
On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest
Security, effective as of January 1, 1997. In connection with this purchase,
Mutual and State Auto Financial entered into an Option Agreement granting State
Auto Financial the right to purchase Midwest Security from Mutual within five
years at a price determined by a formula set out in the Option Agreement. As of
March 16, 1998, State Auto Financial has not exercised its right to acquire
Midwest Security.
Effective January 1, 1998, 518 Property Management and Leasing, LLC (518 PML)
was created. The initial members of 518 PML are Stateco and State Auto P&C.
Stateco contributed $7.0 million in cash and real property located in
Goodlettsville, Tennessee, while State Auto P&C contributed real property
located in Greer, South Carolina. 518 PML plans to develop an office building on
the real property in Goodlettsville which it expects to lease to Mutual in 1999
for Mutual's use as its Nashville Regional Office. 518 PML has leased the Greer
property to Mutual for use as Mutual's Southern Regional Office facility.
Operations from 518 PML are not material to the Company at this time.
On March 6, 1998, the Board of Directors of State Auto Financial declared a
quarterly cash dividend of $0.045 per common share, payable on March 31, 1998,
to shareholders of record on March 17, 1998. Additionally, the Board also
declared a two-for-one stock split to be distributed July 8, 1998, to
shareholders of record on June 18, 1998. The split is contingent upon
shareholder approval of a proposal to increase the number of authorized common
shares, without par value, from 30 million to 100 million at the Company's
Annual Meeting of Shareholders on May 28, 1998.
The maximum amount of dividends that may be paid to State Auto Financial
during 1998 by its insurance subsidiaries as a non-extraordinary dividend is
limited to $28.9 million, without prior approval under current law. The Company
is required to notify the insurance subsidiaries' respective State Insurance
Commissioner within five business days after declaration of all dividends and at
least ten days prior to payment. Additionally, the domiciliary Commissioner of
each insurer subsidiary has the authority to limit a non-extraordinary dividend
when the Commissioner determines, based on factors set forth in the law, that an
insurer's surplus is not reasonable in relation to the insurer's outstanding
liabilities and adequate to its financial needs. Such restrictions are not
expected to limit the capacity of State Auto Financial to meet its cash
obligations.
The National Association of Insurance Commissioners (NAIC) adopted risk-based
capital requirements for property and casualty insurers effective December 31,
1994. Risk-based capital is a formula that attempts to evaluate the adequacy of
statutory capital and surplus in relation to investment and insurance risks such
as asset quality, loss reserve adequacy and other business factors. Applying the
risk-based capital requirements as of December 31, 1997, each of the State Auto
Insurance Companies exceeded all standards tested by the formula.
YEAR 2000
The Year 2000 Issue is the result of computer programs having been written
using two digits rather than four to define the applicable year. Any of the
computer programs used by State Auto Financial and Mutual and their respective
subsidiaries (all of which are collectively, referred to as "State Auto" for the
purposes of this section) that have time-sensitive software may recognize a date
using "00" as the year 1900 rather than the year 2000. This could result in a
system failure or miscalculations causing disruptions of uncertain duration in
State Auto's operations, including, among other things, an inability to process
transactions, send invoices, or engage in similar normal business activities.
Based on an analysis of its systems software, management determined that it
is required to modify or replace significant portions of State Auto's software
so that its computer systems will function properly with respect to dates in the
year 2000 and thereafter. Management presently believes that with modifications
to existing software and conversions to new software, the Year 2000 Issue will
not pose significant
31
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
operational problems for State Auto. However, if such modifications and
conversions are not made, or are not completed timely, the Year 2000 Issue could
adversely affect the operations of State Auto.
To address the Year 2000 issue in a timely and effective manner, management
purchased software from a third party vendor to assist in diagnosing and
correcting certain of State Auto's major policy processing software systems. In
addition, management is utilizing State Auto's internal resources to reprogram,
or replace, and test the balance of its software for necessary Year 2000
modifications. Management presently anticipates completing the Year 2000
modifications on State Auto's critical business applications software by October
1998 and its remaining non-critical business applications software during 1999.
Management expects to have these changes completed prior to the Year 2000 Issue
having an adverse impact on State Auto's operations and operating systems. The
total cost of the Year 2000 project for State Auto Financial is estimated at
$1.5 million and is being funded through cash flows. To date, State Auto
Financial's incurred cost is approximately $0.8 million and approximately 50% of
State Auto's computer programs (lines of code) are Year 2000 compliant.
Also, management has initiated communications with all of State Auto's
significant suppliers and business partners to determine the extent to which
State Auto's interface systems are vulnerable to such third parties' failure to
remediate their own Year 2000 Issues. State Auto Financial's estimate of its
total Year 2000 project cost and its dates of completion include the estimated
costs and time associated with the impact of third party Year 2000 Issues, based
on presently available information. However, there can be no guarantee that the
software systems of other companies on which State Auto's computer systems rely
will be timely converted and would not have an adverse effect on State Auto.
Also, engaging in the property casualty insurance business presents an
additional exposure to financial losses for State Auto Financial. There is a
significant amount of speculation that many businesses will themselves suffer
financial losses due to the Year 2000 issue for which such businesses will
likely seek reimbursement from their own insurance companies. State Auto
Financial cannot estimate the nature or extent of its liabilities arising out of
claims related to the Year 2000 Issue which may be filed by insureds under the
insurance policies it has sold, although it has, along with much of the rest of
the industry, sought to clarify its policies' provisions that financial losses
arising out of its insureds failures to correct their own Year 2000 Issues are
not insured losses. However, the enforceability of these policy endorsements is
unknown at this time. In addition, some state insurance departments are
resisting insurers' efforts to file such amendatory endorsements.
The estimated costs of the project and the date by which State Auto believes
it will complete the Year 2000 modifications are based on management's judgment,
and information available to it as well as its assumptions of future events,
including the continued availability of certain resources, third party
modification plans and other factors. However, there can be no guarantee that
these estimates will be achieved and actual results could differ materially from
those anticipated. Specific factors that might cause such material differences
include, but are not limited to, the availability and cost of personnel trained
in this area, the ability to locate and correct all relevant software code, and
the affect of the Year 2000 Issue on regulators and other government agencies,
among others.
INVESTMENTS
Stateco performs investment management services on behalf of the Company and
Mutual and its subsidiaries. Investment policies followed by Stateco are set by
each company's Investment Committee of its Board of Directors.
The primary investment objectives are to generate income, preserve capital
and maintain adequate liquidity for the payment of claims. Fixed maturities that
are purchased with the intention and ability of holding them until maturity are
categorized as held to maturity and are carried at amortized cost. Fixed
maturities that may be sold due to changing investment strategies, are
categorized as available for sale and are carried at fair value.
As of December 31, 1997, the Company had fixed maturities with a fair value
of $320.3 million designat-
32
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
ed as available for sale compared to $294.1 million at December 31, 1996. During
1997, the Company began a program to build an equity portfolio to enhance growth
of statutory surplus over the long term. At December 31, 1997, the equity
portfolio totaled $4.6 million.
The Company's investable assets as of December 31, 1997 and 1996 were $428.2
million and $397.2 million, respectively. At December 31, 1997, 93.3% of the
investable assets were in fixed maturities, 1% in equity securities with the
remaining 5.7% allocated to cash and cash equivalents.
As of December 31, 1997, the Company had no fixed maturity investments rated
below investment grade, nor any mortgage loans. The Company does not intend to
change its investment policy on the quality of its fixed maturity investments.
NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS No.
130, "Reporting Comprehensive Income," which is effective for fiscal years
beginning after December 15, 1997. SFAS No. 130 establishes standards for the
reporting and display of comprehensive income and its components in a full set
of general purpose financial statements. Also in June 1997, the FASB issued SFAS
No. 131, "Disclosures about Segments of an Enterprise and Related Information,"
which is effective for fiscal years beginning after December 15, 1997. SFAS No.
131 changes the way public companies report segment information in annual
financial statements and also requires those companies to report selected
segment information in interim financial reports to shareholders. The Company
has not yet determined the reporting changes required by SFAS No. 130 and 131 to
comprehensive income and segment information.
IMPACT OF SIGNIFICANT EXTERNAL CONDITIONS
Inflation can have a significant impact on property and casualty insurers
because premium rates are established before the amounts of losses and loss
expenses are known. When establishing rates, the Company attempts to anticipate
increases from inflation subject to limitations imposed for competitive pricing.
The Company considers inflation when estimating liabilities for losses and
loss expenses, particularly for claims having a long period between occurrence
and settlement. The liabilities for losses and loss expenses are management's
estimates of the ultimate net cost of underlying claims and expenses and are not
discounted for the time value of money. In times of high inflation, the normally
higher yields on investment income may partially offset potentially higher
claims and expenses.
33
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements, including the Notes to
Consolidated Financial Statements and the Report of Independent Auditors are as
follows:
34
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
State Auto Financial Corporation
We have audited the accompanying consolidated balance sheets of State Auto
Financial Corporation and subsidiaries as of December 31, 1997 and 1996 and the
related consolidated statements of earnings, stockholders' equity and cash flows
for each of the three years in the period ended December 31, 1997. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of State
Auto Financial Corporation and subsidiaries as of December 31, 1997 and 1996,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles.
/s/ Ernst & Young LLP
Columbus, Ohio
February 20, 1998
except for Note 15, as to which the date is
March 6, 1998
35
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED BALANCE SHEETS
- ---------------------------------------------------------------------------------------------------------------------------
DECEMBER 31
1997 1996
---- ----
ASSETS (dollars in thousands,
except share data)
Fixed maturities:
Held to maturity, at amortized cost (fair value $81,571 and $91,058,
respectively)................................................................. $ 79,300 90,251
Available for sale, at fair value (amortized cost $307,589 and $286,790,
respectively)................................................................. 320,299 294,056
Equity securities, available for sale, at fair value (cost $4,287 and $ - , respectively) 4,580 --
----------------------------
Total investments.................................................................. 404,179 384,307
Cash and cash equivalents.......................................................... 23,918 12,868
Deferred policy acquisition costs.................................................. 17,689 15,711
Accrued investment income and other assets......................................... 16,327 13,845
Net prepaid pension expense........................................................ 12,133 10,623
Reinsurance recoverable on losses and loss expenses payable........................ 9,871 9,691
Prepaid reinsurance premiums....................................................... 3,627 3,380
Property and equipment, at cost, net of accumulated depreciation of $1,381
and $1,265, respectively........................................................ 3,228 2,541
Due from affiliates................................................................ 2,179 --
Deferred federal income taxes...................................................... -- 154
----------------------------
Total assets....................................................................... $ 493,151 453,120
----------------------------
- ---------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable................................................... $ 162,446 165,875
Unearned premiums.................................................................. 99,445 93,884
Federal income taxes:
Current......................................................................... 15 2,076
Deferred........................................................................ 3,049 --
Other liabilities.................................................................. 2,717 2,903
Due to affiliates.................................................................. -- 1,921
----------------------------
Total liabilities.................................................................. 267,672 266,659
----------------------------
Commitments and contingencies
Stockholders' equity:
Class A Preferred stock (nonvoting), without par value. Authorized 2,500,000
shares; none issued........................................................... -- --
Class B Preferred stock, without par value. Authorized 2,500,000 shares;
none issued................................................................... -- --
Common stock, without par value. Authorized 30,000,000 shares; 18,341,899
and 18,135,526 shares issued and outstanding, respectively, at stated value
of $5 per share............................................................... 91,709 90,678
Additional paid-in capital......................................................... 2,894 1,456
Net unrealized holding gains....................................................... 8,830 5,179
Retained earnings.................................................................. 122,046 89,148
----------------------------
Total stockholders' equity......................................................... 225,479 186,461
----------------------------
Total liabilities and stockholders' equity......................................... $ 493,151 453,120
----------------------------
See accompanying notes to consolidated financial statements.
36
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF EARNINGS
- ----------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
---- ---- ----
(dollars in thousands, except per share amount)
Earned premiums (net of ceded earned premiums of $11,859,
$11,079 and $11,273, respectively) ....................................... $ 254,682 240,345 232,524
Net investment income ....................................................... 25,078 23,879 22,617
Management services income .................................................. 8,705 8,020 7,574
Net realized gains on investments ........................................... 543 1,401 1,201
-------------------------------------------
Total revenues .............................................................. 289,008 273,645 263,916
-------------------------------------------
Losses and loss expenses (net of ceded losses and loss expenses of
$6,379, $5,429 and $4,745, respectively) ................................. 165,790 173,540 158,913
Acquisition and operating expenses .......................................... 74,213 67,447 67,348
Other expense, net .......................................................... 1,921 2,510 2,316
-------------------------------------------
Total expenses .............................................................. 241,924 243,497 228,577
-------------------------------------------
Earnings before federal income taxes ........................................ 47,084 30,148 35,339
-------------------------------------------
Federal income tax expense (benefit):
Current .................................................................. 11,888 7,457 10,542
Deferred ................................................................. 1,237 89 (745)
-------------------------------------------
Total federal income taxes .................................................. 13,125 7,546 9,797
-------------------------------------------
Net earnings ................................................................ $ 33,959 22,602 25,542
-------------------------------------------
Net earnings per common share:
Basic .................................................................... $ 1.86 1.25 1.42
-------------------------------------------
Diluted .................................................................. $ 1.82 1.23 1.41
-------------------------------------------
Dividends paid per common share ............................................. $ 0.17 0.15 0.14
-------------------------------------------
See accompanying notes to consolidated financial statements.
37
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
- ----------------------------------------------------------------------------------------------------------------------------
Year ended December 31
----------------------
1997 1996 1995
---- ---- ----
(in thousands)
Common stock shares:
Beginning of year ........................................................ 18,135 18,025 17,905
Issuance of common stock ................................................. 207 110 120
--------------------------------------------
End of year .............................................................. 18,342 18,135 18,025
--------------------------------------------
Class A preferred stock:
Beginning and end of year ................................................ $ -- -- --
--------------------------------------------
Class B preferred stock:
Beginning and end of year ................................................ -- -- --
--------------------------------------------
Common stock:
Beginning of year ........................................................ 90,678 90,127 89,523
Issuance of common stock ................................................. 1,031 551 604
--------------------------------------------
End of year .............................................................. 91,709 90,678 90,127
--------------------------------------------
Additional paid-in capital:
Beginning of year ........................................................ 1,456 681 273
Issuance of common stock ................................................. 1,438 775 408
--------------------------------------------
End of year .............................................................. 2,894 1,456 681
--------------------------------------------
Net unrealized holding gains (losses):
Beginning of year ........................................................ 5,179 9,965 (2,384)
Change in net unrealized holding gains (losses) .......................... 3,651 (4,786) 12,349
--------------------------------------------
End of year .............................................................. 8,830 5,179 9,965
--------------------------------------------
Retained earnings:
Beginning of year ........................................................ 89,148 67,479 42,774
Change in minority interest of subsidiaries .............................. (2) -- --
Cash dividends paid ...................................................... (1,059) (933) (837)
Net earnings ............................................................. 33,959 22,602 25,542
--------------------------------------------
End of year .............................................................. 122,046 89,148 67,479
--------------------------------------------
Total stockholders' equity .................................................. $ 225,479 186,461 168,252
--------------------------------------------
See accompanying notes to consolidated financial statements.
38
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF CASH FLOWS
- ------------------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
---- ---- ----
(in thousands)
Cash flows from operating activities:
Net earnings ............................................................. $ 33,959 22,602 25,542
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Depreciation and amortization, net ..................................... 862 764 557
Net realized gains on investments ...................................... (543) (1,401) (1,201)
Changes in operating assets and liabilities:
Deferred policy acquisition costs .................................... (1,978) 155 126
Accrued investment income and other assets ........................... (2,482) (677) (3,624)
Net prepaid pension expense .......................................... (1,510) (1,238) (894)
Reinsurance receivable on losses and loss
expenses payable and prepaid reinsurance premiums .................. (427) (623) 63
Other liabilities and due to/from affiliates, net .................... (4,290) 2,162 5,120
Losses and loss expenses payable ..................................... (3,428) (4,700) 1,623
Unearned premiums .................................................... 5,561 3,776 4,558
Federal income taxes ................................................. (825) 1,600 (1,574)
----------------------------------------------
24,899 22,420 30,296
Cash provided from the change in the reinsurance pool
participation percentage ............................................. -- -- 46,061
----------------------------------------------
Net cash provided by operating activities ................................... 24,899 22,420 76,357
----------------------------------------------
Cash flows from investing activities:
Purchase of fixed maturities - held to maturity .......................... -- (9,074) (18,478)
Purchase of fixed maturities - available for sale ........................ (97,790) (124,954) (134,082)
Purchase of equity securities ............................................ (5,128) -- --
Maturities, calls and principal reductions of fixed maturities - held
to maturity ............................................................ 10,680 10,111 4,367
Maturities, calls and principal reductions of fixed maturities - available
for sale ............................................................... 14,077 3,624 3,152
Sale of fixed maturities - available for sale ............................ 62,829 99,220 68,158
Sale of equity securities ................................................ 875 -- --
Net additions of property and equipment .................................. (802) (99) (377)
----------------------------------------------
Net cash used in investing activities ....................................... (15,259) (21,172) (77,260)
----------------------------------------------
Cash flows from financing activities:
Net proceeds from issuance of common stock ............................... 2,469 1,326 1,012
Payment of dividends ..................................................... (1,059) (933) (837)
----------------------------------------------
Net cash provided by financing activities ................................... 1,410 393 175
----------------------------------------------
Net increase (decrease) in cash and cash equivalents ........................ 11,050 1,641 (728)
----------------------------------------------
Cash and cash equivalents at beginning of year .............................. 12,868 11,227 11,955
----------------------------------------------
Cash and cash equivalents at end of year .................................... $ 23,918 12,868 11,227
----------------------------------------------
See accompanying notes to consolidated financial statements.
39
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of State Auto
Financial Corporation (the Company) and its wholly-owned subsidiaries State Auto
Property and Casualty Insurance Company (State Auto P&C), State Auto National
Insurance Company (National) and Stateco Financial Services, Inc. (Stateco) and
majority-owned subsidiary Strategic Insurance Software, Inc. (SIS). State Auto
Financial Corporation and subsidiaries are referred to herein as "the
Companies." The Company, an Ohio corporation, is a majority-owned subsidiary of
State Automobile Mutual Insurance Company (Mutual). All significant intercompany
balances and transactions have been eliminated in consolidation.
(b) DESCRIPTION OF BUSINESS
The Company, through State Auto P&C, a South Carolina corporation, and
National, an Ohio corporation, provides personal and commercial insurance to its
policyholders, primarily in the eastern half of the United States, excluding New
York, New Jersey, and the New England states through an independent insurance
agency system. The Company's principal lines of business include personal and
commercial automobile, homeowners, commercial multi-peril, workers'
compensation, general liability and fire insurance. State Auto P&C and National
are chartered and licensed as property and casualty insurers in the states of
South Carolina and Ohio, respectively, and are licensed in various other states.
As such, they are subject to the regulations of the Departments of Insurance of
the states of South Carolina and Ohio (collectively, the Departments) and the
regulations of each state in which they operate. State Auto P&C and National
undergo periodic financial examination by the Departments and insurance
regulatory agencies of the states that choose to participate. Through State Auto
P&C, the Company also provides executive management services to its affiliated
insurance companies.
Through Stateco, the Company provides investment management services to
affiliated companies and also provides insurance premium finance services to
customers of State Auto P&C, Mutual and Milbank Insurance Company (Milbank), a
wholly-owned subsidiary of Mutual.
Beginning in July 1995, the Company, through SIS, began developing and
selling software for the processing of insurance transactions, database
management for insurance agents and electronic interfacing of information
between insurance companies and agencies. SIS sells services and products to
affiliated companies and their agents and markets similar services and products
to nonaffiliated insurers and their agencies.
(c) BASIS OF PRESENTATION
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles, which vary in certain respects from
statutory accounting practices followed by State Auto P&C and National that are
prescribed or permitted by the Departments.
The National Association of Insurance Commissioners (NAIC) currently has a
project to codify statutory accounting practices, the result of which is
expected to constitute the only source of prescribed statutory accounting
practices. Accordingly, that project, expected to be completed in 1998, will
likely change the definitions of what comprises prescribed versus permitted
statutory accounting practices, and may result in changes to the accounting
policies that insurance companies use to prepare their statutory financial
statements.
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the balance sheet, revenues and expenses for the
period then ended and the accompanying notes to the financial statements. Such
estimates and assumptions could change in the future as more information becomes
known which could impact the amounts reported and disclosed herein.
Material estimates that are particularly susceptible to significant change in
the near term relate to the determination of losses and loss expenses payable
and the recoverability of deferred policy acquisition costs. In connection with
the determination of these items, management uses historical data and current
business conditions to formulate estimates including assumptions related to the
ultimate cost to settle claims. These estimates by their nature are subject to
uncertainties for various reasons. The Company's results of operations and
financial condition could be impacted in the future should the ultimate payments
required to settle claims vary from the liability currently provided.
40
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(d) PREMIUM REVENUES
Premiums are recognized as earned using the monthly pro rata method over the
contract period.
(e) DEFERRED POLICY ACQUISITION COSTS
Acquisition costs, consisting of commissions, premium taxes, and certain
underwriting expenses related to the production of property and casualty
business, are deferred and amortized ratably over the contract period. The
method followed in computing deferred policy acquisition costs limits the amount
of such deferred costs to their estimated realizable value. In determining
estimated realizable value, the computation gives effect to the premium to be
earned, losses and loss expenses to be incurred, and certain other costs
expected to be incurred as premium is earned, without credit for anticipated
investment income. These amounts are based on estimates and accordingly, the
actual realizable value may vary from the estimated realizable value. Net
deferred policy acquisition costs were:
Year ended December 31
----------------------
1997 1996 1995
---- ---- ----
(dollars in thousands)
Balance, beginning of year...................$ 15,711 15,866 12,521
Acquisition costs deferred................... 62,522 57,752 57,229
Amortized to expense during the year......... (60,544) (57,907) (53,884)
----------------------------------
Balance, end of year.........................$ 17,689 15,711 15,866
----------------------------------
(f) LOSSES AND LOSS EXPENSES PAYABLE
Losses and loss expenses payable are based on formula and case-basis
estimates for reported claims, and on estimates, based on experience, for
unreported claims and loss expenses. The liability for unpaid losses and loss
expenses, net of estimated salvage and subrogation recoverable of $8,487,000 and
$8,265,000 at December 31, 1997 and 1996, respectively, has been established to
cover the estimated ultimate cost of insured losses. The amounts are necessarily
based on estimates of future rates of inflation and other factors, and
accordingly there can be no assurance that the ultimate liability will not vary
from such estimates. The estimates are continually reviewed and adjusted as
necessary; such adjustments are included in current operations (see note 4).
Salvage and subrogation recoverables are estimated using historical experience.
(g) INVESTMENTS
Investments in fixed maturities, where the Companies have the ability and
intent to hold to maturity, are carried at amortized cost. Accordingly,
unrealized holding gains or losses are not reflected in the accompanying
consolidated financial statements. Investments in fixed maturities and equity
securities held as available for sale are carried at fair value. The net
unrealized holding gains or losses, net of applicable deferred taxes, are shown
as a separate component of stockholders' equity, and are not included in the
determination of net earnings. Gains and losses on the sale of equity securities
are computed using the first-in, first-out method.
(h) MANAGEMENT SERVICES INCOME
Management services income includes income for executive management services
provided by State Auto P&C and income for investment management services
provided by Stateco. Executive management income is recognized quarterly based
on a percentage of the average adjusted annual statutory surplus of each company
managed except for Midwest Security Insurance Company (Midwest Security), a
wholly-owned subsidiary of Mutual, which is based on a percentage of quarterly
direct premiums written. Investment management income is recognized quarterly
based on a percentage of the average fair value of investable assets and the
performance of the equity portfolio of each company managed.
(i) SOFTWARE REVENUE RECOGNITION
SIS recognizes revenue from license fees when the product is delivered and
service revenue when services are performed. Costs of developing and testing new
or enhanced software products are capitalized and are amortized on a
product-by-product basis utilizing the straight-line method over a period not to
exceed three years. Unamortized software development costs of $1,285,000 and
$1,055,000 are included in accrued investment income and other assets at
December 31, 1997 and 1996, respectively. Software amortization, included in
other expenses, was $489,000 and $394,000 in 1997 and 1996, respectively.
41
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(j) FEDERAL INCOME TAXES
The Companies file a consolidated federal income tax return and pursuant to
an agreement, each entity within the consolidated group pays its share of
federal income taxes based on separate return calculations.
Income taxes are accounted for using the liability method. Using this method,
deferred tax assets and liabilities are determined based on differences between
financial reporting and tax bases of assets and liabilities and are measured
using the enacted tax rates and laws that will be in effect when the differences
are expected to reverse.
(k) CASH EQUIVALENTS
For purposes of the statements of cash flows, the Company considers all
highly liquid debt instruments with a maturity of three months or less to be
cash equivalents.
(l) NET EARNINGS PER COMMON SHARE
In 1997, the Financial Accounting Standards Board issued SFAS No. 128,
"Earnings per Share." SFAS No. 128 replaced the calculation of primary and fully
diluted earnings per share with basic and diluted earnings per share. Unlike
primary earnings per share, basic earnings per share excludes any dilutive
effects of options, warrants and convertible securities. Diluted earnings per
share is very similar to the previously reported fully diluted earnings per
share. All earnings per share amounts for all periods have been presented, and
where appropriate, restated to conform to SFAS No. 128 presentation. For
additional disclosure, see Note 12.
(m) NEW ACCOUNTING STANDARDS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income,"
which is effective for fiscal years beginning after December 15, 1997. Statement
130 establishes standards for the reporting and display of comprehensive income
and its components in a full set of general purpose financial statements. Also
in June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information," which is effective for fiscal years
beginning after December 15, 1997. SFAS No. 131 changes the way public companies
report segment information in annual financial statements and also requires
those companies to report selected segment information in interim financial
reports to shareholders. The Company has not yet determined the reporting
changes required by SFAS Nos. 130 and 131 to comprehensive income and segment
information.
42
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
(2) INVESTMENTS
Realized and unrealized gains and losses are summarized as follows:
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
---- ---- ----
(dollars in thousands)
Realized gains:
Fixed maturities available for sale............................................ $ 691 1,793 1,226
Equity securities.............................................................. 63 -- --
---------------------------------------
Total realized gains.............................................................. 754 1,793 1,226
---------------------------------------
Realized losses:
Fixed maturities available for sale............................................ $ 182 392 25
Equity securities.............................................................. 29 -- --
---------------------------------------
Total realized losses............................................................. 211 392 25
---------------------------------------
Net realized gains on investments................................................. $ 543 1,401 1,201
---------------------------------------
Increase (decrease) in unrealized holding gains or losses -- Fixed
maturities held to maturity.................................................... $ 1,464 (1,604) 5,561
---------------------------------------
Increase in unrealized holding gains -- Equity
securities..................................................................... $ 293 -- --
Increase (decrease) in unrealized holding gains or losses -- Fixed
maturities available for sale at fair value.................................... 5,444 (7,231) 18,166
Change in deferred unrealized gain................................................ (119) (132) 833
Deferred federal income taxes thereon............................................. (1,967) 2,577 (6,650)
---------------------------------------
Increase (decrease) in net unrealized holding gains or losses..................... $ 3,651 (4,786) 12,349
---------------------------------------
43
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The Company's investments in held to maturity securities and available for sale
securities are summarized as follows:
GROSS GROSS
HELD TO MATURITY AT DECEMBER 31, 1997: AMORTIZED UNREALIZED UNREALIZED FAIR
COST HOLDING GAINS HOLDING LOSSES VALUE
---- ------------- -------------- -----
(dollars in thousands)
U.S. Treasury securities and obligations of U.S.
government corporations and agencies................... $ 6,689 73 2 6,760
Obligations of states and political subdivisions.......... 7,068 430 -- 7,498
Mortgage-backed securities................................ 65,543 1,806 36 67,313
---------------------------------------------------------------
Total..................................................... $ 79,300 2,309 38 81,571
---------------------------------------------------------------
AVAILABLE FOR SALE AT DECEMBER 31, 1997:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies................... $ 72,916 1,955 79 74,792
Obligations of states and political subdivisions.......... 222,823 10,358 8 233,173
Corporate securities...................................... 10,117 496 65 10,548
Mortgage-backed securities................................ 1,733 53 -- 1,786
---------------------------------------------------------------
Total fixed maturities................................. 307,589 12,862 152 320,299
Equity securities......................................... 4,287 423 130 4,580
---------------------------------------------------------------
Total..................................................... $ 311,876 13,285 282 324,879
---------------------------------------------------------------
Deferred federal income taxes on the net unrealized holding gain was $4,755,000
at December 31, 1997.
HELD TO MATURITY AT DECEMBER 31, 1996:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies................... $ 6,728 6 36 6,698
Obligations of states and political subdivisions.......... 7,081 223 12 7,292
Mortgage-backed securities................................ 76,442 1,167 541 77,068
---------------------------------------------------------------
Total..................................................... $ 90,251 1,396 589 91,058
---------------------------------------------------------------
AVAILABLE FOR SALE AT DECEMBER 31, 1996:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies................... $ 86,349 1,662 660 87,351
Obligations of states and political subdivisions.......... 188,296 6,415 404 194,307
Corporate securities...................................... 10,133 428 202 10,359
Mortgage-backed securities................................ 2,012 27 -- 2,039
---------------------------------------------------------------
Total..................................................... $ 286,790 8,532 1,266 294,056
---------------------------------------------------------------
Deferred federal income taxes on the net unrealized holding gain was $2,788,000
at December 31, 1996.
44
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The amortized cost and fair value of fixed maturities segregated by held to
maturity and available for sale, at December 31, 1997, by contractual maturity,
are summarized as follows:
HELD TO MATURITY AVAILABLE FOR SALE
---------------- ------------------
AMORTIZED FAIR AMORTIZED FAIR
COST VALUE COST VALUE
---- ----- ---- -----
(dollars in thousands)
Due after 1 year or less............................ $ 376 376 9,000 9,014
Due after 1 year through 5 years.................... 3,787 3,823 30,394 31,641
Due after 5 years through 10 years.................. 3,519 3,620 139,943 146,250
Due after 10 years.................................. 6,075 6,439 126,519 131,608
-----------------------------------------------------------
13,757 14,258 305,856 318,513
Mortgage-backed securities.......................... 65,543 67,313 1,733 1,786
-----------------------------------------------------------
$79,300 81,571 307,589 320,299
-----------------------------------------------------------
Expected maturities may differ from contractual maturities because the issuers
may have the right to call or prepay the obligations with or without call or
prepayment penalties.
Fixed maturities with carrying values of approximately $3,936,000 and $3,890,000
were on deposit as required by law or specific escrow agreement at December 31,
1997 and 1996, respectively.
Components of net investment income are summarized as follows:
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
---- ---- ----
(dollars in thousands)
Fixed maturities............................................................. $ 24,232 23,578 22,275
Equity securities............................................................ 27 -- --
Cash and cash equivalents.................................................... 1,020 814 850
-------------------------------------------
Investment income............................................................ 25,279 24,392 23,125
-------------------------------------------
Investment expenses.......................................................... 201 513 508
-------------------------------------------
Net investment income........................................................ $ 25,078 23,879 22,617
-------------------------------------------
(3) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating
its fair value disclosures for financial instruments:
Cash and cash equivalents: The carrying amounts reported in the balance
sheet for these instruments approximate their fair value.
Investment securities: Fair values for investments in fixed maturities are
based on quoted market prices, where available. For fixed maturities not
actively traded, fair values are estimated using values obtained from
independent pricing services. The fair values for equity securities are
based on quoted market prices.
See note 2 for additional fair value disclosures.
45
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(4) LOSSES AND LOSS EXPENSES PAYABLE
Activity in the liability for losses and loss expenses is summarized as
follows:
Year ended December 31
----------------------
1997 1996 1995
---- ---- ----
(dollars in thousands)
Losses and loss expenses payable, net of reinsurance receivables,
at beginning of year......................................................... $ 156,184 161,297 126,742
Incurred related to:
Current year................................................................. 179,295 194,568 171,449
Prior years.................................................................. (13,505) (21,028) (12,536)
-----------------------------------------
Total incurred.................................................................. 165,790 173,540 158,913
-----------------------------------------
Paid related to:
Current year................................................................. 107,537 116,983 95,011
Prior years.................................................................. 61,862 61,670 62,248
-----------------------------------------
Total paid...................................................................... 169,399 178,653 157,259
-----------------------------------------
Impact of pooling change, January 1, 1995 (note 5).............................. -- -- 32,901
-----------------------------------------
Losses and loss expenses payable, net of reinsurance recoverables,
at end of year............................................................... $ 152,575 156,184 161,297
-----------------------------------------
The liability for losses and loss expenses decreased by $13,505,000 in 1997,
$21,028,000 in 1996 and $12,536,000 in 1995, for claims that had occurred in
prior years. These decreases have resulted primarily from moderating trends in
the frequency and severity of losses and loss expenses due to lower inflation.
This along with fundamental improvements primarily in the auto liability and
workers' compensation lines of business resulted in incurred losses and loss
expenses developing favorably. Because of the nature of the business written
over the years, the Company's management believes that the Company has limited
exposure to environmental claim liabilities.
(5) REINSURANCE
In the ordinary course of business, State Auto P&C assumes and cedes
reinsurance with other insurers and reinsurers and is a member in various pools
and associations. The voluntary arrangements provide greater diversification of
business and limit the maximum net loss potential arising from large risks and
catastrophes. Most of the ceded reinsurance is effected under reinsurance
contracts known as treaties; some is by negotiation on individual risks.
Although the ceding of reinsurance does not discharge the original insurer from
its primary liability to its policyholder, the insurance company that assumes
the coverage assumes the related liability.
Amounts recoverable from reinsurers are estimated in a manner consistent with
the claim liability associated with the reinsured business. The recoverability
of these assets depends on the reinsurers' ability to perform under the
reinsurance agreements. The Company evaluates and monitors the financial
condition and concentrations of credit risk associated with its reinsurers under
voluntary reinsurance arrangements to minimize its exposure to significant
losses from reinsurer insolvencies.
State Auto P&C and Milbank participate in a reinsurance pooling arrangement
with Mutual. The arrangement provides that all premiums, losses, loss expenses,
underwriting expenses, premiums in course of collection and reinsurance
recoverable on loss payments (all transactions and balances in the underwriting
accounts) of the companies be pooled and then allocated to each company based on
percentages outlined in the agreement. The pooling participation percentages
allocate 35% to State Auto P&C, 55% to Mutual and 10% to Milbank. In connection
with a January 1, 1995 change in pooling percentages, State Auto P&C received
approximately $46 million to cover its increased share of pool liabilities.
Subject to regulatory approval, the pooling arrangement was amended pursuant
to an Amended and Restated Reinsurance Pooling Agreement, effec-
46
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
tive as of January 1, 1998, to include all of the property and casualty business
of Midwest Security. Concurrently, with the inclusion of Midwest Security, the
pooling participation percentages were amended to allocate 37% to State Auto
P&C, 52% to Mutual, 10% to Milbank and 1% to Midwest Security. In connection
with the January 1, 1998 change in pooling percentages, State Auto P&C received
approximately $17.2 million to cover its increased share of pool liabilities.
Pursuant to the pooling arrangement, Mutual is responsible for the collection
of premiums and payment of losses, loss expenses and underwriting expenses of
the pooled companies. Unpaid balances are reflected in due to or due from
affiliates in the accompanying consolidated balance sheets. Settlements of the
intercompany account are made quarterly. No interest is paid on this account.
All premium balances receivable and reinsurance recoverable on paid losses from
unaffiliated reinsurers are carried by Mutual.
Effective July 1, 1996, the State Auto Insurance Companies (State Auto P&C,
Mutual, Milbank and National) negotiated a change in their catastrophe
reinsurance program. State Auto P&C has assumed catastrophe reinsurance from
Mutual, Milbank and National pursuant to a catastrophe reinsurance agreement in
the amount of $100 million excess of $120 million. To protect against a
catastrophe loss event in which the State Auto Insurance Companies would incur
catastrophe losses in excess of $120 million, the Company entered into a
structured contingent financing transaction with Chase Manhattan Bank (Chase) to
provide up to $100 million of additional reinsurance protection. Under this
arrangement, in the event of such a loss, the Company would sell redeemable
preferred shares to SAF Funding Corporation, a special purpose company (SPC),
which will borrow the money necessary for such purchase from Chase and a
syndicate of other lenders. The Company will contribute to State Auto P&C the
proceeds from the sale of its preferred shares. State Auto P&C will use the
contributed capital to pay its direct catastrophe losses and losses assumed
under the catastrophe reinsurance agreement. The Company is obligated to repay
SPC by redeeming the preferred shares over a six year period. This layer of $100
million in excess of $120 million has been excluded from the pooling arrangement
pursuant to the terms of the Amended and Restated Reinsurance Pooling Agreement,
also effective July 1, 1996.
In addition, the Company's obligation to repay SPC has been secured by a Put
Agreement among the Company, Mutual and the Lenders, under which, in the event
of a default by the Company, as described in the Credit Agreement or in the Put
Agreement, Mutual would be obligated to put either the preferred shares or the
loan(s) outstanding.
The Company has reported ceded losses and loss expenses payable and prepaid
reinsurance premiums as assets. The amounts reported represent State Auto P&C's
pooling percentage of the total amounts ceded to unaffiliated reinsurers and
National's ceded amounts. All contracts providing indemnification against loss
or liability relating to insurance risk have been accounted for as reinsurance.
Contracts for which it is not clear that the treaty results in the reasonable
possibility that the reinsurer may realize a significant loss from the insurance
risk assumed have been accounted for as deposits.
47
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The following table summarizes State Auto P&C's direct business, amounts
contributed to the pool and State Auto P&C's participation in the pool:
DECEMBER 31
-----------
1997 1996
---- ----
(dollars in thousands)
Losses and loss expenses payable:
Direct........................................................ $ 158,112 161,458
Assumed (excluding intercompany pooling)...................... 11,633 12,734
Ceded (excluding intercompany pooling)........................ (8,876) (10,919)
------------------------------
Net amount contributed to the pool......................... 160,869 163,273
------------------------------
Direct and assumed (intercompany pooling)..................... 153,712 160,478
Ceded (intercompany pooling).................................. (7,785) (8,538)
------------------------------
Net participation in the pool.............................. $ 145,927 151,940
------------------------------
Unearned premiums:
Direct........................................................ $ 106,095 101,224
Assumed (excluding intercompany pooling)...................... 4,679 5,236
Ceded (excluding intercompany pooling)........................ (3,074) (3,547)
------------------------------
Net amount contributed to the pool......................... 107,700 102,913
------------------------------
Direct and assumed (intercompany pooling)..................... 89,558 86,325
Ceded (intercompany pooling).................................. (2,001) (2,117)
------------------------------
Net participation in the pool.............................. $ 87,557 84,208
------------------------------
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
----------------------------------------------
(dollars in thousands)
Earned premiums:
Direct.................................................................... $ 282,255 271,435 260,288
Assumed (excluding intercompany pooling).................................. 14,871 17,804 22,132
Ceded (excluding intercompany pooling).................................... (12,728) (14,822) (16,548)
----------------------------------------------
Net amount contributed to the pool..................................... 284,398 274,417 265,872
----------------------------------------------
Direct and assumed (intercompany pooling)................................. 237,973 233,560 232,907
Ceded (intercompany pooling).............................................. (7,715) (8,379) (9,467)
----------------------------------------------
Net participation in the pool.......................................... 230,258 225,181 223,440
Assumed from affiliates (excluding intercompany pooling).................. 2,925 1,470 --
----------------------------------------------
Total.................................................................. $ 233,183 226,651 223,440
----------------------------------------------
Losses and loss expenses incurred:
Direct.................................................................... $ 175,355 210,077 182,975
Assumed (excluding intercompany pooling).................................. 14,848 19,673 20,205
Ceded (excluding intercompany pooling).................................... (5,620) (9,672) (10,404)
----------------------------------------------
Net amount contributed to the pool..................................... 184,583 220,078 192,776
----------------------------------------------
Direct and assumed (intercompany pooling)................................. 152,213 167,036 156,299
Ceded (intercompany pooling).............................................. (3,429) (3,962) (3,855)
----------------------------------------------
Net participation in the pool.......................................... $ 148,784 163,074 152,444
----------------------------------------------
48
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
National has a reinsurance agreement with Mutual to cede 20% of its premiums
written and losses and loss expenses incurred to Mutual for liability lines. The
agreement also has a provision for excess of loss coverage, whereby Mutual will
reinsure National for all losses over a prescribed limit for each individual
occurrence. Through Mutual's participation, the effects of the reinsurance
agreement are indirectly subject to the pooling agreement between Mutual, State
Auto P&C and Milbank.
Amounts related to National's reinsurance agreement that are reported as
assets in the accompanying consolidated balance sheets are summarized as
follows:
DECEMBER 31
-----------
1997 1996
---- ----
(dollars in thousands)
Losses and loss expenses payable...............$ 2,086 1,153
Unearned premiums.............................. 1,626 1,263
----------------------------
The effects of the agreement on the indicated income and expense accounts are
summarized as follows:
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
---- ---- ----
(dollars in thousands)
Earned premiums................................$ 4,144 2,700 1,806
Losses and loss expenses incurred.............. 2,950 1,467 890
------------------------------------
(6) TRANSACTIONS WITH MUTUAL
State Auto P&C provides Mutual and its insurance affiliates executive
management services to oversee the insurance operations of these companies. Fees
relating to these services amounted to $5,392,000 in 1997, $4,956,000 in 1996
and $4,662,000 in 1995.
Stateco provides Mutual and its affiliates investment management services.
Fees related to these services amounted to $3,313,000 in 1997, $3,064,000 in
1996 and $2,912,000 in 1995.
Effective July 1, 1995, SIS began providing insurance software products and
services to Mutual and its affiliates. Fees relating to these services amounted
to $1,051,000 in 1997, $1,015,000 in 1996 and $423,000 in 1995 and is included
in other expense.
State Auto P&C's December 31, 1990 liability for losses and loss expenses of
$65,464,000 has been guaranteed by Mutual. Pursuant to the guaranty agreement,
all ultimate adverse development of the December 31, 1990 liability, if any, is
to be reimbursed by Mutual to State Auto P&C. As of December 31, 1997, there has
been no adverse development of the liability.
49
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(7) FEDERAL INCOME TAXES
A reconciliation between actual federal income taxes and the amount computed
at the indicated statutory rate is as follows:
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
AMOUNT % AMOUNT % AMOUNT %
------ - ------ - ------ -
(dollars in thousands, except percentages)
Amount at statutory rate ........................................ $ 16,479 35 10,552 35 12,369 35
Tax-free interest and dividends received deduction .............. (3,455) (7) (3,051) (10) (2,812) (8)
Other, net ...................................................... 101 -- 45 -- 240 1
-------------------------------------------------------
Effective tax rate .............................................. $ 13,125 28 7,546 25 9,797 28
-------------------------------------------------------
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and deferred tax liabilities at December 31,
1997 and 1996 are presented below:
1997 1996
---- ----
(dollars in thousands)
Deferred tax assets:
Unearned premiums not deductible .......................... $ 6,707 6,336
Losses and loss expenses payable discounting .............. 5,409 5,686
Other ..................................................... 994 871
---------------------------
Total deferred tax assets ............................. 13,110 12,893
---------------------------
Deferred tax liabilities:
Deferral of policy acquisition costs ...................... 6,191 5,499
Net pension expense ....................................... 4,246 3,718
Unrealized holding gain on investments .................... 4,755 2,788
Other ..................................................... 967 734
---------------------------
Total deferred tax liabilities ........................ 16,159 12,739
---------------------------
Net deferred tax assets (liabilities) ................. $ (3,049) 154
---------------------------
The Company is required to establish a valuation allowance for any portion of
the deferred tax asset that management believes will not be realized. In the
opinion of management, it is more likely than not that the Company will realize
the benefit of the deferred tax assets and, therefore, no such valuation
allowance has been established.
Federal income taxes paid during 1997, 1996 and 1995 were $13,435,000,
$5,883,000 and $11,371,000, respectively.
50
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(8) BENEFIT PLANS
State Auto P&C, Stateco and SIS, pursuant to an intercompany agreement, are
participants, together with Mutual, in a defined benefit pension plan that
covers substantially all employees of Mutual, State Auto P&C, Stateco and SIS.
The assets of the plan are represented primarily by U.S. government and agency
obligations, bonds, and common stocks. Mutual, State Auto P&C, Stateco and SIS's
policy is to fund pension costs in accordance with the requirements of the
Employee Retirement Income Security Act of 1974. Benefits are determined by
applying factors specified in the plan to a participant's defined average annual
compensation.
Information regarding the funded status and net periodic pension cost for State
Auto P&C, Stateco and SIS's participation in the plan is as follows:
DECEMBER 31
-----------
1997 1996
---- ----
(dollars in thousands)
Accumulated benefit obligation:
Vested................................................................$ 29,897 (30,473)
Nonvested............................................................. 202 (237)
----------------------------
$ 30,099 (30,710)
----------------------------
Projected benefit obligation (PBO) for services rendered to date.........$ (31,832) (31,049)
Plan assets at fair value................................................ 51,735 43,963
----------------------------
Plan assets in excess of PBO............................................. 19,903 12,914
Unrecognized net gain.................................................... (8,261) (2,775)
Unrecognized net assets at end of period................................. (1,209) (1,330)
Unrecognized prior service cost.......................................... 1,700 1,814
----------------------------
Net prepaid pension expense..............................................$ 12,133 10,623
----------------------------
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
---- ---- ----
(dollars in thousands)
Net periodic pension cost consists of the following:
Service cost (benefits earned during the period).............................. $ 1,246 1,191 952
Interest cost on PBO.......................................................... 2,211 2,116 2,059
Actual return on plan assets.................................................. (3,798) (3,334) (2,907)
Net amortization and deferral................................................. (10) (7) (7)
------------------------------------------
Net periodic pension (benefit) expense........................................... $ (351) (34) 97
------------------------------------------
The actuarial assumptions used in these calculations are as follows:
1997 1996 1995
---- ---- ----
Weighted average discount rate................................................... 7.25% 7.25% 7.25%
Rates of increase in compensation levels......................................... 4.50% 4.50% 4.50%
Expected long-term rate of return on assets...................................... 9.00% 9.00% 9.00%
State Auto P&C, Stateco and SIS are also participants with Mutual in a
defined contribution plan that covers substantially all employees of Mutual,
State Auto P&C, Stateco and SIS. Contributions to the plan are based on employee
contributions and the level of Company match. State Auto P&C, Stateco and SIS's
share of the expense under the plan totaled $581,000, $534,000 and $496,000 for
the years 1997, 1996 and 1995, respectively.
51
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(9) STOCKHOLDERS' EQUITY
(a) STOCK SPLIT
On May 30, 1996, the Board of Directors approved a three-for-two common stock
split to be effected in the form of a stock dividend, which has been given
retroactive effect. Fractional shares were paid in cash.
(b) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION
State Auto P&C and National are subject to regulations and restrictions under
which payment of dividends from statutory surplus can be made to the Company
during the year without prior approval of regulatory authorities. Pursuant to
these rules, approximately $28.9 million is available for payment to the Company
in 1998 without prior approval.
Reconciliations of statutory capital and surplus and net income or loss, as
determined using statutory accounting practices, to the amounts included in the
accompanying consolidated financial statements are as follows:
DECEMBER 31
-----------
1997 1996
---- ----
(dollars in thousands)
Statutory capital and surplus of insurance subsidiaries....................... $ 151,762 126,742
Net assets of noninsurance parent and affiliates.............................. 15,869 11,870
---------------------------
167,631 138,612
Add (subtract) cumulative effect of adjustments:
Deferred policy acquisition costs.......................................... 17,689 15,711
Losses and loss expenses payable........................................... 8,487 8,265
Net prepaid pension expense................................................ 12,102 10,583
Deferred federal income taxes.............................................. (2,826) 205
Excess of statutory loss liabilities over case basis amounts............... 7,748 4,199
Fixed maturities at fair value............................................. 13,285 7,978
Other, net................................................................. 1,363 908
---------------------------
Stockholders' equity per accompanying consolidated
financial statements................................................... $ 225,479 186,461
---------------------------
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
---- ---- ----
(dollars in thousands)
Statutory net income of insurance subsidiaries............................... $ 28,696 18,336 14,652
Net earnings of noninsurance parent and affiliates........................... 2,581 2,301 2,406
-------------------------------------------
31,277 20,637 17,058
Increases (decreases):
Deferred policy acquisition costs......................................... 1,978 (155) 3,345
Losses and loss expenses payable.......................................... 222 887 2,242
Net prepaid pension expense............................................... 1,519 1,253 2,012
Deferred federal income taxes............................................. (1,071) (56) 782
Other, net................................................................ 34 36 103
-------------------------------------------
Net earnings per accompanying consolidated
financial statements................................................... $ 33,959 22,602 25,542
-------------------------------------------
52
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(10) PREFERRED STOCK
The Company has authorized two classes of preferred stock. For both classes,
upon issuance, the Board of Directors has authority to fix and determine the
significant features of the shares issued, including, among other things, the
dividend rate, redemption price, redemption rights, conversion features and
liquidation price payable in the event of any liquidation, dissolution, or
winding up of the affairs of the Company. See Note (5) regarding the Company's
obligation to issue redeemable preferred shares to SPC in connection with its
catastrophe reinsurance arrangements with Chase Manhatten Bank.
The Class A preferred stock is not entitled to voting rights until, for any
period, dividends are in arrears in the amount of six or more quarterly
dividends.
(11) STOCK INCENTIVE PLANS
The Company follows Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" (APB 25), and related Interpretations in
accounting for its stock incentive plans. Under APB 25, because the exercise
price of the Company's employee stock options equals the market price of the
underlying stock on the date of grant, no compensation expense is recognized.
Had compensation cost for the Company's plans been determined based on the fair
values at the grant dates consistent with the method of SFAS No. 123,
"Accounting for Stock-Based Compensation," (SFAS No. 123), the Company's pro
forma net earnings and net earnings per share information would have been as
follows:
1997 1996 1995
---- ---- ----
(in thousands, except
per share figures)
Pro forma net earnings ............................................. $ 33,006 21,760 24,533
Pro forma net earnings per common share
Basic ......................................................... $ 1.81 1.20 1.37
Diluted ....................................................... $ 1.77 1.18 1.35
The Company has stock option plans for certain directors and key employees of
Mutual, State Auto P&C, Stateco and SIS. The nonemployee directors' plan
provides each nonemployee director an option to purchase 1,000 shares of common
stock following each annual meeting of the shareholders at an option price equal
to the fair market value at the last business day prior to the annual meeting.
The Company has reserved 150,000 shares of common stock under this plan. These
options are exercisable at issuance to 10 years from date of grant. The key
employee's plan provides that qualified stock options may be granted at an
option price not less than fair market value at date of grant and that
nonqualified stock options may be granted at any price determined by the options
committee of the Board of Directors. The Company has reserved 1,800,000 shares
of common stock under this plan. For certain employees these options are
exercisable from 1 to 10 years from date of grant, and 3 to 10 years for
remaining employees.
The fair value of these options utilized in the pro forma information above
were estimated at the date of grant using the Black-Scholes option-pricing model
with the following weighted-average assumptions for 1997 and 1996, respectively:
dividend yield of 1.0% for both years; expected volatility factors of .24 and
.23; risk-free interest rates of 6.7% and 6.6%; and expected life of the option
of 8 years for both years.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
option, the existing models do not necessarily provide a reliable single measure
of the fair value of its employee stock options.
53
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
A summary of the Company's stock option activity and related information for
these plans for the years ended December 31, 1997, 1996 and 1995, follows:
---------------------------- ---------------------------- ----------------------------
1997 1996 1995
Weighted - Average Weighted - Average Weighted - Average
Options Exercise Price Options Exercise Price Options Exercise Price
------- -------------- ------- -------------- ------- --------------
(numbers in thousands, except per share figures)
Outstanding, beginning
of year 1,131 $ 9.57 950 $ 8.33 684 $7.12
Granted 19 18.63 217 14.72 292 11.03
Exercised (138) 6.98 (36) 7.76 (23) 6.64
Cancelled (2) 14.63 -- -- (3) 8.83
-- -----
Outstanding, end of year 1,010 $10.08 1,131 $ 9.57 950 $8.33
----- ----- ---
Weighted - average fair
value of options granted
during the year: $8.73 $ 5.81 $4.52
A summary of information pertaining to options outstanding and exercisable as of
December 31, 1997 follows:
----------------------------------------------------- ------------------------------
Options Outstanding Options Exercisable
Weighted - Average
Remaining Weighted - Average Weighted - Average
Range of Exercise Prices Number Contractual Life Exercise Price Number Exercise Price
------------------------ ------ ---------------- -------------- ------ --------------
(numbers in thousands, except per share figures)
Less than $9.00 508 4.7 years $ 7.39 508 $ 7.39
Greater than $9.00 502 7.8 12.82 453 12.46
--- ---
1,010 961
----- ---
The Company has an employee stock purchase plan with a dividend reinvestment
feature, under which employees of Mutual, State Auto P&C, Stateco and SIS 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 1,200,000 shares of
common stock under this plan. At December 31, 1997, 641,285 shares have been
purchased under this plan. Compensation expense is recognized for the fair value
of the employee's purchase rights, which was estimated using the Black-Scholes
model with the following weighted-average assumptions for 1997 and 1996,
respectively: dividend yield of 1.0% for both years; expected volatility factors
of .32 and .24; risk-free interest rates of 5.6% and 6.5%; and expected lives of
6 months for both years. The weighted-average fair value of those purchase
rights granted in 1997 and 1996 was $5.21 and $3.52, respectively.
54
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(12) NET EARNINGS PER COMMON SHARE
The following table sets forth the compilation of basic and diluted net earnings per common share:
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995
---- ---- ----
( in thousands, except per share data)
Numerator:
Net earnings for basic and diluted earnings per common share..............$ 33,959 22,602 25,542
----------------------------------------------
Denominator:
Weighted average shares for basic net earnings
per common share..................................................... 18,204 18,070 17,957
Effect of dilutive stock options.......................................... 453 334 229
Adjusted weighted average shares for
diluted net earnings per common share .............................. 18,657 18,404 18,186
----------------------------------------------
Basic net earnings per common share.......................................... 1.86 1.25 1.42
----------------------------------------------
Diluted net earnings per common share........................................ 1.82 1.23 1.41
----------------------------------------------
(13) QUARTERLY FINANCIAL DATA (UNAUDITED)
FOR THREE MONTHS ENDED
----------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
--------- -------- ------------- ------------
1997
----
(dollars in thousands, except per share amounts)
Total revenues.......................................... $ 70,931 72,380 72,431 73,266
Earnings before federal income taxes.................... 10,345 11,278 11,283 14,178
Net earnings ........................................... 7,531 8,118 8,009 10,301
Net earnings per common share (note 9a):
Basic................................................ .42 .44 .44 .56
Diluted.............................................. .41 .43 .43 .55
-----------------------------------------------------------------
FOR THREE MONTHS ENDED
----------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
--------- -------- ------------- ------------
1996
----
(dollars in thousands, except per share amounts)
Total revenues.......................................... $67,332 68,375 68,491 69,447
Earnings before federal income taxes.................... 7,681 6,667 4,530 11,270
Net earnings ........................................... 5,607 4,850 3,660 8,485
Net earnings per common share (note 9a):
Basic................................................ .31 .27 .20 .47
Diluted.............................................. .31 .26 .20 .46
-----------------------------------------------------------------
55
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
(14) CONTINGENCIES
State Auto P&C and National are involved in litigation and may become
involved in potential litigation arising in the ordinary course of business. In
the opinion of management, the effects, if any, of such litigation are not
expected to be material to the consolidated financial statements.
(15) SUBSEQUENT EVENTS
On March 6, 1998, the Board of Directors of the Company announced its
intention to declare a two-for-one stock split to be distributed July 8, 1998,
to shareholders of record on June 18, 1998. The stock split is contingent upon
shareholder approval of a proposal to increase the number of authorized common
shares, without par value, from 30 million to 100 million at the Company's
Annual Meeting of Shareholders on May 28, 1998. Accordingly, the impact of this
stock split is not reflected in these financial statements.
The Board also voted to authorize the officers of the Company to undertake
such actions as are necessary to effect the exercise the Company's option to
acquire Milbank from Mutual. The Company's acquisition of Milbank is subject to
the completion of certain procedural matters contemplated by the Option
Agreement as approved by the Boards of Directors of Mutual and the Company and
regulatory approval in Ohio and South Dakota, where the respective companies are
domiciled. The proposed effective date of transfer is third quarter 1998.
Milbank was acquired in 1993 by Mutual and an Option Agreement granted the
Company the right to acquire Milbank from Mutual within five years.
56
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required under this Item with respect to directors will be
contained in the Company's proxy statement to be filed within 120 days of
December 31, 1997, and is hereby incorporated herein by reference.
Information required under this Item with respect to executive officers
is contained under the heading "Executive Officers of the Registrant" in Item 1
of this Form 10-K report.
ITEM 11. EXECUTIVE COMPENSATION
Information required under this Item will be contained in the Company's
proxy statement to be filed within 120 days of December 31, 1997, and is hereby
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required under this Item will be contained in the Company's
proxy statement to be filed within 120 days of December 31, 1997, and is hereby
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required under this Item will be contained in the Company's
proxy statement to be filed within 120 days of December 31, 1997, and is hereby
incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) LISTING OF FINANCIAL STATEMENTS
The following consolidated financial statements of the
Company, are filed as part of this Form 10-K Report and are
included in Item 8:
Report of Independent Auditors
Consolidated Balance Sheets as of
December 31, 1997 and 1996
Consolidated Statements of Earnings for
each of the three years in the
period ended December 31, 1997
Consolidated Statements of Stockholders'
Equity for each of the three years in the
period ended December 31, 1997
Consolidated Statements of Cash Flows for
each of the three years in the
period ended December 31, 1997
Notes to Consolidated Financial Statements
57
(a)(2) LISTING OF FINANCIAL STATEMENT SCHEDULES
The following financial statement schedules of the Company for
the years 1997, 1996, and 1995 are included in Item 14(d),
following the signatures, and should be read in conjunction
with the consolidated financial statements contained in this
Form 10-K Annual Report.
Schedule
Number Schedule
- -------- --------
I. Summary of Investments - Other Than
Investments in Related Parties
II. Condensed Financial Information of Registrant
IV. Reinsurance
VI. Supplemental Information Concerning Property -
Casualty Insurance Operations
Independent Auditors' Consent (filed as Exhibit 23).
All other schedules are omitted because they are not
applicable or the required information is included in the
consolidated financial statements or notes thereto.
58
(a)(3) LISTING OF EXHIBITS
If incorporated by reference document
Exhibit No. Description of Exhibit with which Exhibit was previously filed with SEC
- ----------- ---------------------- ------------------------------------------------
3(A)(1) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No.
Articles of Incorporation 33-40643 on Form S-1 (see Exhibit 3(a)
therein)
3(A)(2) State Auto Financial Corporation's Amendment to the 1933 Act Registration Statement No.
Amended and Restated Articles of Incorporation 33-89400 on Form S-8 (see Exhibit 4(b)
therein)
3(B) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No.
Code of Regulations 33-40643 on Form S-1 (see Exhibit 3(b)
therein)
4 State Auto Financial Corporation's Amended and Restated See Exhibit 3(A) and 3(B)
Articles of Incorporation, and Articles 1, 3, 5 and 9 of
the Company's Amended and Restated Code of Regulations
10(A) Reinsurance Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and Southern Home Insurance Company, 33-40643 on Form S-1 (see Exhibit 10(a)
now known as State Auto Property and Casualty Insurance therein)
Company, dated January 1, 1987
10(B) Amendment Number 1 effective January 1, 1992 to Reinsurance Form 10-K Annual Report for the year
Agreement between State Automobile Mutual Insurance Company ended December 31, 1991 (see Exhibit 10(B)
and State Auto Property and Casualty Insurance Company therein)
formerly known as Southern Home Insurance Company, effective
as of January 1, 1987
10(C) Amendment Number 2 dated as of December 1, 1993 to the Form 10-K Annual Report for the year
Reinsurance Agreement between State Automobile Mutual Insurance ended December 31, 1993 (see Exhibit 10(C)
Company and State Auto Property and Casualty Insurance Company therein)
formerly known as Southern Home Insurance Company, effective as
of January 1, 1987
10(D) Amendment Number 3 dated as of December 1, 1994 effective Form 10-K Annual Report for the year
as of January 1, 1995 to the Reinsurance Agreement between ended December 31, 1994 (see Exhibit
State Automobile Mutual Insurance Company 10(D) therein)
and State Auto Property and Casualty Insurance Company
10(E)* Amended and Restated Management Agreement among State Form 10-K Annual Report for the year
Automobile Mutual Insurance Company, State Auto Property ended December 31, 1994 (see Exhibit
and Casualty Insurance Company, State Auto National 10(E) therein)
Insurance Company, State Auto Financial Corporation,
State Auto Life Insurance Company, and Milbank effective
April 1, 1994 as approved by insurance regulatory
officials in Ohio, South Carolina and South Dakota
10(F)* Amendment Number 1-A to the Amended and Restated Form 10-K Annual Report for the year
Management Agreement among State Automobile Mutual ended December 31, 1994 (see Exhibit
Insurance Company, State Auto Property and Casualty 10(F) therein)
Insurance Company, State Auto National Insurance
Company, State Auto Financial Corporation, State Auto
Life Insurance Company and Milbank Insurance Company
effective as of January 1, 1995
10(G) Guaranty Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and State Auto Property and Casualty 33-40643 on Form S-1 (see Exhibit 10(d)
Insurance Company dated as of May 16, 1991 therein)
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
59
10(H) Form of Indemnification Agreement between State Auto 1933 Act Registration Statement No.
Financial Corporation and each of its directors 33-40643 on Form S-1 (see Exhibit 10
(e) therein)
10(I)* State Auto 1991 Quality Performance Bonus Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10
(f) therein)
10(J)* Non-Qualified Deferred Compensation Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10
(g) therein)
10(K)* 1991 Stock Option Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10
(h) therein)
10(L)* Amendment Number 1 to the 1991 Stock Option Plan 1933 Act Registration Statement No.
33-89400 on Form S-8 (see Exhibit 4 (a)
therein)
10(M)* 1991 Directors' Stock Option Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10
(i) therein)
10(N) Lease Agreement between Longhollow Associates Limited 1933 Act Registration Statement No.
Partnership and State Automobile Mutual Insurance 33-40643 on Form S-1 (see Exhibit 10
Company dated July 8, 1988, as amended (j) therein)
10(O) License Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and Policy Management Systems 33-40643 on Form S-1 (see Exhibit 10
Corporation dated December 28, 1984 (k) therein)
10(P) Investment Management Agreement between Stateco Form 10-K Annual Report for the year
Financial Services, Inc. and State Automobile Mutual ended December 31, 1992 (see Exhibit 10
Insurance Company, effective April 1, 1993 (N) therein)
10(Q) Option Agreement between State Automobile Mutual Form 10-K Annual Report for year ended
Insurance Company and State Auto Financial Corporation December 31, 1993 (see Exhibit 10 (R)
dated as of August 20, 1993 therein)
10(R)* Supplemental Executive Retirement Income Plan effective Form 10-K Annual Report for the year
December 1, 1992 ended December 31, 1992 (see Exhibit
10(O) therein)
10(S)* State Auto Insurance Companies Directors' Deferred Form 10-K Annual Report for year ended
Compensation Plan December 31, 1995 (see Exhibit 10(S)
therein)
10(T)* State Auto Insurance Companies Non-Qualified Incentive Form 10-K Annual Report for year ended
Deferred Compensation Plan December 31, 1995 (see Exhibit 10(T)
therein)
10(U)* Strategic Insurance Software, Inc. 1995 Stock Option Plan Form 10-K Annual Report for year ended
December 31, 1995 (see Exhibit 10(U)
therein)
10(V)* Strategic Insurance Software, Inc. Warrant to purchase Form 10-K Annual Report for year ended
common stock December 31, 1995 (see Exhibit 10(V)
therein)
10(W)* Strategic Insurance Software, Inc. Shareholder's Form 10-K Annual Report for year ended
Agreement December 31, 1995 (see Exhibit 10(W)
therein)
10(X)* Robert L. Bailey Employment Contract Form 10-K Annual Report for year ended
December 31, 1995 (see Exhibit 10(X)
therein)
- ---------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
60
10(Y) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended between
State Automobile Mutual Insurance Company, State September 30, 1996 (see Exhibit 10(Y)
Auto Property and Casualty Insurance Company and Milbank therein)
Insurance Company effective July 1, 1996
10(Z) Property Catastrophe Overlying Excess of Loss Form 10-Q for the period ended
Reinsurance Contract between State Automobile Mutual September 30, 1996 (see Exhibit 10(Z)
Insurance Company, Milbank Insurance Company, State Auto therein)
National Insurance Company and State Auto Property and
Casualty Insurance Company dated July 1,1996
10(AA) Credit Agreement between SAF Funding Corporation and The Form 10-Q for the period ended
Chase Manhattan Bank dated August 16, 1996 September 30, 1996 (see Exhibit 10(AA)
therein)
10(BB) Put Agreement between State Automobile Mutual Insurance Form 10-Q for the period ended
Company, State Auto Financial Corporation and The Chase September 30, 1996 (see Exhibit 10(BB)
Manhattan Bank dated August 16, 1996 therein)
10(CC) Standby Purchase Agreement between State Auto Financial Form 10-Q for the period ended
Corporation and SAF Funding Corporation dated August 16, September 30, 1996 (see Exhibit 10(CC)
1996 therein)
10(DD)* Amendment Number 2 to the 1991 Stock Option Plan Form 10-K Annual Report for the year
ended December 31, 1996 (see Exhibit
10(DD) therein)
10(EE)* Amendment Number 1 to the 1991 Directors' Stock Option Form 10-K Annual Report for the year
Plan ended December 31, 1996 (see Exhibit
10(EE) therein)
10(FF) Option Agreement between State Auto Mutual and State Form 10-K Annual Report for the year
Auto Financial dated March 11, 1997. ended December 31, 1996 (see Exhibit
10(FF) therein)
10(GG) Amended and Restated Credit Agreement dated August 16, Form 10-Q for the period ended
1996 amended and restated July 18, 1997 between SAF September 30, 1997 (see Exhibit 10(GG)
Funding Corporation and the Chase Manhattan Bank therein)
10(HH) Amended and Restated SERP of State Auto Mutual effective Included herein
as of January 1, 1994
11 Statement regarding computation of earnings per share Included herein
21 List of Subsidiaries of State Auto Financial Corporation Form 10-K Annual Report for the year
ended December 31, 1995 (see Exhibit 22
therein)
23 Consent of Independent Auditors Included Herein
24 Powers of Attorney - John R. Lowther, David L. Form 10-K Annual Report for the year
Bickelhaupt, Paul W. Huesman, George R. Manser and ended December 31, 1991 (see Exhibit 25
Robert J. Murchake therein)
24(A) Power of Attorney - William J. Lhota Form 10-K Annual Report for the year
ended December 31, 1994 (see Exhibit
25(A) therein)
24(B) Power of Attorney - David J. D'Antoni Form 10-K Annual Report for the year
ended December 31, 1995 (see Exhibit
25(B) therein)
- ------------------
* Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
61
24(C) Powers of Attorney - William J. Lhota, Urlin G. Harris, Form 10-Q for the period ended June 30,
Jr., Robert J. Murchake, Paul W. Huesman, George R. 1997 (see Exhibit 24(C) therein)
Manser, David L. Bickelhaupt, and David J. D'Antoni
27 Financial Data Schedule Included Herein
(b) REPORTS ON FORM 8-K
The Company did not file any Form 8-K current reports
during the fourth quarter of the Company's fiscal
year ended December 31, 1997.
(c) EXHIBITS
The exhibits have been submitted as a separate
section of this report following the financial
statement schedules.
(d) FINANCIAL STATEMENT SCHEDULES
The financial statement schedules have been submitted
as a separate section of this report following the
signatures.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
STATE AUTO FINANCIAL CORPORATION
Dated: March 25, 1998 /s/ROBERT L. BAILEY
--------------------------------
Robert L. Bailey, Chairman
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed by the following persons on behalf of the Registrant
and in the capacities and on the dates indicated.
Name Title Date
---- ----- ----
/s/ROBERT L. BAILEY Chairman of the Board March 25, 1998
- ------------------------ Chief Executive Officer
Robert L. Bailey and Director (principal
executive officer)
/s/STEVEN J. JOHNSTON Chief Financial Officer, March 25, 1998
- ------------------------ Vice President, Treasurer
Steven J. Johnston (principal financial officer
and principal accounting
officer)
62
/s/JOHN R. LOWTHER Secretary and Director March 25, 1998
- ------------------------
John R. Lowther
DAVID L. BICKELHAUPT* Director March 25, 1998
- ------------------------
David L. Bickelhaupt
URLIN G. HARRIS, JR.* Director March 25, 1998
- ------------------------
Urlin G. Harris, Jr.
PAUL W. HUESMAN* Director March 25, 1998
- ------------------------
Paul W. Huesman
GEORGE R. MANSER* Director March 25, 1998
- ------------------------
George R. Manser
ROBERT J. MURCHAKE* Director March 25, 1998
- ------------------------
Robert J. Murchake
WILLIAM J. LHOTA* Director March 25, 1998
- ------------------------
William J. Lhota
DAVID J. D'ANTONI* Director March 25, 1998
- ------------------------
David J. D'Antoni
*Steven J. Johnston by signing his name hereto, does sign this document
on behalf of the person indicated above pursuant to a Power of Attorney duly
executed by such person.
/s/STEVEN J. JOHNSTON March 25, 1998
- ------------------------
Steven J. Johnston
Attorney in Fact
form10k\97
63
Item 14(d)
Financial Statement Schedules
64
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I(a) - SUMMARY OF INVESTMENTS - OTHER THAN
INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1997
Column A Column B Column C Column D
-------- -------- -------- --------
HELD TO MATURITY Amount at
which shown
in the
Type of Investment Cost Value balance sheet
------------------ ---- ----- -------------
(in thousands)
Fixed maturities:
Bonds:
United States Government and
government agencies and authorities $72,232 $74,073 $72,232
States, municipalities and
political subdivisions 7,068 7,498 7,068
------- ------- -------
Total fixed maturities $79,300 $81,571 $79,300
======= ======= =======
SCHEDULE I(b) - SUMMARY OF INVESTMENTS - OTHER THAN
INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1997
Column A Column B Column C Column D
-------- -------- -------- --------
AVAILABLE FOR SALE Amount at
which shown
in the
Type of Investment Cost Value balance sheet
------------------ ---- ----- -------------
(in thousands)
Fixed maturities:
Bonds:
United States Government and
government agencies and authorities $74,649 $76,578 $76,578
States, municipalities and
political subdivisions 222,823 233,173 233,173
Public utilities 8,082 8,256 8,256
All other corporate bonds 2,035 2,292 2,292
-------- -------- --------
Total fixed maturities $307,589 $320,299 $320,299
-------- -------- --------
Equity securities:
Public utilities 218 271 271
Banks, trust and insurance companies 438 509 509
Industrial, miscellaneous and all
other 3,631 3,800 3,800
-------- -------- --------
Total equity securities 4,287 4,580 4,580
-------- -------- --------
Total investments $311,876 $324,879 $324,879
======== ======== ========
65
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONDENSED BALANCE SHEETS
December 31
------------------------------------
ASSETS 1997 1996
---- ----
(dollars in thousands)
Investments in common stock of subsidiaries
(equity method) $222,624 $184,787
Cash 1,501 731
Other assets 711 755
Federal income tax benefit 952 461
-------- --------
Total assets $225,788 $186,734
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Due to affiliates $142 $173
Accrued expenses 167 100
-------- --------
Total liabilities 309 273
STOCKHOLDERS' EQUITY
Class A Preferred stock (nonvoting), without
par value. Authorized 2,500,000 shares;
none issued -- --
Class B Preferred stock, without par value.
Authorized 2,500,000 shares; none issued -- --
Common stock, without par value. Authorized
30,000,000 shares; issued and outstanding
18,341,899 and 18,135,526 shares issued
and outstanding, respectively, at stated
value of $5 per share 91,709 90,678
Additional paid-in capital 2,894 1,456
Net unrealized holding gains of subsidiaries 8,830 5,179
Retained earnings 122,046 89,148
-------- --------
Total stockholders' equity 225,479 186,461
-------- --------
Total liabilities and stockholders' equity $225,788 $186,734
======== ========
66
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT, CONTINUED
CONDENSED STATEMENTS OF EARNINGS
Year ended December 31
---------------------------------------------------
1997 1996 1995
---- ---- ----
(in thousands)
Investment income $68 $30 $16
------- ------- -------
Total revenue 68 30 16
------- ------- -------
Total operating expenses 1,188 1,074 475
------- ------- -------
Earnings before federal income taxes (1,120) (1,044) (459)
Federal income tax benefit (378) (405) (147)
Net earnings before equity in undistributed
------- ------- -------
net earnings of subsidiaries (742) (639) (312)
Equity in undistributed net earnings of subsidiaries 34,701 23,241 25,854
------- ------- -------
Net earnings $33,959 $22,602 $25,542
======= ======= =======
67
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT, CONTINUED
CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31
---------------------------------------------------
1997 1996 1995
---- ---- ----
(in thousands)
Cash flows from operating activities:
Net earnings $33,959 $22,602 $25,542
------- ------- -------
Adjustments to reconcile net earnings to net cash
used in operating activities:
Equity in undistributed earnings of subsidiaries (34,701) (23,241) (25,854)
Change in accrued expenses and due to affiliates 36 (188) 403
Change in other assets 45 (294) (391)
Change in federal income taxes (492) (303) (25)
------- ------- -------
Net cash used in operating activities (1,153) (1,424) (325)
------- ------- -------
Cash flows from investing activities:
Capitalization of subsidiary -- (5,000) (952)
Dividends received from subsidiaries 1,250 6,402 1,000
Acquisition of land (738) -- --
------- ------- -------
Net cash provided by investing activities 512 1,402 48
------- ------- -------
Cash flows from financing activities:
Net proceeds from sale of common stock 2,470 1,325 1,012
Payment of dividends (1,059) (933) (837)
------- ------- -------
Net cash provided by (used in) financing activities 1,411 392 175
------- ------- -------
Net increase (decrease) in cash and invested cash 770 370 (102)
------- ------- -------
Cash and cash equivalents at beginning of year 731 361 463
------- ------- -------
Cash and cash equivalents at end of year $1,501 $731 $361
======= ======= =======
Supplemental Disclosures:
Federal income taxes received ($401) ($165) ($123)
======= ======= =======
Noncash investing activity:
Capitalization of subsidiary $738 -- --
======= ======= =======
68
STATE AUTO FINANCIAL CORPORATION
SCHEDULE IV - REINSURANCE
YEARS ENDED DECEMBER 31, 1997, 1996 AND 1995
(in thousands, except percentages)
Column A Column B Column C Column D Column E Column F
-------- -------- -------- -------- -------- --------
Percentage
Ceded to Assumed from of amount
Outside Affiliated Outside Affiliated assumed
Gross Amount Companies Companies(1) Companies Companies(1) Net Amount to net(2)
------------ --------- ------------ --------- ------------ ---------- ---------
Year ended 12-31-97
property-casualty earned premiums $307,898 $12,728 $288,542 $14,871 $233,183 $254,682 5.8%
Year ended 12-31-96
property-casualty earned premiums $287,828 $14,822 $277,116 $17,804 $226,651 $240,345 7.4%
Year ended 12-31-95
property-casualty earned premiums $271,177 $16,548 $267,677 $22,132 $223,440 $232,524 9.5%
- --------------
(1) These columns include the effect of intercompany pooling.
(2) Calculated as earned premiums assumed from outside companies to net amount.
69
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE VI - SUPPLEMENTAL INFORMATION CONCERNING
PROPERTY-CASUALTY INSURANCE OPERATIONS
Years Ended December 31, 1997, 1996 and 1995
(in thousands)
Column A Column B Column C Column D Column E Column F Column G
-------- -------- -------- -------- -------- -------- --------
Deferred Policy Losses and Discount, if Net
Acquisition Loss Expense any, deducted Unearned Earned Investment
Affiliation with Registrant Cost Payable in Column C Premiums Premiums Income
--------------------------- --------------- ------------ ------------- -------- -------- ----------
Consolidated
Property-Casualty Subsidiary
Year Ended:
December 31, 1997 * * n/a * * *
December 31, 1996 * * n/a * * *
December 31, 1995 * * n/a * * *
Column H Column I Column J Column K
-------- -------- -------- --------
Losses and Loss Amortization
Expenses Incurred of Paid Losses
Related to Acquisition and Loss Premiums
Current Year Prior Years Costs Expenses Written
------------ ----------- ------------ ----------- --------
Year Ended:
December 31, 1997 * * * * $259,995
December 31, 1996 * * * * $243,911
December 31, 1995 * * * * $253,468
- ------------
* Information included in consolidated financial statements or accompanying
notes thereto.
70
Item 14(c)
Exhibit Index
(a)(3) LISTING OF EXHIBITS
If incorporated by reference
Exhibit No. Description of Exhibit document with which Exhibit was
----------- ---------------------- previously filed with SEC
-------------------------
3(A)(1) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement
Articles of Incorporation No. 33-40643 on Form S-1 (see
Exhibit 3(a) therein)
3(A)(2) State Auto Financial Corporation's Amendment to the 1933 Act Registration Statement
Amended and Restated Articles of Incorporation No. 33-89400 on Form S-8 (see
Exhibit 4(b) therein)
3(B) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement
Code of Regulations No. 33-40643 on Form S-1 (see
Exhibit 3(b) therein)
4 State Auto Financial Corporation's Amended and Restated See Exhibit 3(A) and 3(B)
Articles of Incorporation, and Articles 1, 3, 5 and 9
of the Company's Amended and Restated Code of
Regulations
10(A) Reinsurance Agreement between State Automobile Mutual 1933 Act Registration Statement
Insurance Company and Southern Home Insurance Company, No. 33-40643 on Form S-1 (see
now known as State Auto Property and Casualty Insurance Exhibit 10(a) therein)
Company, dated January 1, 1987
10(B) Amendment Number 1 effective January 1, 1992 to Form 10-K Annual Report for the
Reinsurance Agreement between State Automobile Mutual year ended December 31, 1991
Insurance Company and State Auto Property and Casualty (see Exhibit 10 (B) therein)
insurance Company formerly known as Southern Home
Insurance Company, effective as of January 1, 1987
10(C) Amendment Number 2 dated as of December 1, 1993 to the Form 10-K Annual Report for the
Reinsurance Agreement between State Automobile Mutual year ended December 31, 1993
Insurance Company and State Auto Property and Casualty (see Exhibit 10 (C) therein)
Insurance Company formerly known as Southern Home
Insurance Company, effective as of January 1, 1987
10(D) Amendment Number 3 dated as of December 1, 1994 Form 10-K Annual Report for the
effective as of January 1, 1995 to the Reinsurance year ended December 31, 1994
Agreement between State Automobile Mutual Insurance (see Exhibit 10(D) therein)
Company and State Auto Property and Casualty Insurance
Company
10(E)* Amended and Restated Management Agreement among State Form 10-K Annual Report for the
Automobile Mutual Insurance Company, State Auto year ended December 31, 1994
Property and Casualty Insurance Company, State Auto (see Exhibit 10(E) therein)
National Insurance Company, State Auto Financial
Corporation, State Auto Life Insurance Company, and
Milbank effective April 1, 1994 as approved by
insurance regulatory officials in Ohio, South Carolina
and South Dakota
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
71
10(F)* Amendment Number 1-A to the Amended and Restated Form 10-K Annual Report for the
Management Agreement among State Automobile Mutual year ended December 31, 1994
Insurance Company, State Auto Property and Casualty (see Exhibit 10(F) therein)
Insurance Company, State Auto National Insurance
Company, State Auto Financial Corporation, State Auto
Life Insurance Company and Milbank Insurance Company
effective as of January 1, 1995
10(G) Guaranty Agreement between State Automobile Mutual 1933 Act Registration Statement
Insurance Company and State Auto Property and Casualty No. 33-40643 on Form S-1 (see
Insurance Company dated as of May 16, 1991 Exhibit 10 (d) therein)
10(H) Form of Indemnification Agreement between State Auto 1933 Act Registration Statement
Financial Corporation and each of its directors No. 33-40643 on Form S-1 (see
Exhibit 10 (e) therein)
10(I)* State Auto 1991 Quality Performance Bonus Plan 1933 Act Registration Statement
No. 33-40643 on Form S-1 (see
Exhibit 10 (f) therein)
10(J)* Non-Qualified Deferred Compensation Plan 1933 Act Registration Statement
No. 33-40643 on Form S-1 (see
Exhibit 10 (g) therein)
10(K)* 1991 Stock Option Plan 1933 Act Registration Statement
No. 33-40643 on Form S-1 (see
Exhibit 10 (h) therein)
10(L)* Amendment Number 1 to the 1991 Stock Option Plan 1933 Act Registration Statement
No. 33-89400 on Form S-8 (see
Exhibit 4 (a) therein)
10(M)* 1991 Directors' Stock Option Plan 1933 Act Registration Statement
No. 33-40643 on Form S-1 (see
Exhibit 10 (i) therein)
10(N) Lease Agreement between Longhollow Associates Limited 1933 Act Registration Statement
Partnership and State Automobile Mutual Insurance No. 33-40643 on Form S-1 (see
Company dated July 8, 1988, as amended Exhibit 10 (j) therein)
10(O) License Agreement between State Automobile Mutual 1933 Act Registration Statement
Insurance Company and Policy Management Systems No. 33-40643 on Form S-1 (see
Corporation dated December 28, 1984 Exhibit 10 (k) therein)
10(P) Investment Management Agreement between Stateco Form 10-K Annual Report for the
Financial Services, Inc. and State Automobile Mutual year ended December 31, 1992
Insurance Company, effective April 1, 1993 (see Exhibit 10 (N) therein
10(Q) Option Agreement between State Automobile Mutual Form 10-K Annual Report for year
insurance Company and State Auto Financial Corporation ended December 31, 1993 (see
dated as of August 20, 1993 Exhibit 10 (R) therein)
10(R)* Supplemental Executive Retirement Income Plan effective Form 10-K Annual Report for the
December 1, 1992 year ended December 31, 1992
(see Exhibit 10(O) therein)
10(S)* State Auto Insurance Companies Directors' Deferred Form 10-K Annual Report for year
Compensation Plan ended December 31, 1995 (see
Exhibit 10(S) therein)
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
72
10(T)* State Auto Insurance Companies Non-Qualified Incentive Form 10-K Annual Report for year
Deferred Compensation Plan ended December 31, 1995 (see
Exhibit 10(T) therein)
10(U)* Strategic Insurance Software, Inc. 1995 Stock Option Form 10-K Annual Report for year
Plan ended December 31, 1995 (see
Exhibit 10(U) therein)
10(V) Strategic Insurance Software, Inc. Warrant to purchase Form 10-K Annual Report for year
common stock ended December 31, 1995 (see
Exhibit 10(V) therein)
10(W* Strategic Insurance Software, Inc. Shareholder's Form 10-K Annual Report for year
Agreement ended December 31, 1995 (see
Exhibit 10(W) therein)
10(X)* Robert L. Bailey Employment Contract Form 10-K Annual Report for year
ended December 31, 1995 (see
Exhibit 10(X) therein)
10(Y) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended
between State Automobile Mutual Insurance Company, September 30, 1996 (see Exhibit
State Auto Property and Casualty Insurance Company and 10(Y) therein)
Milbank Insurance Company effective July 1, 1996
10(Z) Property Catastrophe Overlying Excess of Loss Form 10-Q for the period ended
Reinsurance Contract between State Automobile Mutual September 30, 1996 (see Exhibit
Insurance Company, Milbank Insurance Company, State 10(Z) therein)
Auto National Insurance Company and State Auto Property
and Casualty Insurance Company dated July 1,1996
10(AA) Credit Agreement between SAF Funding Corporation and Form 10-Q for the period ended
The Chase Manhattan Bank dated August 16, 1996 September 30, 1996 (see Exhibit
10(AA) therein)
10(BB) Put Agreement between State Automobile Mutual Insurance Form 10-Q for the period ended
Company, State Auto Financial Corporation and The Chase September 30, 1996 (see Exhibit
Manhattan Bank dated August 16, 1996 10(BB) therein)
10(CC) Standby Purchase Agreement between State Auto Financial Form 10-Q for the period ended
Corporation and SAF Funding Corporation dated August September 30, 1996 (see Exhibit
16, 1996 10(CC) therein)
10(DD)* Amendment Number 2 to the 1991 Stock Option Plan Form 10-K Annual Report for the
year ended December 31, 1996
(see Exhibit 10(DD) therein)
10(EE)* Amendment Number 1 to the 1991 Directors' Stock Option Form 10-K Annual Report for the
Plan year ended December 31, 1996
(see Exhibit 10(EE) therein)
10(FF) Option Agreement between State Auto Mutual and State Form 10-K Annual Report for the
Auto Financial dated March 11, 1997. year ended December 31, 1996
(see Exhibit 10(FF) therein)
10(GG) Amended and Restated Credit Agreement dated August 16, Form 10-Q for the period ended
1996 amended and restated July 18, 1997 between SAF September 20, 1997 (see Exhibit
Funding Corporation and the Chase Manhattan Bank 10(GG) therein)
10(HH) Amended and Restated SERP of State Auto Mutual Included herein
effective as of January 1, 1994
11 Statement regarding computation of earnings per share Included herein
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
73
21 List of Subsidiaries of State Auto Financial Corporation Form 10-K Annual Report for the
year ended December 31, 1995
(see Exhibit 22 therein)
23 Consent of Independent Auditors Included Herein
24 Powers of Attorney - John R. Lowther, David L. Form 10-K Annual Report for the
Bickelhaupt, Paul W. Huesman, George R. Manser and year ended December 31, 1991
Robert J. Murchake (see Exhibit 25 therein)
24(A) Power of Attorney - William J. Lhota Form 10-K Annual Report for the
year ended December 31, 1994
(see Exhibit 25(A) therein)
24(B) Power of Attorney - David J. D'Antoni Form 10-K Annual Report for the
year ended December 31, 1995
(see Exhibit 25(B) therein)
24(C) Powers of Attorney - William J. Lhota, Urlin G. Harris, Form 10-Q for the period ended
Jr., Robert J. Murchake, Paul W. Huesman, George R. June 30, 1997 (see Exhibit 24(C)
Manser, David L. Bickelhaupt, and David J. D'Antoni therein)
27 Financial Data Schedule Included herein