Because the operations of the Company and Mutual are integrated with one another pursuant to the terms of the 2000 Management Agreement, the Company and Mutual share their operating facilities. See Item 1, "Management Agreement" in the "Narrative Description of Business." 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, 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. Mutual also now owns an office building in Indianapolis, Indiana which was the corporate headquarters of the former Meridian Mutual and its affiliates. This now serves as the location of the State Auto Indianapolis Regional Office.
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 central 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 is a majority-owned subsidiary of State Automobile Mutual Insurance Company ("Mutual"), an Ohio domiciled property and casualty insurer. State Auto Financial and its subsidiaries are referred to collectively herein as the "Company."
Through State Auto P&C, the Company provides management and operations services under the Midwest Management Agreement (as defined below), the Farmers Casualty Management Agreement (as defined below) and the Mutual Management Agreement (as defined below) each effective as of January 1, 2000 (collectively the "2000 Management Agreement"), for insurance and noninsurance affiliates. As of January 1, 2000, all individuals providing services to any of the State Auto Companies who were not already employees of State Auto P&C became employees of State Auto P&C. Under the 2000 Management Agreement, State Auto P&C through its employees, is responsible for performing all organizational, operational, and management functions for each of the managed companies. For its performance of these services, State Auto P&C was paid quarterly a management and operations services fee based on formulas outlined in the 2000 Management Agreement. This fee from a managed company would be withheld if a managed company's performance did not meet performance criteria set forth in the 2000 Management Agreement. In early 2001, the Ohio Department of Insurance (the "ODI") requested that Mutual file an analysis with the ODI on a quarterly basis, starting with the quarter beginning January 1, 2001, that justified the apportionment of the service fee paid by Mutual to State Auto P&C under the Mutual Management Agreement under accounting guidance outlined in Statement of Statutory Accounting Principles No. 70 - Allocation of Expenses ("SSAP No. 70"). The Company believed its accounting for such service fee was consistent with all statutory accounting principals. On October 24, 2001, the board of directors of the Company and Mutual and special independent committees thereof approved a resolution of the disagreement between the Company and the ODI regarding the service fee paid by Mutual to State Auto P&C. The disagreement with ODI was resolved and ODI expressly did not take issue with Mutual's payment of the service fee for the first three quarters of 2001, which amounted to $12.5 million, pre-tax, nor with Mutual's accounting for the service fee in each of those quarters. The ODI also approved regulatory filings, effective October 1, 2001, implementing a revised Mutual Management Agreement, changing the Pooled Subsidiaries (defined below) pooling participation percentages and implementing a stop loss reinsurance arrangement.
will be included in the other category for segment reporting as the results of this segment will no longer meet the quantitative thresholds for separate presentation as a reportable segment. See "Reportable Segments" included herein and footnote 14 regarding the Company's operating segments included in the consolidated financial statements of the Company.
Through Strategic Insurance Software, Inc. (S.I.S.), a wholly-owned subsidiary, the Company develops and sells software for the processing of insurance transactions, database management systems for insurance agents and electronic interfacing of information between insurance companies and agents. S.I.S. sells its 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, is engaged in the business of owning and leasing real and personal property to affiliated companies. The members of 518 PML are State Auto P&C and Stateco.
In October of 2000, Mutual entered into an agreement with Meridian Mutual Insurance Company ("Meridian Mutual"), an Indiana domiciled property and casualty insurance company, pursuant to which Meridian Mutual would be merged with and into Mutual, with Mutual continuing as the surviving corporation. The effective date of the merger transaction was June 1, 2001. With the merging of Meridian Mutual into Mutual, all insurance business that had been written by Meridian Mutual became, legally, Mutual business. For the period June 1, 2001 through June 30, 2001, the insurance business formerly known as the Meridian Mutual business prior to the June 1 merger transaction was excluded from the Pooling Arrangement. Effective July 1, 2001, the insurance business of the former Meridian Mutual became part of the Pooling Arrangement and the Pooled Subsidiaries assumed 53% of the Meridian Mutual business on this same date. Concurrent with this transaction, the Pooled Subsidiaries received cash of $6.4 million and fixed maturities totaling $109.7 million from Mutual, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on July 1, 2001.
In discussing Results of Operations for 2001 and 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. The Pooled Subsidiaries, Mutual and Midwest are collectively referred to below as the "Pooled Companies."
