We evaluate the performance of our insurance segments using industry financial measurements determined under SAP and certain measures determined under GAAP. We evaluate our investment operations segment based on investment returns of assets managed. Financial information about our segments for 2017 is set forth in this Item 7 and in Note 16 to our consolidated financial statements included in Item 8 of this Form 10-K.
We delivered significant progress in 2017 toward our goal of profitable growth. During 2017, we continued the rollout of our “State Auto Connect” digital quote and issue platform for personal auto and homeowners new business. State Auto Connect is now accessible to agents in 22 of the 28 states where we are licensed to write personal auto and homeowners policies. We plan on launching the remaining six personal lines states in 2018. We are now a solely digital insurance company for new customers in those states. Additionally, we launched State Auto Connect for our commercial auto and small commercial package products in the fourth quarter of 2017 and will continue the rollout of this platform to our existing states throughout 2018. Both of our platforms include new products and rates, and incorporate advanced data analytics. We believe these platforms will make us the carrier of choice for independent agents as their customers increasingly demand products and services from digital companies. We plan to complete our transformation to digital for commercial auto and small commercial package in 2018. Our workers’ compensation and farm and ranch products will follow.
Our Claims and Risk Engineering (CARE) associates are focused on being faster and more effective while still maintaining quality. They continue to identify improvements to our claim handling capabilities. As an example, during 2017 we began offering claimants the option to receive claim payments electronically, which not only streamlines the claims payment process, but also lowers our overall payment costs.
We recognize that we can’t become the transformational company we aspire to be without a culture that is aligned with that objective. We have made great strides in developing a culture that encourages openness, candor and collaboration; one in which all associates are empowered to speak up and are comfortable doing so; and finally, one in which the sharing of information is an expectation. Additionally, we strive to create a culture in which mistakes are not viewed as failures, but opportunities to learn and improve. We have built an environment that is diverse and inclusive of thought, opinions, ideas and people. We continue building upon a nearly century-long commitment to giving back to the communities in which we live and work through our time and financial resources.
The following table sets forth the participants and their participation percentages in the Pooling Arrangement. There were no changes to the participants or to their participation percentages during 2017.
Under the terms of the Pooling Arrangement, all subject premiums, incurred losses, loss expenses and other underwriting expenses are prorated among our Pooled Companies on the basis of their participation in the pool. By spreading the underwriting risk, the Pooling Arrangement is designed to produce more uniform and stable underwriting results for each of our Pooled Companies
than any one company would experience individually. This has the effect of providing each of our Pooled Companies with a similar mix of pooled property and casualty insurance business on a net basis.
Our 2017 net loss was $10.7 million compared to net income of $21.0 million and $51.2 million in 2016 and 2015, respectively. Our 2017 results included a provisional net charge of $36.4 million resulting from revaluing our deferred tax assets and liabilities as a result of the enactment of the TCJA.
Net realized gains on investments were $65.1 million in 2017 compared to $36.5 million and $24.7 million in 2016 and 2015, respectively. Net realized gains in 2017 were impacted by (i) realized gains of $18.5 million from the sale of our U.S. small-cap equity portfolio and (ii) sales within our U.S. large-cap equity portfolio. The proceeds from the sale of our U.S. small-cap equity portfolio were reinvested in U.S. small-cap focused mutual and exchange traded funds. Net realized gains in 2016 were impacted by the recognition of a $12.0 million gain from the redemption of a limited partnership investment in international equities.
The following table sets forth certain key performance indicators for our insurance segments for the years ended December 31, 2017, 2016 and 2015:
In October 2016, we launched State Auto Connect for our personal auto and homeowners products in five states. State Auto Connect is a fully digital quote and issue platform that incorporates advanced data analytics and updated pricing models, enabling us to offer new products and coverages for our personal auto and homeowners products. The platform enables our agents to submit, quote, bind, issue and bill policies through a completely digital and integrated platform. We continued the rollout of State Auto Connect throughout 2017, launching it in all but six of our states prior to December 31, 2017. We expect to complete the rollout of our personal auto and homeowners products to our remaining six states during the first half of 2018.
Net written premiums for the year ended December 31, 2016 were flat compared to 2015 (Tables 2 - 3). While total policies in force continued to decline, new business policy counts were up, and personal auto and homeowners new business premiums increased when compared to the same 2015 period. During 2016, we took actions to improve our new business trends, including increasing the number of personal lines agency appointments and launching State Auto Connect in five states in October for our personal auto and homeowners products.
The SAP catastrophe loss ratio for the year ended December 31, 2017 was 7.5%, compared to 8.4% in 2016 and 5.8% in 2015 (Tables 1 - 3). During 2017, we were primarily impacted by (i) Hurricanes Harvey and Irma and (ii) widespread storms that affected the Ohio Valley region, South Carolina, Texas, Mississippi and Georgia. During 2016, we were impacted by (i) storms in Texas, primarily wind and hail, (ii) Hurricane Matthew, and (iii) wildfires in Tennessee.
The SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2016 increased 3.6 points when compared to 2015 (Tables 2 -3). Personal auto results in 2016 were impacted by increased levels of bodily injury severity trends that resulted in increases in ultimate loss and ALAE estimates for prior accident years, primarily 2014 and 2015. In addition, the 2016 accident year loss and ALAE estimates reflected the impact of continued increased bodily injury severity trends.
