Effective October 1, 2001, the Mutual Management Agreement was amended to eliminate the management and operations service fee charged by State Auto P&C to participants to the agreement, including Mutual. The Mutual 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 the Mutual Management Agreement, substantially all of State Auto P&C's services income has been eliminated effective October 1, 2001. Consequently, beginning with the first quarter 2002, the management and operations services segment
As noted above, as part of the resolution of the service fee disagreement with ODI, ODI approved an amendment to the Pooling Arrangement (defined below) in which the Pooled Subsidiaries aggregate participation was increased from 53% to 80% effective October 1, 2001. In conjunction with this change in pool participation, the Pooled Subsidiaries 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 Pooled Subsidiaries on October 1, 2001. Additionally, for the period October 1, 2001 through December 31, 2003, Mutual entered into a stop loss reinsurance arrangement (the "Stop Loss") with the Pooled Subsidiaries. Under the Stop Loss, Mutual has 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 (the "loss ratio") is between 70.75% and 80.00% (after the application of all available reinsurance), Mutual will reinsure the Pooled Subsidiaries 27% of the Pooling Arrangement's losses in excess of a loss ratio of 70.75% up to 80.00%. The Pooled Subsidiaries would be responsible for their share of the Pooling Arrangement's losses over the 80.00% threshold. Also, Mutual will have the right to participate in the profits of the Pooling Arrangement. Mutual will assume 27% of the Pooling Arrangement's underwriting profits attributable to loss ratios less than 69.25%, but more than 59.99%.
The Midwest Management Agreement and the Farmers Casualty Management agreement were not affected by the disagreement with the ODI or its resolution.
Pursuant to the 2000 Management Agreement, in 2000, the Company received cash of $28.1 million equal to the net pension and post-retirement plan benefit liabilities assumed relating to the above described transfer of those individuals who were employees of Mutual as of December 31, 1999. Prior to January 1, 2000, State Auto P&C provided only executive management services to all insurance affiliates.
The Midwest Management Agreement is a management agreement under which State Auto P&C provides management and operations services to Midwest Security Insurance Company, a Wisconsin domiciled, wholly-owned subsidiary of Mutual ("Midwest Security"). The Farmers Casualty Management Agreement is a management agreement under which State Auto P&C provides management and operations services to Farmers Casualty and Mid-Plains. The Mutual Management Agreement is a management agreement under which State Auto P&C provides management and operations services to Mutual, Milbank, National and SAIC, and other non-insurance affiliates.
In 1998, State Auto Financial acquired all of the outstanding shares of Milbank from Mutual pursuant to the Option Agreement dated August 1993. 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.
In August 1998, State Auto Financial purchased $9.0 million of surplus notes from Farmers Casualty Company Mutual ("FCCM"), an Iowa domiciled property casualty insurer for the standard insurance market. In 1998, a plan to convert FCCM into a stock insurance company was approved by the board of FCCM, its policyholders and the Iowa Division of Insurance. The plan of conversion provided 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, FCCM, 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, an Iowa domiciled property casualty insurer, which principally writes nonstandard auto insurance.
SAIC was formed in 1999 to engage in the business of providing standard personal insurance to its policyholders through the use of leading edge technology within the independent agency system. Effective January 1, 2000, SAIC became licensed as a property and casualty insurer and began operating in the state of Ohio.
Through Stateco Financial Services, Inc. ("Stateco"), a wholly-owned subsidiary, the Company provides investment management services to affiliated companies and also provides insurance premium finance services to commercial policyholders of State Auto P&C, Milbank and Mutual.
