While we did not meet our profit or growth goals for 2016, our focus remains on achieving profitable growth for each of our lines of business. During 2016, we completed most of the work to rebuild our foundation and implemented changes designed to enable us to compete effectively in a rapidly changing industry.
Building on the efforts initiated in 2015 to address a number of issues impacting our underwriting results, in 2016, we implemented a number of changes to improve our market competitiveness and underwriting profitability. Examples of changes implemented include:
Specialty insurance segment - Growth in our specialty insurance segment was driven by increases in our E&S casualty and programs units. Our E&S casualty unit continued to grow organically and programs net written premiums increased compared to 2015 due to the addition of new programs during the latter half of 2015. Despite the continued competitiveness of the catastrophe-exposed property marketplace, E&S property net written premiums remained flat compared to 2015, reflecting the addition of an internal underwriting team during the third quarter of 2016. During 2016, we announced our decision to exit the traditional programs business, enabling us to focus capital and resources on our E&S property and E&S casualty product lines.
We continued to transform our culture throughout 2016, creating an environment in which every associate feels empowered to speak up and be heard, and challenges one another candidly and respectfully. We believe our culture is one of diversity and inclusion that makes everyone feel welcomed and respected as members of our team. We also share the deep commitment to giving back to our communities, especially those less fortunate than our own, that’s been at the heart of our company since its founding.
The following table sets forth certain key performance indicators we use to monitor our operations for the years ended December 31, 2016, 2015 and 2014:
Our 2016 net income was $21.0 million compared to $51.2 million and $107.4 million in 2015 and 2014, respectively. Our 2014 net income included a non-cash income tax benefit of $82.6 million related to the reversal of a valuation allowance against our net deferred tax assets.
The following highlights significant factors that impacted 2016 results as compared to 2015 and 2014:
Net realized gains on investments were $36.5 million compared to $24.7 million and $20.7 million in 2015 and 2014, respectively. Net realized gains in 2016 were impacted by the recognition of a $12.0 million gain from the redemption of a limited partnership investment in international equities. 2015 net realized gains increased $4.0 million when compared to 2014 partially driven by an increase in realized gains in the fixed income portfolio as a result of reducing our TIPS position due to our inflation outlook.
Insurance industry regulators require our insurance subsidiaries to report their financial condition and results of operations using SAP. We use SAP financial results, along with industry standard financial measures determined on a SAP basis and certain measures determined on a GAAP basis, to internally monitor the performance of our insurance segments and reward our employees.
To reduce risk and volatility, while at the same time providing us with additional catastrophe reinsurance protection, the State Auto Group entered into a quota share reinsurance agreement on December 31, 2011 with a syndicate of unaffiliated reinsurers covering its homeowners line of business (the “HO QS Arrangement”). Under the HO QS Arrangement, the State Auto Group ceded to the reinsurers 75% of its homeowners business under policies in force at December 31, 2011 and new and renewal policies thereafter issued during the term of the agreement. The HO QS Arrangement expired on December 31, 2014. Upon expiration, the Company recognized $89.5 million of unearned premium returned from the reinsurers. In accordance with the terms of the HO QS Arrangement, the participating reinsurers’ margin was capped at 9.0%, with any excess returned to the State Auto Group in the form of a profit commission. For the years ended December 31, 2016, 2015 and 2014, the Company recognized profit
commission of $1.9 million, $4.2 million, and $19.0 million, respectively, reflected as a reduction in acquisition and operating expenses on the consolidated statements of income.
The following table sets forth, on a GAAP and pro forma basis, certain of our key performance indicators before and after the impact of the HO QS Arrangement cession for the year ended December 31, 2014.
The personal insurance segment’s net written premiums for the year ended December 31, 2016 were flat when compared to 2015 (Table 1). While total policies in force continued to decline, new business policy counts were up, and personal auto and homeowners new business premiums increased when compared to the same 2015 period. During 2016, we increased the number of personal lines agency appointments and conducted pricing reviews designed to improve personal lines production.
For the year ended December 31, 2014, the following table sets forth the reconciliation of as reported net written premiums to pro forma net written premiums that exclude the impact of the return of unearned premium associated with the termination of the HO QS Arrangement:
Throughout 2016, we continued the efforts that began in 2015 to improve the competitiveness and profitability of our personal lines products. These efforts were focused on technology, pricing/rates and claims.
Technology - In October of 2016, we launched our new digital platform for our personal auto and homeowners products in five states. The platform offers new products and coverages using new pricing models. In addition, the platform incorporates advanced data analytics, and it gives our agents the ability to submit, rate, quote, bind, issue and bill policies through a completely digital and integrated platform. During 2017, we plan on completing the rollout of this digital platform to our remaining states.
Pricing/Rates - As a result of the rate review process initiated in the fourth quarter of 2015, we revised our rate filings in numerous states and implemented policy form changes designed to improve profitability.
Claims - At the end of 2015, the claims department was re-aligned to create a dedicated personal auto team to improve our (i) claims handling processes, (ii) vendor utilization, (iii) fraud awareness and referral, and (iv) integration of data/metrics to expedite operational responses to identified trends.
The personal insurance segment’s SAP catastrophe loss ratio for the year ended December 31, 2016 was 8.7%, compared to 5.9% in 2015 and the pro forma SAP catastrophe loss ratio of 5.2% in 2014 (Table 2 and Reconciliation Table 4). Weather events classified as catastrophes during 2016 were generally more severe than those experienced in 2015 and 2014. During 2016, we were impacted by storms in Texas, primarily wind and hail, Hurricane Matthew and wildfires in Tennessee. These events accounted for 2.4 points, or $13.7 million, of the cat loss ratio.
prior accident years, primarily 2014 and 2015, when compared to the same 2015 period. The personal auto current accident year loss and ALAE estimates reflect the impact of continued increased bodily injury severity trends.
The following tables set forth, on a SAP and pro forma basis, certain of our key performance indicators for the homeowners line of business before and after the impact of the HO QS Arrangement cession for the year ended December 31, 2014:
As a result of changes to our reporting structure that occurred during late 2015, effective December 31, 2015, the workers’ compensation unit moved from the specialty insurance segment to the business insurance segment. Prior reporting periods have been restated to conform to the new presentation.
The following table sets forth the SAP loss and ALAE ratios by major product line of business for our business insurance segment with the catastrophe and non-catastrophe impact shown separately for the years ended December 31, 2016, 2015 and 2014:
Throughout 2016, we continued efforts that began in 2015 designed to improve the competitiveness and profitability of our business insurance products. These efforts were focused on technology and underwriting improvements.
Technology - We anticipate introducing our new technology platform (as described in the personal insurance segment discussion) for our business owners’ policy and small commercial auto products to our business insurance agents in the second quarter of 2017.