Net written premiums for the year ended December 31, 2017 decreased 1.3% compared to 2016 (Tables 4 - 5), as new business premium growth was offset by a decline in renewal premiums. While overall new business premium for commercial insurance products increased 6.6% compared to 2016, new business policy counts declined 8.3%. The new business premium growth reflects the impact of rate and other actions taken beginning in 2016 and continuing into 2017. With the exception of workers’ compensation, new business premiums for each of the remaining commercial insurance products increased in 2017 compared to 2016. Renewal premiums and policy counts both declined in 2017 compared to 2016 due to (i) rate actions to improve profitability in commercial auto, (ii) more competitive market conditions in workers' compensation, and (iii) our continued focus on underwriting discipline across our commercial insurance products.
In October 2017, we launched State Auto Connect for new business in one state for our commercial auto and small commercial package products. Similar to the State Auto Connect platform for our personal insurance products, the State Auto Connect commercial lines platform is completely digital and incorporates data analytics and more sophisticated pricing models compared to our legacy underwriting systems. The platform enables our agents to submit, quote, bind, issue and bill policies through a completely digital and integrated platform. During 2018, we plan on completing the rollout of State Auto Connect in our remaining states for commercial auto and small commercial package and we also plan on expanding the products offered through the platform to include middle market commercial, workers’ compensation and farm & ranch.
Net written premiums for the year ended December 31, 2016 decreased 4.6% compared to 2015 (Tables 5 - 6). The 2016 decrease was primarily due to (i) our decision to exit our large account business, (ii) rate and underwriting actions to improve profitability in commercial auto, and (iii) changes made to our regional sales teams during the first quarter of 2016, including staff reductions and reassignment of agency relationships among the remaining staff.
The commercial auto SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2017 improved 20.8 points when compared to 2016 (Tables 4 - 5) primarily due to favorable development of prior accident year losses of $8.9 million compared to adverse development of $3.6 million in 2016. The majority of the 2017 favorable development was driven by lower than anticipated bodily injury severity from accident years 2014 and 2015. The 2016 commercial auto ratio improved 3.8 points compared to 2015 (Tables 5 - 6) primarily due to less adverse development of prior accident year losses as a result of revising our previous estimates for accident years 2014 and 2015, slightly offset by increases in the current accident year loss and ALAE estimates that reflect the impact of increasing bodily injury severity trends.
The small commercial package SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2017 improved 3.2 points compared to 2016 (Tables 4 -5) primarily driven by greater favorable development of prior accident year losses compared to 2016. The 2017 favorable development was primarily due to lower than anticipated bodily injury severity from the 2016 accident year. The 2016 small commercial package ratio improved 9.0 points when compared to the same 2015 period primarily driven by (i) underwriting actions taken to improve production and profitability and (ii) large fire losses that occurred during the second half of 2015.
The workers’ compensation SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2017 improved 5.8 points compared to 2016 (Tables 4 - 5) primarily driven by greater favorable development of prior accident year losses compared to 2016. The 2017 favorable development occurred primarily within accident years 2015 and 2016. While lower than anticipated severity accounted for the majority of the development, lower than expected frequency contributed as well. The 2016 workers’ compensation ratio increased 1.1 points compared to 2015 (Tables 5 - 6) primarily due to less favorable development of prior accident year losses when compared to the same 2015 period.
Net written premiums for the year ended December 31, 2016 increased 21.7% compared to 2015 (Tables 8 - 9). E&S casualty net written premiums increased 41.3% compared to 2015 primarily due to (i) continued organic growth within our general liability and umbrella lines, which comprised the majority of the increase, (ii) changes to the reinsurance treaty covering casualty risks within the specialty insurance segment, including an increase in our retention per loss occurrence (see “Liquidity and Capital Resources - Reinsurance Arrangements" in this Item 7 for further information), and (iii) the impact of the reinsurance correction recorded in the second quarter of 2015, which reduced E&S casualty net written premiums by $7.2 million. Programs unit net written premiums increased 17.4% compared to 2015 due to new programs added during the second half of 2015 and growth of existing programs. E&S property net written premiums were flat compared to the same 2015 period as a result of continuing competitiveness of the catastrophe-exposed property market.
The 2016 E&S property SAP non-catastrophe loss and ALAE ratio increased 19.7 points compared to 2015 (Tables 8 - 9) primarily driven by increases in the ultimate loss and ALAE estimates for prior accident years for the liability coverage of our Florida package business. The 2016 E&S casualty non-cat loss and ALAE ratio increased 7.4 points compared to 2015 driven by (i) increases in the ultimate loss and ALAE estimates for the current and prior accident years for our healthcare line, which was placed in run-off during the first quarter of 2016, and (ii) an increase in the ultimate loss and ALAE estimates for the current accident year in our general liability line due to increased severity. The programs loss and ALAE ratio increased 4.9 points compared to 2015 primarily driven by elevated severity trends within programs with commercial auto exposures, which contributed to (i) higher 2016 accident year loss and ALAE ratios and (ii) adverse development of prior accident year losses.
Losses and loss expenses for a calendar year represent the combined estimated ultimate liability for claims occurring in the current calendar year along with any change in the estimated ultimate liability for claims occurring in prior years. The following table sets forth the provision for losses and loss expenses for those claims occurring in the current and prior years, along with the GAAP loss and LAE ratio for the years ended December 31, 2017, 2016 and 2015:
The following table sets forth a tabular presentation of the development of the ultimate liability of prior accident years by line of business for the years ended December 31, 2017, 2016 and 2015:
The following table sets forth a tabular presentation of the development of the ultimate liability by accident year for the year ended December 31, 2017:
The commercial insurance segment non-catastrophe loss and ALAE reserves contributed $44.0 million of favorable development, driven by small commercial package, workers’ compensation, commercial auto and middle market commercial of $11.4 million, $8.9 million, $8.9 million and $8.2 million, respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years.