The Company's significant accounting policies are more fully described in note 1 to the Company's consolidated 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 financial entries in 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 therein.
Losses and loss expenses payable are management's best estimates at a given point in time of what the Company expects to pay to claimants, based on facts, circumstances and historical trends then known. It can be expected that the ultimate liability will exceed or be less than such estimates. During the loss settlement period, additional facts regarding individual claims may become known, and consequently it often becomes necessary to refine and adjust the estimate of liability. Reserves for reported losses are established on either a case-by-case or formula basis depending on the type and circumstances of the loss. The case-by-case reserve amounts are determined based on the Company's reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. The formula reserves are based on historical paid loss data for similar claims with provision for trend changes caused by inflation. Loss and loss expense reserves for incurred claims that have not yet been reported are estimated based on many variables including historical and statistical information, inflation, legal developments, storm loss estimates, and economic conditions. Case and formula basis loss reserves are reviewed on a regular basis and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Although management uses many resources to calculate reserves, there is no precise method for determining the ultimate liability.
costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned. These amounts are based on estimates and accordingly, the actual realizable value may vary from the estimated realizable value.
Net investment income increased $8.5 million (21.7%) in 2001. Contributing to the increase over the previous year was an increase in investable assets due to the transfer of cash and fixed maturity securities from Mutual totaling $354.6 million to the Pooled Subsidiaries in conjunction with the Pooled Subsidiaries assuming 53% of the former Meridian Mutual business on July 1, 2001 and the change in the Pooled Subsidiaries pooling participation percentages, effective October 1, 2001, from 53% to 80%. Total cost of investable assets at December 31, 2001 and 2000, was $1,150.3 million and $741.1 million, respectively.
The investment yields, based on fixed and equity securities at cost, were 5.4% and 5.5% for the annual periods ending 2001 and 2000, respectively. During 2001, the Company experienced an increase in the number of calls over prior years on higher yielding fixed maturities. Monies from these calls were reinvested at lower rates. See further discussion regarding investments at the "Liquidity and Capital Resources", "Investments" and "Market Risk" sections, included herein.
Management services income, including investment management fees, decreased $2.0 million to $15.6 million for the year ended December 31, 2001. This decrease is attributable to the resolution of the disagreement between the Company and ODI regarding the recognition of the service fee paid by Mutual to State Auto P&C. The service fee under the 2000 Mutual Management Agreement paid by Mutual in 2001 was $12.5 million down from $14.5 million in 2000. See "Overview" included herein, for discussion of the resolution regarding the management and operations service fee. See "Liquidity and Capital Resources" included herein, for discussion of the overall impact of the loss of the management and operations service fee on the Company's cash flow and operations.
The Company's State Auto standard segment reflected an improvement in its loss ratio in 2001 to 66.3 from 67.6 in 2000. This segment's largest line of business, automobile, reflected a 1.6 point improvement in its loss ratio in 2001 from 2000. This segment's next largest line of business, homeowners, has experienced some deterioration in its loss ratio over the last several years. Management has been monitoring this line of business and has taken some corrective action through rate increases and improved underwriting techniques such as credit scoring. The Company's State Auto nonstandard segment experienced an improvement in its loss ratio in 2001 to 77.9 from 81.4 in 2000. In 2000, this segment began experiencing some volatility in loss activity in those states where National began operations in 1999. Consequently, management began monitoring the premium rate adequacy in these new states and reacted accordingly throughout 2000 and 2001 by increasing rates in these new states. Additionally, this segment has implemented a number of underwriting tools, including "point-of-sale" underwriting as well as the use of credit scoring. Management believes these two tools have contributed to this segment's profit improvement.
The Meridian nonstandard segment produced significant underwriting losses generating a loss ratio for the six months ended December 31, 2001 of 168.2%. An integration plan is currently in place to write all new nonstandard auto business produced by former Meridian agents through National on the National system platform. The National system provides several enhancements that management anticipates will improve the nonstandard loss ratio for new risks written. Most notably, the National system uses credit scoring and "point-of-sale" underwriting tools. The order of integration has been prioritized such that the states with the most need for profit improvement are migrating to National first. New business for six of the 12 states that the Meridian nonstandard segment operates in is currently being written through National, with the remaining six states to follow throughout 2002.