State Auto P&C, Milbank, Farmers Casualty and SAIC (the "Pooled Subsidiaries"), State Auto Financial's companies comprising the standard insurance segment, participate in a quota share reinsurance pooling arrangement (the "Pooling Arrangement") with Mutual. The Pooling Arrangement provides that the Pooled Subsidiaries cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation percentages as outlined in the Pooling Arrangement. Effective January 1, 1998, the Pooled Subsidiaries aggregate participation in the Pooling Arrangement increased from 45% to 47% (State Auto P&C - 37% and Milbank - 10%) and Midwest Security became a participant in the Pooling Arrangement. On January 1, 1999, Farmers Casualty was acquired by State Auto Financial and became a participant in the Pooling Arrangement on that same date, at which time the Pooled Subsidiaries' aggregate participation increased to 50% (State Auto P&C - 37%, Milbank - 10% and Farmers Casualty - 3%). In conjunction with these changes in pool participation, the Pooled Subsidiaries received cash from Mutual of $11.4 million and $19.7 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 1999 and 1998, respectively. Effective January 1, 2000, the Pooling Arrangement was amended to make SAIC a participant in the Pooling Arrangement and the Pooled Subsidiaries aggregate participation increased to 53% (State Auto P&C - 39%, Milbank - 10%, Farmers Casualty - 3% and SAIC - 1%). In conjunction with this change in pool participation, the Pooled Subsidiaries received cash from Mutual of $18.6 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 2000. As noted above, the Pooling Arrangement changed again effective October 1, 2001 with the Pooled Subsidiaries aggregate participation increasing to 80% ( State Auto P&C - 59%, Milbank - 17%, Farmers Casualty - 3% and SAIC - 1%). All parties that participate in the Pooling Arrangement have an A. M. Best rating of A+ (Superior).
The business written by the former Meridian Mutual provides both standard and nonstandard personal lines and standard commercial lines to its policyholders. The principal lines of business include standard personal and commercial automobile, nonstandard personal automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. The former Meridian Mutual business represents approximately 20% of the Pooled Companies business.
As the former Meridian Mutual business continues to be written and processed through the underwriting and claims system for both the standard and nonstandard business on the Meridian systems platform, management will monitor this business as a separate segment from the State Auto standard and nonstandard processed business. Monitoring of these segments separately is necessary in order to facilitate the integration of the business as it migrates through new policies and renewals to the State Auto systems platform where State Auto policies, pricing, underwriting , and claims philosophies will be fully integrated. Over time, it is anticipated that the Meridian operating segments will decrease and eventually disappear as they become fully integrated on to the State Auto systems platform. Consequently, with the addition of the former Meridian Mutual business to the Pooling Arrangement, the Company renamed the two insurance segments that existed prior to 2001 to be the "State Auto standard segment" and the "State Auto nonstandard segment" and that business consisting of the business known formerly as the Meridian Mutual business to be the "Meridian standard segment" and "Meridian nonstandard segment."
Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses relating to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed computing the acquisition costs limits the amount of such deferred
Investments are either classified as held to maturity, and carried at amortized cost, or available for sale, and carried at fair value. For investments classified as available for sale, 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. The Company regularly reviews its investments based on current economic conditions, credit loss experience and other factors. If there is a decline in an investment's fair value that is determined to be other than temporary, this decline is treated as a realized loss and the cost basis of the investment is reduced to its estimated fair value at the date of determination. Review for impairment of investments requires significant management judgment.
Net income for the Company decreased 56.8% in 2001. Contributing to this decease was an increase in the Company's statutory combined ratio to 105.2% from 95.5% in 2000. Negatively impacting the Company's insurance operations in 2001 were the loss results of the former Meridian Mutual business, assumed by the Pooled Subsidiaries beginning in July 2001, and a decrease in the Company's management and operations service fee income. See discussion below.
Consolidated earned premiums increased 39.5%. This increase was principally the result of the addition of the former Meridian Mutual business to the Pooling Arrangement, effective July 1, 2001, and a change in the Pooled Subsidiaries' aggregate pooling participation percentage from 53% to 80%, effective October 1, 2001 (see discussion above regarding these two transactions). These actions increased consolidated earned premiums 30.9%. The internal growth of the State Auto standard segment's earned premiums increased consolidated earned premiums 6.8%. This increase has been largely driven by growth in commercial lines of business over the last twelve months; however, during the last half of the calendar year, personal lines of business began to experience sales increases. Management believes the personal lines sales increases are due to changes in the market place and to its establishing the position of Personal Lines Sales Specialist. The internal growth of the State Auto nonstandard segment earned premiums increased consolidated earned premiums 2.0%. Production levels in this segment continued to improve during 2001 as a result of improved processing routines for agents and the easing of competitive pricing pressures it had felt from certain market leaders in the first half of 2000. The internal growth of both the Meridian standard and nonstandard segment on consolidated earned premium was flat. See discussion below regarding management's action during 2001 on the Group Advantage(R) Program as well as management's response to adequacy of premium rate levels within the standard segment and the Company's plan on integration with regard to the Meridian nonstandard segment.