The business insurance segment’s SAP catastrophe loss and ALAE ratio for 2016 was 5.0% compared to 3.3% and 3.6% in 2015 and 2014, respectively (Table 4). The business insurance segment's SAP catastrophe loss ratio was impacted by the same weather events described in the personal insurance segment discussion above. The improvement in 2015 when compared to 2014 was primarily due to fewer and less severe catastrophe events during the year ended 2015.
The business insurance segment’s SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2015 increased 7.8 points when compared to 2014 (Table 4) primarily due to commercial auto, other & product liability and commercial multi-peril lines ratio increases of 24.9 points, 15.6 points and 3.6 points, respectively (Table 4). The increase in the commercial auto ratio was due to an increase in frequency and severity loss trends in third party liability and physical damage coverages when compared to 2014. The elevated severity trends in third party liability coverages also contributed to adverse development of prior accident year losses. The increase in the other & product liability ratio was primarily due to less favorable development of prior accident year losses and an increase in the severity of losses during the current accident year when compared to 2014. The increase in the commercial multi-peril ratio was due to an increase in the severity of losses during the current accident year when compared to 2014. Partially offsetting these increases was an 8.2 point improvement in the fire & allied lines ratio when compared to 2014 (Table 4), due to fewer and less severe losses, and an elevated level of large fire losses during the first six months of 2014 as well as the extreme cold weather during the first quarter of 2014.
Certain business previously included in the programs unit has been reclassified to the E&S property unit. Prior reporting periods have been restated to conform to the new presentation.
The specialty insurance segment’s SAP catastrophe loss and ALAE ratio for 2016 was 3.1% compared to 0.2% and 1.1% in 2015 and 2014, respectively (Table 6). The 2016 SAP catastrophe loss ratio reflects the impact of Hurricane Matthew which added 2.4 points, or $5.9 million, to the cat loss ratio.
The specialty insurance segment’s SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2016 was 72.2% compared to 59.7% and 104.0% in 2015 and 2014, respectively (Table 6). E&S property increased 19.7 points when compared to 2015 (Table 6) primarily driven by increases in the ultimate loss and ALAE estimates for prior accident years for the
During the third quarter of 2016, the Company’s management completed an evaluation of business written within the programs unit due primarily to the unit’s poor underwriting results. As a result of the evaluation, management concluded that the business generated by the programs unit was not core to our strategy and decided to exit the programs business. We will stop writing program business by the middle of 2017; however, exposure to the risks underlying this business will continue as the premiums are earned through mid-2018. Exiting the programs business allows us to focus on our E&S property and E&S casualty books of business.
The E&S property unit’s 2015 SAP non-catastrophe loss and ALAE ratio improved 4.5 points when compared to 2014 (Table 6), primarily due to lower current year losses.
The E&S casualty unit’s 2015 SAP non-catastrophe loss and ALAE ratio increased 23.1 points, when compared to 2014 (Table 6), primarily due to (i) a shift in the business mix attributable to the Partners General Agency acquisition in the second quarter of 2014, and (ii) adverse development of prior accident year losses during 2015 and favorable development of prior accident year losses during 2014.
As shown above, the 2016 loss and loss expenses attributable to prior years was $27.0 million, or an unfavorable development in the estimated ultimate liability for prior years’ claims.
For further information, see the discussion below and the "Personal Insurance Segment", "Business Insurance Segment" and "Specialty Insurance Segment" sections of “Results of Operations - Insurance Segments” included in this Item 7.
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the adverse development in 2016 resulted primarily from accident years 2015 and 2014. The more notable items contributing to the 2016 development were as follows:
The business insurance segment non-catastrophe loss and ALAE reserves contributed $3.9 million of favorable development, driven by other & product liability and workers’ compensation of $4.5 million and $4.2 million , respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years. The favorable development was partially offset by adverse development in commercial auto of $3.3 million, which was driven by higher than anticipated bodily injury severity from the prior two accident years.
The following table sets forth a tabular presentation of the development of the ultimate liability by accident year for the year ended December 31, 2015:
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the adverse development in 2015 resulted primarily from accident year 2013. The more notable items contributing to the 2015 development were as follows:
In the personal and business insurance segments, the non-catastrophe loss and ALAE reserves contributed $9.8 million of unfavorable development. The personal insurance segment contributed $9.4 million of the adverse development, due to higher than anticipated bodily injury severity trends from the 2014 and 2013 accident years in personal auto. The business insurance segment contributed $0.4 million of unfavorable development, with adverse development in commercial auto offset by favorable development in other & product liability and workers’ compensation. Higher than anticipated bodily injury severity from the prior two accident years contributed to the commercial auto development, while the favorable development in the other & product liability and workers’ compensation lines was due to lower than anticipated severity emerging from multiple accident years.
In the specialty insurance segment, the non-catastrophe loss and ALAE reserves accounted for $7.1 million of adverse development, which was due to programs and E&S casualty with unfavorable development of $9.6 million and $2.7 million, respectively. Unfavorable development in programs was due to higher than expected severity in programs with commercial auto exposure. Partially offsetting the unfavorable development was favorable development of $5.2 million in the E&S property unit due to lower than anticipated severity emerging from accident year 2014.
The following table sets forth a tabular presentation of the favorable development by accident year for the year ended December 31, 2014:
The adverse development in 2014 resulted primarily from accident years 2012 and 2011. The more notable items contributing to the 2014 development were as follows:
The following table sets forth loss and loss expenses payable by major line of business at December 31, 2016 and 2015:
The loss and loss expenses payable at December 31, 2016 increased $130.9 million from the loss and loss expenses payable at December 31, 2015, primarily due to (i) exposure growth in workers' compensation and E&S casualty, (ii) increased bodily injury severity trends which resulted in increases in ultimate loss and ALAE estimates for current and prior accident years in personal auto, commercial auto and programs with auto exposures, and (iii) seasonality of weather-related catastrophe losses.
We conduct quarterly reviews of loss development reports and make judgments in determining the reserves for ultimate losses and loss expenses payable. Several factors are considered by us when estimating ultimate liabilities, including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, accounting projections, exposure changes, anticipated inflation, current business conditions, catastrophe developments, late reported claims, and other reasonableness tests.
The risks and uncertainties inherent in our estimates include, but are not limited to, actual settlement experience different from historical data trends, changes in business and economic conditions, court decisions creating unanticipated liabilities, ongoing interpretation of policy provisions by the courts, inconsistent decisions in lawsuits regarding coverage and additional information discovered before settlement of claims. Our results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required to settle claims vary from the liability currently recorded. For a discussion of our reserving methodologies, see “Critical Accounting Policies - Losses and Loss Expenses Payable” included in this Item 7.
