claims office facilities which they share through the Management Agreement. These facilities include a 53,500 square foot regional office in Greer, South Carolina, 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 addition, Mutual currently leases a 22,800 square foot regional office in Nashville, Tennessee pursuant to a 10-year lease. In the first quarter of 1998, 518 PML acquired land in Goodlettsville, Tennessee on which it is constructing an office building which the Company expects to become Mutual's Nashville Regional Office following expiration of the current lease in June 1999. Milbank owns an office facility in Milbank, South Dakota where Mutual employees provide services to Milbank agents and policyholders. Midwest Security leases an office facility in Onalaska, Wisconsin where Mutual employees service Midwest Security's agents and policyholders. Mutual also leases a number of small offices throughout its operating area for the claims operations of Mutual and the Company.
State Auto P&C provides executive management services to oversee the insurance operations of all the State Auto Insurance Companies, which include National and State Automobile Mutual Insurance Company (Mutual), a majority shareholder of State Auto Financial, and Mutual's wholly-owned subsidiaries, Milbank Insurance Company (Milbank), Midwest Security Insurance Company (Midwest Security) (Midwest Security was acquired by Mutual effective January 1, 1997) and until June 30, 1997, State Auto Life Insurance Company (State Auto Life was sold by Mutual effective July, 1997). Stateco Financial Services, Inc. (Stateco), a wholly-owned subsidiary of State Auto Financial, provides investment management services to affiliated companies and also provides insurance premium finance services to customers of State Auto P&C, Mutual and Milbank.
Strategic Insurance Software, Inc. (SIS), a majority owned subsidiary, develops and sells software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance companies and agents. SIS sells services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies. State Auto Financial and its subsidiaries, State Auto P&C, National, Stateco and SIS are referred to collectively as the Company.
Effective July 1, 1993, Mutual acquired Milbank. In connection with this purchase, Mutual and State Auto Financial entered into an Option Agreement granting State Auto Financial the right to acquire Milbank from Mutual within five years at a price determined by a formula set out in the Option Agreement. On March 6, 1998, the Board of Directors of State Auto Financial adopted a resolution authorizing the officers of State Auto Financial to take such steps as are necessary to effect the exercise of State Auto Financial's option to acquire Milbank from Mutual. State Auto Financial's acquisition of Milbank is subject to procedural matters contemplated by the Option Agreement, as approved by the directors of Mutual and State Auto Financial, being completed and regulatory approval in Ohio and South Dakota. The proposed effective date of transfer is third quarter 1998.
Midwest Security are referred to collectively as the State Auto Insurance Companies, while State Auto P&C, Mutual and Milbank are referred to as the Pooled Companies.
Net investment income increased $1.2 million or 5.0% to $25.1 million. An increase in invested assets over the same 1996 period contributed to this increase. Total cost of invested assets at December 31, 1997 was $391.1 million compared to $377.0 million at December 31, 1996. During the last half of 1997, the Company began a program to build an equity portfolio to enhance growth of statutory surplus over the long term. At December 31, 1997, the equity portfolio totaled $4.6 million. The investment yield, based on fixed and equity securities at cost, decreased to 6.2% from 6.4% in 1996.
Earned premiums increased $7.8 million or 3.4% to $240.3 million. Direct written premiums for commercial business increased approximately 10.9% from the same 1995 period. Except for National, the Company's personal lines experienced no growth in 1996. Contributing to the results in personal lines, was the introduction of the PRIME of LIFE personal auto and homeowners plan beginning on a state-by-state basis in late 1995 (the Plan). The Plan focuses on the 50 and older segment of the personal lines market, a group that has generally produced more favorable underwriting and retention results for the industry than any other segment of the personal lines market. The Plan offers a combination of auto and homeowners discounts and enhances coverages. As a consequence of moving existing eligible policyholders to the Plan and reflecting the actuarially justified discounts, along with conservative underwriting and newer agency appointments of more commercial lines oriented agencies, personal lines written premium was flat. The Company remains committed to profitable premium growth as it is continually reviewing current strategies and developing new programs in both commercial and personal lines sales. Positively contributing to both commercial and personal lines sales in 1996, was the Company's entry into its 23rd state of operation, Oklahoma. National, which began operations in the non-standard personal auto market in 1992, recorded an increase in its direct written premiums of approximately 43%. During the fourth quarter of 1996, National began writing business in Arkansas and Georgia and wrote its first policy in the state of Minnesota in February of 1997 bringing the total number of its operating states to eight. It began operations in three additional states during 1997.