Losses and loss expenses, as a percentage of earned premiums (the "loss ratio"), were 76.9% and 68.4% for the years 2001 and 2000, respectively. During the fourth quarter of 2001, the Pooled Subsidiaries produced a loss ratio under the Stop Loss (described above) that exceeded the 80% threshold, thereby recovering the full layer of $6.2 million from Mutual. Adversely impacting the current year results were the loss results of the former Meridian Mutual business assumed by the Pooled Subsidiaries. For discussion purposes, the following table provides comparative statutory loss and loss adjustment expense ratios ("Statutory Loss Ratio"), net of the Stop Loss recovery, for the Company's insurance operating segments:
Corrective action is taking place in both the standard and nonstandard segments. Group Advantage(R) was a program within Meridian's standard segment where Meridian made its personal lines products available to Sam's Club members through insurance kiosks located in Sam's Club retail outlets. While this program generated significant premium growth, it consistently failed to meet profitability objectives. As a result, in late 2000, the former Meridian Mutual stopped writing new Group Advantage(R) business and began to terminate existing business as permitted by law. At the end of 2000, there were approximately 15,000 Group Advantage(R) policies in force. At year end 2001, there are approximately 800 of such policies in force. These remaining policies are expected to non-renew over the course of 2002.
Net income for the Company increased 11.4% in 2000. Contributing to this increase was an improvement in the Company's statutory combined ratio to 95.5% in 2000 from 96.9% in 1999. Positively impacting the Company's operations in 2000 was a change in the services provided by State Auto P&C that generated an increase in management services income. See discussion below.
The Company's nonstandard insurance segment (National and Mid-Plains) earned premium was $27.4 million in 2000 and $30.9 million in 1999, an 11.3% decrease. Intense price competition by certain market leaders is generally believed to be responsible for the internal growth performance for the year 2000. Production levels in this segment did begin to improve over the last half of 2000 but that improvement was not sufficient to make internal growth positive for the year.
The investment yield based on fixed and equity securities at cost, were 5.5% and 5.4% for the annual periods ending 2000 and 1999, respectively. The Company continued to shift the composition of its fixed maturity portfolio from taxables to tax-exempt fixed maturities. At December 31, 2000 and 1999, respectively, tax-exempt securities comprised approximately 82% and 76% of the fixed maturity portfolio. Additionally, during 2000 the Company continued to experience a number of calls on its higher yielding fixed maturities. Monies from these calls were reinvested at the then lower yielding rates. See further discussion regarding investments at the "Liquidity and Capital Resources", "Investments" and "Market Risk" sections included herein.
Acquisition and operating expenses, as a percentage of earned premiums (the "expense ratio"), were 30.0% and 28.5% for the years 2000 and 1999, respectively. The increase in the expense ratio is impacted by the fixed costs such as salaries, depreciation and utilities which comprised a larger portion of earned premiums in 2000 than they did in 1999 as a result of the Company's less than anticipated premium writings in 2000.
Interest expense relates to the line of credit agreement the Company entered into with Mutual during the second quarter of 1999 to assist in the funding of its stock repurchase program. See additional discussion in the "Liquidity and Capital Resources" section included herein.
The effective federal tax rate was 22% and 25% for the years ended 2000 and 1999, respectively. During 2000, the Company continued to shift its fixed maturity portfolio from taxable to tax-exempt securities. As a result of this continued shift, tax-exempt income comprised a larger proportion of income before federal income taxes in 2000 than in 1999. For additional clarification, see the reconciliation between actual federal income taxes and the amount computed at the statutory rate as detailed in footnote 7 in the notes to the Company's consolidated financial statements.
