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" in the "Narrative Description of Business." 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 claims office facilities which they share through the Amended and Restated Management Agreement. These facilities include a 6,600 square foot branch office in Cleveland, Ohio owned by Mutual, and a 29,000 square foot branch office in Cincinnati, Ohio owned by Mutual. In addition, Mutual currently leases a 22,800 square foot regional office in Nashville, Tennessee pursuant to a 10-year lease. In June 1999, the Company expects an office building being constructed by 518 PML containing 38,000 square feet to be completed and occupied by Mutual as its Nashville Regional Office. Mutual also leases the regional office facility in Greer, South Carolina from 518 PML. Milbank owns an office facility in Milbank, South Dakota where Mutual employees provide services to Milbank agents and policyholders. Midwest Security leases an office facility in Onalaska, Wisconsin where Mutual employees service Midwest Security's agents and policyholders. Farmers Casualty leases an office in West Des Moines, Iowa where Mutual's employees service Farmers Casualty's and Mid-Plains' policyholders and agents. Mutual also leases a number of small offices throughout its operating area for the claims operations of Mutual and the Company.
On July 7, 1998, State Auto Financial completed the exercise of its option, pursuant to the Option Agreement dated August 1993, with Mutual by acquiring the outstanding shares of Milbank. Milbank had been a wholly owned subsidiary of Mutual since July 1, 1993, but as a result of this transaction, Milbank is now a wholly owned subsidiary of State Auto Financial. The purchase price of Milbank was approximately $81.9 million. The transaction was effected through an exchange with Mutual of approximately 5.1 million State Auto Financial common shares for all the issued and outstanding capital stock of Milbank. This exchange of Milbank shares for State Auto Financial common shares increased Mutual's ownership of State Auto Financial to approximately 70% of its issued and outstanding shares. Since the transaction was a combination of entities under common control it has been accounted for similar to a pooling of interests. The prior years' financial information has been restated to include the financial position and operations of Milbank.
standard insurance market. In 1998, a plan to convert Farmers Casualty into a stock insurance company was approved by the board of Farmers Casualty, its policyholders and the Iowa Division of Insurance. The plan of conversion contemplated that State Auto Financial, in exchange for the redemption of the surplus notes, would acquire the newly issued shares of Farmers Casualty. Effective January 1, 1999, Farmers Casualty, renamed Farmers Casualty Insurance Company, became a wholly owned subsidiary of State Auto Financial. In addition, Farmers Casualty owns 100% of the outstanding shares of Mid-Plains Insurance Company, an Iowa domiciled property casualty insurer, which principally writes nonstandard auto insurance.
Consolidated earned premiums increased 11.3% in 1998 (5.1% in 1997). This 11.3% increase was derived from three sources. The impact of the change in allocation percentages of the Company's pooling percentages as well as the addition of Midwest Security to the pool increased consolidated earned premiums 7.1%. The growth in the standard insurance segment, excluding the impact of the changes in the pooling arrangement, increased consolidated earned premiums 2.9% (2.6% in 1997). The Company's nonstandard insurance segment (i.e., National) increased consolidated earned premiums 1.3% from the previous period (2.5% in 1997).
With respect to personal lines, in both 1998 and 1997, the Pooled Companies' produced an increase of approximately 1.0% in its direct written premiums despite a significant increase in aggressive price competition in this book of business. Contributing favorably to the personal lines business over the last few years has been the Company's Prime of Life program (the Program), that targets insureds 50 and older, that was first introduced by the Company in late 1995. The Program, which has consistently generated 25% of the Company's new business, has also exhibited a significantly higher than average retention rate. The continued growth of the Program is gradually changing the profile of the Company's personal lines book of business as more and more baby boomers age into eligibility.
The nonstandard segment (National) increased its earned premiums in 1998 19.0% (56.8% in 1997). This segment's growth has slowed compared to prior year levels due to aggressive underwriting action designed to improve profitability in Tennessee and Arkansas, National's two largest states, a more restrictive underwriting posture with several larger producers in its other states, and rate increases implemented during 1997 in several operating states. While these actions have resulted in a decrease in growth over prior year levels, National`s statutory loss experience has improved over comparative prior periods. See discussion below. National began operations in four new states during 1998: Indiana, Pennsylvania, Utah and Wisconsin. Contributing to National's 56.8% increase in premiums in 1997 was entry into Arkansas and Georgia in December 1996, Minnesota in February 1997 and in the later half of 1997, Alabama, Illinois and Missouri. In 1999, National has planned entry into at least three new states: South Carolina, South Dakota and Maryland.