Losses and loss expenses, as a percentage of earned premiums, increased to 72.2% from 68.3% in
1995. During 1996, the Company experienced several significant weather related catastrophes. Severe winter weather in January and February, tornado and hailstorms in the Louisville, Kentucky area in May and storm losses in Raleigh, North Carolina resulting from Hurricane Fran moving inland in September, increased losses and loss expenses by approximately $16.0 million. The impact of these storms increased this loss and loss expense ratio 6.7 points. Despite these significant losses, the Company continued to record improvements in its underlying book of business. Automobile, the Company's largest line of business, showed an improvement in its statutory loss ratio of 69.5%, down from 74.1% in 1995.
Acquisition and operating expenses, as a percentage of earned premiums, decreased to 28.1% from 29.0% in 1995. The decrease in the ratio for 1996 is due primarily to the decrease in the amount of Quality Performance Bonus earned by nearly all permanent employees of the State Auto Companies in 1996 compared to the same periods in 1995.
Net cash provided by operating activities increased to $24.9 million from $22.4 million in the same 1996 period. Net cash used in investing activities decreased to $15.3 million from $21.2 million from the same 1996 period. Net cash provided by financing activities increased to $1.4 million from $0.4 million in the same 1996 period. As of December 31, 1997, funds consisting of cash and cash equivalents for general operations were $23.9 million compared to $12.9 million at December 31, 1996. No long-term fixed maturies were required to be sold to meet financial obligations in 1997.
In addition, State Auto Financial's obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which, in the event of a default by State Auto Financial as described in the Credit Agreement or in
On March 6, 1998, the Board of Directors of State Auto Financial declared a quarterly cash dividend of $0.045 per common share, payable on March 31, 1998, to shareholders of record on March 17, 1998. Additionally, the Board also declared a two-for-one stock split to be distributed July 8, 1998, to shareholders of record on June 18, 1998. The split is contingent upon shareholder approval of a proposal to increase the number of authorized common shares, without par value, from 30 million to 100 million at the Company's Annual Meeting of Shareholders on May 28, 1998.
The maximum amount of dividends that may be paid to State Auto Financial during 1998 by its insurance subsidiaries as a non-extraordinary dividend is limited to $28.9 million, without prior approval under current law. 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 non-extraordinary 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) adopted risk-based capital requirements for property and casualty insurers effective December 31, 1994. 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, 1997, each of the State Auto Insurance Companies exceeded all standards tested by the formula.
The Year 2000 Issue is the result of computer programs having been written using two digits rather than four to define the applicable year. Any of the computer programs used by State Auto Financial and Mutual and their respective subsidiaries (all of which are collectively, referred to as "State Auto" for the purposes of this section) that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of uncertain duration in State Auto's operations, including, among other things, an inability to process transactions, send invoices, or engage in similar normal business activities.
operational problems for State Auto. However, if such modifications and conversions are not made, or are not completed timely, the Year 2000 Issue could adversely affect the operations of State Auto.