Our GAAP expense ratio was 33.3% in 2016 compared to 33.6% and 33.7% in 2015 and 2014, respectively. Acquisition and operating expenses for 2016 were flat compared to 2015 and pro forma 2014 (Reconciliation Table 1). The 2016 expense ratio was impacted by an increase in technology investments offset by decreases in personnel costs and incentive compensation. The 2015 expense ratio was impacted by management’s overall expense initiatives and organizational goals, during the fourth quarter of 2015, we recognized $6.8 million of severance expenses for (i) an early retirement incentive offered to eligible employees and (ii) headcount reductions within our underwriting, claims and information technology departments. The severance expenses recognized during the fourth quarter of 2015 were offset by lower bonus and contingent commission expenses.
Our investment portfolio and the investment portfolios of other members of the State Auto Group are managed by our subsidiary, Stateco. Stateco utilizes its own personnel to invest in fixed maturities, large-cap equities, MLP exchange traded funds, mutual funds and small-cap equity funds, and outside investment managers to invest in small-cap equities and international funds.
We have investment policy guidelines with respect to purchasing fixed maturity investments for our insurance subsidiaries which preclude purchases of bonds that are rated below investment grade by a recognized rating service. Our fixed maturity portfolio is composed of high quality, investment grade issues, comprised mostly of debt issues rated A or higher. We obtain investment ratings from Moody’s, Standard & Poor’s and Fitch. If there is a split rating, we assign the lowest rating obtained. At December 31, 2016, there were two fixed maturity investments rated below investment grade in our available-for-sale investment portfolio. These securities are rated below investment grade due to a rating agency downgrade subsequent to the purchase of the securities. Both securities are in the energy sector.
The following table sets forth the composition of our investment portfolio at carrying value at December 31, 2016 and 2015:
Our 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. Our fixed maturity securities are subject to interest rate risk whereby the value of the securities varies as market interest rates change. We manage this risk by closely monitoring the duration of the fixed maturity portfolio. The duration of the fixed maturity portfolio was approximately 4.45 and 4.85 as of December 31, 2016 and 2015, respectively. The following table sets forth our interest rate risk and the effects of a parallel change in interest rates on the fair value of the available-for-sale fixed maturity portfolio at December 31, 2016:
There are no mortgage backed securities in our fixed maturity portfolio which may be labeled sub-prime mortgage backed securities. We invest only in mortgage backed securities issued by a federal agency or that are U.S. Government guaranteed. Specifically, at December 31, 2016, approximately $611.3 million, or 29.0%, of our fixed maturity available-for-sale investment portfolio was in either GNMA pools, which are guaranteed by the full faith and credit of the U.S. Government, or FNMA or Freddie Mac pools.
At December 31, 2016, our fixed maturity investment portfolio included obligations of states and political subdivisions with a total carrying value of $643.7 million, with $72.1 million of these securities, or 11.2% of our municipal securities portfolio (“Muni Portfolio”), enhanced by third party monoline insurers (a “Credit Enhancement”) for the payment of principal and interest in the event of an issuer default. A Credit Enhancement is not a primary consideration to us when purchasing a municipal security, as we consider the underlying credit quality of the security as the primary rating factor in our evaluation process. At December 31, 2016, 66.9% of the total $643.7 million of municipal securities in our investment portfolio were rated AA or better, without the benefit of a Credit Enhancement. We do not believe that a loss of a Credit Enhancement would have a material adverse impact on our results of operations, financial position or liquidity, due to the underlying strength of the issuers of the securities, as well as our ability and intent to hold the securities. In addition, at December 31, 2016, we had no direct investment in any guarantor including any bond insurer.
The following table sets forth the credit ratings of our municipal securities, excluding Credit Enhancements, based on ratings by nationally recognized rating agencies at December 31, 2016:
At December 31, 2016, our small-cap and large-cap equity portfolios had a beta of 0.81 and 1.07, respectively, using the Russell 2000 and the S&P 500 Index as benchmarks, respectively. At December 31, 2016, our mutual and exchange traded funds portfolio had a beta of 0.97 using the S&P 500 Index as a benchmark. Beta estimates the degree the portfolio’s price will fluctuate based on a given movement in the market index. The following tables set forth what changes might occur in the value of the small-cap and large-cap equity and mutual and exchange traded funds portfolios given a change in the S&P 500 Index at December 31, 2016:
Our investment operations revenue for the year ended December 31, 2016 was primarily impacted by an increase of $1.8 million in Treasury Inflation-Protected Securities (“TIPS”) interest income and an increase in dividend income. Because TIPS are dependent on changes in the Consumer Price Index, they are directly impacted by the change in the rate of inflation (as inflation declines TIPS income decreases and vice versa). Interest earned on our fixed maturity securities in 2015 decreased primarily due to a decrease of $3.3 million in TIPS income.
The following table sets forth realized gains (losses) and the proceeds received on sale for our investment portfolio for the years ended December 31, 2016, 2015 and 2014:
We primarily use one independent nationally recognized pricing service in developing fair value estimates. We obtain one price per security, and our processes and control procedures are designed to ensure the value is accurately recorded on an unadjusted basis. Through discussions with the pricing service, we gain an understanding of the methodologies used to price the different types of securities, that the data and the valuation methods utilized are appropriate and consistently applied, and that the assumptions are reasonable and representative of fair value. To validate the reasonableness of the valuations obtained from the pricing service, we compare to other fair value pricing information gathered from other independent pricing sources. See Note 3, “Fair Value of Financial Instruments” to our consolidated financial statements included in Item 8 of this Form 10-K for a presentation of our available-for-sale investments within the fair value hierarchy at December 31, 2016.
As of December 31, 2016, Level 3 assets as a percentage of total assets were 0.1%, which we have determined to be insignificant.
See “Critical Accounting Policies - Income Taxes” included in this Item 7. See Note 9, “Federal Income Taxes” to our consolidated financial statements included in Item 8 of this Form 10-K for a reconciliation between our actual federal income tax (benefit) expense and the amount computed at the indicated statutory rate for the years ended December 31, 2016, 2015 and 2014.
maturity and equity securities are traded on public markets. For a further discussion regarding investments, see “Results of Operations - Investments Operations Segment” included in this Item 7.
Net cash provided by operating activities was $113.5 million, $149.8 million and $75.6 million in 2016, 2015 and 2014, respectively. Net cash from operations will vary from period to period if there are significant changes in underwriting results, primarily a combination of the level of premiums written and loss and loss expenses paid, changes in cash flows from investment income or federal income tax activity. The change from 2016 compared to 2015 and 2014 was primarily due to the expiration of the HO QS Arrangement at December 31, 2014, resulting in STFC receiving return premium of $63.5 million during the first quarter of 2015.