ULAE was $3.2 million lower than anticipated in the reserves at December 31, 2016.
The specialty insurance segment non-catastrophe loss and ALAE reserves accounted for $20.8 million of adverse development, which was driven by programs and E&S casualty with adverse development of $14.3 million and $4.6 million, respectively. Programs adverse development was driven by higher than expected severity in programs with commercial auto exposures. E&S casualty adverse development was driven by increased severity from the healthcare line, which was placed in run-off in the first quarter of 2016.
The personal insurance segment non-catastrophe loss and ALAE reserves contributed $9.0 million of the adverse development, driven by personal auto which contributed $7.9 million of adverse development, primarily due to higher than anticipated bodily injury severity from the prior two accident years.
The commercial insurance segment non-catastrophe loss and ALAE reserves contributed $5.1 million of favorable development, primarily driven by workers’ compensation, other commercial, and farm & ranch, of $4.2 million, $1.8 million, and $1.7 million respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years. The favorable development was partially offset by adverse development in commercial auto of $3.6 million, which was driven by higher than anticipated bodily injury severity from the prior two accident years.
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the adverse development in 2015 resulted primarily from accident year 2013. The more notable items contributing to 2015 development were as follows:
The following table sets forth loss and loss expenses payable by major line of business at December 31, 2017 and 2016:
Our investment portfolio and the investment portfolios of other members of the State Auto Group are managed by our subsidiary, Stateco. Stateco utilizes its own personnel to invest in fixed maturities, U.S. large-cap equities, U.S. small-cap equity funds, international equity funds, and MLP exchange traded funds. In addition, Stateco uses an outside investment manager who invests in international funds. The Investment and Finance Committee (the “Committee”) of our Board of Directors establishes the investment policies to be followed by Stateco. Our primary investment objectives are to maintain adequate liquidity and capital
We have investment policy guidelines with respect to purchasing fixed maturity investments for our insurance subsidiaries which preclude purchases of bonds that are rated below investment grade by a recognized rating service. Our fixed maturity portfolio is composed of high quality, investment grade issues, comprised mostly of debt issues rated A, or higher. We obtain investment ratings from nationally recognized ratings agencies. If there is a split rating, we assign the lowest rating obtained. At December 31, 2017, there was one fixed maturity investment rated below investment grade in our available-for-sale investment portfolio. This security is rated below investment grade due to a rating downgrade subsequent to the purchase of the security.
At December 31, 2017, our equity portfolio consisted of approximately 42 different large-cap stocks and 15 mutual and exchange traded funds. The largest single fund holding was 20.2% of the equity portfolio based on fair value and the top ten positions accounted for 71.1% of the equity portfolio. During the fourth quarter of 2017, we sold our externally-managed small-cap holdings and reinvested the proceeds into small-cap focused mutual and exchange traded funds. At December 31, 2016, our equity portfolio consisted of approximately 44 different large-cap stock, 73 small-cap stocks and 11 mutual and exchange traded funds. The largest single fund holding was 12.7% of the equity portfolio based on fair value and the top ten positions accounted for 45.5% of the equity portfolio.
We believe that the fixed maturity portfolio’s exposure to credit risk is minimal as approximately 63.1% of the bonds we own are rated AA or better. We do not intend to change our investment policy or the quality of our fixed maturity investments. The fixed maturity portfolio is managed in a laddered-maturity style and considers business mix and liability payout patterns to ensure adequate cash flow to meet claims as they are presented. We also manage liquidity risk by maintaining sufficient cash
balances, owning some agency and U.S. Treasury securities at all times, purchasing bonds of major issuers, and purchasing bonds that are part of a medium or large issue. The fixed maturity portfolio does not have any direct exposure to either exchange rate risk or commodity risk. We do not rely on the use of derivative financial instruments. We categorize our fixed maturities as available-for-sale in order to provide us greater flexibility in managing our portfolio. We do not maintain a trading portfolio.
At December 31, 2017, our large-cap equity portfolio had a beta of 1.03 using the S&P 500 Index as the benchmark. At December 31, 2017, our mutual and exchange traded funds portfolio had a beta of 0.97 using the S&P 500 Index as a benchmark. Beta estimates the degree the portfolio’s price will fluctuate based on a given movement in the market index. The following tables set forth what changes might occur in the value of the large-cap equity portfolio and the mutual and exchange traded funds portfolio given a change in the S&P 500 Index at December 31, 2017:
The above analysis does not take into account any actions that might be taken by the portfolio managers in response to these changes. As a result, the actual impact of a change in international equity market prices and the resulting international equity value may differ significantly from what is shown in the table above.
Our investment operations revenue for the year ended December 31, 2017 was primarily impacted by an increase in dividend income when compared to the same 2016 and 2015 periods. The dividend income increase was due primarily to higher dividends from our international fund and master limited partnership (MLP) holdings. With the enactment of TCJA, we anticipate that our effective tax rate on investment income will be approximately 17% in 2018.
As of December 31, 2017, we no longer hold any Level 3 assets.
