Because the operations of the Company and Mutual are integrated with one another pursuant to the terms of the Amended and Restated Management Agreement, the Company and Mutual share their operating facilities. See Item 1, "Management Agreement." The Company's and Mutual's corporate headquarters are located in Columbus, Ohio in buildings owned by Mutual that contain approximately 270,000 square feet of office space. The Company and Mutual also have regional underwriting and claims office facilities which they share through the Management Agreement. These facilities include a 53,500 square foot regional office in Greer, South Carolina, which is owned by State Auto P&C, a 22,800 square foot regional office in Nashville, Tennessee which is leased by Mutual from a third party pursuant to a 10-year lease, 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. 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. Each company maintains the facilities owned or leased by it and, because the facilities are used in common and shared, does not charge rent to the other State Auto Companies using those facilities except with respect to space within a facility dedicated to the exclusive use of a particular company. With respect to the Tennessee location, the Board of Directors of State Auto Financial and Mutual have authorized State Auto Financial to purchase land and develop an office building for Mutual to occupy as a tenant of State Auto Financial when the lease in Nashville expires in 1999.
1996 Compared to 1995 - -------------------------------------------------------------------------------- Net earnings for the Company decreased 11.5% due primarily to numerous storm-related catastrophe claims in the first three quarters of the year. Despite these significant losses, the Company was able to produce a statutory combined ratio of 99.0% bettering preliminary industry expectations for the year of 107%.
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 enhanced 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 anticipates beginning operations in two to three additional states during 1997. Net investment income increased $1.3 million or 5.6% to $23.9 million. An increase in invested assets over the same 1995 period contributed to this increase. Total amortized cost of invested assets at December 31, 1996 was $377.0 million compared to $355.4 million at December 31, 1995. The investment yield decreased to 6.16% from 6.38% in 1995. Management services income, which includes income generated from investment and executive management services provided by Stateco and State Auto P&C, respectively, increased $0.4 million or 5.9% to $8.0 million. 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 losses 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. Federal income taxes decreased $2.3 million to $7.5 million. This decrease is reflective of the lower taxable income experienced by the Company in the current year. The effective tax rate decreased to 25% from 28% in 1995.
1995 Compared to 1994 - -------------------------------------------------------------------------------- The Company recorded a 74.2% increase in net earnings in 1995 reflecting substantial improvements in its insurance operations as well as the change in the pooling percentages. All major lines of insurance experienced an improvement operationally. The Company produced a statutory combined ratio of 98.7% compared to industry experience for the year of 106.4%. Earnings before federal income taxes increased $16.2 million or 85% to $35.3 million. As previously discussed, this improvement in operations reflects the positive underwriting results and the effect of the change in the pooling percentages. Earned premiums increased $56.9 million or 32.4% to $232.5 million primarily as a result of the change in the pooling arrangement. Absent the impact of this change, earned premiums increased $10.9 million or 4.9%. Direct written premiums for commercial lines of business increased approximately 11% from the same period in 1994. Management believes this increase is attributable to changes in the structure of the sales organization and an increase in emphasis on commercial lines of business. Personal lines of business, except for National's non-standard auto products, are currently experiencing a period of no real growth. Management believes this is caused by several factors, including price competition and underwriting actions taken to both reduce the Company's exposure to natural catastrophes and to maintain the quality of what it believes to be an improved book of personal lines business. Management has been emphasizing sales of personal lines by encouraging personal lines specialists to contact agents directly about personal lines sales opportunities, reviewing pricing levels, seeking new agency appointments and introducing new products. For example, in 1995 the Company appointed 109 new agents and during the fourth quarter launched its PRIME of LIFE Plan in Ohio, Indiana, Tennessee, and Arkansas. The Plan is designed to focus on the 50 and older age market by offering a combination of auto and homeowners discounts and enhanced coverages. The Plan will be introduced in most of the Company's other operating states in 1996. National began operations in Kentucky in mid-1995, bringing the total number of states it currently operates in to five. It anticipates beginning operations in at least two additional states during 1996. Net investment income increased $4.9 million or 27.4% to $22.6 million, primarily due to an increase in invested assets. The increase in invested assets resulted from the $46.0 million cash transfer to State Auto P&C in connection with the pooling change and an increase in cash flow from operations. The investment yield increased slightly to 6.38% from 6.36% for 1994. Management services income, which includes income generated from investment and executive services provided by Stateco and State Auto P&C, respectively, increased $1.5 million or 24.6% to $7.6 million. Services income for 1995 reflects four quarters of income for State Auto P&C, while 1994 reflects only three quarters as State Auto P&C commenced executive management services April 1, 1994.