Net cash provided by financing activities was $7.1 million in 2016 compared to net cash used in of $10.3 million, and $13.1 million in 2015 and 2014, respectively. The increase in 2016 when compared to 2015 and 2014 was primarily driven by proceeds from the new term loan with the Federal Home Loan Bank of Cincinnati ("the "FHLB") in the principal amount of $21.5 million.
State Auto P&C has a credit facility (the “SPC Credit Facility”) with a syndicate of lenders that provides State Auto P&C with a $100.0 million five-year revolving credit facility maturing in July 2018. During the term of the SPC Credit Facility, State Auto P&C has the right to increase the total facility to a maximum amount of $150.0 million, provided that no event of default has occurred. The SPC Credit Facility is available for general corporate purposes and provides for interest-only payments during its term, with principal and interest due in full at maturity. Interest is based on LIBOR or a base rate plus a calculated margin amount. All advances under the SPC Credit Facility are to be fully secured by a pledge of specific investment securities of State Auto P&C. The SPC Credit Facility includes certain covenants and requirements, including financial requirements that State Auto Financial maintain a minimum net worth and a certain debt to capitalization ratio. As of December 31, 2016, State Auto P&C had not made any borrowings under the SPC Credit Facility and State Auto P&C and State Auto Financial were in compliance with all covenants and requirements of the SPC Credit Facility.
Related to our notes payable, our primary market risk exposure is to the change in interest rates and our credit rating. For a discussion regarding our credit ratings see “Liquidity and Capital Resources - Credit and Financial Strength Ratings” included in this Item 7. Based upon the notes payable carrying value at December 31, 2016, we had $15.2 million notes payable with variable interest and $85.4 million and $21.5 million of notes payable with interest fixed at 5.03% and 1.73%, respectively, and, which equated to approximately 12.4% variable interest debt and 87.6% fixed interest debt. Our decision to obtain fixed versus variable interest rate debt is influenced primarily by the following factors: (a) current market interest rates; (b) anticipated future market interest rates; (c) availability of fixed versus variable interest instruments; and (d) our currently existing notes payable fixed and variable interest rate position. See our contractual obligations table included in “Liquidity and Capital Resources -Contractual Obligations” included in this Item 7.
At December 31, 2014, the State Auto Group entered into an adverse development reinsurance agreement that provided $40.0 million of coverage for adverse development in excess of carried reserves for the terminated RED restaurant program.
As of June 1, 2016, the State Auto Group renewed the property per risk excess of loss reinsurance agreement. This reinsurance agreement provides that the State Auto Group is responsible for the first $3.0 million of losses, subject to an additional $2.0 million annual aggregate deductible ("AAD"). Claims arising from named storms for E&S property are excluded from this treaty. The reinsurers are responsible for 100.0% of the loss excess of the $3.0 million retention and $2.0 million AAD for property business up to $20.0 million of covered loss.
As of July 1, 2016, the State Auto Group renewed our casualty excess of loss reinsurance agreement. Under this reinsurance agreement, the State Auto Group is responsible for the first $2.0 million of losses that involve workers' compensation, auto liability, other liability and umbrella liability policies, subject to an additional $2.0 million AAD. This reinsurance agreement provides coverage up to $10.0 million, except for umbrella policies which are covered for limits up to $15.0 million. E&S casualty and programs units risks are not subject to this casualty excess of loss reinsurance agreement.
The following table sets forth our significant contractual obligations at December 31, 2016:
State Auto P&C, Milbank and SA Ohio are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Under the insurance regulations of Iowa and Ohio (the states of domicile), the maximum amount of dividends that the Company may pay out of earned surplus to shareholders within a twelve month period without prior approval of the Department is limited to the greater of 10% of the most recent year-end policyholders’ surplus or net income for the twelve month period ending the 31st day of December of the previous year-end. Pursuant to these rules, $84.4 million is available for payment to State Auto Financial from its insurance subsidiaries in 2015 without prior approval. State Auto Financial received dividends from its insurance subsidiaries in the amount of $10.0 million, $15.0 million and $20.0 million in 2016, 2015 and 2014.
The Company’s insurance subsidiaries are subject to risk-based capital (“RBC”) requirements that have been adopted by individual states. These requirements subject insurers having statutory capital less than that required by the RBC calculation to varying degrees of regulatory action, depending on the level of capital inadequacy. The RBC formulas specify various weighting factors to be applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of total adjusted capital to authorized control level RBC. Generally no remedial action is required by an insurance company if its adjusted statutory surplus exceeds 200% of the authorized level RBC. At December 31, 2016, the ratio of total adjusted statutory capital to authorized control level of State Auto Financial’s insurance subsidiaries ranged from 438% to 10,114%.
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, we attempt to anticipate increases from inflation subject to the limitations of modeling economic variables. Even when general inflation, as measured by the Consumer Price Index, has been relatively modest, as has been the case over the last several years, price inflation on the goods and services purchased by insurance companies in settling claims can steadily increase. For example, historically medical care costs have risen at a higher rate than general inflation over the last few years. Costs for building materials typically rise significantly following widespread natural catastrophes, such as what the industry experienced in areas affected by Superstorm Sandy in 2012. We continue to adjust our pricing projections to reflect current and anticipated changes in costs in all lines of business.
Acquisition costs, consisting of net commissions (including ceding commissions), premium taxes and certain underwriting expenses related to the successful acquisition or renewal of property and casualty business, are deferred and amortized over the same period in which the related premiums are earned. Ceding commissions relating to reinsurance agreements reimburse us for both deferrable and non-deferrable acquisition costs. To the extent these ceding commissions exceed the deferrable amount of acquisition costs, the excess is reported as a deferred liability and is included in other liabilities in our consolidated balance sheet. Excess ceding commissions are amortized in proportion to net revenue recognized on the underlying policies resulting in excess ceding commissions being recognized as a reduction of acquisition and operating expenses.
Short-Tail Business: For short-tail business, claims are typically settled within five years, and the most common actuarial estimates are based on techniques using link ratio projections of incurred losses, paid losses, claim counts and claim severities. Each of these methods is described below in detail. Separate projections are made for catastrophes that are in the very early stages of development based on specific information known through the reporting date.
(formula and case reserves) for claims that have been reported and are still open. The underlying assumption of the Incurred Loss Development Method is that case reserve adequacy remains consistent over time. This method’s advantage is its responsiveness to changes in reported losses, which is particularly valuable in the less mature accident years. The disadvantage of the Incurred Loss Development Method is that case reserve adequacy changes will distort the IBNR projections.
