State Auto Financial’s principal subsidiaries are State Auto P&C, Milbank, Farmers and SA Ohio, each of which is a property and casualty insurance company, and Stateco, which provides investment management services to affiliated insurance companies.
Prior to January 1, 2011, we operated our business in three reportable segments: personal insurance, business insurance (collectively the “insurance segments” or “our insurance segments”) and investment operations. The three segments reflected the manner in which we managed our business and reported our results internally to our principal operating decision makers. The personal insurance segment provides primarily personal auto and homeowners to the personal insurance market. The business insurance segment provides primarily commercial auto, commercial multi-peril, fire & allied lines, other & product liability and workers’ compensation insurance to small-to-medium sized businesses within the commercial insurance market. The investment operations segment, managed by Stateco, provides investment services for our invested assets. In 2010, the State Auto Group began writing new commercial specialty business through RED, which allowed us to offer insurance coverages in the program and alternative risk markets for business products such as general liability, commercial auto, workers’ compensation and property. In 2010, the financial results of business written through RED were included in our business insurance segment results.
Our growth in 2008 and 2009 outperformed the industry, which generally contracted, and based on preliminary data now available to us, we believe our premium growth again outperformed the industry in 2010. We consider rational growth to be premium growth that matches or exceeds the premium growth rates of designated peer property and casualty insurance companies, as well as the property and casualty insurance industry as a whole, while still considering underwriting profit, risk management, and capital management.
We also seek growth in ways other than price. When we are faced with untenably low prices from our competition, our goal is to remain an attractive market to our insureds, retail agents and wholesale brokers by stressing the strengths we bring to the marketplace, such as our product offerings and innovation; underwriting criteria; quality of service to insureds, retail agents and wholesale brokers; relationships with our retail agents and wholesale brokers; prompt and fair claims handling and settlement; financial stability; and technology, making us a preferred business partner.
While organic growth in the standard business insurance market has been difficult, we are competing effectively in the personal lines market. Our retail agents are finding attractive sales opportunities for auto and homeowners business. In addition, because we are heavily cross-sold in personal lines and continue to experience strong retention, we are well positioned to benefit from this trend.
Pricing the property and casualty insurance product has become a sophisticated science, and to that end we have made significant investment in our actuarial and financial teams, adding depth and talent to these important functions. We are dedicated to cost-based pricing, with each line of business priced to generate a profit. We implement periodic rate changes throughout our states.
Changes currently underway in our claim organization are expected to positively impact indemnity payout, improve service and reduce costs. We have already reduced salvage yard vendor fees through negotiation with vendors. A new auto physical damage unit has significantly reduced independent adjuster expenses and improved indemnity benefits on auto physical damage claims. The expansion of our house counsel operation not only contributes to a lower loss ratio, but also improves service.
The objective of our enterprise risk management program is to help identify, understand, communicate and assure satisfactory mitigation or exploitation of risks associated with our business. Numerous risks are addressed, including a variety of underwriting, operational, market, credit and strategic risks. All of our business units play important roles in risk identification and in developing and executing risk mitigation strategies.
or in areas where the catastrophe risk is uncorrelated to our existing footprints, are effective approaches to spread risk. Our merger and acquisition strategy also contributes to spread of risk. For example, the RED, Rockhill and RTW operations provide an additional measure of product and geographical diversification.
Catastrophe exposure management focuses on the perils of hurricane, earthquake, severe thunderstorms, tornadoes and hail. Computer modeling is used to project estimates of potential losses from these events. Such modeling is an important element of designing our property reinsurance programs. The results of hurricane modeling affect our risk appetites across six relevant geographic zones: Texas, the Gulf States, Florida, the Southeast, the Mid-Atlantic, and the Northeast. Modeling for severe thunderstorms, tornadoes and hail has helped us identify areas of Midwest property concentrations for reduction or constraint, as well as areas with lower and/or uncorrelated exposure to target for growth.
Our disciplined investment strategy emphasizes the quality of our investment grade fixed maturity portfolio and an internally managed, diversified equity portfolio. We have diversified our equity portfolio, utilizing outside managers to invest in U.S. small-cap equities and international equity funds. This was designed to achieve greater total return over time with reduced volatility. We suffered investment losses in the broad-based and dramatic market decline in 2008, but we have since more than recovered those losses in the healthier markets of 2009 and 2010. In our opinion, a diversified portfolio heavily weighted in investment grade bonds, coupled with a diversified equity portfolio, is the right strategy for most market cycles.
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 equity securities and other invested assets for OTTI: (1) the length of time and/or the significance of decline below cost; (2) our ability and intent to hold these securities through their recovery periods; (3) the current financial condition of the issuer and its future business prospects; and (4) the ability of the market value to recover to cost in the near term. We recognize OTTI charges on our externally managed small-cap equity portfolio and a segment of our large-cap portfolio, as we are unable to make the assertion regarding our intent to hold these securities that are currently valued below cost until recovery in the near term. When an equity security or other invested asset has been determined to have a decline in fair value that is other-than-temporary, we adjust the cost basis of the security to fair value. This results in a charge to earnings as a realized loss, which is not reversed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other-than-temporary, are included in accumulated other comprehensive income (loss).
Acquisition costs, consisting of commissions, premium taxes and certain underwriting expenses relating to the production of property and casualty business, are deferred and amortized over the same period in which the related premiums are earned. The method followed for computing the acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premiums to be earned, losses and loss expenses expected to be incurred, and certain other costs expected to be incurred as premium is earned. Future changes in estimates, the most significant of which is expected losses and loss adjustment expenses, that indicate a reduction in expected future profitability may result in unrecoverable deferred acquisition costs. We have not recorded any significant changes in estimates for the years ended December 31, 2010, 2009 and 2008, respectively.
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
Least Square Loss Development Method: In the Least Squares Loss Development Method the statistical technique of least squares regression is applied to a triangle of reported loss ratios to project the ultimate loss ratio in each accident year. Using historical loss ratios puts the data for each time period on a more consistent exposure basis, because premium levels are generally correlated with insured exposures. A by-product of the regression function is an estimate of credibility for each stage of development. In cases where the regression parameters fall outside of a reasonable range, the projection defaults to the incurred loss method.
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, $904.7 million, the reserve increase of $20.6 million corresponds to an after-tax decrease of $13.4 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, $811.4 million, the $72.7 million reserve decrease would add $47.3 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.
An important assumption underlying the loss reserve estimation methods for the major casualty lines is that the loss cost trends implicitly built into the loss and ALAE patterns will continue into the future. To estimate the sensitivity of reserves to an unexpected change in inflation, projected calendar year payment patterns were applied to the December 31, 2010, other & product liability loss and ALAE reserve to generate estimated annual incremental loss and ALAE payments for each subsequent calendar year. Then, for purposes of sensitivity testing, an additional annual loss cost trend of 10% was added to the trend implicitly embedded in the estimated payment pattern, and revised incremental loss and ALAE payments were calculated. This type of inflationary increase could arise from a variety of sources including tort law changes, development of new medical procedures, social inflation, and other inflationary changes in costs beyond assumed levels.
