We share our operating facilities with State Auto Mutual pursuant to the terms of the 2005 Management Agreement. Our corporate headquarters are located in Columbus, Ohio, in buildings owned by State Auto Mutual that contain approximately 280,000 square feet of office space. State Auto Mutual also owns and leases other office facilities in numerous locations throughout the State Auto Group’s geographical areas of operation.
Capitalized terms used in this Item 7 and not otherwise defined have the meanings ascribed to such terms under the caption “Important Defined Terms Used in this Form 10-K” which immediately precedes Part I of this Form 10-K. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Form 10-K and the narrative description of our business contained in Item 1 of this Form 10-K. For information regarding our financial results for the fiscal year ended December 31, 2017, please see the discussion included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018.
State Auto Financial is a property and casualty insurance holding company. Our insurance subsidiaries are part of the State Auto Group and Pooling Arrangement described below. The State Auto Group markets its insurance products throughout the United States primarily through independent agencies, which include retail agencies and brokers. Our Pooled Companies are rated A- (Excellent) by A.M. Best.
In 2019, although we did not meet our goal of profitable growth, we made considerable progress toward positioning our company to be able to produce more consistent profitable results. Our personal and commercial lines' 101.2% SAP combined ratio and 10.2% net written premium growth fell short of our expectations, but were accompanied by efforts throughout our company to become more effective and efficient.
Our personal lines business did not meet our expectations for profit or growth in 2019. Personal lines were impacted by technology and pricing issues in our personal auto and homeowners' products, that should be addressed with the introduction of an updated pricing model in 2020. We also experienced execution challenges during upgrades of our platform architecture. We have addressed those issues, as well. In commercial lines, we delivered profit and strong growth. This was the result of two years of rebuilding our commercial lines teams and products. We are well positioned to continue delivering outstanding results in this part of our business.
Our culture is central to our progress to date, and will remain critical to our future success. We encourage openness, candor, transparency, creativity and challenge. Our associates are expected to act like owners by participating, asking questions, challenging assumptions and proposing solutions. We believe the culture that we have created enables us to move quickly and effectively, with agents and customers at the forefront. It also includes a shared commitment to the communities in which we live and work, which has been at the heart of our company since our founding. Our success will be measured not only in our business performance, but in the difference we make in our communities.
losses and expenses from each of the Pooled Companies and in turn cedes to each of the Pooled Companies a specified portion of premiums, losses and expenses based on each of the Pooled Companies’ respective pooling percentages. State Auto Mutual then retains the balance of the pooled business.
The following table sets forth certain key performance indicators we use to monitor our operations for the years ended December 31, 2019 and 2018:
•Net investment gain was $74.2 million, which included $73.8 million of unrealized gains from equity securities and other invested assets. Net investment income was $80.4 million, which included $62.3 million of income from the fixed maturities portfolio.
•The SAP non-cat loss and ALAE ratio was 53.5%, or $669.7 million. Non-catastrophe losses and ALAE included 5.8 points of favorable development relating to prior years, or $72.4 million, primarily from the commercial insurance segment which contributed $58.8 million. The current accident year non-cat loss and ALAE was primarily impacted by non-cat weather losses and large losses, including fires.
The following highlights significant factors that impacted our 2018 net income of $12.8 million:
•Net investment loss of $49.7 million, which was impacted by $57.4 million of unrealized losses from equity securities and other invested assets due to the adoption of ASU 2016-01 effective January 1, 2018 which requires changes in fair value for equity securities and other invested assets still held to be reported through net income.
•The catastrophe loss and ALAE ratio was 5.8%, or $71.7 million. 2018 was impacted by wind and hail storms.
The following tables set forth certain key performance indicators by major product line of business for our personal insurance segment for the years ended December 31, 2019 and 2018:
The personal insurance segment's net written premiums for the year ended December 31, 2019 increased 9.1% compared to 2018 (Tables 1 - 2), primarily driven by new business growth and increased rates in homeowners and other personal. The new business growth resulted in higher levels of policies in force for homeowners during 2019 compared to 2018. Partially offsetting the 2019 net written premium growth was a decrease in personal auto net written premiums primarily driven by a decline in new business and retention when compared to 2018.
The personal insurance segment's SAP catastrophe loss ratio for the year ended December 31, 2019 was 9.4%, compared to 7.2% in 2018 (Tables 1 - 2). During 2019, catastrophe losses, primarily wind and hail storms, were more severe when compared to the same 2018 period, with most of the catastrophe losses impacting homeowners. While the number of catastrophe events in 2019 was flat when compared to 2018, the 2019 events were more severe with over half of the reported losses occurring in Texas. During 2018, catastrophe losses were primarily related to wind and hail storms with approximately one-third of the losses occurring in Texas and Colorado.
The personal insurance segment's SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2019 was 56.8% compared to 52.2% in 2018. (Tables 1 - 2).
The personal auto SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2019 increased 4.0 points when compared to the same 2018 period (Tables 1 - 2). Favorable development of prior accident year losses improved the 2019 loss ratio by 2.5 points compared to 6.1 points in 2018. The 3.6 points of less favorable development in 2019 was across multiple coverages including bodily injury and uninsured and under-insured motorist coverages as well as adverse development of property damage claims, primarily from the 2018 and 2017 accident years. The 2018 prior accident year favorable development was primarily attributable to lower than anticipated severity for bodily injury claims from the 2016 and 2017 accident years.
The homeowners SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2019 increased 8.3 points when compared to the same 2018 period (Tables 1 - 2). The current accident year loss ratio increased 5.3 points when compared to 2018, primarily attributable to an elevated level of non-cat weather losses. The 2019 prior accident year losses were minimally impacted by development compared to favorable development of 2.9 points in 2018. The 2018 prior accident year favorable development was primarily attributable to favorable emergence on liability claims from multiple accident years.
The following tables set forth certain key performance indicators by major product line of business for our commercial insurance segment for the years ended December 31, 2019 and 2018:
In October 2017, we launched State Auto Connect for new business in one state for our commercial auto and small commercial package products. Similar to the State Auto Connect platform for our personal insurance products, the State Auto Connect commercial lines platform is completely digital and incorporates data analytics and more sophisticated pricing models compared to our legacy underwriting systems. This platform enables our agents to submit, quote, bind, issue and bill policies through a completely digital and integrated platform. During 2018, we completed the rollout of State Auto Connect for commercial auto, and in January 2019 we finished the rollout of State Auto Connect for small commercial package. We anticipate launching our farm and ranch product in State Auto Connect during the first quarter of 2020, our middle market commercial product during the second half of 2020 followed by workers' compensation in 2021.
The commercial insurance segment's SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2019 was 48.0% compared to 49.0% in 2018. (Tables 3 - 4).
The commercial auto SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2019 increased 6.4 points when compared to 2018 (Tables 3 - 4). The non-catastrophe loss and ALAE ratio for 2019 was impacted by less
favorable development of prior accident year losses of 5.1 points compared to favorable development of 11.2 points in 2018. The 2019 favorable development was primarily from the 2017 and 2018 accident years. The 2018 favorable development was primarily attributable to lower than anticipated bodily injury severity from the 2016 and 2017 accident years.
The middle market commercial SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2019 improved 1.0 point compared to 2018 (Tables 3 - 4). The 2019 improvement was primarily driven by greater favorable development of prior accident year losses due to lower than expected bodily injury claim severity from multiple accident years. Partially offsetting the 2019 improvement in the non-catastrophe loss and ALAE ratio when compared to 2018 were large fire losses in the current accident year, including a single large loss that added 2.0 points to the loss ratio.
The workers' compensation SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2019 improved 4.7 points when compared to the same 2018 period. The 2019 loss ratio was impacted by greater favorable development of prior accident year losses when compared to the same 2018 period, primarily due to lower than anticipated severity from multiple accident years. Partially offsetting the 2019 improvement was a higher current accident year loss ratio when compared to 2018, which reflected (i) elevated claim frequency and severity, and (ii) a single large loss that added 3.5 points to the loss ratio.
The following table sets forth a tabular presentation of the development of the ultimate liability of prior accident years by line of business for the years ended December 31, 2019 and 2018:
For further information, see the discussion below and the "Personal Insurance Segment" and "Commercial Insurance Segment" sections of “Results of Operations - Insurance Segments” included in this Item 7.
•The commercial insurance segment non-catastrophe loss and ALAE reserves contributed $58.8 million of favorable development, driven by workers’ compensation, small commercial package, and middle market commercial which contributed $20.9 million, $15.2 million, and $11.8 million, respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years.
•Catastrophe reserves in specialty run-off contributed $10.7 million of adverse development primarily from Hurricanes Irma and Harvey. Partially offsetting the adverse development in specialty run-off was $5.0 million of favorable development in the personal and commercial insurance segments.
The following table sets forth a tabular presentation of the development of the ultimate liability by accident year for the year ended December 31, 2018:
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the more notable items contributing to 2018 development were as follows:
•The commercial insurance segment non-catastrophe loss and ALAE reserves contributed $46.9 million of favorable development, driven by workers’ compensation, small commercial package, commercial auto, and middle market commercial, which contributed $13.3 million, $9.6 million, $8.4 million and $8.0 million, respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years.
The following table sets forth loss and loss expenses payable by major line of business at 2019 and 2018:
The loss and loss expenses payable at December 31, 2019 decreased $88.4 million from the loss and loss expenses payable at December 31, 2018, primarily due to the run-off of specialty business.
Our GAAP acquisition and operating expenses were $442.0 million in 2019 compared to $449.8 million in 2018. Acquisition and operating expenses for 2019 decreased when compared to 2018 primarily due to a decrease in variable incentive compensation and amortization of deferred acquisition costs, partially offset by increases in report ordering costs and EDP software cost amortization.
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, U.S. large-cap equities, U.S. small-cap equity funds, international equity funds, master limited partnership ("MLP") funds and exchange traded funds ("ETF"). In addition, Stateco uses an outside investment manager who invests in international funds. The Investment and Finance Committee (the “Committee”) of our Board of Directors establishes the investment policies to be followed by Stateco. Our primary investment objectives are to maintain adequate liquidity and capital to meet our responsibilities to policyholders, grow long term economic surplus to increase our capital position, maintain a consistent level of income to support operations and manage investment risk. Our current investment strategy does not rely on the use of derivative financial instruments.
At December 31, 2019, our investments in fixed maturities, equity securities and certain other invested assets were carried at fair value. The unrealized holding gains or losses of our available-for-sale fixed maturities, net of applicable deferred taxes, are included as a separate component of stockholders’ equity as accumulated other comprehensive income and as such are not included in the determination of net income.
Effective January 1, 2018, we adopted Accounting Standards Update (ASU) No. 2016-01 which, among other things, requires unrealized gains and losses for equity securities and other invested assets previously identified as available-for-sale to be recognized in net income. Previously, the unrealized gains and losses for these securities were recognized in other comprehensive income. Accordingly, changes in the fair value of equity securities and other invested assets are reported in "net investment gain (loss)" in the condensed consolidated statements of income for the years ended December 31, 2019 and 2018, respectively.
We believe that the fixed maturity portfolio’s exposure to credit risk is minimal as approximately 88.9% of the bonds we own are rated A or better. We do not intend to change our investment policy or the quality of our fixed maturity investments. The fixed maturity portfolio is managed in a laddered-maturity style and considers business mix and liability payout patterns to ensure adequate cash flow to meet claims as they are presented. We also manage liquidity risk by maintaining sufficient cash balances, owning some agency and U.S. Treasury securities at all times, purchasing bonds of major issuers, and purchasing bonds that are part of a medium or large issue. The fixed maturity portfolio does not have any direct exposure to either exchange rate risk or commodity risk. We do not rely on the use of derivative financial instruments. We categorize our fixed maturities as available-for-sale in order to provide us greater flexibility in managing our portfolio. We do not maintain a trading portfolio.
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, 2019, approximately $652.5 million, or 30.7%, 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, 2019, we had one international fund, which was included in other invested assets. The international fund had a beta of 0.71 using the MSCI EAFE Index as a benchmark. The following table sets forth what changes might occur in the value of Funds 1 given a change in the MSCI EAFE Index at December 31, 2019:
Based upon our review of our investment portfolio at December 31, 2019, we determined that there were no individual investments with an unrealized holding loss that had a fair value significantly below cost continually for more than one year. The following table sets forth detailed information on our available-for-sale investment portfolio by lot at fair value for our gross unrealized holding gains (losses) at December 31, 2019:
The following table sets forth our unrealized holding gains by investment type, net of deferred tax that was included as a component of accumulated comprehensive income at December 31, 2019 and 2018, and the change in unrealized holding gains, net of deferred tax, for the year ended December 31, 2019:
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 expense (benefit) and the amount computed at the indicated statutory rate for the years ended December 31, 2019 and 2018.
We maintain a portion of our investment portfolio in relatively short-term and highly liquid investments to ensure the immediate availability of funds to pay claims and expenses. At December 31, 2019 and 2018, we had $78.0 million and $59.8 million, respectively, in cash and cash equivalents, and $2,592.8 million and $2,523.3 million, respectively, of total investments. Our available-for-sale fixed maturities included $9.3 million and $8.9 million, respectively, of securities on deposit with insurance regulators, as required by law, at December 31, 2019 and 2018. In addition, substantially all of our fixed 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 used in operating activities was $43.9 million and $13.4 million in 2019 and 2018, respectively. Net cash from operations will vary from period to period if there are significant changes in underwriting results, primarily the level of premiums written or loss and loss expenses paid, and in cash flows from investment income.
Net cash used in financing activities was $12.0 million and $2.3 million in 2019 and 2018, respectively. The change was primarily driven by a decrease in stock option exercises in 2019 when compared to 2018.
current intention is to renew the OLC for another year. Draws under the OLC are to be funded at a daily variable rate advance with a term of no more than 180 days with interest payable monthly. All advances under the OLC are to be fully secured by a pledge of specific investment securities of State Auto P&C. As of December 31, 2019, no advances had been made under the OLC.
The following table sets forth our notes payable at December 31, 2019:
Members of the State Auto Group maintain a property catastrophe excess of loss reinsurance agreement, covering property catastrophe related events affecting at least two risks. This property catastrophe reinsurance agreement renewed as of July 1, 2019. Under this reinsurance agreement, we retain the first $75.0 million of catastrophe loss, each occurrence, with a 5.0% co-participation on the next $125.0 million of covered loss, each occurrence. The reinsurers are responsible for 95.0% of the catastrophe losses excess of $75.0 million up to $200.0 million, each occurrence. The State Auto Group is responsible for catastrophe losses above $200.0 million. There is also an automatic restatement of the limit, for 125% of the deposit premium.
As of July 1, 2019, the State Auto Group renewed the property per risk excess of loss reinsurance agreement. This reinsurance agreement provides individual property risk coverage for the State Auto Group for losses exceeding $4.0 million. The reinsurers are responsible for 100.0% of the loss excess of the $4.0 million retention for property business up to $20.0 million of covered loss.
As of July 1, 2019, the State Auto Group renewed the casualty excess of loss reinsurance agreement. Under this reinsurance agreement, the State Auto Group is responsible for the first $3.0 million of losses that involve workers' compensation, auto liability, other liability and umbrella liability policies. This reinsurance agreement provides coverage up to $10.0 million, except for commercial umbrella policies which are covered for limits up to $15.0 million.
The following table sets forth our significant contractual obligations at December 31, 2019:
At December 31, 2019 and 2018, each of our insurance subsidiaries was in compliance with statutory requirements relating to capital adequacy.
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 we 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, $91.3 million is available for payment to State Auto Financial from its insurance subsidiaries in 2020 without prior approval. State Auto Financial received dividends from its insurance subsidiaries in the amount of $10.0 million and $10.0 million in 2019 and 2018.
We believe that these ratings provide a meaningful way for policyholders, agents, creditors, shareholders and others to compare us to our competitors. Our ratings are influenced by many factors, including operating and financial performance, asset quality, liquidity, financial leverage, exposure to catastrophe risks and operating leverage.
regular basis, and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis and not settled after six months are case reserved at that time. The process for calculating the IBNR component of the loss reserve is to develop an estimate of the ultimate losses and allocated loss adjustment expenses incurred, and subtract all amounts already paid or held as case or formula reserves. Note that reference to losses below implicitly includes allocated loss adjustment expenses.
Our internal actuarial staff conducts quarterly reviews of loss development information to assist management in making estimates of ultimate losses and loss expenses. Several factors are considered in estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, exposure growth, current business conditions, catastrophe developments and late reported claims. In addition, reasonableness tests are performed on many of the assumptions underlying each reserving methodology, such as claim frequency, claim severity and loss ratios. Nonetheless, changes which are not contemplated do occur over time, and those changes are incorporated in subsequent valuations of our loss reserves.
Incurred Loss Development Method: The Incurred Loss Development Method is probably the most common actuarial method used in projecting ultimate losses, and thus indicated IBNR reserves. This method uses paid loss experience as well as the outstanding amounts (formula and case reserves) for claims that have been reported and are still open. With this method, a pattern of reported losses is estimated to project ultimate incurred values for each accident year. An important assumption underlying 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 can distort the projections.
Claim Counts and Severities Method: The Counts and Severities Method calculations are very similar to the development methods described above. The incurred claim counts reported to date are projected to an ultimate number. Similarly, the incurred loss severities are projected to an ultimate value. The ultimate incurred count is multiplied by the ultimate incurred severity, for each accident year, to arrive at the ultimate incurred loss estimate.
Incurred Bornhuetter-Ferguson Method: The Incurred 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 to-date as the weight on the Incurred Loss Development Method. This method is particularly useful where there is a low volume of data in the more recent accident periods or where the experience is volatile. In general, this method produces estimates that are similar to the Incurred Loss Development Method.
Paid Bornhuetter-Ferguson Method: The Paid Bornhuetter-Ferguson Method is a weighted average of the Expected Loss Ratio Method and the Paid Loss Development Method, using the percentage of losses paid to-date as the weight on the Paid Loss Development Method. In less mature accident periods in which payment activity is relatively low, this method produces estimates that are similar to the Expected Loss Ratio Method.
An important assumption underlying certain loss reserve estimation methods for casualty lines is that the loss cost trends underlying historical data 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, 2019, workers’ compensation loss and ALAE reserve balance 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 5% 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 following table sets forth a reconciliation of MBE of our direct loss and LAE reserve to our net losses and loss expenses payable at December 31, 2019 and 2018. The STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement for the years ended December 31, 2019 and 2018, respectively, has been reflected in the table below as assumed by STFC Pooled Companies.
The following tables set forth the net losses and loss expenses payable by major line of business at December 31, 2019 and 2018:
At December 31, 2019, asbestos reserves were $2.2 million and environmental reserves were $20.8 million, for a total reserve of $23.0 million, or 2.2% of net losses and loss expenses payable. Relative to December 31, 2018, asbestos and environmental reserves increased $1.0 million and $4.1 million, respectively.
The State Auto Group has a defined benefit pension plan covering substantially all employees hired prior to January 1, 2010 and a postretirement healthcare plan covering certain associates and retirees (collectively “the benefit plans”). We record the funded status of these plans on our balance sheet while the annual net periodic costs are allocated to affiliated companies based on allocations pursuant to intercompany management agreements including the Pooling Arrangement for insurance subsidiaries and affiliates party to this agreement. We receive reimbursement of 35% of the annual net periodic costs from the Mutual Pooled Companies in accordance with the terms of the Pooling Arrangement.
Several factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the benefit plans. Key factors include assumptions about the expected rates of return on plan assets, discount rates, and health care cost trend rates. We consider market conditions, including changes in investment returns and interest rates, in making these assumptions. The actuarial assumptions used by us in determining benefit obligations may differ materially from actual results due to changing market and economic conditions, higher or lower turnover and retirement rates, or longer or shorter life spans of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect our financial position or results of operations.
For the December 31, 2019 and 2018 valuations, the Adjusted RP-2014 mortality table was used as a baseline for the mortality assumption and to project future mortality rates. Incorporated into the table are rates projected generationally using
To calculate the State Auto Group’s December 31, 2019 benefit obligation for each of the benefit plans, we used a discount rate of 3.10% based on an evaluation of the expected future benefit cash flows of our benefit plans used in conjunction with the Citigroup Pension Discount Curve at the measurement date. A lower discount rate, all else being equal, results in a higher present value benefit obligation. To calculate our benefit obligation at December 31, 2019 and net periodic benefit cost for the year ended December 31, 2020, a discount rate of 3.10% and an expected long-term rate of return on plan assets of 6.50% were used. We selected an expected long-term rate of return on our plan assets by considering the mix of investments and stability of investment portfolio along with actual investment experience during the lifetime of the plans. Our assumptions regarding the discount rate and expected return on plan assets could have a significant effect on the amounts related to our benefit obligations and net periodic benefit cost depending on the degree of change between reporting periods.
As a result of revised mortality assumptions and the change in the discount rate, the benefit plan’s liability decreased $3.6 million for the year ended December 31, 2019 and increased $5.0 million for the year ended December 31, 2018.
The following table sets forth an illustration of variability with respect to the discount rate on the December 31, 2019 benefit obligation and expected net periodic benefit cost for the year ending December 31, 2020, along with the variability of the expected return on plan assets to the expected net periodic benefit cost for the year ending December 31, 2020. Holding all other assumptions constant, sensitivity to changes in any one of our key assumptions are as follows:
The unfunded status on the pension plan and supplemental executive retirement plan decreased from $57.5 million at December 31, 2018, to $47.9 million at December 31, 2019. 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.
The following table sets forth the components of our federal income tax expense (benefit) for the years ended December 31, 2019 and 2018:
We have audited State Auto Financial Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2019, 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). In our opinion, State Auto Financial Corporation and subsidiaries (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on the COSO criteria.
•State Auto Property and Casualty Insurance Company (“State Auto P&C”), an Iowa corporation
The Company’s insurance subsidiaries, domiciled in Ohio and Iowa, are required to prepare statutory basis financial statements in accordance with the accounting practices prescribed or permitted by the insurance departments of the states of domicile. Prescribed statutory accounting practices are those practices that are incorporated directly or by reference in state laws, regulations, and general administrative rules applicable to all insurance enterprises domiciled in a particular state. The Ohio and Iowa Departments of Insurance require insurers domiciled in their respective states to prepare statutory financial statements in accordance with National Association of Insurance Commissioners’ (“NAIC”) statutory accounting practices. Permitted statutory accounting practices are those practices that differ either from state-prescribed statutory accounting practices or NAIC statutory accounting practices. The Company’s insurance subsidiaries do not apply any statutory accounting practices that would be considered a prescribed statutory accounting practice that differs from NAIC statutory accounting practices.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the periods then
ended, and the accompanying notes to the financial statements. Such estimates and assumptions could change in the future as more information becomes known which could impact the amounts reported and disclosed herein.
The following table sets forth net deferred acquisition costs for the years ended December 31, 2019, 2018 and 2017:
Losses and loss expenses payable are based on formula and case-basis estimates for reported claims and on estimates, based on experience and perceived trends, for unreported claims and loss expenses. The liability for unpaid losses and loss expenses, net of estimated salvage and subrogation recoverable of $26.4 million and $24.8 million at December 31, 2019 and 2018, 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.
In February 2016, the FASB issued ASU 2016-02, "Leases (Topic 842)" that amended previous guidance on lease accounting. The new guidance requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The guidance became effective beginning January 1, 2019 and it did not have a material impact on the Company’s results of operations, consolidated financial position or cash flows, as the Company is not a party to any material leases as a lessee or lessor as defined by the guidance. The Company elected the practical expedients contained in ASC 842-10-65-1(f) and therefore did not reassess the lease classification of its existing leases.
In August 2018, the FASB issued ASU 2018-13 which changes the fair value measurement disclosure requirements of ASC 820 by adding, eliminating and modifying disclosures. The effective date of ASU 2018-13 is for interim and annual reporting periods beginning after December 15, 2019. The ASU has not yet been adopted; however, it is not expected to have a material impact on the Company's results of operations, consolidated financial position, or cash flows.
Disclosure Framework - Changes to the Disclosure Requirements for Defined Benefit Plans
In August 2018, the FASB issued ASU 2018-14 which changes the defined benefit pension and other postretirement plan disclosure requirements of ASC 715 by adding, eliminating and modifying disclosures. The effective date of ASU 2018-14 is for annual reporting periods ending after December 15, 2020. The ASU has not yet been adopted; however, it is not expected to have a material impact on the Company's results of operations, consolidated financial position, or cash flows.
The following tables set forth the cost or amortized cost and fair value of investments by lot at December 31, 2019 and 2018:
The Company reviewed its investments at December 31, 2019 and 2018 and determined that no additional other-than-temporary impairment existed in the gross unrealized holding losses. The following table sets forth the realized losses related to other-than-temporary impairments on the Company’s investment portfolio recognized for the year ended December 31, 2017:
At December 31, 2019, 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.
Proceeds on sales of investments in 2019, 2018 and 2017 were $355.5 million, $197.0 million and $438.6 million, 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, 2019, 2018 and 2017:
•Level 2 includes observable inputs for assets or liabilities other than quoted prices included in Level 1, and it includes valuation techniques which use prices for similar assets and liabilities.
The fair value estimate of the Company’s fixed maturity investments are determined by evaluations that are based on observable market information rather than market quotes. Inputs to the evaluations include, but are not limited to, market prices from recently completed transactions and transactions of comparable securities, interest rate yield curves, credit spreads, and other market-observable information. The fixed maturity portfolio pricing obtained from the pricing service is reviewed for reasonableness. Regularly, samples of security prices are referred back to the pricing service for more detailed explanation as to how the pricing service arrived at that particular price. The explanations are reviewed for reasonableness by the portfolio manager or investment officer. Additionally, the prices and assumptions are verified against an alternative pricing source for reasonableness and accuracy. Any discrepancies with the pricing are returned to the pricing service for further explanation and if necessary, adjustments are made. To date, the Company has not identified any significant discrepancies in the pricing provided by its third party pricing service. Investments valued using these inputs include U.S. treasury securities and obligations of U.S. government agencies, obligations of states and political subdivisions, corporate securities, and U.S. government agencies mortgage-backed securities. All unadjusted estimates of fair value for fixed maturities priced by the pricing service are included in the amounts disclosed in Level 2 of the hierarchy. If market inputs are unavailable, then no fair value is provided by the pricing service. For these securities, fair value is determined either by requesting brokers who are knowledgeable about these securities to provide a quote; or the Company internally determines the fair values by employing widely accepted pricing valuation models, and depending on the level of observable market inputs, renders the fair value estimate as Level 2 or Level 3.
The following tables set forth the Company’s investments within the fair value hierarchy at December 31, 2019 and 2018:
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 at an interest rate of 7.00%. In May 2019, the Company refinanced the two credit agreements with State Auto Mutual at an interest rate of 4.05%, with principal payable in May 2029. 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.
The Company recorded favorable development related to prior years’ loss and loss expense reserves in 2017 of $46.6 million. Favorable development of prior accident years' non-catastrophe loss and ALAE reserves was primarily driven by $44.0 million of favorable development in the commercial insurance segment. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years. The personal insurance segment non-catastrophe loss and ALAE reserves accounted for $1.6 million of the favorable development in 2017. Personal auto contributed $4.4 million of favorable development primarily driven by lower than anticipated severity emerging from accident years 2015 and 2016. Slightly offsetting the favorable development was adverse development in homeowners and other personal of $1.5 million and $1.3 million, respectively. Homeowners adverse development was primarily from accident year 2016. Adverse development in other personal was driven by higher than anticipated severity emerging from accident years 2015 and 2016. The specialty insurance segment non-catastrophe loss and ALAE reserves accounted for $4.2 million of adverse development, primarily driven by E&S property with adverse development of $3.0 million. E&S property adverse development was driven by higher than anticipated severity for liability coverages on business in run-off.
•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;
The change in incurred losses and loss adjustment expenses for prior accident years was due to lower than expected emergence of all personal insurance products. The emergence was primarily attributable to lower severity for bodily injury claims from the 2017 and 2018 accident years.
Effective June 1, 2017, State Auto P&C entered into a quota share agreement with Home State to assume 100% of the business issued under this agreement, defined as Texas Private Passenger Automobile. Home State receives a variable fee (capped at 2%) in consideration for this arrangement.
The following table sets forth the effect of the Company’s external reinsurance on its balance sheets at December 31, 2019 and 2018, prior to the reinsurance transaction with State Auto Mutual under the Pooling Arrangement, as discussed in Note 7a:
The following table sets forth the effect of the Company’s external reinsurance on its income statements for the years ended December 31, 2019, 2018 and 2017, prior to the reinsurance transaction with State Auto Mutual under the Pooling Arrangement, as discussed in Note 7a:
The following table sets forth the reinsurance transactions on the Company’s balance sheets for the Pooling Arrangement between the STFC Pooled Companies and State Auto Mutual at December 31, 2019 and 2018:
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, 2019, 2018 and 2017:
Pursuant to the Pooling Arrangement, State Auto Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and then settles the intercompany balances generated by these transactions with the participating companies on a quarterly basis within 60 days following each quarter end. No interest is paid on this balance. When settling the intercompany balances, State Auto Mutual provides the pool participants with full credit for the premiums written and net losses paid during the quarter and retains all receivable amounts from insureds and agents and reinsurance recoverable on paid losses from unaffiliated reinsurers. Any receivable amounts that are ultimately deemed to be uncollectible are charged-off by State Auto Mutual and allocated to the pool members on the basis of pool participation. As a result, the Company has an off-balance sheet credit risk related to the balances due to State Auto Mutual from insurers, agents and reinsurers, which are offset by the unearned premium from the respective policies. The Company’s share of the premium balances due to State Auto Mutual from agents and insureds at December 31, 2019 and 2018 is approximately $371.0 million and $347.8 million, respectively.
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 6.11% at December 31, 2019). 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.
The following table sets forth the tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2019 and 2018:
At December 31, 2019, the Company carried no balance for uncertain tax positions. The Company had no accrual for the payment of interest and penalties at December 31, 2019 or 2018.
The defined benefit pension and postretirement benefit plans are referred to herein as “the benefit plans.”
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, 2019, 2018 and 2017:
The postretirement plan’s gross benefit payments for 2019 were $2.5 million, including the prescription drug benefits. The postretirement plan’s subsidy related to Medicare Prescription Drug Improvement and Modernization Act of 2003 estimates future annual subsidies to be approximately $0.3 million.
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, 2019:
Included in the pension plan’s investments are two international funds (“the funds”) that invests in equity securities of foreign issuers and are managed by third party investment managers. The funds had a fair value of $38.2 million and $32.7 million at December 31, 2019 and 2018, respectively, which was determined using the funds' net asset value. In
The actuarially prepared funding amount to the pension plan ranges from the minimum amount the Company would be required to contribute to the maximum amount that would be deductible for tax purposes. Contributed amounts in excess of the minimum amounts are deemed voluntary. Amounts in excess of the maximum amount would be subject to an excise tax and may not be deductible for tax purposes. The Company expects to contribute up to $10.0 million to the pension plan during 2020.
The following tables set forth the changes in the Company’s accumulated other comprehensive income (loss) component ("AOCI(L)"), net of tax, for the years ended December 31, 2019, 2018 and 2017:
The following tables set forth the reclassifications out of accumulated other comprehensive income (loss), by component, to the Company’s consolidated statement of income for the years ended December 31, 2019, 2018 and 2017:
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. As of December 31, 2019, each of the Company’s insurance subsidiaries maintained adjusted statutory surplus in excess of 400% of the authorized control level RBC.
The Company has reserved 2.4 million common shares under the 2017 LTIP. As of December 31, 2019, a total of 1.8 million common shares are available for issuance under the 2017 LTIP. The 2017 LTIP provides that (i) the maximum value of performance stock awards or performance unit awards settled in cash that may be granted in any calendar year is equal to the excess of the number of awards multiplied by the fair market value of the company’s common shares on the applicable payment or settlement date of the award multiplied by 5 and (ii) the maximum number of common shares subject to awards of performance stock and performance units that may be granted in any calendar year to any one individual is 250,000 shares. The 2017 LTIP automatically terminates on May 4, 2027.
Company recognizes compensation expense based on the number of restricted shares granted at the then grant date fair value over the Restriction Period. The Company recognizes forfeitures as they occur.
The following table sets forth the Company’s total activity and related information for performance unit award activity for the years ended December 31, 2019, 2018 and 2017:
The following table sets forth the Company’s total activity and related information for service-based restricted stock award activity for the years ended December 31, 2019, 2018 and 2017:
The following table sets forth the Company’s stock option activity and related information for the years ended December 31, 2019, 2018 and 2017:
Aggregate intrinsic value for total options outstanding and exercisable at December 31, 2019 was $9.0 million, respectively.
The RSU Plan is an unfunded deferred compensation plan which currently provides each outside director with an award of 1,400 restricted share units (the “RSU award”) following each annual meeting of shareholders. The amount of the award may change from year to year, based on the provision described below. The RSU awards are fully vested six months after the date of grant. RSU awards are not common shares of the Company and, as such, no participant has any rights as a holder of common shares under the RSU Plan. RSU awards represent the right to receive an amount, payable in cash or common shares of the Company, as previously elected by the outside director, equal to the value of a specified number of common shares of the Company at the end of the restricted period. Such election may be changed within the constraints set forth in the RSU Plan. The restricted period for the RSU awards begins on the date of grant and expires on the date the outside director retires from or otherwise terminates service as a director of the Company. During the restricted period, outside directors are credited with dividends, equivalent in value to those declared and paid on the Company’s common shares, on all RSU awards granted to them. At the end of the restricted period, outside directors receive cash or common share distributions of their RSU awards either (i) in a single lump sum payment, or (ii) in annual installment payments over a 5- or 10-year period, as previously elected by the outside director. The administrative committee for the RSU Plan (currently the Company’s Compensation Committee) retains the right to increase the annual number of RSU awards granted to each outside director to as many as 10,000 or to decrease such annual number to not less than 500, without seeking shareholder approval, if such increase or decrease is deemed appropriate by the administrative committee to maintain director compensation at appropriate levels. The RSU Plan automatically terminates on May 31, 2026. The Company accounts for the RSU Plan as a liability plan. There were 18,837 RSUs, 23,080 RSUs, and 26,323 RSUs granted in 2019, 2018 and 2017, respectively.
During 2019 and 2018, common shares valued at approximately $1,217,996 and $110,256, respectively, were distributed by the Company under the RSU Plan.
The Company changed its reportable segments from four to three effective January 1, 2019. The exit from the specialty insurance business resulted in the elimination of specialty insurance as a reportable segment. Specialty results, labeled as "specialty run-off," are included in the tables below to enable reconciliation to total underwriting results.
The three remaining reportable segments are: personal insurance, commercial insurance, and investment operations. The reportable insurance segments are business units managed separately because of the differences in the type of customers they serve, the products they provide or services they offer.