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
The industry combined ratios are from A.M. Best. The 2008 industry combined ratio is an estimate.
* Reflects changes in Pooling Arrangements, effective January 1, 2008 and 2005.
Under the Pooling Arrangement, State Auto Mutual assumes premiums, losses and expenses from each of the remaining 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 participation percentage for the STFC Pooled Companies has remained at 80% since 2001. In general, the Pooling Arrangement covers all the property and casualty insurance written by the Pooled Companies except State Auto Mutual’s voluntary assumed reinsurance.
The following table presents the impact on our balance sheet on January 1, 2008, relating to the Pooling Change:
We evaluate the performance of our insurance segments using industry financial measurements determined based on Statutory Accounting Principles (“SAP”), and certain measures determined under Generally Accepted Accounting Principles (“GAAP”). We evaluate our investment operations segment based on investment returns of assets managed. Financial information about our segments is set forth in this Item 7 and in Note 15 to our Consolidated Financial Statements included in Item 8 of this Form 10-K.
Premium Growth/Underwriting Profitability: The property and casualty insurance industry is highly cyclical. Our industry has been historically characterized by periods of intense price competition due to excess underwriting capacity, as well as periods of shortages of underwriting capacity that result in increased prices and more favorable underwriting terms. During periods of excess underwriting capacity, some property and casualty insurers attempt to generate additional top line growth by setting their prices at levels inappropriate for the risk underwritten. While in the short term this may result in additional revenues, this action compromises their long term underwriting profitability. Our strategy is to insure personal and small-to-medium business risks while adhering to disciplined and consistent underwriting principles through all market cycles. Over the last several months the industry has been moving from soft market conditions in which insurer competition has been intense and there has been pressure to lower rates toward hard market conditions in which insurers tend to raise prices. We have been monitoring this situation and have responded in ways consistent with our goals not to compromise underwriting profitability and to protect the interests of our stakeholders.
management uses many resources to calculate reserves, there is no precise method for determining the ultimate liability. We do not discount loss reserves for financial statement purposes. Our objective is to set reserves that are adequate such that the amounts originally recorded as reserves reasonably approximate the ultimate liability for insured losses and loss expenses. We regularly review and adjust loss reserves as appropriate.
Catastrophic Events: We are exposed to claims arising out of catastrophic events. Catastrophe losses can and do cause substantial volatility in our financial results for any fiscal quarter or year. Catastrophes can be caused by various natural events, including hurricanes, hailstorms, tornadoes, windstorms, earthquakes, severe winter weather and fires, none of which are within our control. The frequency and severity of catastrophes are inherently unpredictable. The magnitude of loss from a catastrophe is a function of the severity of the event and the total amount of insured exposure in the affected area. Catastrophes, to which we are exposed, including hurricanes, earthquakes and other perils, may be severe and produce significant loss. We are also exposed to significant loss from less severe catastrophes when they affect large geographic areas or areas that are heavily populated Although catastrophes can cause losses in a variety of our property and casualty lines, most of our catastrophe claims in the past have related to homeowners, allied lines and commercial multiple peril coverages. We deploy specific strategies designed to mitigate our exposure to catastrophe losses, which include obtaining reinsurance. We continually seek to diversify our business on a geographic basis. The number of states we actively operate in has increased from 27 states in 2003 to 33 states as of December 31, 2008. As we begin 2009, the concentration of our direct written premiums for our property and casualty operations in our largest five states has decreased from 48% for the year ended December 31, 2003, to approximately 44% at December 31, 2008. Our catastrophe management strategies are designed to mitigate our exposure to earthquakes and hurricanes.
In addition to our adherence to our cost-based pricing, investment and catastrophe risk mitigation strategies discussed above, our management focuses on several other key areas with the intention of continually improving the results of our operations and financial results, including the following:
Claims Service: We believe an important element of our success is our focus on claims service. We expect our claim service to be fair, fast and friendly. The role of the claims division is to deliver the promise that we and the independent agent made to the insured. We have the capability of receiving claims 24 hours a day, seven days a week. Claims may be reported to our Claims Contact Center, to the policyholder’s independent agent or via the Internet at www.StateAuto.com. We make a pledge to our policyholders to try and make contact with them within two hours of a claim being assigned to a claims handler (except in catastrophe loss situations). In addition, we established internal claims catastrophe teams to enhance our response to policyholders in these loss situations.
Independent Insurance Agent Network: We offer our products through over 3,330 agencies in 33 states. We believe the success of our independent insurance agent network, which is our only distribution channel, grows out of our commitment to promote and foster close working relationships with our agents. We seek relationships with agencies where we will be one of their top three insurers, measured on the basis of direct premiums written, for the type of business we desire. Our agents’ compensation package includes competitive commission rates and other sales inducements designed to maintain and enhance relationships with existing independent agents as well as to attract new independent agents. We provide our agents with a co-operative advertising program, sales training programs, contingent commissions, travel incentives and agency recognition. We continually monitor our agencies for compatibility with us, taking into account factors such as loss ratio, premium volume, business profiles and relationship history. This allows us to be proactive in helping our agents grow their book of business with us profitably and, thus, enhance the long-term value of our relationship. Our senior management meets frequently with agents to encourage mutual growth and demonstrate our commitment. We believe each of these elements creates a relationship that has resulted in our independent insurance agents placing quality insurance business with us.
Technology: Our technology efforts are focused on making us as efficient and effective as possible. Our personal insurance segment technology has leveraged past successes with our netXpressSM agency portal by providing more integration with the systems our independent agents commonly use in their offices. This integration of data directly into our netXpress portal eliminates the re-keying effort for our agents and at the same time increases the quality of that data. We have also streamlined the way we acquire outside information like motor vehicle reports and address-based information so that our technology can provide fast and accurate quotes. Our independent agents have welcomed this functionality and rewarded us with increased quote opportunities and submissions.
During the course of 2008, improvements in our project management, quality assurance, and IT governance all improved our technology efficiency and effectiveness. These improvements help us maximize the business results we ultimately receive from our technology investments.
Our fixed maturity, equity security and certain other invested asset investments are classified as available-for-sale and carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders’ equity as “accumulated other comprehensive loss,” and as such are not included in the determination of net income. Investment income is recognized when earned, and capital gains and losses are recognized when investments are sold.
We regularly monitor our investment portfolio for declines in value that are other-than-temporary impaired (“OTTI”), an assessment which requires significant management judgment regarding the evidence known. Such judgments could change in the future as more information becomes known which could negatively impact the amounts reported herein. We consider many factors when assessing our investments for OTTI which include: (1) the financial condition and near-term prospects of the issuer, including any specific events that may influence the issuer’s operations; (2) the length of time and/or the depth of decline below cost; (3) our ability and intent to hold the security through its near term recovery period; and (4) the ability of the fair value to recover to cost in
Loss and loss expense reserves for incurred claims that have not yet been reported (“IBNR”) are estimated based on many variables including historical and statistical information, inflation, legal developments, storm loss estimates, and economic conditions. The process for calculating IBNR is to develop an estimate of the ultimate
5.3 points of the increase for 2008 is related to the one-time $53.6 million transfer of unearned premium to us on January 1, 2008, in conjunction with the Pooling Change.