The Company's segment profits (losses) of the State Auto standard insurance segment, the State Auto nonstandard insurance segment, the Meridian standard insurance segment, the Meridian nonstandard insurance segment and the investment management services segment, are monitored by
management on an unconsolidated basis, as reflected in footnote 14, Reportable Segments, in the Company's consolidated financial statements and therefore do not reflect adjustments for transactions with other segments. The following table reflects segment profit or loss for these segments for the years ended 2001, 2000, and 1999:
In 2001, net cash provided by operating activities decreased to $63.5 million from $87.7 million in 2000. This decrease was due to a cash transfer in 2000 of $18.6 million to the Pooled Subsidiaries in connection with the 2000 amended Pooling Arrangement, as well as a cash transfer of $28.1 million to State Auto P&C relating to the net plan benefit liabilities assumed in connection with the Mutual
Management Agreement, whereas in 2001, the settlement of approximately $355.0 million between the Company and Mutual due to the impact on the Pooled Subsidiaries from adding the Meridian Mutual business to the Pooling Arrangement and changing the pooling participation percentages was $8.6 million in cash and the balance in fixed maturity securities. Absent the impact of these transactions, net cash provided by operating activities was $54.9 million in 2001 versus $40.9 million in 2000. The increase in cash flow from operations in 2001 is largely attributable to the increase in premium writings and net investment income over the same time period in 2000. In 2000, net cash provided by operating activities increased to $87.7 million from $48.9 million in 1999. Absent the cash provided from the January 1, 2000 and January 1, 1999 Pooled Subsidiaries pooling participation percentage changes, cash provided from operating activities was $40.9 million in 2000 and $37.5 million in 1999, respectively. This 2000 increase in cash flow from operations was largely attributable to an increase in the management and operation services fee and net investment income over 1999 levels. 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. The combination of the elimination of the relatively consistent cash flow from the management and operations services fee from Mutual in 2001 along with a significantly larger insurance segment, is expected to result in more volatility going forward but will also provide opportunity for increased earnings and cash flows from operations.
Net cash used in investing activities reflects cash flows used in purchases of fixed maturity and equity securities, respectively, of $246.3 million and $16.4 million in 2001, $187.7 million and $15.8 million in 2000, and $207.8 million and $25.6 million in 1999. The fluctuation in the purchase of fixed maturity securities between years has been largely driven by the call activity in response to the changes in the interest rate environment over the last three years. During 1999, market interest rates on fixed maturities declined from previous years' levels and the Company experienced a significantly higher number of calls on fixed maturities than in previous years. During 2000, this call activity slowed somewhat from previous year's levels. The activity in the call level increased again during 2001 with another decline in market interest rates in response to the Federal Reserve Board's monetary policy and easing inflationary pressure. Cash flows provided by maturities, calls and principal reductions of fixed maturities were $50.2 million in 2001, $27.0 million in 2000 and $37.3 million in 1999. Overall, net cash used in investing activities was $55.3 million in 2001, $90.9 million in 2000 and $56.9 million in 1999. The increase in the 2000 investing activities was the result of the Company investing the proceeds received on the cash transfers discussed under cash flows from operating activities.
stock repurchase plan, State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million at an interest rate of 6.0%. The interest rate adjusts each January 1 based on a formula set forth in the note. The interest rate was 5.0% during 2001 and will be 4.75% for 2002. Commencing in 2001, principal is due upon demand, with final payment to be received on or prior to December 31, 2005. On March 1, 2002, the Board of Directors of State Auto Financial again approved a plan to repurchase up to 1.0 million shares of its common stock over a period extending to and through December 31, 2003 from the public.
Mutual, State Auto P&C, Milbank, Midwest Security, Farmers Casualty, SAIC, National, Mid-Plains, and effective June 1, 2001, the Meridian Insurers, are participants in a catastrophe reinsurance program. Collectively, these participants in the catastrophe reinsurance program are referred to as the "State Auto Insurance Companies." The amount retained by the State Auto Insurance Companies is $40.0 million for each occurrence. For up to $80.0 million in losses, excess of $40.0 million, traditional reinsurance coverage is provided. At the beginning of 2001, State Auto P&C was assuming catastrophe reinsurance from Mutual, Milbank, Midwest Security, Farmers Casualty, SAIC, National, Mid-Plains and the Meridian Insurers, beginning June 1, 2001, in the amount of $115 million excess of $120 million. Effective November 2001, the catastrophe reinsurance program was renegotiated whereby State Auto P&C now assumes $100 million excess of $120 million. This layer of $100 million in excess of $120 million has been excluded from the Pooling Arrangement. There have been no losses assumed under this agreement.
