approximately 270,000 square feet of office space. The Company and Mutual also have regional underwriting and claims office facilities, including a 6,600 square foot branch office in Cleveland, Ohio, owned by Mutual, and a 29,000 square foot branch office in Cincinnati, Ohio, owned by Mutual. In May 1999, an office building constructed by 518 PML containing 38,000 square feet was completed and leased to Mutual as its Nashville Regional Office. Mutual also leases the regional office facility in Greer, South Carolina, from 518 PML. Milbank owns an office facility in Milbank, South Dakota, where Company employees provide services to Milbank agents and policyholders. Midwest Security leases an office facility in Onalaska, Wisconsin, where Company employees service Midwest Security's agents and policyholders. In December 2000, 518 PML acquired a 21,600 square foot office building in West Des Moines, Iowa, that is now leased to Mutual as its Des Moines Regional Office. Mutual also leases a number of small offices throughout its operating area for the claims operations of Mutual and the Company.
* Reflects change in pooling arrangement, effective January 1, 2000, 1999, 1998 and 1995.
State Auto Financial Corporation ("State Auto Financial"), through its principal insurance subsidiaries, State Auto Property and Casualty Insurance Company ("State Auto P&C"), Milbank Insurance Company ("Milbank"), Farmers Casualty Insurance Company ("Farmers Casualty") and State Auto Insurance Company ("SAIC"), provides personal and commercial insurance for the standard insurance market primarily in the Midwest and eastern United States, excluding New York, New Jersey, and the New England states. Their principal lines of business include personal and commercial auto, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. State Auto National Insurance Company ("National") and Mid-Plains Insurance Company ("Mid-Plains") write personal automobile insurance for risks in the nonstandard insurance market. State Auto P&C, Milbank, Farmers Casualty, SAIC, National and Mid-Plains products are marketed through independent agents. State Auto Financial and its subsidiaries are referred to collectively herein as the "Company."
approximately 5.1 million State Auto Financial common shares for all the issued and outstanding capital stock of Milbank. This exchange of Milbank shares for State Auto Financial common shares increased Mutual's ownership of State Auto Financial to approximately 70% of its issued and outstanding shares. Since the transaction was a combination of entities under common control, it has been accounted for similar to a pooling of interests.
Through Stateco Financial Services, Inc. ("Stateco"), a wholly owned subsidiary, the Company provides investment management services to affiliated companies and also provides insurance premium finance services to customers of State Auto P&C, Milbank and Mutual.
State Auto P&C, Milbank, Farmers Casualty and SAIC (the "Pooled Subsidiaries"), the companies comprising the standard insurance segment, participate in a quota share reinsurance pooling arrangement (the "Pooling Arrangement") with Mutual. The Pooling Arrangement provides that the Pooled Subsidiaries cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation percentages as outlined in the Pooling Arrangement. Effective January 1, 1998, the Pooled Subsidiaries aggregate participation in the Pooling Arrangement increased from 45% to 47% (State Auto P&C - 37% and Milbank - 10%) and Midwest Security became a participant in the Pooling Arrangement. On January 1, 1999, Farmers Casualty was acquired by State Auto Financial and became a participant in the Pooling Arrangement on that same date, at which time the Pooled Subsidiaries' aggregate participation increased to 50% (State Auto P&C - 37%, Milbank - 10% and Farmers Casualty - 3%). In conjunction with these changes in pool participation, the Pooled Subsidiaries received cash from Mutual of $11.4 million and $19.7 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 1999 and 1998, respectively. Effective January 1, 2000, the Pooling Arrangement was amended to make SAIC a participant in the Pooling Arrangement and the Pooled Subsidiaries aggregate participation increased to 53% (State Auto P&C - 39%, Milbank - 10%, Farmers Casualty - 3% and SAIC - 1%). In conjunction with this change in pool participation, the Pooled Subsidiaries received cash from Mutual of $18.6 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 2000. All parties that participate in the Pooling Arrangement have an A. M. Best rating of A+ (Superior).