The Company has attempted to address the difficulties of securing growth by making selective acquisitions which afford opportunities for increased writings in new, desirable states of operation. Within the last eight years, entry into new states, other than Oklahoma, has been by acquisition. In 1993 Mutual acquired Milbank which took the State Auto Insurance Companies into South and North Dakota, Minnesota and Utah. In 1997 Mutual acquired Midwest Security, thus entering Wisconsin. In 1999, State Auto Financial acquired Farmers Casualty and Mid-Plains taking the State Auto Insurance Companies into Iowa and Kansas. Though all of these acquisitions have been primarily personal lines companies, they have taken the Company into additional targeted states with an established independent agency force with an existing book of business on which to build. Management believes this reduces start up costs and permits faster growth in new states than has been the case with starting in a new state from scratch. With an established agency force, the Company has a "ready made" distribution force for offering an expanded product portfolio, including commercial lines and additional personal lines products.
Net investment income increased 4.5% in 1998 (4.2% in 1997). Contributing to the increase over previous years was an increase in cash flow from operations and a general increase in investable assets over the previous year's levels. Total cost of investable assets at December 31, 1998, 1997 and 1996, respectively, was $590.8 million, $535.2 million and $488.3 million. Additionally, in 1998 State Auto P&C and Milbank received approximately $19.7 million in conjunction with the change in the pooling arrangement.
The investment yields, based on fixed and equity securities at cost, were 5.7%, 6.0% and 6.1% for the annual periods ending 1998, 1997 and 1996, respectively. Contributing to the decrease in the investment yields over these periods has been a decline in the overall market fixed maturity interest rate environment from the previous comparable periods as well as a gradual shift in the composition of the fixed maturity portfolio from taxable to tax-exempt fixed maturities. At December 31, 1998, 1997 and 1996, respectively, tax exempt securities comprised approximately 71%, 59%, and 52% of the fixed maturity portfolio. Somewhat lower yields are expected in 1999 on the fixed maturity portfolio given that a number of high yield fixed maturities are being called or maturing and are being reinvested at current
In February 1999, President Clinton proposed the 2000 fiscal year budget. One of the more significant revenue raising proposals contained in the budget directly affects property and casualty insurance companies. Property and casualty insurance companies are currently limited on the deductibility of the investment income earned on tax exempt fixed maturities and certain dividends received to 85%. This reduction was the result of the Tax Act of 1986. President Clinton, in his February proposal, has proposed a further limitation of 10% (i.e., deductibility of investment income earned from tax exempt fixed maturities and certain dividends received would be limited to 75%). The current proposal would be effective for taxable years beginning after the date of enactment, with respect to investments acquired on or after the date of first committee action. President Clinton had proposed a similar action for the 1999 fiscal year budget limiting the deductibility of investment income earned on tax exempt fixed maturities and certain dividends received to 70%. The municipalities lobbied very hard against such action as property and casualty insurance companies and other financial service industries are the largest investors in municipalities' fixed maturities. If this revenue raising proposal passes as it currently stands, certain tax exempt securities would become less appealing to the property and casualty insurance industry as the relative spread between after tax yields on tax-exempt and taxable fixed income maturities will narrow. This management will be monitoring the government's actions regarding this proposal. However, it is still too early in the budget process to anticipate the outcome.
Management services income, which includes income generated from the investment management services segment and executive management services provided by Stateco and State Auto P&C, respectively, increased $0.6 million in both 1998 and 1997.
Losses and loss expenses, as a percentage of earned premiums, for the nonstandard insurance segment, were 74.4%, 79.4% and 76.6% for the years ended 1998, 1997 and 1996, respectively. Increase in the 1997 ratio was due to underwriting problems that occurred in two of the segment's larger states of operations as previously discussed. In early 1997, National implemented rate increases in these two states and took a more aggressive underwriting posture with several of its larger agencies in an effort to control the underwriting losses this segment was beginning to experience.
