Our 2014 results reflect a number of the actions we took in the fourth quarter of 2014 to address certain issues that impacted our financial performance in recent years and overshadowed improvement in our overall underwriting performance. We replaced the HO QS Arrangement (defined and described below) with a one year property aggregate excess catastrophe reinsurance agreement and entered into an adverse development cover ("ADC") reinsurance agreement to provide protection against adverse development related to the terminated RED restaurant program business in run-off. We believe the ADC reinsurance agreement, combined with the actions taken to strengthen our RED reserves during 2014, reduces the likelihood of RED underwriting results materially impacting our future results. In addition, our cumulative profitability since 2011, among other factors, led management to conclude that the valuation allowance against our net deferred tax assets was no longer necessary. As a result, the valuation allowance was reversed, resulting in increases to both GAAP equity and statutory surplus. Finally, our 2014 results benefited from below average catastrophe losses and price increases across all lines and segments.
Since the second quarter of 2011, STFC has carried a valuation allowance against its net deferred tax assets. At December 31, 2013, the was $82.6 million. Management periodically evaluates STFC's deferred tax assets to determine if they are realizable based upon available evidence, both positive and negative. When evaluating the ability to realize STFC's deferred tax assets at December 31, 2014, we focused on STFC’s recent profitability, including (i) three-year cumulative pre-tax income of $98.7 million; (ii) three consecutive years of pre-tax income; and (iii) expected future profitability. We also considered the following factors, all of which were determined to have contributed to STFC’s profitability since 2011 and which we believe will contribute to future profitability: (i) the improved financial performance of our homeowners line since 2011, (ii) the expiration of the HO QS Arrangement under which we ceded a certain portion of our homeowners underwriting profits to the participating reinsurers, (iii) the actions we took (including reserve strengthening and entering into an ADC reinsurance agreement protecting against the risk of further adverse development for one of the programs) with respect to the terminated RED program business, which significantly reduced our reported financial results since 2011, (iv) increased pricing, which has contributed to improved underwriting margins,
and (v) profitable growth within our specialty insurance segment, excluding the terminated RED program business. As a result of our evaluation of all of the above factors, we determined positive evidence outweighed negative evidence and concluded that the valuation allowance was no longer necessary. Accordingly, the valuation allowance as of the beginning of 2014 was reversed, resulting in an income tax benefit of $82.6 million. Management’s assessment of expected future profitability was based on management's opinion that 2014 and 2013 pre-tax operating profitability is a strong indicator of future profitability, along with the anticipated benefits from the expiration of the HO QS Arrangement and from the actions taken with respect to RED.
Remediation efforts in our homeowners line of business have resulted in improved loss and LAE ratios, higher policy premiums and fewer retail agency relationships. While these efforts resulted in declines in new business for both our homeowners and personal auto lines, renewal retention for those lines has remained stable. We are working to stabilize production and promote new business growth in these lines through the introduction of new marketing initiatives targeting our “prime of life” consumer base, but we do not anticipate these efforts to result in meaningful direct written premium growth until 2016.
In our workers’ compensation unit, we focus on a two-pronged “barbell” strategy, with approximately one-half of the our underwriting efforts focused on the “debit mod” market, targeting accounts with premiums in excess of $100,000, and the other half focused on “four wall” classes of business with premiums less than $25,000. This strategy continues to produce strong underwriting performance and we continue to see opportunities to expand into new states and to broaden our distribution network.
We have completed the transformation of our claim operations by redesigning business processes, restructuring the organization, reducing reliance on third-party vendors, and implementing a new technology platform. We believe that we are now positioned to capitalize on these investments by using analytics to improve our fraud detection, improve our first notice of loss handling, and identify opportunities to improve customer service and speed.
We remain a company focused on the property and casualty insurance business, committed to distributing our products through independent agents and brokers, and positioned to enhance the security and financial interests of our policyholders and shareholders by growing book value and surplus through our strong underwriting performance.
Our 2014 net income was $107.4 million compared to 2013 and 2012 net income of $60.8 million and $10.7 million, respectively. Our 2014 net income included a non-cash income tax benefit of $82.6 million related to the reversal of a valuation allowance against our net deferred tax assets.
The following highlights significant factors that impacted 2014 results as compared to 2013 and 2012:
The 2014 catastrophe loss ratio was 3.0% compared to 3.4% and 6.4% for 2013 and 2012, respectively. The improvement was primarily the result of fewer and less severe catastrophe events during 2014.