In discussing Results of Operations for 2000, State Auto P&C, Milbank, Farmers Casualty, SAIC, National, Mid-Plains, Mutual and Midwest Security are referred to collectively as the "State Auto Insurance Companies", while for 1999, the State Auto Insurance Companies and Pooled Subsidiaries exclude SAIC. State Auto P&C, Milbank, Farmers Casualty and SAIC are collectively referred to below as
As noted in prior reports, during 1999, the underwriting performance of the Companies' commercial lines book of business written by its standard segment began to evidence deterioration from previous performance levels. This prompted management to commence a careful review of its underwriters' adherence to the Company's underwriting guidelines for commercial lines. This action had a negative impact on direct written premiums in 1999 that continued into the first half of 2000.
The Company's nonstandard insurance segment (National and Mid-Plains) earned premium was $27.4 million in 2000 and $30.9 million in 2000, an 11.3% decrease. Intense price competition by certain market leaders is generally believed to be responsible for the internal growth performance for the year 2000. Production levels in this segment did begin to improve over the last half of 2000 but that improvement was not sufficient to make internal growth positive for the year.
Net investment income increased $4.7 million (13.6%) in 2000. Contributing to the increase over the previous year was the cash transfers to the Company in conjunction with the change in the Pooling Arrangement and transfer of employees to State Auto P&C referred to above. Total cost of investable assets at December 31, 2000 and 1999, respectively was $741.1 million and $651.9 million.
The investment yield, based on fixed and equity securities at cost, were 5.5% and 5.4% for the annual periods ending 2000 and 1999, respectively. The Company continued to shift the composition of its fixed maturity portfolio from taxables to tax-exempt fixed maturities. At December 31, 2000 and 1999, respectively, tax exempt securities comprised approximately 82% and 76% of the fixed maturity portfolio. Additionally, during 2000 the Company continued to experience a number of calls on its higher yielding fixed maturities. Monies from these calls were reinvested at the then lower yielding rates. See further discussion regarding investments at the Liquidity and Capital Resources and Investments and Market Risk sections included herein.
Management services income increased $8.9 million to $17.6 million for the year ended December 31, 2000. This increase is largely attributable to the change in the nature of the management services provided by State Auto P&C as discussed above. The Department has requested that, beginning in 2001, Mutual file an analysis on a quarterly basis with the Department that justifies the apportionment of the service fee paid by Mutual to State Auto P&C under statutory accounting guidance outlined in SSAP No. 70. See "Overview."
Consolidated earned premiums increased 10.1% in 1999. This increase was principally the result of the change in the Pooled Subsidiaries aggregate pooled participation percentage from 47% to 50% (discussed above) and the addition of Farmers Casualty to the pool. These actions increased consolidated earned premiums by 8.6%. The standard insurance segment's internal growth, as written by the Pooled Companies, excluding the impact of the changes in the Pooling Arrangement and the addition of Farmers Casualty to the pool, decreased consolidated earned premiums by 0.10%. The addition of Mid-Plains to the nonstandard insurance segment increased consolidated earned premiums 2.1%. However, the nonstandard insurance segment decreased consolidated earned premiums by 0.50%.
Like many other insurers in its industry, 1999 was a difficult year for so-called internal growth for the Company. In its standard insurance segment, management continued to stress responsible pricing and sound underwriting despite a significant increase in aggressive price competition in both personal and commercial lines. The Company's personal lines program, Prime of Life, that targets the 50 and over age group, continues to generate approximately 25% of the Company's new homeowner and automobile lines of business. This age group also typically exhibits a significantly higher than average retention rate as a whole among all policyholders in a group than any other age group. The Company's underwriting experience in commercial lines showed some deterioration during 1999, which prompted management to commence a careful review of adherence to its underwriting guidelines in these lines of business.
Management services income, which includes income generated from the investment management services segment and executive management services provided to affiliated companies by
Losses and loss expenses, as a percentage of earned premiums, were 67.5% and 68.0% for the years 1999 and 1998, respectively. As previously noted, during 1999, the Company experienced a decrease in the level of catastrophe losses compared to the same 1998 periods. The impact of the 1999 catastrophe losses amounted to 4.7 GAAP loss ratio points whereas catastrophe losses in 1998 totaled 8.1 GAAP loss ratio points. Offsetting the improvement in the 1999 catastrophe levels was an increase in the amount of commercial claims impacting the year to date results. This is being addressed in the manner described above in the discussion concerning commercial lines underwriting.
