We evaluate the performance of our insurance segments using industry financial measurements determined under SAP and certain measures determined under GAAP. We evaluate our investment operations segment based on investment returns of assets managed. Financial information about our segments for 2019 is set forth in this Item 7 and in Note 16 to our consolidated financial statements included in Item 8 of this Form 10-K.
Our Claims and Risk Engineering (CARE) organization is focused on providing an exceptional customer experience for those who rely on us during some of their greatest times of need. Our CARE team is continually exploring new ways to streamline and improve the claim process through the use of technology, while keeping in mind that people ultimately make the difference. We are committed to improving all aspects of the claim experience for our customers.
In 2019, we completed the multi-year rollout of our digital quote and issue platform for personal lines, small commercial and commercial auto, which continued to drive significant growth. The flexibility of this platform allows us to offer new products and rates and incorporates advanced data analytics, giving us the ability to more efficiently match rate to risk. Throughout 2019, our efforts were focused on delivering a stable technology experience for our agents and policyholders, while working toward a 2020 launch of farm and ranch and middle market commercial on the new platform, followed by workers' compensation in 2021.
The STFC Pooled Companies and the Mutual Pooled Companies participate in a quota share reinsurance pooling arrangement referred to as the “Pooling Arrangement.” Under the Pooling Arrangement, State Auto Mutual assumes premiums,
The following table sets forth the participants and their participation percentages in the Pooling Arrangement. There were no changes to the participants or to their participation percentages during 2019.
We anticipate that the STFC Pooled Companies will maintain a 65% participation percentage in the Pooling Arrangement for the foreseeable future. However, under applicable governance procedures, if the Pooling Arrangement were to be amended, management would make recommendations to the Independent Committees of the Board of Directors of both State Auto Mutual and STFC. The Independent Committees review and evaluate such factors as they deem relevant and recommend any appropriate pooling change to the Board of Directors of both State Auto Mutual and STFC subject to regulatory approval by each participant’s respective domiciliary insurance department. The Pooling Arrangement is terminable by any of our Pooled Companies at any time by any party by giving twelve months’ notice to the other parties and their respective domiciliary insurance departments. None of our Pooled Companies currently intends to terminate the Pooling Arrangement.
The following highlights significant factors that impacted our 2019 net income of $87.4 million:
•Earned premiums were $1,253.0 million, which reflected new business growth in homeowners, commercial auto, middle market commercial, and other personal as well as increased rates in personal auto.
•Earned premiums were $1,238.0 million and reflected new business growth in the personal insurance segment and the exit of the specialty business.
•The SAP non-cat loss and ALAE ratio was 52.7%, or $653.0 million. Non-catastrophe losses and ALAE included 6.2 points of favorable development relating to prior years, or $76.6 million. The personal and commercial insurance segments contributed 7.0 points, or $79.7 million, due primarily to lower than anticipated severity emerging from multiple accident years with the majority of favorable development from the 2016 and 2017 accident years.
The accounting for pension benefits also contributes to the difference between our GAAP loss and expense ratios and our SAP loss and expense ratios. For a discussion of our pension and postretirement benefit obligations, see the “Critical Accounting Policies - Pension and Postretirement Benefit Obligations” section included in this Item 7.
The following table sets forth certain key performance indicators for our insurance segments for the years ended December 31, 2019 and 2018:
All new business is now issued through State Auto Connect, a fully digital quote and issue platform that incorporates advanced data analytics and updated pricing models. The flexibility of this platform allows us to offer new products and coverages. This platform enables our agents to submit, quote, bind, issue and bill policies through a completely digital and integrated platform. We started the rollout of State Auto Connect in five states in 2016 and launched the final state in January 2019.
The commercial insurance segment's net written premiums for the year ended December 31, 2019 increased 12.0% compared to 2018 (Tables 3 - 4), primarily driven by new business growth in commercial auto and middle market commercial. The 2019 increases were partially offset by a decrease in net written premiums in workers’ compensation due to lower retention as a result of the continued intense competition in this market.
The small commercial package SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2019 improved 8.0 points compared to 2018 (Tables 3 - 4) primarily driven by greater favorable development of prior accident year losses attributable to lower than expected bodily injury severity from multiple accident years. In addition, 2019 was impacted by a lower level of current accident year property losses when compared to the same 2018 period, which was impacted by more weather-related claims and large fire losses.
The following table sets forth a tabular presentation of the development of the ultimate liability by accident year for the year ended December 31, 2019:
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the more notable items contributing to 2019 development were as follows:
•ULAE was $2.0 million lower than anticipated in the reserves at December 31, 2018.
•The personal insurance segment non-catastrophe loss and ALAE reserves contributed $32.8 million of the favorable development, driven by personal auto and homeowners which contributed $24.4 million and $7.3 million, respectively, of favorable development, primarily due to lower than anticipated bodily injury severity from the prior two accident years.
We conduct quarterly reviews of loss development reports and make judgments in determining the reserves for ultimate losses and loss expenses payable. Several factors are considered by us when estimating ultimate liabilities, including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, exposure changes, anticipated inflation, current business conditions, catastrophe developments, late reported claims and other reasonableness tests.