Paid Loss Development Method: The Paid Loss Development Method uses calculations that are very similar to the Incurred Loss Development Method. The key difference is that the data used in the paid method exclude case reserve estimates, so only paid losses are utilized. With this method, a payment pattern is estimated to project ultimate settlement values for each accident year, with the underlying assumption that claims are settled at a consistent rate over time. Neither case reserves nor the rate at which claims are reported (except to the extent that the reporting pattern influences the payment pattern) is relevant to the results of this method. This method’s advantage is that the estimates of ultimate loss are independent of case reserve adequacy and are unaffected by company changes in case reserving philosophy. The disadvantages are that the paid method does not use all of the available information, and in some cases the liability payment patterns require the application of very large development factors to relatively small payments in less mature accident years.
Bornhuetter-Ferguson Method: The Bornhuetter-Ferguson Method is a weighted average of the Expected Loss Ratio Method and the Incurred Loss Development Method, using the percentage of losses reported as the weight. This method is particularly useful where there is a low volume of data in the current accident period, or where the experience is volatile. In general, this method produces estimates that are similar to the Incurred Loss Development Method.
rate of 35%. Likewise, should ultimate losses decline to a level corresponding to the low point of the range, $1,010.7 million, the $170.0 million reserve decrease would add $110.5 million of after-tax net income. The loss reserve range noted above represents a range of reasonably likely reserves, not a range of all possible reserves. Therefore, the ultimate losses could reach levels corresponding to reserve amounts outside the range provided.
An important assumption underlying the loss reserve estimation methods for casualty lines is that the loss cost trends implicitly built into the loss and ALAE patterns will continue into the future. To estimate the sensitivity of reserves to an unexpected change in inflation, projected calendar year payment patterns were applied to the December 31, 2016, other & product liability loss and ALAE reserve to generate estimated annual incremental loss and ALAE payments for each subsequent calendar year. Then, for purposes of sensitivity testing, an additional annual loss cost trend of 10% was added to the trend implicitly embedded in the estimated payment pattern, and revised incremental loss and ALAE payments were calculated. This type of inflationary increase could arise from a variety of sources including tort law changes, development of new medical procedures, social inflation, and other inflationary changes in costs beyond assumed levels.
The estimated cumulative impact that this additional, unexpected 10% increase in the loss cost trend would have on our results of operations over the lifetime of the underlying claims in other & product liability is an increase of $67.4 million on reserves, or a $43.8 million reduction to net income, assuming a tax rate of 35%. Inflation changes have much more impact on the longer tail commercial lines like other & product liability and workers’ compensation, and much less impact on the shorter tail personal lines’ reserves.
The following tables set forth the net losses and loss expenses payable by major line of business at December 31, 2016 and 2015:
The following table sets forth an illustration of variability with respect to the discount rate on our share of the State Auto Group’s December 31, 2016 benefit obligation and expected net periodic benefit cost for the year ending December 31, 2017, along with the variability of the expected return on plan assets to our expected net periodic benefit cost for the year ending December 31, 2017. Holding all other assumptions constant, sensitivity to changes in any one of our key assumptions are as follows:
The accumulated benefit obligation (“ABO”) of a defined benefit pension plan represents the actuarial present value of benefits attributed by the pension benefit formula to employee service rendered prior to the measurement date and based on current and past compensation levels, while the projected benefit obligation (“PBO”) is the ABO plus a factor for future compensation levels. The ABO, which considers current compensation levels only, provides information about the obligation an employer would have if the plan were discontinued at the measurement date. At December 31, 2016, our share of the State Auto Group’s ABO and PBO was $267.5 million and $284.5 million, respectively. At December 31, 2016, STFC’s share of the defined benefit pension plan’s fair value of the assets was $235.7 million, which resulted in an underfunded status within our balance sheet of $48.8 million. On a cash flow basis, we target an annual contribution level that meets at least the targeted normal cost plus any shortfall amortizations of the plan, as defined by ERISA. Currently, we expect to make a cash contribution to the pension plan up to $13.0 million in 2017.
The unfunded status on the pension plan and supplemental executive retirement plan decreased from $83.7 million at December 31, 2015, to $55.6 million at December 31, 2016. Primarily influencing the change from year to year are actuarial gains and losses arising from factors that include (i) changes in the discount rate, (ii) expected to actual demographic changes, such as retirement age, mortality, turnover, rate of compensation changes, and (iii) changes in returns on our plan assets.
For 2016, we recognized a federal income tax benefit of $1.8 million compared to federal income tax expense of $16.1 million for 2015 and a federal income tax benefit of $80.6 million for 2014. Income taxes for the year ended 2016 reflect the impact of a correction of prior period deferred tax expense related to expired stock options. As a result of the correction, deferred federal income tax expense and additional paid-in-capital were reduced by $1.6 million, respectively. The income tax benefit in
Deferred income tax assets and liabilities represent the tax effect of the differences between the financial statement carrying value of existing assets and liabilities and their respective tax bases. During 2011, we experienced a net loss due to the magnitude of record level catastrophe storm losses in the second quarter that significantly exceeded our projections. We considered both positive and negative evidence and concluded that a valuation allowance should be established.
In accordance with the FASB’s ASC 740, Income Taxes (ASC 740), we periodically evaluate our deferred tax assets, which requires significant judgment, to determine if they are realizable based upon weighing all available evidence, both positive and negative, including our historical and anticipated future taxable income. In making such judgments, significant weight is given to evidence that can be objectively verified.
We have audited State Auto Financial Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). State Auto Financial Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
In our opinion, State Auto Financial Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016 based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016, and our report dated March 1, 2017, expressed an unqualified opinion thereon.
The consolidated financial statements also include the operations and financial position of 518 Property Management and Leasing, LLC (“518 PML”), an Ohio limited liability company whose only members are State Auto P&C and Stateco.
Acquisition costs, consisting of net commissions (including ceding commissions), premium taxes and certain underwriting expenses related to the successful acquisition or renewal of property and casualty business, are deferred and amortized over the same period in which the related premiums are earned. Ceding commissions relating to reinsurance agreements reimburse us for both deferrable and non-deferrable acquisition costs. Excess ceding commissions are amortized in proportion to net revenue
The method followed for computing the acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses expected to be incurred, and certain other costs expected to be incurred as premium is earned. Future changes in estimates, the most significant of which is expected losses and loss adjustment expenses, that indicate a reduction in expected future profitability may result in unrecoverable deferred acquisition costs. Anticipated investment income is considered in determining whether a premium deficiency exists.
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 $27.0 million and $24.7 million at December 31, 2016 and 2015, respectively, has been established to cover the estimated ultimate cost to settle insured losses. The amounts are 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 materially from such estimates. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations (see Note 4). Anticipated salvage and subrogation is 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.
The amendments in this guidance simplify the presentation of debt issuance costs by requiring them to be presented in the balance sheet as a direct deduction from the carrying amount of the related recognized debt liability, consistent with debt discounts. The Company adopted this guidance at January 1, 2016 on a retrospective basis and it resulted in a $0.3 million decrease to notes payable and accrued investment income and other assets at December 31, 2015 and 2014, respectively.