In 1998, the Company realigned its claims procedures by establishing a Central Claims Department (the "Department") staffed by trained claim representatives who focus exclusively on losses that are small and routine in nature. The establishment of the Department has allowed for quicker response time to the insured and allows the fully trained claims representative to focus on the more serious claims, thereby reducing the use of independent adjusters. During 1999, the staffing in this Department was expanded as it began handling claims for additional states of operation.
The Company's segment profits of the standard insurance segment, the non-standard insurance segment, and the investment management services segment, are monitored by management on an unconsolidated basis, as reflected in footnote 14 on Reportable Segments in the Company's consolidated financial statements and therefore do not reflect adjustments for transactions with other segments. The following table reflects segment profit or loss for these three segments for the years ended 2000, 1999, and 1998:
1998, the cash transfer relating to the 1998 amended Pooling arrangement was $19.7 million. Over the last three years, operating cash flows have been sufficient to meet the operating needs of the Company while providing opportunities for increased investment and financing needs. Management does not anticipate any significant changes in its operating cash flow.
Net cash provided by or used in financing activities consists of proceeds from issuance of common stock and payment of dividends to shareholders. Mutual, whose ownership in State Auto Financial is approximately 68%, has waived its right to receipt of the dividends declared by State Auto Financial in an effort to enhance the statutory surplus of the insurance subsidiaries of State Auto Financial for use in support of underwriting operations. Prior to the declaration of each dividend by State Auto Financial, Mutual's directors review the facts and circumstances then present in deciding whether to waive such dividend.
Impacting cash used in financing activities during 2000 was State Auto Financial's Board of Directors approving a plan to repurchase up to 1.0 million shares of its common stock from the public over a period ending December 31, 2001. Through March 15, 2001, State Auto Financial repurchased 25,122 shares. Impacting 1999 was a previous repurchase program of State Auto Financial's common stock. During the second quarter of 1999, State Auto Financial's Board of Directors approved a plan to repurchase up to 4.0 million shares of its outstanding common stock over a period ending December 31, 2000. Repurchases were transacted to maintain the same ownership ratios between Mutual and the public as it existed in May 1999, with 69% repurchased from Mutual and 31% from the public. Through December 31, 1999, all 4.0 million shares were repurchased, with approximately 2.7 million shares repurchased from Mutual and 1.3 million shares from the public. In conjunction with the stock repurchase plan, State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million, at an interest rate of 6.0%. The interest rate adjusts each January 1 based on a formula set forth in the note. During 2001 the interest rate is 5.0%. Commencing in 2001, principal is due upon demand from Mutual.
To provide funding if the State Auto Insurance Companies were to incur catastrophe losses in excess of $120.0 million, State Auto Financial entered into a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the Lenders) to provide up to $115.0 million for
reinsurance purposes. In the event of such a loss, this arrangement provides that State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which would borrow the money necessary for such purchase from the Lenders. State Auto Financial would then contribute to State Auto P&C the funds received from the sale of its preferred shares. State Auto P&C would use the contributed capital to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC (which would repay the Lenders) by redeeming the preferred shares over a six-year period. In the event of a default by State Auto Financial, the obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to put either the preferred shares or the loan(s) outstanding.
On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest Security, effective as of January 1, 1997. In connection with this purchase, Mutual and State Auto Financial entered into an Option Agreement granting State Auto Financial the right to purchase Midwest Security from Mutual within five years at a price determined by a formula set out in the Option Agreement. As of March 23, 2001, State Auto Financial has not exercised its right to acquire Midwest Security.
The maximum amount of dividends that may be paid to State Auto Financial during 2001 by its insurance subsidiaries without prior approval under current law is limited to $44.9 million. The Company is required to notify the insurance subsidiaries' respective State Insurance Commissioner within five business days after declaration of all dividends and at least ten days prior to payment. Additionally, the domiciliary Commissioner of each insurer subsidiary has the authority to limit a dividend when the Commissioner determines, based on factors set forth in the law, that an insurer's surplus is not reasonable in relation to the insurer's outstanding liabilities and adequate to its financial needs. Such restrictions are not expected to limit the capacity of State Auto Financial to meet its cash obligations.
The National Association of Insurance Commissioners (NAIC) maintains risk-based capital requirements for property and casualty insurers. Risk-based capital is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy and other business factors. Applying the risk-based capital requirements as of December 31, 2000, each of the State Auto Insurance Companies exceeded all standards established by the formula.
Investable assets comprise approximately 86% of the Company's total assets. Of the total investments, 90% are invested in fixed maturities, 7.6% in equity securities and the remaining in cash and cash equivalents.
The following table provides information about the Company's fixed maturity investments used for purposes other than trading that are sensitive to changes in interest rates. The table presents principal cash flows from maturities, anticipated calls and estimated prepayments, or pay downs from holdings in mortgage backed securities. The table also presents the average interest rate for each period presented.
o As discussed in Item 1 of this Form 10-K, Mutual has entered into agreements with Meridian Mutual and MIGI pursuant to which Meridian Mutual will be merged with and into Mutual, with Mutual continuing as the surviving corporation of the merger, and MIGI will be acquired by Mutual. In addition, during the past several years, Mutual and the Company have acquired other insurance companies, such as Milbank, Farmers Casualty, and Midwest Security, and it is anticipated that Mutual and the Company will continue to pursue acquisitions of other insurance companies in the future. Acquisitions involve numerous risks and uncertainties, including the following: obtaining necessary regulatory approvals of the acquisition may prove to be more difficult than anticipated; integrating the acquired business may prove to be
o The property and casualty insurance industry is highly competitive. Price competition has been very intense during recent years. This continued to be true in regards to both commercial lines and personal lines, particularly auto insurance in 2000. Several "national" carriers' active marketing efforts with respect to personal lines auto insurance have had an impact on the market for this coverage. The Company competes with numerous insurance companies, many of which are substantially larger and have considerably greater financial resources. In addition, because the Company's products are marketed exclusively through independent insurance agencies, most of which represent more than one company, the Company faces competition within each agency. The Company competes through
underwriting criteria, appropriate pricing, and quality service to the policyholder and the agent and through a fully developed agency relations program. See "Marketing" in the "Narrative Description of Business" in Item 1.
o The Company is subject to numerous other factors which effects its operations, including, without limitation, the development of new insurance products, geographic spread of risk, fluctuations of securities markets, economic conditions, technological difficulties and advancements, availability of labor and materials in storm hit areas, late reported claims, previously undisclosed damage, utilities and financial institution disruptions, and shortages of technical and professional employees.
Columbus, Ohio February 20, 2001, except for Note 17, as to which the date is March 30, 2001 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
(a) PRINCIPLES OF CONSOLIDATION The consolidated financial statements of State Auto Financial Corporation include State Auto Financial Corporation (State Auto Financial) and its wholly-owned subsidiaries that consist of:
- - State Auto Property and Casualty Insurance Company (State Auto P&C), a South Carolina corporation - - Milbank Insurance Company (Milbank), a South Dakota corporation - - Farmers Casualty Insurance Company (Farmers Casualty), an Iowa corporation - - State Auto Insurance Company (SAIC), an Ohio corporation - - State Auto National Insurance Company (National), an Ohio corporation - - Stateco Financial Services, Inc. (Stateco), an Ohio corporation - - Strategic Insurance Software, Inc. (S.I.S.), an Ohio corporation.
On July 7, 1998, State Auto Financial exercised its option with State Automobile Mutual Insurance Company (Mutual), pursuant to the Option Agreement dated August 20, 1993, by acquiring the outstanding shares of Milbank. Milbank had been a wholly-owned subsidiary of Mutual since July 1, 1993, but as a result of this transaction, is now a wholly-owned subsidiary of State Auto Financial. The purchase price of Milbank was approximately $81.9 million. The transaction was effected through an exchange with Mutual of approximately 5.1 million State Auto Financial common shares for all the issued and outstanding capital stock of Milbank. Since the transaction was a combination of entities under common control it has been accounted for similar to a pooling-of-interests.
State Auto Financial and subsidiaries are referred to herein as "the Companies" or "the Company." State Auto Financial, an Ohio corporation, is a majority-owned subsidiary of Mutual. All significant inter-company balances and transactions have been eliminated in consolidation.