Our internally managed equity portfolio invests in U.S. large-cap companies across many different industries, selected based upon their potential for appreciation. This diversification across companies and industries reduces volatility in the value of the large-cap equity portfolio. Our investment policy guidelines limit the purchase of a specific stock to no more than 5.0% of the market value of the stock at the time of purchase, and no individual company’s equity holding should exceed 5.0% of the total equity portfolio. In addition, we also invest in dividend-paying exchange traded funds and mutual funds which add to the diversification of the portfolio by allowing us to invest in a large number of companies via one security.
The following table sets forth the composition of our investment portfolio at carrying value at December 31, 2019 and 2018:
The following table sets forth the amortized cost and fair value of available-for-sale fixed maturities by contractual maturity at December 31, 2019:
At December 31, 2019, our equity portfolio consisted of approximately 38 different large-cap stocks and 17 mutual and exchange traded funds. The largest single fund holding was 18.7% of the equity portfolio based on fair value and the top ten positions accounted for 68.6% of the equity portfolio. At December 31, 2018, our equity portfolio consisted of approximately 42 different large-cap stocks and 16 mutual and exchange traded funds. The largest single fund holding was 22.2% of the equity portfolio based on fair value and the top ten positions accounted for 72.6% of the equity portfolio.
Our primary market risk exposures are to changes in market prices for equity securities and changes in interest rates and credit ratings for fixed maturity securities. Our fixed maturity securities are subject to interest rate risk whereby the value of the securities varies as market interest rates change. We manage this risk by closely monitoring the duration of the fixed maturity portfolio. The duration of the fixed maturity portfolio was approximately 4.17 and 4.23 as of December 31, 2019 and 2018, respectively. The following table sets forth our interest rate risk and the effects of a parallel change in interest rates on the fair value of the available-for-sale fixed maturity portfolio at December 31, 2019:
We believe our Muni Portfolio is well diversified by issuer and state. We have 4.9% invested in securities which have been either pre-refunded or escrowed to maturity bonds. No single issuer comprises more than 5.0% of our Muni Portfolio. For the bonds that are not in the pre-refunded category, no more than 15% is concentrated in any one state. We believe our Muni Portfolio is invested within the strongest sectors of the municipal bond market. Revenue bonds represent 61.3% of our Muni Portfolio and state and local government general obligation bonds make up 22.7% of our Muni Portfolio. Our credit research is an important part of our investment management process, and we continually monitor all holdings for any signs of deterioration. We believe that our municipal holdings will maintain their high credit quality and that the issuers will be able to make all principal and interest payments as they come due.
At December 31, 2019, our large-cap equity portfolio had a weighted beta of 1.02 using the S&P 500 Index as the benchmark. At December 31, 2019, our mutual and exchange traded funds portfolio had a weighted beta of 1.00 using the S&P 500 Index and the CRSP US Small Cap Index as benchmarks. Beta estimates the degree the portfolio’s price will fluctuate based on a given movement in the market index. The following tables set forth what changes might occur in the value of the large-cap equity portfolio and the mutual fund and ETF portfolio given a change in the respective index at December 31, 2019:
The following table sets forth the components of net investment income for the years ended December 31, 2019 and 2018:
Our investment operations revenue for the year ended December 31, 2019 decreased when compared to the same 2018 period due to (i) lower yields on bonds purchased and bonds owned in the portfolio, (ii) decreased income from our TIPS bonds, driven by the change in the CPI Index, and (iii) a slightly smaller bond portfolio.
The following table sets forth realized gains (losses) and the proceeds received on sale for our investment portfolio for the years ended December 31, 2019 and 2018:
We did not recognize any impairments on our fixed maturity portfolio during 2019 or 2018. When a fixed maturity security has been determined to have an other-than-temporary decline in fair value, the impairment charge is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to non-credit factors, which is recognized in accumulated other comprehensive income. Future increases or decreases in fair value, if not other-than-temporary, are included in accumulated other comprehensive income (loss). See “Critical Accounting Policies - Investments” included in this Item 7 for OTTI impairment indicators.
We primarily use one independent nationally recognized pricing service in developing fair value estimates. We obtain one price per security, and our processes and control procedures are designed to ensure the value is accurately recorded on an unadjusted basis. Through discussions with the pricing service, we gain an understanding of the methodologies used to price the different types of securities, that the data and the valuation methods utilized are appropriate and consistently applied, and that the assumptions are reasonable and representative of fair value. To validate the reasonableness of the valuations obtained from the pricing service, we compare to other fair value pricing information gathered from other independent pricing sources. See Note 3, “Fair Value of Financial Instruments” to our consolidated financial statements included in Item 8 of this Form 10-K for a presentation of our available-for-sale investments within the fair value hierarchy at December 31, 2019.
For the year ended December 31, 2019, the federal income tax expense was $19.6 million compared to $0.1 million for 2018. Our effective tax rate for 2019 was 18.3% compared with 0.5% in 2018. The change in our effective tax rate in 2019 when compared to 2018 was primarily due to unrealized gains in 2019 versus unrealized losses in 2018 in relation to the tax exempt income that remained comparable.