Losses and loss expenses, as a percentage of earned premiums, decreased to 68.3% from 74.9% in 1994. The extent of this improvement in the underwriting operations in its major lines of business is apparent when one considers that 1995 catastrophe losses were only slightly lower than 1994 catastrophe losses. The Company recorded an improvement in its statutory loss ratio in its largest line of business, automobile. The statutory loss ratio for automobile in 1995 was 74.1%, down from 76.6% in 1994. The Company's second largest line, homeowners, produced its best statutory loss ratio in 1995, since going public in 1991. The statutory loss ratio for homeowners in 1995 was
purchase from Chase and a syndicate of other lenders. State Auto Financial will contribute to State Auto P&C the proceeds from the sale of its preferred shares. State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank and National pursuant to a catastrophe reinsurance agreement in the amount of $100.0 million excess of $120.0 million. State Auto P&C will 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 will repay the lenders) by redeeming the preferred shares over a six year period. This layer of $100.0 million in excess of $120.0 million has been excluded from the pooling agreement as well by virtue of an Amended and Restated Reinsurance Pooling Agreement. 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 the Put Agreement, Mutual would be obligated to put either the preferred shares or the loan(s) outstanding. 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 purchase Milbank from Mutual within five years at a price determined by a formula set out in the Option Agreement. As of March 4, 1997, State Auto Financial has not exercised its right to acquire Milbank. On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest Security, effective 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. The State Auto Insurance Companies' Tennessee office location is currently leased by Mutual from a third party pursuant to a 10-year lease which expires in 1999. The Boards of Directors of State Auto Financial and Mutual have authorized State Auto Financial to purchase land and develop an office building for Mutual to occupy as a tenant of State Auto Financial when the lease expires. No commitment has been made to acquire land as of March 4, 1997. The maximum amount of dividends that may be paid to State Auto Financial during 1997 by its insurance subsidiaries as a non-extraordinary dividend is limited to $12.3 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, 1996, each member of the State Auto Insurance Companies exceeded all standards tested by the formula.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Continued
INVESTMENTS 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. In December 1995, the Company reclassified $84.6 million in fixed maturities from the held to maturity category to available for sale. This reclassification was performed in accordance with the Financial Accounting Standards Board (FASB) Special Report - " A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities." As of December 31, 1996, the Company had fixed maturities with a fair value of $294.1 million designated as available for sale compared to $278.3 million at December 31, 1995. The Company's investable assets as of December 31, 1996 and 1995 were $397.2 million and $381.0 million, respectively. At December 31, 1996, 96.8% of the investable assets were in fixed maturities with the remaining 3.2% allocated to cash and cash equivalents. As of December 31, 1996, 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.
IMPACT OF SIGNIFICANT EXTERNAL CONDITIONS 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.
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1996. Our audits also included the financial statement schedules listed in the Index at Item 14(a)(2). These financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
(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.
(I) SOFTWARE REVENUE RECOGNITION SIS recognizes revenue from license fees when the product is delivered and service revenue when services are performed. Costs of developing and testing new or enhanced software products are capitalized and are amortized on a product-by-product basis utilizing the straight-line method over a period not to exceed three years. Unamortized software development costs of $1,055,000 and $1,190,000 are included in accrued investment income and other assets at December 31, 1996 and 1995, respectively. Software amortization, included in other expenses, was $394,000 and zero in 1996 and 1995, respectively.
(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.
(L) NET EARNINGS PER COMMON SHARE Net earnings per common share is computed on the basis of the weighted average number of common shares outstanding during each period. The dilutive effect of stock options is not material to the computation of net earnings per common share.
In December 1995, the Company reclassified from the held to maturity category to available for sale fixed maturities with an amortized cost of $84,573,000. On the date of reclassification there was a related unrealized holding gain of $4,081,000 included in stockholders' equity. This reclassification was recorded in accordance with the FASB Special Report, "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities."
Cash and cash equivalents: The carrying amounts reported in the balance sheet for these instruments approximate their fair value.
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 liability for losses and loss expenses decreased by $21,028,000 in 1996, $12,536,000 in 1995 and $7,748,000 in 1994, 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.
(5) REINSURANCE In the ordinary course of business, State Auto P&C assumes and cedes reinsurance with other insurers and reinsurers and is a member in various pools and associations. The voluntary arrangements provide greater diversification of business and limit the maximum net loss potential arising from large risks and catastrophes. Most of the ceded reinsurance is effected under reinsurance contracts known as treaties; some is by negotiation on individual risks. Although the ceding of reinsurance does not discharge the original insurer from its primary liability to its policyholder, the insurance company that assumes the coverage assumes the related liability. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. The recoverability of these assets depends on the reinsurers' ability to perform under the reinsurance agreements. The Company evaluates and monitors the financial condition and concentrations of credit risk associated with its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. Since January 1, 1987, State Auto P&C has participated in a reinsurance pooling arrangement with Mutual. The arrangement provides that all premiums, losses, loss expenses, underwriting expenses, premiums in course of collection and reinsurance recoverable on loss payments (all transactions and balances in the underwriting accounts) of the companies be pooled and then allocated to each company based on percentages outlined in the agreement. During 1994, State Auto P&C assumed 30% of the pool with 70% retained by Mutual. Effective January 1, 1995, the arrangement was amended to include all of the property and casualty business of Milbank. Concurrently, with the inclusion of Milbank, the pooling participation percentages were amended to allocate 35% to State Auto P&C, 55% to Mutual and 10% to Milbank. In connec-
tion with the January 1, 1995 change in pooling percentages, State Auto P&C received approximately $46 million to cover its increased share of pool liabilities. Pursuant to the pooling arrangement, Mutual is responsible for the collection of premiums and payment of losses, loss expenses and underwriting expenses of the pooled companies. Unpaid balances are reflected in due to or due from affiliates in the accompanying consolidated balance sheets. Settlements of the intercompany account are made quarterly. No interest is paid on this account. All premium balances receivable and reinsurance recoverable on paid losses from unaffiliated reinsurers are carried by Mutual. Effective July 1, 1996, the State Auto Insurance Companies (State Auto P&C, Mutual, Milbank and National) negotiated a change in their catastrophe reinsurance program. State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank and National pursuant to a catastrophe reinsurance agreement in the amount of $100.0 million excess of $120.0 million. To protect against a catastrophe loss event in which the State Auto Insurance Companies would incur catastrophe losses in excess of $120.0 million, the Company entered into a structured contingent financing transaction with Chase Manhattan Bank (Chase) to provide up to $100.0 million of additional reinsurance protection. Under this arrangement, in the event of such a loss, the Company would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which will borrow the money necessary for such purchase from Chase and a syndicate of other lenders. The Company will contribute to State Auto P&C the proceeds from the sale of its preferred shares. State Auto P&C will use the contributed capital to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. The Company is obligated to repay SPC by redeeming the preferred shares over a six year period. This layer of $100.0 million in excess of $120.0 million has been excluded from the pooling arrangement pursuant to the terms of the Amended and Restated Reinsurance Pooling Agreement, also effective July 1996. In addition, the Company's obligation to repay SPC has been secured by a Put Agreement among the Company, Mutual and the Lenders, under which, in the event of a default by the Company, as described in the Credit Agreement or in the Put Agreement, Mutual would be obligated to put either the preferred shares or the loan(s) outstanding. The Company has reported ceded losses and loss expenses payable and prepaid reinsurance premiums as assets. The amounts reported represent State Auto P&C's pooling percentage of the total amounts ceded to unaffiliated reinsurers and National's ceded amounts. All contracts providing indemnification against loss or liability relating to insurance risk have been accounted for as reinsurance. Contracts for which it is not clear that the treaty results in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed have been accounted for as deposits.
National has a reinsurance agreement with Mutual to cede 20% of its premiums written and losses and loss expenses incurred to Mutual for liability lines. The agreement also has a provision for excess of loss coverage, whereby Mutual will reinsure National for all losses over a prescribed limit for each individual occurrence. Through Mutual's participation, the effects of the reinsurance agreement are indirectly subject to the pooling agreement between Mutual and State Auto P&C.
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 1996, 1995 and 1994 were $5,883,000, $11,371,000 and $2,200,000, respectively.
Information regarding the funded status and net periodic pension cost for State Auto P&C, Stateco and SIS's participation in the plan is as follows:
(A) STOCK SPLIT On May 30, 1996, the Board of Directors approved a three-for-two common stock split to be effected in the form of a stock dividend, which has been given retroactive effect. Fractional shares were paid in cash.
(11) STOCK INCENTIVE PLANS The Company follows Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and related Interpretations in accounting for its stock incentive plans. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. 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:
A summary of the Company's stock option activity and related information for these plans for the years ended December 31, 1996, 1995 and 1994, follows:
The Company has an employee stock purchase plan with a dividend reinvestment feature, under which employees of Mutual, State Auto P&C, Stateco and SIS 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 1,200,000 shares of common stock under this plan. At December 31, 1996, 568,652 shares have been purchased under this plan. Compensation expense is recognized for the fair value of the employee's purchase rights, which was estimated using the Black-Scholes model with the following weighted-average assumptions for 1996 and 1995, respectively: dividend yield of 1.0% for both years; expected volatility of .24 for both years; risk-free interest rates of 6.5% and 6.4%; and expected lives of 6 months for both years. The weighted-average fair value of those purchase rights granted in 1996 and 1995 was $3.52 and $2.92, respectively.