Catastrophe losses for 2008 were $156.1 million or 13.9 loss ratio points compared to $37.1 million or 3.7 loss ratio points for the same 2007 period. Hurricane Ike delivered tropical storm force winds to Texas and three of our largest states-Ohio, Kentucky and Indiana, accounting for $44.1 million of catastrophe losses or 3.9 loss ratio points. See the “Loss and Expenses” section included in this Item 7.
Our non-catastrophe losses for 2008 were $686.3 or 60.9 loss ratio points compared to $548.5 or 54.2 loss ratio points for the same 2007 period. All of our lines of business have contributed to this increase. See the “Loss and LAE” section included in this Item 7.
Insurance industry regulators require our insurance subsidiaries to report their financial condition and results of operations using SAP. We use SAP financial results, along with industry standard financial measures determined on a SAP basis and certain measures determined on a GAAP basis, to internally monitor the performance of our insurance segments and reward our employees. The more common financial measures used are Loss and LAE ratio, underwriting expense ratio, combined ratio, net premiums written and net premiums earned. The combined ratio is the sum of the Loss and LAE ratio and the underwriting expense ratio. When the combined ratio is less than 100%, the insurer is operating at an underwriting gain and when it is greater than 100%, the insurer is operating at an underwriting loss. Underwriting gain (loss) is determined by subtracting from net earned premiums, losses and loss expenses and underwriting expenses.
One of the more significant differences between GAAP and SAP is that SAP requires all underwriting expenses to be expensed immediately and not deferred over the same period that the premium is earned. In converting SAP underwriting results to GAAP underwriting results, acquisition costs are deferred and amortized over the periods the related written premiums are earned. For a discussion of deferred policy acquisition costs see “Critical Accounting Policies-Deferred Acquisition Costs” section included in this Item 7. The “GAAP combined ratio” is defined as the sum of the “GAAP Loss and LAE ratio” (loss and loss expenses as a percentage of earned premiums) plus “GAAP expense ratio” (acquisition and operating expenses as a percentage of earned premiums). All references to financial measures or components thereof in this discussion are calculated on a GAAP basis, unless otherwise noted.
The following tables provide a summary of our insurance segments’ SAP underwriting (loss) gain and SAP combined ratio for the years ended December 31, 2008 and 2007:
The following table shows the reconciliation of the one-time impact on net written premiums for the year ended December 31, 2008 with respect to the unearned premiums transferred to us on January 1, 2008, in conjunction with the Pooling Change.
Impacting both our written and earned premiums in 2008 were the following:
As of July 1, 2008, we terminated our State Auto P&C intercompany catastrophe reinsurance agreement, which resulted in $1.4 million less net written and earned premiums within our property lines for 2008 when compared to the same 2007 period.
Nonstandard auto net written premium decreased 1.2% from 2007. This decrease was due to tightening underwriting controls and aggressive rate actions which contributed to a decline in our new business writings. These actions were taken to drive an improvement in our underwriting results. See SAP Loss and LAE Ratios Table in the “Losses and Expenses” section included in this Item 7.
processing rather than in a large batch at night. In addition to the efficiency gains we have achieved for internal employees, we have leveraged this real-time and straight through processing functionality with bizXpress. In 2008, we expanded our bizXpress functionality by giving agents the ability to quote business auto policies as well as businessowners policies, a capability which we introduced to them in 2007.
Our GAAP Loss and LAE ratio was 75.2% in 2008 compared to 58.4% in 2007. The increase in the GAAP Loss and LAE Ratio was largely due to an increase in catastrophe storm losses. Our catastrophe losses, which primarily impacted our property lines of business, accounted for 13.9 points of the Loss and LAE ratio in 2008 compared to only 3.7 points in 2007. Our non-catastrophe Loss and LAE ratio was 60.9% in 2008 compared to 54.2% in 2007. The increase in our non-catastrophe Loss and LAE ratio was driven mostly by bodily injury claim severity in the personal and commercial auto lines. With auto lines representing a significant portion of our earned premiums, this line of business contributed roughly 50% of the increase in our non-catastrophe ratio.
As shown above, the 2008 loss and loss expenses attributable to prior years totaled ($27.3) million. This corresponded to a decrease, or favorable development, in the estimated ultimate liability for prior years’ claims. A tabular presentation of the $27.3 million favorable development in 2008 by accident year is shown below.
The December 31, 2007 loss and loss expenses payable balance has been adjusted for comparative purposes to reflect the loss and loss expenses payable assumed by us on January 1, 2008 from the Pooling Change.
Our investment portfolio and the investment portfolios of other members of the State Auto Group are managed by our subsidiary, Stateco. The Investment Committee (the “Committee”) of the Board of Directors establishes the investment policies to be followed by Stateco.
Diversifying our portfolio into small-cap equities and international funds was designed to achieve a greater total return with reduced volatility. In 2008 almost all asset classes experienced a decline in value and our
The following table provides the composition of our available-for-sale investment portfolio at fair value at December 31:
Our fixed maturity investment portfolio at December 31, 2008 included securities issued by numerous municipalities with a total carrying value of $1,451.0 million. Approximately $634.6 million or 44% of these securities were enhanced by third-party insurance (the “Credit Enhancement”) for the payment of principal and interest in the event of an issuer default. The downgrade of credit ratings of insurers of these securities could result in a corresponding downgrade in the ratings of the securities to the underlying rating of the respective security without giving effect to the benefit of the Credit Enhancement. Credit Enhancement is not a primary consideration to us when purchasing a municipal security as we consider the underlying credit rating of the security by Moody’s and S&P as a more important factor in our evaluation process. Of the total $1,451.0 million of municipal securities in our investment portfolio at December 31, 2008, approximately 92% were rated AA or better, without the benefit of a Credit Enhancement. We do not believe that a loss of a Credit Enhancement would have a material adverse impact on our results of operations, financial position or liquidity, due to the underlying strength of the issuers of the securities, as well as our ability and intent to hold the securities.
The above analysis is limited in that it does not take into account any actions that might be taken by us in response to these changes. As a result, the actual impact of a change in equity market prices and the resulting equity values may differ significantly from what is shown in the table. By investing in mostly large-cap issues we hope to limit liquidity risk in the equity portfolio. The equity portfolio does not have any direct exposure to exchange rate risk since we do not directly hold any foreign stocks. We constantly monitor the equity portfolio holdings for any credit risk issues that may arise. We do not invest in any commodity futures or commodity oriented mutual funds.