To address the Year 2000 issue in a timely and effective manner, management purchased software from a third party vendor to assist in diagnosing and correcting certain of State Auto's major policy processing software systems. In addition, management is utilizing State Auto's internal resources to reprogram, or replace, and test the balance of its software for necessary Year 2000 modifications. Management presently anticipates completing the Year 2000 modifications on State Auto's critical business applications software by October 1998 and its remaining non-critical business applications software during 1999. Management expects to have these changes completed prior to the Year 2000 Issue having an adverse impact on State Auto's operations and operating systems. The total cost of the Year 2000 project for State Auto Financial is estimated at $1.5 million and is being funded through cash flows. To date, State Auto Financial's incurred cost is approximately $0.8 million and approximately 50% of State Auto's computer programs (lines of code) are Year 2000 compliant.
The estimated costs of the project and the date by which State Auto believes it will complete the Year 2000 modifications are based on management's judgment, and information available to it as well as its assumptions of future events, including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those anticipated. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant software code, and the affect of the Year 2000 Issue on regulators and other government agencies, among others.
Stateco performs investment management services on behalf of the Company and Mutual and its subsidiaries. Investment policies followed by Stateco are set by each company's Investment Committee of its Board of Directors.
The primary investment objectives are to generate income, preserve capital and maintain adequate liquidity for the payment of claims. Fixed maturities that are purchased with the intention and ability of holding them until maturity are categorized as held to maturity and are carried at amortized cost. Fixed maturities that may be sold due to changing investment strategies, are categorized as available for sale and are carried at fair value.
As of December 31, 1997, the Company had fixed maturities with a fair value of $320.3 million designat-
The Company's investable assets as of December 31, 1997 and 1996 were $428.2 million and $397.2 million, respectively. At December 31, 1997, 93.3% of the investable assets were in fixed maturities, 1% in equity securities with the remaining 5.7% allocated to cash and cash equivalents.
As of December 31, 1997, the Company had no fixed maturity investments rated below investment grade, nor any mortgage loans. The Company does not intend to change its investment policy on the quality of its fixed maturity investments.
In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS No. 130, "Reporting Comprehensive Income," which is effective for fiscal years beginning after December 15, 1997. SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Also in June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which is effective for fiscal years beginning after December 15, 1997. SFAS No. 131 changes the way public companies report segment information in annual financial statements and also requires those companies to report selected segment information in interim financial reports to shareholders. The Company has not yet determined the reporting changes required by SFAS No. 130 and 131 to comprehensive income and segment information.
Inflation can have a significant impact on property and casualty insurers because premium rates are established before the amounts of losses and loss expenses are known. When establishing rates, the Company attempts to anticipate increases from inflation subject to limitations imposed for competitive pricing. The Company considers inflation when estimating liabilities for losses and loss expenses, particularly for claims having a long period between occurrence and settlement. The liabilities for losses and loss expenses are management's estimates of the ultimate net cost of underlying claims and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on investment income may partially offset potentially higher claims and expenses.
(a) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of State Auto Financial Corporation (the Company) and its wholly-owned subsidiaries State Auto Property and Casualty Insurance Company (State Auto P&C), State Auto National Insurance Company (National) and Stateco Financial Services, Inc. (Stateco) and majority-owned subsidiary Strategic Insurance Software, Inc. (SIS). State Auto Financial Corporation and subsidiaries are referred to herein as "the Companies." The Company, an Ohio corporation, is a majority-owned subsidiary of State Automobile Mutual Insurance Company (Mutual). All significant intercompany balances and transactions have been eliminated in consolidation.
(c) BASIS OF PRESENTATION The consolidated financial statements have been prepared in conformity with generally accepted accounting principles, which vary in certain respects from statutory accounting practices followed by State Auto P&C and National that are prescribed or permitted by the Departments. The National Association of Insurance Commissioners (NAIC) currently has a project to codify statutory accounting practices, the result of which is expected to constitute the only source of prescribed statutory accounting practices. Accordingly, that project, expected to be completed in 1998, will likely change the definitions of what comprises prescribed versus permitted statutory accounting practices, and may result in changes to the accounting policies that insurance companies use to prepare their statutory financial statements. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the period then ended and the accompanying notes to the financial statements. Such estimates and assumptions could change in the future as more information becomes known which could impact the amounts reported and disclosed herein. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of losses and loss expenses payable and the recoverability of deferred policy acquisition costs. In connection with the determination of these items, 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.
