Because the operations of the Company and Mutual are integrated with one another pursuant to the terms of the Amended and Restated Management Agreement, the Company and Mutual share their operating facilities. See Item 1, "Management Agreement." The Company's and Mutual's corporate headquarters are located in Columbus, Ohio in buildings owned by Mutual that contain approximately 270,000 square feet of office space. The Company and Mutual also have regional underwriting and
State Auto Financial Corporation (State Auto Financial), through its principal insurance subsidiary State Auto Property and Casualty Insurance Company (State Auto P&C), provides personal and commercial insurance primarily in the central and eastern parts of the United States, excluding New York, New Jersey, and the New England states. State Auto P&C's principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. Another insurance subsidiary, State Auto National Insurance Company (National), writes personal automobile insurance for non-standard risks. In 1997 National wrote insurance in eleven states. State Auto P&C and National's products are marketed through independent agents.
Since 1987 State Auto P&C has participated in a reinsurance pooling arrangement (the Arrangement) with Mutual. The Arrangement provides that all premiums, losses, loss expenses and underwriting expenses of each company be pooled and then allocated back to each company based on percentages outlined in the Arrangement. Effective January 1, 1995, the Arrangement was amended to include all of the property and casualty business of Milbank. Concurrently with the inclusion of Milbank, the pooling participation percentages were amended to allocate 35% to State Auto P&C, 55% to Mutual and 10% to Milbank. Effective January 1, 1998, subject to regulatory approval, the arrangement was amended to include all of the property and casualty business of Midwest Security. Concurrently, with the inclusion of Midwest Security, the pooling participation percentages were amended to allocate 37% to State Auto P&C, 52% to Mutual, 10% to Milbank and 1% to Midwest Security. The change in the Arrangement did not affect a prior agreement between State Auto P&C and Mutual whereby Mutual agreed to reimburse State Auto P&C for the development of any losses or loss expenses on claims occurring on or prior to December 31, 1990, that is in excess of State Auto P&C's reserves on that date. As of December 31, 1997, there has been no adverse development of the liability.
Net earnings for the Company increased 50% over 1996. The Company's statutory combined ratio decreased to 93.1% in 1997 from 99.0% in 1996, reflecting improvements in almost all major lines of insurance.
State Auto P&C increased its earned premium approximately 2.9% from the same 1996 period. During the 1997 year, the Pooled Companies' experienced minimal growth in direct written premiums on its personal lines of business of approximately 1.0%, while commercial lines reflected an increase of approximately 8.3% from the same 1996 period. Commercial lines growth decreased from 1996 levels due primarily to a substantial reduction in workers' compensation loss costs as promulgated by the National Council on Compensation Insurance that began approximately one year ago. As a result of these lower loss costs, workers' compensation direct written premiums decreased approximately 6.6% from 1996. The workers' compensation line of business represents approximately 12% of the Pooled Companies' commercial business. National's earned premium increased 56.8% from the same 1996 period. Contributing to this increase was National's entry into the states of Arkansas and Georgia in December 1996, Minnesota in February 1997 and in the later half of 1997, Alabama, Illinois and Missouri. Currently licensed in six additional states and seeking certificates of authority in at least three others, National anticipates beginning operations in at least six of these states during 1998. Total earned premiums for the Company increased $14.3 million or 6.0% to $254.7 million.
Losses and loss expenses, as a percentage of earned premiums, decreased to 65.1% from 72.2% in 1996. The decrease in this ratio is due to a reduction in the level of catastrophe losses experienced by the Company as compared to the same period in 1996 and continuing improvement in the Company's core underwriting operations. Homeowners' line of business, which comprises approximately 16.0% of the Company's earned premiums, reflected a substantial improvement in its statutory loss ratio of 71.0%, down from 101.7% in 1996. Additionally, automobile, the Company's largest line of business (approximately 60% of the Company's earned premiums), also reflected an improvement in its statutory loss ratio of 65.5%, down from 69.5% in 1996.
Acquisition and operating expenses, as a percentage of earned premiums, increased to 29.1% from 28.1% in 1996. The increase in this percentage is due to the amortization of software expenses, the Quality Performance Bonus (the Bonus) and the amount of bonus compensation earned by the Company's agents. Beginning with the first quarter of 1997, the State Auto Insurance Companies began amortizing costs associated with the development of its claims and billing processing system that began a little over two years ago. The amortization period of these costs will be approximately three years. Additionally, there was an increase over the same periods in 1996 of the Bonus earned by nearly all permanent employees. Performance is measured quarterly and the Bonus is earned if the State Auto Insurance Companies' quarterly direct statutory combined ratio is better than predetermined targets set at the beginning of each fiscal year. A Bonus has been MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
paid in each of the 1997 quarterly periods. Also contributing to this increase was an increase over 1996 of the amount of bonus compensation earned by the Company's agents. Each agent shares in the underwriting profits generated by insurance placed by them. Thus, the improvement in the underwriting operations of the Company is shared with the agents who produced the profitable business. Currently, approximately 20% of the Company's policy transactions are now sent electronically from the agent to the Company, thereby enhancing the efficiency of the Company's operations and which is expected to have a long-term positive impact on the Company's expenses.
Decrease in other expenses of $0.6 million to $1.9 million is primarily due to the State Auto Insurance Companies changing the catastrophe portion of its reinsurance program beginning July 1, 1996, that prior to this period was accounted for as deposit reinsurance (See Liquidity and Capital Resources). Expenses associated with the catastrophe portion of the program accounted for as deposit reinsurance were included in Other Expenses.
Federal income taxes increased $5.6 million to $13.1 million. This increase is due to the increase in taxable income as a result of the improvement in insurance operations in 1997 compared to the same period in 1996. The tax benefit from tax exempt securities for 1997 remained comparable to the 1996 level. See footnote (7) to consolidated financial statements of State Auto Financial Corporation and Subsidiaries.
Net earnings for the Company decreased 11.5% due primarily to numerous storm-related catastrophe claims in the first three quarters of the year. Despite these significant losses, the Company was able to produce a statutory combined ratio of 99.0% bettering industry results for the year of 105.9%.
Net investment income increased $1.3 million or 5.6% to $23.9 million. An increase in invested assets over the same 1995 period contributed to this increase. Total amortized cost of invested assets at December 31, 1996 was $377.0 million compared to $355.4 million at December 31, 1995. The investment yield decreased to 6.4% from 6.5% in 1995.
Management services income, which includes income generated from investment and executive management services provided by Stateco and State Auto P&C, respectively, increased $0.4 million or 5.9% to $8.0 million.
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.
Effective July 1, 1996, the State Auto Insurance Companies negotiated a change in their catastrophe reinsurance program. The amount retained by the State Auto Insurance Companies is $40.0 million for each occurrence, an increase of $20.0 million over the prior program. For up to $80.0 million in losses, excess of $40.0 million, traditional reinsurance coverage is provided. To provide funding if the State Auto Insurance Companies were to incur catastrophe losses in excess of $120.0 million, State Auto Financial entered into a structured contingent financing transaction with Chase Manhattan Bank (Chase) to provide up to $100.0 million for reinsurance purposes. Under this arrangement, in the event of such a loss, State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which will borrow the money necessary for such purchase from Chase and a syndicate of other lenders. State Auto Financial will contribute to State Auto P&C the proceeds from the sale of its preferred shares. State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank and National pursuant to a catastrophe reinsurance agreement in the amount of $100.0 million excess of $120.0 million. State Auto P&C will use the contributed capital to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC (which will repay the lenders) by redeeming the preferred shares over a six year period. This layer of $100.0 million in excess of $120.0 has been excluded from the pooling agreement as well by virtue of an Amended and Restated Reinsurance Pooling Agreement.
the Put Agreement, Mutual would be obligated to put either the preferred shares or the loan(s) outstanding.
On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest Security, effective as of January 1, 1997. In connection with this purchase, Mutual and State Auto Financial entered into an Option Agreement granting State Auto Financial the right to purchase Midwest Security from Mutual within five years at a price determined by a formula set out in the Option Agreement. As of March 16, 1998, State Auto Financial has not exercised its right to acquire Midwest Security.
Effective January 1, 1998, 518 Property Management and Leasing, LLC (518 PML) was created. The initial members of 518 PML are Stateco and State Auto P&C. Stateco contributed $7.0 million in cash and real property located in Goodlettsville, Tennessee, while State Auto P&C contributed real property located in Greer, South Carolina. 518 PML plans to develop an office building on the real property in Goodlettsville which it expects to lease to Mutual in 1999 for Mutual's use as its Nashville Regional Office. 518 PML has leased the Greer property to Mutual for use as Mutual's Southern Regional Office facility. Operations from 518 PML are not material to the Company at this time.
Based on an analysis of its systems software, management determined that it is required to modify or replace significant portions of State Auto's software so that its computer systems will function properly with respect to dates in the year 2000 and thereafter. Management presently believes that with modifications to existing software and conversions to new software, the Year 2000 Issue will not pose significant
Also, management has initiated communications with all of State Auto's significant suppliers and business partners to determine the extent to which State Auto's interface systems are vulnerable to such third parties' failure to remediate their own Year 2000 Issues. State Auto Financial's estimate of its total Year 2000 project cost and its dates of completion include the estimated costs and time associated with the impact of third party Year 2000 Issues, based on presently available information. However, there can be no guarantee that the software systems of other companies on which State Auto's computer systems rely will be timely converted and would not have an adverse effect on State Auto.
Also, engaging in the property casualty insurance business presents an additional exposure to financial losses for State Auto Financial. There is a significant amount of speculation that many businesses will themselves suffer financial losses due to the Year 2000 issue for which such businesses will likely seek reimbursement from their own insurance companies. State Auto Financial cannot estimate the nature or extent of its liabilities arising out of claims related to the Year 2000 Issue which may be filed by insureds under the insurance policies it has sold, although it has, along with much of the rest of the industry, sought to clarify its policies' provisions that financial losses arising out of its insureds failures to correct their own Year 2000 Issues are not insured losses. However, the enforceability of these policy endorsements is unknown at this time. In addition, some state insurance departments are resisting insurers' efforts to file such amendatory endorsements.
ed as available for sale compared to $294.1 million at December 31, 1996. During 1997, the Company began a program to build an equity portfolio to enhance growth of statutory surplus over the long term. At December 31, 1997, the equity portfolio totaled $4.6 million.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of State Auto Financial Corporation and subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles.
except for Note 15, as to which the date is March 6, 1998
(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.
(d) PREMIUM REVENUES Premiums are recognized as earned using the monthly pro rata method over the contract period.
(e) DEFERRED POLICY ACQUISITION COSTS Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses related to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned, without credit for anticipated investment income. These amounts are based on estimates and accordingly, the actual realizable value may vary from the estimated realizable value. Net deferred policy acquisition costs were:
(f) LOSSES AND LOSS EXPENSES PAYABLE Losses and loss expenses payable are based on formula and case-basis estimates for reported claims, and on estimates, based on experience, for unreported claims and loss expenses. The liability for unpaid losses and loss expenses, net of estimated salvage and subrogation recoverable of $8,487,000 and $8,265,000 at December 31, 1997 and 1996, respectively, has been established to cover the estimated ultimate cost of insured losses. The amounts are necessarily based on estimates of future rates of inflation and other factors, and accordingly there can be no assurance that the ultimate liability will not vary from such estimates. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations (see note 4). Salvage and subrogation recoverables are estimated using historical experience.
(h) MANAGEMENT SERVICES INCOME Management services income includes income for executive management services provided by State Auto P&C and income for investment management services provided by Stateco. Executive management income is recognized quarterly based on a percentage of the average adjusted annual statutory surplus of each company managed except for Midwest Security Insurance Company (Midwest Security), a wholly-owned subsidiary of Mutual, which is based on a percentage of quarterly direct premiums written. Investment management income is recognized quarterly based on a percentage of the average fair value of investable assets and the performance of the equity portfolio of each company managed.
(i) SOFTWARE REVENUE RECOGNITION SIS recognizes revenue from license fees when the product is delivered and service revenue when services are performed. Costs of developing and testing new or enhanced software products are capitalized and are amortized on a product-by-product basis utilizing the straight-line method over a period not to exceed three years. Unamortized software development costs of $1,285,000 and $1,055,000 are included in accrued investment income and other assets at December 31, 1997 and 1996, respectively. Software amortization, included in other expenses, was $489,000 and $394,000 in 1997 and 1996, respectively.
(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.
(m) NEW ACCOUNTING STANDARDS In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income," which is effective for fiscal years beginning after December 15, 1997. Statement 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Also in June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which is effective for fiscal years beginning after December 15, 1997. SFAS No. 131 changes the way public companies report segment information in annual financial statements and also requires those companies to report selected segment information in interim financial reports to shareholders. The Company has not yet determined the reporting changes required by SFAS Nos. 130 and 131 to comprehensive income and segment information.
The amortized cost and fair value of fixed maturities segregated by held to maturity and available for sale, at December 31, 1997, by contractual maturity, are summarized as follows:
(5) REINSURANCE In the ordinary course of business, State Auto P&C assumes and cedes reinsurance with other insurers and reinsurers and is a member in various pools and associations. The voluntary arrangements provide greater diversification of business and limit the maximum net loss potential arising from large risks and catastrophes. Most of the ceded reinsurance is effected under reinsurance contracts known as treaties; some is by negotiation on individual risks. Although the ceding of reinsurance does not discharge the original insurer from its primary liability to its policyholder, the insurance company that assumes the coverage assumes the related liability. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. The recoverability of these assets depends on the reinsurers' ability to perform under the reinsurance agreements. The Company evaluates and monitors the financial condition and concentrations of credit risk associated with its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. State Auto P&C and Milbank participate in a reinsurance pooling arrangement with Mutual. The arrangement provides that all premiums, losses, loss expenses, underwriting expenses, premiums in course of collection and reinsurance recoverable on loss payments (all transactions and balances in the underwriting accounts) of the companies be pooled and then allocated to each company based on percentages outlined in the agreement. The pooling participation percentages allocate 35% to State Auto P&C, 55% to Mutual and 10% to Milbank. In connection with a January 1, 1995 change in pooling percentages, State Auto P&C received approximately $46 million to cover its increased share of pool liabilities. Subject to regulatory approval, the pooling arrangement was amended pursuant to an Amended and Restated Reinsurance Pooling Agreement, effec-
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 1997 and 1996 are presented below:
(a) STOCK SPLIT On May 30, 1996, the Board of Directors approved a three-for-two common stock split to be effected in the form of a stock dividend, which has been given retroactive effect. Fractional shares were paid in cash.
(b) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION State Auto P&C and National are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to the Company during the year without prior approval of regulatory authorities. Pursuant to these rules, approximately $28.9 million is available for payment to the Company in 1998 without prior approval.
A summary of the Company's stock option activity and related information for these plans for the years ended December 31, 1997, 1996 and 1995, follows:
The Company has an employee stock purchase plan with a dividend reinvestment feature, under which employees of Mutual, State Auto P&C, Stateco and SIS may choose at two different specified time intervals each year to have up to 6% of their annual base earnings withheld to purchase the Company's common stock. The purchase price of the stock is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 1,200,000 shares of common stock under this plan. At December 31, 1997, 641,285 shares have been purchased under this plan. Compensation expense is recognized for the fair value of the employee's purchase rights, which was estimated using the Black-Scholes model with the following weighted-average assumptions for 1997 and 1996, respectively: dividend yield of 1.0% for both years; expected volatility factors of .32 and .24; risk-free interest rates of 5.6% and 6.5%; and expected lives of 6 months for both years. The weighted-average fair value of those purchase rights granted in 1997 and 1996 was $5.21 and $3.52, respectively.
(15) SUBSEQUENT EVENTS On March 6, 1998, the Board of Directors of the Company announced its intention to declare a two-for-one stock split to be distributed July 8, 1998, to shareholders of record on June 18, 1998. The stock split is contingent upon shareholder approval of a proposal to increase the number of authorized common shares, without par value, from 30 million to 100 million at the Company's Annual Meeting of Shareholders on May 28, 1998. Accordingly, the impact of this stock split is not reflected in these financial statements.
The Board also voted to authorize the officers of the Company to undertake such actions as are necessary to effect the exercise the Company's option to acquire Milbank from Mutual. The Company's acquisition of Milbank is subject to the completion of certain procedural matters contemplated by the Option Agreement as approved by the Boards of Directors of Mutual and the Company and regulatory approval in Ohio and South Dakota, where the respective companies are domiciled. The proposed effective date of transfer is third quarter 1998. Milbank was acquired in 1993 by Mutual and an Option Agreement granted the Company the right to acquire Milbank from Mutual within five years.