Net investment income for 2008 was $87.4 million compared to $84.7 million in 2007. The growth in net investment income is attributed to an increase in average invested assets, from $1,987.1 million at December 31, 2007 to $2,127.6 million at December 31, 2008, primarily due to the January 1, 2008 $92.0 million in cash received in conjunction with the Pooling Change.
We regularly monitor our investment portfolio for declines in value that are OTTI, an assessment which requires significant management judgment regarding the evidence known. Such judgments could change in the future as more information becomes known which could negatively impact the amounts reported herein. We consider many factors when assessing our investments for OTTI which include: (1) the financial condition of the issuer, including any specific events that may influence the issuer’s operations; (2) the length of time and/or the depth of decline below cost; (3) our ability and intent to hold the security through its near term recovery period; and (4) the ability of the fair value to recover to cost in the near term. We recognized OTTI charges on our externally managed small cap equity portfolio and a segment of our large cap portfolio where we are unable to make the assertion regarding our intent to hold these securities that are currently valued below cost until recovery in the near term. When a security in our investment portfolio has been determined to have a decline in fair value that is other-than-temporary, we adjust the cost basis of the security to fair value. This results in a charge to earnings as a realized loss, which is not reversed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other-than-temporary, are included in other comprehensive income.
The following table provides detailed information on our available-for-sale investment portfolio at fair value for our gross unrealized gains and losses at December 31, 2008.
The following table presents a summary of our cumulative unrealized holding (loss) gain by investment type, net of deferred taxes that were included as a component of accumulated comprehensive loss at December 31, 2008 and December 31, 2007, respectively, and the change in unrealized holding gain (loss), net of deferred tax, for the year ended December 31, 2008:
On January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which was issued by the FASB in September 2006. For financial statement elements currently required to be measured at fair value, SFAS 157 defines fair value, establishes a framework for measuring fair value under GAAP and enhances disclosures about fair value measurements. The new definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (“exit price”) regardless of whether an observable liquid market price exists. An exit price valuation will include margins for risk even if they are not observable.
SFAS 157 establishes a fair value hierarchy that categorizes the inputs to valuation techniques which are used to measure fair value into three broad levels as defined below:
Net written premiums for nonstandard personal auto increased 0.7% in 2007 compared to 2006. This represents a significant improvement compared to the 2006 premium result which declined 13.3% from 2005. Targeted rate decreases coupled with the introduction of new discounts and an increased marketing effort contributed to an increased level of new policy submissions, leading to an increase in premiums.
We believe independent agents value ease of doing business and make it an important factor in their choice of insurance companies when quoting personal auto products to their customers. During 2007, we introduced in 17 states various “real time” comparative rating tools which can be used by our independent agents to prepare comparative rate quotes from multiple insurance companies by entering the rating information once. We believe our independent agents will quote and write more personal standard and nonstandard auto with us as a result of a more efficient quoting process.
Our GAAP Loss and LAE ratio was 58.4% in 2007 compared to 57.4% in 2006. Loss results for the year have been mixed. Our core auto (personal and business) and other and product liability lines continue to perform well. On the property side, catastrophe losses for 2007 were lower than in 2006, but we experienced significantly higher frequency of large fire losses within our personal and business lines during 2007.
The following table presents the provision for losses and loss expenses for those claims occurring in the current calendar year and prior years, along with the GAAP Loss and LAE ratio for the years 2007 and 2006, respectively:
Adjusting and other expense reserves accounted for approximately $11.8 million of prior year reserve change. These expense reserves have a proportional relationship to the overall claim inventory and held
The business insurance segment’s loss ratio for 2007 was 4.5 points higher than in 2006. Catastrophes accounted for 1.6 loss ratio points in 2007 compared to 4.3 points in 2006. Excluding the impact of catastrophes, the business lines loss ratio in 2007 was 7.2 points higher than in 2006. The overall increase reflects rate reductions in premium per exposure on business written in 2006 and 2007 and an increase in the number of large property losses. Workers’ compensation, which represents approximately 9.0% of our business insurance portfolio and less than 4.0% of our overall insurance segment portfolio, tends to be a more volatile line of business due to its size and risks written. We do not write mono-line workers’ compensation, but make our product available as part of the business package policy. The increase in the level of 2007 losses as compared to 2006 was driven largely by an increase in severity rather than frequency. We regularly monitor frequency and severity trends, as well as the overall construction of our workers’ compensation book of business. In addition, we promote the writing of the low-hazard risk types that have developed a consistent pattern of profitability.
We have investment policy guidelines with respect to purchasing fixed maturity investments for our insurance subsidiaries which preclude investments in bonds that are rated below investment grade by a recognized rating service. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 5.0% or less of statutory assets, other than obligations of the U.S. government or government agencies, for which there is no limit. Our fixed maturity portfolio is composed of high quality, investment grade issues, comprised almost entirely of debt issues rated AAA or AA. At December 31, 2007, we had no fixed maturity investments rated below investment grade. Our only investments in asset-backed securities were in federal agency pools (Fannie Mae and Freddie Mac) and government guaranteed pools (Ginnie Mae).
During the fourth quarter 2007, we began to diversify our equity portfolio and utilize outside money managers to invest in U.S. small-cap equities and international funds. These managers are permitted to manage the portfolios according to their own respective portfolio objectives. In selecting our outside money managers we confirm that their portfolio objectives, including risk tolerance, are acceptable to us; however, there may be slight differences in their objectives with respect to dividend payments and other constraints that we apply to our large cap equity holdings. By further diversifying our portfolio into small-cap equities and international funds, we hope to achieve a greater total return with reduced volatility.
Beginning in the fourth quarter of 2007, we began investing funds as they became available moving toward our targeted asset allocations over the next 12 to 18 months. The following table provides a breakdown of our investments relative to our targeted allocated percentages provided above at December 31, 2007. We measure our investment portfolio allocation with fixed maturities at amortized cost and equities and international funds at fair value.
The following table provides the composition of our available-for-sale investment portfolio at December 31, 2007 and 2006, respectively:
The amortized cost and fair value of fixed maturities at December 31, 2007, by contractual maturity, are as follows:
portfolio typically performs well compared to benchmarks. Conversely, when growth stocks outperform value and/or small- to mid-cap stocks outperform large-cap stocks, our equity portfolio does not perform as well compared to benchmarks.
The chart below shows the industry sector breakdown of our large-cap equity portfolio versus the S&P 500 Index based on fair value as of December 31, 2007.
Realized gains and losses on investments for the years ended December 31, 2007 and 2006, respectively are summarized as follows:
We regularly monitor our investment portfolio for declines in value that are OTTI, an assessment which requires significant management judgment. Among the factors considered by management are the nature of the investment, severity and length of decline in fair value, events impacting the issuer, overall market conditions, and our intent and ability to hold securities until recovery. When a security in our investment portfolio has been determined to have a decline in fair value that is OTTI, we adjust the cost basis of the security to fair value. This results in a charge to earnings as a realized loss, which is not changed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not OTTI, are included in other comprehensive income.