Under the terms of the Pooling Arrangement, State Auto Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the STFC Pooled Companies and the other pool participants, and then it settles the intercompany balances generated by these transactions with the pool participants within 60 days following each quarter end. We believe this provides State Auto Mutual with sufficient liquidity to pay losses and expenses of our insurance operations on a timely basis. When settling the intercompany balances, State Auto Mutual provides the pool participants with full credit for the premiums written net of losses paid during the quarter, retaining all receivable amounts from insureds and agents and reinsurance recoverable on paid losses from unaffiliated reinsurers. Any receivable amounts that are ultimately deemed to be uncollectible are charged-off by State Auto Mutual and allocated to the pool participant on the basis of its pooling percentage.
We generally manage our cash flows through current operational activity and maturing investments, without a need to liquidate any of our other investments. However, should our written premiums decline or paid losses increase significantly, or a combination thereof, our cash flows from operations could be impacted requiring us to liquidate investments. This action was not necessary in 2019 or 2018.
Net cash provided by investing activities was $74.1 million in 2019, compared to net cash used by investing activities of $16.0 million in 2018. The change from 2019 compared to 2018 was primarily driven by increases in the proceeds from the sales and maturities of fixed maturities partially offset by an increase in the purchases of fixed maturities.
State Auto P&C has an Open Line of Credit Commitment (the "OLC") with the FHLB that provides State Auto P&C with a $100.0 million one-year open line of credit available for general corporate purposes. The OLC matures in April 2020, and our
State Auto P&C has outstanding two term loans with the FHLB in the principal amounts of $21.5 million and $85.0 million, respectively (the “2016 FHLB Loan” and "2018 FHLB Loan", respectively). The 2016 FHLB Loan matures in September 2021 and may be prepaid without penalty. The 2016 FHLB Loan provides for interest-only payments during its term, with principal due in full at maturity. The interest rate is fixed over the term of the loan at 1.73%. The 2018 FHLB Loan matures in May 2033 and provides for interest-only payments during its term, with principal due in full at maturity. The interest rate is fixed over the term of the loan at 3.96%. Prepayment of the 2018 FHLB Loan would require a prepayment fee.
State Auto Financial’s Delaware business trust subsidiary (the “Capital Trust”) has outstanding $15.0 million liquidation amount of capital securities, due 2033. In connection with the Capital Trust’s issuance of the capital securities and the related purchase by State Auto Financial of all of the Capital Trust’s common securities (liquidation amount of $0.5 million), State Auto Financial has issued to the Capital Trust $15.5 million aggregate principal amount of unsecured Floating Rate Junior Subordinated Debt Securities due 2033 (the “Subordinated Debentures”). The sole assets of the Capital Trust are the Subordinated Debentures and any interest accrued thereon. Interest on the Capital Trust’s capital and common securities is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly. The applicable interest rates for December 31, 2019 and 2018 were 6.11% and 6.94%, respectively.
Related to our notes payable, our primary market risk exposure is to the change in interest rates and our credit rating. For a discussion regarding our credit ratings see “Liquidity and Capital Resources - Credit and Financial Strength Ratings” included in this Item 7. Based upon the notes payable carrying value at December 31, 2019, we had $15.2 million notes payable with variable interest and $85.3 million and $21.5 million of notes payable with interest fixed at 3.96% and 1.73%, respectively, which equated to approximately 12.5% variable interest debt and 87.5% fixed interest debt. Our decision to obtain fixed versus variable interest rate debt is influenced primarily by the following factors: (a) current market interest rates; (b) anticipated future market interest rates; (c) availability of fixed versus variable interest instruments; and (d) our currently existing notes payable fixed and variable interest rate position. See our contractual obligations table included in “Liquidity and Capital Resources -Contractual Obligations” included in this Item 7.
Each member of the State Auto Group is party to working reinsurance treaties for casualty, workers’ compensation and property lines with several reinsurers arranged through reinsurance intermediaries. These agreements are described in more detail below. We have also secured other reinsurance to limit the net cost of large loss events for certain types of coverage. The State Auto Group also makes use of facultative reinsurance for unique risk situations. The State Auto Group also participates in state insurance pools and associations. In general, these pools and associations are state sponsored and/or operated, impose mandatory participation by insurers doing business in that state, and offer coverage for hard-to-place risks at rates established by the state sponsor or operator, thereby transferring risk of loss to the participating insurers in exchange for premiums which may not be commensurate with the risk assumed.
The State Auto Group has an adverse development reinsurance agreement implemented at the end of 2014, that provides for $40.0 million of coverage for adverse claims development in excess of carried reserves as of November 30, 2014 for the terminated restaurant program business previously underwritten by a MGU-subsidiary of State Auto Mutual.
In addition, each company in the State Auto Group is party to a workers’ compensation catastrophe insurance agreement that provides additional reinsurance coverage for workers’ compensation losses involving multiple workers. Subject to $10.0 million of retention, reinsurers are responsible for 100.0% of the excess over $10.0 million up to $30.0 million of covered loss. For loss amounts over $30.0 million, the casualty excess of loss reinsurance agreement provides $20.0 million coverage in excess of $30.0 million. Workers’ compensation catastrophe coverage is subject to a “Maximum Any One Life” limitation of $10.0 million. This limitation means that losses associated with each worker may contribute no more than $10.0 million to covered loss under these agreements.
