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 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.
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.
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 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.
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.
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.
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.