For the year ended December 31, 2007, we recognized $1.9 million OTTI compared to $5.4 million for the same 2006 period. During 2007, we recognized no OTTI on our fixed maturity portfolio; however, we recognized $1.9 million in realized losses related to OTTI within our equity portfolio. Of the $1.9 million in realized losses, $1.1 million related to two equity positions within the consumer cyclical sector impacted by the downturn in the housing industry. The remaining $0.8 million in realized losses was limited to our externally managed U.S. small-cap portfolio for which we were unable to make the assertion regarding our intent to hold particular securities that were currently valued below cost until recovery in the near term. The OTTI recognized in 2007 were limited to these securities, based on specific facts and judgments related to these particular issuers. The 2006 write-downs related primarily to our investment in certain subordinate income notes and principal protected units representing purchased beneficial interests in securitized financial assets. We reduced the estimate of future cash flows we expected to receive from these securities in light of actual default rates of the underlying collateral securities exceeding the assumed defaults.
Liquidity refers to our ability to generate adequate amounts of cash to meet our short and long term needs. Our primary sources of cash are premiums, investment income, investment sales and the maturity of fixed income security investments. The significant outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt and investment purchases. The cash outflows can vary due to uncertainties regarding settlement of large losses or catastrophe events. As a result, we continually monitor our investment and reinsurance programs to ensure they are appropriately structured to enable the insurance subsidiaries to meet anticipated short and long-term cash requirements without the need to sell investments to meet fluctuations in claim payments.
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, 2008 and 2007, we had $150.5 million and $70.9 million, respectively, in cash and cash equivalents, and $1,939.9 million and $2,019.4 million, respectively, of total available-for-sale investments at fair value. Included in our fixed maturities available-for-sale at fair value are $56.0 million and $55.1 million of securities on deposit with insurance regulators as required by law at December 31, 2008 and 2007, respectively. In addition, substantially all of our fixed maturity and equity securities are traded on public markets. For a further discussion regarding investments see “Investments Operations Segment” included in this Item 7.
Despite the increased level of catastrophe losses in 2008, we managed our cash flows through current operational activity and maturities of investments, without a need to liquidate investments in the 2008 uncertain market environment. See “Investment Operations Segment-Composition of Investment Portfolio” included in this Item 7 for further discussion. However, should our written premium decline or paid losses increase significantly or a combination thereof our cash flows from operations could be impacted requiring us to liquidate investments at a loss.
During 2008, 2007 and 2006, as permitted by regulations of the Internal Revenue Service, we made cash contributions of $12.0 million, $11.5 million and $10.0 million, respectively, to our defined benefit pension plan on behalf of our employees. The actuarially determined contribution to our defined benefit pension plan ranges from the minimum amount we would be required to contribute to the maximum amount that would be tax deductible. Amounts contributed in excess of the minimum are deemed voluntary while amounts in excess of the maximum would be subject to an excise tax and may not be deductible for tax purposes. Amounts paid in each of these three years were within the minimum and maximum funding amounts that would be deductible for tax purposes. The actuarially determined funding amount to the plan is generally not determined until the second quarter with respect to the contribution year, though we currently expect to make a minimum cash contribution to our defined benefit pension plan of approximately $15.0 million during 2009. For a further discussion regarding our defined benefit pension plan, see “Employee Benefit Plans” included in this Item 7.
The increase in 2007 versus 2006 was principally the result of:
an increase in the level of cash provided from operations between the two years.
Our financing activities for 2008, 2007 and 2006 produced net cash outflows of $52.4 million, $38.0 million, and $5.6 million, respectively. The following contributed to the fluctuations between those years:
On August 17, 2007, State Auto Financial’s board of directors authorized the repurchase, from time to time, of up to 4.0 million of its common shares, or approximately 10% of State Auto Financial’s outstanding shares, over a period extending to and through December 31, 2009. State Auto Financial will repurchase shares from State Auto Mutual in amounts that are proportional to the respective current ownership percentages of State Auto Mutual, which is approximately 64%, and other shareholders. For the year ended December 31, 2008 a total of 1,214,586 of common shares were purchased under this program at an average repurchase price of $27.25 per share for a total of $33.2 million. Since inception through December 31, 2008, a total of 2,028,116 common shares have been purchased under this program at an average purchase price of $27.26 per share for a total of $55.3 million.
State Auto Financial has a credit agreement (“Credit Agreement”) with a syndicate of lenders which provides for a $200.0 million five-year unsecured revolving credit facility (“Credit Facility”). The Credit Facility is available for general corporate purposes. The Credit Facility provides for interest-only payments during its term, with principal due in full at maturity. Interest is based on a London interbank market rate or a base rate plus a calculated margin amount. The Credit Agreement contains certain covenants, including financial covenants that require us to maintain a minimum net worth and not exceed a certain debt to capitalization ratio. As of December 31, 2008, State Auto Financial had not made any borrowings and was in compliance with all of the covenants under the Credit Agreement. We are currently evaluating whether we should amend or terminate this agreement based on our needs and other options available for contingency funding. We believe our other sources of cash are sufficient to fund our liquidity needs for the foreseeable future. We currently do not intend to drawdown any funds under the Credit Facility.
During 2007, the Beacon Insurance Group was added to the State Auto Group’s reinsurance programs described below and as of January 1, 2008, the Patrons Group was added to these programs.
The property per risk excess of loss reinsurance agreement provides that each company in the State Auto Group is responsible for the first $3.0 million of each covered loss. The reinsurers are responsible for 100% of the excess over $3.0 million up to $20.0 million of covered loss. The rates for this reinsurance are negotiated annually.
Members of the State Auto Group maintain a property catastrophe excess of loss reinsurance agreement covering catastrophe related events affecting at least two risks. On July 1, 2008, concurrent with the renewal of the agreement, we increased the limit of coverage by $20.0 million from $80.0 million to $100 million. The limit of $100 million is structured in two layers. The first is $25.0 million excess of our retention, and the second is $75 million excess of the first layer. On a combined basis, the members of the State Auto Group retain the first $55.0 million of catastrophe loss, each occurrence, with a 5% co-participation on the next $100 million of covered loss, each occurrence. The reinsurers are responsible for 95% of the excess over $55.0 million up to $155.0 million of covered losses, each occurrence. Our companies are responsible for losses above $155.0 million. The rates for this reinsurance are negotiated annually.