Effective March 1, 2018, the State Auto Group entered into a quota share agreement ("Oil & Gas Quota Share") covering its gas & propane distribution book of business. The Oil & Gas Quota Share expired February 28, 2019 on a run-off basis.
Our insurance subsidiaries are subject to risk-based capital (“RBC”) requirements that have been adopted by individual states. These requirements subject insurers having statutory capital less than that required by the RBC calculation to varying degrees of regulatory action, depending on the level of capital inadequacy. The RBC formulas specify various weighting factors to be applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of total adjusted capital to authorized control level RBC. Generally no remedial action is required by an insurance company if its adjusted statutory surplus exceeds 200% of the authorized level RBC. At December 31, 2019, the ratio of total adjusted statutory capital to authorized control level of State Auto Financial’s insurance subsidiaries ranged from 482% to 21,472%.
As of June 20, 2019, the State Auto Group’s financial strength rating from A.M. Best was A- (Excellent) with a stable outlook and its credit rating from A.M. Best was bbb- with a stable outlook.
The financial strength rating is for the State Auto Group and expresses the opinion of the rating agency as to the ability of the State Auto Group to meet its ongoing obligations to policyholders. The A.M. Best financial strength rating influences our ability to write insurance business as agents and policyholders generally prefer higher rated companies. Lower rated companies may be required to compete for agents and policyholders by offering higher commissions or lower premiums and expanded coverage, or a combination thereof.
ultimate net cost of underlying claims and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on investment income may partially offset potentially higher claims and expenses.
Effective January 1, 2018, we adopted Accounting Standards Update (ASU) No. 2016-01 that, among other things requires unrealized gains and losses for equity securities and other invested assets previously identified as available-for-sale to be recognized in net income. Previously, the unrealized gains and losses for these securities were recognized in other comprehensive income. Accordingly, changes in the fair value of equity securities and other invested assets are reported in "net investment gain (loss)" in the condensed consolidated statements of income for the year ended December 31, 2019 and 2018.
We regularly monitor our investment portfolio for declines in value that are other-than-temporarily impaired (“OTTI”), an assessment that requires significant management judgment regarding the evidence known. Such judgments could change in the future as more information becomes known which could negatively impact the amounts reported herein. We consider the following factors when assessing our fixed maturity investments for OTTI: (i) the financial condition of the issuer including receipt of scheduled principal and interest cash flows; (ii) our intent to sell; and (iii) if it is more likely than not that we will be required to sell the investments before recovery. When a fixed maturity has been determined to have an other-than-temporary impairment, the impairment charge is separated into an amount representing the credit loss, which is recognized in earnings as a realized loss, and the amount related to non-credit factors, which is recognized in other comprehensive (loss) income. Future increases or decreases in fair value, if not other-than-temporary, are included in other comprehensive (loss) income.
Loss reserves are management’s best estimates (“MBE”) at a given point in time of what we expect to pay to settle all claims incurred as of that date based on known facts, circumstances and historical trends. Loss reserves at the individual claim level are established on either a case reserve basis or formula reserve basis depending on the type and circumstances of the loss. The case reserve amounts are determined by claims adjusters based on our reserving practices, which take into account the type of risk, the circumstances surrounding each claim and applicable policy provisions. The formula reserves are based on historical data for similar claims with provision for changes caused by inflation. Case reserves and formula reserves are reviewed on a
We use a number of different methodologies to estimate the ultimate losses, and thus the IBNR component of our loss reserves. Our loss reserves include amounts related to short-tail and long-tail lines of business. “Tail” refers to the time period between the occurrence of a loss and the settlement of the claim. In general, the longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount can vary. The most common reserving methods and strengths and weaknesses of each are described below.
Paid Loss Development Method: The Paid Loss Development Method uses calculations that are very similar to the Incurred Loss Development Method. The key difference is that the data used in the paid method exclude outstanding amounts, so only paid losses are utilized. With this method, a payment pattern is estimated to project ultimate settlement values for each accident year, with an important underlying assumption that claims are settled at a consistent rate over time. Neither case reserves nor the rate at which claims are reported (except to the extent that the reporting pattern influences the payment pattern) is relevant to the results of this method. This method’s advantage is that the estimates of ultimate loss are independent of case reserve adequacy and are unaffected by company changes in case reserving philosophy. The disadvantages are that (i) the paid method does not use all of the available information, (ii) in some cases the liability payment patterns require the application of very large development factors to relatively small payments in less mature accident years, and (iii) changes in the claims settlement rate will distort the projections.
Long-Tail Business: For long-tail business, a material portion of claims may not be settled within five years. Reserve estimates for long-tail business use the same methods listed above along with several other methods as determined by the actuaries. For example, premium-based methods may be used in developing ultimate loss estimates, including the Expected Loss Ratio and Bornhuetter-Ferguson methods described below.