On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest Security, effective as of January 1, 1997. In connection with this purchase, Mutual and State Auto Financial entered into an Option Agreement granting State Auto Financial the right to purchase Midwest Security from Mutual within five years at a price determined by a formula set out in the Option Agreement. State Auto Financial did not exercise this right to acquire Midwest Security.
On March 1, 2002, the Board of Directors of State Auto Financial declared a quarterly cash dividend of $0.0325 per common share, payable on March 29, 2002, to shareholders of record on March 14, 2002. This is the 43rd consecutive cash dividend declared by State Auto Financial's Board since State Auto Financial had its initial public offering of common stock on June 28, 1991. State Auto Financial has increased cash dividends to shareholders for eight consecutive years.
As discussed above, there was particular emphasis throughout 2001 on improving the former Meridian Mutual book of business. That is expected to continue in 2002. 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 it believes offer the most profit potential.
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, 2001, the Company had no fixed maturity investments rated below investment grade, nor any mortgage loans.
Investable assets comprise approximately 85% of the Company's total assets. Of the total investable assets, 92.3% are invested in fixed maturities, 5.1% in equity securities and the remaining in cash and cash equivalents.
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, 2001, the Company's fixed maturity portfolio had an average maturity of 12.9 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. The fixed maturity portfolio is very high in quality with all holdings either in Government obligations, municipal, or corporate obligations. The average rating of the fixed maturity portfolio is AA. 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, is included in footnote 2 of the consolidated financial statements.
The Company's primary market risk exposures are to changes in market prices 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 rely on the use of 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 maturities as available for sale. Also, the Company does not maintain a trading portfolio.
2001 was characterized by significant changes in the Company's investment portfolio. These changes were the result of the financial market environment as well as the Pooled Subsidiaries assumption through the Pooling Arrangement of the former Meridian Mutual business on July 1, 2001 and the October 1, 2001 change in the Pooled Subsidiaries pooling participation percentages. The impact to the Company from the assumption of the Meridian Mutual business as well as the October 1, 2001 pooling participation percentage change, resulted in additional assets of $354 million, comprised primarily of fixed maturity investments, being transferred to the Pooled Subsidiaries. These transfers of assets are primarily responsible for the 51.1% increase in the Company's investable assets at December 31, 2001 ($1,168.7 million in 2001 versus $772.2 million in 2000).
The equity markets declined in 2001, the first time since the 1973/1974 bear market in which the market declined two years in a row. For the year, the Company's equity portfolio holds unrealized gains of $9.5 million at December 31, 2001, down $4.6 million from December 31, 2000.
The fixed maturity portfolio was impacted by the asset transfers discussed above. While the interest rate environment did not change significantly from 2000, the market did weaken a bit near the end
of the year resulting in the Company experiencing a decline of $8.1 million in its unrealized gains on its available for sale fixed maturity portfolio at December 31, 2001.
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 pay downs from holdings in asset backed securities. The table also presents the average interest rate for each period presented.
Inflation can have a significant impact on property and casualty insurers because premium rates are established before the amount of losses and loss expenses are known. When establishing rates, the Company attempts to anticipate increases from inflation subject to limitations imposed for competitive pricing. Inflation has been relatively modest over the last several years thereby allowing a better opportunity for premiums to keep pace with inflation on certain lines of business.
- The Company's financial results are subject to the occurrence of weather-related and other types of catastrophic events, none of which are within the Company's control.
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, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.
Mid-Plains Insurance Company (Mid-Plains), an Iowa corporation, is a wholly-owned subsidiary of Farmers Casualty. The financial statements also include the operations and financial position of 518 Property Management and Leasing, LLC (518 PML), whose members are State Auto P&C and Stateco. In August 1998, State Auto Financial purchased $9.0 million of surplus notes from Farmers Casualty Company Mutual (FCCM), an Iowa domiciled standard property casualty insurer. In 1998, a plan to convert FCCM into a stock insurance company was approved by the board of FCCM, 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, FCCM, renamed Farmers Casualty Insurance Company, became a wholly-owned subsidiary of State Auto Financial. 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.