Acquisition and operating expenses, as a percentage of earned premiums (the "expense ratio"), were 30.1% and 30.0% for the years 2001 and 2000, respectively. Impacting the current year expenses was approximately $1.3 million (0.2%) related to the Company's estimate of its future guaranty fund assessments related to the Reliance Insurance Company insolvency that was announced during the fourth quarter of 2001.
Other expense, as a percentage of earned premiums, were 1.6% and 1.7% for the year 2001 and 2000, respectively. Other expense for 2000 included $530,000 in interest relating to the return of premiums to the policyholders in the state of North Carolina as discussed under "2000 Compared to 1999" in "Results of Operations" included herein. Absent this interest charge in 2000, other expense, as a percentage of earned premiums, was comparable between the two time periods.
During 2001, the Company experienced an underwriting loss on its insurance operations, largely due to the loss results of the former Meridian Mutual business assumed by the Pooled Subsidiaries. This underwriting loss, coupled with net investment income being largely comprised of tax-exempt income, produced an effective tax rate in 2001 of (15%) versus 22% in 2000. For additional clarification, see the reconciliation between actual federal income taxes and the amount computed at the statutory rate as detailed in footnote 7 in the notes to the Company's consolidated financial statements.
Consolidated earned premiums increased 1.5% in 2000. This increase was principally the result of the change in the Pooled Subsidiaries' aggregate pooled participation percentage from 50% to 53% (referred to above). This action increased consolidated earned premiums 5.5%. The standard insurance segment's internal growth, as written by the Pooled Companies, excluding the impact of the change in the Pooling Arrangement, decreased consolidated earned premiums by 2.8%. The Company's nonstandard insurance segment's internal growth also decreased consolidated earned premiums by approximately 0.9%. Also negatively impacting the Company's consolidated earned premiums by approximately 0.3% was a return of premiums to the policyholders in the state of North Carolina as a result of a rate reduction dating back to 1994 that was mandated by the North Carolina Insurance Department. In 1994 and 1996, the North Carolina Rate Bureau ("NCRB") filed an auto rate increase, which was challenged by the North Carolina Insurance Department. The parties agreed to a settlement of the dispute in late March 2000, which resulted in a rate reduction for the 1994 rate filing and the 1996 rate filing being approved as originally filed by the NCRB. Consequently, the Company was required to return approximately $1.1 million in disputed premiums, plus $530,000 in interest. The interest portion of the returned premium has been reflected in the miscellaneous expense line item.
During the latter half of 2000, the Company saw commercial lines sales activity increase over 1999 levels. The Pooled Companies experienced 6.0% growth in its commercial lines direct written premiums over 1999. The Company's personal lines of business within its standard segment continued to feel the effects of extreme price competition even though, during the first half of 2000, there was some evidence that an increasing number of companies were reacting to continuing underwriting losses by increasing rates. The Company's rate of decline in internal growth in these lines has diminished in the last half of 2000, but internal growth remained negative. The Company believes that its underwriting and pricing discipline was a key factor in the Company's underwriting results for the year, particularly as compared to other property casualty insurers. The Company believes that its strategy of taking modest price increases on a regularly scheduled basis and continuing its diligence in risk selection has positioned it to take advantage of this change in the market that the Company perceives is occurring. The Company is active in the personal and commercial lines markets, developing new products to enhance its product portfolio; appointing new agents in its operating territories; and refining its pricing levels for the markets and lines it believes offer the most profit potential.
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".
Losses and loss expenses, as a percentage of earned premiums (the "loss ratio"), were 68.4% and 67.5% for the years 2000 and 1999, respectively. The increase in the current year loss ratio was largely the result of the Company experiencing a relatively small number of large unusual commercial claims in its standard insurance segment. Management noted that these large commercial losses did not impact any one line of business or geographic region and does not believe the nature of these claims indicates deterioration in core underwriting operations. See discussion above regarding management's response to its perception of the current underwriting environment. Additionally, the Company's nonstandard segment experienced an increase in its losses over 1999 levels particularly in those states where National began operations in 1999. The nonstandard segment is particularly volatile for new states due to the relatively small level of premium earned in the initial years of operation. Management has been monitoring the premium rate adequacy in these new states and has reacted throughout 2000 accordingly by increasing rates in these new states.
Improvement in the Company's current year segment profit within the State Auto standard and nonstandard insurance segments is primarily due to an improvement in these segments' current year loss experience and management's response to premium rate inadequacy as discussed at "2001 Compared to 2000" in "Results of Operations." The fluctuation in segment profit for the State Auto standard insurance segment in 2000 compared to 1999 is due to a decline in its underwriting income resulting from an increase in the level of commercial losses, as discussed above. Prior to 1997, the State Auto nonstandard segment focused on improving its loss experience through implementation of a more restrictive underwriting posture and rate increases in several operating states. While this segment showed improvement as a result of these actions, 2000 experienced significant losses in several of its new states of operation. As discussed above, management continually monitors this segment's premium rate adequacy given the nature of the risks that are written through the nonstandard market. Meridian standard and nonstandard insurance segments' operational loss reflects the impact of State Auto management's integration plan, which included the Company's review of Meridian's case reserves during the second half of 2001 as described more fully above at "2001 Compared to 2000" in "Results of Operations". The increase in segment profit of the investment management segment in 2001 is the result of this segment providing its services to the MIGI Insurers beginning June 1, 2001. This segment's profits increased slightly in 2000 due to increasing market rates within the fixed maturity market. This segment's revenue is based on the average market value of the portfolio of the companies managed, which is largely comprised of fixed maturities. With the change in the interest rate environment throughout 2000, the average market value of the portfolio of the companies managed increased throughout 2000. Segment profits related to management and operations services decreased in 2001 as a result of the resolution of the disagreement between the Company and ODI regarding the service fee paid by Mutual to the Company in 2001. See discussion at "Overview" as well as "2001 Compared to 2000" in "Results of Operations". Segment profits related to management and operations services increased in 2000 from 1999 due to the change in the Management and Operations Agreement as discussed in Note 1(j) in the consolidated financial statements. For additional information on the Company's reportable segments, see footnote 14 on "Reportable Segments" in the Company's consolidated financial statements.
Impacting cash used in financing activities during 2001 and 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 December 31, 2001, State Auto Financial repurchased 50,522 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
State Auto P&C's December 31, 1990 liability for losses and loss expenses of $65.5 million 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 in conformance with pooling percentages in place at that time. As of December 31, 2001, there has been no adverse development of the liability.
The maximum amount of dividends that may be paid to State Auto Financial during 2002 by its insurance subsidiaries without prior approval under current law is limited to $25.1 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, 2001, each of the State Auto Insurance Companies exceeded all standards established by the formula.
As of December 31, 2001, the Company had fixed maturities with a fair value of $1,051.4 million designated as available for sale compared to $653.3 million at December 31, 2000. During 2001, the Company continued its program to increase its equity portfolio to enhance growth of statutory surplus over
the long term. At December 31, 2001 and 2000, respectively, the equity portfolio totaled $59.8 and $58.3 million, respectively.
In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill will no longer be amortized but will be subject to impairment tests in accordance with the statements. Other intangible assets will continue to be amortized over their useful lives. The Company will apply the new rules beginning in the first quarter of 2002. The Company has determined that the adoption of the statements will not have a material impact on the Company's financial position and results of operations.
- In addition to the acquisition of the Meridian Insurers and Mutual's merger with Meridian Mutual as discussed above, 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 more costly or difficult than anticipated; integrating the acquired business without material disruption to existing operations may prove to be more difficult than anticipated; anticipated cost savings may not be fully realized (or not realized within the anticipated time frame) or additional or unexpected costs may be incurred; loss results of the Company acquired may be worse than expected; and retaining key employees of the acquired business may prove to be more difficult than anticipated. In addition, other companies in the insurance industry have similar acquisition strategies. There can be no assurance that any future acquisitions will be successfully integrated into the Company's operations, that competition for acquisitions will not intensify or that the Company will be able to complete such acquisitions on acceptable terms and conditions. In addition, the costs of unsuccessful acquisition efforts may adversely affect the Company's financial performance.
- The laws of the various states establish insurance departments with broad regulatory powers relative to approving intercompany arrangements, such as management, pooling, and investment management agreements, granting and revoking licenses to transact business,
regulating trade practices, licensing agents, approving policy forms, setting reserve requirements, determining the form and content of required statutory financial statements, prescribing the types and amount of investments permitted and requiring minimum levels of statutory capital and surplus. In addition, although premium rate regulation varies among states and lines of insurance, such regulations generally require approval of the regulatory authority prior to any changes in rates. Furthermore, all of the states in which the State Auto Group transacts business have enacted laws which restrict these companies' underwriting discretion. Examples of these laws include restrictions on agency terminations and laws requiring companies to accept any applicant for automobile insurance and laws regulating underwriting "tools". These laws may adversely affect the ability of the insurers in the State Auto Group to earn a profit on their underwriting operations.