For the year ended December 31, 2017, the federal income tax expense was $44.1 million compared to an income tax benefit of $1.8 million for 2016 and an income tax expense of $16.1 million for 2015. Our effective tax rate for 2017 was 132.0% compared with (9.4%) in 2016 and 23.9% in 2015. The change in our effective tax rate in 2017 was primarily due to the revaluation of our net deferred tax asset as a result of the enactment of the TCJA. The revaluation of our deferred tax asset resulted in a provisional deferred tax charge of $36.4 million.
Income taxes for the year ended 2016 reflect the impact of a correction of prior period deferred tax expense related to expired stock options. As a result of the correction, deferred federal income tax expense and additional paid-in-capital were reduced by $1.6 million, respectively.
See “Critical Accounting Policies - Income Taxes” included in this Item 7. See Note 9, “Federal Income Taxes” to our consolidated financial statements included in Item 8 of this Form 10-K for a reconciliation between our actual federal income tax expense (benefit) and the amount computed at the indicated statutory rate for the years ended December 31, 2017, 2016 and 2015.
We generally manage our cash flows through current operational activity and maturing investments, without a need to liquidate any of our other investments. However, should our written premiums decline or paid losses increase significantly, or a combination thereof, our cash flows from operations could be impacted requiring us to liquidate investments. This action was not necessary in 2017, 2016 or 2015.
Net cash provided by operating activities was $67.9 million, $113.5 million and $149.8 million in 2017, 2016 and 2015, respectively. Net cash from operations will vary from period to period if there are significant changes in underwriting results, primarily a combination of the level of premiums written and loss and loss expenses paid, changes in cash flows from investment income or federal income tax activity.
State Auto P&C has a credit facility (the “SPC Credit Facility”) with a syndicate of lenders that provides State Auto P&C with a $100.0 million five-year revolving credit facility maturing in July 2018. During the term of the SPC Credit Facility, State Auto P&C has the right to increase the total facility to a maximum amount of $150.0 million, provided that no event of default has occurred. The SPC Credit Facility is available for general corporate purposes and provides for interest-only payments during its term, with principal and interest due in full at maturity. Interest is based on LIBOR or a base rate plus a calculated margin amount. All advances under the SPC Credit Facility are to be fully secured by a pledge of specific investment securities of State Auto P&C. The SPC Credit Facility includes certain covenants and requirements, including financial requirements that State Auto Financial maintain a minimum net worth and a certain debt to capitalization ratio. As of December 31, 2017, State Auto P&C had not made any borrowings under the SPC Credit Facility and State Auto P&C and State Auto Financial were in compliance with all covenants and requirements of the SPC Credit Facility.
State Auto P&C has a term loan from the FHLB in the principal amount of $21.5 million (the “2016 FHLB Loan”). The 2016 FHLB Loan matures in September 2021 and may be called (prepaid) after September 2018 with no prepayment penalty. The 2016 FHLB Loan provides for interest-only payments during its term, with principal due in full at maturity. The interest rate is fixed over the term of the loan at 1.73%. The 2016 FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C. Proceeds from the loan were contributed to our pension plan to reduce our future pension costs.
The 2013 and 2016 FHLB Loans are fully secured by a pledge of specific investment securities of State Auto P&C.
Related to our notes payable, our primary market risk exposure is to the change in interest rates and our credit rating. For a discussion regarding our credit ratings see “Liquidity and Capital Resources - Credit and Financial Strength Ratings” included in this Item 7. Based upon the notes payable carrying value at December 31, 2017, we had $15.2 million notes payable with variable interest and $85.4 million and $21.5 million of notes payable with interest fixed at 5.03% and 1.73%, respectively, and, which equated to approximately 12.4% variable interest debt and 87.6% fixed interest debt. Our decision to obtain fixed versus variable interest rate debt is influenced primarily by the following factors: (a) current market interest rates; (b) anticipated future market interest rates; (c) availability of fixed versus variable interest instruments; and (d) our currently existing notes payable fixed and variable interest rate position. See our contractual obligations table included in “Liquidity and Capital Resources -Contractual Obligations” included in this Item 7.
As of July 1, 2017, the State Auto Group renewed its property per risk excess of loss reinsurance agreement. This reinsurance agreement provides individual property risk coverage for the State Auto Group for losses exceeding $3.0 million, subject to an additional $2 million annual aggregate retention (AAD). Claims arising from named storms and earthquake for E&S property are excluded from this treaty. The reinsurers are responsible for 100.0% of the loss excess of the $3.0 million retention and $2.0 million AAD for property business up to $20.0 million of covered loss.
The following table sets forth our significant contractual obligations at December 31, 2017:
As of June 6, 2017, the State Auto Group’s financial strength rating from A.M. Best was A- (Excellent) with a stable outlook and its credit rating from A.M. Best was bbb- with a stable outlook.
Our fixed maturity, equity security and certain other invested asset investments are classified as available-for-sale and carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders’ equity in accumulated other comprehensive income (loss), and as such are not included in the determination of net income. Investment income is recognized when earned, and capital gains and losses are recognized when investments are sold.
and case reserves) for claims that have been reported and are still open. With this method, a pattern of reported losses is estimated to project ultimate incurred values for each accident year. The underlying assumption of the Incurred Loss Development Method is that case reserve adequacy remains consistent over time. This method’s advantage is its responsiveness to changes in reported losses, which is particularly valuable in the less mature accident years. The disadvantage of the Incurred Loss Development Method is that case reserve adequacy changes will distort the IBNR projections.
Paid Loss Development Method: The Paid Loss Development Method uses calculations that are very similar to the Incurred Loss Development Method. The key difference is that the data used in the paid method exclude case reserve estimates, so only paid losses are utilized. With this method, a payment pattern is estimated to project ultimate settlement values for each accident year, with the underlying assumption that claims are settled at a consistent rate over time. Neither case reserves nor the rate at which claims are reported (except to the extent that the reporting pattern influences the payment pattern) is relevant to the results of this method. This method’s advantage is that the estimates of ultimate loss are independent of case reserve adequacy and are unaffected by company changes in case reserving philosophy. The disadvantages are that (i) the paid method does not use all of the available information, (ii) in some cases the liability payment patterns require the application of very large development factors to relatively small payments in less mature accident years, and (iii) changes in the claims settlement rate will distort the projections.
Reserve ranges provide a quantification of the variability in the loss reserve projections. The primary determinant in estimating the loss reserve range boundaries are the variances measured within the historical reserving data for the various lines of business. MBE of loss reserves considers the expected variation to establish an appropriate position within a range. At December 31, 2017, MBE of our direct loss and ALAE reserves for the STFC Pooled Companies’ share of the Pooled Companies’ reserves were $1,258.6 million, within an estimated range of $1,094.6 million to $1,311.9 million.
An important assumption underlying certain loss reserve estimation methods for casualty lines is that the loss cost trends underlying historical data will continue into the future. To estimate the sensitivity of reserves to an unexpected change in inflation, projected calendar year payment patterns were applied to the December 31, 2017, workers’ compensation loss and ALAE reserve to generate estimated annual incremental loss and ALAE payments for each subsequent calendar year. Then, for purposes of sensitivity testing, an additional annual loss cost trend of 5% was added to the trend implicitly embedded in the estimated payment pattern, and revised incremental loss and ALAE payments were calculated. This type of inflationary increase could arise from a variety of sources including tort law changes, development of new medical procedures, social inflation, and other inflationary changes in costs beyond assumed levels.
The following tables set forth the net losses and loss expenses payable by major line of business at December 31, 2017 and 2016:
As a result of revised mortality assumptions and the change in the discount rate, the benefit plan’s liability increased $0.7 million for the year ended December 31, 2017 and increased $2.9 million for the year ended December 31, 2016.
In computing taxable income, property and casualty insurers are required to discount their unpaid loss reserves. The discount is determined using interest rates and claim payment patterns prescribed by the U.S. Treasury. The TCJA changed the prescribed
Management anticipates generating taxable income over the next three years that will allow for the realization of all of our net operating loss (“NOL”) carryforwards by the end of 2020. The NOL carryforwards do not begin to expire until 2030 and will not fully expire until 2036.
The following table sets forth the components of our federal income tax expense (benefit) for the years ended December 31, 2017, 2016 and 2015:
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries (the Company) as of December 31, 2017 and 2016, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and financial statement schedules listed in the Index at Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 28, 2018 expressed an unqualified opinion thereon.
We have audited State Auto Financial Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission “(2013 framework)” (the COSO criteria). In our opinion, State Auto Financial Corporation and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017, based on the COSO criteria.
Investments in fixed maturities, equity securities and certain other invested assets are classified as available-for-sale and are carried at fair value. The unrealized holding gains and losses, net of applicable deferred income taxes, are shown as a separate component of stockholders’ equity as a part of accumulated other comprehensive income and, as such, are not included in the determination of net income. Realized gains and losses on the sales of investments are computed using the first-in, first-out method.
recognized on the underlying policies resulting in excess ceding commissions being recognized as a reduction of acquisition and operating expenses.
In May 2014, the FASB issued guidance that requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. Insurance contracts do not fall within the scope of this new guidance. The guidance is effective for annual reporting periods beginning after December 15, 2017, with early adoption permitted. The guidance has not yet been adopted. The Company completed its contract analysis during the third quarter of 2017 and noted that 0.1% of revenue, primarily affiliated investment management fee revenue, is subject to the new revenue recognition guidance. Revenue will not change under the new guidance; thus, upon adoption, the Company does not expect any impact to its' results of operations and consolidated financial position.
In January 2016, the FASB issued guidance to improve certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Specifically the guidance (i) requires equity investments, including equity securities and limited partnership interests, that are not accounted for under the equity method of accounting or result in consolidation to be measured at fair value with changes in fair value recognized in earnings, (ii) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment, (iii) eliminates the requirement to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost, (iv) requires the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes, (v) requires an entity to present separately in other comprehensive income the portion of the total change in fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option, (vi) requires separate presentation of financial assets and liabilities by measurement category and form on the balance sheet or the notes to the financial statements, and (vii) clarifies that the need for a valuation allowance on a deferred tax asset related to an available for sale security should be evaluated with other deferred tax assets. The guidance is effective beginning January 1, 2018. The Company will recognize $60.7 million of net unrealized gains (net of tax) as a cumulative effect adjustment that will increase retained earnings as of January 1, 2018 and decrease accumulated other comprehensive income (“AOCI”) by a corresponding amount. There are no other significant impacts anticipated to the Company’s results of operations, consolidated financial position or cash flows.
In August 2016, the FASB issued guidance that addresses eight specific cash flow issues with the objective of reducing existing diversity in practice. The new guidance is effective beginning January 1, 2018 and it is not expected to have a material impact on the Company's cash flows.
In February 2018, the FASB issued guidance that addresses certain stranded income tax effects in AOCI resulting from the Tax Cuts and Jobs Act of 2017 (“TCJA”). Current guidance requires the effect of a change in tax laws or rates on deferred tax balances to be reported in income from continuing operations in the accounting period that includes the period of enactment, even if the related income tax effects were originally charged or credited directly to AOCI. The amount of the reclassification would include the effect of the change in the U.S. federal corporate income tax rate on the gross deferred tax amounts and related valuation allowances, if any, at the date of the enactment of TCJA related to items in AOCI. The updated guidance is effective for reporting periods beginning after December 15, 2018 and is to be applied retrospectively to each period in which the effect of the TCJA related to items remaining in AOCI are recognized or at the beginning of the period of adoption. Early adoption is permitted. The Company expects to adopt the updated guidance effective January 1, 2018. The adoption of this guidance will not affect the Company's results of operations, consolidated financial position, or liquidity.
Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost
The following tables set forth the Company’s gross unrealized losses and fair value on its investments by lot, aggregated by investment category and length of time for individual securities that have been in a continuous unrealized loss position at December 31, 2017 and 2016:
The following table sets forth the amortized cost and fair value of available-for-sale fixed maturities by contractual maturity at December 31, 2017:
During the fourth quarter of 2016, the Company redeemed a limited partnership investment in international equities that had been classified as other invested assets. The redemption proceeds were reinvested in an international equity mutual fund classified as an equity security. The Company recognized a gain of $12.0 million on the redemption. Out of the total proceeds related to this redemption and reinvestment, $44.0 million was non-cash and therefore excluded from net cash used in investing activities in the consolidated statements of cash flows.
Transfers between levels may occur due to changes in the availability of market observable inputs. Transfers in and out of levels are reported as having occurred at the beginning of the quarter in which the transfer occurred. There were no transfers between levels during the years ended December 31, 2017 and 2016.
The fair value estimate of the Company’s fixed maturity investments are determined by evaluations that are based on observable market information rather than market quotes. Inputs to the evaluations include, but are not limited to, market prices from recently completed transactions and transactions of comparable securities, interest rate yield curves, credit spreads, and other market-observable information. The fixed maturity portfolio pricing obtained from the pricing service is reviewed for reasonableness. Regularly, samples of security prices are referred back to the pricing service for more detailed explanation as to how the pricing service arrived at that particular price. The explanations are reviewed for reasonableness by the portfolio manager or investment officer. Additionally, the prices and assumptions are verified against an alternative pricing source for reasonableness and accuracy. Any discrepancies with the pricing are returned to the pricing service for further explanation and if necessary, adjustments are made. To date, the Company has not identified any significant discrepancies in the pricing provided by its third party pricing service. Investments valued using these inputs include U.S. treasury securities and obligations of U.S. government agencies, obligations of states and political subdivisions, corporate securities (except for a security discussed below), and U.S. government agencies mortgage-backed securities. All unadjusted estimates of fair value for fixed maturities priced by the pricing service are included in the amounts disclosed in Level 2 of the hierarchy. If market inputs are unavailable, then no fair value is provided by the pricing service. For these securities, fair value is determined either by requesting brokers who are knowledgeable about these securities to provide a quote; or the Company internally determines the fair values by employing widely accepted pricing valuation models, and depending on the level of observable market inputs, renders the fair value estimate as Level 2 or Level 3. The Company held one fixed maturity corporate security included in Level 3 and estimated its fair value using the present value of the future cash flows. This security was sold during the second quarter of 2017.
The Company recorded favorable development related to prior years’ loss and loss expense reserves in 2017 of $46.6 million, compared to adverse development in 2016 and 2015 of $27.0 million and $10.0 million, respectively. Unallocated loss adjustment expenses and catastrophe reserves contributed $3.2 million and $2.0 million, respectively, of favorable development in 2017. Favorable development of prior accident years' non-catastrophe loss and ALAE reserves was primarily driven by $44.0 million of favorable development in the commercial insurance segment. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years. The personal insurance segment non-catastrophe loss and ALAE reserves accounted for $1.6 million of the favorable development in 2017. Personal auto contributed $4.4 million of favorable development primarily driven by lower than anticipated severity emerging from accident years 2015 and 2016. Slightly offsetting the favorable development was adverse development in homeowners and other personal of $1.5 million and $1.3 million, respectively. Homeowners adverse development was primarily from accident year 2016. Adverse development in other personal was driven by higher than anticipated severity emerging from accident years 2015 and 2016. The specialty insurance segment non-catastrophe loss and ALAE reserves accounted for $4.2 million of adverse development, primarily driven by E&S property with adverse development of $3.0 million. E&S property adverse development was driven by higher than anticipated severity for liability coverages on business in run-off.
Unallocated loss adjustment expenses contributed $3.7 million of the adverse development and catastrophe reserves contributed $1.4 million of the favorable development in 2016. The personal insurance segment non-catastrophe loss and ALAE reserves accounted for $9.0 million of the adverse development, driven by personal auto which contributed $7.9 million of adverse development, primarily due to higher than anticipated bodily injury severity from the prior two accident years. The commercial insurance segment non-catastrophe loss and ALAE reserves contributed $5.1 million of favorable development, driven by workers’ compensation, other commercial, and farm & ranch of $4.2 million, $1.8 million, and $1.7 million respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years. The favorable development was partially offset by adverse development in commercial auto of $3.6 million, which was driven by higher than anticipated bodily injury severity from the prior two accident years. The specialty insurance segment non-catastrophe loss and ALAE reserves accounted for $20.8 million of adverse development in 2016, which was driven by programs and E&S casualty with adverse development of $14.3 million and $4.6 million, respectively. Programs adverse development was driven by higher than expected severity in programs with commercial auto exposures. E&S casualty adverse development was driven by increased severity from the healthcare line, which was placed in run-off in the first quarter of 2016.
Favorable development of unallocated loss adjustment expenses and catastrophe reserves were approximately $6.2 million and $0.7 million, respectively, of the 2015 development. The personal insurance segment contributed $10.5 million of the adverse development, driven by personal auto which developed unfavorably by $11.1 million, primarily due to higher than anticipated bodily injury severity from the prior two accident years. The commercial insurance segment contributed $0.7 million of favorable development, driven by favorable development in workers’ compensation and middle market commercial of $5.1 million and $4.3
million, respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years. The favorable development was offset by commercial auto which developed unfavorably by $9.8 million, due to higher than anticipated bodily injury severity from the prior two accident years. The specialty insurance segment non-catastrophe loss and ALAE reserves accounted for $7.1 million of adverse development, which was driven by programs and E&S casualty with adverse development of $9.6 million and $2.7 million, respectively. Adverse development in programs was driven by higher than expected severity in programs with commercial auto exposures. Somewhat offsetting the adverse development was favorable development of $5.2 million in the E&S property unit driven by lower than anticipated severity emerging from accident year 2014.
average annual percentage payout of incurred claims by age, net of reinsurance.
The personal insurance segment generally only consists of short-tail business, whereas the commercial and specialty insurance segments have both short and long-tail business. The Company determined that these disaggregated groupings have homogeneous risk characteristics with similar development patterns and are generally subject to similar trends.
The change in incurred losses and loss adjustment expenses for prior accident years was caused by lower than expected emergence during 2017 in the commercial auto, small commercial package and middle market commercial products. The unanticipated emergence in these products was driven by lower than expected severity from (i) accident years 2013 and 2014 in commercial auto, (ii) accident years 2013 - 2016 in small commercial package, and (iii) accident years 2014 - 2016 in middle market commercial. These accident years account for approximately 80% of the change in incurred losses and loss adjustment expenses.
The change in incurred losses and loss adjustment expenses for prior accident years was due to lower than expected emergence during 2017 in the workers’ compensation product. The unanticipated emergence in the workers’ compensation product was driven by lower than expected severity from accident years 2015 and 2016.
The insurance subsidiaries of State Auto Financial, including State Auto P&C, Milbank and SA Ohio (collectively referred to as the “STFC Pooled Companies”) participate in a quota share reinsurance pooling arrangement (“the Pooling Arrangement”) with State Auto Mutual and its subsidiaries and affiliates, State Auto Insurance Company of Wisconsin, Meridian Security Insurance Company, Patrons Mutual Insurance Company of Connecticut, Rockhill Insurance Company, Plaza Insurance Company, American Compensation Insurance Company and Bloomington Compensation Insurance Company, (collectively referred to as the “Mutual Pooled Companies”). RIC, Plaza, American Compensation and Bloomington Compensation are referred to as the “Rockhill Insurers.” The STFC Pooled Companies, the Mutual Pooled Companies and the Rockhill Insurers are collectively referred to as the “State Auto Group.”
The following table sets forth the reinsurance transactions on the Company’s balance sheets for the Pooling Arrangement between the STFC Pooled Companies and State Auto Mutual at December 31, 2017 and 2016:
Pursuant to the Pooling Arrangement, State Auto Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and then settles the intercompany balances generated by these transactions with the participating companies on a quarterly basis within 60 days following each quarter end. No interest is paid on this balance. When settling the intercompany balances, State Auto Mutual provides the pool participants with full credit for the premiums written and net losses paid during the quarter and retains all receivable amounts from insureds and agents and reinsurance recoverable on paid losses from unaffiliated reinsurers. Any receivable amounts that are ultimately deemed to be uncollectible are charged-off by State Auto Mutual and allocated to the pool members on the basis of pool participation. As a result, the Company has an off-balance sheet credit risk related to the balances due to State Auto Mutual from insurers, agents and reinsurers, which are offset by the unearned premium from the respective policies. The Company’s share of the premium balances due to State Auto Mutual from agents and insureds at December 31, 2017 and 2016 is approximately $323.1 million and $310.5 million, respectively.
Under these agreements, the Company earned interest of $4.9 million for each of the three years ended December 31, 2017, 2016 and 2015, respectively. See Note 3 for the notes receivable fair value discussion.
State Auto P&C has a credit facility (the “SPC Credit Facility”) with a syndicate of lenders that provides State Auto P&C with a $100.0 million five-year revolving credit facility maturing in July 2018. During the term of the SPC Credit Facility, State Auto P&C has the right to increase the total facility to a maximum amount of $150.0 million, provided that no event of default has occurred and is continuing. The SPC Credit Facility is available for general corporate purposes and provides for interest-only payments during its term, with principal and interest due in full at maturity. Interest is based on the London Interbank Offered Rate (“LIBOR”) or a base rate plus a calculated margin amount. All advances under the SPC Credit Facility are to be fully secured by a pledge of specific investment securities of State Auto P&C. The SPC Credit Facility includes certain requirements, including financial requirements that State Auto Financial maintain a minimum net worth and a certain debt to capitalization ratio.
Total income tax expense for 2017 included a provisional net charge of $36.4 million to reflect the change in tax laws and tax rates included in TCJA at the date of enactment, resulting primarily from revaluing the Company's deferred tax assets and liabilities.
In computing taxable income, property and casualty insurers are required to discount their unpaid loss reserves. TCJA changes the prescribed interest rates to rates based on corporate bond yield curves, requires the use of IRS-prescribed claims payment patterns and extends the applicable time periods for the claims payment patterns. These changes are effective for tax years beginning after 2017 and are subject to a transition rule that spreads the additional tax payment from the amount determined by applying these changes over the subsequent eight years beginning in 2018. The pre-tax provisional change in discounted loss reserves attributable to the TCJA changes to loss reserve discounting is determined to be $50.9 million. As a result of changes to the IRS Code, deferred tax assets were increased by that amount, with an offsetting deferred tax liability. The deferred tax liability will be amortized over a period of eight years beginning in 2018. This item is a taxable temporary difference and has no direct impact on total tax expense for 2017 and future years. The provisional amount will be adjusted once the IRS publishes the official discount factors that should be used.
The following table sets forth the tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2017 and 2016:
Deferred income tax assets and liabilities represent the tax effect of the differences between the financial statement carrying value of existing assets and liabilities and their respective tax bases. The Company periodically evaluates its deferred tax assets,
At December 31, 2017, the Company carried no balance for uncertain tax positions. The Company had no accrual for the payment of interest and penalties at December 31, 2017 or 2016.
The following table sets forth the Company’s share of the amounts included in accumulated other comprehensive income (loss) that have not been recognized in net periodic cost at December 31, 2017 and 2016:
The postretirement plan’s gross benefit payments for 2017 were $1.8 million, including the prescription drug benefits. The postretirement plan’s subsidy related to Medicare Prescription Drug Improvement and Modernization Act of 2003 was $0.2 million for 2017 and estimates future annual subsidies to be approximately $0.1 million.
The following table sets forth the weighted average assumptions used to determine the benefit plans’ obligations at December 31, 2017 and 2016:
The assumed health care cost trend rates have a significant effect on the amounts reported for the postretirement plan. The following table sets forth the effects of a one percentage point change in assumed health care cost trend rates for the year ended December 31, 2017:
The following tables set forth the Company’s share of pension plan’s available-for-sale securities within the fair value hierarchy at December 31, 2017 and 2016:
The following tables set forth the changes in the Company’s accumulated other comprehensive income component (AOCI), net of tax, for the years ended December 31, 2017, 2016 and 2015:
State Auto P&C, Milbank and SA Ohio are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Under the insurance regulations of Iowa and Ohio (the states of domicile), the maximum amount of dividends that the Company may pay out of earned surplus to shareholders within a twelve month period without prior approval of the Department is limited to the greater of 10% of the most recent year-end policyholders’ surplus or net income for the twelve month period ending the 31st day of December of the previous year-end. Pursuant to these rules, approximately $85.8 million is available for payment to State Auto Financial from its insurance subsidiaries in 2016 without prior approval. State Auto Financial received dividends from its insurance subsidiaries in the amount of $15.0 million, $10.0 million and $15.0 million in 2017, 2016 and 2015, respectively.
The following table set forth the Company’s total activity and related information for employee restricted stock and performance unit award activity for the years ended December 31, 2017, 2016 and 2015:
The following tables present the weighted-average assumptions used in the option pricing model for options granted to employees during 2016 and 2015. The expected life of the options for employees represents the period of time the options are expected to be outstanding and is based on historical trends. For non-employees the expected life of the option approximates the remaining contractual term of the option. The expected stock price volatility is based on the historical volatility of the Company’s stock for a period approximating the expected life and the expected dividend yield is based on the Company’s most recent period’s dividend payout. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant and has a term approximating the expected life of the option.
The fair value of share-based awards granted to employees was estimated at the date of grant using the Black-Scholes option-pricing model. The following table sets forth the weighted average fair values and related assumptions for options granted for the years ended December 31, 2016 and 2015:
The following table sets forth the Company’s stock option activity and related information for the years ended December 31, 2017, 2016 and 2015:
Intrinsic value for stock options is defined as the difference between the current market value and the grant price. For the years ended December 31, 2017, 2016 and 2015, the total intrinsic value of stock options exercised was $3.5 million, $3.0 million and $2.6 million, respectively. The tax benefit for tax deductions from share-based awards totaled $1.4 million and $0.3 million for the years ended December 31, 2016 and 2015, respectively. In addition, income taxes for the year ended December 31, 2016 reflected the impact of a $1.6 million correction of prior period deferred tax expense related to expired stock options. See Note 9 for additional information.
The Company also has a broad-based employee stock purchase plan under which employees of the Company may choose, at two different specified time intervals each year, to have up to 6% of their annual base earnings withheld to purchase the Company’s common shares. The purchase price of the common shares is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 3.7 million common shares under this plan. As of December 31, 2017, a total of 3.5 million common shares have been purchased under this plan. This plan remains in effect until terminated by the Board of Directors.
During 2017 and 2016, common shares valued at approximately $106,581 and $753,000, respectively, were distributed by the Company under the RSU Plan.
After a review of strategic alternatives for our excess and surplus lines business in the specialty insurance segment, during the second half of 2017 management made the decision to begin exiting the excess and surplus lines business either through a series of renewal right transactions or by placing lines of business into run-off since this business is not core to the Company’s ongoing business strategy. The impact of this decision, along with the 2016 decision to exit programs business, on future results will result in the elimination of the specialty insurance segment and its related underwriting results from the State Auto Group.