(b) DESCRIPTION OF BUSINESS The Company, through State Auto P&C, Milbank, Farmers Casualty and SAIC, provides standard personal and commercial insurance to its policyholders. Their principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. National and Mid-Plains provide nonstandard automobile insurance. State Auto P&C, Milbank, Farmers Casualty, SAIC, National, and Mid-Plains operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. State Auto P&C, Milbank, Farmers Casualty, SAIC, National and Mid-Plains are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota, Iowa, Ohio (SAICand 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. Through State Auto P&C, effectiveJanuary 1, 2000, the Company provides management and operation services under new management agreements for all insurance and non-insurance affiliates. Pursuant to these agreements, the Company received approximately $28.1 million equal to the net pension and postretirement plan benefit liabilities assumed relating to the transfer to the Company of all employees from Mutual and other affiliated companies. Prior to January 1, 2000, the Company, through State Auto P&C, provided executive insurance management services to all insurance affiliates. SAIC was formed in 1999 to engage in the business of providing standard personal insurance to its policyholders through the use of leading edge technology within the independent agency system. Effective January 1, 2000, SAIC was chartered and licensed as a property and casualty insurer in the state of Ohio and began operations at that time. Through Stateco, the Company provides investment management services to affiliated companies and also provides insurance premium finance services to customers of State Auto P&C, Mutual and Milbank. The Company, through S.I.S., develops and sells software for the processing of insurance transactions,
(c) BASIS OF PRESENTATION The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which vary in certain respects from statutory accounting practices followed by State Auto P&C, Milbank, Farmers Casualty, SAIC, National and Mid-Plains that are prescribed or permitted by the Departments. 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. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of losses and loss expenses payable. In connection with the determination of this estimate, management uses historical data and current business conditions to formulate estimates including assumptions related to the ultimate cost to settle claims. These estimates by their nature are subject to uncertainties for various reasons. The Company's results of operations and financial condition could be impacted in the future should the ultimate payments required to settle claims vary from the liability currently provided.
YEAR ENDED DECEMBER 31 --------------------------- 2001 2000 1999 ---- ---- ---- (dollars in thousands) Balance, beginning of year.................. $ 32,458 28,936 24,799 Acquisition costs deferred.............. 143,651 101,305 96,578 Amortized to expense during the year....... 109,022 97,783 92,441 --------- ------ ------ Balance, end of year............... $ 67,087 32,458 28,936 ========= ====== ======
(f) GOODWILL 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 $1,863,657 and $1,605,000 at December 31, 2001 and 2000, respectively. See related goodwill discussion at note 1(n).
The amortized cost and fair value of fixed maturities segregated by held to maturity and available for sale, at December 31, 2001, by contractual maturity, are summarized as follows:
Investment expenses.................. 639 427 219 ----- ----- ----- Net investment income................ $47,375 38,915 34,262 ======= ====== ======
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.
(a) REINSURANCE State Auto P&C, Milbank, Farmers Casualty, SAIC (the Pooled Subsidiaries) and Midwest Security participate in a quota share reinsurance pooling arrangement (the Pooling Arrangement) with Mutual whereby the Pooled Subsidiaries and Midwest Security cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation percentages in the Pooling Arrangement. All premiums, losses and loss expenses and underwriting expenses are allocated among the participants on the basis of each company's participation percentage in the Pooling Arrangement. The Pooling Arrangement provides indemnification against loss or liability relating to insurance risk and has been accounted for as reinsurance.