- The property and casualty insurance industry is highly competitive. While prices have generally increased in some lines, price competition continues to be intense. 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.
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2001 and 2000 and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2001. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conduct our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
- State Auto Property and Casualty Insurance Company (State Auto P&C), a South Carolina corporation
database management for insurance agents and electronic interfacing of information between insurance companies and agencies. 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 PML, an Ohio limited liability company, was formed to engage in the business of owning and leasing real and personal property to affiliated companies.
(e) INVESTMENTS 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. The Company regularly reviews its investments based on current economic conditions, credit loss experience and other factors. If there is a decline in an investment's fair value that is determined to be other than temporary, it is treated as a realized loss and the cost basis of the investment is reduced to its estimated fair value.
(g) LOSSES AND LOSS EXPENSES PAYABLE Losses and loss expenses payable are based on formula and case-basis estimates for reported claims, and on estimates, based on experience and perceived trends, for unreported claims and loss expenses. The liability for unpaid losses and loss expenses, net of estimated salvage and subrogation recoverable of $26,216,000 and $13,403,000 at December 31, 2001 and 2000, respectively, has been established to cover the estimated ultimate cost of insured losses. The amounts are necessarily based on estimates of future rates of inflation and other factors, and accordingly there can be no assurance that the ultimate liability will not vary from such estimates. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations (see note 4). Salvage and subrogation recoverables are estimated using historical experience. As such, losses and loss expenses payable represent management's best estimate of the ultimate liability related to reported and unreported claims.
(h) PREMIUM REVENUES Premiums are recognized as earned using the monthly pro rata method over the contract period.
(i) MANAGEMENT SERVICES INCOME Management services income includes income for management and operations services provided by State Auto P&C in 2001 and 2000 and executive insurance management services provided in 1999 and income for investment management services provided by Stateco. See note 6(d) regarding the Company's resolution of its disagreement with the Ohio Department of Insurance (ODI) regarding its recognition of management and operations service fee revenue paid by Mutual in 2001. Management and operations services income in 2001 and 2000, 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 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.
(j) SOFTWARE REVENUE RECOGNITION 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 $186,000 and $626,000 are included in accrued investment income and other assets at December 31, 2001 and 2000, respectively. Software amortization, included in other expenses, was $440,000, $622,000 and $614,000 in 2001, 2000 and 1999, respectively.
(k) FEDERAL INCOME TAXES The Company files 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.
(l) CASH EQUIVALENTS TheCompany considers all highly liquid debt instruments with a maturity of three months or less to be cash equivalents.
(m) 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 represents net unrealized gains and losses on available-for-sale fixed maturities and equity securities.
(n) NEW ACCOUNTING STANDARDS In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwilll and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill will no longer be amortized but will be subject to impairment tests in accordance with the statements. Other intangible assets will continue to be amortized over their useful lives. The Company will apply the new rules beginning in the first quarter of 2002. The Company has determined that the adoption of the statements will not have a material impact on the Company's financial position and results of operations.
YEAR ENDED DECEMBER 31 ------------------------------------- 2001 2000 1999 ---- ---- ---- (in thousands)
Fixed maturities..................... $41,262 36,568 32,096 Equity securities...................... 996 848 678 Cash and cash equivalents.............. 5,756 1,926 1,707 ----- ----- ----- Investment income.................... 48,014 39,342 34,481 ------ ------ ------
(3) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS: The carrying amounts reported in the balance sheets for these instruments approximate their fair value.
Activity in the liability for losses and loss expenses is summarized as follows:
(5) REINSURANCE In the ordinary course of business, the Company assumes and cedes reinsurance with other insurers and reinsurers and are members in various pools and associations. See Note 6(a) for discussion of reinsurance with affiliates. 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. The Company has reported ceded losses and loss expenses payable and prepaid reinsurance premiums with other insurers and reinsurers as assets. All reinsurance contracts provide indemnification against loss or liability relating to insurance risk and have been accounted for as reinsurance. Prior to the reinsurance transaction with Mutual under the Pooling Arrangement, as discussed in note 6(a), the effect of the Company's reinsurance on its balance sheets and income statements, is as follows:
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 2001) up to $100 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 five-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 either purchase the preferred shares from the SPC or repay the SPC for the loan(s) outstanding.
For the period October 1, 2001 through December 31, 2003, Mutual entered into a stop loss reinsurance arrangement (Stop Loss) with the Pooled Subsidiaries. Under the Stop Loss, Mutual has agreed to participate in the Pooling Arrangement's quarterly underwriting losses and gains in the manner described. If the Pooling Arrangement's statutory loss and loss adjustment expense ratio (loss ratio) is between 70.75% and 80% (after the application of all available reinsurance), Mutual will reinsure the Pooled Subsidiaries 27% of the Pooling Arrangement's losses in excess of a loss ratio of 70.75% up to 80.00%. The Pooled Subsidiaries would be responsible for their share of the Pooling Arrangement's losses over the 80% threshold. Also, Mutual will have the right to participate in the profits of the Pooling Arrangement. Mutual will assume 27% of the Pooling Arrangement's underwriting profits attributable to loss ratios less than 69.25%, but more than 59.99%. During 2001, the Pooled Subsidiaries ceded to Mutual, $6,177,000 under the Stop Loss, which has been reflected in reinsurance recoverable on losses and loss expenses payable at December 31, 2001, while no premium was assumed by Mutual under the Stop Loss.
(b) INTERCOMPANY BALANCES 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 Subsidiaries. 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 balance receivables and reinsurance recoverable on paid losses from unaffiliated reinsurers are carried by Mutual. The Company had off-balance-sheet credit risk of approximately $123 million and $60 million related to premium balances due to Mutual from agents and insureds at December 31, 2001 and 2000, 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 amount to $12,621,000 and $14,654,000 in 2001 and 2000, respectively. 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 in 1999. Stateco provides Mutual and its affiliate investment management services. Revenue related to these services amount to $2,965,000, $2,940,000 and $3,099,000 in 2001, 2000, and 1999, respectively.
During early 2001, the ODI requested that Mutual file an analysis with the ODI on a quarterly basis, starting with the quarter beginning January 1, 2001, that justified the apportionment of the management and operation services fee paid by Mutual to State Auto P&C under the accounting guidance outlined in Statement of Statutory Accounting Principles No. 70 - Allocation of Expenses. The Company believed its accounting for such service fee was consistent with all statutory accounting principles. On October 24, 2001, the board of directors of the Company and Mutual and special committees thereof approved a resolution of the disagreement between the Company and the ODI regarding the service fee paid by Mutual to State Auto P&C. The disagreement with ODI was resolved and ODI expressly did not take issue with Mutual's payment of the service fee to State Auto P&C for the nine-month period ending September 30, 2001 which amounted to $12.5 million, pre-tax, nor with Mutual's accounting for the service fee for this same time period. The ODI also approved regulatory filings, effective October 1, 2001, implementing a revised management agreement, changing the Pooled Subsidiaries pooling participation percentages and implementing a stop loss reinsurance arrangement. See note 6(a) regarding the change in the Pooled Subsidiaries pooling participation percentages and the implementation of a stop loss reinsurance arrangement.
Effective October 1, 2001, the management agreement between State Auto P&C and certain affiliate companies, including Mutual, was amended to eliminate the management and operations service fee charged by State Auto P&C. The management agreement continues to allocate costs and apportion those costs among the parties to the agreement in accordance with terms outlined therein. As a result of the loss of the management and operations services income under this management agreement, substantially all of State Auto P&C's services income has been eliminated, effective October 1, 2001. See note 14. The management agreement between State Auto P&C and Midwest Security was not affected by the disagreement or resolution with the ODI.
