MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - ------- -----------------------------------------------------------------------
State Auto Financial Corporation (State Auto Financial), through its principal insurance subsidiaries, State Auto Property and Casualty Insurance Company (State Auto P&C) and Milbank Insurance Company (Milbank), 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. Another insurance subsidiary of State Auto Financial, State Auto National Insurance Company (National), writes personal automobile insurance for risks in the nonstandard insurance market. State Auto P&C, Milbank and National's products are marketed through independent agents.
State Auto P&C provides executive management services to oversee the insurance operations of all the State Auto Insurance Companies, which include: Milbank, National and State Automobile Mutual Insurance Company (Mutual) - a majority shareholder of State Auto Financial - and Mutual's wholly owned subsidiary, 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).
Strategic Insurance Software, Inc. (S.I.S.), 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. S.I.S. sells services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies.
518 Property Management and Leasing, LLC (518 PML), an Ohio limited liability company, was formed in December 1997 to engage in the business of owning and leasing real and personal property to affiliated companies. On January 1, 1998, State Auto P&C and Stateco became the initial members of 518 PML with State Auto P&C contributing real property and Stateco contributing $7.0 million in cash and real property.
State Auto Financial, State Auto P&C, Milbank, National, Stateco, S.I.S. and 518 PML are referred to collectively herein as the Company.
In August 1998, State Auto Financial purchased $9.0 million of surplus notes from Farmers Casualty Company Mutual (Farmers Casualty), an Iowa domiciled property casualty insurer for the
In discussing Results of Operations, State Auto P&C, National, Mutual, Milbank and Midwest Security are referred to collectively as the State Auto Insurance Companies, while State Auto P&C, Mutual, Milbank and Midwest Security are referred to as the Pooled Companies.
Net income for the Company decreased 8.5% in 1998 (increased 55.3% in 1997). The Company's statutory combined ratios for 1998, 1997 and 1996, respectively, were 97.8%, 94.1% and 100.0%. Impacting the Company's results for 1998 and 1996 was an increase in the level of catastrophe losses for these periods; 1996 being the worst catastrophe year in the Company's history and 1998 being the second worst.
State Auto P&C and Milbank, which represents State Auto Financial's standard insurance segment, achieved a 10.7% increase in earned premiums in both personal and commercial lines in 1998 (2.7% in 1997). Of the 10.7% increase, 7.6% was due to the change in the pooling arrangement and 3.1% (2.7% in 1997) was due to external growth.
The commercial lines direct written premium of the Pooled Companies increased in 1998 approximately 3.3% (8.3% in 1997). The rate of growth on the Company's commercial lines has slowed in recent years due primarily to a reduction in premiums in the Company's workers' compensation line of business which is due to rate reductions resulting from decreases in loss costs as promulgated by various rating bureaus. This phenomena, that began in late 1996, continued into 1998. The workers' compensation line of business represents approximately 10% of the Pooled Companies' commercial business at the end of 1998.
Other income includes primarily revenue from S.I.S.' sales of its software products, and beginning in 1998 rental income on property leased by 518 PML. In 1998, other income increased 76% (17% in 1997). 518 PML's commencement of leasing operations in 1998 increased other income 19% while S.I.S.' increase in software sales over 1997 contributed a 47% increase. In 1997, other income was comprised mainly of S.I.S. software sales which increased 17% from same period in 1996.
Losses and loss expenses, as a percentage of earned premiums, were 68.0%, 65.1% and 72.3% for years 1998, 1997 and 1996, respectively. As previously discussed, the Company experienced increased levels in storm-related catastrophe losses in 1998 and 1996, primarily in the standard insurance segment. The second quarter 1998 was impacted by storm-related catastrophe losses occurring in nearly all operating states and the third quarter was adversely affected by several Midwestern wind and hail storms. The impact of the 1998 catastrophe losses amounted to 8.1 GAAP loss ratio points whereas catastrophe losses totaled 2.4 GAAP loss ratio points. Despite the higher level of catastrophe losses as compared to 1997, the Company did not experience any significant loss activity from hurricanes Bonnie, Earl and Georges. In 1996 the Company was impacted by severe winter weather and storm losses in Raleigh, North Carolina resulting from Hurricane Fran moving inland. The impact of the 1996 catastrophe claims amounted to 9.3 GAAP loss ratio points. The relatively low level of hurricane losses within the last three years validates the Company's strategy of closely monitoring concentration of risks subject to coastal losses. Absent the increased level of catastrophes, the Company's underlying book remained strong and in fact, reflects improvement from prior years, validating the Company's philosophy of responsible underwriting versus emphasis on premium growth achieved with irresponsible pricing or risk selection.