As of January 1, 2009, members of the State Auto Group entered into a property catastrophe net aggregate excess of loss reinsurance agreement (the “Catastrophe Aggregate Agreement”). This is a new agreement which provides reinsurance coverage for certain catastrophic events, including certain events falling below the $55.0 million retention under the property catastrophe excess of loss reinsurance agreement previously described. Events covered by the Catastrophe Aggregate Agreement must be PCS numbered catastrophes, excluding earthquakes and named storms such as hurricanes and tropical storms. Individual occurrences are capped at $55.0 million and are subject to a $5.0 million franchise deductible, meaning occurrences producing losses totaling less than $5.0 million are excluded. Subject to these limitations, qualifying losses from individual occurrences are then aggregated over the course of the reinsurance term, January 1, 2009 through December 31, 2009. On an aggregate basis, the members of the State Auto Group combined retain the first $80.0 million of covered loss, with a 25% co-participation on the next $30.0 million of covered loss. The reinsurer is responsible for 75% of the excess over $80.0 million up to $110.0 million of covered loss on an aggregate basis.
We derived expected payment patterns separately for the direct loss and ALAE reserves. Amounts included the STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement. For a reconciliation of management’s best estimate, see “Loss and Loss Expense Reserves” included in this Item 7. These patterns were applied to the December 31, 2008, loss and ALAE payable to generate estimated annual incremental loss and ALAE payments for each subsequent calendar year. These amounts are based on historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates.
For a discussion of these debt instruments, see “Liquidity and Capital Resources-Borrowing Arrangements” included in this Item 7.
financial condition of insurance companies operating in their respective states. One such set of analytical tools is 12 key financial ratios that are known in the insurance industry as the “IRIS” ratios. IRIS ratios are derived from financial statements prepared on a statutory accounting basis, which are accounting practices prescribed or permitted by the insurance department with regulatory authority over our insurance subsidiaries. A “defined range” of results for each ratio has been established by the NAIC for solvency monitoring. While management utilizes each of these IRIS ratios in monitoring our insurance companies’ operating performance on a statutory accounting basis (each of our insurance subsidiaries operates within the defined range for the other measures), the net written premium to statutory surplus ratio (the “leverage ratio”) is monitored to ensure that each of our insurance subsidiaries continue to operate within the “defined range” of 3.0 to 1.0. The higher the leverage ratio, the more risk a company bears in relation to statutory surplus available to absorb losses. In considering this range, management also considers the distribution of net premiums between property and liability lines of business. A company with a larger portion of net premiums from liability lines should generally maintain a lower leverage ratio.
Our insurance subsidiaries pay dividends to State Auto Financial which in turn may be used by State Auto Financial to pay dividends to stockholders or to make principal and interest payments on debt. Individual states limit the amount of dividends that our insurance subsidiaries domiciled in those states can pay without prior approval. Under current law, at December 31, 2008 $73.8 million is available in 2009 for payment as a dividend from our insurance subsidiaries to State Auto Financial, without prior approval from our respective domiciliary state insurance departments. In 2008 and 2007, State Auto Financial received $39.0 million and $50.0 million, respectively in dividends from its insurance subsidiaries and none in 2006. We are required to notify the insurance subsidiaries’ applicable state insurance commissioner within five business days after declaration of all such dividends and at least ten days prior to payment. Additionally, the domiciliary state commissioner of each insurance 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 meet its financial needs. Such restrictions are not expected to limit the capacity of State Auto Financial to meet its cash obligations.
calculation of a ratio of total adjusted statutory capital to authorized control level. Insurers with a ratio below 200% are subject to different levels of regulatory intervention and action. At December 31, 2008, the ratio of total adjusted statutory capital to authorized control level of State Auto Financial’s insurance subsidiaries ranged from 699% to 1,902%.
The following table summarizes our credit and insurance company financial strength ratings as of March 13, 2009:
The published financial strength ratings on the insurance company subsidiaries of State Auto Financial are opinions as to the ability of those companies to meet their ongoing obligations to their policyholders. The A.M. Best financial strength ratings influence our ability to write insurance business as agents and policyholders generally prefer higher rated companies. Lower rated companies may be required to compete for agents and policyholders by offering higher commissions or lower premiums and expanded coverage, or a combination thereof. State Auto Mutual has received A.M. Best’s A+ or higher rating every year since 1954. The STFC Pooled Companies and the Mutual Pooled Companies are collectively assigned a pool rating by A.M. Best while SA National is rated by A. M. Best as a part of the total group.
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.
Effective January 1, 2008, we adopted the measurement date requirement under transition alternative method one, as defined in SFAS 158. This transition method resulted in a one-time adjustment that decreased beginning retained earnings by $2.4 million, net of tax. The combined impact of the measurement date transition and re-measurement of plan assets and obligations on January 1, 2008, increased beginning accumulated comprehensive income by $3.5 million, net of tax. The discount rate used to re-measure our benefit plan obligations at January 1, 2008 was 6.50% an increase of 0.25 points from the earlier measurement date of September 30, 2007, which was used to report our benefit obligations on December 31, 2007.
To calculate the State Auto Group’s December 31, 2008 pension projected benefit obligation (“PBO”), we used a discount rate of 6.0% based on an evaluation of the expected future benefit cash flows of our defined benefit pension plan used in conjunction with the Citigroup Pension Discount Curve at the measurement date. A lower discount rate results in, all else equal, a higher present value of the benefit obligation. We selected an expected long-term rate of return on our plan assets of 9.0% by considering the mix of investments and stability of investment portfolio along with actual investment experience during the lifetime of the plan. To calculate the net periodic benefit cost for the year ended December 31, 2008, a discount rate of 6.5% and an expected long-term rate of return on plan assets of 9.0% were used.
Our unfunded status on our postretirement medical plan (“retiree med plan”) decreased from $118.2 million at January 1, 2008 to $109.1 million at December 31, 2008. The factors influencing this decrease are as follows: (1) In October 2008, we announced a substantive change to increase retiree cost sharing in the retiree med plan, effective January 1, 2009. This change will allow us to decrease our overall company costs and continue to provide a competitive retiree med plan for all associates and current retirees. The increase in the cost sharing will be phased in over five years for current retirees and those associates who announced their retirement before December 31, 2008 and retire in the first half of 2009. On October 1, 2008, this change reduced our PBO and unrecognized prior service balance, a component of accumulated comprehensive loss in our equity, by $28.1 million. (2) Offsetting the cost share plan change is a combination of the following factors: (a) Key assumptions used in determining the amount of the benefit obligation and related periodic cost are the discount rate and the assumed health care cost trend rate. We decreased our selected discount rate by 0.50 points to 6.00% from the 6.50% rate used at January 1, 2008. We assume that the relative increase in health care costs will continue to rise over the next several years. For 2008 the expected rate of increase in future health care costs was 10% for 2008, trending down 1% per year to 5% thereafter. Changes to these two key assumptions, had the effect of increasing our obligation and unrecognized actuarial loss at December 31, 2008. (b) Additional unrecognized net actuarial gains or losses adjustments arising from demographic changes and expected to actual claims experience, which at December 31, 2008 had the effect of increasing our obligation and unrecognized actuarial loss.