(7) FEDERAL INCOME TAXES A reconciliation between actual federal income taxes (benefit) and the amount computed at the indicated statutory rate is as follows:
(b) POSTRETIREMENT BENEFITS In addition to pension benefits, the Company provides certain health care and life insurance benefits for its eligible retired employees. Substantially all of the Company's employees may become eligible for these benefits if they retire between age 55 and 65 with 15 years or more of service or if they retire at age 65 or later with 5 years or more of service. Prior to 2000, State Auto P&C, Stateco and S.I.S., pursuant to an intercompany agreement, were participants, together with Mutual, in a postretirement medical and life insurance benefit plan. The postretirement benefit obligation was immaterial to the consolidated balance sheet prior to 2000. 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. Plan assets are primarily composed of mutual funds and government securities. Information regarding the funded status and net periodic benefit cost for the Company's participation in the postretirement benefit plan is as follows:
An 8.0% weighted average discount rate was used for 2001 and 2000 to determine the accumulated postretirement benefit obligation. An 8.5% weighted average rate was used for 2001 and 2000 to determine the long-term rate of return on plan assets. Effective January 1, 2000, the postretirement benefit liability is carried on the financial statements of the Company and the net periodic benefit cost is allocated to affiliated companies based on allocations pursuant to intercompany management agreements. The Company's share of the 2001 and 2000 net periodic cost was $3.0 million and $2.6 million, respectively. The assumed rate of future increases in per capita cost of health care benefits was 10% for the first year and grading down 1% per year to an ultimate rate of 5%. The health care cost trend rate assumption affects the amounts reported. For example, increasing the assumed health care cost trend rate by one percentage point would increase the accumulated postretirement benefit obligation by approximately $7,464,000 and would increase the medical service and interest cost by approximately $1,156,000. The Company also has a supplemental executive retirement plan for which the accrued obligation at December 31, 2001 and 2000 was $1,709,000 and $2,356,000, respectively.
(a) 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 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. See related footnote at note 6 (c). In May 2000, State Auto Financial's Board of Directors approved 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 December 31, 2001, State Auto Financial repurchased 50,522 shares from the public. Repurchases during 2000 and 2001 were funded through dividends from subidiaries. On March 1, 2002, the State Auto Financial's Board of Directors approved a plan to repurchase up to 1.0 million shares of common stock from the public over a period extending to and through December 31, 2003.
(b) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION State Auto P&C, Milbank, Farmers Casualty, SAIC and Nationalare subject to regulations and restrictions under which payment of dividends from statutory earned surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Pursuant to these rules, approximately $25.1 million is available for payment to State Auto Financial in 2002 without prior approval.
(10) PREFERRED STOCK 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 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.
(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 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 2001, 2000 and 1999 were $14,000, $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:
The fair value of options granted in 2001, 2000 and 1999 were estimated at the date of grant using the Black-Scholes option-pricing model. The weighted average fair values and related assumptions for options granted were as follows:
A summary of the Company's stock option activity and related information for these plans for the years ended December 31, 2001, 2000 and 1999, follows:
(12) NET EARNINGS PER COMMON SHARE The following table sets forth the compilation of basic and diluted net earnings per common share:
prior to 2001 to be State Auto standard insurance and State Auto nonstandard insurance and the former Meridian Mutual business assumed through the Pooling Arrangement by the Pooled Subsidiaries to be Meridian standard insurance and Meridian nonstandard insurance. Monitoring the performance of the Meridian segments allows management to review the results of its integration efforts of these segments while this business continues to be processed through the Meridian systems platform. As this business begins to migrate through new and renewal policy issuance on the State Auto systems platform where State Auto policies, pricing and underwriting philosophies are fully integrated, it is anticipated that the Meridian segments will decrease. The investment management services segment manages the investment portfolios of affiliated insurance companies. The management and operations services segment provided employee services and managed the day-to-day operations of all affiliated Companies. As a result of the loss of the management and operations services income as described in note 6(d), the management and operations service segment will be included in the all other category for segment reporting beginning in the first quarter of 2002 as the results for this segment will no longer meet the quantitative thresholds for separate presentation as a reportable segment. The Company evaluates performance of its reportable segments and allocates resources thereon 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 monitors its assets for the insurance segments on a legal entity basis, which for the Pooled Subsidiaries includes assets of three of the four reportable insurance segments (State Auto standard insurance, Meridian standard insurance and Meridian nonstandard insurance). 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. Revenue from segments in the other category is attributable to three other operating segments of the Company; an insurance software development and resale segment, a premium finance segment and a property management and leasing segment. These segments have never met the quantitative thresholds for individual presentation as reportable segments. The following provides financial information regarding the Company's reportable segments:
The standard insurance segments and the Meridian nonstandard insurance segment participate in a reinsurance pooling agreement with other standard and nonstandard insurance affiliates. For discussion regarding this arrangement and these segments' contribution to the pool and participation in the pool, see note 6.