(b) DESCRIPTION OF BUSINESS The Company, through State Auto P&C, Milbank, Farmers Casualty and SAIC, provides standard personal and commercial insurance to its policyholders. Their principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. National and Mid-Plains provide nonstandard automobile insurance. State Auto P&C, Milbank, Farmers Casualty, SAIC, National, and Mid-Plains operate primarily in the midwest and eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. State Auto P&C, Milbank, Farmers Casualty, SAIC, National and Mid-Plains are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota, Iowa, Ohio (SAIC and National) and Iowa, respectively, and are licensed in various other states. As such, they are subject to the regulations of the applicable Departments of Insurance of their respective states of domicile (the Departments) and the regulations of each state in which they operate. These property and casualty insurance companies undergo periodic financial examination by the Departments and insurance regulatory agencies of the states that choose to participate.
Through State Auto P&C, effective January 1, 2000, the Company provides management and operation services under new management agreements for all insurance and non-insurance affiliates. Pursuant to these agreements, the Company received approximately $28.1 million equal to the net plan benefit liabilities assumed relating to the transfer to the Company of all employees from Mutual and other affiliated companies. Prior to January 1, 2000, the Company, through State Auto P&C, provided executive insurance management services to all insurance affiliates.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of losses and loss expenses payable. In connection with the determination of this estimate, management uses historical data and current business conditions to formulate estimates including assumptions related to the ultimate cost to settle claims. These estimates by their nature are subject to uncertainties for various reasons. The Company's results of operations and financial condition could be impacted in the future should the ultimate payments required to settle claims vary from the liability currently provided.
Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses related to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned, without credit for anticipated investment income. These amounts are based on estimates and accordingly, the actual realizable value may vary from the estimated realizable value. Net deferred policy acquisition costs were:
Investments in fixed maturities, where the Companies have the ability and intent to hold to maturity, are carried at amortized cost. Mortgage-backed securities are carried at amortized cost using the scientific method of amortization including anticipated prepayments. Prepayment assumptions are obtained from a pricing service and are based on the current interest rate and economic environment. The retrospective adjustment method is used to value all such securities. For fixed maturities classified as held to maturity, unrealized holding gains or losses are not reflected in the accompanying consolidated financial statements. Investments in fixed maturity and equity securities held as available for sale are carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity as accumulated other comprehensive income and as such are not included in the determination of net income. Gains and losses on the sale of equity securities are computed using the first-in, first-out method.
(j) MANAGEMENT SERVICES INCOME Management services income includes income for management and operations services provided by State Auto P&C in 2000 and executive insurance management services provided in 1999 and 1998 and income for investment management services provided by Stateco. Management and operations services income, to the extent certain operational ratios are achieved, is recognized quarterly based on a percentage of the three year average of each managed company's adjusted surplus or equity, whereas in 1999 and 1998 executive management income was based on a five year average of each managed insurer's adjusted statutory surplus. Midwest Security Insurance Company (Midwest Security), a wholly-owned subsidiary of Mutual, is an exception to this, calculating its fee based on a percentage of quarterly direct premiums written. Investment management income is recognized quarterly based on a percentage of the average fair value of investable assets and the performance of the equity portfolio of each company managed.
Income taxes are accounted for using the liability method. Using this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets
(n) OTHER COMPREHENSIVE INCOME Comprehensive 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 income includes net income and other comprehensive income. Other comprehensive income includes all other non-owner related changes to equity and includes net unrealized gains and losses on available-for-sale fixed maturities and equity securities.
(o) RECLASSIFICATIONS Certain items in the 1999 and 1998 consolidated financial statements and notes thereto have been reclassified to conform with the 2000 presentation.
Fixed maturities with carrying values of approximately $21,633,000 and $20,473,000 were on deposit with regulators as required by law or specific escrow agreement at December 31, 2000 and 1999, respectively.
Investment securities:Fair values for investments in fixed maturities are based on quoted market prices, where available. For fixed maturities not actively traded, fair values are estimated using values obtained from independent pricing services. The fair values for equity securities are based on quoted market prices.
The liability for losses and loss expenses decreased by $5,638,000 in 2000, $6,878,000 in 1999 and $13,591,000 in 1998, for claims that had occurred in prior years. The change in the redundancy over the three year period ending December 31, 2000 has resulted primarily from less favorable development in the long-tail lines such as general liability, commercial auto liability, workers' compensation and no-fault insurance. Because of the nature of the business written over the years, the Company's management believes that the Company has limited exposure to environmental claim liabilities.
Since 1995, State Auto P&C and Milbank have participated in the Pooling Arrangement with Mutual. Effective January 1, 1998, the Pooled Subsidiaries aggregate participation in the Pooling Arrangement increased from 45% to 47% and Midwest Security Insurance Company (Midwest), a wholly-owned subsidiary of Mutual, became a participant in the Pooling Arrangement. On January 1, 1999, Farmers Casualty was acquired by State Auto Financial and became a participant in the Pooling Arrangement on that same date, at which time the Pooled Subsidiaries' aggregate participation increased to 50%. In conjunction with these changes in pool participation, the Pooled Subsidiaries received cash from Mutual of $11.4 million and $19.7 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 1999 and 1998, respectively. Effective January 1, 2000, the Pooling Arrangement was amended to make SAIC a participant in the Pooling Arrangement and the Pooled Subsidiaries aggregate participation increased to 53%. In conjunction with this change in pool participation, the Pooled Subsidiaries received cash from Mutual of $18.6 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 2000. All parties that participate in the Pooling Arrangement have an A. M. Best rating of A+ (Superior).
During 1996, Mutual, State Auto P&C, Milbank and National negotiated a change in their catastrophe reinsurance program. In 1998, Midwest Security, 1999, Farmers Casualty and Mid-Plains, and 2000, SAIC, became parties to the catastrophe reinsurance program. Collectively, these participants in the catastrophe reinsurance program are referred to as the "State Auto Insurance Companies." State Auto P&C assumed catastrophe reinsurance from Mutual, Milbank, Midwest Security, Farmers Casualty, SAIC, National and Mid-Plains in the amount of $135 million excess of $120 million. Effective November 2000, the catastrophe reinsurance program was renegotiated whereby State Auto P&C assumed $115 million excess of $120 million. Under this agreement, the Company has assumed from Mutual and its affiliate premiums written and earned of $3,129,000, $2,355,000 and $2,475,000 for 2000, 1999 and 1998, respectively. There have been no losses assumed under this agreement. The catastrophe reinsurance program with State Auto P&C has been excluded from the Pooling Arrangement.
To protect against a catastrophe loss event, in which the State Auto Insurance Companies would incur catastrophe losses in excess of $120 million, State Auto Financial entered into a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the Lender) to provide (effective November 2000) up to $115 million for reinsurance purposes. In the event of such a loss, this arrangement provides that State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which would borrow the money necessary for such purchase from the Lenders. This arrangement with the Lenders, SPC and State Auto Financial is a financing arrangement, whereby State Auto Financial would receive cash funding in the event of a catastrophe event as described above. State Auto Financial would then contribute to State Auto P&C the funds received from the sale of its preferred shares. State Auto P&C would use the contributed capital proceeds to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC by redeeming the preferred shares over a six-year period. In the event of a default by State Auto Financial, the obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to put either the preferred shares or the loan(s) outstanding.
(c) NOTE PAYABLE State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million in conjunction with its stock repurchase program, at an interest rate of 6.0%. See related footnote at note 9 (b). Principal payment is due on demand after December 31, 2000, with final payment to be received on or prior to December 31, 2005. The interest rate is adjustable annually after the year 2000 to reflect adjustments in the then current prime lending rate as well as State Auto Financial's current financial position. Interest rate for the year 2001 is 5.0%. Interest expense on the loan from Mutual was $2,730,000 and $955,000 in 2000 and 1999, respectively.
(d) MANAGEMENT SERVICES Effective January 1, 2000, State Auto P&C began providing management and operation services to Mutual and its insurance affiliate. Revenue relating to these services amounted to $14,654,000 in 2000. Prior to 2000, State Auto P&C provided Mutual and its insurance affiliate executive management services to oversee the insurance operations of these companies. Revenue relating to these services amounted to $4,908,000 and $4,563,000 in 1999 and 1998, respectively. Stateco provides Mutual and its affiliate investment management services. Revenue related to these services amount to $2,940,000, $3,099,000 and $3,037,000 in 2000, 1999 and 1998, respectively.
(7) FEDERAL INCOME TAXES A reconciliation between actual federal income taxes and the amount computed at the indicated statutory rate is as follows:
Federal income taxes paid during 2000, 1999 and 1998 were $12,638,000, $12,621,000 and $11,768,000, respectively.
(8) (a) PENSION BENEFIT PLANS Prior to 2000, State Auto P&C, Stateco and S.I.S., pursuant to an intercompany agreement, were participants, together with Mutual, in a defined benefit pension plan and a defined contribution plan that covered substantially all employees of Mutual and the Company.
The assets of the defined benefit pension plan are represented primarily by U.S. government and agency obligations, bonds, and common stocks. The Company's policy is to fund pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Benefits are determined by applying factors specified in the plan to a participant's defined average annual compensation.
Effective January 1, 2000, the net prepaid pension expense is carried on the financial statements of the Company and the annual periodic pension benefit or cost is allocated to affiliated companies based on allocations pursuant to intercompany management agreements. The Company's share of the 2000 net periodic benefit was $2.5 million.
Effective January 1, 2000, all employees of Mutual, Stateco and S.I.S., became employees of State Auto P&C, under new management agreements effective on that same date. See related discussion at Note (1)(b). Pursuant to the new management agreements, the Company received cash of approximately $49.6 million from Mutual, equal to the funded status of the postretirement obligation assumed.
An 8.0% weighted average discount rate was used for 2000 to determine the accumulated postretirement benefit obligation. An 8.5% weighted average rate was used for 2000 to determine the long-term rate of return on plan assets. Net periodic pension costs for the postretirement plan for the year ended December 31, 2000 include the following components:
(b) TREASURY SHARES In May 1999, State Auto Financial's Board of Directors approved a plan to repurchase up to 4.0 million shares of its outstanding common stock over a period ending December 31, 2000. Repurchases were transacted to maintain the same ownership ratios between Mutual and the public as it existed in May 1999, with 69% repurchased from Mutual and 31% from the public. Through December 31, 1999 all 4.0 million shares have been repurchased, with approximately 2.7 million shares repurchased from Mutual and 1.3 million shares from the public. In conjunction with the stock repurchase plan, State Auto Financial entered into a line of credit agreement with Mutual. See related footnote at note 6 (c).
(c) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION State Auto P&C, Milbank, Farmers Casualty, SAIC and National are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Pursuant to these rules, approximately $44.9 million is available for payment to State Auto Financial in 2001 without prior approval.
In March 1998, the National Association of Insurance Commissioners revised the Accounting Practices and Procedures Manual for insurance companies in a process referred to as Codification. The revised manual became effective January 1, 2001. The revised manual has changed, to some extent, prescribed statutory insurance accounting practices and will result in changes to the accounting practices that the insurance subsidiaries of State Auto Financial use to prepare its statutory-basis financial statements. The cumulative effect of changes in accounting principles adopted to conform to the revised Accounting Practices and Procedures Manual will be reported as an adjustment to statutory surplus as of January 1, 2001. The Company estimates that the adoption of Codification, as of January 1, 2001, will increase statutory surplus of the insurance subsidiaries of State Auto Financial by approximately $26.8 million.
State Auto Financial has authorized two classes of preferred stock. For both classes, upon issuance, the Board of Directors has authority to fix and determine the significant features of the shares issued, including, among other things, the dividend rate, redemption price, redemption rights, conversion features and liquidation price payable in the event of any liquidation, dissolution, or winding up of the affairs of State Auto Financial. See note 6 (a) regarding State Auto Financial's obligation to issue redeemable preferred shares to SPC in connection with its catastrophic reinsurance arrangements with a financial institution.
The Company follows Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock incentive plans. For stock options granted to employees of Mutual in 1999, the Company also followed APB 25 and related Interpretations, as the Company deemed such employees to be common law employees of the Company. Compensation cost charged against operations in 2000 and 1999 were $31,000 and $137,000, respectively, for those employee stock options granted where the exercise price was less than the market price of the underlying stock on the date of grant. Had compensation cost for the Company's plans been determined based on the fair values at the grant dates consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123), the Company's pro forma net earnings and net earnings per share information would have been as follows:
2000 1999 1998 ---- ---- ---- (in thousands, except per share figures)
may be granted at an option price not less than fair market value at date of grant and that nonqualified stock options may be granted at any price determined by the options committee of the Board of Directors. The Company has reserved 5,000,000 shares of common stock under this plan. These options are exercisable at such time or times as may be determined by a committee of the Company's Board of Directors. Normally, for certain employees these options are exercisable from 1 to 10 years from date of grant and 3 to 10 years for remaining employees.