In October 2008, we offered an early retirement incentive option to retirement eligible associates. This early retirement option is deemed a special termination benefit under SFAS No 88-“Employers’ Accounting for Settlements and Curtailments of Define Benefit Pension Plans and for Termination Benefits. An employer offering special termination benefits to employees must recognize a liability and an expense when the following conditions are met: 1) the employees accept the offer, and 2) the amount can be reasonably estimated. We recognized an expense of $1.9 million for the acceleration of certain plan benefits for those retirement eligible associates who elected early retirement.
Losses and allocated loss expense reserves (“Loss and ALAE Reserve”) are management’s best estimates (“MBE”) at a given point in time of what we expect to pay to settle all claims incurred as of that date based on known facts, circumstances and historical trends. Reserves for reported losses are established on either a case-by-case or formula basis depending on the type and circumstances of the loss. The case-by-case reserve amounts are determined by claims adjusters based on our reserving practices, which take into account the type of risk, the circumstances surrounding each claim and applicable policy provisions. The formula reserves are based on historical data for similar claims with provision for trend changes caused by inflation. Case and formula basis loss reserves are reviewed on a 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 and ALAE Reserve is to develop an estimate of the ultimate losses and allocated loss expenses incurred, and subtract all amounts already paid or held as case or formula reserves.
Our internal actuarial staff conducts quarterly reviews of projected 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, accounting 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 the loss reserves.
Claim Counts and Severities Method: The Counts and Severities Method calculations are very similar to the other methods. 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
Long-Tail Business: Reserve estimates for long-tail business use the same methods listed above along with several other methods as determined by the actuary. For example, premium-based methods may be used in developing ultimate loss estimates, including the Expected Loss Ratio, Bornhuetter-Ferguson, and Least-Squares techniques as described below. We also use statistical models when the historical patterns can be reasonably approximated.
point of the range, $869.0 million, the reserve increase of $17.2 million corresponds to an after-tax decrease of $11.2 million in net income. Likewise, should ultimate losses decline to a level corresponding to the low point of the range, $784.4 million, the $67.4 million reserve decrease would add $43.8 million of after-tax net income. The reserve range noted above represents a range of reasonably likely reserves, not a range of all possible reserves. Therefore, the ultimate losses could reach levels corresponding to reserve amounts outside the range provided.
In addition to establishing Loss and ALAE Reserves, as described above, we establish reserves for loss adjustment expenses related to functions and costs that are not attributable to a specific claim, which is called Unallocated Loss Adjustment Expense (“ULAE”). Historical patterns of paid ULAE relative to paid loss are analyzed along with historical claim counts including claims opened, claims closed, and claims remaining open. The product of this analysis is an estimate of the relationship, or ratio, between ULAE and loss underlying the current loss reserves. This ratio is applied to the current outstanding loss reserves to estimate the required ULAE reserve. Consequently, this component of the loss expense reserve has a proportional relationship to the overall claim inventory and held loss reserves by accident year. The method assumes that the underlying claims process and mix of business do not change materially over time.
The risks and uncertainties inherent in the loss and loss expense reserve estimates include, but are not limited to, actual settlement experience being different from historical data and trends, changes in business and economic conditions, court decisions creating unanticipated liabilities, ongoing interpretation of policy provisions by the courts, inconsistent decisions in lawsuits regarding coverage and additional information discovered before settlement of claims. Our results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required to settle claims vary from the liability currently recorded.
Inflation can have a significant impact on property and casualty insurers because premium rates are established before the amount of losses and loss expenses are known. When establishing rates, we attempt to anticipate increases from inflation subject to the limitations of modeling economic variables. Even when general inflation, as measured by the Consumer Price Index, is relatively modest, as has been the case over the last several years, price inflation on the goods and services purchased by insurance companies in settling claims can steadily increase. For example, medical care costs have risen at a higher rate than general inflation over the last few years. Costs for building materials typically rise dramatically following substantial, widespread natural
catastrophes, such as the industry experienced in Florida and adjacent states in 2004 in Mississippi and Alabama in 2005, and more recently with Hurricane Katrina in 2006. We continue to adjust our pricing projections to reflect current and anticipated changes in costs in all lines of business.
In June 2007, the FASB issued EITF 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF 06-11”). EITF 06-11 addresses how a company should recognize the income tax benefit received on dividends that are (a) paid to employees holding equity-classified non-vested shares, equity-classified non-vested share units, or equity-classified outstanding share options, and (b) charged to retained earnings under FAS 123(R). The tax benefit received on dividends paid to employees associated with their share-based awards should be recorded in additional paid-in capital until the award is settled through exercise (if the award is an option) or vesting (if the award is non-vested stock). This will be effective for tax benefits of dividends declared in fiscal years beginning after December 15, 2007. The Company adopted this guidance effective January 1, 2008 and it did not have a material impact on the Company’s financial statements.
In September 2006, FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”) that requires employers with defined benefit pension and postretirement benefit plans other than pensions
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of State Auto Financial Corporation and subsidiaries at December 31, 2008 and 2007, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
In our opinion, State Auto Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of State Auto Financial Corporation as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008 of State Auto Financial Corporation and our report dated March 12, 2009 expressed an unqualified opinion thereon.
The Company, through S.I.S., develops and sells software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance companies and agencies. S.I.S. sells services and products to insurance agencies and nonaffiliated insurers and their agencies. S.I.S. also delivers services and sells products to affiliated entities.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of losses and loss expenses payable. In connection with the determination of this estimate, management uses historical data, current business conditions and assumptions about future conditions to formulate estimates of the ultimate cost to settle claims. These estimates by their nature are subject to uncertainties for various reasons. The Company’s results of operations and financial condition could be materially impacted in future periods should the ultimate payments required to settle claims vary from the amount of the liability currently provided.
Investments in fixed maturities, equity securities and certain other invested assets are classified as available-for-sale and, therefore, are carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders’ equity as a part of “accumulated other comprehensive income (loss)” and, as such, are not included in the determination of net income (loss). Realized gains and losses on the sales of investments are computed using the first-in, first-out method.
Acquisition costs, consisting of commissions, premium taxes and certain underwriting expenses that relate to and vary with the production of new and renewal 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. These amounts are based on estimates and accordingly, the actual realizable value may vary from the estimated realizable value. Net deferred policy acquisition costs for the years ended December 31 are:
The Company files a consolidated federal income tax return, and pursuant to a written tax sharing agreement, each entity within the consolidated group pays or receives its share of federal income taxes based on separate return calculations.
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 $31.5 million and $29.3 million at December 31, 2008 and 2007, 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.
Premiums are recognized as earned in proportion to the insurance protection provided using the monthly pro rata method over the contract period. Unearned premiums represent the portion of premiums written relative to the unexpired terms of coverage.