Since 1998, State Auto P&C, Milbank and Midwest Security have participated in the Pooling Arrangement with Mutual. On January 1, 1999, Farmers Casualty was acquired by State Auto Financial and became a participant in the Pooling Arrangement on that same date, at which time the Pooled Subsidiaries' aggregate participation increased from 47% to 50%. In conjunction with this change in pool participation, the Pooled Subsidiaries received cash from Mutual of $11.4 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 1999. Effective January 1, 2000, the Pooling Arrangement was amended to make SAIC a participant in the Pooling Arrangement and the Pooled Subsidiaries aggregate participation increased to 53%. In conjunction with this change in pool participation, the Pooled Subsidiaries received cash from Mutual of $18.6 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 2000. 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 Pooled Subsidiaries assumed 53% of the former Meridian Mutual business on this same date. Concurrently, with this transaction, the Pooled Subsidiaries 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 Pooled Subsidiaries on July 1, 2001. As part of the resolution of the disagreement with the ODI regarding the recognition of the service fee revenue paid by Mutual to State Auto P&C (see note 6(d)), the Pooled Subsidiaries aggregate participation in the Pooling Arrangement was increased to 80%, effective October 1, 2001. In conjunction with this change in pool participation, the Pooled Subsidiaries 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 Pooled Subsidiaries and Mutual:
Effective with the June 1, 2001 merger transaction of Meridian Mutual into Mutual, Mutual also acquired all of the outstanding shares of Meridian Insurance Group, Inc. (MIGI), an Indiana domiciled insurance holding company. MIGI's wholly-owned insurance subsidiaries are Meridian Security Insurance Company, an Indiana domiciled property and casualty insurer, Meridian Citizens Security Insurance Company, an Indiana domiciled property and casualty insurer, and Insurance Company of Ohio, an Ohio domiciled property and casualty insurer. MIGI is also party to an affiliation agreement with Meridian Citizens Mutual Insurance Company, an Indiana domiciled property and casualty insurer. Collectively, the MIGIinsurer subsidiaries and affiliates are hereafter collectively referred to as the "Meridian Insurers".
Mutual, State Auto P&C, Milbank, Midwest Security, Farmers Casualty, SAIC, National, Mid Plains, and, effective June 1, 2001, the Meridian Insurers, are participants in a catastrophe reinsurance program. Collectively, these participants in the catastrophe reinsurance program are referred to as the "State Auto Insurance Companies." State Auto P&C assumed catastrophe reinsurance from Mutual, Milbank, Midwest Security, Farmers Casualty, SAIC, National, Mid-Plains and the Meridian Insurers in the amount of $115 million excess of $120 million. Effective November 2001, the catastrophe reinsurance program was renegotiated whereby State Auto P&C assumed $100 million excess of $120 million. Under this agreement, the Company has assumed from Mutual and its affiliate premiums written and earned of $3,021,000, $3,129,000 and $2,355,000 for
2001, 2000 and 1999, 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.
(c) NOTE PAYABLE 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, at an interest rate of 6.0%. See related footnote at note 9(a). Principal payment is due on demand after December 31, 2000, with final payment to be received on or prior to December 31, 2005. The interest rate is adjustable annually after the year 2000 to reflect adjustments in the then current prime lending rate as well as State Auto Financial's current financial position. Interest rate for the year 2002 is 4.75% and in 2001 was 5.0%. Interest expense on the loan from Mutual was $2,275,000, $2,730,000 and $955,000 in 2001, 2000 and 1999, respectively.
(e) OTHER TRANSACTIONS S.I.S. provides insurance software products and services to Mutual and its affiliate. Revenue relating to these services amount to $692,000, $900,000 and $1,109,000 in 2001, 2000 and 1999, respectively, and is included in other income. 518 PML leases assets to Mutual and its affiliate. Revenue relating to these services amount to $758,000, $646,000 and $567,000 in 2001, 2000 and 1999, respectively and is included in other income.
The Company is required to establish a valuation allowance for any portion of the deferred tax asset that management believes will not be realized. In the opinion of management, it is more likely than not that the Company will realize the benefit of the deferred tax assets and, therefore, no such valuation allowance has been established. Federal income taxes paid during 2001, 2000 and 1999 were $11,500,000, $12,638,000 and $12,621,000, respectively.
