The Company shares its operating facilities with Mutual pursuant to the terms of the 2000 Management Agreement. The Company's corporate headquarters are located in Columbus, Ohio, in buildings owned by Mutual that contain approximately 280,000 square feet of office space. The Company and Mutual also own or lease other office facilities in numerous locations throughout the State Auto Group's geographical areas of operation.
(2) Net income less preferred share dividends, if any, divided by average common stockholders' equity.
(4) The earnings per share amounts prior to 1998 have been restated as required to comply with SFAS No. 128.
- State Auto Property and Casualty Insurance Company ("State Auto P&C")
State Auto Financial also provides personal automobile insurance to the nonstandard insurance market through the following principal wholly owned insurance subsidiaries:
- Meridian Insurance Group, Inc. ("MIGI") and its wholly owned subsidiaries:
* Time period is for the year ended December 31, unless otherwise noted. - ---------------- On January 1, 2003, the Pooling Arrangement was amended to add SA Florida as a participant, but the Company's aggregate pooling participation percentage remained at 80%. Since SA Florida did not commence insurance operations until after January 1, 2003, there was no impact on the Company's books at January 1, 2003 relating to the foregoing Pooling Arrangement amendment.
Stateco provides investment management services to the Company and Affiliates, which comprises the Company's investment management services segment. S.I.S. develops and sells software for the processing of insurance transactions, database management systems for insurance agents and electronic interfacing of information between insurance companies and agents. S.I.S. sells its services and products to the Affiliates and their agents, and S.I.S. also markets similar services and products to nonaffiliated insurers and their agencies. 518 PML is engaged in the business of owning and leasing real and personal property to the Affiliates. The members of 518 PML are State Auto P&C and Stateco. The results of operations of S.I.S. and 518 PML are not material to the total operations of the Company.
The following is a summary of significant transactions that occurred during 2001 through 2003 that will assist in the discussion of the Company's current period financial results:
Effective October 1, 2001, the 2000 Management Agreement was amended to eliminate the management and operations services fee charged by State Auto P&C to participants to the agreement, including Mutual. As a result of the loss of this income, substantially all of State Auto P&C's management services income was eliminated at that time. Consequently, beginning with the first quarter 2002, the "management and operations services" segment is included in the "all other" category for segment reporting, as the results of this segment no longer meet the quantitative thresholds for separate presentation as a reportable segment. See "Reportable Segments" included herein and footnote 15 regarding the Company's operating segments in the consolidated financial statements of the Company.
The Pooling Arrangement was amended, effective October 1, 2001, such that the STFC Pooled Companies' aggregate participation was increased from 53% to 80%. In conjunction with this change in pool participation, the STFC Pooled Companies received cash of $2.2 million and fixed maturities totaling $236.3 million from Mutual, which related to the additional net insurance liabilities assumed by the STFC Pooled Companies on October 1, 2001.
Losses and loss expenses payable are management's best estimates at a given point in time of what the Company expects to pay claimants, based on known facts, circumstances and historical trends. Reserves for reported losses are established on either a case-by-case or formula basis depending on the type and circumstances of the loss. The case-by-case reserve amounts are determined based on the Company's reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. The formula reserves are based on historical data for similar claims with provision for trend changes caused by inflation. Loss and loss expense reserves for incurred claims that have not yet been reported are estimated based on many variables including historical and statistical information, inflation, legal developments, storm loss estimates, and economic conditions. Case and formula basis loss reserves are reviewed on a regular basis and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis and not settled after six months, are case reserved at that time. Although management uses many resources to calculate reserves, there is no method for determining the exact ultimate liability.
Fixed maturity and equity security investments are classified as available for sale and carried at fair value. The net unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity as "accumulated other comprehensive income," and as such are not included in the determination of net income. Investment income is recognized when earned, and capital gains and losses are recognized when investments are sold.
As part of the Company's management of its exposure to fluctuations in interest rates, the Company entered into interest rate swap agreements in connection with the issuance of its $100.0 million 6.25% senior notes. The interest rate swap agreements are the only derivative contracts to which the Company is party and are accounted for in accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. This Statement requires all derivatives to be recorded at fair value on the consolidated balance sheet.
Changes in fair value of derivatives designated as cash flow hedges, to the extent effective, are recorded in net unrealized gains/losses on derivatives, a separate component of accumulated other comprehensive income. Amounts are reclassified to earnings from accumulated other comprehensive income when the underlying hedged item impacts earnings. Changes in fair value of derivatives designated as fair value hedges are recorded currently in earnings which are offset to the extent the derivative was affected by changes in fair value of the hedged item.
** The Company uses the statutory net premiums written to surplus ratio because there is no comparable GAAP measure. This ratio, also called the leverage ratio, measures the Company's statutory surplus available to absorb losses. - ----------------------- During 2003, the Company attained record level net income while also incurring record level catastrophe losses. The combined ratio improvements are the direct result of management's obtaining adequate cost based rates across all lines of business, re-underwriting the former Meridian Mutual business applying State Auto underwriting guidelines along with terminating unprofitable Meridian programs. Management of the Company continues to focus on growing premiums without compromising profitability. The Company's investment yield has declined consistent with the decrease in long term interest rates. The Company invests for yield while maintaining a conservative approach for principal preservation. During 2003, the Company debt issuance, net of debt repayments, was $85.5 million. The net proceeds of debt were used by State Auto Financial to contribute additional paid in capital to certain of its insurance subsidiaries to strengthen the statutory surplus
The following table summarizes the consolidated earned premiums by segment and by line of business for the years ended December 31, 2003 and 2002:
Consolidated losses and loss adjustment expenses, as a percentage of earned premiums (the "GAAP loss and LAE ratio"), were 67.8% and 72.9% for the years 2003 and 2002, respectively. See the Stop Loss discussion above regarding earned premiums cessions. For the years 2003 and 2002, the STFC Pooled Companies ceded a total of $5.6 million and $8.8 million, respectively, in losses and loss adjustment expenses to Mutual in accordance with the Stop Loss arrangement. The net effect of the earned premium and losses and loss adjustment expenses cessions under the Stop Loss increased the GAAP loss and LAE ratio by 0.3 points in 2003 and decreased the GAAP loss and LAE ratio by 0.9 points in 2002.