Expected Loss Ratio Method: The Expected Loss Ratio Method generates indicated IBNR by multiplying an expected loss ratio by earned premiums, then subtracting incurred-to-date losses. For slower reporting lines of business, new products, or data that is very immature, the actual claim data is often too limited or too volatile to rely upon other projection methods. With this method the premiums are used as a measure of loss exposure, and the loss ratios can be derived from pricing expectations or other sources.
Selection Process: In determining which reserving method to use for a particular line of business or accident year, diagnostic tests of loss ratios and severity trends are considered, as well as the historical case reserve adequacy and claim settlement rate. In general, the Incurred Loss Development Method is used if the projections are stable, the data is credible, historical case reserve adequacy is consistent, and the loss ratios and loss severities are reasonable. Other reserving methods are considered as well for particular lines of business or accident years, along with supplemental information such as open claim counts, open claim severity, and prior period development. For example, if more than one method provides a reasonable projection, the actuary may select a weighted average of those methods. There is considerable judgment applied in the analysis of the historical patterns and in applying business knowledge of our underwriting and claims functions.
The potential impact of the loss reserve variability on net income can be illustrated using the range end points and carried reserve amounts listed above. For example, if ultimate losses reach a level corresponding to the high point of the range, $1,094.4 million, the reserve increase of $41.5 million corresponds to an after-tax decrease of $32.7 million in net income, assuming a tax rate of 21%. Likewise, should ultimate losses decline to a level corresponding to the low point of the range, $927.7 million, the $125.2 million reserve decrease would add $98.9 million of after-tax net income. The loss reserve range noted above represents a range of reasonably likely reserves, not a range of all possible reserves. Therefore, the ultimate losses could reach levels corresponding to reserve amounts outside the range provided.
The estimated cumulative impact that this additional, unexpected 5% increase in the loss cost trend would have on our results of operations over the lifetime of the underlying claims in workers’ compensation is an increase of $111.3 million on reserves, or a $88.0 million reduction to net income, assuming a tax rate of 21%. Inflation changes have much more impact on the longer tail commercial lines like workers’ compensation, and much less impact on the shorter tail personal lines.
Scale MP-2017 to reflect mortality improvement (Scale MP-2016 was used at the beginning of the year). The January 1, 2019 and 2018 actuarial reports of the benefit plans included these revised mortality assumptions.
The accumulated benefit obligation (“ABO”) of a defined benefit pension plan represents the actuarial present value of benefits attributed by the pension benefit formula to employee service rendered prior to the measurement date and based on current and past compensation levels, while the projected benefit obligation (“PBO”) is the ABO plus a factor for future compensation levels. The ABO, which considers current compensation levels only, provides information about the obligation an employer would have if the plan were discontinued at the measurement date. At December 31, 2019, our ABO and PBO were $453.8 million and $478.2 million, respectively. At December 31, 2019, our defined benefit pension plan’s fair value of the assets was $442.1 million, which resulted in an underfunded status within our balance sheet of $36.1 million. On a cash flow basis, we target an annual contribution level that meets at least the targeted normal cost plus any shortfall amortizations of the plan, as defined by ERISA. Currently, we expect to make a cash contribution to the pension plan up to $10.0 million in 2020.
See Note 10, “Pension and Postretirement Benefit Plans,” to our consolidated financial statements included in Item 8 of this Form 10-K for further disclosures regarding our benefit plans.
For 2019, we recognized federal income tax benefit of $19.6 million compared to a federal income tax expense of $0.1 million for 2018.
The net operating loss carryforwards do not begin to expire until 2032 and will not fully expire until 2038. Management anticipates generating future taxable income that will allow for the realization of all of our net operating loss carryforwards before expiration.
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries (the Company) as of December 31, 2019 and 2018, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and financial statement schedules listed in the Index at Item 15(a)(2) (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 27, 2020 expressed an unqualified opinion thereon.
To the Stockholders and the Board of Directors of State Auto Financial Corporation
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2019 and 2018, the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and financial statement schedules listed in the Index at Item 15(a)(2) and our report dated February 27, 2020, expressed an unqualified opinion thereon.
•State Auto Insurance Company of Ohio (“SA Ohio”), an Ohio corporation
Investments in fixed maturities are classified as available-for-sale and are carried at fair value. The unrealized holding gains and losses, net of applicable deferred income taxes, are shown as a separate component of stockholders’ equity as a part of accumulated other comprehensive income and, as such, are not included in the determination of net income. Realized gains and losses on the sales of investments are computed using the first-in, first-out method.
Acquisition costs, consisting of net commissions (including ceding commissions), premium taxes and certain underwriting expenses related to the successful acquisition or renewal of property and casualty business, are deferred and amortized over the same period in which the related premiums are earned. Ceding commissions relating to reinsurance agreements reimburse us for both deferrable and non-deferrable acquisition costs. Excess ceding commissions are amortized in proportion to net revenue recognized on the underlying policies resulting in excess ceding commissions being recognized as a reduction of acquisition and operating expenses.