The SAP non-catastrophe loss and ALAE ratio for 2014 was 62.1% compared to 58.6% and 61.7% for 2013 and 2012, respectively. The ratios were impacted by strengthening RED reserves within the specialty insurance segment by $96.7 million, which included the net cost of the ADC reinsurance agreement, in 2014, $21.3 million in 2013 and $30.5 million in 2012. In addition, the HO QS Arrangement increased our SAP non-catastrophe loss and ALAE ratio 3.4 points in 2014, 2.8 points in 2013 and 2.3 points in 2012.
Our 2014 net income was favorably impacted by the recognition of $19.0 million of profit commission from the HO QS Arrangement. The HO QS Arrangement reduced our GAAP expense ratio by 0.9 points in 2014 and increased our GAAP expense ratios by 0.6 points in 2013 and 2012, respectively.
All references to financial measures or components thereof in this discussion are calculated on a GAAP basis, unless otherwise noted.
The following tables set forth, on a SAP and pro forma basis, certain of our key performance indicators before and after the impact of the HO QS Arrangement cession for the years ended December 31, 2014 and 2013 and 2012.
The following table sets forth certain key performance indicators for our insurance segments for the years ended December 31, 2014, 2013 and 2012:
The personal insurance segment's SAP catastrophe loss ratio for the year ended December 31, 2014 was 3.1%, compared to 3.0% and 5.7% for the same 2013 and 2012 periods, respectively. The personal auto SAP catastrophe loss ratio increased slightly compared to the same 2013 period (Table 2), primarily due to catastrophe events in Colorado and Texas during 2014. Partially offsetting the personal auto increase were improvements in both the as reported homeowners and other personal SAP catastrophe loss ratios of 2.8 points and 4.1 points, respectively, when compared to the same 2013 period (Table 2). The improvements were attributable to a combination of successful remediation efforts in our homeowners line of business, where we have reduced our exposure in previously identified unprofitable states, and fewer and less severe catastrophe events during the year as compared to the same 2013 and 2012 periods, respectively. The 2013 SAP catastrophe loss ratio improved as a result of underwriting actions, rate increases and a return to better weather patterns when compared to 2012, when catastrophe losses were primarily related to a tornado, wind and hail activity in Louisville, Kentucky, and St. Louis, Missouri and wind activity from a storm in the Midwest and Mid-Atlantic states.
The following table sets forth the SAP loss and ALAE ratios by major product line of business for our business insurance segment with the catastrophe and non-catastrophe impact shown separately for the years ended December 31, 2014, 2013 and 2012:
Net written premiums for the business insurance segment for the years ended December 31, 2014 and 2013 increased 3.8% and 7.3%, respectively, compared to the same 2013 and 2012 periods. The 2014 increase in premiums was primarily due to growth in commercial auto and commercial multi-peril, resulting from (i) writing policies with larger average premiums for new business accounts, (ii) achieving price increases in the low-single digits, and (iii) higher retention. The 2013 increase in premiums was primarily due to (i) writing larger average premium new business accounts, (ii) achieving price increases in the high single digits, and (iii) experiencing more growth on existing polices due to improved economic conditions. Net written premiums for the year ended December 31, 2012 reflected the impact of the termination of an umbrella quota share reinsurance agreement, effective July 1, 2012, and included $7.2 million related to the transfer of unearned premium remaining under the agreement.
We are in the process of implementing several strategies to capitalize on opportunities to grow our business insurance segment. With the implementation of Business Insurance Evolution ("BIE") in 2013, our ongoing initiative to automate our small commercial accounts with premiums less than $25,000, we have been able to shift our underwriting focus from smaller to larger commercial accounts. Through our practice group initiative, we provide expertise for all lines of insurance solutions for niche or target markets, with a focus on writing premiums in excess of $25,000. For example, in 2013, we launched our food industry practice group, which focuses on food manufacturing and processing risks. We continue to identify industries and areas of focus where we believe we have underwriting expertise and look to expand into those markets through 2015.
BIE has proven successful as we continue to increase the number of small commercial accounts processed without human intervention. As we move forward, we are also looking to automate the processing of new business, provide more consistent pricing and underwriting service to our agents and insureds, and improving our overall efficiency.
The business insurance segment’s SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2014 was 51.5% compared to 50.0% and 50.7%, respectively for the same 2013 and 2012 periods (Table 4). The increase was primarily driven by commercial multi-peril and fire & allied lines SAP non-catastrophe loss and ALAE ratio increases of 4.7 points and 6.7 points, respectively, when compared to the same 2013 period (Table 4). The commercial multi-peril increase was driven by an increase in large loss activity during the third quarter of 2014 in addition to wind events, large fire losses and the extreme cold weather during the first quarter of 2014. The fire & allied lines increase was driven by large fire losses during the first half of 2014 and the extreme cold weather during the first quarter of 2014. Partially offsetting these increases were improvements in other & product liability and other commercial compared to the same 2013 period (Table 4). These improvements were primarily the result of prior period rate actions emerging in earned premiums and greater favorable development of prior accident year losses in 2014 compared to 2013.
The business insurance segment’s SAP catastrophe loss and ALAE ratio for 2014 was 4.3% compared to 5.7% and 11.5%, respectively, for the same 2013 and 2012 periods (Table 4). The improvements in 2014 and 2013 were primarily due to fewer and less severe catastrophe events during the years ended 2014 and 2013 when compared to the same 2013 and 2012 periods.
The E&S property unit's 2014 SAP non-catastrophe loss and ALAE ratio improved 7.3 points when compared to the same 2013 period (Table 6), primarily due to prior year rate actions emerging in earned premiums and favorable prior accident year development. The E&S property unit's 2013 SAP non-catastrophe loss and ALAE ratio increased 7.7 points, when compared to the same 2012 period (Table 6), primarily due to favorable prior accident year development in 2012 that affected year- over- year comparisons.
Our acquisition and operating expenses were $361.9 million in 2014 compared to $354.8 million and $345.9 million in 2013 and 2012, respectively. The change from 2013 to 2014 was primarily a result of (i) $4.6 million of employee severance expenses recognized as a result of the reorganization of our IT department and (ii) increased contingent commissions and incentive compensation expenses. Partially offsetting these increases was the recognition of $19.0 million of profit commission in accordance with the terms of the HO QS Arrangement. The change from 2012 to 2013 was primarily driven by increases in agent and employee incentive compensation.
As shown above, the 2014 loss and loss expenses attributable to prior years was $45.1 million, or an unfavorable development, in the estimated ultimate liability for prior years’ claims. The following table sets forth a tabular presentation of the adverse development by accident year for the year ended December 31, 2014:
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the adverse development in 2014 resulted primarily from accident years 2012 and 2011. The more notable items contributing to the 2014 development were as follows:
We experienced favorable catastrophe loss development of $5.2 million in 2014 related to catastrophe losses primarily from accident year 2013.
The following table sets forth a tabular presentation of the favorable development by accident year for the year ended December 31, 2013:
The favorable development in 2013 resulted primarily from accident years 2012, 2011, 2010 and 2009. The more notable items contributing to the 2013 favorable development were:
In the specialty insurance segment, the non-catastrophe loss and ALAE reserves contributed $10.5 million of adverse development related to the prior three accident years, which was driven by RED reserve strengthening. Somewhat offsetting the unfavorable development was favorable development of prior accident year non-catastrophe loss and ALAE reserves of $10.9 million in 2013, of which $12.3 million related to the Workers' compensation unit. The favorable Workers' compensation unit development was primarily attributable to better than anticipated severity emerging across all accident years, with approximately one third coming from accident year 2012. Adverse development of prior accident year RED reserves was $21.3 million, more than offsetting the favorable development reported by non-RED specialty insurance segment units.
The following table sets forth a tabular presentation of the favorable development by accident year for the year ended December 31, 2012:
We experienced favorable catastrophe loss development of $10.4 million in 2012 related to the higher level of catastrophe losses we experienced in accident year 2011.
In the specialty insurance segment, the non-catastrophe loss and ALAE reserves contributed $27.8 million of adverse development related to the prior two accident years, which was driven by RED reserve strengthening.
Our investment portfolio and the investment portfolios of other members of the State Auto Group are managed by our subsidiary, Stateco. Stateco utilizes its own personnel to invest in fixed maturities, large-cap equities and small-cap equity funds, and outside investment managers to invest in small-cap equities and international funds. The Investment Committee (the “Committee”) of our Board of Directors establishes the investment policies to be followed by Stateco. Our primary investment objectives are to maintain adequate liquidity and capital to meet our responsibilities to policyholders, grow long term economic surplus to increase our capital position, maintain a consistent level of income to support operations and manage investment risk. Our current investment strategy does not rely on the use of derivative financial instruments.
We have investment policy guidelines with respect to purchasing fixed maturity investments for our insurance subsidiaries which preclude investments in bonds that are rated below investment grade by a recognized rating service. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 5.0% or less of the investment portfolio, other than
Our internally managed equity portfolio invests in U.S. large-cap, dividend-paying companies across many different industries selected based upon their potential for appreciation as well as ability to continue paying dividends. 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 single equity holding should exceed 5.0% of the total equity portfolio. In addition, we also invest in U.S. large-cap, dividend-paying exchange traded funds which adds to the diversification of the portfolio by allowing us to invest in a large number of companies via one security.
At December 31, 2014, our investments in fixed maturities, equity securities and certain other invested assets were held as available-for-sale and carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are included as a separate component of stockholders’ equity as accumulated other comprehensive income (loss) and as such are not included in the determination of net income.
The following table sets forth the composition of our investment portfolio at carrying value at December 31, 2014 and 2013:
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 4.32 and 4.83 as of December 31, 2014 and 2013, 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, 2014:
This table summarizes only the effects that a parallel change in interest rates could have on the fixed maturity portfolio. Changes in rates would also change the value of our liabilities and possibly other financial assets. We caution the reader that this analysis does not take into account nonparallel changes in interest rates. It is likely that some rates would increase or decrease more than others depending upon market conditions at the time of the change. This nonparallel change would alter the value of the fixed maturity portfolio. The analysis is also limited in that it does not take into account any actions that might be taken by us in response to these changes. As a result, the actual impact of a change in interest rates and the resulting fixed maturity values may differ significantly from what is shown in the table.
We believe that the fixed maturity portfolio’s exposure to credit risk is minimal as approximately 77.4% of the bonds we own are rated AA or better. We do not intend to change our investment policy or the quality of our fixed maturity investments. The fixed maturity portfolio is managed in a laddered-maturity style and considers business mix and liability payout patterns to
There are no mortgage backed securities in our fixed maturity portfolio which may be labeled sub-prime mortgage backed securities. We invest only in conventional mortgage backed securities issued by a federal agency or that are U.S. Government guaranteed. Specifically, at December 31, 2014, approximately $472.5 million, or 25.0%, of our fixed maturity available-for-sale investment portfolio was in either GNMA pools, which are guaranteed by the full faith and credit of the U.S. Government, or FNMA or Freddie Mac pools.
We believe our Muni Portfolio is well diversified by issuer and state. We have 20.8% 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 10.0% 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 38.0% of our Muni Portfolio and state and local government general obligation bonds make up 18.8% 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, 2014, our small-cap and large-cap equity portfolios had a beta of 0.38 and 0.97, respectively, using the Russell 2000 and the S&P 500 Index as benchmarks, respectively. 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 small-cap and large-cap equity portfolios given a change in the S&P 500 Index at December 31, 2014:
The above analysis is limited in that it does not take into account any actions that might be taken by us in response to these changes. As a result, the actual impact of a change in equity market prices and the resulting equity values may differ significantly from what is shown in the table. By investing in mostly large-cap issues we hope to limit liquidity risk in the equity portfolio. The small-cap and large-cap equity portfolios do not have any direct exposure to exchange rate risk since we do not directly hold any
foreign stocks. We constantly monitor the equity portfolio holdings for any credit risk issues that may arise. We do not invest in any commodity futures or commodity oriented mutual funds.
The following table sets forth the components of net investment income for the years ended December 31, 2014, 2013 and 2012:
Interest rates generally declined in 2014 compared to 2013. As a result, the proceeds from bonds that matured, or were called by the issuers, were reinvested at lower rates.
The following table sets forth realized gains (losses) and the proceeds received on sale for our investment portfolio for the years ended December 31, 2014, 2013 and 2012:
The following table sets forth the realized losses related to OTTI on our investment portfolio recognized for the years ended December 31, 2014, 2013 and 2012:
Based upon our review of our investment portfolio at December 31, 2014, we determined that there were no individual investments with an unrealized holding loss that had a fair value significantly below cost continually for more than one year. The following table sets forth detailed information on our available-for-sale investment portfolio by lot at fair value for our gross unrealized holding gains (losses) at December 31, 2014:
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, 2014.
Our insurance subsidiaries must have adequate liquidity to ensure that their cash obligations are met. However, as discussed below, the STFC Pooled Companies do not have the day-to-day liquidity concerns normally associated with an insurance company due to their participation in, and the terms of, the Pooling Arrangement. In addition, State Auto P&C’s $100.0 million credit facility is available for general corporate purposes such as funding liquidity needs. See “Borrowing Arrangements - Credit Facility” included in this Item 7.
As a result of the Pooling Arrangement, we have 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. While the total amount due to State Auto Mutual from policyholders and agents is significant, the individual amounts due are relatively small at the policyholder and agency level. Based on historical data, this credit risk exposure is not considered to be material to our financial position, though the impact to income on a quarterly basis may be material. The State Auto Group mitigates its exposure to this credit risk through its in-house collections unit for both personal and commercial accounts which is supplemented by third party collection service providers. The 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.
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 2014, 2013 or 2012.
The change in 2014 was primarily attributable to the level of purchases, sales and maturities in our investment portfolio in 2014 when compared to the same 2013 period.
The following table sets forth our notes payable at December 31, 2014:
occurrence. The reinsurers are responsible for 95% of the excess over $55.0 million up to $340.0 million (previously $320.0 million) of covered losses, each occurrence. Under this agreement, our companies are responsible for losses above $340.0 million (previously $320.0 million).
The State Auto Group also maintains a separate property catastrophe excess of loss reinsurance agreement covering E&S property and Programs catastrophe related events affecting at least two risks. Under this agreement, the State Auto Group retains the first $15.0 million of catastrophe loss, each occurrence, and the reinsurers are responsible for 100.0% of the excess over $15.0 million up to $55.0 million of covered loss, each occurrence.
At June 1, 2014, the State Auto Group renewed the property per risk excess of loss reinsurance agreement. This reinsurance agreement provides that the State Auto Group is responsible for the first $1.0 million of each covered loss for E&S property and Programs units, and the first $3.0 million of each covered loss for other property business. The State Auto Group is also responsible for an additional $2.0 million in aggregate retention per treaty year for losses exceeding $3.0 million. The reinsurers are responsible for 75% of the loss in excess of $1.0 million for the E&S property and Programs units and 100.0% of the loss excess of $3.0 million for other property business up to $20.0 million of covered loss. The rates for this reinsurance are negotiated annually.
As of July 1, 2014, the State Auto Group renewed the casualty excess of loss reinsurance agreement. Under this agreement, the State Auto Group is responsible for the first $1.0 million of workers' compensation losses, each loss occurrence, subject to an additional $1.0 million in annual aggregate retention, and $2.0 million of losses that involve auto liability, other liability and umbrella liability policies, subject to an additional $2.0 million in annual aggregate retention. The reinsurance agreement provides coverage up to $10.0 million, except for umbrella policies which are covered for limits up to $15.0 million. E&S casualty and Programs units risks are not subject to this casualty excess of loss reinsurance agreement.
The following table sets forth the statutory leverage ratios for our insurance subsidiaries at December 31, 2014, 2013 and 2012:
The Company's 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, 2014, the ratio of total adjusted statutory capital to authorized control level of State Auto Financial’s insurance subsidiaries ranged from 462.8% to 5,824.1%.
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. To the extent these ceding commissions exceed the deferrable amount of
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 historic 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, historic 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 and prior period development. For example, if more than one method provides a reasonable projection, the actuary may select an 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, $984.1 million, the reserve increase of $33.6 million corresponds to an after-tax decrease of $21.8 million in net income, assuming a tax rate of 35%. Likewise, should ultimate losses decline to a level corresponding to the low point of the range, $817.0 million, the $133.5 million reserve decrease would add $86.8 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 following table sets forth a reconciliation of MBE of our direct loss and ALAE reserve to our net loss and loss expenses payable at December 31, 2014 and 2013. The STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement for the years ended December 31, 2014 and 2013, respectively, has been reflected in the table below as assumed by STFC Pooled Companies.
Asbestos reserves are $1.4 million, and environmental reserves are $10.5 million, for a total of $11.9 million, or 1.2% of net losses and loss expenses payable. Asbestos reserves remained the same and environmental reserves increased $0.8 million from 2013.
MP-2014 improvement scale with indefinite improvement was used to project future mortality rates. The January 1, 2015 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, 2014, our share of the State Auto Group’s ABO and PBO was $260.1 million and $292.5 million, respectively. At December 31, 2014, STFC’s share of the defined benefit pension plan’s fair value of the assets was $205.1 million, which resulted in an underfunded status within our balance sheet of $87.4 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 $13.0 million in 2014.
For 2014, we recognized a federal income tax benefit of $80.6 million compared to federal income tax expense of $0.5 million for 2013 and a federal income tax benefit of $0.1 million for 2012. The income tax benefit in 2014 was primarily due to the reversal of our deferred tax asset valuation allowance, which resulted in an income tax benefit of $82.6 million.
Deferred income tax assets and liabilities represent the tax effect of the differences between the financial statement carrying value of existing assets and liabilities and their respective tax bases. During 2011, we experienced a net loss driven by the magnitude
of record level catastrophe storm losses in the second quarter that significantly exceeded our projections. We considered both positive and negative evidence and concluded that a valuation allowance should be established.
The following table sets forth the components of our federal income tax expense for the years ended December 31, 2014 and 2013:
See Note 8, “Federal Income Taxes,” to our consolidated financial statements included in Item 8 of this Form 10-K for further disclosures regarding our income tax matters.
In our opinion, State Auto Financial Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2014 and 2013, and 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, 2014, and our report dated March 3, 2015, expressed an unqualified opinion thereon.
The following table sets forth net deferred acquisition costs for the years ended December 31, 2014, 2013 and 2012:
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 $23.8 million and $24.7 million at December 31, 2014 and 2013, respectively, has been established to cover the estimated ultimate cost to settle insured losses. The amounts are 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 materially from such estimates. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations (see Note 4). Anticipated salvage and subrogation is 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.
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, 2014 and 2013:
The following table sets forth the realized losses related to other-than-temporary impairments on the Company’s investment portfolio recognized for the years ended December 31, 2014, 2013 and 2012:
At December 31, 2014, State Auto P&C had fixed maturity securities, with a carrying value of approximately $85.0 million, that were pledged as collateral for the FHLB Loan (as defined in Note 7). In accordance with the terms of the FHLB Loan, State Auto P&C retains all rights regarding these securities, which are included in the "U.S. government agencies residential mortgage-backed securities" classification of the Company's fixed maturity securities portfolio.
Fixed maturities with fair values of approximately $8.8 million and $8.7 million were on deposit with insurance regulators as required by law at December 31, 2014 and 2013, respectively.
Transfers between levels may occur due to changes in the availability of market observable inputs. Transfers in and out of levels are reported as having occurred at the beginning of the quarter in which the transfer occurred. There were no transfers between levels during the years ended December 31, 2014 and 2013.
Included in other invested assets are two international funds (“the funds”) that invest in equity securities of foreign issuers and are managed by third party investment managers. The funds had a fair value of $72.9 million and $74.2 million at December 31, 2014 and 2013, respectively, which was determined using each fund’s net asset value. The Company employs procedures to assess the reasonableness of the fair value of the funds including obtaining and reviewing each fund’s audited financial statements. There are no unfunded commitments related to the funds. The Company may not sell its investment in the funds; however, the Company may redeem all or a portion of its investment in the funds at net asset value per share with the appropriate prior written notice. The funds are disclosed in Level 2 within the hierarchy due to the Company’s ability to redeem its investment in the funds at net asset value per share at the measurement date.
For assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3), the following tables set forth a reconciliation of the beginning and ending balances for 2014 and 2013, separately for each major category of assets:
The Company recorded adverse development related to prior years' loss and loss expense reserves in 2014 of $45.1 million, compared to favorable development for 2013 and 2012 of $21.2 million and $16.9 million, respectively. Favorable development of unallocated loss adjustment expenses contributed approximately $12.5 million of the 2014 development, while favorable development of catastrophe reserves was approximately $5.2 million, which was slightly lower than 2013. The personal and business insurance segments non-catastrophe loss and ALAE reserves accounted for $23.1 million of favorable development. The business insurance segment contributed $16.7 million of favorable development, driven by the other & product liability and commercial auto lines with $11.9 million and $5.3 million of favorable development, respectively. The favorable development in these lines was driven by the emergence of lower than anticipated claim severity from accident years 2012 and prior. The personal insurance segment contributed $6.4 million of favorable development, primarily from accident year 2013. Somewhat offsetting the favorable development was adverse development of $2.1 million in the commercial multi-peril line, driven by third party liability coverage. The specialty insurance segment non-catastrophe loss and ALAE reserves accounted for $85.9 million of adverse development, driven by RED reserve strengthening of $96.7 million related to a large restaurant program and a commercial auto trucking program. Somewhat offsetting the unfavorable development was favorable development of $5.7 million in the Workers' compensation unit, $3.9 million in the E&S property unit and $2.1 million in the E&S casualty unit. These results were driven by better than anticipated severity emerging from the 2012 and 2013 accident years.
Favorable development on prior years loss adjustment expense reserves contributed approximately $6.3 million of the 2012 development, while $10.4 million was attributable to favorable development on catastrophe reserves from accident year 2011. The personal and business insurance segments' non-catastrophe loss and ALAE reserves accounted for $28.0 million of favorable development related to the latest three accident years, primarily in the personal auto liability, other & product liability, and fire & allied lines with $10.5 million, $9.4 million and $5.1 million of favorable development, respectively. The favorable development in these lines was driven by emergence of lower than anticipated claim severity. The specialty insurance segment non-catastrophe
The following table sets forth the effect of the Company’s external reinsurance on its balance sheets at December 31, 2014 and 2013, prior to the reinsurance transaction with State Auto Mutual under the Pooling Arrangement, as discussed in Note 6a:
The insurance subsidiaries of State Auto Financial, including State Auto Property & Casualty Insurance Company (“State Auto P&C”), Milbank Insurance Company and State Auto Insurance Company of Ohio (collectively referred to as the “STFC Pooled Companies”) participate in a quota share reinsurance pooling arrangement (“the Pooling Arrangement”) with State Auto Mutual which includes Meridian Citizens Mutual Insurance Company (merged with State Auto Mutual at the close of business on July 2, 2014), and its subsidiaries and affiliates, State Auto Insurance Company of Wisconsin, Meridian Security Insurance Company, Patrons Mutual Insurance Company of Connecticut, Rockhill Insurance Company, Plaza Insurance Company, American Compensation Insurance Company and Bloomington Compensation Insurance Company, (collectively referred to as the “Mutual Pooled Companies”). State Auto P&C, Milbank and SA Ohio are referred to as the “STFC Pooled Companies,” State Auto Mutual, SA Wisconsin, Meridian Security and Patrons Mutual are referred to as the “Mutual Pooled Companies,” and RIC, Plaza, American Compensation and Bloomington Compensation are referred to as the "Rockhill Insurers." The STFC Pooled Companies, the Mutual Pooled Companies and the Rockhill Insurers are collectively referred to as the “State Auto Group.”
On July 11, 2013, State Auto Financial's subsidiary, State Auto P&C, borrowed $85.0 million (the "FHLB Loan") from the FHLB. The FHLB Loan is a 20-year term loan and is callable after three years with no prepayment penalty thereafter. The 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 5.03%. The FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C.
As of December 31, 2014, State Auto P&C had not made any borrowings and both State Auto P&C and State Auto Financial were in compliance with all covenants and requirements of the SPC Credit Facility.
The following table sets forth the reconciliation between actual federal income tax (benefit) expense and the amount computed at the indicated statutory rate for the years ended December 31, 2014, 2013 and 2012:
During 2011, the Company determined that a valuation allowance should be established due to the magnitude of the catastrophe losses from unprecedented storms experienced industry wide. As part of its assessment of the appropriateness of the deferred tax asset valuation allowance at December 31, 2014, management considered the following positive evidence: (i) three-year cumulative pre-tax income of $98.7 million, (ii) three consecutive years of pre-tax income, (iii) the expiration of the HO QS Arrangement under which we ceded 75% of our homeowners line underwriting results to the participating reinsurers, (iv) the actions the Company took (including reserve strengthening and entering into an ADC reinsurance agreement protecting against the risk of further adverse development for one of the programs) with respect to the terminated RED program business, which significantly reduced the Company's reported financial results since 2011, (v) more adequate pricing, which has contributed to improved underwriting margins, and (vi) profitable growth within the specialty insurance segment, excluding the terminated RED program business. Management concluded that this positive evidence outweighed available negative evidence and further concluded that a valuation allowance against the Company's net deferred tax assets was no longer appropriate. As a result, the
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, 2014 and 2013:
The following table sets forth the Company’s share of the amounts included in accumulated other comprehensive income (loss) that have not been recognized in net periodic cost at December 31, 2014 and 2013:
The following table sets forth the Company’s share of amortization expected to be recognized for the year ending December 31, 2015:
The postretirement plan’s gross benefit payments for 2014 were $1.2 million, including the prescription drug benefits. The postretirement plan’s subsidy related to Medicare Prescription Drug Improvement and Modernization Act of 2003 was $0.3 million for 2014 and estimates future annual subsidies to be approximately $0.2 million.
The following table sets forth the weighted average assumptions used to determine the benefit plans’ net periodic cost for the years ended December 31, 2014, 2013 and 2012:
The pension plan's investment policy objective is to preserve the investment principal while generating income and appreciation in fair value to meet the pension plan's obligations. The pension plan's investment strategy and risk tolerance is balanced between meeting cash obligation requirements and a long-term relatively high risk tolerance takes into account the predictable cash requirements, nature of the plan’s liabilities and the plan’s long term time horizon. Since the nature and timing of the benefit plans’ liabilities and cash requirements are predictable, the liquidity requirements are somewhat moderate. One of the goals of diversifying the benefit plans’ portfolio among different asset classes is the elimination of concentration of risk in one asset class. Management also has investment policy guidelines with respect to limiting the ownership in any single debt or equity issuer. The international fund investments are also composed of numerous securities to reduce our exposure to a single issuer.
The actuarially prepared funding amount to the pension plan ranges from the minimum amount the Company would be required to contribute to the maximum amount that would be deductible for tax purposes. Contributed amounts in excess of the minimum amounts are deemed voluntary. Amounts in excess of the maximum amount would be subject to an excise tax and may not be deductible for tax purposes. The Company’s share of expected contributions during 2015 is approximately $13.0 million.
The following tables set forth the reclassifications out of accumulated other comprehensive income, by component, to the Company’s consolidated statement of income for the years ended December 31, 2014, 2013 and 2012:
The Company's 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. As of December 31, 2014, each of the Company's insurance subsidiaries maintained adjusted statutory surplus in excess of 450% of the authorized control level RBC.
The following table sets forth the status of the Company’s non-vested and vested restricted shares and changes for the years ended December 31, 2014, 2013 and 2012:
The Company also has a broad-based employee stock purchase plan under which employees of the Company may choose at two different specified time intervals each year to have up to 6% of their annual base earnings withheld to purchase the Company’s common shares. The purchase price of the common shares is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 3.4 million common shares under this plan. As of December 31, 2014, a total of 3.2 million common shares have been purchased under this plan. This plan remains in effect until terminated by the Board of Directors.
for the RSU awards begins on the date of grant and expires on the date the outside director retires from or otherwise terminates service as a director of the Company. During the restricted period, outside directors are credited with dividends, equivalent in value to those declared and paid on the Company’s common shares, on all RSU awards granted to them. At the end of the restricted period, outside directors receive distributions of their RSU awards either (i) in a single lump sum payment, or (ii) in annual installment payments over a five- or ten-year period, as previously elected by the outside director. The administrative committee for the RSU Plan (currently the Company’s Compensation Committee) retains the right to increase the annual number of RSU awards granted to each outside director to as many as 5,000 or to decrease such annual number to not less than 500, without seeking shareholder approval, if such increase or decrease is deemed appropriate by the administrative committee to maintain director compensation at appropriate levels. The RSU Plan automatically terminates on May 31, 2015. The Company accounts for the RSU Plan as a liability plan. There were 25,960 RSUs, 33,712 RSUs, and 26,480 RSUs granted in 2014, 2013 and 2012, respectively.
The following table sets forth the Company’s total stock option activity and related information for these plans for the years ended December 31, 2014, 2013 and 2012:
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, 2014, 2013 and 2012, the total intrinsic value of stock options exercised was $0.5 million, $0.5 million and $0 million, respectively. The tax benefit for tax deductions from share-based awards totaled $0 for the years ended December 31, 2014, 2013 and 2012, respectively.
Aggregate intrinsic value for total options outstanding at December 31, 2014 was $17.2 million. Aggregate intrinsic value for total options exercisable at December 31, 2014 was $8.4 million.
The following table sets forth the compilation of basic and diluted net earnings per common share for the years ended December 31, 2014, 2013 and 2012:
The Company has four reportable segments: personal insurance, business insurance, specialty insurance (the “insurance segments”) and investment operations. The insurance segments are business units managed separately because of the differences in the type of customers they serve or products they provide or services they offer. The personal insurance segment provides primarily personal automobile and homeowners to the personal insurance market. The business insurance segment provides primarily commercial automobile, commercial multi-peril, fire & allied and general liability insurance covering small-to-medium sized commercial exposures in the business insurance market. The specialty insurance segment provides commercial coverages that require specialized product underwriting, claims handling or risk management services through a distribution channel of retail agents and wholesale brokers, which may include program administrators and other specialty sources. The investment operations segment, managed by Stateco, provides investment services.
As of January 1, 2013 our units within the specialty insurance segment changed from RED, Rockhill and Workers’ Compensation to E&S property, E&S casualty, Programs and Workers’ compensation. This change did not have any impact on segment reporting.
The following table sets forth financial information regarding the Company’s reportable segments at December 31, 2014 and 2013:
The following tables set forth quarterly financial data for 2014 and 2013:
The following describes a pending legal proceeding in which the Company is a party:
In April 2013, a putative class action lawsuit (Schumacher vs. State Automobile Mutual Insurance Company, et al.) was filed against State Auto Mutual, State Auto Financial and State Auto P&C in Federal District Court in Ohio. Plaintiffs claim that in connection with the homeowners policies of various State Auto companies, the coverage limits and premiums were improperly increased as a result of an insurance to value (“ITV”) program and Plaintiffs allege that they purchased coverage in excess of that which was necessary to insure them in the event of loss. Plaintiffs’ claims include breach of good faith and fair dealing, negligent misrepresentation and fraud, violation of the Ohio Deceptive Trade Practices Act, and fraudulent inducement. Plaintiffs sought compensatory and punitive damages to be determined by the court, as well as class certification. On February 2, 2015, the Court struck the class allegations, and on February 13, 2015, the Court stayed the proceedings to allow the parties to engage in settlement discussions.
The Company is involved in other lawsuits in the ordinary course of its business arising out of or otherwise related to its insurance policies. Additionally, from time to time the Company may be involved in lawsuits, including class actions, in the ordinary course of business but not arising out of or otherwise related to its insurance policies. These lawsuits are in various stages of development. The Company generally will contest these matters vigorously but may pursue settlement if appropriate. Based on currently available information, the Company does not believe it is reasonably possible that any such lawsuit or related lawsuits will be material to its results of operations or have a material adverse effect on its consolidated financial position or cash flows.