In an attempt to improve the efficiency of its operations and thereby reduce overall operating expenditures in the long-term, the Company has been making strides in the use of technology to streamline its personal and commercial operations, specifically in the area of electronic upload and download with its agencies using the APT industry standard. The advent of electronic transfers between the agent and the Company should have a long-term positive impact on the Company's expenses as the Company has been able to reduce its paper and postage costs as well as stabilize its employee count which should continue as this process expands to more agencies and lines of business. Additionally, it should improve the efficiency and effectiveness of the operations of both the agent and the Company through quicker response time and increased accuracy.
In addition to the use of technology, the Company is realigning its claims procedures in order to improve service and reduce settlement expenses. The Company extensively trains its claims adjusters, whose professionalism is exhibited by the low number of complaints received by the various state insurance regulators. While the Company trains each adjuster to handle all types of claims, the Company recognizes that many claims are small and routine in nature. Rather than have a thoroughly trained adjuster spend time on these claims, the Company has established a Central Claims Department staffed by persons who focus exclusively on these losses. This allows for quicker response time to the insured, allows the fully trained claims adjuster to focus on the more serious claims, and reduces the use of independent adjusters.
In 1998, net cash provided by operating activities increased to $56.7 million ($28.9 million in 1997). This increase is due to the transfer of $19.7 million to State Auto P&C and Milbank in connection with the amended pooling arrangement, as discussed above, as well as a general increase in cash flows that resulted from a change in pool percentages from previous periods. In 1997, net cash provided by operating activities increased to $28.9 million ($24.2 million in 1996). This 1997 increase in cash flow was due to an overall improvement in the insurance operations of the Company, attributable to lower catastrophe losses from the previous year. Over the last three years, operating cash flows have been sufficient to meet the operating needs of the Company while providing opportunities for increased investment and financing needs. Management does not anticipate any significant changes in its operating cash flow.
Net cash used in investing activities reflects cash flows used in purchases of fixed maturities and equity securities, respectively, of $193.9 million and $17.1 million in 1998, $137.6 million and $13.7 million in 1997 and $164.5 million and $11.8 million in 1996. The decline in the purchase of fixed maturities in 1997 was a matter of timing, as funds invested in cash equivalents at December 31, 1997 were allocated for investment in early 1998. As market interest rates on fixed maturities began to decline over the last three years, the Company began experiencing a steady increase in the amount of calls on fixed maturities. Cash flows provided by maturities, calls and principal reductions of fixed maturities were $47.8 million in 1998, $28.2 million in 1997 and $17.9 million in 1996. During 1998 518 PML began construction of a building in Goodlettsville, Tennessee that will be leased to Mutual and its affiliates in 1999. It is anticipated that the total construction costs of this building, excluding land will be approximately $4.5 million.
During the first quarter of 1999, State Auto Financial commenced the process of forming a new Ohio stock corporation and obtaining for it a certificate of authority from the Ohio Department of Insurance. It is expected to be a wholly owned subsidiary of State Auto Financial with initial capitalization of approximately $5.75 million. The capitalization is expected to be funded through dividends from subsidiaries. It is anticipated that this new subsidiary, to be called State Auto Insurance Company, will utilize leading edge technology to achieve maximum efficiencies for a carrier operating within the independent agency system.
The primary investment objectives of the Company are to generate income, preserve capital and maintain adequate liquidity for the payment of claims. Fixed maturities that are purchased with the intention and ability of holding them until maturity are categorized as held to maturity and carried at amortized cost. Fixed maturities that may be sold due to changing investment strategies are categorized as available for sale and are carried at fair value. At December 31, 1998, the Company had no fixed maturity investments rated below investment grade, nor any mortgage loans.
The Company's primary market risk exposures are to changes in market price for equity securities and changes in interest rates and credit ratings for fixed maturity securities. The Company has no exposure to foreign currency exchange rate risk nor does it own any derivative financial instruments. To provide the Company greater flexibility in order to manage its market risk exposures, the Company has segregated a portion of its fixed maturity investments, in accordance with SFAS No. 115, as available for sale. Also, the Company does not maintain a trading portfolio.
The following table provides information about the Company's fixed maturity investments used for purposes other than trading that are sensitive to changes in interest rates. The table presents principal cash flows from maturities, anticipated calls and estimated prepayments, or paydowns from holdings in mortgage backed securities. The table also presents the average interest rate for each period presented.
Following months of intensive remediation effort, in April 1998, the Company conducted its first major test of one of its major insurance policy processing systems. The results of that test were positive. The Company conducted a second comprehensive Millennium test at an off-site computer facility in August 1998. All major insurance policy processing systems were tested as if it were the Year 2000. Testing also included Leap Day, February 29, 2000. This test was also successful. In 1999, two additional tests are planned for March and September. Additionally, all internal test systems run with advanced dates giving the Company the opportunity to identify Y2K issues early enough to react to them.
State Auto's Y2K project team has, through February 1999, completed its efforts on approximately 95% of State Auto's applications software. That means that approximately 95% of the software systems State Auto uses in its insurance operations or in meeting its general business needs has been through Y2K remediation, testing, and has been introduced back into the Company's production environment. Included within this 95% are the systems that address policy issuance, premium billing and collection and claims processing at State Auto. The remaining 5% of applications software code that is not presently Y2K compliant involves applications that are not "mission critical", such as certain management reports and other similar tools. Some of this remaining code may well be determined to be obsolete. State Auto plans to have 100% of its non-obsolete applications software Y2K compliant by mid-year 1999.
In addition, a number of State Auto Agencies and the Company are able to communicate policy data electronically. There are several agency management systems that permit this so-called upload and download of information but not all are Y2K compliant. If upload and download are disrupted by Y2K issues, it will likely affect the efficiency with which the Company operates its business.
The Company has surveyed all State Auto Agencies that currently upload data electronically to State Auto and verified that every one of these agencies has a Y2K compliant agency vendor system. For those agencies that only receive a download of policy information from State Auto, current information on the Y2K compliance status of their systems available to State Auto indicates that the majority of them are Y2K compliant. In the event that any of these agencies encounters any difficulty with download, State Auto is prepared to suspend the electronic transfer and turn back on the generation of policy documents of which an agency would need to maintain records manually.
The consequences of the disruption would depend on the extent to which State Auto's various lines of business may be uploaded and downloaded at the time the disruption would occur and the duration of the disruption. Thus, it is not possible to reasonably estimate the financial impact of such reduced efficiency.
Stateco Financial Services, Inc. ("Stateco"), a wholly owned subsidiary of State Auto Financial which provides investment management services to each of the State Auto insurers, has had in place a third party vendor investment management system which is represented by the vendor to be Y2K compliant. Based on its present use of this system, Stateco does not expect its services to be disrupted by Y2K issues affecting it, although Stateco will be included in the contingency planning discussed below should some unanticipated system failure arise.
State Auto Financial's Y2K compliance expense to date for resources has been $1.7 million dollars of a projected $2.4 million dollars. This estimate is subject to change depending on future, presently unforeseen developments which could affect the cost of Y2K compliance for State Auto. The money spent to date is virtually all payroll costs attributable to the State Auto employees on the Y2K project team. The foregoing expense does not include approximately $0.2 million spent by State Auto Financial on accelerated technology purchases for systems or equipment to ensure Y2K compliance for such system or equipment. Also, an outsourcing agreement with State Auto's primary third party software vendor to provide additional resources for other systems projects has generated an additional expense to State Auto Financial of approximately $1.3 million over the last two years.
State Auto has not yet created a formal Y2K contingency plan. Discussions and communications have begun in regards to this. Each internal department has responded to a survey relating to its use of external systems which might be subject to disruption. State Auto has also had one meeting with a
consultant regarding contingency planning. The Company expects to have a contingency plan in place by the 4th quarter 1999. Some of the issues that the plan would likely contemplate would be manual processing alternatives, non-electronic forms of information distribution, assurance of adequate supplies, and mitigation of the impact of utilities and financial institution disruptions.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133), which is required to be adopted in years beginning after June 15, 1999. SFAS No. 133 will require companies to recognize all derivatives on the balance sheet at fair value. The Company does not anticipate that the adoption of SFAS No. 133 will have a significant effect on its results of operations or financial position.
ITEM 7(a). QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK - ---------- ----------------------------------------------------------
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
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, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles.
As discussed in Note 1, the Company acquired the outstanding shares of Milbank Insurance Company from State Automobile Mutual Insurance Company on July 7, 1998 in a transaction accounted for similar to a pooling of interest. Accordingly, the Company's consolidated financial statements for each of the two years ended December 31, 1997 have been restated to include the financial position and operations of Milbank Insurance Company.
On July 7, 1998, the Company exercised its option with State Automobile Mutual Insurance Company (Mutual), pursuant to the Option Agreement dated August 20, 1993, by acquiring the outstanding shares of Milbank. Milbank had been a wholly owned subsidiary of Mutual since July 1, 1993, but as a result of this transaction, is now a wholly owned subsidiary of the Company. The purchase price of Milbank was approximately $81.9 million. The transaction was effected through an exchange with Mutual of approximately 5.1 million Company common shares for all the issued and oustanding capital stock of Milbank. Since the transaction was a combination of entities under common control it has been accounted for similar to a pooling-of-interests. The prior years' financial information has been restated to include the financial position and operations of Milbank.
The following provides financial information for Milbank included in the accompanying financial statements for the years ended December 31, 1997 and 1996:
State Auto Financial Corporation and subsidiaries are referred to herein as "the Companies." The Company, an Ohio corporation, is a majority-owned subsidiary of Mutual. All significant intercompany balances and transactions have been eliminated in consolidation.
The Company, through S.I.S., develops and sells software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance companies and agencies. S.I.S. sells services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies.
518 PML, an Ohio limited liability company, was formed in December 1997 to engage in the business of owning and leasing real and personal property to affiliated companies. On January 1, 1998, State Auto P&C and Stateco became initial members of 518 PML. State Auto P&C contributed real property, while Stateco contributed $7.0 million in cash and real property. STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the period then ended and the accompanying notes to the financial statements. Such estimates and assumptions could change in the future as more information becomes known which could impact the amounts reported and disclosed herein.
In August 1998, the Company purchased $9.0 million of surplus notes from Farmers Casualty Company Mutual (Farmers Casualty), an Iowa domiciled standard property casualty insurer. In 1998, a plan to convert Farmers Casualty into a stock insurance company was approved by the board of Farmers Casualty, its policyholders and the Iowa Division of Insurance. The plan of conversion contemplated that the Company, in exchange for the redemption of the surplus notes, would acquire the newly issued shares of Farmers Casualty. Effective January 1, 1999, Farmers Casualty, renamed Farmers Casualty Insurance Company, became a wholly owned subsidiary of the Company. In addition, Farmers Casualty owns 100% of the outstanding shares of Mid-Plains Insurance Company, an Iowa domiciled property casualty insurer, which principally writes nonstandard auto insurance. STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Goodwill represents the excess of cost of acquisition over the fair value of the net assets acquired and is being amortized using the straight-line method over 15 years. Accumulated amortization is $1,089,000 and $891,000 at December 31, 1998 and 1997, respectively.
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 $12,817,000 and $10,870,000 at December 31, 1998 and 1997, 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.
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 five year 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.
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 basis 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.
Certain items in the 1997 and 1996 consolidated financial statements have been reclassified to conform with the 1998 presentation.
Expected maturities may differ from contractual maturities because the issuers may have the right to call or prepay the obligations with or without call or prepayment penalties.
Cash and cash equivalents and surplus note receivable: The carrying amounts reported in the balance sheet for these instruments approximate their fair value.
Since 1995, State Auto P&C and Milbank have participated in a reinsurance pooling arrangement with Mutual. During 1996 and 1997 the pooling participation percentages allocated 35% to State Auto P&C, 55% to Mutual and 10% to Milbank.
Effective January 1, 1998, the pooling arrangement was amended to include all of the property and casualty business of Midwest Security Insurance Company (Midwest), a wholly owned subsidiary of Mutual. Concurrent, with the inclusion of Midwest, 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. In connection with the January 1, 1998 change in pooling percentages, State Auto P&C and Milbank received approximately $19.7 million to cover their increased share of pool liabilities.
to a Reinsurance Pooling Agreement, amended and restated, referred to hereafter to include each of its predecessor agreements as the "Pooling Agreement", as of January 1, 1999, to include all of the property and casualty business of Farmers Casualty. Concurrent, with the inclusion of Farmers Casualty, the pooling participation percentages were amended to allocate 37% to State Auto P&C, 49% to Mutual, 10% to Milbank, 1% to Midwest and 3% to Farmers Casualty. In connection with the January 1, 1999 change in pooling percentages, State Auto P&C, Milbank and Farmers Casualty received approximately $ 11.4 million to cover their increased share of pool liabilities.