The amendments in this guidance remove the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also remove the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. Rather, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. The amendments in this update are effective for public business entities for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years and should be applied retrospectively to all periods presented. The Company adopted this guidance at January 1, 2016. The new guidance affects disclosures only and it did not impact the Company’s results of operations or consolidated financial position.
The amendments in this guidance require expanded disclosures for insurance entities that issue short-duration contracts. The expanded disclosures are designed to provide additional insight into an insurance entity’s significant estimates made in measuring the liability for unpaid claims and claim adjustment expenses. The disclosures include information about incurred and paid claims development by accident year, on a net basis after reinsurance, for the number of years claims incurred typically remain outstanding, not to exceed ten years. Each period presented in the disclosure about claims development that precedes the current reporting period is considered required supplementary information. The expanded disclosures also include information about significant changes in methodologies and assumptions, a reconciliation of incurred and paid claims development to the carrying amount of the liability for unpaid claims and claim adjustment expenses, the total amount of incurred but not reported liabilities plus expected development, the incidence of claims including the methodology used to determine the incidence of claims, and claim duration. The guidance is effective for annual periods beginning after December 15, 2015, and interim periods beginning after December 15, 2016, and is to be applied retrospectively. The Company adopted this guidance at December 31, 2016. The new guidance affects disclosures only and it did not impact the Company’s results of operations or consolidated financial position.
In January 2016, the FASB issued guidance to improve certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Specifically the guidance (i) requires equity investments, including equity securities and limited partnership interests, that are not accounted for under the equity method of accounting or result in consolidation to be measured at fair value with changes in fair value recognized in earnings, (ii) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment, (iii) eliminates the requirement to disclose the methods and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost, (iv) requires the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes, (v) requires an entity to present separately in other comprehensive income the portion of the total change in fair value of a liability resulting from a change in the instrument-specific credit risk when the entity has elected to measure the liability at fair value in accordance with the fair value option, (vi) requires separate presentation of
The following table sets forth the realized losses related to other-than-temporary impairments on the Company’s investment portfolio recognized for the years ended December 31, 2016, 2015 and 2014:
The Company reviewed its investments at December 31, 2016, and determined that no additional other-than-temporary impairment exists in the gross unrealized holding losses.
At December 31, 2016, State Auto P&C had fixed maturity securities, with a carrying value of approximately $106.5 million, that were pledged as collateral for the FHLB Loan (as defined in Note 8). In accordance with the terms of the FHLB Loan, State Auto P&C retains all rights regarding these securities, which are included in the “U.S. government agencies mortgage-backed securities” classification of the Company’s fixed maturity securities portfolio.
Fixed maturities with fair values of approximately $9.2 million and $8.8 million were on deposit with insurance regulators as required by law at December 31, 2016 and 2015, respectively.
The following table sets forth the realized and unrealized holding gains (losses) on the Company’s investment portfolio for the years ended December 31, 2016, 2015 and 2014:
The Company utilizes one nationally recognized pricing service to estimate the majority of its available-for-sale investment portfolio’s fair value. The Company obtains one price per security. The Company’s processes and control procedures are designed to ensure the price is accurately recorded on an unadjusted basis. Through discussions with the pricing service, the Company obtains an understanding of the methodologies used to price the different types of securities, that the data and the valuation methods utilized are appropriate and consistently applied, and that the assumptions are reasonable and representative of fair value. To validate the reasonableness of the valuations obtained from the pricing service, the Company compares the valuations received to other fair value pricing from other independent pricing sources. At December 31, 2016 and 2015, the Company did not adjust any of the prices received from the pricing service.
Included in other invested assets is one international fund (“the fund”) that invests in equity securities of foreign issuers and is managed by third party investment managers. The fund had a fair value of $35.7 million and $33.3 million at December 31, 2016 and 2015, respectively, which was determined using the fund’s net asset value. The Company employs procedures to assess the reasonableness of the fair value of the fund including obtaining and reviewing the fund’s audited financial statements. There is no unfunded commitment related to the fund. The Company may not sell its investment in the fund; however, the Company may redeem all or a portion of its investment in the fund at net asset value per share with the appropriate prior written notice.
At December 31, 2015, the Company held another international fund that was managed by third party investment managers. During the fourth quarter of 2016, the Company redeemed its investment in the fund. At December 31, 2015, the fund had a fair value of $43.7 million.
In May 2009, the Company entered into two separate credit agreements with State Auto Mutual pursuant to which it loaned State Auto Mutual a total of $70.0 million. The Company estimates the fair value of the notes receivable from affiliates using market quotations for U.S. treasury securities with similar maturity dates and applies an appropriate credit spread. This has been placed in Level 2 of the fair value hierarchy.
Favorable development of unallocated loss adjustment expenses and catastrophe reserves were approximately $6.2 million and $0.7 million, respectively, of the 2015 development. The personal and business insurance segments non-catastrophe loss and ALAE reserves contributed $9.8 million of adverse development. The personal insurance segment contributed $9.4 million of the adverse development, driven by personal auto which developed unfavorably by $11.0 million, primarily due to higher than anticipated bodily injury severity from the prior two accident years. The business insurance segment contributed $0.4 million of adverse development, driven by commercial auto which developed unfavorably by $10.5 million, also due to higher than anticipated bodily injury severity from the prior two accident years. The adverse development was partially offset by favorable development in workers’ compensation and other & product liability of $5.1 million and $3.8 million, respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years. The specialty insurance segment non-catastrophe loss and ALAE reserves accounted for $7.1 million of adverse development, which was driven by programs and E&S casualty with adverse development of $9.7 million and $2.7 million, respectively. Adverse development in programs was driven by higher than expected severity in programs with commercial auto exposures. Somewhat offsetting the adverse development was favorable development of $5.3 million in the E&S property unit driven by lower than anticipated severity emerging from accident year 2014.
the sum of IBNR claims liabilities + expected development on reported claims ("IBNR+") included within the incurred claims development tables, for each accident year, for the most recent reporting period; and
The above information is provided for each of our reportable insurance segments and then is further disaggregated between short and long-tail where "tail" refers to the time period between the occurrence of a loss and the settlement of the claims. See Note 16 for discussion of our reportable segments. The personal insurance segment generally only consists of short-tail business, whereas the business and specialty insurance segments have both short and long-tail business. We believe our disaggregated groupings have homogeneous risk characteristics with similar development patterns and are generally subject to similar trends.
Short-Tail Business: For short-tail business, claims are typically settled within five years, and the most common actuarial estimates are based on techniques using link ratio projections of incurred losses, paid losses, claim counts and claim severities. Each of these methods is described in the "Losses and Loss Expenses Payable" section of "Critical Accounting Policies" included in Item 7 of this Form10-K. Separate projections are made for catastrophes that are in the very early stages of development based on specific information known through the reporting date.