(k) CASH EQUIVALENTS For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments with a maturity of three months or less to be cash equivalents.
Fixed maturities with carrying values of approximately $3,936,000 and $3,890,000 were on deposit as required by law or specific escrow agreement at December 31, 1997 and 1996, respectively.
The liability for losses and loss expenses decreased by $13,505,000 in 1997, $21,028,000 in 1996 and $12,536,000 in 1995, for claims that had occurred in prior years. These decreases have resulted primarily from moderating trends in the frequency and severity of losses and loss expenses due to lower inflation. This along with fundamental improvements primarily in the auto liability and workers' compensation lines of business resulted in incurred losses and loss expenses developing favorably. 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.
Amounts related to National's reinsurance agreement that are reported as assets in the accompanying consolidated balance sheets are summarized as follows:
(6) TRANSACTIONS WITH MUTUAL State Auto P&C provides Mutual and its insurance affiliates executive management services to oversee the insurance operations of these companies. Fees relating to these services amounted to $5,392,000 in 1997, $4,956,000 in 1996 and $4,662,000 in 1995. Stateco provides Mutual and its affiliates investment management services. Fees related to these services amounted to $3,313,000 in 1997, $3,064,000 in 1996 and $2,912,000 in 1995. Effective July 1, 1995, SIS began providing insurance software products and services to Mutual and its affiliates. Fees relating to these services amounted to $1,051,000 in 1997, $1,015,000 in 1996 and $423,000 in 1995 and is included in other expense. State Auto P&C's December 31, 1990 liability for losses and loss expenses of $65,464,000 has been guaranteed by Mutual. Pursuant to the guaranty agreement, all ultimate adverse development of the December 31, 1990 liability, if any, is to be reimbursed by Mutual to State Auto P&C. As of December 31, 1997, there has been no adverse development of the liability.
The Company is required to establish a valuation allowance for any portion of the deferred tax asset that management believes will not be realized. In the opinion of management, it is more likely than not that the Company will realize the benefit of the deferred tax assets and, therefore, no such valuation allowance has been established. Federal income taxes paid during 1997, 1996 and 1995 were $13,435,000, $5,883,000 and $11,371,000, respectively.
Reconciliations of statutory capital and surplus and net income or loss, as determined using statutory accounting practices, to the amounts included in the accompanying consolidated financial statements are as follows:
The Company 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 the Company. See Note (5) regarding the Company's obligation to issue redeemable preferred shares to SPC in connection with its catastrophe reinsurance arrangements with Chase Manhatten Bank. The Class A preferred stock is not entitled to voting rights until, for any period, dividends are in arrears in the amount of six or more quarterly dividends.
The Company has stock option plans for certain directors and key employees of Mutual, State Auto P&C, Stateco and SIS. The nonemployee directors' plan provides each nonemployee director an option to purchase 1,000 shares of common stock following each annual meeting of the shareholders at an option price equal to the fair market value at the last business day prior to the annual meeting. The Company has reserved 150,000 shares of common stock under this plan. These options are exercisable at issuance to 10 years from date of grant. The key employee's plan provides that qualified stock options 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 1,800,000 shares of common stock under this plan. 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 fair value of these options utilized in the pro forma information above were estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for 1997 and 1996, respectively: dividend yield of 1.0% for both years; expected volatility factors of .24 and .23; risk-free interest rates of 6.7% and 6.6%; and expected life of the option of 8 years for both years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's option, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Consolidated Financial Statements, Continued
(14) CONTINGENCIES State Auto P&C and National are involved in litigation and may become involved in potential litigation arising in the ordinary course of business. In the opinion of management, the effects, if any, of such litigation are not expected to be material to the consolidated financial statements.