In addition, the Company's obligation to repay SPC has been secured by a Put Agreement among the Company, Mutual and the Lenders, under which, in the event of a default by the Company, as described in the Credit Agreement or in the Put Agreement, Mutual would be obligated to put either the preferred shares or the loan(s) outstanding.
State Auto P&C provides Mutual and its insurance affiliates executive management services to oversee the insurance operations of these companies. Fees relating to these services amounted to $4,908,000 in 1998, $4,563,000 in 1997 and $4,144,000 in 1996.
Effective January 1, 1998, 518 PML began leasing assets to Mutual and its affiliates. Fees relating to these services amounted to $268,000 in 1998 and is included in other income.
A reconciliation between actual federal income taxes and the amount computed at the indicated statutory rate is as follows:
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997 are presented below:
Federal income taxes paid during 1998, 1997 and 1996 were $11,768,000, $14,254,000 and $13,602,000, respectively.
State Auto P&C, Stateco and S.I.S. are also participants with Mutual in a defined contribution plan that covers substantially all employees of Mutual, State Auto P&C, Milbank, Stateco and S.I.S. Contributions to the plan are based on employee contributions and the level of Company match. State Auto P&C, Milbank, Stateco and S.I.S.'s share of the expense under the plan totaled $782,000, $726,000 and $667,000 for the years 1998, 1997 and 1996, respectively.
On May 28, 1998, the Company's authorized capital was increased to 100,000,000 shares of common stock and the Company's Board of Directors declared a two-for-one common stock split. Also, on May 30, 1996, the Company's Board declared a three-for-two common stock split effected in the form of a stock dividend. The financial statements, notes and other references to share information and per share data have been given retroactive effect to reflect the stock splits for all periods presented. Fractional shares were paid in cash.
State Auto P&C, Milbank, National and Farmers Casualty 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 $21.9 million is available for payment to the Company in 1999 without prior approval.
The Company has authorized two classes of preferred stock. For both classes, upon issuance, the Board of Directors has authority to fix and determine the significant features of the shares issued, including, among other things, the dividend rate, redemption price, redemption rights, conversion features and liquidation price payable in the event of any liquidation, dissolution, or winding up of the affairs of the Company. See note (5) regarding the Company's obligation to issue redeemable preferred shares to SPC in connection with its catastrophic reinsurance arrangements with Chase Manhattan Bank.
The Company follows Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and related Interpretations in accounting for its stock incentive plans. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Had compensation cost for the Company's plans been determined based on the fair values at the grant dates consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123), the Company's pro forma net earnings and net earnings per share information would have been as follows:
The Company has stock option plans for certain directors and key employees of Mutual, State Auto P&C, Stateco and S.I.S. The nonemployee directors' plan provides each nonemployee director an option to purchase 1,000 shares of common stock following each annual meeting of the shareholders at an option price equal to the fair market value at the last business day prior to the annual meeting. The Company has reserved 300,000 shares of common stock under this plan. These options are exercisable at issuance to 10 years from date of grant. The key employee's plan provides that qualified stock options may be granted at an option price not less than fair market value at date of grant and that nonqualified stock options may be granted at any price determined by the options committee of the Board of Directors. The Company has reserved 3,600,000 shares of common stock under this plan. For certain employees these options are exercisable from 1 to 10 years from date of grant, and 3 to 10 years for remaining employees.
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 option, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
A summary of information pertaining to options outstanding and exercisable as of December 31, 1998 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 S.I.S. 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 2,400,000 shares of common stock under this plan. At December 31, 1998, 1,407,000 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 1998, 1997 and 1996, respectively: dividend yield of .75%, 1.0% and 1.0%; expected volatility factors of .44, .32 and .24; risk-free interest rates of 4.7%, 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 1998, 1997 and 1996 were $3.92, $2.61 and $1.76, respectively.
The reportable segments are business units that are each managed separately because of the differences in products or service they offer and type of customer they serve.
Revenue from segments in the other category is attributable to three other operating segments of the Company; an insurance software development and resale segment, a premium finance segment and a property management and leasing segment. These segments have never met the quantitative thresholds for determing reportable segments.
The standard insurance segment (State Auto P&C and Milbank) participates in a reinsurance pooling agreement with other standard insurance affiliates. For discussion regarding this arrangement and the segment's contribution to the pool and participation in the pool, see note 5.