The Company has an employee stock purchase plan with a dividend reinvestment feature, under which employees of the Company may choose at two different specified time intervals each year to have up to 6% of their annual base earnings withheld to purchase the Company's common stock. The purchase price of the stock is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 2,400,000 shares of common stock under this plan. At December 31, 2000, 1,699,000 shares have been purchased under this plan.
YEAR ENDED DECEMBER 31 ---------------------- 2000 1999 1998 ---- ---- ---- (in thousands, except per share data)
(13) OTHER COMPREHENSIVE INCOME The related federal income tax effects of each component of other comprehensive income (loss) are as follows:
Net unrealized holding losses on securities: Unrealized holding losses arising during 1999 ........................... $(28,361) 9,926 (18,435) Reclassification adjustments for gains realized in net income ................ (2,593) 908 (1,685) ----------------------------------- Net unrealized holding losses ........... (30,954) 10,834 (20,120) ----------------------------------- Other comprehensive loss .................. $(30,954) 10,834 (20,120) ===================================
YEAR ENDED DECEMBER 31, 1998 ---------------------------- BEFORE-TAX TAX (EXPENSE) NET-OF-TAX AMOUNT OR BENEFIT AMOUNT ------ ---------- ------ (in thousands)
Net unrealized holding gains on securities: Unrealized holding gains arising during 1998 ........................... $11,410 (3,993) 7,417 Reclassification adjustments for gains realized in net income ................ (2,925) 1,023 (1,902) ---------------------------------- Net unrealized holding gains ............ 8,485 (2,970) 5,515 ---------------------------------- Other comprehensive income ................ $ 8,485 (2,970) 5,515 ==================================
(14) REPORTABLE SEGMENTS The Company has four reportable segments: standard insurance, nonstandard insurance, investment management services and management and operations services (prior to 2000, executive insurance management services). The standard insurance segment provides personal and commercial insurance to its policyholders. Its principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. The nonstandard insurance segment provides personal automobile insurance to policyholders that are typically rejected or canceled by standard insurance carriers because of poor loss experience or a history of late payment of premiums. Both the standard and nonstandard insurance segments operate primarily in the Midwest and Eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. The investment management services segment manages the investment portfolios of affiliated insurance companies. The management and operations services segment provides employee services and manages the day to day operations of all affiliated Companies.
The Company evaluates performance and allocates resources based on profit or loss from operations, excluding net realized gains on investments on the Company's investment portfolio, before federal income taxes. The Company does not allocate assets to the management and operations services segment. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.
REVENUES FROM EXTERNAL CUSTOMERS: Standard insurance ...................... $406,602 392,557 360,601 Nonstandard insurance ................... 29,595 32,973 27,064 Investment management services .......... 3,360 3,371 3,328 Management and operations services ...... 14,654 5,628 4,909 All other ............................... 3,227 3,537 2,906 -------------------------------- Total revenues from external customers .... 457,438 438,066 398,808
SEGMENT PROFIT (LOSS): Standard insurance ......................... $ 35,579 41,146 34,341 Nonstandard insurance ...................... (116) 1,647 1,313 Investment management services ............. 5,354 5,191 4,908 Management and operations services ......... 17,552 6,330 5,290 All other .................................. 905 1,238 1,323 ------------------------------ Total segment profit ....................... 59,274 55,552 47,175
NET INVESTMENT INCOME: Standard insurance ......................... $ 33,436 29,060 27,710 Nonstandard insurance ...................... 1,899 1,839 1,383 Investment management services ............. 360 272 292 All other .................................. 244 268 432 ------------------------------ Total net investment income .................. 35,939 31,439 29,817
During 2000, service fee revenue, included in management services income from affiliates in the accompanying financial statements, paid by Mutual accounted for $14,538,000 or 3.1 percent of total revenues and $0.24 on a basic and diluted earnings per share, after tax, basis.