As a result of the Pooling Arrangement, the Company has an off-balance sheet credit risk related to the balances due to State Auto Mutual from insureds, agents and reinsurers, which are offset by the unearned premiums from the respective policies. When settling the intercompany balances, State Auto Mutual provides the STFC Pooled Companies with full credit for the premiums written and net losses paid during the quarter and retains all receivable amounts from insureds and agents and reinsurance recoverable on paid losses from unaffiliated reinsurers. Any amounts deemed uncollectible by State Auto Mutual and allocated to the STFC Pooled Companies are included in the other expenses line item in the accompanying consolidated statements of income. Based on historical data, this credit risk exposure is not considered to be material to our financial position or results of operations.
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses ( Topic 326)" that amended previous guidance on the impairment of financial instruments by adding an impairment model that requires an entity to recognize expected credit losses as an allowance rather than impairing as they are incurred. The new guidance is intended to reduce complexity of credit impairment models and result in a more timely recognition of expected credit losses. The measurement of credit losses for available-for-sale debt securities measured at fair value is not affected except that credit losses recognized are limited to the amount by which fair value is below amortized cost and the carrying value adjustment is recognized as an allowance rather than impairing as they are incurred. The effective date of ASU 2016-13 is for interim and annual reporting periods beginning after December 15, 2019. The Company will adopt the guidance when it becomes effective for the Company on January 1, 2020.
The Company will adopt ASC 326 using the modified retrospective method for all financial assets measured at amortized cost and off-balance-sheet credit exposures, which include reinsurance recoverables and premiums receivables. The measurement of expected credit losses is based on relevant information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. The Company will record a net decrease to retained earnings as of January 1, 2020 for the cumulative effect of adopting ASC 326, which will not have a material impact on the Company's results of operations, consolidated financial position, or cash flows.
The Company will adopt ASC 326 using the prospective transition approach for available-for-sale debt securities. As a result, the amortized cost basis remains the same before and after the effective date of ASC 326 and no adjustment will be made upon adoption.
Disclosure Framework -Changes to the Disclosure Requirements for Fair Value Measurement
The following tables set forth the Company’s gross unrealized losses and fair value on its investments by lot, aggregated by investment category and length of time for individual securities that have been in a continuous unrealized loss position at December 31, 2019 and 2018:
At December 31, 2019, State Auto P&C had fixed maturities with fair values of approximately $27.3 million pledged as collateral for the performance obligations under its reinsurance agreement with Home State County Mutual Insurance Company ("Home State") as defined in Note 6. In accordance with the terms of the trust agreement, State Auto P&C retains all rights regarding these securities, which are included in the “U.S. treasury securities and obligations of U.S. government agencies” classification of the Company’s fixed maturity securities portfolio.
Fixed maturities with fair values of approximately $9.3 million and $8.9 million were on deposit with insurance regulators as required by law at December 31, 2019 and 2018, respectively.
The following table sets forth the components of net investment income for the years ended December 31, 2019, 2018 and 2017:
The Company utilizes a nationally recognized pricing service to estimate the majority of its investment portfolio’s fair value. The Company obtains one price per security. The Company’s processes and control procedures are designed to ensure the price is accurately recorded on an unadjusted basis. Through discussions with the pricing service, the Company obtains an understanding of the methodologies used to price the different types of securities, that the data and the valuation methods utilized are appropriate and consistently applied, and that the assumptions are reasonable and representative of fair value. To validate the reasonableness of the valuations obtained from the pricing service, the Company compares the valuations received to other fair value pricing from other independent pricing sources. At December 31, 2019 and 2018, the Company did not adjust any of the prices received from the pricing service.
Included in other invested assets is one international fund (“the fund”) that invests in equity securities of foreign issuers and is managed by third party investment managers. The fund had a fair value of $56.4 million and $38.5 million at December 31, 2019 and 2018, respectively, which was determined using the fund’s net asset value. The Company employs procedures to assess the reasonableness of the fair value of the fund including obtaining and reviewing the fund’s audited financial statements. There is no unfunded commitment related to the fund. The Company may not sell its investment in the fund; however, the Company may redeem all or a portion of its investment in the fund at net asset value per share with the appropriate prior written notice. In accordance with Accounting Standard Codification 820-10, this investment is measured at fair value using the net asset value per share practical expedient and has not been classified in the fair value hierarchy. Fair values presented here are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheets.
Included in other invested assets are common stock of the Federal Home Loan Bank of Cincinnati (the “FHLB”), and the Trust Securities (as defined in Note 7b). The Trust Securities and FHLB common stock are carried at cost, which approximates fair value. The fair value of the FHLB common stock at December 31, 2019 was $6.0 million and the fair value of the Trust Securities were $0.5 million. Both investments have been placed in Level 3 of the fair value hierarchy.
Included in notes payable are the FHLB Loans (as defined in Note 8) and Subordinated Debentures. The Company estimates the fair value of the FHLB Loans by discounting cash flows using a borrowing rate currently available to the Company for a loan with similar terms. The FHLB Loans have been placed in Level 3 of the fair value hierarchy. The carrying amount of the Subordinated Debentures approximates its fair value as the interest rate adjusts quarterly and has been disclosed in Level 3.