Comprehensive (loss) income is defined as all changes in an enterprise’s equity during a period other than those resulting from investments by owners and distributions to owners. Comprehensive (loss) income includes net income and other comprehensive (loss) income. Other comprehensive (loss) income includes all other non-owner related changes to equity and includes net unrealized gains and losses on available-for-sale investments, derivative instruments and unrecognized benefit plan obligations, adjusted for deferred federal income taxes.
classified non-vested share units, or equity-classified outstanding share options, and (b) charged to retained earnings under FAS 123(R). The tax benefit received on dividends paid to employees associated with their share-based awards should be recorded in additional paid-in capital until the award is settled through exercise (if the award is an option) or vesting (if the award is non-vested stock), effective for tax benefits of dividends declared in fiscal years beginning after December 15, 2007. The Company adopted this guidance effective January 1, 2008 and it did not have a material impact on the Company’s financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 expands the standards under SFAS 157 (defined below) to provide entities a one-time election to measure financial instruments and certain other items at fair value. SFAS 159 also amends SFAS No. 115 (defined below) to require a specific presentation of investments categorized as available-for-sale. SFAS 159 was effective for the first year that began after November 15, 2007. The Company adopted this guidance effective January 1, 2008 and did not elect the fair value option for any of its eligible assets or liabilities as of this date.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which became effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. SFAS 157 established a single authoritative definition of fair value, set out a framework for measuring fair value, and required additional disclosures about fair-value measurements. The Statement imposed no new requirements for additional fair-value measures in financial statements. The Company adopted the provisions of SFAS 157 on January 1, 2008. The adoption of SFAS 157 did not require any adjustments to the Company’s previously reported financial statements.
The following tables summarize the cost or amortized cost of available-for-sale securities to fair value at December 2008 and 2007:
Components of net investment income for the year ended December 31 are summarized as follows:
Realized losses related to other-than-temporary impairments on its fixed maturity portfolio in 2008 were less than $0.1 million. The Company considers the following factors when assessing its investments for other-than-temporary impairment: (1) the financial condition of the issuer; (2) the length of time and/or the significance of decline below cost; and (3) its ability and intent to hold theses securities through their recovery periods (4) the ability of the market value to recover to cost in the near term. The Company reviewed its investments at December 31, 2008 and determined no additional other-than-temporary impairment exists in the gross unrealized holding losses.
Realized and unrealized holding gains and losses for the years ended December 31 are summarized as follows:
There was a deferred federal tax benefit on the net unrealized holding losses at December 31, 2008 of $3.7 million, net of a valuation allowance of $2.6 million. There was a deferred federal tax liability on the net unrealized holding gains at December 31, 2007 of $23.3 million.
SFAS 157 establishes a fair value hierarchy that categorizes the inputs to valuation techniques that are used to measure fair value into three levels:
The fair values of our equity securities are based on observable market quotations for identical assets and are priced by the same pricing service discussed above. All equity securities are recorded using unadjusted market quotes and have been disclosed in Level 1.
Other invested assets managed by third party investment managers are based on values provided to the Company by the custodians employed by these managers. Due to the significant unobservable inputs used in these valuations, the Company includes the valuations in the amount disclosed in Level 3. The remainder of the Company’s other invested assets consist primarily of holdings in publicly-traded mutual funds. The Company believes that its estimates for these publicly-traded mutual funds reasonably reflect their fair values and consequently these securities have been disclosed in Level 1.
The table below summarizes the Company’s available-for-sale investments within the fair value hierarchy at December 31, 2008:
The Company recorded favorable loss and loss expense reserve development in 2008, 2007, and 2006 of $27.3 million, $54.7 million and $71.7 million, respectively. Approximately half of the 2008 favorable development is attributable to loss adjustment expense being lower than anticipated. The remainder is primarily
attributable to favorable emergence of catastrophe losses as well as non-catastrophe homeowners losses, where claims severity emerged lower than anticipated. The favorable development in 2007 was primarily due to auto liability and other liability losses being approximately $23.5 million less than anticipated as revised loss projections using more mature claim data resulted in lower claim severity than in past projections, loss adjustment expenses being approximately $11.8 million lower than anticipated in proportion to losses and ceded losses being above previously anticipated levels by approximately $10.0 million. The favorable development in 2006 was largely due to ceded reserves being above previously anticipated levels by $23.7 million, auto liability losses being $24.7 million less than anticipated as revised loss projections using more mature claim data resulted in lower average claim severities than in past projections, and loss adjustment expenses emerging $13.5 million lower than anticipated previously.
In conjunction with the Pooling Arrangement amendment, the STFC Pooled Companies received $92.0 million in cash, for additional net insurance liabilities assumed on January 1, 2008. The following table presents the impact on the Company’s balance sheet on January 1, 2008, relative to the additional net insurance liabilities assumed on this date.
In general, under the Pooling Arrangement, the STFC Pooled Companies, State Auto Wisconsin, State Auto Florida, Meridian Citizens Mutual, Meridian Security, Beacon, Patrons and Litchfield cede to State Auto Mutual all of their insurance business and assume from State Auto Mutual an amount equal to their respective participation percentages in the Pooling Arrangement. The STFC Pooled Companies’ pooling participation percentage remained at 80% under the amended Pooling Arrangement effective January 1, 2008. 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 pool participants and State Auto National are collectively referred to as the “State Auto Group.”
Until June 30, 2008, State Auto P&C assumed catastrophe reinsurance from the State Auto Group in the amount of $100.0 million excess of $135.0 million in exchange for a premium paid by each reinsured company. Under this agreement, the Company had assumed from State Auto Mutual and its affiliates premiums written and earned of $1.7 million, $3.1 million and $3.0 million for 2008, 2007 and 2006, respectively. There have been no losses assumed under this agreement. The catastrophe reinsurance program with State Auto P&C had been excluded from the Pooling Arrangement.
The following provides a summary of the ceded reinsurance transactions on the Company’s balance sheet and income statement related to a terminated reinsurance agreement that is in run-off between State Auto National and State Auto Mutual:
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 45 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 member 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, 2008 and 2007 is approximately $296.8 million and $266.9 million, respectively.
dates on the Trust Securities, thereby 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 23, 2008. In accordance with FASB Interpretation No. 46(R), (and related amendments and interpretations) “Consolidation of Variable Interest Entities,” State Auto Financial determined that the business trust is a variable interest entity for which it is not the primary beneficiary and therefore, does not consolidate the Capital Trust with the Company. State Auto Financial has unconditionally and irrevocably guaranteed payment of any required distributions on the capital securities, the redemption price when the capital securities are 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.