In an effort to reduce its exposures to any one type of catastrophic loss, the Company, in recent years, has sought to geographically diversify into regions of the country not exposed to earthquakes and hurricanes. As previously discussed, this has been accomplished through the acquisitions of Milbank, Midwest Security, Farmers Casualty and Mid-Plains. While some states are not subject to the threats of hurricanes or earthquakes, virtually all have some windstorm and or hail exposure. Along with the increasing geographic dispersion of the Company's underwriting risk portfolio, the Company continues to refine its methods of monitoring its exposures to all types of catastrophe hazards.
The increase in the 1997 expense ratio from that in 1996 is due to the amortization of software expenses, the Bonus and the amount of bonus compensation earned by the Company's agents. Beginning with the first quarter of 1997, the State Auto Insurance Companies began amortizing costs associated with the development of its claims and billing processing system that began a little over two years ago. The amortization period of these costs will be approximately three years. The Bonus in 1997 exceeded that which was earned in 1996 due to an improvement in the underwriting operations of the Company in 1997. Also contributing to this increase was an increase over 1996 of the amount of bonus compensation earned by the Company's agents. Each agent who meets certain premium production thresholds shares in the underwriting profits generated by insurance placed by them.
Other expense includes those operating expenses associated with general corporate expenses, S.I.S., 518 PML and Stateco's investment management services (the investment management services segment). In 1998 other expense increased 58.2% (12.1% decrease in 1997). S.I.S.' operating expenses increased over 1997 contributing an increase of 20% to other expense. Also contributing to this increase was an increase in write-offs of premium receivable during 1998, primarily in the nonstandard insurance segment. This segment has sought to improve its premium receivable collections by retaining the services of a third party whose business is receivables collection. Additionally, there was a general increase in corporate expenses over 1997. The decrease in other expenses in 1997 is primarily due to the State Auto Insurance Companies changing the catastrophe portion of its reinsurance program beginning July 1, 1996, that prior to this period was accounted for as deposit reinsurance (See Liquidity and Capital Resources). Expenses associated with the catastrophe portion of the program accounted for as deposit reinsurance were included in other expense.
The effective Federal tax rate was 24%, 27% and 24% for the years ended 1998, 1997 and 1996, respectively. The lower rates in 1998 and 1996 were due to a decrease in the underwriting profit compared to the 1997 period as a result of the increased storm related catastrophes experienced by the Company during these periods as well as a shift in the composition of its investment portfolio from taxables to tax-exempts, as previously noted. The increased rate in 1997 was due to an increase in underwriting profit recorded for the year and higher realized capital gains.
Liquidity refers to the ability of a company to generate adequate amounts of cash to meet its needs for both long and short-term cash obligations as they come due. The Company's significant sources of cash are premiums, investment income and investments as they mature. The Company continually monitors its investment and reinsurance programs to ensure they are appropriately structured to enable the insurance subsidiaries to meet anticipated and unanticipated short and long-term cash requirements without the need to sell investments to meet fluctuations in claim payments.
Net cash provided by financing activities consists of proceeds from issuance of common stock that has exceeded the payment of dividends for the last three years. Mutual, whose ownership in State Auto Financial has increased from 65% to almost 70% in 1998, 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. Additionally, waivers of dividends by Mutual enhance the Company's financial position which benefits Mutual, the Company's largest shareholder, and other shareholders as well. Each dividend waiver is reviewed by Mutual's Board of Directors.
Effective July 1, 1996, the State Auto Insurance Companies negotiated a change in their catastrophe reinsurance program. The amount retained by the State Auto Insurance Companies is $40.0 million for each occurrence, an increase of $20.0 million over the prior program. For up to $80.0 million in losses, excess of $40.0 million, traditional reinsurance coverage is provided. 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 Chase Manhattan Bank (Chase) to provide up to $100.0 million for reinsurance purposes. Under this arrangement, in the event of such a loss, State Auto Financial 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. 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,
National and beginning July 1, 1998, Midwest Security, pursuant to a catastrophe reinsurance agreement in the amount of $100.0 million excess of $120.0 million (Farmers Casualty and Mid-Plains will be added to the catastrophe reinsurance program in 1999). 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.
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.
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 19, 1999, State Auto Financial has not exercised its right to acquire Midwest Security.
On March 5, 1999, the Board of Directors of State Auto Financial declared a quarterly cash dividend of $0.025 per common share, payable on March 31, 1999, to shareholders of record on March 17, 1999. This is the 31st consecutive cash dividend declared by the Company's Board since State Auto Financial had its initial public offering of common stock on June 28, 1991. Additionally, State Auto Financial has increased cash dividends to shareholders for seven consecutive years. During 1998, the Company's authorized common shares increased to 100 million and the Board declared a two-for-one stock split to be distributed July 8, 1998, to shareholders of record on June 18, 1998. The impact of this stock split has been appropriately reflected in the accompanying consolidated financial statements.
The maximum amount of dividends that may be paid to State Auto Financial during 1999 by its insurance subsidiaries, including Farmers Casualty, as a non-extraordinary dividend is limited to $21.9 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) 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, 1998, each of the State Auto Insurance Companies exceeded all standards tested by the formula.
As of December 31, 1998, the Company had fixed maturities with a fair value of $481.8 million designated as available for sale compared to $421.0 million at December 31, 1997. During 1998, the Company continued its program to increase its equity portfolio to enhance growth of statutory surplus over the long term. At December 31, 1998 and 1997, respectively, the equity portfolio totaled $42.2 million and $26.1 million.
Investable assets comprise approximately 86% of the Company's total assets. Of the total investments, 88% are invested in fixed maturities, 6.9% in equity securities and the remaining in cash and cash equivalents.
The fixed maturity portfolio is managed in a ladder-maturity style to ensure adequate cash flow to meet claims as they are presented. At December 31, 1998, the Company's fixed maturity portfolio had an average maturity of 11.1 years. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 2.0% of statutory assets, other than obligations of the U.S. government or government agencies, for which there is no limit. The fixed maturity portfolio is very high in quality with all holdings either in Government obligations, municipal, corporate obligations rated AA or better by the major bond rating agencies. The Company does not intend to change its investment policy on the quality of its fixed maturity investments. Investments in equity securities are selected based on their potential for appreciation as well as ability to continue paying dividends. Additional information regarding the composition of investments, along with maturity schedules regarding investments in fixed maturities, is included in note (2) of the Consolidated Financial Statements.
Description of the Year 2000 Issues Affecting the Company - ----------------------------------------------------------
At this time, one hundred percent (100%) of the Company's in-force insurance policies are being processed on a Y2K compliant system, based on the test results mentioned above. However, in an effort to ensure that no material problems arise from the policy processing systems used by the Company and its affiliates or subsidiaries (all of which are sometimes collectively referred to hereafter as "State Auto") the Company plans to continue simulated Year 2000 testing throughout 1999.
There are certain other vendors which have a material relationship with the company by virtue of the fact that they provide a product or service that State Auto uses in the ordinary course of its business, such as underwriting information providers, task specific software or hardware product vendors, and financial institutions. Y2K compliance by third party vendors will continue to be one of State Auto's focal points throughout the remainder of 1999. State Auto expects to have third party vendor products then in use Y2K compliant by the end of the 3rd quarter of 1999.
State Auto Financial's Costs to Address Year 2000 Issues - --------------------------------------------------------
State Auto does not expect a material adverse impact from Y2K issues arising from embedded chip processing failures occurring on site. Those embedded chip issues which the Company has some opportunity to control or address that have been identified to date have been generally facilities related or involving small business equipment (i.e. fax machines). Upgrades and equipment replacement are being coordinated by a variety of business managers responsible for such equipment.
State Auto continues to work with its business recovery service provider. State Auto is following a program developed by that provider that requires a comprehensive Y2K preparation approach. Conforming to this allows State Auto to take advantage of its provider's facilities for business recovery in the event that an external Y2K issue that was addressed does happen to fail.
Statements contained herein expressing the beliefs of management and the other statements which are not historical facts contained in this report are forward looking statements that involve risks and uncertainties. Such statements include, without limitation, those pertaining to the weather related catastrophes impacting the Company's losses, product offerings, National's premium receivable collections effort, the Year 2000 discussion, the statements relating to the new insurer to be created, State Auto Insurance Company, the legislative and regulatory environment and sales forecasts. These risks and uncertainties include, but are not limited to, legislative changes, judicial and regulatory decisions, the impact of competitive products and pricing, product development, geographic spread of risk, weather and weather-related events, other types of catastrophic events, 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, shortages of programmers, and regulatory or governmental systems breakdowns.
The Company, through State Auto P&C, a South Carolina corporation and Milbank, a South Dakota Corporation, provide 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, an Ohio corporation, provides nonstandard automobile insurance. State Auto P&C, Milbank and National 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 and National are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota and Ohio, respectively, and are licensed in various other states. As such, they are subject to the regulations of the applicable Departments of Insurance of the states of South Carolina, South Dakota and Ohio (collectively, the Departments) and the regulations of each state in which they operate. State Auto P&C, Milbank and National undergo periodic financial examination by the Departments and insurance regulatory agencies of the states that choose to participate. Through State Auto P&C, the Company also provides executive management services to its affiliated insurance companies.
Through Stateco, the Company provides investment management services to affiliated companies and also provides insurance premium finance services to customers of State Auto P&C, Mutual and Milbank.
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, Milbank and National that are prescribed or permitted by the Departments.
Investments in fixed maturities, where the Companies have the ability and intent to hold to maturity, are carried at amortized cost. Accordingly, 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 net 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.
S.I.S. 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 $1,567,000 and $1,285,000 are included in accrued investment income and other assets at December 31, 1998 and 1997, respectively. Software amortization, included in other expenses, was $673,000, $489,000 and $394,000 in 1998, 1997 and 1996, respectively.
The Companies file a consolidated federal income tax return and pursuant to an agreement, each entity within the consolidated group pays its share of federal income taxes based on separate return calculations. Milbank will file a consolidated federal income tax return with the Company for periods subsequent to July 1, 1998. Prior to this time, Milbank was included in the consolidated federal income tax return of Mutual and its subsidiaries.
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.
In 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings per Share." SFAS No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to SFAS No. 128 presentation. For additional disclosure, see note 12.
As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income" (SFAS No. 130), which establishes new rules for the reporting and display of comprehensive income and its components. 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, and excludes any impact of changes in minority interest of subsidiaries. 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.
SFAS No. 130 also requires separate presentation of the accumulated balance of other comprehensive income within the equity section of the statement of financial position. The Company has presented the required displays of total comprehensive income and its components, within the "Consolidated Statements of Stockholders' Equity." The adoption of SFAS No. 130 had no impact on the Company's net income or shareholders' equity. Prior year financial statements have been reclassified to conform to the requirements of SFAS No. 130. See additional disclosures at note 13.
The amortized cost and fair value of fixed maturities segregated by held to maturity and available for sale, at December 31, 1998, by contractual maturity, are summarized as follows:
Fixed maturities with carrying values of approximately $17,666,000 and $16,360,000 were on deposit as required by law or specific escrow agreement at December 31, 1998 and 1997, respectively.
(4) Losses and Loss Expenses Payable Activity in the liability for losses and loss expenses is summarized as follows:
The liability for losses and loss expenses decreased by $13,591,000 in 1998, $17,432,000 in 1997 and $26,852,000 in 1996, 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.
In the ordinary course of business, State Auto P&C and Milbank assume and cede reinsurance with other insurers and reinsurers and are members 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.
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. In 1998, Midwest Security became party to the catastrophe reinsurance program. State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank, Midwest Security 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 Pooling Agreement.
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 and Milbank'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 reinsurance may realize a significant loss from the insurance risk assumed have been accounted for as deposits.
The following table summarizes State Auto P&C's and Milbank's direct business, amounts contributed to the pool and their participation in the pool:
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, State Auto P&C and Milbank.
The effects of the agreement on the indicated income and expense accounts are summarized as follows:
Stateco provides Mutual and its affiliates investment management services. Fees related to these services amounted to $3,037,000 in 1998, $2,804,000 in 1997 and $2,588,000 in 1996.
S.I.S. provides insurance software products and services to Mutual and its affiliates. Fees relating to these services amounted to $1,048,000 in 1998, $889,000 in 1997 and $859,000 in 1996 and is included in other income.
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, 1998, there has been no adverse development of the liability.
State Auto P&C, Stateco and S.I.S., pursuant to an intercompany agreement, are participants, together with Mutual, in a defined benefit pension plan that covers substantially all employees of Mutual, State Auto P&C, Milbank, Stateco and S.I.S. The assets of the plan are represented primarily by U.S. government and agency obligations, bonds, and common stocks. Mutual, State Auto P&C, Stateco and S.I.S.'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.
Information regarding the funded status and net periodic pension cost for State Auto P&C, Milbank, Stateco and S.I.S.'s participation in the plan is as follows:
Reconciliations of statutory capital and surplus and net income, as determined using statutory accounting practices, to the amounts included in the accompanying consolidated financial statements are as follows:
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 1998, 1997 and 1996, respectively: dividend yield of .75%, 1.0% and 1.0%; expected volatility factors of .26, .24 and .23; risk-free interest rates of 5.5%, 6.7% and 6.6%; and expected life of the option of 8.5, 8.0 and 8.0 years.
A summary of the Company's stock option activity and related information for these plans for the years ended December 31, 1998, 1997 and 1996, follows:
The related federal income tax effects of each component of other comprehensive income are as follows:
The Company has three reportable segments: standard insurance, nonstandard insurance and investment 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.
State Auto P&C, Milbank 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.