The Company recorded favorable development related to prior years’ loss and loss expense reserves in 2019 of $68.7 million. Favorable development of prior accident years' non-catastrophe loss and ALAE reserves was due to $71.3 million of favorable development in the personal and commercial insurance segments. In the personal insurance segment, personal auto contributed $10.7 million of favorable development, primarily from the 2018 and 2017 accident years. In the commercial insurance segment, workers' compensation, small commercial package, and middle market commercial contributed $20.9 million, $15.2 million, and $11.8 million, respectively, of favorable development from multiple accident years. The favorable development from prior years' non-catastrophe loss and ALAE reserves was partially offset by $5.7 million of adverse development in catastrophe reserves driven by $10.7 million of adverse development from specialty run-off, primarily from the 2017 accident year.
•undiscounted, incurred and paid claims and allocated claim adjustment expenses by accident year, on a net basis after reinsurance;
The above information is provided for each of the Company’s reportable insurance segments and specialty run-off and then is further disaggregated between short and long-tail where "tail" refers to the time period between the occurrence of a loss and the ultimate settlement of the claims. See Note 16 for discussion of the Company’s reportable segments.
Long-Tail Business: For long-tail business, a material portion of claims may not be settled within five years. Reserve estimates for long-tail business use the same methods listed above along with several other methods as determined by the actuary. For example, premium-based methods may be used in developing ultimate loss estimates, including the Expected Loss Ratio and Bornhuetter-Ferguson methods as described in the "Losses and Loss Expenses Payable" section of "Critical Accounting Policies" included in Item 7 of this Form 10-K.
The change in incurred losses and loss adjustment expenses for prior accident years was due to lower than expected emergence in the workers’ compensation product, primarily driven by lower than expected severity.
The following table sets forth the reconciliation of the claims development tables to the balance sheet losses and loss expenses payable, with separate disclosure of unallocated loss adjustment expenses, net of reinsurance ("ULAE") and reinsurance recoverable on losses and loss expenses payable, for the years ended December 31:
The following table sets forth the historical average annual payout of incurred losses and allocated loss adjustment expenses (claims duration) for short-duration contracts, based on the disaggregated information in the paid loss development tables, net of reinsurance:
In May 2009, the Company entered into two separate credit agreements with State Automobile Mutual Insurance Company pursuant to which it loaned State Auto Mutual a total of $70.0 million at an interest rate of 7.00%. In May 2019, the Company refinanced the two credit agreements with State Auto Mutual at an interest rate of 4.05%, with principal payable in May 2029. There is no prepayment penalty, and no collateral was given as security for the payment for these loans.
Pursuant to these agreements, the Company earned interest of $3.6 million for the year ended December 31, 2019 and $4.9 million for the years ended December 31, 2018 and 2017, respectively. See Note 3 for the notes receivable fair value discussion.
Stateco provides State Auto Mutual and its affiliates investment management services. Investment management income is recognized quarterly based on a percentage of the average fair value of investable assets and the equity portfolio performance of each company managed. Revenue related to these services amounted to $2.1 million, $2.0 million and $2.0 million in 2019, 2018 and 2017, respectively, and is included in other income (affiliates) on the consolidated statements of income.
State Auto Financial’s subsidiary, State Auto P&C, is a member of the Federal Home Loan Bank of Cincinnati (the “FHLB”). On May 17, 2018, State Auto P&C refinanced its $85.0 million loan (the "2013 FHLB loan") for a period of fifteen years at a fixed rate of 3.96%. The new loan (the "2018 FHLB loan") provides for interest-only payments during its term, with principal due in full at maturity. Prepayment of the 2018 FHLB Loan would require a prepayment fee. State Auto P&C incurred a $0.4 million prepayment fee which is included in interest expense in the condensed consolidated statements of income for the year ended December 31, 2018. State Auto P&C has a term loan with the FHLB in the principal amount of $21.5 million (the “2016 FHLB Loan”). The 2016 FHLB Loan is a five-year term loan and may be prepaid after three years with no prepayment penalty. The 2016 FHLB Loan provides for interest-only payments during its term, with principal due in full at maturity. The interest rate is fixed over the term of the loan at 1.73%.
State Auto P&C has an Open Line of Credit Commitment (the "OLC") with the FHLB that provides State Auto P&C with a $100.0 million one-year open line of credit available for general corporate purposes. The OLC matures in April 2020. Draws under the OLC are to be funded at a daily variable rate advance with a term of no more than 180 days with interest payable monthly. All advances under the OLC are to be fully secured by a pledge of specific investment securities of State Auto P&C. As of December 31, 2019, no advances had been made under the OLC.
The following table sets forth the reconciliation between actual federal income tax expense and the amount computed at the indicated statutory rate for the years ended December 31, 2019, 2018 and 2017:
On December 22, 2017, the United States enacted the TCJA which, among other changes, reduced the U.S. federal tax rate from 35.0% to 21.0% beginning on January 1, 2018. The estimated effects of enactment of TCJA were reflected in the net deferred tax asset that was reported on the Company's balance sheet at December 31, 2017. Total income tax expense for 2017 included a provisional net charge of $43.5 million to reflect the change in tax laws and tax rates included in TCJA at the date of enactment, resulting primarily from revaluing the Company's deferred tax assets and liabilities.
State Auto Financial and its subsidiaries file a consolidated U.S. federal income tax return. State Auto Financial and its subsidiaries also file in various state jurisdictions. The Company is no longer subject to U.S. federal or state and local income tax examinations by tax authorities for years before 2016. The Company has no current U.S. federal or state and local income tax examinations on-going at this time.
The following table sets forth information regarding the pension and postretirement benefit plans’ change in benefit obligation, plan assets and funded status at December 31, 2019 and 2018:
No assets are expected to be returned during the fiscal year ending December 31, 2019.
The following table sets forth the amounts included in accumulated other comprehensive income (loss) that has not been recognized in net periodic cost at December 31, 2019 and 2018:
The following table sets forth the weighted average assumptions used to determine the benefit plans’ obligations at December 31, 2019 and 2018:
The following table sets forth the weighted average assumptions used to determine the benefit plans’ net periodic cost for the years ended December 31, 2019, 2018 and 2017:
The following table sets forth the assumed health care cost trend rates used for the years ended December 31, 2019, 2018 and 2017:
See Note 3 for the valuation methods used by the Company for each type of financial instrument the plans hold that are carried at fair value. There were no transfers between level categorizations during the years ended December 31, 2019 and 2018.
accordance with ASC 820-10, since these investments are measured at fair value using the net asset value per share practical expedient they have not been classified in the table below.
The following tables set forth the plan’s investments within the fair value hierarchy at December 31, 2019 and 2018:
The Company maintains a defined contribution plan that covers substantially all employees of the Company. The Company matches the first 1% of contributions of participants’ salary at the rate of one dollar for each dollar contributed. Participant contributions of 2% to 6% are matched at a rate of 50 cents for each dollar contributed. In addition, the Company contributes a percentage of the employee’s annual income for those employees hired on or after January 1, 2010, and for those employees hired prior to January 1, 2010 who chose to freeze their existing accrued pension benefit effective June 30, 2010. The Company’s share of the expense under the plan totaled $6.4 million, $5.6 million and $6.4 million for 2019, 2018 and 2017, respectively.
State Auto P&C, Milbank and SA Ohio are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Under the insurance regulations of Iowa and Ohio (the states of domicile), the maximum amount of dividends that the Company may pay out of earned surplus to shareholders within a twelve month period without prior approval of the Department is limited to the greater of 10% of the most recent year-end policyholders’ surplus or net income for the twelve month period ending the 31st day of December of the previous year-end. Pursuant to these rules, approximately $91.3 million is available for payment to State Auto Financial from its insurance subsidiaries in 2020 without prior approval. State Auto Financial received dividends from its insurance subsidiaries in the amount of $10.0 million, $10.0 million and $15.0 million in 2019, 2018 and 2017, respectively.
The Company's statutory capital and surplus was $913.3 million and $871.9 million at December 31, 2019 and 2018, respectively. The Company's net income, as determined using SAP, was $31.1 million, $65.1 million, and $43.5 million for the years ended December 31, 2019, 2018, and 2017, respectively.
The Company’s share-based compensation plans authorize the granting of various equity-based incentives including performance stock awards, performance unit awards, restricted stock, and other stock based awards to employees and non-employee directors. The expense for these equity-based incentives is based on their fair value at the date of grant and amortized over their vesting period.
As of December 31, 2019, there was $5.9 million of total unrecognized compensation cost related to performance unit awards. The remaining cost is expected to be recognized over a period of 1.01 years.
As of December 31, 2019, there was $0.7 million of total unrecognized compensation cost related to service-based restricted stock awards. The remaining cost is expected to be recognized over a period of 0.81 years.
In accordance with the terms of the 2009 Equity Plan, options previously granted were all vested as of December 31, 2019 and must be exercised no later than ten years from the date of grant. If not exercised, outstanding options will expire in 2026.
Intrinsic value for stock options is defined as the difference between the current market value and the grant price. For the years ended December 31, 2019, 2018 and 2017, the total intrinsic value of stock options exercised was $4.5 million, $7.2 million and $3.0 million, respectively.
The following table sets forth information pertaining to the total options outstanding and exercisable at December 31, 2019:
Share-based compensation expense recognized during 2019, 2018 and 2017 was $6.1 million, $11.1 million and $4.2 million, respectively. Share-based compensation is recognized as a component of loss and loss adjustment expense and acquisition and operating expense in a manner consistent with other employee compensation. As of December 31, 2019, there was $6.6 million of total unrecognized compensation cost related to compensation arrangements granted under the plans. The remaining cost is expected to be recognized over a period of 0.98 years.
The following table sets forth the compilation of basic and diluted net earnings (loss) per common share for the years ended December 31, 2019, 2018 and 2017:
The following table sets forth the options to purchase shares of common stock and the restricted share units (“RSU award”) provided to each outside director of the Company, that were not included in the computation of diluted earnings per common share because the exercise price of the options, or awards, was greater than the average market price or their inclusion would have been antidilutive for the years ended December 31, 2018 and 2017:
The Company’s reportable insurance segments, and the products within each, are as follows:
The following table sets forth financial information regarding the Company’s reportable segments for the years ended December 31, 2019, 2018 and 2017:
The following table sets forth financial information regarding the Company’s reportable segments at December 31, 2019 and 2018:
The following tables set forth quarterly financial data for 2019 and 2018: