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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, 1998
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ___________ to _____________
Commission File Number 0-19289
STATE AUTO FINANCIAL CORPORATION
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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.
On March 22, 1999, 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 $142,774,951.
On March 22, 1999, the Registrant had 42,057,917 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 27, 1999, which Proxy Statement
will be filed within 120 days of December 31, 1998, 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
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(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 70% owned by State Automobile Mutual Insurance Company, an Ohio
property and casualty insurance company formed in 1921 ("Mutual").
State Auto Financial owns 100% of the outstanding shares of State Auto
Property and Casualty Insurance Company, a South Carolina corporation ("State
Auto P&C") and Milbank Insurance Company, a South Dakota corporation
("Milbank"). State Auto P&C and Milbank are regional standard insurers engaged
primarily in writing personal and commercial automobile, homeowners, commercial
multi-peril, workers' compensation and fire insurance.
While Mutual originally acquired Milbank, Mutual sold Milbank to STFC
in July 1998. State Auto Financial issued approximately 5.1 million shares of
STFC to Mutual in exchange for 100% of the outstanding shares of Milbank and as
a result, Milbank became a wholly owned subsidiary of State Auto Financial.
Since the transaction was a combination of entities under common control it has
been accounted for similar to a pooling of interest. Any reference to prior
years' financial information of State Auto Financial Corporation and
Subsidiaries has been restated to include the financial position and operations
of Milbank.
State Auto National Insurance Company ("National"), an Ohio corporation
formed by State Auto Financial in 1991 began writing personal automobile
insurance for non-standard risks in early 1992. At year end National was
operating in 15 states and in February 1999 it added South Carolina to its
operating territory.
As of January 1, 1999, Farmers Casualty Insurance Company ("Farmers
Casualty") an Iowa domiciled standard property casualty insurer, writing in Iowa
and Kansas, became a wholly owned subsidiary of STFC, following completion of
its plan of conversion from a mutual insurer. In August 1998, STFC contributed
$9.0 million in capital to Farmers Casualty in the form of a surplus note. On
completion of Farmers Casualty's conversion, STFC exchanged the surplus note for
all the issued and outstanding shares of Farmers Casualty. Farmers Casualty owns
100% of the outstanding shares of Mid-Plains Insurance Company ("Mid-Plains")
which is an Iowa based insurer which principally writes nonstandard auto
insurance in Iowa and Kansas.
In addition to the above described insurers, effective as of January 1,
1997, Mutual acquired 100% of the outstanding shares of Midwest Security
Insurance Company ("Midwest Security"), a Wisconsin domiciled standard personal
lines property and casualty insurer. Midwest Security participates in the
pooling arrangement discussed below. See "Pooling Arrangement" in the "Narrative
Description of Business." In addition, 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.
State Auto P&C, Mutual, Milbank, Midwest Security and Farmers Casualty,
all of which participate in the pooling arrangement are collectively referred to
hereafter as the "Pooled Companies". The Pooled Companies, National, and
Mid-Plains are collectively referred to as the "State Auto Group". See "Pooling
Arrangement" in the "Narrative Description of Business."
At this time, the insurers in the State Auto Group market their
insurance products through approximately 12,500 independent insurance agents
associated with approximately 2,200 agencies in 26 states. Iowa and Kansas have
been added to STFC's states of operation as of January 1, 1999. STFC's
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insurance 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 wholly owned subsidiary of State Auto Financial, Stateco
Financial Services, Inc., an Ohio corporation ("Stateco"), provides investment
management services to affiliated companies and insurance premium finance
services to customers of State Auto P&C, Mutual and Milbank. See "Investment
Management Services" and "Insurance Premium Finance Services" in the "Narrative
Description of Business."
Strategic Insurance Software, Inc. ("S.I.S."), an Ohio corporation
formed by State Auto Financial in January 1995, began operations in July 1995.
S.I.S. 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. S.I.S. is a
majority-owned subsidiary of State Auto Financial. See "Insurance Software
Business" in the "Narrative Description of Business."
In December 1997, 518 Property Management and Leasing, LLC ("518 PML")
was organized. 518 PML is an Ohio limited liability company formed to engage in
the business of owning and leasing real and personal property to affiliated
companies. The members of 518 PML are State Auto P&C and Stateco. See "Property
Leasing Business" in the "Narrative Description of Business."
State Auto Financial and its subsidiaries, State Auto P&C, Stateco,
National, Milbank, S.I.S., 518 PML, Farmers Casualty and Mid-Plains are
collectively referred to as the "Company". IN ANY REFERENCE TO FINANCIAL
INFORMATION FOR 1998 AND PRIOR PERIODS, IT IS UNDERSTOOD THAT, UNLESS OTHERWISE
STATED, ALL REFERENCES TO THE COMPANY INCLUDE ONLY STATE AUTO P&C, STATECO,
MILBANK, NATIONAL, S.I.S. AND 518 PML AND EXCLUDE FARMERS CASUALTY AND
MID-PLAINS.
Since January 1, 1987, State Auto P&C has participated in an
underwriting pooling arrangement with Mutual. While it has been modified several
times since 1987, as of January 1, 1999, the current pool participants and
percentages of participation are State Auto Mutual (49%), State Auto P&C (37%),
Milbank (10%), Midwest Security (1%), and Farmers Casualty (3%). See "Pooling
Arrangement" in the "Narrative Description of Business."
Pursuant to the Amended and Restated Management Agreement dated April
1, 1994 (the "Amended and Restated Management Agreement"), the Midwest
Management Agreement (defined below), and the Farmers Casualty Management
Agreement (defined below), State Auto P&C provides executive management services
for all of its insurance affiliates and for Mutual and its insurer subsidiary,
Midwest Security. Mutual provides non-executive employees and facilities for
such entities. See "Management Agreement" in the "Narrative Description of
Business."
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS.
See Note 14 to the Company's Consolidated Financial Statements,
included in Item 8, "Financial Statements and Supplementary Data" regarding the
company's reportable segments. Additional information regarding the Company's
segments is provided in the "Narrative Description of Business."
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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. Such statements
include, without limitation, those pertaining to the weather related
catastrophes impacting the Company's losses, product offerings, National's
premium receivable collections effort, the Year 2000 discussion, the statements
relating to the new insurer to be created, State Auto Insurance Company, the
legislative and regulatory environment and sales forecasts. These risks and
uncertainties include, but are not limited to, legislative changes, judicial and
regulatory decisions, 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, technological difficulties and advancements, availability of labor
and materials in storm hit areas, late reported claims, previously undisclosed
damage, utilities and financial institution disruptions, shortages of
programmers, and regulatory or governmental systems breakdowns.
(d) NARRATIVE DESCRIPTION OF BUSINESS.
PROPERTY AND CASUALTY INSURANCE
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%. Effective January 1, 1998, Midwest Security was 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%. With the addition of Farmers
Casualty to the State Auto Group, it was added to the pooling arrangement
pursuant to a Reinsurance Pooling Agreement, Amended and Restated as of January
1, 1999 (the "99 Pooling Agreement"). Concurrently, with the inclusion of
Farmers Casualty, the pooling percentages were also amended as follows: Mutual
49%, State Auto P&C 37%, Milbank 10%, Midwest 1% and Farmers Casualty 3%.
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,
Farmers Casualty 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, Farmers
Casualty 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" in the "Narrative Description of
Business." The pooling arrangement is terminable by any party on 90 days notice
or by mutual agreement of the parties. Neither Mutual, State Auto P&C, Milbank,
Farmers Casualty nor Midwest Security currently intends to terminate the pooling
arrangement.
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The pooling arrangement is designed to produce more uniform and stable
underwriting results for each of the Pooled Companies than any one company would
experience individually, 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, Farmers Casualty 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" in the
"Narrative Description of Business."
The '99 Pooling Agreement contains a provision which excludes from the
scope of the pooling arrangement catastrophic loss claims and loss adjustment
expenses incurred by State Auto P&C, Mutual, Milbank, National, Midwest
Security, Farmers Casualty and Mid-Plains in the amount of $100.0 million in
excess of $120.0 million but less than $220.0 million and the premium for such
exposures. State Auto P&C has become the reinsurer for each insurer in the State
Auto Group for this layer of reinsurance under a Catastrophe Assumption
Agreement. See "Reinsurance" in the "Narrative Description of Business."
MANAGEMENT AGREEMENT
The Company operates and manages its business in conjunction with
Mutual 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 these companies.
State Auto P&C does not provide investment management services because these
services are provided by Stateco. See "Investment Management Services" in the
"Narrative Description of Business." 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. 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 1998, the
managed companies paid a management fee of $6.0 million to State Auto P&C.
In addition to the above-described Amended and Restated Management
Agreement, State Auto P&C and Mutual entered into a Management Agreement with
Midwest Security effective as of January 1, 1997 (the "Midwest Management
Agreement") and with Farmers Casualty and Mid-Plains effective as of January 1,
1999, (the "Farmers Casualty Management Agreement"). Mutual is providing
clerical and non-executive employees to Midwest Security, Farmers Casualty and
Mid-Plains. Under the Midwest Management Agreement, 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 1998 was 0.75% of direct
written premium of Midwest Security and it includes a performance standard, as
well. In 1998, Midwest Security paid a management fee of $158,000 to State Auto
P&C. Under the Farmers Casualty Management Agreement, specific services are
assigned to State Auto P&C by resolution of the Boards of Farmers Casualty and
Mid-Plains. The fee due is dependent on the scope of the services assigned but
it is capped at 0.75% of direct written premium.
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
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incurred on behalf of Mutual, State Auto P&C, Milbank, Midwest Security, and
from January 1, 1999 forward, Farmers Casualty, continue to be shared pro rata
among Mutual, State Auto P&C, Milbank, Midwest Security and Farmers Casualty
through the 99 Pooling Agreement. "See Pooling Arrangement" in the "Narrative
Description of Business." For companies not participating in the 99 Pooling
Agreement, e.g., National and Mid-Plains, expenses directly attributable to a
particular company continue to be charged 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 to each company which has dedicated space within Mutual's facilities
(currently National and Stateco).
The Amended and Restated Management Agreement, the Midwest Management
Agreement, and the Farmers Casualty 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 subsidiary, and two directors of the Company, who represent the interests of
State Auto Financial 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, State Auto Financial 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 non-renewal. 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 Farmers Casualty Management Agreement has a 10-year term
expiring on December 31, 2008 with an automatic renewal provision unless sooner
terminated in accordance with its terms. 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.
STANDARD INSURANCE SEGMENT
The Company's share of the business written by the Pooled Companies
(i.e., State Auto P&C and Milbank) constitutes the Company's standard insurance
segment. This includes 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 for both the standard insurance
products and the non-standard insurance products. Footnote 14 in the Company's
Consolidated Financial Statements included herewith sets forth the amount of the
Company's net earned premiums by line of insurance for both standard lines and
nonstandard lines.
As mentioned above, the insurance business of Mutual, State Auto P&C,
Milbank, Midwest Security and as of January 1, 1999, Farmers Casualty is
combined through the pooling arrangement. This pooling arrangement effectively
gives each of the Pooled Companies an identical mix of personal and commercial
business as written by all five insurers. The Pooled Companies products' sales
are predominantly personal lines. As part of their effort to increase the volume
of commercial lines business, commercial lines were introduced in Wisconsin in
the second quarter of 1998 and work has begun to
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make commercial lines available in Kansas during the second quarter of 1999 and
in Iowa during the first quarter of 2000.
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. As of January 1, 1999, the same is true
for business written by Mid-Plains. See "Pooling Arrangement" in the "Narrative
Description of Business." Both National's and Mid-Plains' 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 its
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.
The following table sets forth the statutory loss ratios by line of
insurance and the combined ratios for the standard insurance segment of the
Company's business, 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)
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1998 1997 1996
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Loss ratios:
Automobile................................. 65.7% 63.3% 68.6%
Homeowners and Farmowners.................. 86.0% 71.6% 102.1%
Commercial multi-peril..................... 57.1% 72.8% 70.5%
Workers' compensation...................... 51.1% 64.2% 44.9%
Fire and allied lines...................... 81.8% 59.3% 76.8%
Other commercial liability................. 61.2% 64.9% 60.6%
Other personal lines....................... 32.3% 34.6% 35.2%
Other commercial lines..................... 20.0% 16.8% 11.1%
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Total loss ratio................................ 67.9% 64.2% 72.4%
Expense ratio................................... 29.8% 29.5% 27.8%
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Combined ratio.................................. 97.7% 93.7% 100.2%
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(1) This reflects a combination of the loss ratios of State Auto P&C and
Milbank, after giving effect to reinsurance and the 98 Pooling
Agreement.
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NON-STANDARD INSURANCE SEGMENT
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 expanded into West Virginia in October 1993, Tennessee
and Mississippi in August 1994 and Kentucky in March 1995. National entered
Arkansas and Georgia in December 1996, Minnesota in February 1997 and Alabama,
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Illinois and Missouri in December 1997. It most recently expanded operations
into Indiana, Pennsylvania, Utah and Wisconsin in December 1998. National is
currently licensed in 21 states altogether, with plans to begin operations in
Maryland and South Carolina within the first six months of 1999, with South
Dakota to follow in the second half of 1999. National is seeking a certificate
of authority in one additional state at this time. In addition to National, as
of January 1, 1999, the Company writes nonstandard auto insurance through
Mid-Plains. Mid-Plains operates in Kansas and Iowa. The Company currently does
not contemplate combining the operations of Mid-Plains and National. 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.
The following Table sets forth the statutory loss ratios and combined
ratios of National, which is engaged in the nonstandard segment of the business.
Year Ended December 31
---------------------------------
1998 1997 1996
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Loss Ratio
Automobile................................. 75.0% 79.8% 78.2%
Expense Ratio................................ 25.0% 20.6% 18.3%
----- ----- -----
Combined Ratio............................... 100.0% 100.4% 96.5%
===== ===== =====
MARKETING
In its 26 states of operation, the State Auto Group markets its
products through approximately 12,500 insurance agents associated with
approximately 2,200 independent insurance agencies. State Auto Financial's
acquisition of Farmers Casualty gave the Company the opportunity to enter its
25th and 26th states of operation effective January 1, 1999 adding approximately
200 agencies and 1,200 agents to market its products. Farmers Casualty markets
personal lines only; the Company will introduce commercial lines to Farmers
Casualty's product offerings in both states as soon as practicable.
None of the company's in the State Auto Group has any contracts with
managing general agencies.
State Auto National markets non-standard products exclusively through
the Company's network of independent agents. As noted above, State Auto National
is licensed in 21 states and operated in 15 states in 1998. Four of those were
added in 1998. Three more are expected to be added in 1999. Mid-Plains markets
nonstandard auto insurance in Iowa and Kansas through the agency network of
Farmers Casualty in those states. See "Non-Standard Automobile Insurance" in the
"Narrative Description of Business."
Because independent insurance agents significantly influence which
insurance company their customers select, management views the Company's
independent insurance agents as its primary customers. Management strongly
supports the independent agency system and believes that maintenance of a strong
agency system is essential for the Company's present and future success. As
such, the Company continually develops programs and procedures to enhance agency
relationships. Examples include regular travel by senior management and branch
office staff to meet with agents, in person, in their home states and as
discussed below, training opportunities, an agent stock purchase plan and an
agent stock option plan.
The Company actively helps its agencies develop professional sales
skills within their staff. The training programs include both products and sales
training in concentrated programs in the Company's home office. Further, the
training programs include disciplined follow-up and coaching for an extended
time.
The Company takes a leadership role in the insurance industry with
respect to agency automation, promoting single entry multi-company interface
using industry standards, especially through software developed and marketed by
S.I.S. (SEMCI Partner(R)). Since agents and their customers realize better
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service and efficiencies through automation, they value their relationship with
the Company and it makes the Company attractive to new agency appointments.
The Company shares the cost of approved advertising with selected
agencies. The Company provides agents with certain travel and cash incentives if
they achieve certain sales and underwriting profit levels. Further, the Company
recognizes its very top agencies as Inner Circle Agents; rewarding them with
additional trip and financial incentives including additional profit sharing
bonus and additions to the agent's contributions to their Inner Circle Agent
Stock Purchase Plan, which is part of the Agent Stock Purchase Plan described
below.
To strengthen agency commitment to producing profitable business and
further develop its agency relationships, the Company's Agent Stock Purchase
Plan offers its agents the opportunity to use commission income to purchase the
Company's stock. The Company's transfer agent administers the plan using
commission dollars assigned by the agents to purchase shares on the open market
through a broker. As of year-end 1998, 366 agencies participated in this agent
stock purchase plan.
In addition to the Agent Stock Purchase Plan, the Company has created
an Agent Stock Option Plan incentive for a select group of agencies which
represent the Company. If an agent/agency meets specific production requirements
over a five year period, that agent/agency qualifies to earn State Auto
Financial stock options granted at the market price on the day these performance
based options are earned. The options vest only upon meeting additional sales
and profitability targets. Options granted and vested under this program have a
10-year term.
Under the Company's agency agreements with its independent insurance
agencies, each agent the Company licenses is authorized to sell and bind
coverage in accordance with established procedures. They are also authorized 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 Company
controls risk by its right to terminate coverage on a policy bound by the agent.
In addition, the Company does not grant binding authority for risks it considers
to present a greater than normal exposure to loss. Each agency receives a
percentage of direct premiums written as a commission. As bonus compensation,
the agency receives a share of the underwriting profits generated by their
policies. This is 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, Iowa, Kansas, Kentucky, Maryland,
Michigan, Minnesota, Mississippi, Missouri, North Carolina, North Dakota, Ohio,
Oklahoma, Pennsylvania, South Carolina, South Dakota, Tennessee, Utah, Virginia,
West Virginia and Wisconsin. During 1998, the seven states that contributed the
greatest percentage of direct premiums written to the State Auto Group were Ohio
(22.3%), Kentucky (10.6%), Tennessee (7.6%), South Carolina (5.8%), North
Carolina (5.5%), Maryland (5.1%) and Minnesota (4.8%).
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.
11
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The Company attempts to minimize claims costs by settling as many
claims as possible through its internal claims staff and, if possible, by
settling disputes regarding automobile physical damage and property insurance
claims (first party claims) through arbitration. In addition, selected agents
have authority to settle small first party claims which improves claims service.
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 fourth attorney was added
to the Cleveland Office in 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. In addition, in 1998, the Company
put into place two measures that it expects will have a positive impact on
claims expenses. It signed a contract with a vendor to create a glass network
through which economies and efficiencies have been brought to bear in settling
glass claims. It has also begun to centralize the handling of smaller, less
complicated claims through a Central Claims Department ("CCD") created in the
Company's home office. It expects that the CCD will be able to handle these
smaller claims more efficiently, reducing loss expenses.
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.
Mutual has guaranteed the adequacy of State Auto P&C's loss and loss
expense reserves as of December 31, 1990. Pursuant to the guarantee, Mutual has
agreed to reimburse State Auto P&C for any losses and loss expenses in excess of
State Auto P&C's December 31, 1990 reserves ($65.5 million) that may develop
from claims that have occurred on or prior to that date. This guarantee ensures
that any deficiency in the reserves of State Auto P&C as of December 31, 1990,
under the pooling arrangement percentages effective on December 31, 1990 will be
reimbursed by Mutual. As of December 31, 1998, 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.
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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, 1998:
Year Ended December 31
--------------------------------------------
1998 1997 1996
------------ ------------ ------------
(in thousands)
Reserve for losses and loss expenses
at beginning of year(1)................................. $194,155 $199,480 $206,327
------------ ------------ ------------
Provision for losses and loss
expenses occurring:
Current year....................................... 255,885 225,666 246,886
Prior years(2)..................................... (13,591) (17,432) (26,852)
------------ ------------ ------------
Total 242,294 208,234 220,034
------------ ------------ ------------
Loss and loss expense payments
for claims occurring during:
Current year....................................... 157,988 134,890 148,095
Prior years........................................ 86,671 78,669 78,786
------------ ------------ ------------
Total........................................... 244,659 213,559 226,881
------------ ------------ ------------
Impact of pooling change 1/1/98.............................. 13,244 - -
============ ============ ============
Reserve for losses and loss expenses at end of year(1)....... $205,034 $194,155 $199,480
============ ============ ============
- ---------------
(1) This line item is net of reinsurance receivable on losses and loss
expenses payable of approximately $13,667,000, $12,095,000 and
$12,129,000 for the years 1998, 1997 and 1996, respectively.
(2) This line item shows redundancies in the provision for losses and loss
expenses attributable to prior years in the amounts of approximately
$13,591,000, $17,432,000 and $26,852,000 for the years 1998, 1997 and
1996, 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 1988 through 1998 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.
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, 1998, the Company had paid 87.4% of the
currently estimated losses and loss expenses that had been incurred, but not
paid, as of December 31, 1989.
The amounts on the "cumulative redundancy (deficiency)" line represent
the aggregate change in the estimates over all prior years. For example, the
1988 reserve has developed a $3,233,000 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.
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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 1991, but
incurred in 1988, will be included in the cumulative redundancy amount for years
1988, 1989 and 1990. 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.
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 and
Milbank from Mutual in 1992, 1995 and in 1998 from Mutual and Midwest Security
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 and for years prior to 1998 for the January 1, 1998 pooling change.
[See table on following page.]
14
State Auto Financial Corp.
Years Ended December 31
----------------------------------------------------------------------------
1988 1989 1990 1991 1992
(Dollars in Thousands)
Net liability for losses
and loss expenses payable $ 51,142 $58,203 $65,464 $71,139 $119,044
Paid (cumulative)
as of:
One year later 47.7% 48.1% 43.3% 12.2% 41.3%
Two years later 65.7% 68.8% 46.1% 43.0% 60.9%
Three years later 76.0% 70.9% 62.9% 58.7% 60.6%
Four years later 76.1% 79.9% 71.8% 58.4% 68.0%
Five years later 80.8% 84.4% 72.1% 63.9% 71.9%
Six years later 83.0% 83.3% 75.5% 67.5% 73.2%
Seven years later 82.0% 86.0% 77.8% 68.6%
Eight years later 84.1% 87.7% 77.9%
Nine years later 85.6% 87.4%
Ten years later 85.4%
Net liability re-estimate
as of:
One year later 93.7% 98.0% 95.4% 91.2% 92.7%
Two years later 91.6% 97.4% 92.1% 87.2% 90.5%
Three years later 91.3% 95.9% 89.7% 85.4% 87.6%
Four years later 90.4% 95.4% 88.1% 84.5% 85.6%
Five years later 90.6% 95.0% 89.7% 82.3% 87.3%
Six years later 89.9% 96.1% 88.4% 86.7% 84.5%
Seven years later 92.0% 95.5% 93.2% 83.1%
Eight years later 91.7% 100.1% 89.5%
Nine years later 95.3% 97.2%
Ten years later 93.7%
Cumulative redundancy (deficiency) $ 3,233 $ 1,639 $ 6,843 $12,004 $ 18,443
Cumulative redundancy (deficiency) 6.3% 2.8% 10.5% 16.9% 15.5%
Gross* liability - end of year
Reinsurance receivable
Net liability - end of year
Gross liability re-estimated - latest
Reinsurance receivable re-estimated - latest
Net liability re-estimated - latest
* Gross liability includes: Direct & assumed losses & loss expenses payable.
State Auto Financial Corp.
Years Ended December 31
---------------------------------------------------------------------------------------
1993 1994 1995 1996 1997 1998
Net liability for losses
and loss expenses payable $123,337 $126,743 $206,327 $199,480 $194,155 $205,034
Paid (cumulative)
as of:
One year later 42.2% 1.5% 38.2% 39.4% 37.8% --
Two years later 41.3% 29.1% 55.4% 56.7%
Three years later 55.6% 44.5% 64.6%
Four years later 64.5% 52.4%
Five years later 68.2%
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Net liability re-estimate
as of:
One year later 93.7% 87.4% 87.0% 91.3% 93.0% --
Two years later 90.0% 77.1% 86.4% 87.3%
Three years later 85.0% 77.0% 83.2%
Four years later 86.3% 72.9%
Five years later 82.8%
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Cumulative redundancy (deficiency) $ 21,233 $34,403 $34,570 $25,343 $13,591 --
Cumulative redundancy (deficiency) 17.2% 27.1% 16.8% 12.7% 7.0% --
Gross* liability - end of year $206,250 $218,701
Reinsurance receivable $12,095 $13,667
Net liability - end of year $194,155 $205,034
Gross liability re-estimated - latest 93.5%
Reinsurance receivable re-estimated - latest 101.9%
Net liability re-estimated - latest 93.0%
* Gross liability includes: Direct & assumed losses & loss expenses payable.
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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"):
1998 1997 1996
------------- -------------- --------------
(in thousands)
GAAP losses and loss
expenses payable $218,701 $206,250 $211,611
Less: ceded reinsurance receivable
on losses and loss expenses payable 13,667 12,095 12,129
Add: salvage and subrogation
recoverable 12,817 10,870 10,612
------------- -------------- --------------
STAT losses and loss
expenses payable $217,851 $205,025 $210,094
============= ============== ==============
REINSURANCE
The Company, Mutual 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, 1999,
reinsurance premiums and reimbursements are allocated among State Auto P&C,
Milbank, Mutual, Midwest Security, and Farmers Casualty according to their
relative pooling percentages. National and Mid-Plains do not directly
participate in the pooling arrangement. Although reinsurance does not legally
discharge State Auto P&C, Mutual, National, Milbank, Midwest Security, Farmers
Casualty, or Mid-Plains from primary liability for the full amount of limits
applicable under their policies, it does make the assuming reinsurer liable to
the extent of the reinsurance ceded.
Each member of the State Auto Group 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 $2.0 million of each
defined loss and the reinsurers are responsible for 100% of the excess over $2.0
million up to $10.0 million 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 $2.0 million of a
covered loss. The reinsurers are responsible for 100% of the loss excess of $2.0
million and up to $5.0 million. 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 $10.0 million of coverage above a $5.0 million
retention for each loss occurrence. This layer of reinsurance sits above the
$3.0 million excess of $2.0 million arrangement.
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 $15.0 million
above a maximum $600,000 retention. The State Auto Group also makes use of the
facultative market for unique risk situations and participates in involuntary
pools and associations in certain states.
Catastrophe reinsurance has been arranged for property business,
including automobile physical damage. Effective July 1, 1998, the Company and
Mutual renewed, without change, both the traditional and structured financing
pieces of their catastrophe reinsurance program, originally placed in July 1996.
Each of State Auto P&C, Mutual, Milbank, Midwest Security, National, Farmers
Casualty and Mid-Plains retain the first $40.0 million of each occurrence.
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$80.0 million of traditional reinsurance is available above the $40.0
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, Midwest Security, National and
Farmers Casualty and Mid-Plains 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 the
`99 Pooling Agreement. See "Pooling Arrangement" in the "Narrative Description
of Business." 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. This
Chase contingent financing transaction originally could be extended only through
July 1, 1999. The Company is currently studying catastrophe reinsurance
alternatives which include non-traditional programs similar to the one currently
in place.
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. Changes to this program that are being contemplated for 1999
include reducing the 20% quota share on liability coverages to 10% and extending
a 2% quota share to the physical damage coverages.
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, Midwest Security, respectively, and Iowa which regulates Farmers
Casualty and Mid-Plains. 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, Midwest Security, Farmers Casualty and Mid-Plains 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, National, Milbank and Farmers
Casualty to State Auto Financial. Pursuant to these laws, all transactions
within the holding company system affecting Mutual, State Auto P&C, National,
Milbank, Midwest Security, Farmers Casualty or Mid-Plains 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 that person has obtained the prior
written approval of the Chief Insurance Commissioner of South Carolina for such
acquisition. Ohio has similar statutory provisions in place which would be
applicable to National, as does South Dakota for Milbank, Wisconsin for Midwest
Security and Iowa for Farmers Casualty and Mid-Plains.
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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 the State Auto
Group transacts business have enacted laws which restrict these companies'
underwriting discretion. Examples of these laws include restrictions on policy
terminations, restrictions on agency terminations and laws requiring companies
to accept any applicant for automobile insurance. These laws may adversely
affect the ability of the State Auto 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 the State Auto Group.
Dividends. State Auto P&C, National, Milbank and Farmers Casualty 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.
State Auto Financial's insurer subsidiaries are permitted to pay
dividends without prior approval from their respective domiciliary insurance
departments unless the dividend is an "extraordinary dividend." While the
statutes affecting each insurer subsidiary of State Auto Financial have
different words, there is a common thread that runs through each state's statute
regulating extraordinary dividends. That thread is the basic definition of an
extraordinary dividend which is the greater of 10% of the insurer's surplus or
net income. In three states, Ohio, South Dakota and Iowa, there is excluded from
the net income of the insurer a distribution of the insurers own securities. In
South Carolina, net realized capital gains and losses are excluded from the
calculation of annual net income. In South Dakota, annual net income excludes
net realized capital gains that exceed 20% of net unrealized capital gains.
The laws of South Carolina, Iowa and Ohio also require advance notice
of payment of an ordinary dividend. In addition, by acting within a statutory
time frame, the insurance commissioner in each state has the authority to limit
ordinary dividends if an insurer's surplus as regards policyholders is not
reasonable in relation to the insurer's outstanding liabilities and adequate to
its financial needs.
Pursuant to these rules, a total of $21.9 million is available for
payment to State Auto Financial as a dividend from State Auto P&C, National,
Milbank and Farmers Casualty during 1999 without prior approval from the South
Carolina, Ohio, South Dakota and Iowa Insurance Departments, respectively, 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 1998 which would present material obstacles to the Company's
overall business.
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 has tested insurer's
risk-based capital requirements since 1994. Each insurer affiliated with the
Company as of December 31, 1998 exceeded all standards tested by the formula
applying risk-based capital requirements as of year-end 1998.
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Page 18
The property and casualty insurance industry is also affected by court
decisions. Premium rates are actuarially determined to enable an insurance
company to generate an underwriting profit. These rates contemplate a certain
level of risk. The courts may modify, in a number of ways, the level of risk
which insurers had expected to assume including eliminating exclusions,
multiplying limits of coverage, creating rights for policyholders not intended
to be included in the contract and interpreting applicable statutes expansively
to create obligations on insurers not originally considered when the statute was
passed. Courts have also undone legal reforms passed by legislatures, which
reforms were intended to reduce a litigant's rights of action or amounts
recoverable and so reduce the costs borne by the insurance mechanism. These
court decisions can adversely affect an insurer's profitability. They also
create pressure on rates charged for coverages adversely affected and this can
cause a legislative response resulting in rate suppression that can adversely
affect an insurer.
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 each of the
Pooled Companies through the pooling arrangement. 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" in the "Narrative Description of
Business."
The Company's decision to make a specific investment is influenced
primarily by the following factors: (a) investment risks; (b) general market
conditions; (c) relative valuations of investment vehicles; (d) general market
interest rates; (e) the Company's liquidity requirements at any given time; and
(f) the Company's current federal income tax position and relative spread
between after tax yields on tax-exempt and taxable fixed income investments. The
Company has investment policy guidelines with respect to purchasing fixed income
investments which preclude investments in bonds that are rated below investment
grade by a recognized rating service. The maximum investment in any single note
or bond is limited to 2.0% of assets, other than obligations of the U.S.
government or government agencies, for which there is no limit. Investments in
equity securities are selected based on their potential for appreciation as well
as ability to continue paying dividends. (See discussion regarding Market Risk
included in Part II - Item 7 "Management's Discussion and Analysis of Financial
Condition and Results of Operations").
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," 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
flexibility noted above, are categorized as available-for-sale and are carried
at fair value. Fixed maturities available-for-sale totaled $481.8 million, and
$421.0 million at December 31, 1998 and 1997, respectively.
During 1997, the Company began a program to build on the equity
portfolio to enhance growth of surplus over the long term. At December 31, 1998
and 1997, respectively, the equity portfolio totaled $42.2 million and $26.1
million.
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The table below provides information about the quality of the Company's
fixed maturity portfolio
Bond Portfolio Quality
Investment Grade Corporates
and Municipals 73.2%
U.S. Governments 17.7%
U.S. Government Agencies 9.1%
The following table sets forth the Company's investment results for the
periods indicated:
Year Ended December 31
--------------------------------------------------
1998 1997 1996
---- ---- ----
(Dollars in thousands)
Average invested assets (1) $571,152 $519,298 $488,528
Net investment income (2) $32,506 $31,107 $29,863
Average yield 5.7% 6.0% 6.1%
- --------------
(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.
- --------------
INVESTMENT MANAGEMENT SERVICES
Stateco has been providing investment management services since April
1993. These services are provided to all insurance companies affiliated with the
Company or Mutual, including Mutual, Midwest Security, State Auto P&C, Milbank,
National, Farmers Casualty and Mid-Plains. 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.
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.
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INSURANCE SOFTWARE BUSINESS
S.I.S. 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). S.I.S.' principal product, SEMCI Partner(R), is an
alternative to significantly more costly agency management systems. SEMCI
Partner(R), S.I.S. believes will be attractive to a substantial segment of
independent insurance agencies. While S.I.S.' principal customer from a revenue
standpoint 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.
S.I.S.' revenue from SEMCI Partner(R) and other S.I.S. 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 $7.0 million 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 is constructing an office
building on the real estate in Goodlettsville, which it expects to lease to
Mutual commencing in the summer of 1999 for Mutual's Nashville Regional Office
facility. 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.
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 very intense during recent years. This was
particularly true in regards to commercial lines in 1998. In addition, over the
course of the year there was evidence of rate reduction activity primarily by
non-standard and "national" carriers and active marketing efforts with respect
to personal lines auto insurance. The Company competes with numerous insurance
companies, many of which are substantially larger and have considerably greater
financial resources. In addition, because the Company's products are marketed
exclusively through independent insurance agencies, most of which represent more
than one company, the Company faces competition within each agency. See
"Marketing" in the "Narrative Description of Business." The Company competes
through underwriting criteria, appropriate pricing, and quality service to the
policyholder and the agent and through a fully developed agency relations
program.
EMPLOYEES
As of March 5, 1999, the Company had 48 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" in the "Narrative Description of Business." At December 31, 1998,
Mutual had approximately 1,230 full-time permanent 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.