Cumulative Claim Frequency: Cumulative claim frequency is defined as the cumulative number of reported claims ("reported claims"). Reported claims include claims that do not result in a liability (e.g. those below a deductible). Reported claims disclosed in the tables below are for the State Auto Group and have not been pooled (see Note 7a for additional information regarding the Pooling Arrangement).
In the ordinary course of business, the Company assumes and cedes reinsurance with other insurers and reinsurers and is a member in various pools and associations. See Note 7a for discussion of reinsurance with affiliates. The voluntary arrangements provide greater diversification of business and limit the maximum net loss potential arising from large risks and catastrophes. Most of the ceded reinsurance is effected under reinsurance contracts known as treaties; the remainder is by negotiation on individual risks. Although the ceding of reinsurance does not discharge the original insurer from its primary liability to its policyholder, the insurance company that assumes the coverage assumes the related liability.
The following table sets forth the effect of the Company’s external reinsurance on its balance sheets at December 31, 2016 and 2015, prior to the reinsurance transaction with State Auto Mutual under the Pooling Arrangement, as discussed in Note 7a:
The insurance subsidiaries of State Auto Financial, including State Auto Property & Casualty Insurance Company (“State Auto P&C”), Milbank Insurance Company and State Auto Insurance Company of Ohio (collectively referred to as the “STFC Pooled Companies”) participate in a quota share reinsurance pooling arrangement (“the Pooling Arrangement”) with State Auto Mutual and its subsidiaries and affiliates, State Auto Insurance Company of Wisconsin, Meridian Security Insurance Company, Patrons Mutual Insurance Company of Connecticut, Rockhill Insurance Company, Plaza Insurance Company, American Compensation Insurance Company and Bloomington Compensation Insurance Company, (collectively referred to as the “Mutual Pooled Companies”). State Auto P&C, Milbank and SA Ohio are referred to as the “STFC Pooled Companies,” State Auto Mutual, SA Wisconsin, Meridian Security and Patrons Mutual are referred to as the “Mutual Pooled Companies,” and RIC, Plaza, American Compensation and Bloomington Compensation are referred to as the “Rockhill Insurers.” The STFC Pooled Companies, the Mutual Pooled Companies and the Rockhill Insurers are collectively referred to as the “State Auto Group.”
The following table sets forth the reinsurance transactions on the Company’s income statements for the Pooling Arrangement between the STFC Pooled Companies and State Auto Mutual for the years ended December 31, 2016, 2015 and 2014:
In May 2003, State Auto Financial formed a Delaware business trust (the “Capital Trust”) to issue $15.0 million of mandatorily redeemable preferred capital securities to a third party and $0.5 million of common securities to State Auto Financial (the capital and common securities are collectively referred to as the “Trust Securities”). The Capital Trust loaned $15.5 million, the proceeds from the issuance of its Trust Securities, to State Auto Financial in the form of Floating Rate Junior Subordinated Debt Securities due in 2033 (the “Subordinated Debentures”). The Subordinated Debentures and interest accrued thereon are the Capital Trust’s only assets. Interest on the Trust Securities is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20% adjusted quarterly (total 5.13% at December 31, 2016). Because 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, payments from the Subordinated Debentures finance the distributions paid on the Trust Securities. State Auto Financial has the right to redeem the Subordinated Debentures, in whole or in part, on or after May 2008. State Auto Financial has unconditionally and irrevocably guaranteed payment of any required distributions on the capital securities, the redemption price when the capital securities are to be redeemed, and any amounts due if the Capital Trust is liquidated or terminated. State Auto Financial’s equity interest in the Capital Trust is included in other invested assets. In accordance with the Consolidation Topic of the FASB ASC 810, State Auto Financial determined that the business trust is a variable interest entity for which it is not the primary beneficiary and therefore, does not consolidate the Capital Trust with the Company.
State Auto Financial’s subsidiary, State Auto P&C, is a member of the Federal Home Loan Bank of Cincinnati (the “FHLB”) and in September 2016 entered into a new term loan with the FHLB in the principal amount of $21.5 million (the “2016 FHLB Loan”). The 2016 FHLB Loan is a five-year term loan and may be called (prepaid) after three years with no prepayment penalty. The 2016 FHLB Loan provides for interest-only payments during its term, with principal due in full at maturity. The interest rate is fixed over the term of the loan at 1.73%. The 2016 FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C. State Auto P&C has a term loan with the FHLB in the principal amount of $85.0 million (the “2013 FHLB Loan”). The 2013 FHLB Loan is a 20-year term loan and is callable after three years with no prepayment penalty thereafter. The 2013 FHLB Loan provides for interest-only payments during its term, with principal due in full at maturity. The interest rate is fixed over the term of the loan at 5.03%. The 2013 FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C.
The following table sets forth the reconciliation between actual federal income tax (benefit) expense and the amount computed at the indicated statutory rate for the years ended December 31, 2016, 2015 and 2014:
At December 31, 2016, the tax benefit of the net operating loss (“NOL”) carryforward was $58.9 million. The NOL carryforwards do not begin to expire until 2030 and will not fully expire until 2036.
State Auto Financial and its subsidiaries file a consolidated U.S. federal income tax return. State Auto Financial and its subsidiaries also file in various state jurisdictions. The Company is no longer subject to U.S. federal or state and local income tax examinations by tax authorities for years before 2013. The Company has no current U.S. federal or state and local income tax examinations on-going at this time.
The following table sets forth the Company’s share of amortization expected to be recognized for the year ending December 31, 2017:
The following table sets forth information regarding the Company’s share of pension and postretirement benefit plans’ components of net periodic cost for the years ended December 31, 2016, 2015 and 2014:
The postretirement plan’s gross benefit payments for 2016 were $1.4 million, including the prescription drug benefits. The postretirement plan’s subsidy related to Medicare Prescription Drug Improvement and Modernization Act of 2003 was $0.3 million for 2016 and estimates future annual subsidies to be approximately $0.3 million.
The following table sets forth the weighted average assumptions used to determine the benefit plans’ obligations at December 31, 2016 and 2015:
The following table sets forth the assumed health care cost trend rates used for the years ended December 31, 2016, 2015 and 2014:
The assumed health care cost trend rates have a significant effect on the amounts reported for the postretirement plan. The following table sets forth the effects of a one percentage point change in assumed health care cost trend rates for the year ended December 31, 2016:
The pension plan’s investment policy objective is to preserve the investment principal while generating income and appreciation in fair value to meet the pension plan’s obligations. The pension plan’s investment strategy and risk tolerance is balanced between meeting cash obligation requirements and a long-term relatively high risk tolerance takes into account the predictable cash requirements, nature of the plan’s liabilities and the plan’s long term time horizon. Since the nature and timing of the benefit plans’ liabilities and cash requirements are predictable, the liquidity requirements are somewhat moderate. One of the goals of diversifying the benefit plans’ portfolio among different asset classes is the elimination of concentration of risk in one asset class. Management also has investment policy guidelines with respect to limiting the ownership in any single debt or equity issuer. The international fund investments are also composed of numerous securities to reduce our exposure to a single issuer. The following table sets forth the asset allocation targets, as a percentage of total fair value, which are used as a guide by management when allocating funds as they become available.
Effective January 1, 2014, the Investment Committee approved a change to a liability driven investment (LDI) for the pension plan assets. The primary goal of the LDI strategy is to shift the asset allocation to more closely align with the plan liability, thereby reducing the volatility of the funded status. The implementation of the LDI strategy will occur over a period of time and the actual asset allocation at any point in time is dependent upon the funded status and the level of interest rates. This glide path helps to balance interest rate risk, curve steepness risk, and credit spread risk, as incremental changes are made to the allocation over time. The new allocation strategy reduces exposure to equity holdings and increases exposure to long duration fixed maturity holdings. This change will result in lower volatility for the plan assets. By moving more of the plan’s assets to long duration fixed income, the duration of the assets will increase to more closely match the duration of the plan’s liabilities.
See Note 3 for the valuation methods used by the Company for each type of financial instrument the plans hold that are carried at fair value. There were no transfers between level categorizations during the years ended December 31, 2016 and 2015.
Included in the pension plan’s available-for-sale securities is an international fund (“the fund”) that invests in equity securities of foreign issuers and is managed by third party investment managers. The fund had a fair value of $31.3 million and $18.6 million at December 31, 2016 and 2015, respectively, which was determined using the fund’s net asset value. In accordance with Accounting Standard Codification 820-10, since this investment is measured at fair value using the net asset value per share practical expedient this has not been classified in the table below.
The following tables set forth the Company’s share of pension plan’s available-for-sale securities within the fair value hierarchy at December 31, 2016 and 2015:
During 2015, the postretirement plan assets were sold in order to pay retiree medical costs.
The Equity Plan provides for the award of qualified and nonqualified stock options, restricted shares, performance shares, performance units and other stock-based awards. The Company has reserved 5.0 million common shares under the Equity Plan. As of December 31, 2016, a total of 2.4 million common shares are available for issuance under the Equity Plan. The Equity Plan provides that (i) no more than 33% of the common shares authorized for issuance under the Equity Plan may be granted in the form of awards other than stock options, (ii) the maximum number of common shares subject to awards of stock options, restricted shares and performance shares that may be granted in any calendar year is equal to 1.5% of the total number of common shares of the Company outstanding as of December 31 of the prior year, and (iii) the maximum number of common shares subject to awards of stock options, restricted shares and performance shares that may be granted in any calendar year to any one individual is 250,000 shares. The Equity Plan automatically terminates on May 8, 2019.
The Equity Plan provides that qualified stock options may be granted at an option price not less than the fair market value of the common shares at the date of grant and that nonqualified stock options may be granted at any price determined by the Compensation Committee of the Board of Directors. Options granted generally vest over a three-year period, with one-third of the options vesting on each anniversary of the grant date, and must be exercised no later than ten years from the date of grant. Stock options granted under the Equity Plan for 2016, 2015 and 2014 were 0.2 million, 0.3 million and 0.2 million, respectively.
As of December 31, 2016, there was $0.9 million of total unrecognized compensation cost related to non-vested restricted share compensation arrangements. The remaining cost is expected to be recognized over a period of 2.25 years.
The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes closed-form pricing model. The following tables present the weighted-average assumptions used in the option pricing model for options granted to employees during 2016, 2015 and 2014. The expected life of the options for employees represents the period of time the options are expected to be outstanding and is based on historical trends. For non-employees the expected life of the option approximates the remaining contractual term of the option. The expected stock price volatility is based on the historical volatility of the Company’s stock for a period approximating the expected life and the expected dividend yield is based on the Company’s most recent period’s dividend payout. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant and has a term approximating the expected life of the option.
The following table sets forth the Company’s total activity and related information for these plans for the years ended December 31, 2016, 2015 and 2014:
Intrinsic value for stock options is defined as the difference between the current market value and the grant price. For the years ended December 31, 2016, 2015 and 2014, the total intrinsic value of stock options exercised was $3.0 million, $2.6 million and $0.5 million, respectively. The tax benefit for tax deductions from share-based awards totaled $1.4 million, $0.3 million and $0 for the years ended December 31, 2016, 2015 and 2014, respectively. In addition, income taxes for the year ended December 31, 2016 reflect the impact of a $1.6 million correction of prior period deferred tax expense related to expired stock options. See Note 9 for additional information.
The following table sets forth information pertaining to the total options outstanding and exercisable at December 31, 2016:
Aggregate intrinsic value for total options outstanding at December 31, 2016 was $25.3 million. Aggregate intrinsic value for total options exercisable at December 31, 2016 was $14.9 million.
The Company has four reportable segments: personal insurance, business insurance, specialty insurance (the “insurance segments”) and investment operations. The insurance segments are business units managed separately because of the differences in the type of customers they serve or products they provide or services they offer.
The personal insurance segment primarily provides personal automobile and homeowners to the personal insurance market. The business insurance segment primarily provides commercial automobile, commercial multi-peril, fire & allied, general liability and workers’ compensation insurance covering small-to-medium sized commercial exposures in the business insurance market. The specialty insurance segment provides commercial coverages that require specialized product underwriting, claims handling or risk management services through a distribution channel of retail agents and wholesale brokers, which may include program administrators and other specialty sources. The investment operations segment, managed by Stateco, provides investment services.
The accounting for pension benefits also contributes to the difference between our GAAP loss and expense ratios and our SAP loss and expense ratios. At January 1, 2013, we adopted new SAP pension guidance, which required the recognition of service costs for non-vested participants. In accordance with GAAP, service costs related to non-vested participants was recognized over the two year vesting period ended December 31, 2014.
The investment operations segment is evaluated based on investment returns of assets managed by Stateco. Asset information by segment is not reported for the insurance segments because the Company does not produce such information internally.
Effective January 1, 2017, the Company completed the transition of its internal decision-making process to a product management structure under which its principal operating decision makers assess performance and allocate resources based on
the underwriting results of individual products. Accordingly, beginning January 1, 2017, the Company’s reportable segments, and the products within each, will be as follows:
The following table sets forth financial information regarding the Company’s reportable segments for the years ended December 31, 2016, 2015 and 2014: