OVERVIEW State Auto Financial Corporation (State Auto Financial), through its principal insurance subsidiary State Auto Property and Casualty Insurance Company (State Auto P&C) provides personal and commercial insurance primarily in the eastern half of the United States, excluding New York, New Jersey, and the New England states. State Auto P&C's principal lines of business include personal and commercial automobile, homeowners, commercial multiple peril, workers' compensation, general liability and fire insurance. Another insurance subsidiary, State Auto National Insurance Company (National), writes personal automobile insurance for non-standard risks. In 1996 National wrote insurance in seven states. State Auto P&C and National's products are marketed through independent agents. Effective April 1, 1994, State Auto P&C began providing executive management services to oversee the insurance operations of all the State Auto Insurance Companies, which include National and State Automobile Mutual Insurance Company (Mutual), a majority shareholder of State Auto Financial, and Mutual's wholly-owned subsidiaries Milbank Insurance Company (Milbank) and State Auto Life Insurance Company. Stateco Financial Services, Inc. (Stateco), another subsidiary of State Auto Financial, provides investment management services to affiliated companies and also provides insurance premium finance services to customers of State Auto P&C, Mutual and Milbank. New to State Auto Financial in 1995 was Strategic Insurance Software, Inc. (SIS), a majority owned subsidiary. In July 1995, SIS began developing and selling software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance companies and agents. SIS sells services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies. State Auto Financial and its subsidiaries, State Auto P&C, National, Stateco and SIS are referred to collectively as the Company. Since 1987 State Auto P&C has participated in a reinsurance pooling arrangement (the Arrangement) with Mutual. The Arrangement provides that all premiums, losses, loss expenses and underwriting expenses of each company be pooled and then allocated back to each company based on percentages outlined in the Arrangement. During 1994, State Auto P&C assumed 30% of the pooled business with 70% retained by Mutual. Effective January 1, 1995, the Arrangement was amended to include all of the property and casualty business of Milbank. Concurrently with the inclusion of Milbank, the pooling participation percentages were amended to allocate 35% to State Auto P&C, 55% to Mutual and 10% to Milbank. In connection with the January 1, 1995 change in pooling percentages, State Auto P&C received cash of approximately $46 million to cover its increased share of pool liabilities. The change in the Arrangement did not affect a prior agreement between State Auto P&C and Mutual whereby Mutual agreed to reimburse State Auto P&C for the development of any losses or loss expenses on claims occurring on or prior to December 31, 1990, that are in excess of State Auto P&C's reserves on that date. As of December 31, 1996, there has been no adverse development of the liability. State Auto P&C, National, Mutual, and Milbank are referred to collectively as the State Auto Insurance Companies.
73.1% compared to 89.1% for the same period in 1994. Management believes the improvement in underwriting operations in 1995 is due to the Company's continuing commitment to sound underwriting and pricing policies.
Acquisition and operating expenses, as a percentage of earned premiums, increased to 29.0% from 28.4% in 1994. Most of the increase in this percentage was the increase over 1994 of the amount of Quality Performance Bonus (the Bonus) that was earned by nearly all permanent employees of the State Auto Companies in 1995. Performance is measured quarterly and the Bonus is earned if the State Auto Insurance Company's direct statutory combined ratio is better than predetermined targets set at the beginning of each fiscal year. The State Auto Insurance Companies performed better than the targets for each quarter of 1995 whereas in 1994 performance exceeded the targets for only two quarters. Also contributing to this increase was an increase over 1994 of the amount of bonus compensation earned by the Company's agents. Each agent shares in the underwriting profits generated by insurance placed by them. Thus, the improvement in the underwriting operations of the Company is shared with the agents who produced the profitable business. Federal income taxes increased $5.4 million to $9.8 million. This increase is reflective of higher taxable income experienced by the Company in the current year. The effective tax rate increased to 28% from 23% in 1994.
LIQUIDITY AND CAPITAL RESOURCES Liquidity refers to the ability of a company to generate adequate amounts of cash to meet its needs for both long and short-term cash obligations as they come due. The Company's significant sources of cash are premiums, investment income and investments as they mature. The Company continually monitors its investment and reinsurance programs to ensure they are appropriately structured to enable the insurance subsidiaries to meet anticipated and unanticipated short and long-term cash requirements without the need to sell fixed income investments to meet fluctuations in claim payments. Net cash provided by operating activities was $22.4 million and $76.4 million for 1996 and 1995, respectively. This decrease is primarily due to the fact that on January 1, 1995, $46.0 million was transferred to State Auto P&C, in connection with the amended pooling arrangement. Also contributing to this decrease was that in 1996 the Company experienced an increase in its losses and loss expense payments compared to the same time period in 1995 due to the significant weather related catastrophes discussed above. Net cash used in investing activities decreased to $21.2 million from $77.3 million in 1995. This change is due to the investing of the $46.0 million associated with the pooling change in 1995. As of December 31, 1996, funds consisting of cash and cash equivalents available for general operations were $12.9 million compared to $11.2 million at December 31, 1995. 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
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, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
(B) DESCRIPTION OF BUSINESS The Company, through State Auto P&C, a South Carolina corporation, and National, an Ohio corporation, provides personal and commercial insurance to its policyholders, primarily in the eastern half of the United States, excluding New York, New Jersey, and the New England states through an independent insurance agency system. The Company's principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. State Auto P&C and National are chartered and licensed as property and casualty insurers in the states of South Carolina and Ohio, respectively, and are licensed in various other states. As such, they are subject to the regulations of the Departments of Insurance of the states of South Carolina and Ohio (collectively, the Departments) and the regulations of each state in which they operate. State Auto P&C and National undergo periodic financial examination by the Departments and insurance regulatory agencies of the states that choose to participate. Through State Auto P&C, the Company also provides executive management services to its affiliated insurance companies. Through Stateco, the Company provides investment management services to affiliated companies and also provides insurance premium finance services to customers of State Auto P&C, Mutual and Milbank Insurance Company (Milbank), a wholly-owned subsidiary of Mutual. Beginning in July 1995, the Company, through SIS, began developing and selling software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance companies and agencies. SIS sells services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies.
(E) DEFERRED POLICY ACQUISITION COSTS Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses related to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned, without credit for anticipated investment income. These amounts are based on estimates and accordingly, the actual realizable value may vary from the estimated realizable value. Net deferred policy acquisition costs were:
(G) INVESTMENTS Investments in fixed maturities, where the Companies have the ability and intent to hold to maturity, are carried at amortized cost. Accordingly, unrealized holding gains or losses are not reflected in the accompanying consolidated financial statements. Investments in fixed maturities held as available for sale are carried at fair value. The net unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity, and are not included in the determination of net earnings.
(H) MANAGEMENT SERVICES INCOME Management services income includes income for executive management services provided by State Auto P&C and income for investment management services provided by Stateco. Executive management income is recognized quarterly based on a percentage of the average adjusted annual statutory surplus of each company managed. 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.
(J) FEDERAL INCOME TAXES The Companies file a consolidated federal income tax return and pursuant to an agreement, each entity within the consolidated group pays its share of federal income taxes based on separate return calculations. Income taxes are accounted for using the liability method. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Deferred federal income taxes on the net unrealized holding gain was $5,366,000 at December 31, 1995.
The amortized cost and fair value of fixed maturities segregated by held to maturity and available for sale, at December 31, 1996, by contractual maturity, are summarized as follows:
(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.
(4) LOSSES AND LOSS EXPENSES PAYABLE Activity in the liability for losses and loss expenses is summarized as follows:
The following table summarizes State Auto P&C's direct business, amounts contributed to the pool and State Auto P&C's participation in the pool:
(6) TRANSACTIONS WITH MUTUAL A management fee was paid to Mutual by the Company pursuant to a management agreement. Such fee amounted to $40,000 in 1994, which is included in acquisition and operating expenses in the accompanying consolidated statements of earnings. Effective April 1, 1994, State Auto P&C began providing Mutual and its insurance affiliates executive management services to oversee the insurance operations of these companies. Fees relating to these services amounted to $4,956,000 in 1996, $4,662,000 in 1995 and $3,221,000 in 1994. Stateco provides Mutual and its affiliates investment management services. Fees related to these services amounted to $3,064,000 in 1996, $2,912,000 in 1995 and $2,857,000 in 1994. Effective July 1, 1995, SIS began providing insurance software products and services to Mutual and its affiliates. Fees relating to these services amounted to $1,015,000 in 1996 and $423,000 in 1995 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, 1996, there has been no adverse development of the liability.
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 1996 and 1995 are presented below:
(8) BENEFIT PLANS State Auto P&C, Stateco and SIS, pursuant to an intercompany agreement, are participants, together with Mutual, in a defined benefit pension plan that covers substantially all employees of Mutual, State Auto P&C, Stateco and SIS. The assets of the plan are represented primarily by U.S. government and agency obligations, bonds, and common stocks. Mutual, State Auto P&C, Stateco and SIS's policy is to fund pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Benefits are determined by applying factors specified in the plan to a participant's defined average annual compensation.
State Auto P&C, Stateco and SIS are also participants with Mutual in a defined contribution plan that covers substantially all employees of Mutual, State Auto P&C, Stateco and SIS. Contributions to the plan are based on employee contributions and the level of Company match. State Auto P&C, Stateco and SIS's share of the expense under the plan totaled $534,000, $496,000 and $371,000 for the years 1996, 1995 and 1994, respectively.
(B) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION State Auto P&C and National are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to the Company during the year without prior approval of regulatory authorities. Pursuant to these rules, approximately $12.3 million is available for payment to the Company in 1997 without prior approval.
(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. 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.
The Company has stock option plans for certain directors and key employees of Mutual, State Auto P&C, Stateco and SIS. The nonemployee directors' plan provides each nonemployee director an option to purchase 1,000 shares of common stock following each annual meeting of the shareholders at an option price equal to the fair market value at the last business day prior to the annual meeting. The Company has reserved 150,000 shares of common stock under this plan. These options are exercisable at issuance to 10 years from date of grant. The key employee's plan provides that qualified stock options may be granted at an option price not less than fair market value at date of grant and that nonqualified stock options may be granted at any price determined by the options committee of the Board of Directors. The Company has reserved 1,800,000 shares of common stock under this plan. These options are exercisable from 1 to 10 years from date of grant. 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 1996 and 1995, respectively: dividend yield of 1.0% for both years; expected volatility factors of .23 and .22; risk-free interest rates of 6.6% and 7.3%; and expected life of the option of 8 for both years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
A summary of information pertaining to options outstanding and exercisable as of December 31, 1996 follows:
(13) CONTINGENCIES State Auto P&C and National are involved in litigation and may become involved in potential litigation arising in the ordinary course of business. In the opinion of management, the effects, if any, of such litigation are not expected to be material to the consolidated financial statements.