policyholders. Farmers Casualty leases an office in West Des Moines, Iowa where Company employees service Farmers Casualty's and Mid-Plains' policyholders and agents. Mutual also leases a number of small offices throughout its operating area for the claims operations of Mutual and the Company.
(1) Adjusted for a July 1998 2-for-1 common stock split as well as a July 1996 3-for-2 common stock split effected in the form of a stock dividend.
(2) The earnings per share amounts prior to 1997 have been restated as required to comply with SFAS No. 128.
(*) Reflects change in pooling arrangement, effective January 1, 1999, 1998 and 1995.
State Auto Financial Corporation (State Auto Financial), through its principal insurance subsidiaries, State Auto Property and Casualty Insurance Company (State Auto P&C), Milbank Insurance Company (Milbank), Farmers Casualty Insurance Company (Farmers Casualty) and State Auto Insurance Company (SAIC), provides personal and commercial insurance for the standard insurance market primarily in the Midwest and eastern United States, excluding New York, New Jersey, and the New England states. Their principal lines of business include personal and commercial auto, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. State Auto National Insurance Company (National) and Mid-Plains Insurance Company (Mid-Plains) write personal automobile insurance for risks in the nonstandard insurance market. State Auto P&C, Milbank, Farmers Casualty, SAIC, National and Mid-Plains products are marketed through independent agents.
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 in the state of Ohio, its first state of operation.
Strategic Insurance Software, Inc. (S.I.S.), a wholly owned subsidiary, develops and sells software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance companies and agents. S.I.S. sells services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies.
518 Property Management and Leasing, LLC (518 PML), an Ohio limited liability company, was formed in December 1997 to engage in the business of owning and leasing real and personal property to affiliated companies. As of January 1, 1998, State Auto P&C and Stateco, the only members of 518 PML, contributed capital to 518 PML with State Auto P&C contributing real property and Stateco contributing $7.0 million in cash and real property.
State Auto Financial, State Auto P&C, Milbank, Farmers Casualty, SAIC, National, Mid-Plains, Stateco, S.I.S. and 518 PML are referred to collectively herein as the "Company."
State Auto P&C, Milbank and Farmers Casualty (the "Pooled Subsidiaries"), the 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. Since 1995, State Auto P&C and Milbank have participated in the Pooling Arrangement with Mutual. During 1997, the aggregate pooling participation percentage of the Pooled Subsidiaries was 45% (State Auto P&C - 35% and Milbank - 10%). 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. All parties that participate in the Pooling Arrangement have an A. M. Best rating of A+ (Superior).
In discussing Results of Operations for 1999, State Auto P&C, Milbank, Farmers Casualty, National, Mid-Plains, Mutual and Midwest Security are referred to collectively as the "State Auto Insurance Companies," while State Auto P&C, Mutual, Milbank, Farmers Casualty and Midwest Security are referred to as the "Pooled Companies."
Like many other insurers in its industry, 1999 was a difficult year for so-called internal growth for the Company. In its standard insurance segment, management continues to stress responsible pricing and sound underwriting despite a significant increase in aggressive price competition in both personal and commercial lines. The Company's personal lines program, Prime of Life, that targets the 50 and over age group, continues to generate approximately 25% of the Company's new homeowner and automobile lines of business. This age group also exhibits a significantly higher than average retention rate than any other age group. The Company's underwriting experience in commercial lines showed some deterioration during 1999, which has prompted management to commence a careful review of adherence to its underwriting guidelines in these lines of business. This could be expected to have a future impact on earned premium.
investment income earned from tax exempt fixed maturities and certain dividends received would be limited to 75%). The current proposal would be effective for taxable years beginning after the date of enactment, with respect to investments acquired on or after the date of first committee action. President Clinton had proposed a similar action for the 2000 and 1999 fiscal year budgets. Municipalities continue to lobby very effectively against such action as property and casualty insurance companies and other financial service industries are the largest investors in municipalities' fixed maturities. If this revenue raising proposal passes as currently proposed, certain tax exempt securities would become less appealing to the property and casualty insurance industry as the relative spread between after tax yields on tax-exempt and taxable fixed income maturities would narrow.
Management services income, which includes income generated from the investment management services segment and executive management services provided to affiliated companies by Stateco and State Auto P&C, respectively, increased $0.8 million in 1999. The executive management services provided by State Auto P&C primarily generated the increase.
Other expense includes those operating expenses associated with general corporate expenses, S.I.S., 518 PML and Stateco's investment management services (the investment management services
segment). In 1999, other expense increased 10.0%, which is primarily attributable to an increase in S.I.S.'s operating expenses from 1998.
The effective Federal tax rate was 25% and 24% for the years ended 1999 and 1998, respectively. In 1999, income before federal income taxes increased due to an increase in income from operations compared to 1998. Additionally, during 1999 the Company continued to shift its fixed maturity portfolio from taxable to tax-exempt securities. (See related net investment income discussion above.) As a result of this continued shift, tax exempt income comprised a similar proportion of income before federal income taxes in 1999 to that of 1998. 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.
With respect to personal lines, in both 1998 and 1997, the Pooled Companies' produced an increase of approximately 1.0% in its direct written premiums despite a significant increase in aggressive price competition in this book of business. Contributing favorably to the personal lines business over the last few years has been the Company's Prime of Life that targets the age groups 50 and older. This program, which was first introduced by the Company in late 1995, has consistently generated 25% of the Company's new homeowner and automobile personal lines of business. The continued growth of this program is gradually improving the profile of the Company's personal lines book of business. This is likely to continue as more and more baby boomers age into eligibility.
Net investment income increased 4.5% in 1998. Contributing to the increase over previous years was an increase in cash flow from operations and a general increase in investable assets over previous year's levels. Total cost of investable assets at December 31, 1998 and 1997, respectively, was $590.8 million and $535.2 million. Additionally, in 1998 the Pooled Subsidiaries received approximately $19.7 million in conjunction with the change in the pooling arrangement.
Management services income, which includes income generated from the investment management services segment and executive management services provided by Stateco and State Auto P&C, respectively, increased $0.6 million in 1998.
Losses and loss expenses, as a percentage of earned premiums, for the nonstandard insurance segment, were 74.4% and 79.4% for the years ended 1998 and 1997, respectively. The 1997 ratio was the result of underwriting problems that occurred in two of the segment's larger states of operations as previously discussed. In early 1997, National implemented rate increases in these two states and took a more aggressive underwriting posture with several of its larger agencies in an effort to control the underwriting losses this segment was beginning to experience.
Acquisition and operating expenses, as a percentage of earned premiums (the "expense ratio"), were 29.3% and 29.5% for the years 1998 and 1997, respectively. The decrease in the expense ratio in 1998 can be attributed to a reduced amount of Quality Performance Bonus paid to employees compared to that paid in 1997, but this was partially offset by an increase in guaranty fund assessments.
In addition to the use of technology, the Company is realigning its claims procedures in order to improve service and reduce settlement expenses. The Company extensively trains its claims handlers, whose professionalism is exhibited by the low number of complaints received by the Company and various state insurance regulators. While the Company trains each claim representative to handle all types of claims, the Company recognizes that many claims are small and routine in nature. Rather than have a thoroughly trained representative spend time on these claims, the Company has established a Central Claims Department staffed by persons who focus exclusively on these losses. This allows for quicker response time to the insured, allows the fully trained claims representative to focus on the more serious claims, and reduces the use of independent adjusters.
Other expense includes those operating expenses associated with general corporate expenses, S.I.S., 518 PML and Stateco's investment management services (the investment management services segment). In 1998 other expense increased 58.2%. S.I.S.' operating expenses increased over 1997 contributing an increase of 20% to other expense. Also contributing to this increase was an increase in
The effective Federal tax rate was 24% and 27% for the years ended 1998 and 1997, respectively. During 1997 and continuing into 1998, the Company continued to shift its fixed maturity portfolio from taxable to tax exempt securities. Additionally, in 1998 income before federal income taxes decreased due to an increase in storm related catastrophes compared to 1997. As a result of these two factors, tax exempt income comprised a larger proportion of income before federal income taxes in 1998 versus 1997. 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 of the standard insurance segment, the non-standard insurance segment and the investment management services segment are monitored by management on an unconsolidated basis, as reflected in footnote 14 on 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 for these three segments for the years ended 1999, 1998 and 1997:
1999 1998 1997 ---- ---- ---- (in thousands) Standard insurance $48,225 40,310 48,376 Nonstandard insurance 1,647 1,313 1,192 Investment management services 5,191 4,908 4,901
In 1999, net cash provided by operating activities decreased to $48.9 million from $56.7 million in 1998. This decrease is due to the cash transfer of $11.4 million to the Pooled Subsidiaries in connection with 1999 amended Pooling Arrangement, as discussed above, whereas in 1998, the cash transfer relating to the 1998 amended Pooling Arrangement was $19.7 million. In 1998, net cash provided by operating activities increased to $56.7 million from $28.9 million in 1997. This increase is due to the cash transfer of $19.7 million to the Pooled Subsidiaries in connection with the 1998 amended Pooling
Arrangement as well as a general increase in cash flows that resulted from a change in pool percentages from previous periods. Over the last three years, operating cash flows have been sufficient to meet the operating needs of the Company while providing opportunities for increased investment and financing needs. Management does not anticipate any significant changes in its operating cash flow.
Net cash used in investing activities reflects cash flows used in purchases of fixed maturities and equity securities, respectively, of $207.8 million and $25.6 million in 1999, $193.9 million and $17.1 million in 1998 and $137.6 million and $13.7 million in 1997. As market interest rates on fixed maturities began to decline over the last three years, the Company began experiencing a significantly higher number of calls on fixed maturities than in previous years. Cash flows provided by maturities, calls and principal reductions of fixed maturities were $37.3 million in 1999, $47.8 million in 1998 and $28.2 million in 1997. During 1998, 518 PML began construction of a building in Goodlettsville, Tennessee that was completed in 1999. The building is currently being leased to Mutual and its affiliates. The total construction cost of the building, including land cost, was approximately $6.4 million.
Also impacting cash used in financing activities during 1999 was a repurchase program of the Company's stock. During the second quarter of 1999, State Auto Financial's Board of Directors approved a plan to repurchase up to 4.0 million shares of its outstanding common stock over a period ending December 31, 2000. Repurchases were transacted to maintain the same ownership ratios between Mutual and the public as it existed in May 1999, with 69% repurchased from Mutual and 31% from the public. Through December 31, 1999, all 4.0 million shares have been repurchased, with approximately 2.7 million shares repurchased from Mutual and 1.3 million shares from the public. In conjunction with the 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%. Repayment of principal shall begin no later than 2001.
among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to put either the preferred shares or the loan(s) outstanding.
On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest Security, effective as of January 1, 1997. In connection with this purchase, Mutual and State Auto Financial entered into an Option Agreement granting State Auto Financial the right to purchase Midwest Security from Mutual within five years at a price determined by a formula set out in the Option Agreement. As of March 20, 2000, State Auto Financial has not exercised its right to acquire Midwest Security.
On March 3, 2000, the Board of Directors of State Auto Financial declared a quarterly cash dividend of $0.0275 per common share, payable on March 31, 2000, to shareholders of record on March 15, 2000. This is the 35th 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. During 1998, State Auto Financial's authorized common shares increased to 100 million and the Board declared a two-for-one stock split to be distributed July 8, 1998, to shareholders of record on June 18, 1998. The impact of this stock split has been appropriately reflected in the accompanying consolidated financial statements.
The maximum amount of dividends that may be paid to State Auto Financial during 2000 by its insurance subsidiaries without prior approval under current law is limited to $28.9 million. The Company is required to notify the insurance subsidiaries' respective State Insurance Commissioner within five business days after declaration of all dividends and at least ten days prior to payment. Additionally, the domiciliary Commissioner of each insurer subsidiary has the authority to limit a dividend when the Commissioner determines, based on factors set forth in the law, that an insurer's surplus is not reasonable in relation to the insurer's outstanding liabilities and adequate to its financial needs. Such restrictions are not expected to limit the capacity of State Auto Financial to meet its cash obligations.
The National Association of Insurance Commissioners (NAIC) maintains risk-based capital requirements for property and casualty insurers. Risk-based capital is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy and other business factors. Applying the risk-based capital requirements as of December 31, 1999, each of the State Auto Insurance Companies exceeded all standards established by the formula.
Investable assets comprise approximately 86% of the Company's total assets. Of the total investments, 88% are invested in fixed maturities, 8.5% in equity securities and the remaining in cash and cash equivalents.
The fixed maturity portfolio is managed in a ladder-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, 1999, the Company's fixed maturity portfolio had an average maturity of 12.7 years. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 2.0% 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 rated AA or better by the major bond rating agencies. 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. In 1999 market conditions were characterized by increasing equity market prices and declining fixed maturity market prices. The Company's equity portfolio increased in value during 1999 because new monies being allocated during the year were used to acquire new equity positions and market values increased during the year. For the year, equity securities experienced a $3.3 million increase in unrealized holding gains. The market value of the available for sale fixed maturity portfolio was adversely impacted during the year as a result of rising interest rates. In 1999, the fixed maturity security market experienced the worst year since 1994 and the second worst since 1973 for market rates on fixed maturities. High quality issues, a characteristic of the Company's fixed maturity portfolio, were the worst performers. As a result of these market conditions, the Company experienced a decline of $34.1 million on the market value of its available for sale fixed maturity portfolio through December 31, 1999. As previously discussed, in order to maximize investment income the Company manages its fixed maturity portfolio in a ladder-maturity style to ensure adequate cash flow to meet claims as they are presented for payment. It is not anticipated that fixed maturity investments would need to be sold in order to meet claim payments in the future. In fact, the Company has never had to sell assets to meet payment of its claims.
The Company considers inflation when estimating liabilities for losses and loss expenses, particularly for claims having a long period between occurrence and settlement. The liabilities for losses and loss expenses are management's estimates of the ultimate net cost of underlying claims and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on investment income may partially offset potentially higher claims and expenses.
Statements contained herein expressing the beliefs of management and the other statements, which are not historical facts contained in this report, are forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to certain risks and uncertainties that could cause the Company's actual results to differ materially from those projected. Such statements include, without limitation, those pertaining to the weather related catastrophes impacting the Company's losses, product offerings, the Year 2000 discussion, statements relating to the new insurer, State Auto Insurance Company, the legislative and regulatory environment, including but not limited to the Gramm Leach Bliley Act of 1999 and sales forecasts. These risks and uncertainties include, but are not limited to, legislative changes at both the state and federal level, state and federal regulatory rule making promulgation's, class action litigation involving the insurance industry and judicial decisions affecting claims, policy coverages and the general costs of doing business, the impact of competitive products and pricing, product development, geographic spread of risk, weather and
"Qualitative and Quantitative Disclosures About Market Risk" is included in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Market Risk.
The Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Report of Independent Auditors are as follows:
On July 7, 1998, State Auto Financial exercised its option with State Automobile Mutual Insurance Company (Mutual), pursuant to the Option Agreement dated August 20, 1993, by acquiring the outstanding shares of Milbank. Milbank had been a wholly-owned subsidiary of Mutual since July 1, 1993, but as a result of this transaction, is now a wholly-owned subsidiary of State Auto Financial. The purchase price of Milbank was approximately $81.9 million. The transaction was effected through an exchange with Mutual of approximately 5.1 million State Auto Financial common shares for all the issued and outstanding capital stock of Milbank. Since the transaction was a combination of entities under common control it has been accounted for similar to a pooling-of-interests. The prior years' financial information includes the financial position and operations of Milbank.
State Auto Financial and subsidiaries are referred to herein as "the Companies" or "the Company." State Auto Financial, an Ohio corporation, is a majority-owned subsidiary of Mutual. All significant intercompany balances and transactions have been eliminated in consolidation.
(b) DESCRIPTION OF BUSINESS The Company, through State Auto P&C, Milbank and Farmers Casualty, 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, National, and Mid-Plains operate primarily in the midwest 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, National and Mid-Plains are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota, Iowa, Ohio 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 (the Departments) and the regulations of each state in which they operate. These property and casualty insurance companies undergo periodic financial examination by their Departments and insurance regulatory agencies of the states that choose to participate. Through State Auto P&C, the Company also provides executive management services to its affiliated insurance companies.
and also provides insurance premium finance services to customers of State Auto P&C, Mutual and Milbank.
(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, National and Mid-Plains that are prescribed or permitted by the Departments.
(d) DEFERRED POLICY ACQUISITION COSTS Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses related to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned, without credit for anticipated investment income. These amounts are based on estimates and accordingly, the actual realizable value may vary from the estimated realizable value. Net deferred policy acquisition costs were:
Balance, beginning of year ............................ $24,799 22,440 20,033 Acquisition of Farmers Casualty and Mid-Plains ...................... 730 -- -- Acquisition costs deferred ........................ 95,848 87,573 79,249 Amortized to expense during the year ................. 92,441 85,214 76,842 Balance, end -------------------------------------- of year ......................... $28,936 24,799 22,440 -------------------------------------- (e) INVESTMENTS Investments in fixed maturities, where the Companies have the ability and intent to hold to maturity, are carried at amortized cost. Mortgage-backed securities are carried at amortized cost using the scientific method of amortization including anticipated prepayments. Prepayment assumptions are obtained from a pricing service and are based on the current interest rate and economic environment. The retrospective adjustment method is used to value all such securities. For fixed maturities held to maturity, unrealized holding gains or losses are not reflected in the accompanying consolidated financial statements. Investments in fixed maturity and equity securities held as available for sale are carried at fair value. The net unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity as accumulated other comprehensive income and as such are
(g) 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 $1,347,000 and $1,089,000 at December 31, 1999 and 1998, respectively.
(h) LOSSES AND LOSS EXPENSES PAYABLE Losses and loss expenses payable are based on formula and case-basis estimates for reported claims, and on estimates, based on experience, for unreported claims and loss expenses. The liability for unpaid losses and loss expenses, net of estimated salvage and subrogation recoverable of $13,505,000 and $12,817,000 at December 31, 1999 and 1998, respectively, has been established to cover the estimated ultimate cost of insured losses. The amounts are necessarily based on estimates of future rates of inflation and other factors, and accordingly there can be no assurance that the ultimate liability will not vary from such estimates. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations (see note 4). Salvage and subrogation recoverables are estimated using historical experience.
Farmers Casualty and Mid-Plains will file a consolidated federal income tax return with the Company for periods subsequent to January 1, 1999. Prior to this time, Farmers Casualty and Mid-Plains filed their own consolidated return.
Income taxes are accounted for using the liability method. Using this method, deferred tax assets and
Seven STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Certain items in the 1998 and 1997 consolidated financial statements have been reclassified to conform with the 1999 presentation.
Fixed maturities ................. $32,096 30,182 29,784 Equity securities ................ 678 477 372 Surplus note receivable .......... -- 235 -- Cash and cash equivalents ........ 1,707 1,908 1,210 ------------------------------------- Investment income ................ 34,481 32,802 31,366 -------------------------------------
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. The recoverability of these assets depends on the reinsurers' ability to perform under the reinsurance agreements. The Company evaluates and monitors the financial condition and concentrations of credit risk associated with its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. The Company has reported ceded losses and loss expenses payable and prepaid reinsurance premiums with other insurers and reinsurers as assets. All reinsurance contracts provide indemnification against loss or liability relating to insurance risk and have been accounted for as reinsurance. Prior to the reinsurance transaction with Mutual under the pooling arrangement, as discussed in note 6(a), the effect of the Company's reinsurance on its balance sheet and income statement, is as follows:
(a) REINSURANCE State Auto P&C, Milbank and Farmers Casualty (the Pooled Subsidiaries) participate in a quota share reinsurance pooling arrangement (the Pooling Arrangement) with Mutual whereby the Pooled Subsidiaries 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.
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 sheet and income statements for the Pooling Arrangement between the Pooled Subsidiaries and Mutual:
Losses and loss expenses payable: Ceded .................................... $(206,258) (197,730) Assumed .................................. 208,885 196,818 --------------------------- Net assumed (ceded) ..................... 2,627 (912) --------------------------- Unearned premiums: Ceded .................................... $(143,514) (131,461) Assumed .................................. 130,820 123,022 --------------------------- Net ceded ............................... $ (12,694) (8,439) --------------------------- Fourteen STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Written premiums: Ceded .............................. $(403,679) (359,590) (348,676) Assumed ............................ 356,609 330,410 300,351
To protect against a catastrophe loss event, in which the State Auto Insurance Companies would incur catastrophe losses in excess of $120 million, State Auto Financial entered into a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the Lender) to provide up to $135 million for reinsurance purposes. In the event of such a loss, this arrangement provides that State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which would borrow the money necessary for such purchase from the Lenders. This arrangement with the Lenders, SPC and State Auto Financial is a financing arrangement, whereby State Auto Financial would receive cash funding in the event of a catastrophe event as described above. State Auto Financial would then contribute to State Auto P&C the funds received from the sale of its preferred shares. State Auto P&C would use the contributed capital proceeds to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC by redeeming the preferred shares over a six-year period. In the event of a default by State Auto Financial, the obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to put either the preferred shares or the loan(s) outstanding.
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 1999 and 1998 are presented below:
Deferred tax assets: Unearned premiums not deductible ......................... $ 9,597 8,885 Losses and loss expenses payable discounting ............. 8,375 8,257 Other .................................................... 2,229 1,604 ------------------ Total deferred tax assets .............................. 20,201 18,746 ------------------ Sixteen STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Deferred tax liabilities: Deferral of policy acquisition costs ........... 10,128 8,680 Net pension expense ............................ 6,631 5,732 Unrealized holding gain on investments ......... 84 10,919 Other .......................................... 1,530 1,510 ---------------------- Total deferred tax liabilities ............... 18,373 26,841 ---------------------- Net deferred tax assets (liabilities) ........ $ 1,828 (8,095) ----------------------
State Auto P&C, Stateco and S.I.S., pursuant to an intercompany agreement, are participants, together with Mutual, in a defined benefit pension plan that covers substantially all employees of Mutual and the Company. The assets of the plan are represented primarily by U.S. government and agency obligations, bonds, and common stocks. 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 plan is as follows:
Seventeen STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
YEAR ENDED DECEMBER 31 ---------------------- 1999 1998 1997 ---- ---- ---- (in thousands)
State Auto P&C, Milbank, National, Farmers Casualty and SAIC 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. Pursuant to these rules, approximately $28.9 million is available for payment to State Auto Financial in 2000 without prior approval.
(11) STOCK INCENTIVE PLANS The Company follows Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock incentive plans. For stock options granted to employees of Mutual, the Company also follows APB 25 and related Interpretations, as the Company deems such employees to be common law employees of the Company. Compensation cost charged against operations in 1999 was $137,000 for those employee stock options granted where the exercise price was less than the market price of the underlying stock on the date of grant. Had compensation cost for the Company's plans been determined based on the fair values at the grant dates consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123), the Company's pro forma net earnings and net earnings per share information would have been as follows:
1999 1998 1997 ---- ---- ---- (in thousands, except per share figures)
The fair value of options granted in 1999, 1998 and 1997 were estimated at the date of grant using the Black-Scholes option-pricing model. The weighted average fair values and related assumptions for options granted were as follows:
Fair value ....................................... $4.49 $6.10 $3.00 Dividend yield ................................... .90% .75% 1.00% Risk free interest rate .......................... 5.77% 5.31% 5.85% Expected volatility factor ....................... .32 .31 .30 Expected life (years) ............................ 5.7 6.6 2.2
The Company has an employee stock purchase plan with a dividend reinvestment feature, under which employees of Mutual, State Auto P&C, Stateco and S.I.S. may choose at two different specified time intervals each year to have up to 6% of their annual base earnings withheld to purchase the Company's common stock. The purchase
price of the stock is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 2,400,000 shares of common stock under this plan. At December 31, 1999, 1,558,000 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 1999 were as follows: fair value of $4.02; dividend yield of .90%; expected volatility factor of .30; risk-free interest rate of 6.80%; and expected life of the option of 9.7 years. Expense of $105,000 associated with this plan was recognized in 1999.
A summary of the Company's stock option activity and related information for these plans for the years ended December 31, 1999, 1998 and 1997, follows:
A summary of information pertaining to options outstanding and exercisable as of December 31, 1999 follows:
(14) REPORTABLE SEGMENTS The Company has three reportable segments: standard insurance, nonstandard insurance and investment management services. 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 Midwest and Eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. The investment management services segment manages the investment portfolios of affiliated insurance companies.
Revenue from segments in the other category is attributable to three other operating segments of the Company; an insurance software development and resale segment, a premium finance segment and a property management and leasing segment. These segments have never met the quantitative thresholds for determining reportable segments. The following provides financial information regarding the Company's reportable segments:
The standard insurance segment participates in a reinsurance pooling agreement with other standard insurance affiliates. For discussion regarding this arrangement and the segment's contribution to the pool and participation in the pool, see note 6.
(16) CONTINGENCIES The Company's insurance subsidiaries are involved in litigation and may become involved in potential litigation arising in the ordinary course of business. In the opinion of management, the effects, if any, of such litigation are not expected to be material to the consolidated financial statements.