For the years 2003 and 2002, catastrophe claims contributed 6.8 and 5.6 points, respectively, to the consolidated GAAP loss and LAE ratio. Catastrophe losses discussed herein are as designated by Insurance Services Office's Property Claim Services ("PCS") unit, a nationally recognized industry service. PCS defines catastrophes as events resulting in $25.0 million or more in insured losses industry wide and affecting significant numbers of insureds and insurers. High winds, tornadoes, hail, lightning and resulting fires caused damage in 17 of the Company's 26 operating states between May 2 and May 11, 2003 ("CAT 88"). Claims resulting from CAT 88 totaled $39.6 million or 4.1 GAAP loss and LAE points for the year 2003. In terms of dollars, Cat 88 is the largest catastrophe loss event in State Auto history. The second most costly catastrophe loss event occurred in the second quarter of 2002, from a widespread series of storms that included a tornado in the community of La Plata, Maryland ("CAT 61"). Claims resulting from CAT 61 totaled $27.5 million or 3.1 GAAP loss and LAE points for the year 2002. As discussed below, each of the Company's insurance operating segments was impacted by these catastrophe losses.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED - --------------------------------------------------------------------------------
The following table summarizes the consolidated GAAP loss and LAE ratio by line of business for the years ended December 31, 2003 and 2002, respectively. The Standard results reflect the combined State Auto and Meridian standard segments:
The State Auto standard segment's GAAP loss and LAE ratio improved 3.3 points in 2003 from 2002, despite being impacted by the record level catastrophe losses described above. For the years 2003 and 2002, catastrophe losses represent 7.3 and 5.7 points, respectively, of which Cat 88 accounted for 4.4 points of the 2003 total catastrophe points and Cat 61 accounted for 3.1 points of the 2002 total catastrophe points. Absent the impact of catastrophe losses, this segment's GAAP loss and LAE ratio improved 4.9 points in 2003 from 2002. This improvement reflects the Company's continual emphasis on strict underwriting, which includes taking necessary and appropriate rate increases across most lines of business.
The State Auto nonstandard segment's GAAP loss and LAE ratio improved 2.2 points in 2003 to 75.6 from 77.8 in 2002 (see the Consolidated GAAP loss and LAE ratio table above, nonstandard auto line). The 2003 and 2002 catastrophe losses represent 1.4 points and 0.8 point, respectively, of the foregoing GAAP loss and LAE ratio. Absent the impact of catastrophe losses, this segment's GAAP loss and LAE ratio improved 2.8 points in 2003 from 2002. This improvement was primarily driven by significant underwriting action and rate level improvement on the former Meridian nonstandard segment private passenger auto book of business. Management implemented corrective rate increases on the business that continued to renew on the Meridian systems platform. In addition, all new nonstandard private passenger auto business produced by the former Meridian Mutual agents is now written through the SA National system platform utilizing a more appropriate rating structure as well as credit scoring (as permitted by local law) and "point-of-sale" underwriting tools. Management continually monitors this segment's underwriting performance, as it is typically a more volatile line of business than the standard segment, paying particular attention to rate adequacy and risk selection in states and agencies with unusually high premium written growth. Kentucky, this segment's largest state of operation, had experienced significant written premium growth over the last year, but with unacceptable underwriting results. The Company has terminated or suspended eleven fast growing, but extremely unprofitable, nonstandard auto oriented agencies in Kentucky. While this action adversely affected this segment's premium growth, it is expected to improve long term underwriting results.
The following table summarizes the Meridian standard segment GAAP loss and LAE ratio by line of business for the years ended December 31, 2003 and 2002, respectively:
The Meridian standard segment's GAAP loss and LAE ratio improved 9.5 points in 2003 from 2002, despite also being impacted by the catastrophe losses described above. For 2003 and 2002, catastrophe losses represent 7.6 and 7.0 points, respectively, of which Cat 88 accounted for 4.5 points and Cat 61 4.0 points of the 2003 and 2002 total catastrophe points, respectively. Absent the impact of catastrophe losses, this segment's GAAP loss and LAE ratio improved 10.1 points in 2003 from 2002.
segment reporting, beginning with the first quarter of 2004, the Meridian standard business will be included in the State Auto standard segment.
Consolidated earned premiums increased by $341.4 million (61.5%) in 2002. This increase was the result of the addition of the former Meridian Mutual business to the Pooling Arrangement, effective July 1, 2001, a change in the Pooled Subsidiaries' aggregate pooling participation percentage from 53% to 80%, effective October 1, 2001 and total net internal growth of 16.3%. The addition of the former Meridian Mutual business and the pooling change increased consolidated earned premiums 45.2%. The internal growth of the State Auto standard segment's earned premiums increased consolidated earned premiums 15.1%. This increase was driven by growth in commercial lines of business due to a combination of rate changes as well as increased policy counts. Personal lines of business continued to experience sales increases over prior year due to changes in the marketplace that permitted rate increases, as well as the expansion of the new personal lines sales specialist position that contributed to increased policy counts. The internal growth of the State Auto nonstandard segment earned premiums increased consolidated earned premiums 5.4% due to a combination of rate changes and increased policy counts.
Net investment income increased by $12.3 million (26.0%) in 2002. Contributing to the increase over the previous year was an increase in invested assets due to a transfer of $354.6 million in cash and fixed maturity securities from Mutual to the Pooled Subsidiaries in the second half of 2001. This transfer was made in conjunction with the changes made to the Pooled Subsidiaries participation in the Pooling Arrangement, as more fully described above. Total cost of invested assets at December 31, 2002 and 2001, was $1,303.0 million and $1,150.3 million, respectively. Reflecting a decline in the interest rate environment, the investment yields, based on cash equivalents, fixed and equity securities at cost were 4.9% and 5.4% for the annual periods ending 2002 and 2001, respectively. See further discussion regarding investments at the "Liquidity and Capital Resources," "Investments" and "Market Risk" sections, included herein.
Management services income, including investment management fees, decreased by $12.9 million (83.1%) in 2002. This decrease was attributable to the termination of the fee element of the 2000 Management Agreement. The service fee under the 2000 Management Agreement paid by Mutual in 2001 was $12.5 million.
Representing approximately 42% of this segment's business, personal automobile has over the last five years yielded loss results better than industry average, and in fact, has produced combined ratios of less than 100.0%. While the current year results are expected again to better industry average, this line of business did experience deterioration in its current year loss ratio, specifically within the auto liability and no fault lines, which management believes is due at least in part to increasing rates of inflation applicable to the health care sector of the U.S. economy and an increased volume of new business, as noted above. Adverse loss results on workers' compensation, commercial multi peril and other liability lines of business, which collectively represents approximately 18.2% of this segment's business, also contributed to the current year loss result increase. The Company is taking substantial and necessary rate increases in rate per exposure across these lines of business. Workers' compensation continues to be one of the most volatile lines that the Company provides, and for this reason the Company has always maintained a particularly conservative posture on pricing in this line.
At December 31, 2003, the Company's reportable segments are: State Auto standard insurance, State Auto nonstandard insurance, Meridian standard insurance, and investment management services. Due to the integration efforts by management, along with this segment no longer meeting the quantitative thresholds for segment reporting within the Meridian nonstandard business, beginning with the first quarter of 2003, the Meridian nonstandard business was included in the State Auto nonstandard segment. The 2002 and 2001 disclosures have been revised to reflect this change. Likewise, the Meridian standard business, beginning with the first quarter of 2004, will be included in the State Auto standard segment. The profits (losses) of these segments are monitored by management on an unconsolidated basis, as reflected in footnote 15, Reportable Segments, in the Company's consolidated financial statements and therefore do not reflect adjustments for transactions with other segments or realized gains or losses on sales of investments.
The following table reflects segment profit (loss) for the years ended 2003, 2002, and 2001, respectively:
The increase in the Company's 2003 profits within the State Auto standard and nonstandard insurance segments is primarily due to an improvement in these segments' current year loss experience as discussed at "2003 Compared to 2002" in "Results of Operations." The improved loss experience in 2003 in these segments reflects the Company's continual emphasis on strict underwriting, which includes taking necessary and appropriate rate increases. The decrease in the Company's 2002 profit within the State Auto standard insurance segment is primarily due to an increase in this segment's loss experience as discussed at "2002 Compared to 2001" in "Results of Operations." For the State Auto nonstandard insurance segment in 2002, increased earned premium growth, as well as an increase in the net investment income, despite deterioration in its loss results, contributed positively to this segment's profit. As discussed above, management continually monitors these segments' premium rate adequacy and seeks adequate cost-based rates.
The Company's 2003 profit within the Meridian standard insurance segment is due to an improvement in this segment's current year loss experience as discussed at "2003 Compared to 2002" in "Results of Operations." The improved loss experience in 2003 in this segment is evidence of the Company's successful integration efforts that began in 2001 to obtain adequate cost based rates, re-underwrite the business within State Auto underwriting guidelines and terminate unprofitable programs. Comparison of the Meridian standard segment profit (loss) results of 2002 with that of 2001 was affected by the reserve strengthening that occurred during the second half of 2001.
The increase in segment profit of the investment management segment in 2003, 2002 and 2001 was the result of this segment providing its services to the Meridian Insurers beginning June 1, 2001 and the continued investment portfolio fair
value growth of the State Auto Group. This segment's revenue is based on the average fair value of the portfolio of the companies managed. During these years, the investment management segment profit increased as managed invested assets increased.
During 2003, as permitted by IRS Regulations, the Company contributed $4.6 million in cash to the Company's Plan on behalf of its employees. This is the first year since 1997 that management has been permitted under applicable rules to make a tax deductible contribution to the Plan. During the years when the Company was permitted to make plan contributions, it was the practice of management to contribute the maximum possible as permitted under IRS Regulations. This historic practice faired well for the Company in the past several years, as many companies with defined benefit plans experienced additional minimum liability recognition. In 2004 it is expected the Company will be impacted for the first time in years by a net periodic cost within the Plan of approximately $1.5 million. While management acknowledges that the net periodic benefit the Company recognized in recent years has not been at the levels it experienced in the late 1990s through 2002, it has not impacted the profitability of the Company. As the Company continues to be permitted to make contributions, it is management's intent to make the maximum contribution to the Plan for the benefit of its employees. For 2004, it is estimated that the maximum Plan contribution will again be approximately $4.0 million.
Impacting cash provided by financing activities during 2003, 2002 and 2001 was State Auto Financial's Board of Directors' approving plans to repurchase shares of its common stock from the public. In March 2002, the Board of Directors of State Auto Financial approved a plan to repurchase up to 1.0 million shares of its common stock from the public over a period extending to December 31, 2003. During 2003 and 2002, the Company repurchased 45,000 and 393,000 shares from the public for a total of $729,000 and $6.3 million, respectively. Impacting cash used in financing activities during 2001 was a 2000 stock repurchase plan approved to purchase up to 1.0 million of State Auto Financial's common stock from the public ending December 31, 2001 (the "2000 Repurchase Plan"). In 2001, the Company repurchased approximately 25,000 shares from the public for a total of $388,000.
On May 22, 2003, STFC Capital Trust I, State Auto Financial's Delaware business trust subsidiary, issued $15.0 million liquidation amount of its capital securities to a third party. In connection with the Capital Trust's issuance of the capital securities and the related purchase by State Auto Financial of all of the Capital Trust's common securities (liquidation amount of $464,000) (the Capital Trust's capital and common securities are hereafter referred to as the "Trust Securities"), State Auto Financial issued to the Capital Trust $15.5 million aggregate principal amount of Floating Rate Junior Subordinated Debt Securities due 2033 (the "Subordinated Debentures"). The sole assets of the Capital Trust are the Subordinated Debentures and any interest accrued thereon. Interest on the Trust Securities is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly (5.34% for the period August 24, 2003 through November 23, 2003, adjusted to 4.63% for the period November 24, 2003 through February 23, 2004). Prior to May 2008, the interest rate may not exceed 12.5% per annum. The interest rate and interest payment dates on the Subordinated Debentures are the same as the interest rate and interest payment dates on the Trust Securities. In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities, effective for reporting periods beginning after June 15, 2003. As a result of the Company's adopting FIN 46 effective July 1, 2003, the financial statements of the Capital Trust are no longer consolidated within the accompanying financial statements of the Company. See additional discussion below included in New Accounting Standards.
On November 13, 2003, State Auto Financial issued $100.0 million unsecured senior notes bearing interest fixed at 6.25% due November 15, 2013. Interest on the notes is payable May 15 and November 15 of each year beginning May 15, 2004. The notes are general unsecured obligations ranking senior to all existing and future subordinated indebtedness and equal with all existing and future senior indebtedness. The notes are not guaranteed by any of the State Auto Financial subsidiaries and thereby are effectively subordinated to all State Auto Financial subsidiaries' existing and future indebtedness. State Auto Financial may redeem the notes in whole at anytime or in part from time to time at State Auto Financial's option, on at least 30 but not more than 60 days' prior written notice, at a redemption price equal to the greater of the principal amount of such notes being redeemed on the redemption date or the make whole amount, based on U.S. Treasury rates as defined by the note, plus in each case, accrued and unpaid interest, if any, on the notes to the redemption date. The notes issued contain certain covenants as defined in the notes, which among other things, limit State Auto Financial and its subsidiaries' ability to issue indebtedness secured by the capital stock of certain State Auto Financial subsidiaries and sell the capital stock of certain State Auto Financial subsidiaries. The notes also contain a covenant that requires State Auto Financial to take certain actions in the event it engages in mergers, consolidations or sales of all or substantially all of the assets and prohibits it from engaging in such transaction if State Auto Financial is in default under the notes. State Auto Financial incurred approximately $1.5 million in issuance cost related to the senior notes.
On November 6, 2003 State Auto Financial entered into an interest rate swap contract for a notional amount of $50.0 million, receiving semiannual payments at a fixed rate of 6.25% and making semiannual payments at a variable rate equal to six month LIBOR plus 1.25 percent with LIBOR to be determined the last day of each interest reset period (total 2.47% at December 31, 2003). The swap contract was designated as a fair value hedge to protect against changes in fair value of the senior notes. At December 31, 2003 the fair market value of the fixed to floating interest rate swap was $485,000 of which $229,000 related to net accrued interest to be received and reduced reported interest expense in the period.
In the case of SA National and Mid-Plains, both nonstandard auto insurers that write lines of business that are generally short tail in nature and with generally lower amounts of coverage applicable, there is relatively less loss exposure to the premium than is generally the case with other lines of business that are written for higher limits and for which losses develop over long periods of time, such as workers' compensation or other liability. In sum, a higher premium to surplus ratio with a non standard auto insurer is not necessarily indicative of dangerous financial conditions as might be the case with another type insurer.
(1) The Company uses the statutory leverage ratio as there is no comparable GAAP measure. This ratio measures the company's statutory surplus available to absorb losses.
The maximum amount of dividends that may be paid to State Auto Financial during 2004 by its insurance subsidiaries without prior approval under current law is limited to $52.7 million. The Company is required to notify the insurance subsidiaries' respective State Insurance Commissioner within five business days after declaration of all such dividends and at least ten days prior to payment. Additionally, the domiciliary Commissioner of each insurer subsidiary has the authority to limit a dividend when the Commissioner determines, based on factors set forth in the law, that an insurer's surplus is not reasonable in relation to the insurer's outstanding liabilities and adequate to its financial needs. Such restrictions are not expected to limit the capacity of State Auto Financial to meet its cash obligations.
State Auto P&C assumes catastrophe reinsurance from the State Auto Group, in exchange for a premium paid by each reinsured company, in the amount of $100.0 million excess of $120.0 million to reduce their loss exposure per catastrophe. This layer of $100.0 million in excess of $120.0 million has been excluded from the Pooling Arrangement. There have been no losses assumed under this agreement.
To provide funding if the State Auto Group was to incur catastrophe losses in excess of $120.0 million, State Auto Financial has continued a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the "Lenders") to provide up to $100.0 million for reinsurance purposes. In the event of such a loss, this arrangement provides that State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company ("SPC"), which would borrow the money necessary for such purchase from the Lenders. State Auto Financial would then contribute to State Auto P&C the funds received from the sale of its preferred shares, thereby
Stateco performs investment management services, which comprises the investment management services segment, on behalf of the Company and Mutual and its subsidiaries. The Investment Committee of each insurer's Board of Directors sets investment policies to be followed by Stateco.
The primary investment objectives of the Company are to generate income, preserve capital and maintain adequate liquidity for the payment of claims. Fixed maturity securities are categorized as available for sale and are carried at fair value. At December 31, 2003, the Company had no fixed maturity investments rated below investment grade, nor any mortgage loans.
(1) As rated by Moody's Investors Service - -------------------------------- Despite the volatility in the equity market during 2003, the Company continued its direction of moderately increasing its equity portfolio investments to enhance growth of statutory surplus over the long term. Gains and losses on the sale of equity securities are computed using the first-in, first-out method. The Company's current investment strategy does not rely on the use of derivative financial instruments.
At December 31, 2003 all investments in fixed maturity and equity securities were held as available for sale and therefore are carried at fair value. Other invested assets are comprised of limited liability partnership and other investments that are carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity as "accumulated other comprehensive income" and as such are not included in the determination of net income. Effective December 31, 2002, the Company transferred all of its investments previously classified as held to maturity to the available for sale category to align the investment portfolio with management's investment policy. For fixed maturities classified as held to maturity, unrealized holding gains or losses were not reflected in the accompanying consolidated financial statements; rather they were carried at amortized cost. Upon transfer of the held to maturity investments to available for sale at December 31, 2002, the held to maturity investments' amortized cost, fair value and net unrealized gain were $19.1 million, $20.4 million and $1.3 million, respectively. Other comprehensive income of $0.8 million, net of $0.5 million deferred taxes, was recognized upon transfer.
The following table provides the composition of the Company's investment portfolio at December 31, 2003 and 2002, respectively:
During 2003 the Company recognized realized losses of $289,000 related to other than temporary impairments. The Company reviewed its investments at December 31, 2003, and determined no additional other than temporary impairment exists in the gross unrealized holding losses, as provided in the table below, due to the evidence that exists indicating temporary impairment. At December 31, 2003, there were no investments reflected in the table below with an unrealized holding loss that had a fair value significantly below cost continually for more than one year. There are no individually material securities with an unrealized holding loss at December 31, 2003.
The securities sold during 2003 and 2002, were sold to either recognize the gain available, to dispose of the security because of the Company's opportunity to invest in securities with greater potential return considering capital preservation, or to reposition the taxable/tax-exempt fixed maturity position of the Company.
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. At December 31, 2003, the Company's fixed maturity portfolio had an average maturity of 9.5 years. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 5.0% of statutory assets, other than obligations of the U.S. government or government agencies, for which there is no limit. As indicated in the table above, the fixed maturity portfolio is of high quality with all holdings in either Government obligations, municipal, or corporate obligations. The Company does not intend to change its investment policy on the quality of its fixed maturity investments. Investments in equity securities are selected based on their potential for appreciation as well as ability to continue paying dividends. Additional information regarding the composition of investments, along with maturity schedules regarding investments in fixed maturities at December 31, 2003, is presented in tabular form above.
The Company's total investments at fair value grew approximately 23% during 2003 to $1,570.3 million at December 31, 2003 from $1,272.3 million at December 31, 2002. This growth was generated primarily from cash flow provided by operations and financing, and an increase in the unrealized gains on equity securities partly offset by a decrease in the unrealized gain on fixed maturity securities.
At December 31, 2003, the Company's notes payable and hedge are summarized as follows:
(1) ALAE are those costs that can be related to a specific claim, which may include attorney fees, external claims adjusters, and investigation costs, among others. ULAE are those costs incurred in settling claims, such as in-house processing costs, for which no identification can be made to specific claims. ALAE and ULAE comprise the loss expense portion of the total loss and loss expenses payable.
The following table presents the loss and loss expenses payable by major line of business at December 31, 2003 and 2002, respectively:
Total net losses and loss expenses payable increased 6.2% at December 31, 2003 from 2002 which is consistent with the total earned premium increase of 7.1% during 2003 from 2002. Specifically, 2002 was a growth year for both written premium, along with exposure count, within the commercial lines of business. With this increased growth, the Company experienced more loss activity in 2003 which resulted in commensurate reserve growth throughout 2003. The current year development of the prior years' ultimate liability does not reflect any changes in the Company's fundamental claims reserving practices.
In management's opinion, the 0.30% current year development, given the breakdown by accident year, is well within normal expectations for reserve development and claim settlement uncertainty.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"), which requires the consolidation of certain entities considered to be variable interest entities ("VIEs"). An entity is considered to be
The Company is also affected by court decisions. Premium rates are actuarially determined to enable an insurance company to generate an underwriting profit. These rates contemplate a certain level of risk. The courts may modify, in a number of ways, the level of risk which insurers had expected to assume including eliminating exclusions, multiplying limits of coverage, creating rights for policyholders not intended to be included in the contract and interpreting applicable statutes expansively to create obligations on insurers not originally considered when the statute was passed. Courts have also undone legal reforms passed by legislatures, which reforms were intended to reduce a litigant's rights of action or amounts recoverable and so reduce the costs borne by the insurance mechanism. These court decisions can adversely affect an insurer's profitability. They also create pressure on rates charged for coverages adversely affected and this can cause a legislative response resulting in rate suppression that can adversely affect an insurer. The Company may also be adversely affected by regulatory actions on matters within the jurisdiction of the various insurance departments where the Company does business or has entities domiciled.
After credit scoring, the industry's use of which has been limited to varying extents by certain states' laws, the next most predictive underwriting report available to insurers is previous loss information. Third party vendors obtain loss information from insurers based on the insured, the vehicle and/or the property location. As insurers write new business the database is accessed to analyze any loss experience of the insured, vehicle and/or property location. Many times insurer's premium rates will be adjusted to reflect the loss experience accessed from these databases. In some cases the overall acceptability of the insured's application in the standard market may be determined by these reports. During 2002 and 2003, use of this loss information database product by the insurance industry as a predictive underwriting tool has been challenged by several west coast states and most recently in a few of the Company's states of operation. While it is too soon to determine states' reaction to the utilization of these database systems, any restrictive regulation of the full use of these
underwriting reports could have an adverse impact on the Company as it has utilized these database systems for several years as an underwriting tool. Since such regulation is applicable to all companies writing business which utilize these reports, the Company does not expect to suffer a competitive disadvantage.
As discussed above, there was particular emphasis throughout 2003, 2002 and 2001 on improving the former Meridian Mutual book of business. The Company believes its underwriting and pricing discipline, as well as its commitment to delivering its products as effectively and efficiently as possible, have been key factors in the Company's underwriting results over the last several years. The Company remains active in the personal and commercial markets, developing new products to enhance its product portfolio; appointing new agents in its operating territories; and refining its pricing levels for the markets and lines of business the Company believes offer the most profit potential.
- The Company maintains loss reserves to cover its estimated ultimate unpaid liability for losses and loss expenses with respect to reported and unreported claims incurred as of the end of each accounting period. Reserves do not represent an exact calculation of liability, but instead represent estimates, generally using actuarial projection techniques at a given accounting date. The Company refines reserve estimates in a regular ongoing process as historical loss experience develops and additional claims are reported and settled. The Company records adjustments to reserves in the results of operations for the periods in which the estimates are changed. Because establishing reserves is an inherently uncertain process involving estimates, currently established reserves may not be adequate. If the Company concludes that estimates are incorrect and reserves are inadequate, the Company is obligated to increase its reserves. An increase in reserves results in an increase in losses and a reduction in the Company's net income for the period in which the deficiency in reserves is identified. Accordingly, an increase in reserves could have a material adverse effect on the Company's results of operations, liquidity, and financial condition.
- The Company's insurance operations expose it to claims arising out of catastrophic events. The Company has experienced, and will in the future experience, catastrophe losses that may cause substantial volatility in the Company's financial results for any fiscal quarter or year and could materially reduce the Company's profitability or harm the Company's financial condition. Catastrophes can be caused by various natural events, including hurricanes, hailstorms, windstorms, earthquakes, explosions, severe winter weather, and fires, none of which are within the Company's control. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. The geographic distribution of the Company's business subjects it to catastrophe exposure from hailstorms and earthquakes in the Midwest as well as catastrophe exposure from hurricanes in Florida and the Gulf Coast, southern coastal states, and Mid-Atlantic regions. Catastrophe losses can vary widely and could significantly exceed the Company's recent historic results. The frequency and severity of catastrophes are inherently unpredictable.
- Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate financial stability and a strong ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors that they believe are relevant to policyholders. Ratings are important to maintaining public confidence in the Company and in its ability to market its products. A downgrade in the Company's financial strength ratings could, among other things, negatively affect the Company's ability to sell certain insurance products, the Company's relationships with agents, new sales, and the Company's ability to compete.
- The Company markets its insurance products through independent, non-exclusive insurance agents, whereas some of the Company's competitors sell their insurance products through insurance agents who sell products exclusively for one insurance company. If the Company is unsuccessful in attracting and retaining productive agents to sell the Company's insurance products, the Company's sales and results of operations could be adversely affected. The agents that market and sell the Company's products also sell the Company's competitors' products. These agents may recommend the Company's competitors' products over the Company's products or may stop selling the Company's products altogether. Additionally, the Company competes with the Company's competitors for productive agents, primarily on the basis of the Company's financial position, support services and compensation and product features.
- The laws of the various states establish insurance departments with broad regulatory powers relative to approving intercompany arrangements, such as management, pooling, and investment management agreements, granting and revoking licenses to transact business, regulating trade practices, licensing agents, approving policy forms, setting reserve requirements, determining the form and content of required statutory financial statements, prescribing the types and amount of investments permitted and requiring minimum levels of statutory capital and surplus. In addition, although premium rate regulation varies among states and lines of insurance, such regulations generally require approval of the regulatory authority prior to any changes in rates. Furthermore, all of the states in which the State Auto Group transacts business have enacted laws which restrict these companies' underwriting discretion. Examples of these laws include restrictions on agency terminations and laws requiring companies to accept any applicant for automobile insurance and laws regulating underwriting "tools." These laws may adversely affect the ability of the insurers in the State Auto Group to earn a profit on their underwriting operations.
- The Company is subject to numerous other factors which affects its operations, including, without limitation, the development of new insurance products, geographic spread of risk, fluctuations of securities markets, economic conditions, technological difficulties and advancements, availability of labor and materials in storm hit areas, late reported claims, previously undisclosed damage, utilities and financial institution disruptions, and shortages of technical and professional employees and unexpected challenges to the control of the Company by Mutual.
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedules listed in the Index at Item 15(a)(2). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
State Auto Financial, an Ohio corporation, is a majority-owned subsidiary of State Automobile Mutual Insurance Company (Mutual), an Ohio corporation. State Auto Financial and subsidiaries are referred to herein as the "Companies" or the "Company." All significant intercompany balances and transactions have been eliminated in consolidation.
The Company, through State Auto P&C, Milbank, Farmers and SA Ohio, provides standard personal and commercial insurance to its policyholders. The Company's principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. SA National and Mid-Plains provide nonstandard automobile insurance. State Auto P&C, Milbank, Farmers, SA Ohio, SA National, and Mid-Plains operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, through an independent insurance agency system. State Auto P&C, Milbank, Farmers, SA Ohio, SA National and Mid-Plains are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota, Iowa, Ohio (SA Ohio and SA National) and Iowa, respectively, and are licensed in various other states. As such, they are subject to the regulations of the applicable Departments of Insurance of their respective states of domicile (the Departments) and the regulations of each state in which they operate. These property and casualty insurance companies undergo periodic financial examination by the Departments and insurance regulatory agencies of the states that choose to participate.
Losses and loss expenses payable are based on formula and case-basis estimates for reported claims, and on estimates, based on experience and perceived trends, for unreported claims and loss expenses. The liability for unpaid losses and loss expenses, net of estimated salvage and subrogation recoverable of $26.8 million and $27.1 million at December 31, 2003 and 2002, 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. As such, losses and loss expenses payable represent management's best estimate of the ultimate liability related to reported and unreported claims.
Separate presentation of the accumulated balance of other comprehensive income within the equity section of the statement of financial position is also required. The Company has presented the required displays of total comprehensive income and its components, within the "Consolidated Statements of Stockholders' Equity." See additional disclosures at note 14.
As part of the Company's management of its exposure to fluctuations in interest rates, during 2003 the Company entered into interest rate swap agreements in connection with the issuance of its $100 million 6.25% senior notes. The interest rate swap agreements are the only derivative contracts to which the Company is party and are accounted for in accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended. This Statement requires all derivatives to be recorded at fair value on the consolidated balance sheet.
Changes in fair value of derivatives designated as cash flow hedges, to the extent effective, are recorded in net unrealized gains/losses on derivatives, a separate component of accumulated other comprehensive income. Amounts are reclassified to earnings from accumulated other comprehensive income when the underlying hedged item impacts earnings. Changes in fair value of derivatives designated as fair value hedges are recorded currently in earnings to the extent the derivative was effective in offsetting changes in fair value of the hedged item.
In December 2002, the FASB issued SFAS Statement No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS Statement No. 123 Accounting for Stock-Based Compensation. This Statement AR-7
See footnote 1(e) regarding investments. The Company's investments are summarized as follows:
Management concluded that none of the above unrealized losses are other than temporary. The process to support this conclusion requires management to make material estimates. See footnote 1(c) regarding material estimates. Management believes the above fixed maturity and equity securities unrealized losses are not other than temporary as the Company has the ability and intent to hold the investments for a period of time sufficient for a forecasted market price recovery up to or beyond the cost of the investment. Also, in management's opinion, evidence indicating the cost of the investment is recoverable within a reasonable period of time outweighs evidence to the contrary in considering the severity and duration of the impairment in relation to the forecasted market price recovery.
The amortized cost and fair value of fixed maturities at December 31, 2003, by contractual maturity, are summarized as follows:
The Company's current investment strategy does not rely on the use of derivative financial instruments. See note 3 for additional fair value disclosures.
INVESTMENT SECURITIES: Fair values for investments in fixed maturities are based on quoted market prices, where available. For fixed maturities not actively traded, fair values are estimated using values obtained from independent pricing services. The fair values for equity securities are based on quoted market prices. The fair value of other invested assets is based on equity or cash flow, as applicable. The investment securities fair value adjustments are recorded in the consolidated financial statements.
NOTES PAYABLE AND INTEREST SWAP: The Mutual note and Trust Preferred note (each as defined below) carrying amounts reported in the consolidated balance sheets for these instruments approximate their fair value as the interest rates adjust annually and quarterly, respectively. The $100.0 million, 6.25% senior notes have a fair value at December 31, 2003 of $100.5 million. The financial statements reflect a $256,000 fair value adjustment to the 6.25% senior notes which pertains to the hedged principal amount of $50.0 million. The interest rate swap has a $485,000 ($256,000 related to debt and $229,000 related to accrued interest) fair value at December 31, 2003. The financial statements reflect the fair value adjustments related to the interest rate swap.
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. The Company has reported ceded losses and loss expenses payable and prepaid reinsurance premiums with other insurers and reinsurers as assets. All reinsurance contracts provide indemnification against loss or liability relating to insurance risk and have been accounted for as reinsurance.
Effective January 1, 2003, the Pooling Arrangement was amended, adding SA Florida as a participant. At December 31, 2002, SA Florida had not commenced insurance operations, consequently, there was no impact on the Company's financial statements at January 1, 2003 relating to the Pooling Arrangement amendment. The STFC Pooled Companies share of the Pool remained at 80% during the years 2003 and 2002.
In 2000, Mutual entered into an agreement with Meridian Mutual Insurance Company (Meridian Mutual), an Indiana domiciled property and casualty insurance company, pursuant to which Meridian Mutual would be merged with and into Mutual, with Mutual continuing as the surviving corporation. The effective date of the merger transaction was June 1, 2001. With the merging of Meridian Mutual into Mutual, all insurance business that had been written by Meridian Mutual became, legally, Mutual business. For the period June 1, 2001 through June 30, 2001, the insurance business formerly known as the Meridian Mutual business prior to the June 1 merger transaction was excluded from the Pooling Arrangement. Effective July 1, 2001, the insurance business of the former Meridian Mutual became part of the Pooling Arrangement, and the STFC Pooled Companies assumed 53% of the former Meridian Mutual business on this same date. Concurrently, with this transaction, the STFC Pooled Companies received cash of $6.4 million and fixed maturities totaling $109.7 million from Mutual which related to the additional net insurance liabilities assumed by the STFC Pooled Companies on July 1, 2001. As part of the resolution of the disagreement with the Ohio Department of Insurance (ODI) regarding the recognition of the service fee revenue paid by Mutual to State Auto P&C (see note 6(d)), the STFC Pooled Companies aggregate participation in the Pooling Arrangement was increased to 80%, effective October 1, 2001. In conjunction with this change in pool participation, the STFC Pooled Companies received cash of $2.2 million and fixed maturities totaling $236.3 million from Mutual, which related to the additional net insurance liabilities assumed on October 1, 2001. All parties that participate in the Pooling Arrangement have an A. M. Best rating of A+ (Superior).
The Pooling Arrangement does not relieve each individual pooled subsidiary of its primary liability as the originating insurer, consequently, there is a concentration of credit risk arising from business ceded to Mutual. As the Pooling Arrangement provides for the right of offset, the Company has reported losses and loss expenses payable and prepaid reinsurance premiums to Mutual as assets only in situations when net amounts ceded to Mutual exceed that assumed. The following provides a summary of the reinsurance transactions on the Company's balance sheets and income statements for the Pooling Arrangement between the STFC Pooled Companies and Mutual:
State Auto P&C assumes catastrophe reinsurance from the State Auto Group in the amount of $100 million excess of $120 million in exchange for a premium paid by each reinsured company. Under this agreement, the Company has assumed from Mutual and its affiliates premiums written and earned of $2.8 million, $2.9 million and $3.0 million for 2003, 2002 and 2001, respectively. There have been no losses assumed under this agreement. The catastrophe reinsurance program with State Auto P&C has been excluded from the Pooling Arrangement.
arrangement with the Lenders, SPC and State Auto Financial is a financing arrangement, whereby State Auto Financial would receive cash funding in the event of a catastrophe event as described above. State Auto Financial would then contribute to State Auto P&C the funds received from the sale of its preferred shares. State Auto P&C would use the contributed capital proceeds to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC by redeeming the preferred shares over a five-year period. In the event of a default by State Auto Financial, the obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to either purchase the preferred shares from the SPC or repay the SPC for the loan(s) outstanding.
For the period October 1, 2001 through December 31, 2003, Mutual entered into a stop loss reinsurance arrangement (Stop Loss) with the STFC Pooled Companies. Under the Stop Loss, Mutual have agreed to participate in the Pooling Arrangement's quarterly underwriting losses and gains in the manner described. If the Pooling Arrangement's statutory loss and loss adjustment expense ratio (loss ratio) was between 70.75% and 80% (after the application of all available reinsurance), Mutual reinsured the STFC Pooled Companies 27% of the Pooling Arrangement's losses in excess of a loss ratio of 70.75% up to 80.00%. The STFC Pooled Companies were responsible for their share of the Pooling Arrangement's losses over the 80% threshold. Also, Mutual had the right to participate in the profits of the Pooling Arrangement. Mutual assumed 27% of the Pooling Arrangement's underwriting profits attributable to loss ratios less than 69.25%, but more than 59.99%. During 2003, 2002 and 2001, the STFC Pooled Companies ceded to Mutual, $5.6 million, $8.8 million and $6.2 million in losses, respectively, and $12.8 million, $1.4 million and $0, respectively, in premiums under the Stop Loss. The Stop Loss ceased at December 31, 2003.
SA National and Mid-Plains each have ceding reinsurance agreements with Mutual that include excess of loss and quota share coverages. Through Mutual's participation in the Pooling Arrangement, the effects of these agreements with SA National and Mid-Plains are indirectly subject to the Pooling Arrangement between Mutual and the STFC Pooled Companies.
In 1999 State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million in conjunction with its stock repurchase program. Principal payment is due on demand by December 31, 2005. The interest rate is adjustable annually at January 1 to reflect adjustments in the then current prime lending rate less 1.75% as well as State Auto Financial's current financial position. Interest rate for the years 2003, 2002 and 2001 was 2.50%, 3.00% and 7.75%, respectively. Interest rate for the year 2004 is 2.25%.
Total affiliates interest expense was $2.8 million, $2.3 million and $2.3 million in 2003, 2002 and 2001, respectively. Total interest expense paid to affiliates was $2.8 million, $2.2 million and 2.3 million in 2003, 2002 and 2001, respectively. See discussion of notes payable (non-affiliate) and hedges at Note 7.
State Auto P&C provides management and operation services to Mutual and its insurance affiliates. Revenue relating to these services amounted to $1.1 million, $553,000 and $12.6 million in 2003, 2002 and 2001, respectively. During early 2001, the ODI requested that Mutual file an analysis with the ODI on a quarterly basis, starting with the quarter beginning January 1, 2001, that justified the apportionment of the management and operation services fee paid by Mutual to State Auto P&C under the accounting guidance outlined in Statement of Statutory Accounting Principles No. 70 - Allocation of Expenses. The Company believed its accounting for such service fee was consistent with all statutory accounting principles. On October 24, 2001, the Board of Directors of the Company and Mutual and special committees thereof approved a resolution of the disagreement between the Company and the ODI regarding the service fee paid by Mutual to State Auto P&C. The disagreement with ODI was resolved, and ODI expressly did not take issue with Mutual's payment of the service fee to State Auto P&C for the nine-month period ending September 30, 2001 which amounted to $12.5 million, pre-tax, nor with Mutual's accounting for the service fee for this same time period. The ODI also approved regulatory filings, effective October 1, 2001, implementing a revised management agreement, changing the STFC Pooled Companies pooling participation percentages and implementing a stop loss reinsurance arrangement. See note 6(a) regarding the change in the STFC Pooled Companies pooling participation percentages and the implementation of a stop loss reinsurance arrangement.
Effective October 1, 2001, the management agreement between State Auto P&C and certain affiliate companies, including Mutual, was amended to eliminate the management and operations service fee charged by State Auto P&C. The management agreement continues to allocate costs and apportion those costs among the parties to the agreement in accordance with terms outlined therein. As a result of the loss of the management and operations services income under this management agreement, a substantial portion of State Auto P&C's services income has been eliminated, effective October 1, 2001.
State Auto P&C's December 31, 1990 liability for losses and loss expenses of $65.5 million 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 in conformance with pooling percentages in place at that time. As of December 31, 2003, there has been no adverse development of the liability.
On May 22, 2003, STFC Capital Trust I, State Auto Financial's Delaware business trust subsidiary (the "Capital Trust"), issued $15.0 million liquidation amount of its capital securities to a third party. In connection with the Capital Trust's issuance of the capital securities and the related purchase by State Auto Financial of all of the Capital Trust's common securities (liquidation amount of $464,000 included in other invested assets) (the Capital Trust's capital and common securities are hereafter referred to as the "Trust Securities"), State Auto Financial issued to the Capital Trust $15.5 million aggregate principal amount of Floating Rate Junior Subordinated Debt Securities due 2033 (the "Subordinated Debentures"). The sole assets of the Capital Trust are the Subordinated Debentures and any interest accrued thereon. Interest on the Trust Securities is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly (total 5.37% at December 31, 2003). Prior to May 2008, the interest rate may not exceed 12.5% per annum. The interest rate and interest payment dates on the Subordinated Debentures are the same as the interest rate and interest payment dates on the Trust
Securities. In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities, effective for reporting periods beginning after June 15, 2003. As a result of the Company adopting FIN 46 effective July 1, 2003, the financial statements of the Capital Trust are no longer consolidated within the accompanying financial statements of the Company. See additional discussion of new accounting standards at note 1(l).
On November 13, 2003 State Auto Financial issued $100 million unsecured senior notes (Senior Notes) bearing interest fixed at 6.25% due November 15, 2013. Interest on the Senior Notes is payable May 15 and November 15 of each year beginning May 15, 2004. The Senior Notes are general unsecured obligations ranking senior to all existing and future subordinated indebtedness and equal with all existing and future senior indebtedness. The Senior Notes are not guaranteed by any of the Company subsidiaries and thereby are effectively subordinated to all Company subsidiaries existing and future indebtedness. State Auto Financial may redeem the Senior Notes in whole at anytime or in part from time to time at State Auto Financial's option, on at least 30 but not more than 60 days' prior written notice, at a redemption price equal to the greater of the principal amount of such notes being redeemed on the redemption date or the make whole amount, based on U.S. Treasury rates as defined by the Senior Notes, plus in each case, accrued and unpaid interest, if any, on the Senior Notes to the redemption date. The Senior Notes issued contain certain covenants as defined in the notes, which among other things, limit State Auto Financial and its subsidiaries ability to issue indebtedness secured by the capital stock of certain State Auto Financial subsidiaries and sell the capital stock of certain State Auto Financial subsidiaries. The Senior Notes also contain a covenant that requires State Auto Financial to take certain actions in the event it engages in mergers, consolidations or sales of all or substantially all of the assets and prohibits from engaging in such transaction if State Auto Financial is in default under the Senior Notes. State Auto Financial incurred $1.5 million in issuance costs related to the Senior Notes, which is recorded in other assets and is being amortized into interest expense ($14,000 for 2003) as the underlying interest expense is recognized on the Trust Securities.
On November 6, 2003 State Auto Financial entered into an interest rate swap contract for a notional amount of $50.0 million receiving semiannual payments at a fixed rate of 6.25% and making semiannual payments at a variable rate equal to six month LIBOR plus 1.25 percent with LIBOR to be determined the last day of each interest reset period (total 2.47% at December 31, 2003). The swap contract was designated as a fair value hedge to protect against changes in fair value of the Senior Notes. Recorded in other assets at December 31, 2003, the fair market value of the fixed to floating interest rate AR-17
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities are presented below:
Federal income taxes paid during 2003, 2002 and 2001 were $15.9 million, $6.0 million and $11.5 million, respectively.
In addition to the pension benefit plan, the Company provides a postretirement benefit plan including certain health care and life insurance benefits for its eligible retired employees. Substantially all of the Company's employees may become eligible for these postretirement benefits if they retire between age 55 and 65 with 15 years or more of service or if they retire at age 65 or later with 5 years or more of service.
The Company did not adjust its liability for postretirement benefits obligation in consideration of the potential impact of the Medicare Prescription Drug, Improvement and Modernization Act of 2003, since guidance is not final.
Information regarding the Company's pension and postretirement benefit plans components of net periodic benefit cost and weighted average assumptions for the years ended December 31, 2003, 2002 and 2001are as follows:
Summarized in the following table are the weighted average assumptions used to determine the Company benefit obligations for the years ended December 31, 2003 and 2002:
The assumed health care cost trend rates have a significant effect on the amounts reported for the postretirement plan. A one percentage point change in assumed health care cost trend rates would have the following effects:
The Plan's investment policy objective is to preserve the investment principal while generating income and appreciation in fair value to meet the Plans' obligations. The Plans' investment strategy and risk tolerance is balanced between meeting cash obligation requirements and a long term relatively high risk tolerance. Since the nature and timing of the Plans' liabilities and cash requirements are predictable, the liquidity requirements are somewhat moderate. Therefore at least 75% of the Plans' assets should be in public marketable securities. Bond investments will normally range from 10 to 20 years in maturity. Debt instruments, convertible debt and preferred stock are rated "A" or better by two major rating services. The equity portfolio is comprised primarily of large capitalization, high quality stocks with a strong earnings growth and dividends payment history. Total holding of a specific stock cannot exceed 2% of the outstanding stock. No one equity holding can be greater than 5% of the total equity portfolio. Total holdings of bonds and stocks of any one corporation cannot exceed 5% of admitted assets.
All Company and affiliate personnel are employees of State Auto P&C. The Company through State Auto P&C, provides management and operation services under management agreements for all insurance and non-insurance affiliates. The pension net prepaid expense is carried on the financial statements of the Company, and the annual periodic pension benefit or cost is allocated to affiliated companies based on allocations pursuant to intercompany management agreements. The Company's share of the 2003, 2002 and 2001 net periodic benefit was $164,000, $2.0 million and $4.0 million, respectively.
The postretirement net accrued obligation is also carried on the financial statements of the Company and the annual periodic postretirement benefit or cost is allocated to affiliated companies based on allocations pursuant to intercompany management agreements. The Company's share of the 2003, 2002 and 2001 net periodic cost was $7.0 million, $5.6 million and $3.0 million, respectively.
State Auto P&C, Milbank, Farmers, SA Ohio and SA National are subject to regulations and restrictions under which payment of dividends from statutory earned surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Pursuant to these rules, approximately $52.7 million is available for payment to State Auto Financial in 2004 without prior approval.
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.
The Company has an employee stock purchase plan with a dividend reinvestment feature, 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 stock. The purchase price of the stock is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 2.4 million shares of common stock under this plan. At December 31, 2003 and 2002, 2.0 million and 1.9 million shares, respectively, have been purchased under this plan.
A summary of the Company's total stock option activity and related information for these plans for the years ended December 31, 2003, 2002 and 2001, follows:
A summary of information pertaining to the total options outstanding and exercisable as of December 31, 2003 follows:
At December 31, 2003, the Company has four reportable segments: State Auto standard insurance, State Auto nonstandard insurance, Meridian standard insurance and investment management services. The reportable segments are business units managed separately because of the differences in products or service they offer, type of customer they serve or because of management considerations. The State Auto standard, State Auto nonstandard and the Meridian standard insurance segments operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, through an independent insurance agency system.
The State Auto standard insurance segment provides personal and commercial insurance to its policyholders. Its principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. The State Auto nonstandard insurance segment provides personal automobile insurance to policyholders that are typically rejected or canceled by standard insurance carriers because of poor loss experience or a history of late payment of premiums.
The Company evaluates performance of its reportable segments and allocates resources thereon based on profit or loss from operations, excluding net realized gains on investments on the Company's investment portfolio, before federal income taxes. The Company monitors its assets for the insurance segments on a legal entity basis, which for the STFC Pooled Companies includes assets of two of the three reportable insurance segments (State Auto standard insurance and Meridian standard insurance). The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.
The following provides financial information regarding the Company's reportable segments. The 2001 financial information for the Meridian standard segment reflects the business assumed by the STFC Pooled Companies, beginning July 1, 2001:
The Company's insurance subsidiaries are involved in litigation and may become involved in potential litigation arising in the ordinary course of business. Additionally, the insurance subsidiaries may be impacted by adverse regulatory actions and adverse court decisions where insurance coverages are expanded beyond the scope originally contemplated in the policies at December 31, 2003. In the opinion of management, the effects, if any, of such litigation and published court decisions are not expected to be material to the consolidated financial statements.