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EXECUTIVE OFFICERS OF THE REGISTRANT
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company (1) Age During the Past Five Years of the Company Since (2)
- ------------------------------ ----- -------------------------- ------------------------
Robert L. Bailey, 65 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, 55 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
Financial Officer STFC and Mutual, 5/95 to 4/97;
Assistant Vice President of Mutual,
8/92 to 5/95
John R. Lowther, 48 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
Michael F. Dodd, 61 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, 46 Vice President and Comptroller of STFC 1991
Vice President and and Mutual, 5/91 to present
Comptroller
James E. Duemey, 52 Vice President and Investment Officer 1991
Vice President and of STFC and Mutual, 5/91 to present
Investment Officer
Terrence P. Higerd, 54 Vice President of STFC, 5/91 to 1991
Vice President present; Vice President of Mutual,
6/87 to present
Gary L. Huber, 56 Vice President of STFC, 3/98 to 1997
Vice President present; 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
Noreen W. Johnson, 50 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, 9/92 to 3/97
Robert A. Lett, 59 Vice President of STFC 3/98 to 1994
Vice President present; Vice President of Mutual, 2/88
to present
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EXECUTIVE OFFICERS OF THE REGISTRANT
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company (1) Age During the Past Five Years of the Company Since (2)
- ------------------------------ ----- -------------------------- ------------------------
John B. Melvin, 49 Vice President of STFC, 3/98 to 1994
Vice President present; Vice President of Mutual,
11/93 to present; and prior thereto an
officer of Mutual
Cathy B. Miley,(3) 49 Vice President of STFC, 3/98 to 1995
Vice President present; Vice President of Mutual, 3/95
to present; Assistant Vice President
of Mutual, 8/92 to 3/95
Richard L. Miley,(3) 45 Vice President of STFC, 3/98 to 1995
Vice President present; Vice President of Mutual, 5/95
to present; Assistant Vice President
of Mutual, 8/87 to 5/95
(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) Richard L. Miley and Cathy B. 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" in the "Narrative Description of Business." 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 claims office
facilities which they share through the Amended and Restated Management
Agreement. These facilities include 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 June 1999, the Company expects an office building being constructed by 518
PML containing 38,000 square feet to be completed and occupied by Mutual as its
Nashville Regional Office. Mutual also leases the regional office facility in
Greer, South Carolina from 518 PML. 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.
Farmers Casualty leases an office in West Des Moines, Iowa where Mutual's
employees service Farmers Casualty's and Mid-Plains' policyholders and agents.
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.
23
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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 12, 1999, there were 910 shareholders of record of the
Company's common shares.
MARKET PRICE RANGE, COMMON STOCK(1)
Initial Public Offering -- June 28, 1991, $2.25. The high and low sale
prices for each quarterly period for the past two years as reported by Nasdaq
are:
1997 HIGH Low Dividend
---- ---- --- --------
First Quarter $ 9.50 $ 8.38 $.020
Second Quarter 11.50 8.38 .020
Third Quarter 11.94 10.13 .023
Fourth Quarter $ 16.13 $ 11.63 $.023
1998
----
First Quarter $ 20.00 $ 14.25 $.023
Second Quarter 19.88 15.13 .023
Third Quarter 16.63 12.25 .025
Fourth Quarter $ 14.75 $ 11.44 $.025
(1)Adjusted for a March 1993 two-for-one, a July 1996
three-for-two common stock split effected in the form of a
stock dividend and a July 1998 two-for-one common stock split,
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.
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
----------------------
1998* 1997(1) 1996(1) 1995*(1) 1994(1)
----- ------- ------- -------- -------
STATEMENTS OF INCOME DATA: (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Earned premiums $ 356,210 320,050 304,472 296,364 225,297
Net investment income $ 32,506 31,107 29,863 28,461 22,189
Management services income $ 7,945 7,367 6,774 6,377 5,170
Net realized gains on investments $ 2,925 3,043 2,788 1,758 1,595
Other income $ 2,473 1,409 1,200 525 147
----------------------------------------------------------------
Total revenues $ 402,059 362,976 345,097 333,485 254,398
----------------------------------------------------------------
Income before federal income taxes $ 49,605 56,638 34,792 40,953 20,294
----------------------------------------------------------------
Net income $ 37,497 40,998 26,407 29,894 15,835
----------------------------------------------------------------
Earnings per common share(2)(3):
Basic $ .89 .99 .64 .73 .39
----------------------------------------------------------------
Diluted $ .87 .97 .63 .72 .39
----------------------------------------------------------------
Cash dividends per common share(1) $ .10 .09 .08 .07 .06
----------------------------------------------------------------
BALANCE SHEET DATA AT YEAR END:
Total investments $ 579,966 526,363 499,277 479,908 350,639
Total assets $ 709,778 638,823 586,327 566,445 434,636
Total stockholders' equity $ 340,824 297,258 247,619 225,763 175,852
Book value per common share(2) $ 8.11 7.11 5.98 5.48 4.29
STATUTORY RATIOS:
Loss ratio 68.4 65.2 72.7 68.6 75.4
Expense ratio 29.4 28.9 27.3 31.0 28.2
Combined ratio(4) 97.8 94.1 100.0 99.6 103.6
Industry combined ratio(5) 105.0 101.6 105.8 106.5 108.5
Ratio of net premiums written to statutory capital and surplus 1.63 1.71 1.91 2.12 1.77
(1) Financial information prior to 1998 has been restated to include the financial position and operations of Milbank
Insurance Company.
(2) Adjusted for a July 1998 2-for-1 common stock split as well as a July 1996 3-for-2 common stock split effected in
the form of a stock dividend.
(3) The earnings per share amounts prior to 1997 have been restated as required to comply with SFAS No. 128.
(4) Derived from combined statutory financial statements on a pooled basis, including State Auto National.
(5) Preliminary industry information for 1998 from A.M. Best Co.
* Reflects change in pooling arrangement, effective January 1, 1998 and January
1, 1995.
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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:
OVERVIEW
State Auto Financial Corporation (State Auto Financial), through its
principal insurance subsidiaries, State Auto Property and Casualty Insurance
Company (State Auto P&C) and Milbank Insurance Company (Milbank), provides
personal and commercial insurance for the standard insurance market primarily
in the Midwest and eastern United States, excluding New York, New Jersey, and
the New England states. Their principal lines of business include personal and
commercial auto, homeowners, commercial multi-peril, workers' compensation,
general liability and fire insurance. Another insurance subsidiary of State
Auto Financial, State Auto National Insurance Company (National), writes
personal automobile insurance for risks in the nonstandard insurance market.
State Auto P&C, Milbank 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:
Milbank, National and State Automobile Mutual Insurance Company (Mutual) - a
majority shareholder of State Auto Financial - and Mutual's wholly owned
subsidiary, 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).
On July 7, 1998, State Auto Financial completed the exercise of its
option, pursuant to the Option Agreement dated August 1993, with Mutual by
acquiring the outstanding shares of Milbank. Milbank had been a wholly owned
subsidiary of Mutual since July 1, 1993, but as a result of this transaction,
Milbank is now a wholly owned subsidiary of State Auto Financial. The purchase
price of Milbank was approximately $81.9 million. The transaction was effected
through an exchange with Mutual of approximately 5.1 million State Auto
Financial common shares for all the issued and outstanding capital stock of
Milbank. This exchange of Milbank shares for State Auto Financial common shares
increased Mutual's ownership of State Auto Financial to approximately 70% of its
issued and outstanding shares. Since the transaction was a combination of
entities under common control it has been accounted for similar to a pooling of
interests. The prior years' financial information has been restated to include
the financial position and operations of Milbank.
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, Milbank and Mutual.
Strategic Insurance Software, Inc. (S.I.S.), 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. S.I.S. sells
services and products to affiliated companies and their agents and markets
similar services and products to nonaffiliated insurers and their agencies.
518 Property Management and Leasing, LLC (518 PML), an Ohio limited
liability company, was formed in December 1997 to engage in the business of
owning and leasing real and personal property to affiliated companies. On
January 1, 1998, State Auto P&C and Stateco became the initial members of 518
PML with State Auto P&C contributing real property and Stateco contributing $7.0
million in cash and real property.
State Auto Financial, State Auto P&C, Milbank, National, Stateco,
S.I.S. and 518 PML are referred to collectively herein as the Company.
In August 1998, State Auto Financial purchased $9.0 million of surplus
notes from Farmers Casualty Company Mutual (Farmers Casualty), an Iowa domiciled
property casualty insurer for the
26
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standard insurance market. In 1998, a plan to convert Farmers Casualty into a
stock insurance company was approved by the board of Farmers Casualty, its
policyholders and the Iowa Division of Insurance. The plan of conversion
contemplated that State Auto Financial, in exchange for the redemption of the
surplus notes, would acquire the newly issued shares of Farmers Casualty.
Effective January 1, 1999, Farmers Casualty, renamed Farmers Casualty Insurance
Company, became a wholly owned subsidiary of State Auto Financial. In addition,
Farmers Casualty owns 100% of the outstanding shares of Mid-Plains Insurance
Company, an Iowa domiciled property casualty insurer, which principally writes
nonstandard auto insurance.
Since 1995, State Auto P&C and Milbank, the companies comprising the
standard insurance segment, have 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. Through December 31, 1997, the pooling percentages were
allocated as follows: 35% to State Auto P&C, 10% to Milbank and 55% to Mutual.
Effective January 1, 1998, 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 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 pooling change, State Auto P&C and
Milbank received approximately $19.7 million to cover their increased share of
the pooled liabilities. The pooling Arrangement was amended again effective
January 1, 1999, to include all of the property and casualty business of Farmers
Casualty. With the inclusion of Farmers Casualty in the pool, the pooling
participation percentages were amended to allocate 37% to State Auto P&C, 49% to
Mutual, 10% to Milbank, 1% to Midwest Security and 3% to Farmers Casualty.
In discussing Results of Operations, State Auto P&C, National, Mutual,
Milbank and Midwest Security are referred to collectively as the State Auto
Insurance Companies, while State Auto P&C, Mutual, Milbank and Midwest Security
are referred to as the Pooled Companies.
RESULTS OF OPERATIONS
Net income for the Company decreased 8.5% in 1998 (increased 55.3% in
1997). The Company's statutory combined ratios for 1998, 1997 and 1996,
respectively, were 97.8%, 94.1% and 100.0%. Impacting the Company's results for
1998 and 1996 was an increase in the level of catastrophe losses for these
periods; 1996 being the worst catastrophe year in the Company's history and 1998
being the second worst.
Consolidated earned premiums increased 11.3% in 1998 (5.1% in 1997).
This 11.3% increase was derived from three sources. The impact of the change in
allocation percentages of the Company's pooling percentages as well as the
addition of Midwest Security to the pool increased consolidated earned premiums
7.1%. The growth in the standard insurance segment, excluding the impact of the
changes in the pooling arrangement, increased consolidated earned premiums 2.9%
(2.6% in 1997). The Company's nonstandard insurance segment (i.e., National)
increased consolidated earned premiums 1.3% from the previous period (2.5% in
1997).
State Auto P&C and Milbank, which represents State Auto Financial's
standard insurance segment, achieved a 10.7% increase in earned premiums in both
personal and commercial lines in 1998 (2.7% in 1997). Of the 10.7% increase,
7.6% was due to the change in the pooling arrangement and 3.1% (2.7% in 1997)
was due to external growth.
With respect to personal lines, in both 1998 and 1997, the Pooled
Companies' produced an increase of approximately 1.0% in its direct written
premiums despite a significant increase in aggressive price competition in this
book of business. Contributing favorably to the personal lines business over the
last few years has been the Company's Prime of Life program (the Program), that
targets insureds 50 and older, that was first introduced by the Company in late
1995. The Program, which has consistently generated 25% of the Company's new
business, has also exhibited a significantly higher than average retention rate.
The continued growth of the Program is gradually changing the profile of the
Company's personal lines book of business as more and more baby boomers age into
eligibility.
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The commercial lines direct written premium of the Pooled Companies
increased in 1998 approximately 3.3% (8.3% in 1997). The rate of growth on the
Company's commercial lines has slowed in recent years due primarily to a
reduction in premiums in the Company's workers' compensation line of business
which is due to rate reductions resulting from decreases in loss costs as
promulgated by various rating bureaus. This phenomena, that began in late 1996,
continued into 1998. The workers' compensation line of business represents
approximately 10% of the Pooled Companies' commercial business at the end of
1998.
The nonstandard segment (National) increased its earned premiums in
1998 19.0% (56.8% in 1997). This segment's growth has slowed compared to prior
year levels due to aggressive underwriting action designed to improve
profitability in Tennessee and Arkansas, National's two largest states, a more
restrictive underwriting posture with several larger producers in its other
states, and rate increases implemented during 1997 in several operating states.
While these actions have resulted in a decrease in growth over prior year
levels, National`s statutory loss experience has improved over comparative prior
periods. See discussion below. National began operations in four new states
during 1998: Indiana, Pennsylvania, Utah and Wisconsin. Contributing to
National's 56.8% increase in premiums in 1997 was entry into Arkansas and
Georgia in December 1996, Minnesota in February 1997 and in the later half of
1997, Alabama, Illinois and Missouri. In 1999, National has planned entry into
at least three new states: South Carolina, South Dakota and Maryland.
In 1998 premium growth was harder to achieve than it has been in some
time. While commercial lines pricing continued to be very aggressive, the
personal lines part of our business is also seeing intense price competition,
with increased marketing activity among major players in personal lines auto
insurance. This adversely affected the Pooled Companies ability to generate new
business because management has continued to stress responsible pricing and
diligent underwriting in contrast to much of its competition. At least annually,
the State Auto Insurance Companies reviews each line of business to ensure that
it is appropriately priced. As a result, much of the premium growth noted above
within the standard insurance segment was attributable to the State Auto
Insurance Companies' ability to put into place price increases on the existing
book of business as opposed to the sale of new units.
The Company has attempted to address the difficulties of securing
growth by making selective acquisitions which afford opportunities for increased
writings in new, desirable states of operation. Within the last eight years,
entry into new states, other than Oklahoma, has been by acquisition. In 1993
Mutual acquired Milbank which took the State Auto Insurance Companies into South
and North Dakota, Minnesota and Utah. In 1997 Mutual acquired Midwest Security,
thus entering Wisconsin. In 1999, State Auto Financial acquired Farmers Casualty
and Mid-Plains taking the State Auto Insurance Companies into Iowa and Kansas.
Though all of these acquisitions have been primarily personal lines companies,
they have taken the Company into additional targeted states with an established
independent agency force with an existing book of business on which to build.
Management believes this reduces start up costs and permits faster growth in new
states than has been the case with starting in a new state from scratch. With an
established agency force, the Company has a "ready made" distribution force for
offering an expanded product portfolio, including commercial lines and
additional personal lines products.
Net investment income increased 4.5% in 1998 (4.2% in 1997).
Contributing to the increase over previous years was an increase in cash flow
from operations and a general increase in investable assets over the previous
year's levels. Total cost of investable assets at December 31, 1998, 1997 and
1996, respectively, was $590.8 million, $535.2 million and $488.3 million.
Additionally, in 1998 State Auto P&C and Milbank received approximately $19.7
million in conjunction with the change in the pooling arrangement.
The investment yields, based on fixed and equity securities at cost,
were 5.7%, 6.0% and 6.1% for the annual periods ending 1998, 1997 and 1996,
respectively. Contributing to the decrease in the investment yields over these
periods has been a decline in the overall market fixed maturity interest rate
environment from the previous comparable periods as well as a gradual shift in
the composition of the fixed maturity portfolio from taxable to tax-exempt fixed
maturities. At December 31, 1998, 1997 and 1996, respectively, tax exempt
securities comprised approximately 71%, 59%, and 52% of the fixed maturity
portfolio. Somewhat lower yields are expected in 1999 on the fixed maturity
portfolio given that a number of high yield fixed maturities are being called or
maturing and are being reinvested at current
28
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lower yielding rates. Despite these lower yielding rates, the Company has no
intention of compromising the quality of its portfolio for higher yielding, more
risky investments. Additionally, the Company began a program in late 1997 to
build on the equity portfolio to enhance growth of statutory surplus over the
long term, which continued in 1998. See further discussion regarding investments
at the Investments Market Risk section included herein.
In February 1999, President Clinton proposed the 2000 fiscal year
budget. One of the more significant revenue raising proposals contained in the
budget directly affects property and casualty insurance companies. Property and
casualty insurance companies are currently limited on the deductibility of the
investment income earned on tax exempt fixed maturities and certain dividends
received to 85%. This reduction was the result of the Tax Act of 1986. President
Clinton, in his February proposal, has proposed a further limitation of 10%
(i.e., deductibility of investment income earned from tax exempt fixed
maturities and certain dividends received would be limited to 75%). The current
proposal would be effective for taxable years beginning after the date of
enactment, with respect to investments acquired on or after the date of first
committee action. President Clinton had proposed a similar action for the 1999
fiscal year budget limiting the deductibility of investment income earned on tax
exempt fixed maturities and certain dividends received to 70%. The
municipalities lobbied very hard against such action as property and casualty
insurance companies and other financial service industries are the largest
investors in municipalities' fixed maturities. If this revenue raising proposal
passes as it currently stands, certain tax exempt securities would become less
appealing to the property and casualty insurance industry as the relative spread
between after tax yields on tax-exempt and taxable fixed income maturities will
narrow. This management will be monitoring the government's actions regarding
this proposal. However, it is still too early in the budget process to
anticipate the outcome.
Management services income, which includes income generated from the
investment management services segment and executive management services
provided by Stateco and State Auto P&C, respectively, increased $0.6 million in
both 1998 and 1997.
Other income includes primarily revenue from S.I.S.' sales of its
software products, and beginning in 1998 rental income on property leased by 518
PML. In 1998, other income increased 76% (17% in 1997). 518 PML's commencement
of leasing operations in 1998 increased other income 19% while S.I.S.' increase
in software sales over 1997 contributed a 47% increase. In 1997, other income
was comprised mainly of S.I.S. software sales which increased 17% from same
period in 1996.
Losses and loss expenses, as a percentage of earned premiums, were
68.0%, 65.1% and 72.3% for years 1998, 1997 and 1996, respectively. As
previously discussed, the Company experienced increased levels in storm-related
catastrophe losses in 1998 and 1996, primarily in the standard insurance
segment. The second quarter 1998 was impacted by storm-related catastrophe
losses occurring in nearly all operating states and the third quarter was
adversely affected by several Midwestern wind and hail storms. The impact of the
1998 catastrophe losses amounted to 8.1 GAAP loss ratio points whereas
catastrophe losses totaled 2.4 GAAP loss ratio points. Despite the higher level
of catastrophe losses as compared to 1997, the Company did not experience any
significant loss activity from hurricanes Bonnie, Earl and Georges. In 1996 the
Company was impacted by severe winter weather and storm losses in Raleigh, North
Carolina resulting from Hurricane Fran moving inland. The impact of the 1996
catastrophe claims amounted to 9.3 GAAP loss ratio points. The relatively low
level of hurricane losses within the last three years validates the Company's
strategy of closely monitoring concentration of risks subject to coastal losses.
Absent the increased level of catastrophes, the Company's underlying book
remained strong and in fact, reflects improvement from prior years, validating
the Company's philosophy of responsible underwriting versus emphasis on premium
growth achieved with irresponsible pricing or risk selection.
Losses and loss expenses, as a percentage of earned premiums, for the
nonstandard insurance segment, were 74.4%, 79.4% and 76.6% for the years ended
1998, 1997 and 1996, respectively. Increase in the 1997 ratio was due to
underwriting problems that occurred in two of the segment's larger states of
operations as previously discussed. In early 1997, National implemented rate
increases in these two states and took a more aggressive underwriting posture
with several of its larger agencies in an effort to control the underwriting
losses this segment was beginning to experience.
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In an effort to reduce its exposures to any one type of catastrophic
loss, the Company, in recent years, has sought to geographically diversify into
regions of the country not exposed to earthquakes and hurricanes. As previously
discussed, this has been accomplished through the acquisitions of Milbank,
Midwest Security, Farmers Casualty and Mid-Plains. While some states are not
subject to the threats of hurricanes or earthquakes, virtually all have some
windstorm and or hail exposure. Along with the increasing geographic dispersion
of the Company's underwriting risk portfolio, the Company continues to refine
its methods of monitoring its exposures to all types of catastrophe hazards.
Acquisition and operating expenses, as a percentage of earned premiums
(the "expense ratio"), were 29.3%, 29.5% and 28.2% for the years 1998, 1997 and
1996, respectively. The decrease in the expense ratio in 1998 can be attributed
to a reduced amount of Quality Performance Bonus (the Bonus) paid to employees
compared to that paid in 1997, but this was partially offset by an increase in
guaranty fund assessments.
The increase in the 1997 expense ratio from that in 1996 is due to the
amortization of software expenses, 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. The Bonus in 1997 exceeded that which was earned in 1996 due to an
improvement in the underwriting operations of the Company in 1997. Also
contributing to this increase was an increase over 1996 of the amount of bonus
compensation earned by the Company's agents. Each agent who meets certain
premium production thresholds shares in the underwriting profits generated by
insurance placed by them.
In an attempt to improve the efficiency of its operations and thereby
reduce overall operating expenditures in the long-term, the Company has been
making strides in the use of technology to streamline its personal and
commercial operations, specifically in the area of electronic upload and
download with its agencies using the APT industry standard. The advent of
electronic transfers between the agent and the Company should have a long-term
positive impact on the Company's expenses as the Company has been able to reduce
its paper and postage costs as well as stabilize its employee count which should
continue as this process expands to more agencies and lines of business.
Additionally, it should improve the efficiency and effectiveness of the
operations of both the agent and the Company through quicker response time and
increased accuracy.
In addition to the use of technology, the Company is realigning its
claims procedures in order to improve service and reduce settlement expenses.
The Company extensively trains its claims adjusters, whose professionalism is
exhibited by the low number of complaints received by the various state
insurance regulators. While the Company trains each adjuster to handle all types
of claims, the Company recognizes that many claims are small and routine in
nature. Rather than have a thoroughly trained adjuster spend time on these
claims, the Company has established a Central Claims Department staffed by
persons who focus exclusively on these losses. This allows for quicker response
time to the insured, allows the fully trained claims adjuster to focus on the
more serious claims, and reduces the use of independent adjusters.
Other expense includes those operating expenses associated with general
corporate expenses, S.I.S., 518 PML and Stateco's investment management services
(the investment management services segment). In 1998 other expense increased
58.2% (12.1% decrease in 1997). S.I.S.' operating expenses increased over 1997
contributing an increase of 20% to other expense. Also contributing to this
increase was an increase in write-offs of premium receivable during 1998,
primarily in the nonstandard insurance segment. This segment has sought to
improve its premium receivable collections by retaining the services of a third
party whose business is receivables collection. Additionally, there was a
general increase in corporate expenses over 1997. The decrease in other expenses
in 1997 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 expense.
30
Page 29
The effective Federal tax rate was 24%, 27% and 24% for the years ended
1998, 1997 and 1996, respectively. The lower rates in 1998 and 1996 were due to
a decrease in the underwriting profit compared to the 1997 period as a result of
the increased storm related catastrophes experienced by the Company during these
periods as well as a shift in the composition of its investment portfolio from
taxables to tax-exempts, as previously noted. The increased rate in 1997 was due
to an increase in underwriting profit recorded for the year and higher realized
capital gains.
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 investments to meet fluctuations in claim payments.
In 1998, net cash provided by operating activities increased to $56.7
million ($28.9 million in 1997). This increase is due to the transfer of $19.7
million to State Auto P&C and Milbank in connection with the amended pooling
arrangement, as discussed above, as well as a general increase in cash flows
that resulted from a change in pool percentages from previous periods. In 1997,
net cash provided by operating activities increased to $28.9 million ($24.2
million in 1996). This 1997 increase in cash flow was due to an overall
improvement in the insurance operations of the Company, attributable to lower
catastrophe losses from the previous year. Over the last three years, operating
cash flows have been sufficient to meet the operating needs of the Company while
providing opportunities for increased investment and financing needs. Management
does not anticipate any significant changes in its operating cash flow.
Net cash used in investing activities reflects cash flows used in
purchases of fixed maturities and equity securities, respectively, of $193.9
million and $17.1 million in 1998, $137.6 million and $13.7 million in 1997 and
$164.5 million and $11.8 million in 1996. The decline in the purchase of fixed
maturities in 1997 was a matter of timing, as funds invested in cash equivalents
at December 31, 1997 were allocated for investment in early 1998. As market
interest rates on fixed maturities began to decline over the last three years,
the Company began experiencing a steady increase in the amount of calls on fixed
maturities. Cash flows provided by maturities, calls and principal reductions of
fixed maturities were $47.8 million in 1998, $28.2 million in 1997 and $17.9
million in 1996. During 1998 518 PML began construction of a building in
Goodlettsville, Tennessee that will be leased to Mutual and its affiliates in
1999. It is anticipated that the total construction costs of this building,
excluding land will be approximately $4.5 million.
Net cash provided by financing activities consists of proceeds from
issuance of common stock that has exceeded the payment of dividends for the last
three years. Mutual, whose ownership in State Auto Financial has increased from
65% to almost 70% in 1998, has waived its right to receipt of the dividends
declared by State Auto Financial in an effort to enhance the statutory surplus
of the insurance subsidiaries of State Auto Financial for use in support of
underwriting operations. Additionally, waivers of dividends by Mutual enhance
the Company's financial position which benefits Mutual, the Company's largest
shareholder, and other shareholders as well. Each dividend waiver is reviewed by
Mutual's Board of Directors.
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,
31
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National and beginning July 1, 1998, Midwest Security, pursuant to a catastrophe
reinsurance agreement in the amount of $100.0 million excess of $120.0 million
(Farmers Casualty and Mid-Plains will be added to the catastrophe reinsurance
program in 1999). 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 million has been excluded from the 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 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 19, 1999, State Auto Financial has not exercised its
right to acquire Midwest Security.
During the first quarter of 1999, State Auto Financial commenced the
process of forming a new Ohio stock corporation and obtaining for it a
certificate of authority from the Ohio Department of Insurance. It is expected
to be a wholly owned subsidiary of State Auto Financial with initial
capitalization of approximately $5.75 million. The capitalization is expected to
be funded through dividends from subsidiaries. It is anticipated that this new
subsidiary, to be called State Auto Insurance Company, will utilize leading edge
technology to achieve maximum efficiencies for a carrier operating within the
independent agency system.
On March 5, 1999, the Board of Directors of State Auto Financial
declared a quarterly cash dividend of $0.025 per common share, payable on March
31, 1999, to shareholders of record on March 17, 1999. This is the 31st
consecutive cash dividend declared by the Company's Board since State Auto
Financial had its initial public offering of common stock on June 28, 1991.
Additionally, State Auto Financial has increased cash dividends to shareholders
for seven consecutive years. During 1998, the Company's authorized common shares
increased to 100 million and the Board declared a two-for-one stock split to be
distributed July 8, 1998, to shareholders of record on June 18, 1998. The impact
of this stock split has been appropriately reflected in the accompanying
consolidated financial statements.
The maximum amount of dividends that may be paid to State Auto
Financial during 1999 by its insurance subsidiaries, including Farmers Casualty,
as a non-extraordinary dividend is limited to $21.9 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) maintains
risk-based capital requirements for property and casualty insurers. 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, 1998, each of the State Auto Insurance
Companies exceeded all standards tested by the formula.
32
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OTHER DISCLOSURES
INVESTMENTS
Stateco performs investment management services (the investment
management services segment) on behalf of the Company and Mutual and its
subsidiaries. The Investment Committee of each insurer's Board of Directors sets
investment policies to be followed by Stateco.
The primary investment objectives of the Company are to generate
income, preserve capital and maintain adequate liquidity for the payment of
claims. Fixed 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 due to changing investment
strategies are categorized as available for sale and are carried at fair value.
At December 31, 1998, the Company had no fixed maturity investments rated below
investment grade, nor any mortgage loans.
As of December 31, 1998, the Company had fixed maturities with a fair
value of $481.8 million designated as available for sale compared to $421.0
million at December 31, 1997. During 1998, the Company continued its program to
increase its equity portfolio to enhance growth of statutory surplus over the
long term. At December 31, 1998 and 1997, respectively, the equity portfolio
totaled $42.2 million and $26.1 million.
MARKET RISK
Investable assets comprise approximately 86% of the Company's total
assets. Of the total investments, 88% are invested in fixed maturities, 6.9% in
equity securities and the remaining in cash and cash equivalents.
The Company's decision to make a specific investment is influenced
primarily by the following factors: (a) investment risks; (b) general market
conditions; (c) relative valuations of investment vehicles; (d) general market
interest rates; (e) the Company's liquidity requirements at any given time; and
(f) the Company's current federal income tax position and relative spread
between after tax yields on tax-exempt and taxable fixed income investments.
The fixed maturity portfolio is managed in a ladder-maturity style to
ensure adequate cash flow to meet claims as they are presented. At December 31,
1998, the Company's fixed maturity portfolio had an average maturity of 11.1
years. For the insurance subsidiaries, the maximum investment in any single note
or bond is limited to 2.0% of statutory assets, other than obligations of the
U.S. government or government agencies, for which there is no limit. The fixed
maturity portfolio is very high in quality with all holdings either in
Government obligations, municipal, corporate obligations rated AA or better by
the major bond rating agencies. The Company does not intend to change its
investment policy on the quality of its fixed maturity investments. Investments
in equity securities are selected based on their potential for appreciation as
well as ability to continue paying dividends. Additional information regarding
the composition of investments, along with maturity schedules regarding
investments in fixed maturities, is included in note (2) of the Consolidated
Financial Statements.
The Company's primary market risk exposures are to changes in market
price for equity securities and changes in interest rates and credit ratings for
fixed maturity securities. The Company has no exposure to foreign currency
exchange rate risk nor does it own any derivative financial instruments. To
provide the Company greater flexibility in order to manage its market risk
exposures, the Company has segregated a portion of its fixed maturity
investments, in accordance with SFAS No. 115, as available for sale. Also, the
Company does not maintain a trading portfolio.
The following table provides information about the Company's fixed
maturity investments used for purposes other than trading that are sensitive to
changes in interest rates. The table presents principal cash flows from
maturities, anticipated calls and estimated prepayments, or paydowns from
holdings in mortgage backed securities. The table also presents the average
interest rate for each period presented.
33
Page 32
PRINCIPAL AMOUNT MATURING IN:
(Dollars in thousands)
1999 2000 2001 2002 2003 Thereafter Total Fair Value
---- ---- ---- ---- ---- ---------- ----- ----------
Fixed interest
rate securities $11,074 20,513 32,908 52,644 29,508 361,625 508,272 $539,670
Average
Interest rate 6.4% 6.3% 6.6% 5.9% 5.1% 6.2% 6.0%
YEAR 2000
Description of the Year 2000 Issues Affecting the Company
- ----------------------------------------------------------
The Company commenced work on its Year 2000 ("Y2K") issues in the fall
of 1996. At that time, one of its first tasks was to perform an inventory of all
software systems. As a result of this inventory, it identified approximately 5
million lines of in house maintained program code in its various software
systems. Following this inventory the Company set priorities as to system
remediation based on the role each system played in the Company's being able to
carry on its insurance operations or meet its general business needs. The
Company's applications software must support certain essential functions:
issuing insurance policies, collecting policy premiums and paying claims and
premium refunds. In addition, there is other applications software used by the
Company in the general operation and management of its business.
Following months of intensive remediation effort, in April 1998, the
Company conducted its first major test of one of its major insurance policy
processing systems. The results of that test were positive. The Company
conducted a second comprehensive Millennium test at an off-site computer
facility in August 1998. All major insurance policy processing systems were
tested as if it were the Year 2000. Testing also included Leap Day, February 29,
2000. This test was also successful. In 1999, two additional tests are planned
for March and September. Additionally, all internal test systems run with
advanced dates giving the Company the opportunity to identify Y2K issues early
enough to react to them.
At this time, one hundred percent (100%) of the Company's in-force
insurance policies are being processed on a Y2K compliant system, based on the
test results mentioned above. However, in an effort to ensure that no material
problems arise from the policy processing systems used by the Company and its
affiliates or subsidiaries (all of which are sometimes collectively referred to
hereafter as "State Auto") the Company plans to continue simulated Year 2000
testing throughout 1999.
State Auto's Y2K project team has, through February 1999, completed its
efforts on approximately 95% of State Auto's applications software. That means
that approximately 95% of the software systems State Auto uses in its insurance
operations or in meeting its general business needs has been through Y2K
remediation, testing, and has been introduced back into the Company's production
environment. Included within this 95% are the systems that address policy
issuance, premium billing and collection and claims processing at State Auto.
The remaining 5% of applications software code that is not presently Y2K
compliant involves applications that are not "mission critical", such as certain
management reports and other similar tools. Some of this remaining code may well
be determined to be obsolete. State Auto plans to have 100% of its non-obsolete
applications software Y2K compliant by mid-year 1999.
In addition to addressing its own applications software Y2K problems,
State Auto may be affected by the Y2K issues of third parties with which it has
a material relationship. This includes the independent insurance agents who sell
the Company's products, many of whom have automated agency management systems in
place.
In addition, a number of State Auto Agencies and the Company are able
to communicate policy data electronically. There are several agency management
systems that permit this so-called upload and download of information but not
all are Y2K compliant. If upload and download are disrupted by Y2K issues, it
will likely affect the efficiency with which the Company operates its business.
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The Company has surveyed all State Auto Agencies that currently
upload data electronically to State Auto and verified that every one of these
agencies has a Y2K compliant agency vendor system. For those agencies that
only receive a download of policy information from State Auto, current
information on the Y2K compliance status of their systems available to State
Auto indicates that the majority of them are Y2K compliant. In the event that
any of these agencies encounters any difficulty with download, State Auto is
prepared to suspend the electronic transfer and turn back on the generation of
policy documents of which an agency would need to maintain records manually.
The consequences of the disruption would depend on the extent to which
State Auto's various lines of business may be uploaded and downloaded at the
time the disruption would occur and the duration of the disruption. Thus, it is
not possible to reasonably estimate the financial impact of such reduced
efficiency.
There are certain other vendors which have a material relationship with
the company by virtue of the fact that they provide a product or service that
State Auto uses in the ordinary course of its business, such as underwriting
information providers, task specific software or hardware product vendors, and
financial institutions. Y2K compliance by third party vendors will continue to
be one of State Auto's focal points throughout the remainder of 1999. State Auto
expects to have third party vendor products then in use Y2K compliant by the end
of the 3rd quarter of 1999.
Stateco Financial Services, Inc. ("Stateco"), a wholly owned subsidiary
of State Auto Financial which provides investment management services to each of
the State Auto insurers, has had in place a third party vendor investment
management system which is represented by the vendor to be Y2K compliant. Based
on its present use of this system, Stateco does not expect its services to be
disrupted by Y2K issues affecting it, although Stateco will be included in the
contingency planning discussed below should some unanticipated system failure
arise.
State Auto Financial's Costs to Address Year 2000 Issues
- --------------------------------------------------------
State Auto Financial's Y2K compliance expense to date for resources has
been $1.7 million dollars of a projected $2.4 million dollars. This estimate is
subject to change depending on future, presently unforeseen developments which
could affect the cost of Y2K compliance for State Auto. The money spent to date
is virtually all payroll costs attributable to the State Auto employees on the
Y2K project team. The foregoing expense does not include approximately $0.2
million spent by State Auto Financial on accelerated technology purchases for
systems or equipment to ensure Y2K compliance for such system or equipment.
Also, an outsourcing agreement with State Auto's primary third party software
vendor to provide additional resources for other systems projects has generated
an additional expense to State Auto Financial of approximately $1.3 million over
the last two years.
State Auto's Risks Due to Year 2000 Issues
- ------------------------------------------
As a property casualty insurer, State Auto faces the additional risk of
insured or allegedly insured losses to its policyholders from the Y2K exposure.
State Auto has clarified certain commercial liability insurance policies with
respect to this exposure. It is too early to know the nature and extent of
insured losses that might arise from the Y2K problem, be they from information
systems failures or embedded chip processing failures.
State Auto does not expect a material adverse impact from Y2K issues
arising from embedded chip processing failures occurring on site. Those embedded
chip issues which the Company has some opportunity to control or address that
have been identified to date have been generally facilities related or involving
small business equipment (i.e. fax machines). Upgrades and equipment replacement
are being coordinated by a variety of business managers responsible for such
equipment.
State Auto's Year 2000 Contingency Plans
- ----------------------------------------
State Auto has not yet created a formal Y2K contingency plan.
Discussions and communications have begun in regards to this. Each internal
department has responded to a survey relating to its use of external systems
which might be subject to disruption. State Auto has also had one meeting with a
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consultant regarding contingency planning. The Company expects to have a
contingency plan in place by the 4th quarter 1999. Some of the issues that the
plan would likely contemplate would be manual processing alternatives,
non-electronic forms of information distribution, assurance of adequate
supplies, and mitigation of the impact of utilities and financial institution
disruptions.
State Auto continues to work with its business recovery service
provider. State Auto is following a program developed by that provider that
requires a comprehensive Y2K preparation approach. Conforming to this allows
State Auto to take advantage of its provider's facilities for business recovery
in the event that an external Y2K issue that was addressed does happen to fail.
NEW ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS
No. 133), which is required to be adopted in years beginning after June 15,
1999. SFAS No. 133 will require companies to recognize all derivatives on the
balance sheet at fair value. The Company does not anticipate that the adoption
of SFAS No. 133 will have a significant effect on its results of operations or
financial position.
IMPACT OF SIGNIFICANT EXTERNAL CONDITIONS
Inflation can have a significant impact on property and casualty
insurers because premium rates are established before the amount of losses and
loss expenses are known. When establishing rates, the Company attempts to
anticipate increases from inflation subject to limitations imposed for
competitive pricing. Inflation has been modest over the last several years
thereby allowing pricing of premiums to keep pace with inflation on certain
lines of business.
The Company considers inflation when estimating liabilities for losses
and loss expenses, particularly for claims having a long period between
occurrence and settlement. The liabilities for losses and loss expenses are
management's 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.
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. Such statements
include, without limitation, those pertaining to the weather related
catastrophes impacting the Company's losses, product offerings, National's
premium receivable collections effort, the Year 2000 discussion, the statements
relating to the new insurer to be created, State Auto Insurance Company, the
legislative and regulatory environment and sales forecasts. These risks and
uncertainties include, but are not limited to, legislative changes, judicial and
regulatory decisions, 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, technological difficulties and advancements, availability of labor
and materials in storm hit areas, late reported claims, previously undisclosed
damage, utilities and financial institution disruptions, shortages of
programmers, and regulatory or governmental systems breakdowns.
ITEM 7(a). QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
- ---------- ----------------------------------------------------------
"Qualitative and Quantitative Disclosures About Market Risk" is
included in Item 7 "Management's Discussion and Analysis of Financial Condition
and Results of Operations" under Market Risk.
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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:
37
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, 1998 and 1997 and the
related consolidated statements of income, stockholders' equity and cash flows
for each of the three years in the period ended December 31, 1998. 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, 1998 and 1997,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles.
As discussed in Note 1, the Company acquired the outstanding shares of Milbank
Insurance Company from State Automobile Mutual Insurance Company on July 7, 1998
in a transaction accounted for similar to a pooling of interest. Accordingly,
the Company's consolidated financial statements for each of the two years ended
December 31, 1997 have been restated to include the financial position and
operations of Milbank Insurance Company.
/S/ERNST & YOUNG LLP
Columbus, Ohio
February 12, 1999
38
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED BALANCE SHEETS
- -----------------------------------------------------------------------------------------------------------------------------
DECEMBER 31
-----------
1998 1997
---- ----
ASSETS (dollars in thousands,
except share data)
(Restated-see Note 1)
Fixed maturities:
Held to maturity, at amortized cost (fair value $57,826 and $81,571,
respectively)......................................................................... $ 55,926 79,300
Available for sale, at fair value (amortized cost $464,008 and $405,815,
respectively)......................................................................... 481,844 420,994
Equity securities, available for sale, at fair value (cost $29,233 and $19,120, respectively) 42,196 26,069
----------------------------
Total investments.......................................................................... 579,966 526,363
Cash and cash equivalents.................................................................. 32,605 30,931
Surplus note receivable.................................................................... 9,000 --
Deferred policy acquisition costs.......................................................... 24,799 22,440
Accrued investment income and other assets................................................. 19,542 17,983
Net prepaid pension expense................................................................ 16,378 14,608
Reinsurance recoverable on losses and loss expenses payable................................ 13,667 12,095
Prepaid reinsurance premiums............................................................... 4,014 4,199
Property and equipment, at cost, net of accumulated depreciation of $1,980
and $1,710, respectively................................................................ 7,927 5,315
Goodwill................................................................................... 1,880 2,078
Due from affiliates........................................................................ -- 2,811
----------------------------
Total assets............................................................................... $ 709,778 638,823
----------------------------
- ---------------------------------------------------------------------------------------------------------------------------
Liabilities and Stockholders' Equity
Losses and loss expenses payable........................................................... $ 218,701 206,250
Unearned premiums.......................................................................... 135,088 125,033
Federal income taxes:
Current................................................................................. 2,608 2,278
Deferred................................................................................ 8,095 5,287
Other liabilities.......................................................................... 3,578 2,717
Due to affiliates.......................................................................... 884 --
----------------------------
Total liabilities.......................................................................... 368,954 341,565
----------------------------
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 100,000,000; 42,039,892 and
41,828,845 shares issued and outstanding respectively, at stated value of
$2.50 per share....................................................................... 105,100 104,572
Less 13,212 and 8,118 treasury shares, respectively, at cost............................ (167) (90)
Additional paid-in capital.............................................................. 41,539 40,210
Accumulated other comprehensive income.................................................. 20,276 14,761
Retained earnings....................................................................... 174,076 137,805
----------------------------
Total stockholders' equity................................................................. 340,824 297,258
----------------------------
Total liabilities and stockholders' equity................................................. $ 709,778 638,823
----------------------------
See accompanying notes to consolidated financial statements.
39
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF INCOME
- -----------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31
----------------------
1998 1997 1996
---- ---- ----
(dollars in thousands, except per share amount)
(Restated - (Restated -
see Note 1) see Note 1)
Earned premiums (net of ceded earned premiums of $14,382,
$14,063 and $13,473, respectively) ....................................... $ 356,210 320,050 304,472
Net investment income........................................................ 32,506 31,107 29,863
Management services income .................................................. 7,945 7,367 6,774
Net realized gains on investments............................................ 2,925 3,043 2,788
Other income................................................................. 2,473 1,409 1,200
--------------------------------------------
Total revenues............................................................... 402,059 362,976 345,097
--------------------------------------------
Losses and loss expenses (net of ceded losses and loss expenses of
$6,893, $7,359 and $6,561, respectively).................................. 242,294 208,234 220,034
Acquisition and operating expenses........................................... 104,224 94,351 86,003
Other expense................................................................ 5,936 3,753 4,268
--------------------------------------------
Total expenses............................................................... 352,454 306,338 310,305
--------------------------------------------
Income before federal income taxes........................................... 49,605 56,638 34,792
--------------------------------------------
Federal income tax expense (benefit):
Current................................................................... 12,271 14,130 8,300
Deferred.................................................................. (163) 1,510 85
--------------------------------------------
Total federal income taxes................................................... 12,108 15,640 8,385
--------------------------------------------
Net income................................................................... $ 37,497 40,998 26,407
--------------------------------------------
Earnings per common share:
Basic..................................................................... $ .89 .99 .64
--------------------------------------------
Diluted................................................................... $ .87 .97 .63
--------------------------------------------
Dividends paid per common share.............................................. $ .10 .09 .08
--------------------------------------------
See accompanying notes to consolidated financial statements.
40
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in thousands)
- --------------------------------------------------------------------------------------------------------------------------
ACCUMULATED
ADDITIONAL OTHER
COMMON COMMON TREASURY TREASURY PAID-IN COMPREHENSIVE RETAINED
SHARES STOCK SHARES STOCK CAPITAL INCOME EARNINGS TOTAL
------ ----- ------ ----- ------- ------ -------- -----
BALANCE -
DECEMBER 31, 1995 41,188 $102,969 -- $ -- $37,927 $12,473 $72,394 $225,763
(Restated-see Note 1) ------ -------- ------ ------- ------- ------- ------- --------
Net income 26,407 26,407
Unrealized losses, net of tax
and reclassification
adjustment (4,944) (4,944)
------
Comprehensive income 21,463
------
Issuance of common stock 220 551 775 1,326
Cash dividends paid (933) (933)
BALANCE -
DECEMBER 31, 1996 41,408 103,520 -- -- 38,702 7,529 97,868 247,619
(Restated-see Note 1) ------ -------- ------ ------- ------- ------- ------- --------
Net income 40,998 40,998
Unrealized gains, net of
tax and reclassification
adjustment 7,232 7,232
-----
Comprehensive income 48,230
------
Issuance of common stock 421 1,052 1,508 2,560
Treasury shares acquired on
stock option exercises 8 (90) (90)
Change in minority interest
of subsidiaries (2) (2)
Cash dividends paid (1,059) (1,059)
------ -------- ------ ------- ------- ------- ------- --------
BALANCE -
DECEMBER 31, 1997 41,829 104,572 8 (90) 40,210 14,761 137,805 297,258
(Restated-see Note 1) ------ -------- ------ ------- ------- ------- ------- --------
Net income 37,497 37,497
Unrealized gains, net of tax
and reclassification
adjustment 5,515 5,515
--------
Comprehensive income 43,012
--------
Issuance of common stock 211 528 1,329 1,857
Treasury shares acquired on
stock option exercises 5 (77) (77)
Change in minority interest
of subsidiaries (7) (7)
Cash dividends paid (1,219) (1,219)
------ -------- ------ ------- ------- ------- ------- --------
BALANCE -
DECEMBER 31, 1998 42,040 $105,100 13 ($167) $41,539 $20,276 $174,076 $340,824
============================================================================================
41
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
----------------------
1998 1997 1996
---- ---- ----
(in thousands)
(Restated - (Restated -
see Note 1) see Note 1)
Cash flows from operating activities:
Net income................................................................ $ 37,497 40,998 26,407
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Depreciation and amortization, net...................................... 2,666 2,324 2,069
Net realized gains on investments....................................... (2,925) (3,043) (2,788)
Changes in operating assets and liabilities:
Deferred policy acquisition costs..................................... (1,151) (2,407) 144
Accrued investment income and other assets............................ (2,232) (3,133) (64)
Net prepaid pension expense........................................... (1,029) (1,890) (1,556)
Reinsurance recoverable on losses and loss
expenses payable and prepaid reinsurance premiums................... 4,546 (179) (597)
Other liabilities and due to/from affiliates, net..................... 1,130 (5,728) 2,546
Losses and loss expenses payable...................................... (3,400) (5,361) (6,425)
Unearned premiums..................................................... 1,733 6,484 4,245
Federal income taxes.................................................. 167 871 208
-------------------------------------------
Cash provided from the change in the reinsurance pool
participation percentage.............................................. 19,708 -- --
-------------------------------------------
Net cash provided by operating activities.................................... 56,710 28,936 24,189
-------------------------------------------
Cash flows from investing activities:
Purchase of fixed maturities - held to maturity........................... -- -- (9,073)
Purchase of fixed maturities - available for sale......................... (193,881) (137,599) (155,392)
Purchase of equity securities............................................. (17,051) (13,718) (11,811)
Maturities, calls and principal reductions of fixed maturities - held
to maturity............................................................. 23,106 10,680 10,110
Maturities, calls and principal reductions of fixed maturities - available
for sale................................................................ 24,654 17,545 7,762
Sale of fixed maturities - available for sale............................. 111,085 98,745 121,992
Sale of equity securities................................................. 8,306 9,997 10,943
Purchase of surplus notes receivable...................................... (9,000) -- --
Net additions of property and equipment................................... (2,816) (911) (167)
-------------------------------------------
Net cash used in investing activities........................................ (55,597) (15,261) (25,636)
-------------------------------------------
Cash flows from financing activities:
Net proceeds from issuance of common stock................................ 1,780 2,470 1,325
Payment of dividends...................................................... (1,219) (1,059) (933)
-------------------------------------------
Net cash provided by financing activities.................................... 561 1,411 392
-------------------------------------------
Net increase (decrease) in cash and cash equivalents......................... 1,674 15,086 (1,055)
-------------------------------------------
Cash and cash equivalents at beginning of year............................... 30,931 15,845 16,900
-------------------------------------------
Cash and cash equivalents at end of year..................................... $ 32,605 30,931 15,845
============================================
See accompanying notes to consolidated financial statements.
42
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), Milbank Insurance
Company, (Milbank), State Auto National Insurance Company (National), Stateco
Financial Services, Inc. (Stateco), and majority-owned subsidiary Strategic
Insurance Software, Inc. (S.I.S.). The financial statements also include the
operations and financial position of 518 Property Management and Leasing, LLC
(518 PML), whose members are State Auto P&C and Stateco.
On July 7, 1998, the Company exercised its option with State Automobile
Mutual Insurance Company (Mutual), pursuant to the Option Agreement dated August
20, 1993, by acquiring the outstanding shares of Milbank. Milbank had been a
wholly owned subsidiary of Mutual since July 1, 1993, but as a result of this
transaction, is now a wholly owned subsidiary of the Company. The purchase price
of Milbank was approximately $81.9 million. The transaction was effected through
an exchange with Mutual of approximately 5.1 million Company common shares for
all the issued and oustanding capital stock of Milbank. Since the transaction
was a combination of entities under common control it has been accounted for
similar to a pooling-of-interests. The prior years' financial information has
been restated to include the financial position and operations of Milbank.
The following provides financial information for Milbank included in the
accompanying financial statements for the years ended December 31, 1997 and
1996:
1997 1996
---- ----
Revenues....................... $73,416 71,037
Net income..................... $ 7,039 3,805
State Auto Financial Corporation and subsidiaries are referred to herein as
"the Companies." The Company, an Ohio corporation, is a majority-owned
subsidiary of 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
Milbank, a South Dakota Corporation, provide standard personal and commercial
insurance to its policyholders. Their principal lines of business include
personal and commercial automobile, homeowners, commercial multi-peril, workers'
compensation, general liability and fire insurance. National, an Ohio
corporation, provides nonstandard automobile insurance. State Auto P&C, Milbank
and National operate primarily in the midwest and eastern United States,
excluding New York, New Jersey, and the New England states, through the
independent insurance agency system. State Auto P&C, Milbank and National are
chartered and licensed as property and casualty insurers in the states of South
Carolina, South Dakota and Ohio, respectively, and are licensed in various other
states. As such, they are subject to the regulations of the applicable
Departments of Insurance of the states of South Carolina, South Dakota and Ohio
(collectively, the Departments) and the regulations of each state in which they
operate. State Auto P&C, Milbank 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.
The Company, through S.I.S., develops and sells software for the processing
of insurance transactions, database management for insurance agents and
electronic interfacing of information between insurance companies and agencies.
S.I.S. sells services and products to affiliated companies and their agents and
markets similar services and products to nonaffiliated insurers and their
agencies.
518 PML, an Ohio limited liability company, was formed in December 1997 to
engage in the business of owning and leasing real and personal property to
affiliated companies. On January 1, 1998, State Auto P&C and Stateco became
initial members of 518 PML. State Auto P&C contributed real property, while
Stateco contributed $7.0 million in cash and real property.
43
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(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, Milbank and National
that are prescribed or permitted by the Departments.
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the balance sheet, revenues and expenses for the
period then ended and the accompanying notes to the financial statements. Such
estimates and assumptions could change in the future as more information becomes
known which could impact the amounts reported and disclosed herein.
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.
(d) 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
----------------------
1998 1997 1996
---- ---- ----
(dollars in thousands)
Balance, beginning of
year................... $22,440 20,033 20,176
Acquisition costs
deferred............... 87,573 79,249 73,545
Amortized to expense
during the year ....... 85,214 76,842 73,688
---------------------------------
Balance, end
of year................ $24,799 22,440 20,033
=================================
(e) 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 maturity 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 as accumulated other
comprehensive income and as such are not included in the determination of net
income. Gains and losses on the sale of equity securities are computed using the
first-in, first-out method.
(f) SURPLUS NOTE RECEIVABLE
In August 1998, the Company purchased $9.0 million of surplus notes from
Farmers Casualty Company Mutual (Farmers Casualty), an Iowa domiciled standard
property casualty insurer. In 1998, a plan to convert Farmers Casualty into a
stock insurance company was approved by the board of Farmers Casualty, its
policyholders and the Iowa Division of Insurance. The plan of conversion
contemplated that the Company, in exchange for the redemption of the surplus
notes, would acquire the newly issued shares of Farmers Casualty. Effective
January 1, 1999, Farmers Casualty, renamed Farmers Casualty Insurance Company,
became a wholly owned subsidiary of the Company. In addition, Farmers Casualty
owns 100% of the outstanding shares of Mid-Plains Insurance Company, an Iowa
domiciled property casualty insurer, which principally writes nonstandard auto
insurance.
44
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(g) GOODWILL
Goodwill represents the excess of cost of acquisition over the fair value of
the net assets acquired and is being amortized using the straight-line method
over 15 years. Accumulated amortization is $1,089,000 and $891,000 at December
31, 1998 and 1997, respectively.
(h) LOSSES AND LOSS EXPENSES PAYABLE
Losses and loss expenses payable are based on formula and case-basis
estimates for reported claims, and on estimates, based on experience, for
unreported claims and loss expenses. The liability for unpaid losses and loss
expenses, net of estimated salvage and subrogation recoverable of $12,817,000
and $10,870,000 at December 31, 1998 and 1997, 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.
(i) PREMIUM REVENUES
Premiums are recognized as earned using the monthly pro rata method over the
contract period.
(j) 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 five year 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.
(k) SOFTWARE REVENUE RECOGNITION
S.I.S. 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 $1,567,000 and
$1,285,000 are included in accrued investment income and other assets at
December 31, 1998 and 1997, respectively. Software amortization, included in
other expenses, was $673,000, $489,000 and $394,000 in 1998, 1997 and 1996,
respectively.
(l) 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. Milbank will file a
consolidated federal income tax return with the Company for periods subsequent
to July 1, 1998. Prior to this time, Milbank was included in the consolidated
federal income tax return of Mutual and its subsidiaries.
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 basis 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.
(m) 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.
(n) 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.
45
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(o) OTHER COMPREHENSIVE INCOME
As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income" (SFAS No. 130), which establishes new rules for the
reporting and display of comprehensive income and its components. Comprehensive
income is defined as all changes in an enterprise's equity during a period other
than those resulting from investments by owners and distributions to owners.
Comprehensive income includes net income and other comprehensive income, and
excludes any impact of changes in minority interest of subsidiaries. Other
comprehensive income includes all other non-owner related changes to equity and
includes net unrealized gains and losses on available-for-sale fixed maturities
and equity securities.
SFAS No. 130 also requires separate presentation of the accumulated balance
of other comprehensive income within the equity section of the statement of
financial position. The Company has presented the required displays of total
comprehensive income and its components, within the "Consolidated Statements of
Stockholders' Equity." The adoption of SFAS No. 130 had no impact on the
Company's net income or shareholders' equity. Prior year financial statements
have been reclassified to conform to the requirements of SFAS No. 130. See
additional disclosures at note 13.
(p) NEW ACCOUNTING STANDARD
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" (SFAS No. 133), which is required to be
adopted in years beginning after June 15, 1999. SFAS No. 133 will require
companies to recognize all derivatives on the balance sheet at fair value. The
Company does not anticipate that the adoption of SFAS No. 133 will have a
significant effect on its results of operations or financial position.
(q) RECLASSIFICATIONS
Certain items in the 1997 and 1996 consolidated financial statements have
been reclassified to conform with the 1998 presentation.
46
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
----------------------
1998 1997 1996
---- ---- ----
(dollars in thousands)
Realized gains:
Fixed maturities available for sale............................................ $ 1,588 914 2,007
Equity securities.............................................................. 1,449 2,464 1,469
---------------------------------------
Total realized gains.............................................................. 3,037 3,378 3,476
---------------------------------------
Realized losses:
Fixed maturities available for sale............................................ 32 236 480
Equity securities.............................................................. 80 99 208
---------------------------------------
Total realized losses............................................................. 112 335 688
---------------------------------------
Net realized gains on investments................................................. $ 2,925 3,043 2,788
---------------------------------------
Increase (decrease) in unrealized holding gains -- Fixed
maturities held to maturity.................................................... $ (371) 1,464 (1,604)
---------------------------------------
Increase in unrealized holding gains -- Equity
securities..................................................................... $ 6,014 3,426 1,628
Increase (decrease) in unrealized holding gains -- Fixed
maturities available for sale at fair value.................................... 2,657 7,819 (9,102)
Change in deferred unrealized gain................................................ (184) (119) (132)
Deferred federal income taxes thereon............................................. (2,970) (3,894) 2,662
Minority interest................................................................. (2) -- --
---------------------------------------
Increase (decrease) in net unrealized holding gains or losses..................... $ 5,515 7,232 (4,944)
---------------------------------------
47
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, 1998: 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................... $ 6,291 145 -- 6,436
Obligations of states and political subdivisions.......... 7,055 508 -- 7,563
Mortgage-backed securities................................ 42,580 1,247 -- 43,827
---------------------------------------------------------------
Total..................................................... $ 55,926 1,900 -- 57,826
---------------------------------------------------------------
AVAILABLE FOR SALE AT DECEMBER 31, 1998:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies................... $ 79,089 2,812 24 81,877
Obligations of states and political subdivisions.......... 363,532 14,346 261 377,617
Corporate securities...................................... 8,996 798 -- 9,794
Mortgage-backed securities................................ 12,391 185 20 12,556
---------------------------------------------------------------
Total fixed maturities................................. 464,008 18,141 305 481,844
Equity securities......................................... 29,233 14,081 1,118 42,196
---------------------------------------------------------------
Total..................................................... $ 493,241 32,222 1,423 524,040
---------------------------------------------------------------
HELD TO MATURITY AT DECEMBER 31, 1997:
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................... $ 101,020 2,135 252 102,903
Obligations of states and political subdivisions.......... 280,423 12,597 8 293,012
Corporate securities...................................... 12,148 636 104 12,680
Mortgage-backed securities................................ 12,224 214 39 12,399
---------------------------------------------------------------
Total fixed maturities................................. 405,815 15,582 403 420,994
Equity securities......................................... 19,120 7,207 258 26,069
---------------------------------------------------------------
Total..................................................... $ 424,935 22,789 661 447,063
---------------------------------------------------------------
Deferred federal income taxes on the net unrealized holding gain was $10,919,000 and $7,949,000 at December 31,
1998 and 1997, respectively.
48
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, 1998, 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........................... $ 1,404 1,408 3,207 3,247
Due after 1 year through 5 years................... 2,364 2,457 49,263 51,111
Due after 5 years through 10 years................. 4,541 4,756 155,414 164,481
Due after 10 years................................. 5,037 5,378 243,733 250,449
------------------------------------------------------------
................................................... 13,346 13,999 451,617 469,288
Mortgage-backed securities......................... 42,580 43,827 12,391 12,556
------------------------------------------------------------
$55,926 57,826 464,008 481,844
============================================================
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 $17,666,000 and
$16,360,000 were on deposit as required by law or specific escrow agreement at
December 31, 1998 and 1997, respectively.
Components of net investment income are summarized as follows:
YEAR ENDED DECEMBER 31
----------------------
1998 1997 1996
---- ---- ----
(dollars in thousands)
Fixed maturities............................................................. $ 30,182 29,784 29,141
Equity securities............................................................ 477 372 342
Surplus note receivable...................................................... 235 -- --
Cash and cash equivalents.................................................... 1,908 1,210 995
-------------------------------------------
Investment income............................................................ 32,802 31,366 30,478
-------------------------------------------
Investment expenses.......................................................... 296 259 615
-------------------------------------------
Net investment income........................................................ $ 32,506 31,107 29,863
============================================
(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:
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.
Cash and cash equivalents and surplus note receivable: The carrying amounts
reported in the balance sheet for these instruments approximate their fair
value.
See note 2 for additional fair value disclosures.
49
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
----------------------
1998 1997 1996
---- ---- ----
(dollars in thousands)
Losses and loss expenses payable, net of reinsurance receivables,
at beginning of year......................................................... $ 194,155 199,480 206,327
Incurred related to:
Current year................................................................. 255,885 225,666 246,886
Prior years.................................................................. (13,591) (17,432) (26,852)
-----------------------------------------
Total incurred.................................................................. 242,294 208,234 220,034
-----------------------------------------
Paid related to:
Current year................................................................. 157,988 134,890 148,095
Prior years.................................................................. 86,671 78,669 78,786
-----------------------------------------
Total paid...................................................................... 244,659 213,559 226,881
-----------------------------------------
Impact of pooling change, January 1, 1998 (note 5).............................. 13,244 -- --
-----------------------------------------
Losses and loss expenses payable, net of reinsurance recoverables,
at end of year............................................................... $ 205,034 194,155 199,480
==========================================
The liability for losses and loss expenses decreased by $13,591,000 in 1998,
$17,432,000 in 1997 and $26,852,000 in 1996, 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 and Milbank assume and
cede reinsurance with other insurers and reinsurers and are members 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.
Since 1995, State Auto P&C and Milbank have participated in a reinsurance
pooling arrangement with Mutual. During 1996 and 1997 the pooling participation
percentages allocated 35% to State Auto P&C, 55% to Mutual and 10% to Milbank.
Effective January 1, 1998, the pooling arrangement was amended to include all
of the property and casualty business of Midwest Security Insurance Company
(Midwest), a wholly owned subsidiary of Mutual. Concurrent, with the inclusion
of Midwest, 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 and Milbank received approximately $19.7 million to cover their increased
share of pool liabilities.
The pooling arrangement was amended pursuant
50
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
to a Reinsurance Pooling Agreement, amended and restated, referred to hereafter
to include each of its predecessor agreements as the "Pooling Agreement", as of
January 1, 1999, to include all of the property and casualty business of
Farmers Casualty. Concurrent, with the inclusion of Farmers Casualty, the
pooling participation percentages were amended to allocate 37% to State Auto
P&C, 49% to Mutual, 10% to Milbank, 1% to Midwest and 3% to Farmers Casualty.
In connection with the January 1, 1999 change in pooling percentages, State
Auto P&C, Milbank and Farmers Casualty received approximately $ 11.4 million to
cover their 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. In 1998, Midwest Security became party to the catastrophe
reinsurance program. State Auto P&C has assumed catastrophe reinsurance from
Mutual, Milbank, Midwest Security and National pursuant to a catastrophe
reinsurance agreement in the amount of $100.0 million excess of $120.0 million.
To protect against a catastrophe loss event in which the State Auto Insurance
Companies would incur catastrophe losses in excess of $120.0 million, the
Company entered into a structured contingent financing transaction with Chase
Manhattan Bank (Chase) to provide up to $100.0 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 $100.0 million in excess of $120.0
million has been excluded from the pooling arrangement pursuant to the terms of
the Pooling Agreement.
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
and Milbank'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 reinsurance may realize a significant loss from
the insurance risk assumed have been accounted for as deposits.
51
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 and Milbank's direct
business, amounts contributed to the pool and their participation in the pool:
DECEMBER 31
-----------
1998 1997
---- ----
(dollars in thousands)
Losses and loss expenses payable:
Direct................................................................................... $ 196,473 195,802
Assumed (excluding intercompany pooling)................................................. 10,437 11,675
Ceded (excluding intercompany pooling)................................................... (9,180) (11,224)
------------------------------
Net amount contributed to the pool.................................................... 197,730 196,253
------------------------------
Direct and assumed (intercompany pooling)................................................ 208,161 197,515
Ceded (intercompany pooling)............................................................. (11,343) (10,009)
------------------------------
Net participation in the pool......................................................... $ 196,818 187,506
==============================
Unearned premiums:
Direct................................................................................... $ 130,160 127,057
Assumed (excluding intercompany pooling)................................................. 4,243 4,688
Ceded (excluding intercompany pooling)................................................... (2,943) (3,236)
------------------------------
Net amount contributed to the pool.................................................... 131,460 128,509
------------------------------
Direct and assumed (intercompany pooling)................................................ 125,411 115,146
Ceded (intercompany pooling)............................................................. (2,389) (2,573)
------------------------------
Net participation in the pool......................................................... $ 123,022 112,573
==============================
YEAR ENDED DECEMBER 31
----------------------
1998 1997 1996
---- ---- ----
(dollars in thousands)
Earned premiums:
Direct.................................................................... $ 354,291 340,808 326,779
Assumed (excluding intercompany pooling).................................. 14,386 14,917 17,842
Ceded (excluding intercompany pooling).................................... (12,039) (13,416) (15,512)
----------------------------------------------
Net amount contributed to the pool..................................... 356,638 342,309 329,109
----------------------------------------------
Direct and assumed (intercompany pooling)................................. 337,538 305,965 300,291
Ceded (intercompany pooling).............................................. (9,395) (9,919) (10,773)
----------------------------------------------
Net participation in the pool.......................................... 328,143 296,046 289,518
Assumed from affiliates (excluding intercompany pooling).................. 2,475 2,505 1,260
----------------------------------------------
Total.................................................................. $ 330,618 298,551 290,778
==============================================
Losses and loss expenses incurred:
Direct.................................................................... $ 244,302 227,599 247,790
Assumed (excluding intercompany pooling).................................. 13,644 14,875 19,698
Ceded (excluding intercompany pooling).................................... (5,151) (6,016) (9,571)
----------------------------------------------
Net amount contributed to the pool..................................... 252,795 236,458 257,917
----------------------------------------------
Direct and assumed (intercompany pooling)................................. 227,000 195,636 214,662
Ceded (intercompany pooling).............................................. (3,689) (4,409) (5,094)
----------------------------------------------
Net participation in the pool.......................................... $ 223,311 191,227 209,568
==============================================
52
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
-----------
1998 1997
---- ----
(dollars in thousands)
Losses and loss expenses payable.............................................................. $ 2,324 2,086
Unearned premiums............................................................................. 1,625 1,626
----------------------------
The effects of the agreement on the indicated income and expense accounts are
summarized as follows:
YEAR ENDED DECEMBER 31
----------------------
1998 1997 1996
---- ---- ----
(dollars in thousands)
Earned premiums...................................................................... $ 4,987 4,144 2,700
Losses and loss expenses incurred.................................................... 3,204 2,950 1,467
------------------------------------
(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 $4,908,000 in 1998, $4,563,000 in 1997
and $4,144,000 in 1996.
Stateco provides Mutual and its affiliates investment management services.
Fees related to these services amounted to $3,037,000 in 1998, $2,804,000 in
1997 and $2,588,000 in 1996.
S.I.S. provides insurance software products and services to Mutual and its
affiliates. Fees relating to these services amounted to $1,048,000 in 1998,
$889,000 in 1997 and $859,000 in 1996 and is included in other income.
Effective January 1, 1998, 518 PML began leasing assets to Mutual and its
affiliates. Fees relating to these services amounted to $268,000 in 1998 and is
included in other income.
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, 1998, there has
been no adverse development of the liability.
53
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
----------------------
1998 1997 1996
AMOUNT % AMOUNT % AMOUNT %
------ ---- ------ ---- ------ ----
(dollars in thousands, except percentages)
Amount at statutory rate......................................... $ 17,361 35 19,823 35 12,177 35
Tax-free interest and dividends received deduction............... (5,423) (11) (4,368) (8) (3,913) (11)
Other, net....................................................... 170 -- 185 -- 121 --
----------------------------------------------------------
Effective tax rate............................................... $ 12,108 24 15,640 27 8,385 24
==========================================================
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and deferred tax liabilities at December 31,
1998 and 1997 are presented below:
1998 1997
---- ----
(dollars in thousands)
Deferred tax assets:
Unearned premiums not deductible......................................................... $ 8,885 8,458
Losses and loss expenses payable discounting............................................. 8,257 7,347
Other.................................................................................... 1,604 1,133
--------------------------
Total deferred tax assets............................................................ 18,746 16,938
==========================
Deferred tax liabilities:
Deferral of policy acquisition costs..................................................... 8,680 7,854
Net pension expense...................................................................... 5,732 5,112
Unrealized holding gain on investments................................................... 10,919 7,948
Other.................................................................................... 1,510 1,311
---------------------------
Total deferred tax liabilities....................................................... 26,841 22,225
---------------------------
Net deferred tax liabilities......................................................... $ (8,095) (5,287)
============================
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 1998, 1997 and 1996 were $11,768,000,
$14,254,000 and $13,602,000, respectively.
54
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(8) PENSION BENEFIT PLANS
State Auto P&C, Stateco and S.I.S., 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, Milbank, Stateco
and S.I.S. 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 S.I.S.'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, Milbank, Stateco and S.I.S.'s participation in the plan is as follows:
DECEMBER 31
-----------
1998 1997
---- ----
(in thousands)
CHANGE IN BENEFIT OBLIGATION
Benefit obligation at beginning of year........................................................ $ 39,727 38,838
Service cost................................................................................... 1,686 1,548
Interest cost.................................................................................. 2,977 2,760
Actuarial loss................................................................................. 4,024 348
Benefits paid.................................................................................. (3,656) (3,767)
-----------------------------
Benefit obligation at end of year.............................................................. $ 44,758 39,727
-----------------------------
CHANGE IN PLAN ASSETS
Fair value of plan assets at beginning of year................................................. $ 64,565 54,991
Actual return on plan assets................................................................... 11,984 11,655
Company contributions.......................................................................... -- 1,446
Asset gain..................................................................................... 2,560 240
Benefits paid.................................................................................. (3,656) (3,767)
-----------------------------
Fair value of plan assets at end of year....................................................... $ 75,453 64,565
-----------------------------
Funded status.................................................................................. $ 30,695 24,838
Unrecognized net actuarial gain................................................................ (14,816) (10,721)
Unrecognized prior service cost................................................................ 1,587 1,700
Unrecognized transition asset.................................................................. (1,088) (1,209)
-----------------------------
Prepaid pension expense........................................................................ $ 16,378 14,608
=============================
YEAR ENDED DECEMBER 31
----------------------
1998 1997 1996
---- ---- ----
(in thousands)
COMPONENTS OF NET PERIODIC BENEFIT COST
Service cost..................................................................... $ 1,686 1,548 1,481
Interest cost.................................................................... 2,977 2,760 2,648
Expected return on plan assets................................................... (5,430) (4,742) (4,172)
Amortization of prior service cost............................................... 114 114 114
Amortization of transition asset................................................. (121) (121) (121)
Amortization of net gain......................................................... (8) (3) --
-------------------------------------------
Net periodic benefit cost........................................................ $ (782) (444) (50)
===========================================
55
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
YEAR ENDED DECEMBER 31
----------------------
1998 1997 1996
---- ---- ----
WEIGHTED-AVERAGE ASSUMPTIONS AS OF DECEMBER 31
Discount rate.................................................................... 7.00% 7.25 7.25
Rates of increase in compensation levels......................................... 9.00% 9.00 9.00
Expected long-term rate of return on assets...................................... 4.50% 4.50 4.50
State Auto P&C, Stateco and S.I.S. are also participants with Mutual in a
defined contribution plan that covers substantially all employees of Mutual,
State Auto P&C, Milbank, Stateco and S.I.S. Contributions to the plan are based
on employee contributions and the level of Company match. State Auto P&C,
Milbank, Stateco and S.I.S.'s share of the expense under the plan totaled
$782,000, $726,000 and $667,000 for the years 1998, 1997 and 1996, respectively.
(9) STOCKHOLDERS' EQUITY
(a) STOCK SPLIT
On May 28, 1998, the Company's authorized capital was increased to
100,000,000 shares of common stock and the Company's Board of Directors declared
a two-for-one common stock split. Also, on May 30, 1996, the Company's Board
declared a three-for-two common stock split effected in the form of a stock
dividend. The financial statements, notes and other references to share
information and per share data have been given retroactive effect to reflect the
stock splits for all periods presented. Fractional shares were paid in cash.
(b) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION
State Auto P&C, Milbank, National and Farmers Casualty 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 $21.9 million is
available for payment to the Company in 1999 without prior approval.
56
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
Reconciliations of statutory capital and surplus and net income, as
determined using statutory accounting practices, to the amounts included in the
accompanying consolidated financial statements are as follows:
DECEMBER 31
-----------
1998 1997
---- ----
(dollars in thousands)
Statutory capital and surplus of insurance subsidiaries....................................... $ 232,407 208,050
Net assets of noninsurance parent and affiliates.............................................. 28,677 15,869
-----------------------------
261,084 223,919
Add (subtract) cumulative effect of adjustments:
Deferred policy acquisition costs.......................................................... 24,799 22,440
Losses and loss expenses payable........................................................... 12,817 10,870
Net prepaid pension expense................................................................ 16,368 14,577
Deferred federal income taxes.............................................................. (7,899) (5,211)
Excess of statutory loss liabilities over case basis amounts............................... 11,482 9,940
Fixed maturities at fair value............................................................. 18,809 16,625
Goodwill................................................................................... 1,880 2,078
Other, net................................................................................. 1,484 2,020
-----------------------------
Stockholders' equity per accompanying consolidated
financial statements................................................................... $ 340,824 297,258
=============================
YEAR ENDED DECEMBER 31
----------------------
1998 1997 1996
---- ---- ----
(dollars in thousands)
Statutory net income of insurance subsidiaries............................... $ 28,696 35,660 22,268
Net income of noninsurance parent and affiliates............................. 3,227 2,581 2,301
--------------------------------------------
31,923 38,241 24,569
Increases (decreases):
Deferred policy acquisition costs......................................... 2,359 2,407 (144)
Losses and loss expenses payable.......................................... 1,947 258 1,078
Net prepaid pension expense............................................... 1,791 1,898 1,571
Deferred federal income taxes............................................. 279 (1,344) (51)
Goodwill amortization..................................................... (198) (198) (198)
Other, net................................................................ (604) (264) (418)
--------------------------------------------
Net income per accompanying consolidated
financial statements................................................... $ 37,497 40,998 26,407
============================================
(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
catastrophic reinsurance arrangements with Chase Manhattan 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.
57
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(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:
1998 1997 1996
---- ---- ----
(in thousands, except
per share figures)
Pro forma net earnings....................................................................$ 35,700 40,045 25,565
Pro forma net earnings per common share
Basic................................................................................$ .85 .96 .62
Diluted..............................................................................$ .83 .94 .61
The Company has stock option plans for certain directors and key employees
of Mutual, State Auto P&C, Stateco and S.I.S. 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 300,000 shares of common stock under this plan. These
options are exercisable at issuance to 10 years from date of grant. The key
employee's plan provides that qualified stock options may be granted at an
option price not less than fair market value at date of grant and that
nonqualified stock options may be granted at any price determined by the options
committee of the Board of Directors. The Company has reserved 3,600,000 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 1998, 1997 and 1996,
respectively: dividend yield of .75%, 1.0% and 1.0%; expected volatility factors
of .26, .24 and .23; risk-free interest rates of 5.5%, 6.7% and 6.6%; and
expected life of the option of 8.5, 8.0 and 8.0 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.
58
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, 1998, 1997 and 1996, follows:
1998 1997 1996
---------------------------- ---------------------------- ----------------------------
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 2,019 $5.04 2,261 $4.79 1,900 $4.17
Granted 339 16.31 37 9.31 433 7.36
Exercised (86) 4.02 (276) 3.49 (72) 3.88
Cancelled -- -- (3) 7.32 -- --
----- ----- -----
Outstanding, end of year 2,272 $6.76 2,019 $5.04 2,261 $4.79
===== ===== =====
Weighted - average fair
value of options granted
during the year: $6.78 $4.37 $2.91
A summary of information pertaining to options outstanding and exercisable as of
December 31, 1998 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 $5.00 964 3.8 $ 3.75 964 $ 3.75
$5.01 - $10.00 969 6.8 6.41 902 6.33
Greater than $10.01 339 9.2 16.31 58 12.94
----- -----
2,272 5.9 $ 6.76 1,924 $ 5.24
===== =====
The Company has an employee stock purchase plan with a dividend reinvestment
feature, under which employees of Mutual, State Auto P&C, Stateco and S.I.S. may
choose at two different specified time intervals each year to have up to 6% of
their annual base earnings withheld to purchase the Company's common stock. The
purchase price of the stock is 85% of the lower of its beginning-of-interval or
end-of-interval market price. The Company has reserved 2,400,000 shares of
common stock under this plan. At December 31, 1998, 1,407,000 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 1998, 1997 and 1996,
respectively: dividend yield of .75%, 1.0% and 1.0%; expected volatility factors
of .44, .32 and .24; risk-free interest rates of 4.7%, 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 1998, 1997 and 1996 were $3.92, $2.61 and
$1.76, respectively.
59
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
----------------------
1998 1997 1996
---- ---- ----
(in thousands, except per share data)
Numerator:
Net earnings for basic and diluted earnings per common share.............. $37,497 40,998 26,407
===========================================
Denominator:
Weighted average shares for basic net earnings...........................
per common share ..................................................... 41,887 41,544 41,277
Effect of dilutive stock options.......................................... 1,014 906 668
Adjusted weighted average shares for.....................................
diluted net earnings per common share................................. 42,901 42,450 41,945
===========================================
Basic net earnings per common share.......................................... $ .89 .99 .64
===========================================
Diluted net earnings per common share........................................ $ .87 .97 .63
===========================================
(13) OTHER COMPREHENSIVE INCOME
The related federal income tax effects of each component of other comprehensive
income are as follows:
YEAR ENDED DECEMBER 31, 1998
----------------------------
BEFORE-TAX TAX (EXPENSE) NET-OF-TAX
AMOUNT OR BENEFIT AMOUNT
------ ---------- ------
(in thousands)
Net unrealized holding gains on securities:
Unrealized holding gains arising during 1998.............................. $11,412 (3,994) 7,418
Reclassification adjustments for gains realized in net income............. (2,925) 1,023 (1,902)
Minority interest......................................................... (2) 1 (1)
-------------------------------------------
Net unrealized holding gains.............................................. 8,485 (2,970) 5,515
------------------------------------------
Other comprehensive income................................................... $ 8,485 (2,970) 5,515
============================================
YEAR ENDED DECEMBER 31, 1997
----------------------------
BEFORE-TAX TAX (EXPENSE) NET-OF-TAX
AMOUNT OR BENEFIT AMOUNT
------ ---------- ------
( in thousands)
Net unrealized holding gains on securities:
Net unrealized holding gains.............................................. $11,125 (3,894) 7,232
------------------------------------------
Other comprehensive income................................................... $11,125 (3,894) 7,232
==========================================
YEAR ENDED DECEMBER 31, 1996
----------------------------
BEFORE-TAX TAX (EXPENSE) NET-OF-TAX
AMOUNT OR BENEFIT AMOUNT
------ ---------- ------
( in thousands)
Net unrealized holding losses on securities:
Net unrealized holding losses............................................. $(7,606) 2,662 (4,944)
------------------------------------------
Other comprehensive income................................................... $(7,606) 2,662 (4,944)
==========================================
60
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(14) REPORTABLE SEGMENTS
The Company has three reportable segments: standard insurance, nonstandard
insurance and investment management services. The standard insurance segment
provides personal and commercial insurance to its policyholders. Its principal
lines of business include personal and commercial automobile, homeowners,
commercial multi-peril, workers' compensation, general liability and fire
insurance. The nonstandard insurance segment provides personal automobile
insurance to policyholders that are typically rejected or canceled by standard
insurance carriers because of poor loss experience or a history of late payment
of premiums. Both the standard and nonstandard insurance segments operate
primarily in the Midwest and Eastern United States, excluding New York, New
Jersey, and the New England states, through the independent insurance agency
system. The investment management services segment manages the investment
portfolios of affiliated insurance companies.
The Company evaluates performance and allocates resources based on profit or
loss from operations, excluding net realized gains on investments on the
Company's investment portfolio, before federal income taxes. The accounting
policies of the reportable segments are the same as those described in the
summary of significant accounting policies.
Intersegment sales and transfers are priced at estimated market value.
The reportable segments are business units that are each managed separately
because of the differences in products or service they offer and type of
customer they serve.
Revenue from segments in the other category is attributable to three other
operating segments of the Company; an insurance software development and resale
segment, a premium finance segment and a property management and leasing
segment. These segments have never met the quantitative thresholds for determing
reportable segments.
61
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The following provides financial information regarding the Company's reportable
segments:
1998 1997 1996
---- ---- ----
(in thousands)
REVENUES FROM EXTERNAL CUSTOMERS:
Standard insurance........................................................... $365,510 332,126 323,259
Nonstandard insurance........................................................ 27,064 22,893 14,725
Investment management services............................................... 3,328 3,422 3,048
All other.................................................................... 2,906 1,424 1,247
------------------------------------------
Total revenues from external customers......................................... 398,808 359,865 342,279
Intersegment revenues:
Standard insurance........................................................... 261 261 156
Nonstandard insurance........................................................ (90) (75) (30)
Total intersegment revenues.................................................... 171 186 126
------------------------------------------
Total revenue.................................................................. $398,979 360,051 342,405
==========================================
Reconciling items:
Intersegment revenues........................................................ $ (171) (186) (126)
Corporate revenues........................................................... 326 68 30
Net realized gains on investment............................................. 2,925 3,043 2,788
------------------------------------------
Total consolidated revenues..................................................... $402,059 362,976 345,097
==========================================
Segment profit:
Standard insurance........................................................... $ 40,310 48,376 27,280
Nonstandard insurance........................................................ 1,313 1,192 1,242
Investment management services............................................... 4,908 4,901 4,459
All other.................................................................... 1,323 269 71
------------------------------------------
Total segment profit......................................................... 47,854 54,738 33,052
Reconciling items:
Corporate expenses........................................................... (1,104) (1,120) (1,044)
Net realized gains on investment............................................. 2,925 3,043 2,788
Miscellaneous adjustment in consolidation.................................... (70) (23) (4)
------------------------------------------
Total consolidated income before federal income taxes........................... $ 49,605 56,638 34,792
==========================================
62
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1998 1997 1996
---- ---- ----
(in thousands)
NET INVESTMENT INCOME:
Standard insurance........................................................... $ 27,710 26,984 26,374
Nonstandard insurance........................................................ 1,383 1,315 971
Investment management services............................................... 292 598 460
All other.................................................................... 432 62 60
-------------------------------------------
Total net investment income.................................................... 29,817 28,959 27,865
Reconciling items:
Corporate net investment income.............................................. 326 41 16
Reclassification adjustments in consolidation................................ 2,363 2,107 1,982
-------------------------------------------
Total consolidated net investment income..................................... $ 32,506 31,107 29,863
============================================
DEPRECIATION AND AMORTIZATION EXPENSE:
Standard insurance........................................................... $ 1,865 1,796 1,620
Nonstandard insurance........................................................ 13 8 8
Investment management services............................................... 25 10 28
All other.................................................................... 763 509 413
-------------------------------------------
Total depreciation and amortization expense..................................... $ 2,666 2,323 2,069
===========================================
SEGMENT ASSETS:
Standard insurance........................................................... $641,195 586,042 547,136
Nonstandard insurance........................................................ 37,997 35,037 28,207
Investment management services............................................... 7,449 13,115 9,578
All other.................................................................... 15,741 3,385 3,260
-------------------------------------------
Total segment assets......................................................... 702,382 637,579 588,181
Reconciling items:
Corporate expenses........................................................... 10,979 2,212 1,486
Reclassificaiton adjustments in consolidation................................ (3,583) (968) (3,340)
-------------------------------------------
Total consolidated assets....................................................... $709,778 638,823 586,327
===========================================
EXPENDITURE FOR ADDITIONS TO LONG-LIVED ASSETS:
Standard insurance........................................................... $ 51 109 124
Investment management services............................................... 209 771 --
All other.................................................................... 2,556 31 43
-------------------------------------------
Total expenditure for additions to long-lived assets......................... $ 2,816 911 167
===========================================
63
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
Revenues from external customers include the following products and services:
1998 1997 1996
---- ---- ----
(in thousands)
Earned premiums
Standard insurance:
Automobile................................................................... $186,283 167,241 164,099
Homeowners and farmowners.................................................... 57,983 51,865 51,435
Commercial multi-peril....................................................... 21,791 19,812 18,228
Workers' compensation........................................................ 12,006 12,605 14,878
Fire and allied.............................................................. 23,698 21,310 19,610
Other and products liability................................................. 17,313 15,364 13,478
Other lines.................................................................. 11,545 10,354 9,049
-------------------------------------------
Total standard insurance earned premiums....................................... 330,619 298,551 290,777
Nonstandard insurance:
Automobile................................................................... 25,591 21,499 13,695
-------------------------------------------
Total nonstandard insurance earned premiums.................................... 25,591 21,499 13,695
-------------------------------------------
Total earned permiums.......................................................... 356,210 320,050 304,472
Investment management services................................................. 3,036 2,804 2,588
Net investment income.......................................................... 32,180 31,066 29,868
Other income................................................................... 7,382 5,945 5,351
-------------------------------------------
Total revenues from external customers......................................... $398,808 359,865 342,279
===========================================
The standard insurance segment (State Auto P&C and Milbank) participates in a
reinsurance pooling agreement with other standard insurance affiliates. For
discussion regarding this arrangement and the segment's contribution to the pool
and participation in the pool, see note 5.
Revenues from external customers are derived entirely within the United States.
Also, all long-lived assets are located within the United States.
(15) QUARTERLY FINANCIAL DATA (UNAUDITED)
FOR THREE MONTHS ENDED
----------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
--------- -------- ------------- ------------
1998
----
(dollars in thousands, except per share amounts)
Total revenues.......................................... $ 99,361 99,823 102,212 100,663
Earnings before federal income taxes.................... 15,874 3,296 13,469 16,966
Net earnings ........................................... 11,531 2,780 10,552 12,634
Net earnings per common share (note 9a):
Basic................................................ .27 .07 .25 .30
Diluted.............................................. .27 .06 .25 .29
================================================================
64
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
FOR THREE MONTHS ENDED
----------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
--------- -------- ------------- ------------
1997
----
(dollars in thousands, except per share amounts)
Total revenues.......................................... $ 88,998 90,443 91,052 92,483
Earnings before federal income taxes.................... 12,082 13,345 13,629 17,582
Net earnings ........................................... 8,871 9,680 9,746 12,701
Net earnings per common share (note 9a):
Basic................................................ .21 .24 .23 .31
Diluted.............................................. .21 .23 .23 .30
===============================================================
(16) CONTINGENCIES
State Auto P&C, Milbank 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.
65
Page 36
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, 1998, 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, 1998, 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, 1998, 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, 1998, 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, 1998 and 1997
Consolidated Statements of Income for
each of the three years in the
period ended December 31, 1998
Consolidated Statements of Stockholders' Equity for each of
the three years in the period ended December 31, 1998
Consolidated Statements of Cash Flows for each of the three
years in the period ended December 31, 1998
Notes to Consolidated Financial Statements
66
Page 37
(a)(2) LISTING OF FINANCIAL STATEMENT SCHEDULES
----------------------------------------
The following financial statement schedules of the Company for
the years 1998, 1997 and 1996 are included in Item 14(d),
following the signatures, and should be read in conjunction
with the consolidated financial statements contained in this
Form 10-K Annual Report.
Schedule
Number Schedule
-------- --------
I. Summary of Investments-Other Than
Investments in Related Parties
II. Condensed Financial Information of Registrant
III. Supplementary Insurance Information
IV. Reinsurance
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.
67
Page 38
(a)(3) LISTING OF EXHIBITS
-------------------
If incorporated by reference document
with which Exhibit was previously
Exhibit No. Description of Exhibit 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(A)(3) State Auto Financial Corporation Certificate of Included herein
Amendment to the Amended and Restated Articles of
Incorporation as of June 2, 1998
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
now known as State Auto Property and Casualty Insurance 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 year
Reinsurance Agreement between State Automobile Mutual ended December 31, 1991 (see Exhibit
Insurance Company and State Auto Property and Casualty 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 year
Reinsurance Agreement between State Automobile Mutual ended December 31, 1993 (see Exhibit
Insurance Company and State Auto Property and Casualty 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 year
effective as of January 1, 1995 to the Reinsurance ended December 31, 1994 (see Exhibit
Agreement between State Automobile Mutual Insurance 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 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 Insurance
Company 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
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
68
Page 39
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 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
Partnership and State Automobile Mutual Insurance No. 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
Insurance Company and Policy Management Systems No. 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
Insurance Company, effective April 1, 1993 10(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)
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
69
Page 40
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, 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
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 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 Form 10-K Annual Report for the year
as of January 1, 1994 ended December 31, 1997 (see Exhibit
10(HH) therein)
10(II) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended March
between State Automobile Mutual Insurance Company, State 31, 1998 (see Exhibit 10(II) therein)
Auto Property and Casualty Insurance Company, Milbank
Insurance Company and Midwest Security Insurance Company
effective January 1, 1998
10(JJ) Agreement and Plan of Reorganization dated July 7, 1998, Form 8-K filed on July 7, 1998 (see
by and among State Auto Financial Corporation, SAF Exhibit 10(JJ) therein)
Acquisition Corp., State Automobile Mutual Insurance
Company and Milbank Insurance Company and the Closing
Agreement dated July 7, 1998
10(KK) Reinsurance Pooling Agreement Amended and Restated as of Included herein
January 1, 1999 by and among State Automobile
Mutual Insurance Company, State Auto Property and Casualty
Insurance Company, Milbank Insurance Company, Midwest Security
Insurance Company and Farmers Casualty Insurance Company
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
70
Page 41
21 List of Subsidiaries of State Auto Financial Corporation Included herein
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. ended December 31, 1991 (see
Manser and Robert J. Murchake 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 June
Jr., Robert J. Murchake, Paul W. Huesman, George R. 30, 1997 (see Exhibit 24(C) therein)
Manser, David L. Bickelhaupt, and David J. D'Antoni
24(D) Power of Attorney - John R. Lowther Form 10-Q for the period ended March
31, 1998 (see Exhibit 24(D) therein)
24(E) Power of Attorney - Robert H. Moone Included herein
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, 1998.
(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 29, 1999 /s/ Robert L. Bailey
--------------------------------
Robert L. Bailey, Chairman
and Chief Executive Officer
71
Page 42
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 29, 1999
- ----------------------- Chief Executive Officer
Robert L. Bailey and Director (principal
executive officer)
/s/ Steven J. Johnston Chief Financial Officer, March 29, 1999
- ----------------------- Vice President, Treasurer
Steven J. Johnston (principal financial officer
and principal accounting
officer)
John R. Lowther* Secretary and Director March 29, 1999
- -----------------------
John R. Lowther
Urlin G. Harris, Jr.* Director March 29, 1999
- -----------------------
Urlin G. Harris, Jr.
David L. Bickelhaupt* Director March 29, 1999
- -----------------------
David L. Bickelhaupt
David J. D'Antoni* Director March 29, 1999
- -----------------------
David J. D'Antoni
Paul W. Huesman* Director March 29, 1999
- -----------------------
Paul W. Huesman
William J. Lhota* Director March 29, 1999
- -----------------------
William J. Lhota
George R. Manser* Director March 29, 1999
- -----------------------
George R. Manser
/s/ Robert H. Moone Director March 29, 1999
- -----------------------
Robert H. Moone
72
Page 43
*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 29, 1999
- -----------------------
Steven J. Johnston
Attorney in Fact
73
Item 14(d)
Financial Statement Schedules
74
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I(a) - SUMMARY OF INVESTMENTS - OTHER THAN
INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1998
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 $ 48,871 $ 50,263 $ 48,871
States, municipalities and
political subdivisions 7,055 7,563 7,055
-------- -------- --------
Total fixed maturities - Held to maturity $ 55,926 $ 57,826 $ 55,926
======== ======== ========
SCHEDULE I(b) - SUMMARY OF INVESTMENTS - OTHER THAN
INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1998
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 $ 91,480 $ 94,433 $ 94,433
States, municipalities and
political subdivisions 363,532 377,617 377,617
Public utilities 4,987 5,213 5,213
All other corporate bonds 4,009 4,581 4,581
-------- -------- --------
Total fixed maturities $464,008 $481,844 $481,844
-------- -------- --------
Equity securities:
Public utilities 1,364 2,106 2,106
Banks, trust and insurance companies 3,048 4,760 4,760
Industrial, miscellaneous and all
other 24,821 35,330 35,330
-------- -------- --------
Total equity securities 29,233 42,196 42,196
-------- -------- --------
Total investments - Available for sale $493,241 $524,040 $524,040
======== ======== ========
75
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONDENSED BALANCE SHEETS
December 31
-------------------------
ASSETS 1998 1997
---- ----
(dollars in thousands)
(Restated -
see Note A)
Investments in common stock of subsidiaries
(equity method) $329,104 $294,403
Surplus note receivable 9,000 --
Cash 1,220 1,501
Real estate 461 458
Other assets 759 253
Federal income tax benefit 647 952
-------- --------
Total assets $341,191 $297,567
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Due to affiliates $ 122 $ 142
Accrued expenses 245 167
-------- --------
Total liabilities 367 309
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
100,000,000 shares; issued and outstanding
42,039,892 and 41,828,845 shares issued
and outstanding, respectively, at stated value of
$2.50 per share 105,100 104,572
Less 13,212 and 8,118 treasury shares, respectively, at cost (167) (90)
Additional paid-in capital 41,539 40,210
Accumulated other comprehensive income 20,276 14,761
Retained earnings 174,076 137,805
-------- --------
Total stockholders' equity 340,824 297,258
-------- --------
Total liabilities and stockholders' equity $341,191 $297,567
======== ========
76
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONTINUED
CONDENSED STATEMENTS OF INCOME
Year ended December 31
---------------------------------------
1998 1997 1996
---- ---- ----
(in thousands)
(Restated - (Restated -
see Note A) see Note A)
Investment income $ 326 $ 68 $ 30
Net realized gains on investments 2 -- --
------- ------- -------
Total revenue 328 68 30
------- ------- -------
Total operating expenses 1,423 1,188 1,074
------- ------- -------
Loss before federal income taxes (1,095) (1,120) (1,044)
Federal income tax benefit (394) (378) (405)
------- ------- -------
Net loss before equity in undistributed
net earnings of subsidiaries (701) (742) (639)
Equity in undistributed net earnings of subsidiaries 38,198 41,740 27,046
------- ------- -------
Net Income $37,497 $40,998 $26,407
======= ======= =======
77
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONTINUED
CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31
------------------------------------------
1998 1997 1996
---- ---- ----
(in thousands)
(Restated - (Restated -
see Note A) see Note A)
Cash flows from operating activities:
Net income $ 37,497 $ 40,998 $ 26,407
-------- -------- --------
Adjustments to reconcile net earnings to net cash
used in operating activities:
Depreciation 17 16 16
Equity in undistributed earnings of subsidiaries (38,198) (41,740) (27,046)
Changes in operating assets and liabilities:
Change in accrued expenses and due to affiliates 58 36 (188)
Change in other assets (505) 60 (216)
Change in federal income taxes 305 (492) (303)
-------- -------- --------
Net cash used in operating activities (826) (1,122) (1,330)
-------- -------- --------
Cash flows from investing activities:
Capitalization of subsidiary -- -- (5,000)
Dividends received from subsidiaries 9,004 1,250 6,402
Purchase of surplus notes receivable (9,000) -- --
Additions to real estate (20) (769) (94)
-------- -------- --------
Net cash (used in) provided by investing activities (16) 481 1,308
-------- -------- --------
Cash flows from financing activities:
Net proceeds from sale of common stock 1,780 2,470 1,325
Payment of dividends (1,219) (1,059) (933)
-------- -------- --------
Net cash provided by financing activities 561 1,411 392
-------- -------- --------
Net increase (decrease) in cash and invested cash (281) 770 370
-------- -------- --------
Cash and cash equivalents at beginning of year 1,501 731 361
-------- -------- --------
Cash and cash equivalents at end of year $ 1,220 $ 1,501 $ 731
======== ======== ========
Supplemental Disclosures:
Federal income taxes received $ (902) $ (401) $ (165)
======== ======== ========
Noncash investing activity:
Capitalization of subsidiary -- $ 738 --
======== ======== ========
78
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
CONTINUED
NOTE 1 - BASIS OF PRESENTATION
In the parent company-only financial statements, State Auto Financial's
investment in subsidiaries is stated at cost plus equity in undistributed
earnings of subsidiares and net unrealized gains and losses on investments. The
parent company-only financial statements should be read in conjunction with the
Company's consolidated financial statements.
On July 7, 1998, State Auto Financial exercised its option with Mutual, pursuant
to the Option Agreement dated August 20, 1993, by acquiring the outstanding
shares of Milbank. Milbank had been a wholly-owned subsidiary of Mutual since
July 1, 1993, but as a result of this transaction, is now a wholly-owned
subsidiary of State Auto Financial. The purchase price of Milbank was
approximately $81.9 million. The transaction was effected through an exchange
with Mutual of approximately 5.1 million State Auto Financial common shares for
all the issued and outstanding capital stock of Milbank. Since the transaction
was a combination of entities under common control it has been accounted for
similar to a pooling-of-interests. The prior year's financial information has
been restated to include the financial position and operations of Milbank.
79
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(in thousands)
Column A Column B Column C Column D Column E Column F
-------- -------- -------- -------- -------- --------
Future policy Other policy
benefits, losses, claims and
Deferred policy claims and Unearned benefits Premium
Segment acquisition cost loss expenses premiums payable revenue
------- ---------------- ------------- -------- ------- -------
Year ended December 31, 1998
Standard insurance segment $23,619 $208,161 $125,410 -- $330,709
Nonstandard insurance segment 1,180 10,540 9,678 -- 25,501
------- -------- -------- ------- --------
Total 24,799 218,701 135,088 -- 356,210
======= ======== ======== ======= ========
Year ended December 31, 1997
Standard insurance segment 21,344 197,516 115,146 -- 298,626
Nonstandard insurance segment 1,096 8,734 9,887 -- 21,424
------- -------- -------- ------- --------
Total $22,440 $206,250 $125,033 -- 320,050
======= ======== ======== ======= ========
Year ended December 31, 1996
Standard insurance segment 290,807
Nonstandard insurance segment 13,665
--------
Total $304,472
========
Column G Column H Column I Column J Column K
-------- -------- -------- -------- --------
Amortization
Benefits, claims, of deferred
losses and policy
Net investment settlement acquisition Other operating Premiums
income expenses costs expenses written
------ -------- ----- -------- -------
Year ended December 31, 1998
Standard insurance segment $27,710 $223,311 $ 80,766 $17,802 $332,975
Nonstandard insurance segment 1,383 18,983 4,448 1,208 25,292
------- -------- -------- ------- --------
Total 29,093 242,294 85,214 19,010 358,267
======= ======== ======== ======= ========
Year ended December 31, 1997
Standard insurance segment 26,984 191,228 72,029 18,175 302,931
Nonstandard insurance segment 1,315 17,006 4,813 (666) 23,389
------- -------- -------- ------- --------
Total 28,299 208,234 76,842 17,509 326,320
======= ======== ======== ======= ========
Year ended December 31, 1996
Standard insurance segment 26,374 209,568 70,355 12,985 293,078
Nonstandard insurance segment 971 10,466 3,333 (670) 15,466
------- -------- -------- ------- --------
Total $27,345 $220,034 $ 73,688 $12,315 $308,544
======= ======== ======== ======= ========
80
STATE AUTO FINANCIAL CORPORATION
SCHEDULE IV - REINSURANCE
YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(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 12-31-98
property-casualty earned premiums $384,870 $17,026 $356,638 $14,386 $330,618 $356,210 4.0%
Year ended 12-31-97
property-casualty earned premiums $366,451 $17,560 $342,309 $14,917 $298,551 $320,050 4.7%
Year ended 12-31-96
property-casualty earned premiums $343,173 $18,212 $329,109 $17,842 $290,778 $304,472 5.9%
- --------------
(1) These columns include the effect of intercompany pooling.
(2) Calculated as earned premiums assumed from outside companies to net amount.
81
Item 14(c)
Exhibit Index
(a)(3) LISTING OF EXHIBITS
-------------------
If incorporated by reference
document with which Exhibit was
Exhibit No. Description of Exhibit 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(A)(3) State Auto Financial Corporation Certificate of Amendment Included herein
to the Amended and Restated Articles of Incorporation as
of June 2, 1998
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 Insurance Company 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
82
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)
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)
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
83
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 September 30, 1997 (see Exhibit
between SAF Funding Corporation 10(GG) therein)
and the Chase Manhattan Bank
10(HH) Amended and Restated SERP of State Auto Mutual Form 10-K Annual Report for the year
effective as of January 1, 1994 ended December 31, 1997 (see Exhibit
10(HH) therein)
10(II) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended March 31,
between State Automobile Mutual Insurance Company, State 1998 (see Exhibit 10(II) therein)
Auto Property and Casualty Insurance Company, Milbank
Insurance Company and Midwest Security Insurance Company
effective January 1, 1998
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
84
10(JJ) Agreement and Plan of Reorganization dated July 7, 1998, Form 8-K filed on July 7, 1998
by and among State Auto Financial Corporation, SAF (see Exhibit 10(JJ) therein)
Acquisition Corp., State Automobile Mutual Insurance
Company and Milbank Insurance Company and the Closing
Agreement dated July 7, 1998
10(KK) Reinsurance Pooling Agreement Amended and Restated as of Included herein
January 1, 1999 by and among State Automobile Mutual
Insurance Company, State Auto Property and Casualty
Insurance Company, Milbank Insurance Company, Midwest
Security Insurance Company and Farmers Casualty
Insurance Company
11 Statement regarding computation of earnings per share Included herein
21 List of Subsidiaries of State Auto Financial Corporation Included herein
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)
24(D) Power of Attorney - John R. Lowther Form 10-Q for the period ended
March 31, 1998 (see Exhibit 24(D)
therein)
24(E) Power of Attorney - Robert H. Moone Included herein
27 Financial Data Schedule Included herein