The assets of the defined benefit pension plan are represented primarily by U.S. government and
agency obligations, bonds, and common stocks. The Company's policy is to fund pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Benefits are determined by applying factors specified in the plan to a participant's defined average annual compensation. Information regarding the funded status and net periodic pension benefit for the Company's participation in the defined benefit pension plan is as follows:
Effective January 1, 2000, the net prepaid pension 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 2001 and 2000 net periodic benefit was $4.0 million and $2.6 million, respectively. The Company maintains a defined contribution plan that covers substantially all employees of the Company. Contributions to the plan are based on employee contributions and the level of Company match. The Company's share of the expense under the plan totaled $1,120,000, $890,000 and $852,000 for the years 2001, 2000 and 1999, respectively.
Reconciliations of statutory capital and surplus and net income (loss), as determined using statutory accounting practices, to the amounts included in the accompanying consolidated financial statements are as follows:
In March 1998, the National Association of Insurance Commissioners revised the Accounting Practices and Procedures Manual for insurance companies in a process referred to as Codification. The revised manual became effective January 1, 2001. The revised manual changed, to some extent, prescribed statutory insurance accounting practices and resulted in changes to the accounting practices that the insurance subsidiaries of State Auto Financial use to prepare its statutory-basis financial statements. The cumulative effect of changes in accounting principles adopted to conform to the revised Accounting Practices and Procedures Manual was reported as an adjustment to statutory surplus as of January 1, 2001. The adoption of Codification, as of January 1, 2001, increased statutory surplus of the insurance subsidiaries of State Auto Financial by approximately $19.3 million.
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 stock option plans for certain directors and key employees. In May 2000, the Company's 1991 Stock Option Plan and 1991 Directors' Stock Option Plan were replaced with the 2000 Stock Option Plan (Key Employee Plan) and the 2000 Directors Stock Option Plan (Nonemployee Director Plan), respectively, upon approval of shareholders at the 2000 annual meeting of shareholders. The Nonemployee Directors' Plan provides each nonemployee director an option to purchase 1,500 shares of common stock following each annual meeting of the shareholders at an option price equal to the fair market value at the close of business on the date of 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 5,000,000 shares of common stock under this plan. These options are exercisable at such time or times as may be determined by a committee of the Company's Board of Directors. Normally, these options are exercisable from 1 to 10 years from date of grant. 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 2,400,000 shares of common stock under this plan. At December 31, 2001, 1,803,000 shares have been purchased under this plan. The Company has a stock option incentive plan for certain designated independent insurance agencies that represent the Company and its affiliates. The Company has reserved 400,000 shares of common stock under this plan. The plan provides that the options become exercisable on the first day of the calendar year following the agency's achievement of specific production and profitability requirements over a period not greater than two calendar years from date of grant or a portion thereof in the first calendar year in which an agency commences participation under the plan. Options granted and vested under this plan have a 10-year term. The Company has accounted for the plan in its accompanying financial statements at fair value.The fair value of options granted was estimated at the reporting date or vesting date using the Black-Scholes option-pricing model. The weighted average fair value and related assumptions for 2001, 2000 and 1999, respectively, were as follows: fair value of $8.04, $10.91 and $4.02; dividend yield of .90% for all years; expected volatility factor of .34, .32 and .30; risk-free interest rate of 5.16%, 5.19% and 6.80%; and expected life of the option of 8.7, 9.0 and 9.7 years. Expense of $140,000, $493,000 and $105,000 associated with this plan was recognized in 2001, 2000 and 1999, respectively.
A summary of information pertaining to options outstanding and exercisable as of December 31, 2001 follows:
(14) REPORTABLE SEGMENTS Prior to 2001 the Company had four reportable segments: standard insurance, nonstandard insurance, investment management services and management and operations services (prior to 2000, executive insurance management services). The reportable segments are business units managed separately because of the differences in products or service they offer and type of customer they serve. The 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 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. Both the standard and nonstandard insurance segments operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. Effective July 1, 2001, with the Pooled Subsidiaries assumption of the former Meridian Mutual business through the Pooling Arrangement, as more fully described in note 6(a), the Company's standard and nonstandard insurance segments have been segregated into four reportable segments. While these segments offer similar products and services and operate in the same geographical locations within the United States, they differ within their operating measures, more specifically within their loss and profitability results. Consequently, the Company has defined the two insurance segments that existed