The estimated cumulative impact that this additional, unexpected 10% increase in the loss cost trend would have on our results of operations over the lifetime of the underlying claims in other & product liability is an increase of $76.3 million on reserves, or a $49.6 million reduction to net income, assuming a tax rate of 35%. Inflation changes have much more impact on the longer tail commercial lines like other & product liability and workers’ compensation, and much less impact on the shorter tail personal lines’ reserves.
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, 2010 and 2009. The STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement for the years ended December 31, 2010 and 2009, respectively, has been reflected in the table below as assumed by STFC Pooled Companies.
The State Auto Group has a defined benefit pension plan and a postretirement health care plan covering substantially all employees hired prior to January 1, 2010 (collectively “the benefit plans”). Several factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the benefit plans. Key factors include assumptions about the expected rates of return on plan assets, discount rates, and health care cost trend rates. We consider market conditions, including changes in investment returns and interest rates, in making these assumptions. The actuarial assumptions used by us in determining benefit obligations may differ materially from actual results due to changing market and economic conditions, higher or lower turnover and retirement rates, or longer or shorter life spans of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect our financial position or results of operations.
The following table sets forth an illustration of variability with respect to the discount rate on our December 31, 2010 benefit obligation and expected net periodic benefit cost for the year ending December 31, 2011, along with the variability of the expected return on plan assets to our expected net periodic benefit cost for the year ending December 31, 2011. Holding all other assumptions constant, sensitivity to changes in any one of our key assumptions are as follows:
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 compensations level only, provides information about the obligation an employer would have if the plan were discontinued at the measurement date. At December 31, 2010, the ABO and PBO were $258.3 million and $282.8 million, respectively. At December 31, 2010, the fair value of the assets of our defined benefit pension plan was $219.6 million, which resulted in an underfunded status within our balance sheet of $63.2 million. On a cash flow basis, we target an annual contribution level that meets at least the targeted normal cost of the plan, as defined by ERISA. Currently, we expect to make a cash contribution to the pension plan up to $15.0 million in 2011.
Our unfunded status on our pension plan increased from $52.1 million at December 31, 2009, to $63.2 million at December 31, 2010. Primarily influencing this increase are unrecognized gains and losses arising from factors including a decrease in the discount rate and expected to actual demographic changes, such as retirement age, mortality, turnover, and rate of compensation increases. The cumulative unrecognized actuarial loss is systematically recognized as an increase in net periodic cost over the average future service period of active participants. Additional factors influencing this increase are as follows: (1) actual return on our plan assets was a gain of $24.0 million compared to an expected return of $17.3 million for a net decrease to our obligation and unrecognized actuarial loss of approximately $6.7 million; and (2) a $2.4 million curtailment gain which reduced our obligation and unrecognized actuarial loss.
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 pension and postretirement benefit plans.
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 basis. Deferred tax assets are evaluated periodically by management to determine if they are realizable, requiring us to make certain judgments and assumptions. In evaluating the ability to recover deferred tax assets, we consider all available evidence, including loss carryback potential, past operating results, existence of cumulative losses in the most recent years, projected performance of the business, future taxable income, including the ability to generate capital gains, and prudent and feasible tax planning strategies. If, based on available information, it is more likely than not that the deferred income tax asset will not be realized, then a valuation allowance must be established with a corresponding charge to net income and/or accumulated comprehensive income (loss). No valuation allowance was held by us at December 31, 2010.
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, losses and expenses from each of the remaining Pooled Companies and in turn cedes to each of the Pooled Companies a specified portion of premiums, losses and expenses based on each of the Pooled Companies’ respective pooling percentages. State Auto Mutual then retains the balance of the pooled business. The participation percentage for the STFC Pooled Companies has remained at 80% since 2001.
Added Beacon National to the pool with a participation percentage of 0.0%;
Included State Auto middle market business insurance written by State Auto Mutual and Meridian Security; and
Included voluntary assumed reinsurance from third parties unaffiliated with the Pooled Companies that was assumed on or after January 1, 2009 by State Auto Mutual.
In conjunction with the 2010 pooling changes, the STFC Pooled Companies received $3.7 million in cash from the Mutual Pooled Companies, for net insurance assets transferred on January 1, 2010. The following table sets forth the impact on our balance sheet at January 1, 2010, relating to the 2010 pooling changes:
domiciliary insurance departments. None of our Pooled Companies currently intends to terminate the Pooling Arrangement.
Our 2010 pre-tax income was $24.5 million compared to pre-tax losses of $12.8 million and $75.1 million in 2009 and 2008, respectively. Revenues increased to $1,355.1 million in 2010 from $1,256.9 million and $1,181.9 million in 2009 and 2008, respectively, while expenses increased to $1,330.6 million in 2010 from $1,269.7 million and $1,257.0 million in 2009 and 2008, respectively. The following highlights significant factors that impacted 2010 results as compared to 2009 and 2008:
Net realized gains on investments, excluding OTTI, were $18.5 million in 2010, compared to $3.8 million and $2.9 million in 2009 and 2008, respectively. Included in the 2010 net realized gains on investments was $3.9 million related to the sale of our nonstandard automobile subsidiary, SA National.
On December 31, 2010, we sold SA National to a third party for $14.0 million plus a contingent earn-out. In deciding to sell SA National, we considered those businesses core to our long-term strategy and concluded that the nonstandard auto market was no longer a strategic fit for us. In 2010, SA National wrote approximately $37.0 million in direct written premiums through our independent agents in 21 states, with 80% (or approximately $30.0 million) retained by us under our Pooling Arrangement. We will continue to write SA National renewal business until such business is transitioned from our system to the buyer’s system, which should occur during the second quarter of 2011. See “Reinsurance Arrangements” section included in this Item 7.
termination benefits. SAP requires us to estimate and immediately recognize the entire estimated costs related to severance, while GAAP requires similar estimated costs to be recognized ratably over the remaining service period of the employees impacted. The write-off in 2009 related to the North Carolina Beach Plan was included in the other expenses line item in the accompanying consolidated statements of income, and was therefore not included in the computation of the GAAP expense ratio.
CustomFit SM, our standard auto product, provides additional quoting opportunities by allowing our agents to tailor policies to fit the insured’s needs. Further expanding our product portfolio, in the fourth quarter of 2009 we introduced our new homeowners CustomFit product which employs predictive modeling and by-peril rating, allowing us to target business with expected long-term profit potential. Compared to the traditional method of using fire as the main basis for rating, by-peril rating uses multiple perils (such as wind, hail and water) in the rating process designed to provide a more accurate and adequate rate. Our CustomFit homeowners product has now been deployed in eight states and future deployment is planned for our remaining states.
Over the years, we have focused on improved technology interfaces with our agents and policyholders. This has included enhancing our personal lines sale portal netXpress SM for our agents, including increasing the number of integration points to our rating engine thus eliminating duplicate entry for agents. These actions have resulted in increased levels of quote activity by our agents. For our policyholders, we have increased the number of electronic bill pay options, including 24 x 7 online capability, along with introduction of claim reporting technology.
Homeowners net written premiums for the year ended December 31, 2010 increased 9.6% compared to the same 2009 period. Approximately two-thirds of the growth was attributable to rate increases, while expansion of our business in Texas, Colorado, Arizona and Connecticut contributed to the balance. Net written premiums for the year ended December 31, 2009 increased 11.6% compared to the same 2008 period, with one-third of this premium growth from rate increases, one-third from our expansion into Texas, Colorado, Arizona and Connecticut, and the remaining one-third from expansion in our other states. We continue to aggressively address our rate needs in this line of business, seeking higher rates in 2011. In addition, we intend to continue a state-by-state deployment of our CustomFit homeowners product throughout 2011.
Net written premiums for the business insurance segment for the year ended December 31, 2010 increased 15.5% compared to the same 2009 period, with business written through RED accounting for 19.1 points of this premium growth or $83.2 million of new business written premium opportunities ($52.0 million of commercial auto, $28.4 million of commercial multi-peril, $0.3 million of fire & allied lines and $2.5 million of other & product liability), with our historic mainline business declining 3.6%. Net written premiums for the year ended December 31, 2009 decreased 5.5% compared to the same 2008 period. Business insurance continues to be
We have also expanded the eligibility of our businessowners product to facilitate businesses with greater liability exposures, such as artisan contractors, auto service garages, manufacturers and restaurants. While we regularly insure these types of businesses through other insurance products, offering them in our businessowners program leverages our bizXpress technology, simplifies agents’ rating and submission processes, and offers broader base coverages for these types of risks. In 2010, we completed the implementation of our enhanced businessowners product, which has been introduced into 28 states.
Losses and loss expenses for a calendar year represent the combined estimated ultimate liability for claims occurring in the current calendar year along with any change in estimated ultimate liability for claims occurring in prior years. The following table sets forth the provision for losses and loss expenses for those claims occurring in the current and prior years, along with the GAAP loss and LAE ratio for the years ended December 31, 2010, 2009 and 2008:
In 2009, loss and loss expenses attributable to prior years totaled a decrease of $56.2 million, or favorable development, in the estimated ultimate liability for prior years’ claims. The following table sets forth a tabular presentation of the favorable development by accident year for the year ended December 31, 2009:
Non-catastrophe reserves for the auto liability lines and other & product liability developed lower than anticipated. Standard, nonstandard and commercial auto liability reserves developed $9.5 million lower and other & product liability developed $8.3 million lower than anticipated. This favorable development, which was primarily associated with the 2008 accident year, was driven by lower than anticipated tabular loss severity, as well as lower than anticipated loss frequency for other & product liability.
In 2008, loss and loss expenses attributable to prior years totaled a decrease of $27.3 million, or favorable development, in the estimated ultimate liability for prior years’ claims. The following table sets forth a tabular presentation of the favorable development by accident year for the year ended December 31, 2008:
Catastrophe losses for 2010 totaled $99.0 million (7.9 loss ratio points) compared to $90.3 million (7.7 loss ratio points) for 2009 and $156.1 million (13.9 loss ratio points) for 2008. During 2010, we were impacted by losses from thirty of the thirty-three storms that were classified as numbered catastrophes by PCS as compared to twenty-seven of the twenty-eight PCS classified storms in 2009. In 2008, we were impacted by losses from thirty-five of the thirty-seven PCS classified storms, one of which was Hurricane Ike. The losses from these catastrophes have had a significant impact on both our personal and business insurance property lines.
The following tables set forth our insurance segments’ SAP loss and LAE ratios by major lines of business with the catastrophe and non-catastrophe impact shown separately for the years ended December 31, 2010, 2009 and 2008:
In the personal insurance segment, the overall non-cat loss ratio for the year ended December 31, 2010 improved 3.8 points compared to the same 2009 period. The non-cat loss ratios for standard auto improved 2.6 points, and for homeowners improved 6.4 points, compared to the same 2009 period. The impact of rate increases contributed significantly to the improvement in standard auto. Homeowners also improved relative to 2009, benefitting from rate actions and implementation of mandatory wind and hail deductibles in many of our operating states prone to non-cat weather related losses. In homeowners we continue to file rate increases in the high single digit to low double digit range.
In the business insurance segment, the overall non-cat loss ratio for the year ended December 31, 2010 increased 3.1 points compared to the same 2009 period. The commercial auto non-cat loss ratio increased 6.4 points, principally driven by an increase in the number of large losses which impacted both the current and prior accident years. The other & product liability non-cat loss ratio increased by 18.1 points principally driven by an increase in large losses from prior accident years. Intense competition in the business insurance segment continues to impact our ability to implement price increases where needed.
The business insurance segment overall non-cat loss ratio for 2009 was comparable to 2008. However, commercial auto and commercial multi-peril loss ratios decreased primarily due to a reduction in the number and size of large losses when compared to 2008. The increase in the fire & allied lines loss ratio was the result of more large fires in 2009. The increase in other & product liability was due primarily to an increase in the estimate of internal claim handling expenses.
The following table sets forth loss and loss expenses payable by major line of business at December 31, 2010, 2009 and 2008:
Our GAAP expense ratio was 33.8% in 2010 compared to 34.1% and 34.6% in 2009 and 2008, respectively.
In the second quarter of 2009, we initiated a plan to reorganize our field and claims operations. We recognized restructuring costs totaling $2.3 million during the year ended December 31, 2010, which increased our GAAP loss and LAE and expense ratios by 0.1 points each. We recognized restructuring costs totaling $4.8 million during the year ended December 31, 2009, which increased our GAAP loss and LAE and expense ratios by 0.2 points each. See Note 9, “Restructuring Costs” to our consolidated financial statements included in Item 8 of this Form 10-K.
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 and large-cap equities and outside investment managers to invest in small-cap equities and international funds. The Investment Committee (the “Committee”) of the Board of Directors establishes the investment policies to be followed by Stateco. Our primary investment objectives are to generate income, preserve capital and maintain adequate liquidity for the payment of claims and expenses. Our current investment strategy does not rely on the use of derivative financial instruments.
The following table sets forth the composition of our investment portfolio at carrying value at December 31, 2010 and 2009:
The following table sets forth the amortized cost and fair value of available-for-sale fixed maturities by contractual maturity at December 31, 2010:
At December 31, 2010, our equity portfolio consisted of approximately 65 different large-cap stocks and 75 small-cap stocks. The largest single position was 2.7% of the equity portfolio based on fair value, and the top ten positions accounted for 20.8% of the equity portfolio. At December 31, 2009, our equity portfolio consisted of approximately 67 different large-cap stocks and 76 small-cap stocks. The largest single position was 2.9% of the equity portfolio based on fair value and the top ten positions account for 22.6% of the equity portfolio. Since our equity portfolio consists primarily of large-cap value-oriented stocks, with a small allocation to small-cap equities, when large-cap stocks and/or value-oriented stocks perform well our equity portfolio typically performs well compared to benchmarks. Conversely, when growth stocks outperform value and/or small- to mid-cap stocks outperform large-cap stocks, our equity portfolio does not perform as well compared to benchmarks.
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 5.01 and 4.99 as of December 31, 2010 and 2009, 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, 2010:
We believe that the fixed maturity portfolio’s exposure to credit risk is minimal as approximately 91.8% of the bonds we own are rated AA or better. We do not intend to change our investment policy on 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 ensure adequate cash flow to meet claims as they are presented. We also manage liquidity risk by maintaining sufficient cash balances, owning some agency and U.S. Treasury securities at all times, purchasing bonds of major issuers, and purchasing bonds that are part of a medium or large issue. The fixed maturity portfolio does not have any direct exposure to either exchange rate risk or commodity risk. We do not rely on the use of derivative financial instruments. To provide us greater flexibility in order to manage our market risk exposures, we categorize our fixed maturities as available-for-sale. We do not maintain a trading portfolio.
The following table sets forth the credit ratings of our municipal securities, excluding Credit Enhancements, based on ratings by nationally recognized rating agencies at December 31, 2010:
* Our AAA rating category includes securities which have been either pre-funded or escrowed to maturity.
The following table sets forth the composition of the insurers providing Credit Enhancements, along with the corresponding underlying credit rating of the issuer of the security, at December 31, 2010:
During 2010, the level of call activity in our fixed maturity portfolio increased when compared to 2009 and 2008. The proceeds from the call, maturity or sale of securities within our Muni Portfolio, which are long duration, tax exempt securities, have been reinvested into shorter duration, taxable fixed income securities with lower rates of return.
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 large-cap equity portfolio does 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.
At December 31, 2010, we have two international funds, Fund 1 and Fund 2, which are included in other invested assets available-for-sale. Fund 1 and Fund 2 had betas of 0.71 and 0.90, respectively, using the MSCI EAFE Index as a benchmark. Beta estimates the degree the portfolio’s price will fluctuate based on a given movement in the index. The following tables set forth what changes might occur in the values of Funds 1 and 2 given a change in the MSCI EAFE Index at December 31, 2010:
To offset the decline in interest earned on our fixed maturity securities and to improve yield and cash flows, in 2010 we began to hold more high dividend paying equities when compared to 2009. In 2009, we held fewer large-cap dividend paying stocks than in 2008, and dividend payouts were reduced on certain equity holdings.
sold fixed maturities to shorten the duration of our investment portfolio, which resulted in realized gains on certain municipal bonds that were replaced with taxable bonds.
Based upon our review of our investment portfolio at December 31, 2010, 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, 2010:
The following table sets forth our unrealized holding gains (losses) by investment type, net of deferred tax that was included as a component of accumulated comprehensive income (loss) at December 31, 2010 and 2009, and the change in unrealized holding gains (losses), net of deferred tax, for the year ended December 31, 2010:
As of December 31, 2010, Level 3 assets as a percentage of total assets were 0.1%, which we have determined to be insignificant.
For the year ended December 31, 2010, federal income tax expense was less than $0.1 million compared to a tax (benefit) of $(23.0) million and $(44.0) million for the same 2009 and 2008 periods, respectively. The effective tax rate for 2010 of 0.1% differs from the statutory rate of 35% principally because of tax exempt investment income. In addition, in 2010 we incurred a one-time tax charge of $4.5 million related to the enactment of the Patient Protection and Affordable Care Act. This legislation eliminated the tax benefit associated with Medicare Part D subsidies we receive for providing qualifying prescription drug coverage to retirees.
See Note 8, “Federal Income Taxes” to our consolidated financial statements included in Item 8 of this Form 10-K for a reconciliation between our actual federal income tax expense (benefit) and the amount computed at the indicated statutory rate for the years ended December 31, 2010, 2009 and 2008.
Liquidity refers to our ability to generate adequate amounts of cash to meet our short- and long-term needs. Our primary sources of cash are premiums, investment income, investment sales and the maturity of fixed income security investments. The significant outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt and investment purchases. The cash outflows may vary due to uncertainties regarding settlement of large losses or catastrophe events. As a result, we continually monitor our investment and reinsurance programs to ensure they are appropriately structured to enable the insurance subsidiaries to meet anticipated short- and long-term cash requirements without the need to sell investments to meet fluctuations in claim payments.
The State Auto Group’s reliance on ceded reinsurance is not significant in comparison to the State Auto Group’s total statutory surplus or our total financial position. To minimize the risk of reinsurer default, the State Auto Group cedes only to third party reinsurers who are rated A- or better by A.M. Best and also utilizes both domestic and international markets to diversify its credit risk. We utilize reinsurance to limit our loss exposure and contribute to our liquidity and capital position. For a discussion of our reinsurance arrangements, see “Reinsurance Arrangements” included in this Item 7.
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 at losses. This action was not necessary in 2010, 2009 or 2008 despite the increased level of catastrophe losses.
Net cash provided by operating activities was $131.4 million, $110.5 million and $183.5 million for 2010, 2009 and 2008, respectively. Net cash from operations will vary from period to period if there are significant changes in underwriting results, primarily a combination of the level of premiums written and loss and loss expenses paid, changes in cash flows from investment income or federal income tax activity. Included in 2010 and 2008 operational cash activity are cash inflows of $3.7 million and $92.0 million, respectively, due to pooling changes. 2010 and 2008 reflect cash outflows of $6.2 million and $18.2 million, respectively, related to federal income tax activity, while 2009 recorded tax receipts of $38.1 million. While premium receipt levels between years increased, losses paid on catastrophes fluctuated significantly between years, in particular with respect to 2009. Approximately one-third of the catastrophe losses in 2008, primarily Hurricane Ike, occurred in the last of half of the year, where settlement on much of this claim activity with State Auto Mutual did not occur until 2009.
During 2010, 2009 and 2008, as permitted by regulations of the Internal Revenue Service, we made cash contributions of $13.0 million, $15.0 million and $12.0 million, respectively, to our defined benefit pension plan on behalf of our employees. The actuarially determined contribution to our defined benefit pension plan ranges from the minimum amount we would be required to contribute to the maximum amount that would be tax deductible. Amounts contributed in excess of the minimum are deemed voluntary while amounts in excess of the maximum would be subject to an excise tax and may not be deductible for tax purposes. Amounts paid in each of these three years were within the minimum and maximum funding amounts that would be deductible for tax purposes. The actuarially determined funding amount to the plan is generally not determined until the second quarter with respect to the contribution year, though we currently expect to make a minimum cash contribution to our defined benefit pension plan up to $15.0 million during 2011. For a further discussion regarding our defined benefit pension plan, see “Critical Accounting Policies - Pension and Postretirement Benefit Obligations” included in this Item 7.
In 2010, we had a cash outflow of $7.5 million related to the sale of SA National on December 31, 2010. This amount approximated SA National’s cash position on that date. We received net cash inflows of $13.2 million in early January 2011 related to the sale of SA National.
Our financing activities for 2010, 2009 and 2008 produced net cash outflows of $20.8 million, $20.5 million, and $52.4 million, respectively. The following contributed to the fluctuations between those years:
Cash used to repurchase common shares under our stock repurchase program was $33.2 million in 2008. No shares were repurchased 2009. This repurchase program ended in 2009. See “Other Capital Transactions” below.
Dividends paid to shareholders totaled $24.0 million, $23.8 million and $23.9 million for 2010, 2009 and 2008, respectively. Dividends paid per common share were $0.60 in 2010, 2009 and 2008.
During 2010, SA National and Stateco paid dividends of $56.4 million and $5.0 million, respectively, to State Auto Financial, and State Auto Financial made a capital contribution of $21.0 million to State Auto P&C. The SA National dividend was considered extraordinary for regulatory purposes.
State Auto Financial has a credit facility (the “Credit Facility”) with a syndicate of financial institutions. The Credit Facility provides for a $100.0 million unsecured revolving credit facility maturing in July 2012. The Credit Facility is available for general corporate purposes. The Credit Facility provides for interest-only payments during its term, with principal and interest due in full at maturity. Interest is based on LIBOR or a base
rate plus a calculated margin amount. The Credit Facility includes certain covenants, including financial covenants that require State Auto Financial to maintain a minimum net worth and not exceed a certain debt to capitalization ratio. As of December 31, 2010, State Auto Financial had not made any borrowings and was in compliance with all covenants related to the Credit Facility.
During 2010, members of the State Auto Group also maintained a CAT Aggregate Agreement. The agreement provided reinsurance coverage on an annual basis for certain qualifying catastrophic events, including certain events falling below the $55.0 million retention under the property catastrophe excess of loss reinsurance agreement discussed in the preceding paragraph. Events covered by the Catastrophe Aggregate Agreement would need to be PCS numbered catastrophes, excluding earthquakes and named storms such as hurricanes and tropical storms. Individual occurrences were capped at $55.0 million and were subject to a $5.0 million franchise deductible, meaning occurrences producing losses totaling less than $5.0 million were excluded. Subject to these limitations, qualifying losses from individual occurrences were then aggregated over the course of the reinsurance term, January 1, 2010 through December 31, 2010. On an aggregate basis the members of the State Auto Group combined retained the first $90.0 million of covered loss, with a 25% co-participation on the next $30.0 million of covered loss. The reinsurer was responsible for 75% of the excess over $90.0 million up to $120.0 million of covered loss on an aggregate basis. This agreement was not renewed for 2011.
With the introduction of the Rockhill Insurers into our Pooling Arrangement beginning January 1, 2011, we maintain certain reinsurance agreements to provide protection tailored to the specialized risks written through our Rockhill specialty insurance unit.
For certain casualty lines, we have a consolidated casualty treaty whereby we retain the first $0.5 million of covered loss and the reinsurers are responsible for 95% of the excess over $0.5 million up to $6.0 million per risk. On certain property lines, we maintain a quota share agreement whereby we retain 25% of each loss, per occurrence on all property risks, up to a $12.5 million and the reinsurers are responsible for 75% of each loss up to $12.5 million.
Our Rockhill specialty insurance unit maintains a property catastrophe excess of loss reinsurance agreement covering catastrophe related events affecting at least two risks. Additionally, we retain the first $5.0 million of catastrophe loss, each occurrence, and the reinsurers are responsible for 100% of the excess over $5.0 million up to $80.0 million of covered loss, each occurrence.
Lease and other purchase obligations of State Auto Mutual are allocated to us through the Pooling Arrangement.
At December 31, 2010, 2009 and 2008, each of our insurance subsidiaries was in compliance with statutory requirements relating to capital adequacy.
industry as the “IRIS” ratios. A “defined range” of results for each ratio has been established by the NAIC for solvency monitoring. While management utilizes each of these IRIS ratios in monitoring our insurance companies’ operating performance on a statutory accounting basis (each of our insurance subsidiaries operates within the defined range for the other measures), the net premiums written to surplus or leverage ratio is monitored to ensure that each of our insurance subsidiaries continue to operate within the “defined range” of 3.0 to 1.0. The higher the leverage ratio, the more risk a company bears in relation to statutory surplus available to absorb losses. In considering this range, management also considers the distribution of net premiums between property and liability lines of business. A company with a larger portion of net premiums from liability lines should generally maintain a lower leverage ratio.
Table excludes the one-time impact on net written premiums of $1.4 million and $53.6 million that occurred in conjunction with the 2010 and 2008 pooling changes, respectively.
Our insurance subsidiaries pay dividends to State Auto Financial which in turn may be used by State Auto Financial to pay dividends to stockholders or to make principal and interest payments on debt. Individual states limit the amount of dividends that our insurance subsidiaries domiciled in those states can pay without prior approval. Under current law, $78.3 million is available in 2011 for payment as a dividend from our insurance subsidiaries to State Auto Financial, without prior approval from our respective domiciliary state insurance departments. In 2010, 2009 and 2008, State Auto Financial received $56.4 million, $11.5 million and $39.0 million, respectively in dividends from its insurance subsidiaries. We are required to notify the insurance subsidiaries’ applicable state insurance commissioner within five business days after declaration of all such dividends and at least ten days prior to payment. Additionally, the domiciliary state commissioner of each insurance subsidiary has the authority to limit a dividend when the commissioner determines, based on factors set forth in the law, that an insurer’s surplus is not reasonable in relation to the insurer’s outstanding liabilities and adequate to meet its financial needs. Such restrictions are not expected to limit the capacity of State Auto Financial to meet its cash obligations.
State Auto Financial’s insurance subsidiaries are subject to regulation and supervision by the states in which they do business. The NAIC has developed risk-based capital requirements, which attempts to relate an individual insurance company’s statutory surplus to the risk inherent in its overall operations. RBC requires the calculation of a ratio of total adjusted statutory capital to authorized control level. Insurers with a ratio below 200% are subject to different levels of regulatory intervention and action. At December 31, 2010, the ratio of total adjusted statutory capital to authorized control level of State Auto Financial’s insurance subsidiaries ranged from 671% to 994%.
Our ratings are influenced by many factors including operating and financial performance, asset quality, liquidity, financial leverage, exposure to catastrophe risks and operating leverage. Presently, our A.M. Best ratings are assigned negative outlooks, whereas, Moody’s and Standard & Poor’s ratings are assigned stable outlooks.
In January 2010, the FASB issued guidance to improve the disclosures related to fair value measurements. The new guidance requires expanded fair value disclosures, including the reasons for significant transfers between Level 1 and Level 2 and the amount of significant transfers into each level disclosed separately from transfers out of each level. For Level 3 fair value measurements, information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements shall be presented separately on a gross basis, rather than as one net number. In addition, clarification is provided about existing disclosure requirements, such as presenting fair value measurement disclosures for each class of assets and liabilities that are determined based on their nature and risk characteristics and their placement in the fair value hierarchy (that is, Level 1, 2, or 3), as opposed to each major category of assets and liabilities, as required in the previous guidance. Disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements are required for fair value measurement that fall in either Level 2 or Level 3. We adopted this new guidance effective January 1, 2010, except for the gross presentation of purchases, sales, issuances and settlements in the Level 3 reconciliation, which is effective for annual and interim reporting periods beginning after December 15, 2010. The disclosures required by this new guidance are provided in Note 3 of the accompanying consolidated financial statements.
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. Our audits also included the financial statement schedules listed in the Index at Item 15(a)(2). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of State Auto Financial Corporation and subsidiaries at December 31, 2010 and 2009, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
In our opinion, State Auto Financial Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.
The consolidated financial statements also include the operations and financial position of 518 Property Management and Leasing, LLC (“518 PML”), an Ohio limited liability company whose members are State Auto P&C and Stateco. The consolidated financial statements also include the operations of State Auto National Insurance Company (“SA National”), an Ohio corporation and a wholly owned subsidiary of State Auto Financial through December 31, 2010, the date SA National was sold to a third party.
State Auto Financial is a majority-owned subsidiary of State Automobile Mutual Insurance Company (“State Auto Mutual”), an Ohio corporation. State Auto Financial and its subsidiaries are referred to herein as the “Company.” All significant intercompany balances and transactions have been eliminated in consolidation.
The Company markets a broad line of property and casualty insurance products in all 50 states and the District of Columbia exclusively through independent insurance agencies, which include retail agents and wholesale brokers. The Company’s principal lines of insurance include personal and commercial automobile, homeowners, commercial multi-peril, workers’ compensation, general liability and fire insurance. State Auto P&C, Milbank, Farmers, SA Ohio and SA National are chartered and licensed property and casualty insurers. As such, they are subject to the regulations of the applicable Departments of Insurance of their respective states of domicile (the “Departments”) and the regulations of each state in which they operate. These property and casualty insurance companies undergo periodic financial examination by the Departments and insurance regulatory agencies of the states that choose to participate. A large portion of the Company’s revenues are derived from a reinsurance pooling agreement with State Auto Mutual and its affiliates. The underwriting activity and geographic distribution of State Auto Mutual and its affiliates is generally the same as the underwriting activity and geographic distribution of the Company.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of losses and loss expenses payable and the realizability of deferred tax assets. In connection with the determination of losses and loss expenses payable, management uses historical data, current business conditions and assumptions about future conditions to formulate estimates of the ultimate cost to settle claims. Deferred tax assets are evaluated periodically by management to determine if they are realizable, requiring management to make certain judgments and assumptions. In evaluating the ability to recover deferred tax assets, management considers all available evidence, including loss carryback potential, past operating results, existence of cumulative losses in the most recent years, projected performance of the business, future taxable income, including the ability to generate capital gains, and prudent and feasible tax planning strategies. If, based on available information, it is more likely than not that the deferred income tax asset will not be realized, then a valuation allowance must be established with a corresponding charge to net income and/or accumulated comprehensive loss. These estimates by their nature are subject to uncertainties for various reasons. The Company’s results of operations and financial condition could be materially impacted in future periods should the ultimate payments required to settle claims vary from the amount of the liability currently provided or it is determined the deferred tax asset is not realizable.
The Company recognizes deferred income tax assets and liabilities for the expected future tax effects attributable to temporary differences between the financial statement and tax return bases of assets and liabilities, based on enacted tax rates and other provisions of the tax law. The effect of a change in tax laws or rates on deferred tax assets and liabilities is recognized in income in the period in which such change is enacted. Deferred tax assets and liabilities include provisions for unrealized investment gains and losses as well as the net funded status of pension and other postretirement benefit obligations with the changes for each period included in the respective components of accumulated other comprehensive loss in stockholders’ equity. Deferred tax assets are reduced by a valuation allowance if it is more likely than not that all or some portion of the deferred tax assets will not be realized.
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 $28.3 million and $33.3 million at December 31, 2010 and 2009, 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.
In January 2010, the FASB issued guidance to improve the disclosures related to fair value measurements. The new guidance requires expanded fair value disclosures, including the reasons for significant transfers between Level 1 and Level 2 and the amount of significant transfers into each level disclosed separately from transfers out of each level. For Level 3 fair value measurements, information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements shall be presented separately on a gross basis, rather than as one net number. In addition, clarification is provided about existing disclosure requirements, such as presenting fair value measurement disclosures for each class of assets and liabilities that are determined based on their nature and risk characteristics and their placement in the fair value hierarchy (that is, Level 1, 2, or 3), as opposed to each major category of assets and liabilities, as required in the previous guidance. Disclosures about the valuation techniques and inputs used to measure fair value for both recurring and nonrecurring fair value measurements are required for fair value measurement that fall in either Level 2 or Level 3. The Company adopted this new guidance effective January 1, 2010, except for the gross presentation of purchases, sales, issuances and settlements in the Level 3 reconciliation, which is effective for annual and interim reporting periods beginning after December 15, 2010. The disclosures required by this new guidance are provided in the accompanying Note 3.
In April 2009, the FASB issued guidance for the accounting for other-than-temporary impairments. Under the guidance, which is part of the FASB ASC Topic Investments - Debt and Equity Securities, the indicators used in considering an impairment of a debt security to be other-than-temporary were modified, from management asserting it has both the intent and the ability to hold an impaired security for a period of time sufficient for anticipated recovery in fair value to management asserting that (a) it does not have the intent to sell the security and (b) it is more likely than not it will not have to sell the security before recovery. Additionally, this guidance requires that other-than-temporary impairments on debt securities due to credit be recognized in
earnings while non-credit other-than-temporary impairments be recognized in other comprehensive income. This guidance also requires companies to disclose major security types for both debt and equity securities and to provide meaningful disclosure about individually significant unrealized losses and all such disclosures are required to be included in both interim and annual periods. The Company adopted this guidance effective April 1, 2009, and determined it did not have a material effect on the Company’s consolidated financial statements. The disclosures required by this guidance are provided in Note 2.
In October 2010, the FASB issued updated guidance to address diversity in practice for the accounting of costs associated with acquiring or renewing insurance contracts. This guidance modifies the definition of acquisition costs to specify that a cost be directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. The new guidance is effective on a prospective basis for fiscal years beginning after December 15, 2011, with early adoption permitted. Retrospective application is also permitted, but not required. The Company is still assessing the impact the provisions of the new guidance will have on its consolidated financial statements.
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, 2010 and 2009:
The Company did not recognize other-than-temporary impairments on its fixed maturity securities in 2010 or 2009, and recognized less than $0.1 million in 2008. The Company reviewed its investments at December 31, 2010, and determined no additional other-than-temporary impairment exists in the gross unrealized holding losses.
Proceeds on sales of available-for-sale securities in 2010, 2009 and 2008 were $179.6 million, $357.8 million and $231.6 million, respectively.
Level 3 includes unobservable inputs which reflect the reporting entity’s estimates of the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk).
The Company utilizes one nationally recognized pricing service to estimate the majority of its available-for-sale investment portfolio’s fair value. The Company obtains one price per security and the processes and control procedures employed by the Company are designed to ensure the value is accurately recorded on an unadjusted basis. Through discussions with the pricing service, the Company gains 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 to other fair value pricing information gathered from other independent pricing sources. At December 31, 2010, the Company did not adjust any of the prices received from the pricing service.
Transfers between level categorizations may occur due to changes in the availability of market observable inputs. Transfers in and out of level categorizations are reported as having occurred at the beginning of the quarter in which the transfer occurred. There were no transfers between level categorizations during the years ended December 31, 2010 and 2009, other than within other invested assets as described below.
Included in other invested assets are two international private equity 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 $75.3 million and $48.3 million at December 31, 2010 and 2009, 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
The following table sets forth the carrying value and fair value of financial instruments at December 31, 2010:
Favorable development in 2009 of loss adjustment expense and catastrophe losses contributed approximately $10.9 million each. Of the remaining favorable development in 2009, $9.5 million and $8.3 million was attributable to auto liability, both personal and commercial, and other & product liability, respectively. The favorable development in those lines was driven by emergence of lower than anticipated claim severity, as well as lower than anticipated claim frequency for other & product liability.
The following table sets forth the effect of the Company’s external reinsurance on its balance sheets at December 31, 2010 and 2009, prior to the reinsurance transaction with State Auto Mutual under the Pooling Arrangement, as discussed in Note 6a:
In conjunction with the January 1, 2008 Pooling Arrangement amendment, the STFC Pooled Companies received $92.0 million in cash, for additional net insurance liabilities assumed on January 1, 2008.
In general, under the Pooling Arrangement, the STFC Pooled Companies and the Mutual Pooled Companies other than State Auto Mutual cede to State Auto Mutual all of their insurance business and assume from State Auto Mutual an amount equal to their respective participation percentages in the Pooling Arrangement. The STFC Pooled Companies’ pooling participation percentage has been at 80% since 2001. All premiums, losses and loss expenses and underwriting expenses are allocated among the participants on the basis of each Company’s participation percentage in the Pooling Arrangement. The Pooling Arrangement provides indemnification against loss or liability relating to insurance risk and has been accounted for as reinsurance.
expenses payable and prepaid reinsurance premiums to State Auto Mutual as assets only in situations when net amounts ceded to State Auto Mutual exceed net amounts assumed. All parties that participate in the Pooling Arrangement have an A.M. Best rating of A+ (Superior).
The following table sets forth the reinsurance transactions on the Company’s balance sheets for the Pooling Arrangement between the STFC Pooled Companies and State Auto Mutual at December 31, 2010 and 2009:
The STFC Pooled Companies, the Mutual Pooled Companies and Beacon Lloyds Insurance Company (“Beacon Lloyds”), a subsidiary of State Auto Mutual, are collectively referred to as the “State Auto Group.”
In 2003, State Auto Financial issued $100.0 million of unsecured Senior Notes due November 2013. The Senior Notes bear interest at a fixed rate of 6.25% per annum, which is payable each May 15 and November 15. The Senior Notes are general unsecured obligations ranking senior to all existing and future subordinated indebtedness and equal with all existing and future senior indebtedness. The Senior Notes are not guaranteed by any of State Auto Financial’s subsidiaries and thereby are effectively subordinated to all subsidiaries’ existing and future indebtedness. State Auto Financial incurred $1.5 million in issuance costs related to the Senior Notes, which is recorded in other assets on the consolidated balance sheets and is being amortized into interest expense ($0.1 million each for 2010, 2009 and 2008) as the underlying interest expense is recognized on the Senior Notes.
The following table sets forth the tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2010 and 2009:
If the Company determines it is more likely than not that any of its deferred tax assets will not result in future tax benefits, a valuation allowance must be established for the portion of these assets that are not expected to be realized. Although realization of deferred tax assets is not assured, based upon a review of all available evidence, both positive and negative, including the Company’s historical and anticipated future taxable income, the Company’s management concluded that it is more likely than not that the net deferred income tax assets will be realized. No valuation allowance was held at December 31, 2010 or 2009.
At December 31, 2010, the Company carried no balance for uncertain tax positions. The Company had no accrual for the payment of interest and penalties at December 31, 2010 or 2009.
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 2007. However, the Company is currently under audit by the Internal Revenue Service for the 2009 and 2008 tax years, as required by the Congressional Joint Committee on Taxation due to refunds in excess of the $2.0 million threshold. The audit is anticipated to continue through 2012, and will include a limited scope examination for all tax years impacted by the net operating loss carrybacks, including tax years 2005 through 2009.
In June 2009, the Company initiated a plan to restructure its field and claims operations. Restructuring charges, including employee termination benefits, relocation packages, and costs associated with ceasing to use leased properties, related to this reorganization have been recognized in accordance with the Exit or Disposal Cost Obligations Topic of the FASB ASC. Consideration of this restructuring resulted in a curtailment of the Company’s pension and postretirement benefit plans as of June 30, 2009, due to the elimination of expected years of future services of those impacted employees. The Company recognized restructuring costs totaling $2.3 million and $4.8 million during the years ended December 31, 2010 and 2009, respectively. The restructuring was complete as of December 31, 2010, except for estimated relocation costs of $0.3 million to be recognized in 2011. These charges are included in losses and loss expenses and acquisition and operating expenses on the condensed consolidated statements of income.
The following table sets forth restructuring costs incurred for the years ended December 31, 2010 and 2009:
The following table sets forth the allocation of the restructuring costs to the Company’s insurance segments for the years ended December 31, 2010 and 2009:
The Company, through the employees of State Auto P&C, provides management and operation services under management agreements for all insurance and non-insurance affiliates. The annual periodic costs related to the Company’s benefit plans are allocated to affiliated companies based on allocations pursuant to intercompany management agreements.
In addition to the defined benefit pension plan, the Company provides a postretirement benefit plan including certain health care and life insurance benefits for its eligible retired employees. Substantially all of the Company’s employees hired prior to January 1, 2010 may become eligible for these postretirement benefits if they retire between age 55 and 65 with 15 years or more of service or if they retire at age 65 or later with 5 years or more of service. The defined benefit pension and postretirement benefit plans are referred to herein as “the benefit plans.”
Effective January 1, 2008, the Company adopted the measurement date requirement under transition alternative method one, as defined in SFAS No. 158 (codified in the Compensation - Retirement Benefits Topic of the FASB ASC), moving from a September 30 measurement date to a December 31 date for measuring its benefit plan obligations. This transition method resulted in a one-time adjustment that decreased beginning retained earnings by $2.4 million, net of tax. The combined impact of the measurement date transition and re-measurement of plan assets and obligations on January 1, 2008, increased beginning accumulated comprehensive income by $3.5 million, net of tax.
In November 2009, the Company announced to its employees a one-time election to select between two retirement benefit options: to either continue participation in the existing defined benefit pension plan with no changes; or to choose a new defined contribution plan in which the Company automatically contributes a percentage of the employee’s annual income resulting in a freeze to the employee’s existing accrued defined pension benefit. On May 31, 2010, employees’ elections were finalized which resulted in a $2.4 million curtailment on this date.
The following table sets forth the amount of amortization expected to be recognized for the State Auto Group for the year ending December 31, 2011:
The following table sets forth benefit payments, which reflect expected future service, expected to be paid:
** Due to the curtailment resulting from the restructuring, the expense was remeasured at June 30, 2009, using discount rate of 6.25% and expected long-term rate of return on assets of 8.00%.
The assumed health care cost trend rates have a significant effect on the amounts reported for the postretirement plan. The following table sets forth the effects of a one percentage point change in assumed health care cost trend rates for the year ended December 31, 2011:
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 $3.3 million, $3.3 million and $3.1 million for 2010, 2009 and 2008, respectively.
The Equity Plan provides for the award of qualified and nonqualified stock options, restricted shares, performance shares, performance units and other stock-based awards. The Company has reserved 2.0 million common shares under the Equity Plan. As of December 31, 2010, a total of 1.4 million common shares are available for issuance under the Equity Plan. The Equity Plan provides that (i) no more than 33% of the common shares authorized for issuance under the Equity Plan may be granted in the form of awards other than stock options, (ii) the maximum number of common shares subject to awards of stock options, restricted shares and performance shares that may be granted in any calendar year is equal to 1.5% of the total number of common shares of the Company outstanding as of December 31 of the prior year, and (iii) the maximum number of common shares subject to awards of stock options, restricted shares and performance shares that may be granted in any calendar year to any one individual is 250,000 shares. The Equity Plan automatically terminates on May 8, 2019.
The Equity Plan provides that qualified stock options may be granted at an option price not less than the fair market value of the common shares at the date of grant and that nonqualified stock options may be granted at any price determined by the Compensation Committee of the Board of Directors. Options granted generally vest over a three-year period, with one-third of the options vesting on each anniversary of the grant date, and must be exercised no later than ten years from the date of grant. Stock options granted under the Equity Plan for 2010, 2009 and 2008 were 0.6 million, 0.4 million and 0.4 million, respectively.
As of December 31, 2010, there was $0.2 million of total unrecognized compensation cost related to non-vested restricted share compensation arrangements. The remaining cost is expected to be recognized over a period of 2.25 years.
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, 2010, a total of 2.8 million common shares have been purchased under this plan. This plan remains in effect until terminated by the Board of Directors.
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 24,268 RSUs, 14,800 RSUs, and 11,200 RSUs granted in 2010, 2009 and 2008, respectively.
During 2010 and 2009, common shares valued at approximately $39,000 and $5,300, respectively, were distributed by the Company under the RSU Plan.
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, 2010, 2009 and 2008, the total intrinsic value of stock options exercised was $1.4 million, $0.6 million and $3.3 million, respectively. The tax benefit for tax deductions from share-based awards totaled $0.3 million, $0.2 million and $0.8 million for the years ended December 31, 2010, 2009 and 2008, respectively.
The following table sets forth information pertaining to the total options outstanding and exercisable at December 31, 2010:
Compensation expense recognized during 2010, 2009 and 2008 was $3.7 million, $3.7 million and $5.5 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, 2010, there was $3.1 million of total unrecognized compensation cost related to option-based compensation arrangements granted under the plans. The remaining cost is expected to be recognized over a period of 2.25 years.
The following table sets forth the compilation of basic and diluted net earnings (loss) per common share for the years ended December 31, 2010, 2009 and 2008:
At December 31, 2010, the Company has three reportable segments: personal insurance, business insurance and investment operations. The reportable 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 insurance segments operate primarily in the Midwestern, Southern, Southwestern, and Eastern United States. 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 lines, other & product liability and workers’ compensation insurance to small-to-medium sized businesses within the commercial insurance market. These products are primarily distributed through the independent insurance agency system. The investment operations segment, managed by Stateco, provides investment services.
The following table sets forth financial information regarding the Company’s reportable segments at December 31, 2010 and 2009:
The following tables set forth quarterly financial data for 2010 and 2009:
The Company is involved in a number of lawsuits, and may become involved in other potential litigation, arising in the ordinary course of its business. Generally, the Company’s involvement in a lawsuit involves defending third-party claims brought against its insureds in its role as liability insurer or against the Company as a principal of surety bonds, as well as defending policy coverage claims brought against the Company. The Company considers all lawsuits relating to such insurance claims in establishing the Company’s loss and loss adjustment expense reserves.
In December 2010, a putative class action lawsuit (Kelly vs. State Automobile Mutual Insurance Company, et al.) was filed against State Auto Financial, State Auto P&C and State Auto Mutual in state court in Ohio. In this lawsuit, plaintiffs allege that the State Auto Group has engaged, and continues to engage, in deceptive practices by failing to disclose to plaintiffs the availability, through one or more related companies, of insurance policies providing for identical coverage and service as those policies purchased by plaintiffs but at a lower premium amount. Plaintiffs are seeking class certification and compensatory and punitive damages to be determined by the court and restitution and/or disgorgement of profits derived from plaintiffs and the alleged class. The Company filed a motion to dismiss on March 1, 2011, and it remains
In accordance with the Contingencies Topic of the FASB ASC, the Company accrues for a litigation-related liability, other than insurance claims, when it is probable that such a liability has been incurred and the amount of the loss can be reasonably estimated. Based on currently available information known to the Company, the Company believes that its reserves for these litigation-related liabilities are reasonable and that the ultimate outcomes of any pending matters are not likely to have a material adverse effect on its consolidated financial position or results of operations. However, regarding the putative class action litigation described above, it is not currently possible to predict the legal outcome of this litigation or its impact on the future development of claims and litigation relating to similar claims. Any such development will be affected by future court decisions and interpretations. Because of these uncertainties, additional liabilities may arise in amounts in excess of our currently held reserves. In addition, the Company’s estimate of ultimate claims and claim adjustment expenses may change. These additional liabilities or increases in estimates, or a range of either, cannot now be reasonably estimated and could result in income statement charges that could be material to the Company’s results of operations in future periods.
Additionally, the Company may be impacted by adverse regulatory actions and adverse court decisions where insurance coverages are expanded beyond the scope originally contemplated in its insurance policies. The Company believes that the effects, if any, of such regulatory actions and published court decisions are not likely to have a material adverse effect on its financial position or results from operations.