See discussion of affiliate notes payable at Note 6b. The carrying amount of the Trust Securities note (defined in Note 6b) in the consolidated balance sheets approximates its fair value as the interest rate adjusts quarterly. The $100.0 million, 6.25% Senior Notes have a fair value of $86.9 million and $103.6 million at
December 31, 2008 and 2007, respectively. The fair value of the Senior Notes is based on the quoted market price at December 31, 2008 and 2007, respectively. Notes payable at December 31 consisted of the following:
At December 31, 2008, the Company carried no balance for uncertain tax positions.
The Company is currently not under audit by either the Internal Revenue Service or any state jurisdiction for income tax purposes and all prior audits have been settled. Tax years 2005 through 2007 remain open for audit for federal income tax purposes.
The Company, through its employees of State Auto P&C, provides management and operation services under management agreements for all insurance and non-insurance affiliates. The annual periodic costs related to the Company’s benefit plans are allocated to affiliated companies based on allocations pursuant to intercompany management agreements.
The Company provides a defined benefit pension plan for its eligible employees. Substantially all Company employees become eligible to participate the year after becoming 20 years of age and vest with 5 years of
credited service or attained age 65. The Company’s policy is to fund pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Benefits are determined by applying factors specified in the plan to a participant’s defined average annual compensation.
On December 31, 2006, the Company adopted the recognition and disclosure provisions of SFAS 158. The adjustment, a decrease of $63.9 million, net of tax, to accumulated other comprehensive loss at adoption represents the net unrecognized actuarial losses, unrecognized prior service costs, and unrecognized transition assets remaining from the initial adoption of SFAS 87 and SFAS 106, all of which were previously netted against the plans’ funded status in the Company’s balance sheet pursuant to the provisions of SFAS 87 and SFAS 106. These amounts are being subsequently recognized as net periodic cost pursuant to the Company’s historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic cost in the same periods will be recognized as a component of other comprehensive income. Those amounts will be subsequently recognized as a component of net periodic cost on the same basis as the amounts recognized in accumulated other comprehensive income at adoption of SFAS 158.
The amount of amortization expected to be recognized during the fiscal year ending December 31, 2009 for the State Auto Group is as follows:
In October 2008, the Company announced a substantive change to increase retiree cost sharing within the postretirement medical plan, effective January 1, 2009. This change reduced the Company’s postretirement benefit obligation by $28.1 million. In addition, the Company offered an early retirement incentive option to retirement eligible associates. This early retirement option is deemed a special termination cost under SFAS No 88-“Employers’ Accounting for Settlements and Curtailments of Define Benefit Pension Plans and for Termination Benefits.” At December 31, 2008 the Company recorded a $1.9 million expense to reflect its share of the special termination benefit.
The following benefit payments, which reflect expected future service, are expected to be paid:
The Company’s share of the 2008, 2007, and 2006 net periodic costs for the defined benefit plan were $7.4 million, $7.4 million, and $7.4 million, respectively. For postretirement benefits other than pensions, the Company’s share of the 2008, 2007 and 2006 net periodic costs were $11.3 million, $11.6 million and $10.3 million, respectively. The Company’s gross benefit payments for 2008 post retirement benefits were $3.8 million, including the prescription drug benefits. The Company’s subsidy related to Medicare Prescription Drug Improvement and Modernization Act of 2003 was $0.2 million for 2008 and estimates future annual subsidies to be approximately $0.4 million.
Summarized in the following table are the weighted average assumptions used to determine the Company’s net periodic cost:
The Company’s benefit plan obligations are long-term in nature and consequently the investment strategies have a long-term time horizon. In establishing the long-term rate of return assumption on plan assets, management, along with its pension consulting actuary, reviews the historical performance of the plan assets and the stability in the mix of the investment portfolio. The expected inflation rate and expected real rates of return of applicable asset classes are then determined to assist in setting appropriate assumptions.
The assumed health care cost trend rates used for the year ended December 31 are as follows:
The Company’s benefit plans’ weighted average asset allocations by asset category at the plans’ measurement date of December 31 are as follows:
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. This range is generally not determined until the second quarter with respect to the contribution year. The Company expects to contribute approximately $15.0 million during 2009 to its pension plan, depending on the actuarially calculated funding requirements of such plan. Postretirement and SERP plan payments are deductible for tax purposes when paid.
The Company maintains a defined contribution plan that covers substantially all employees of the Company. The Company matches the first 2% of contributions of participants’ salary at the rate of 75 cents for each dollar contributed. Participant contributions of 3% to 6% are matched at a rate of 50 cents for each dollar contributed. The Company’s share of the expense under the plan totaled $3.1 million, $2.6 million and $2.5 million for the years 2008, 2007 and 2006, respectively.
State Auto P&C, Milbank, Farmers, SA Ohio and SA National are subject to regulations and restrictions under which payment of dividends from statutory earned surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Pursuant to these rules, at December 31, 2008, adjusted for dividend payments made in the previous twelve-month period, approximately $34.8 million is available for payment to State Auto Financial from its insurance subsidiaries in 2009 without prior approval. In 2008 State Auto Financial received dividends of $39.0 million from its insurance subsidiaries, $50.0 million in 2007, and none in 2006.
The Company also has a broad-based employee stock purchase plan, under which employees of the Company may choose at two different specified time intervals each year to have up to 6% of their annual base earnings withheld to purchase the Company’s common shares. The purchase price of the common shares is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 3.4 million common shares under this plan. As of December 31, 2008, a total of 2.5 million common shares have been purchased under this plan. This plan remains in effect until terminated by the board of directors.
During 2008 and 2007, common shares valued at approximately $87,000 and $9,000, respectively, were distributed by the Company under the RSU Plan.
A summary of information pertaining to the total options outstanding and exercisable as of December 31, 2008 follows:
Aggregate intrinsic value for total options outstanding at December 31, 2008 is $20.4 million. Aggregate intrinsic value for total options exercisable at December 31, 2008 is $16.2 million.
The Company has three significant reportable segments: personal insurance, business insurance, and investment operations. The reportable insurance segments are business units managed separately because of the differences in the type of customers they serve or products they provide or services they offer. The insurance segments operate primarily in the central and eastern United States, excluding New York and New Jersey, distributing products through the independent insurance agency system. The personal insurance segment provides primarily personal auto (standard and nonstandard) and homeowners to the personal insurance market. The business insurance segment provides primarily commercial auto, commercial multi-peril, fire and allied lines, other and product liability and workers’ compensation insurance to small to medium sized businesses within the commercial insurance market. The investment operations segment, managed by Stateco, provides investment services.
In accordance with the provisions of SFAS No. 5, “Accounting for Contingencies,” the Company accrues for a litigation-related liability other than insurance claims when it is probable that such a liability has been incurred and the amount of the loss can be reasonably estimated. Based on currently available information known to the Company, the Company believes that its reserves for these litigation-related liabilities are reasonable and that the ultimate outcomes of any pending matters are not likely to have a material adverse effect on its consolidated financial position or results of operations.