We evaluate the performance of our insurance segments using industry financial measurements determined under SAP and certain measures determined under GAAP. We evaluate our investment operations segment based on investment returns of assets managed. Financial information about our segments for 2015 is set forth in this Item 7 and in Note 15 to our consolidated financial statements included in Item 8 of this Form 10-K.
While our 2015 results did not meet our expectations, including our growth objectives, progress was made by our new management team in understanding our issues and implementing initiatives to address them.
Business insurance segment - Our workers' compensation line grew profitably in 2015 and we expect that trend to continue in 2016. Our commercial auto results were below expectations in 2015 and deteriorated when compared to 2014. As with our personal auto business, we have identified the primary causes of the poor underwriting results and believe the corrective actions we are taking will drive improved underwriting performance in this line in 2016.
Specialty insurance segment - Our E&S casualty unit grew profitably in 2015 and we will continue to look for opportunities to further grow this business, both organically and through acquisitions. Our programs unit also experienced growth in 2015 due to increased production from new programs; however, the unit generated an underwriting loss due primarily to programs with commercial auto exposures. We have identified the issues driving the results and are taking corrective actions to address them.
Under new leadership, our claims unit was reorganized, with our claims associates being assigned to specific products in order to better align their claims handling expertise with the exposures driving the losses for their assigned products. For example, we have created specific claims teams for our personal and commercial auto products. We have implemented changes to our claims handling practices to reduce claims leakage, including reducing the number of vendors we utilize in order to increase our pricing leverage.
Among the most significant changes in 2015 was a shift in our culture. While our core strengths of integrity and our relationships with our agents, brokers and policyholders will not change, we recognize that, in order to succeed, we must be nimble, responsive, creative, passionate and driven. To achieve a cultural change, management is emphasizing candor, transparency and respect, along with replacing rules, processes, committees and guidelines that only add to bureaucracy with an open and collaborative approach that focuses on making a decision and moving forward. Additionally, management is encouraging creativity, responsiveness and passion by implementing a coaching approach that delivers regular, ongoing, two-way feedback.
Despite our disappointing results, we believe we made significant progress in 2015 in laying the foundation for improved results in 2016 and beyond. Through a combination of retention, promotion and recruitment, we are confident our new leadership team has the skills to meet emerging challenges in the rapidly changing property and casualty marketplace. Management’s objective is to achieve profitability and growth for each of our products, and our progress will be evaluated going forward based on this objective. 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.
The following table sets forth the participants and their participation percentages in the Pooling Arrangement. There were no changes to the participants or to their participation percentages during 2015.
We anticipate that the STFC Pooled Companies will maintain a 65% participation percentage in the Pooling Arrangement for the foreseeable future. However, under applicable governance procedures, if the Pooling Arrangement were to be amended, management would make recommendations to the Independent Committees of the Board of Directors of both State Auto Mutual and STFC. The Independent Committees review and evaluate such factors as they deem relevant and recommend any appropriate pooling change to the Board of Directors of both State Auto Mutual and STFC subject to regulatory approval by each participant’s respective domiciliary insurance department. The Pooling Arrangement is terminable by any of our Pooled Companies at any time
The following highlights significant factors that impacted 2015 results as compared to 2014 and 2013:
Earned premiums in 2015 were $1,270.5 million compared to $1,074.1 million and $1,055.0 million in 2014 and 2013, respectively. Earned premium growth in 2015 was due to (i) the termination of the HO QS Arrangement (as defined below) and (ii) new business growth in workers’ compensation and the specialty insurance segment.
The SAP non-catastrophe loss and ALAE ratio for 2015 was 57.7% compared to 62.6% and 58.6% for 2014 and 2013, respectively. The 2015 loss ratio improved when compared to the 2014 and 2013 ratios, which 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 and $21.3 million in 2013. In addition, the HO QS Arrangement increased our SAP non-catastrophe loss and ALAE ratio 3.4 points in 2014 and 2.8 points in 2013. The 2015 SAP non-catastrophe loss and ALAE ratio was impacted by higher than expected severity in lines of business with auto exposures.
The accounting for pension benefits also contributes to the difference between our GAAP loss and expense ratios and our SAP loss and expense ratios. At January 1, 2013, we adopted new SAP pension guidance, which required the recognition of service costs for non-vested participants. In accordance with GAAP, service costs related to non-vested participants were recognized over a two year vesting period ending December 31, 2014. See the “Critical Accounting Policies - Pension and Postretirement Benefit Obligations” section included in this Item 7.
Accounting for retroactive reinsurance agreements also contributes to the difference between our GAAP and SAP loss and LAE ratios and expense ratios. In accordance with SAP, the amount paid for a retroactive reinsurance agreement is recognized as other underwriting expense. Under GAAP, the amount recoverable for a retroactive reinsurance agreement is recorded as a reduction to loss and loss expenses up to the amount paid for the reinsurance contract. Recoverable amounts in excess of the amount paid for retroactive reinsurance coverage are deferred and amortized over the claim settlement period of the agreement. The statutory loss and ALAE, and underwriting expenses within this Form 10-K have been adjusted to reflect the impact of a retroactive reinsurance agreement. Accordingly, for the year ended December 31, 2015 we recognized a benefit of $5.9 million, reflected as a reduction in SAP loss and ALAE. For the year ended December 31, 2014 we recognized an expense of $5.9 million, reflected as an increase in SAP loss and ALAE. See the “Reinsurance Arrangements - Other Reinsurance Arrangements” section included in this Item 7.
To reduce risk and volatility, while at the same time providing us with additional catastrophe reinsurance protection, the State Auto Group entered into a quota share reinsurance agreement on December 31, 2011 with a syndicate of unaffiliated reinsurers covering its homeowners line of business (the “HO QS Arrangement”). Under the HO QS Arrangement, the State Auto Group ceded to the reinsurers 75% of its homeowners business under policies in force at December 31, 2011 and new and renewal policies thereafter issued during the term of the agreement. The HO QS Arrangement expired on December 31, 2014. Upon expiration, the Company recognized $89.5 million of unearned premium returned from the reinsurers. In accordance with the terms of the HO QS Arrangement, the participating reinsurers’ margin was capped at 9.0%, with any excess returned to the State Auto Group in the form of a profit commission. For the years ended December 31, 2015 and 2014, the Company recognized profit commission of $4.2 million and $19.0 million, respectively, which is reflected as a reduction in acquisition and operating expenses on our consolidated statements of income.
The following tables set forth, on a GAAP 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.
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.
The following table sets forth the net written premiums by major product line of business for our personal insurance segment for the years ended December 31, 2015, 2014 and 2013.
Technology - we accelerated our transition plan for a new technology platform for our personal auto and homeowners products, with a target of introducing the new technology platform in five states beginning in the third quarter of 2016. We plan on introducing the technology in our remaining states throughout 2016 and 2017. The new platform is expected to enable us to offer new products utilizing a new rating plan. In addition, the platform incorporates advanced data analytics, and is expected to give our agents the ability to submit, rate, quote, bind, issue and bill policies through an automated and integrated platform;
Claims - in connection with an overall re-alignment of the claims unit, a dedicated personal auto claims unit was created to provide more effective and efficient handling of personal auto claims. In addition, reviews were initiated to evaluate our claims handling processes, including coverage interpretation and vendor utilization to identify opportunities to reduce or eliminate claims leakage.
The personal insurance segment’s SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2015 was 54.7%, compared to pro forma SAP non-catastrophe loss and ALAE ratios of 52.3% and 55.5% in 2014 and 2013, respectively
(Table 2 and Reconciliation Tables 7 - 8). The 2.4 point increase in the 2015 ratio when compared to 2014 (Table 2 and Reconciliation Table 7) was due to a 6.6 point increase in the personal auto ratio (Table 2), primarily attributable to increased bodily injury severity trends that resulted in higher ultimate loss and LAE estimates for the current and prior accident years. The personal auto ratio increase was partially offset by a decrease in the homeowners ratio of 3.1 points (Table 2 and Reconciliation Table 5), due to improvement in the current accident year. The 2014 improvement in the personal insurance segment’s SAP non-catastrophe loss and ALAE ratio from 2013 was primarily due to the personal auto SAP non-catastrophe loss & ALAE ratio decline of 3.8 points when compared to 2013 (Table 2), as a result of improved personal injury protection and physical damage results, as well as the impact of prior year rate increases.
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, 2015, 2014 and 2013:
Net written premiums for the business insurance segment for the years ended December 31, 2015 and 2014 increased 1.4% and 5.9% when compared to 2014 and 2013, respectively (Table 3). The 2015 increase in premiums was primarily due to growth in mono-line workers’ compensation business. The 2014 increase in premiums was primarily due to growth in workers’ compensation, commercial auto and commercial multi-peril, resulting from (i) new business growth in workers’ compensation, (ii) writing policies with larger average premiums for new business accounts in commercial auto and commercial multi-peril, (iii) achieving rate increases, and (iv) higher retention.
Underwriting Improvements - during the second half of 2015, business insurance underwriting management performed an in-depth review of underwriting processes for the commercial auto business in response to higher than anticipated losses. As a result of this review, management addressed identified gaps by introducing an updated pricing model and updated underwriting procedures to provide greater consistency with respect to driver evaluation, risk assessment and vehicle classification; and,
The business insurance segment’s SAP catastrophe loss and ALAE ratio for 2015 was 3.3% compared to 3.6% and 4.8%, in 2014 and 2013, respectively (Table 4). The improvements in 2015 and 2014 were primarily due to fewer and less severe catastrophe events during the years ended 2015 and 2014 compared to 2014 and 2013, respectively.
The business insurance segment’s 2014 SAP non-catastrophe loss and ALAE ratio increased 2.0 points when compared to 2013 (Table 4), primarily due to the commercial multi-peril, fire & allied and workers’ compensation lines ratio increases of 4.7 points, 6.7 points and 3.3 points, respectively (Table 4). The increase in the commercial multi-peril ratio was due to 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 increase in the fire & allied lines ratio was due to 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 the other & product liability and other commercial ratios when compared to 2013 (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 when compared to 2013.
The following table sets forth the net written premiums by unit for our specialty insurance segment for the years ended December 31, 2015, 2014 and 2013.
The following table sets forth a tabular presentation of the development of the ultimate liability by accident year by line of business for the years ended December 31, 2015, 2014 and 2013:
The personal insurance segment’s non-catastrophe loss and ALAE reserves developed adversely in 2015 compared to favorable development in 2014 and 2013, respectively. The adverse development in 2015 was due to increased bodily injury severity trends in personal auto that resulted in higher ultimate loss and LAE estimates for prior accident years.
The specialty insurance segment’s non-catastrophe loss and ALAE reserves developed adversely in 2015, 2014 and 2013 due to the programs unit. The adverse development within the programs unit for the year ended December 31, 2015 was primarily due to higher bodily injury severity trends for programs with commercial auto exposures, while adverse development for both 2014 and 2013 was attributable to RED reserve strengthening of $96.7 million and $21.3 million, respectively.
In the personal and business insurance segments, the non-catastrophe loss and ALAE reserves contributed $28.7 million of favorable development. The business insurance segment contributed $22.3 million of this favorable development, due to other & product liability, workers' compensation and commercial auto. The favorable development in these lines was due to lower than anticipated severity from accident years 2013 and prior. The personal insurance segment contributed $6.4 million of this favorable development, primarily from accident year 2013.
In the specialty insurance segment, the non-catastrophe loss and ALAE reserves accounted for $91.5 million of adverse development related primarily to accident years 2011 and 2012, which was due to RED reserve strengthening. Partially offsetting the unfavorable development of RED reserves was favorable development in the E&S property and casualty units. Favorable development in these lines was due to better than anticipated severity emerging primarily from the 2012 and 2013 accident years.
The loss and loss expenses payable at December 31, 2015 increased $73.5 million from the loss and loss expenses payable at December 31, 2014. The increase in the homeowners losses and loss expenses payable balance was attributable to fewer ceded losses and loss expenses due to the absence of the HO QS Arrangement in 2015 compared to 2014. The increase in the commercial auto loss and loss expenses payable was primarily due to strengthening prior year reserves and reflecting higher severity in our loss estimates. The increase in the E&S casualty loss and loss expenses payable was primarily attributable to an increase in the volume of business due to the Partners General Agency acquisition. The change in the programs loss and loss expenses payable was primarily due to payments on outstanding RED claims during 2015.
The risks and uncertainties inherent in our estimates include, but are not limited to, actual settlement experience different from historical data trends, changes in business and economic conditions, court decisions creating unanticipated liabilities, ongoing interpretation of policy provisions by the courts, inconsistent decisions in lawsuits regarding coverage and additional information discovered before settlement of claims. Our results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required to settle claims vary from the liability currently recorded.
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.
At December 31, 2015, our equity portfolio consisted of approximately 65 different large-cap stocks and 69 small-cap stocks. The largest single fund holding was 13.0% of the equity portfolio based on fair value and the top ten positions accounted for 34.1% of the equity portfolio. At December 31, 2014, our equity portfolio consisted of approximately 32 different large-cap stocks and 72 small-cap stocks. The largest single fund holding was 16.3% of the equity portfolio based on fair value, and the top ten positions accounted for 50.1% of the equity portfolio. Since our equity portfolio consists primarily of large-cap value-oriented stocks, with a smaller 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.
We believe that the fixed maturity portfolio’s exposure to credit risk is minimal as approximately 64.4% 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 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. We categorize our fixed maturities as available-for-sale in order to provide us greater flexibility in managing our portfolio. 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, 2015:
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, 2015:
At December 31, 2015, 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 0.70 and 0.85 respectively, using the MSCI EAFE Index as a benchmark. 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, 2015:
The following table sets forth realized gains (losses) and the proceeds received on sale for our investment portfolio for the years ended December 31, 2015, 2014 and 2013:
See “Critical Accounting Policies - Income Taxes” included in this Item 7. 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 (benefit) expense and the amount computed at the indicated statutory rate for the years ended December 31, 2015, 2014 and 2013.
We maintain a portion of our investment portfolio in relatively short-term and highly liquid investments to ensure the immediate availability of funds to pay claims and expenses. At December 31, 2015 and 2014, we had $58.1 million and $86.3 million, respectively, in cash and cash equivalents, and $2,396.4 million and 2,282.6 million, respectively, of total available-for-sale investments. Included in our fixed maturities available-for-sale were $8.8 million, respectively, of securities on deposit with insurance regulators, as required by law, at December 31, 2015 and 2014. In addition, substantially all of our fixed maturity and equity securities are traded on public markets. For a further discussion regarding investments, see “Investments Operations Segment” included in this Item 7.
Net cash provided by operating activities was $149.8 million, 75.6 million and $72.1 million in 2015, 2014 and 2013, 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. The change from 2015 compared to 2014 and 2013 was primarily due to the expiration of the HO QS Arrangement at December 31, 2014, resulting in STFC receiving return premium of $63.5 million during the first quarter of 2015.
The change in 2015 from 2014 was primarily due to the reinvestment of proceeds received from the expiration of the HO QS Arrangement along with the reduction of our average cash on hand balances through additional fixed income and equity purchases.
The change in 2014 from 2013 was primarily attributable to the level of purchases, sales and maturities in our investment portfolio.
State Auto P&C, a member of the Federal Home Loan Bank of Cincinnati (the “FHLB”), has a term loan with the FHLB in the principal amount of $85.0 million maturing in July 2033 (the “FHLB Loan”). The FHLB Loan is callable after July 11, 2016 with no prepayment penalty. 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. Proceeds from the FHLB Loan, along with cash on hand, were used by State Auto Financial to redeem all of its outstanding Senior Notes.
The following table sets forth our notes payable at December 31, 2015:
Related to our notes payable, our primary market risk exposure is to the change in interest rates and our credit rating. For a discussion regarding our credit ratings see “Credit and Financial Strength Ratings” included in this Item 7. Based upon the notes payable carrying value at December 31, 2015, we had $15.5 million notes payable with variable interest and $85.3 million notes payable with interest fixed at 5.03%, which equated to approximately 15.3% variable interest debt and 84.7% fixed interest debt. Our decision to obtain fixed versus variable interest rate debt is influenced primarily by the following factors: (a) current market interest rates; (b) anticipated future market interest rates; (c) availability of fixed versus variable interest instruments; and (d) our currently existing notes payable fixed and variable interest rate position. See our contractual obligations table included in “Contractual Obligations” included in this Item 7.
At December 31, 2014, the State Auto Group entered into an ADC reinsurance agreement that provided $40.0 million of coverage for adverse development in excess of carried reserves for the terminated RED restaurant program.
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, with a 15.0% co-participation on the next $40.0 million of covered loss, each occurrence. The reinsurers are responsible for 85.0% of the excess over $15.0 million up to $55.0 million of covered loss, each occurrence. The rates for this reinsurance agreement are negotiated annually.
As of July 1, 2015, the State Auto Group renewed our 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.
For E&S casualty and programs unit risks, the State Auto Group has a combined casualty treaty whereby under Section A, we retain the first $1.0 million of covered loss and the reinsurers are responsible for 90.0% of loss in excess of $1.0 million up to $10.0 million for all primary business with policy limits issued greater than $1.0 million. A separate retention of $1.0 million applies to lead excess business (excess business written directly above a primary policy), and the reinsurers are responsible for 90.0% of loss in excess of $1.0 million up to $10.0 million. For lead excess business to be ceded to Section A the excess limits issued must be greater than $1.0 million. Under Section B, as respects non-lead excess policies, we have a $10.0 million proportional agreement where we retain $1.0 million of each risk and the reinsurers are responsible for 90.0% of loss for each risk based on the percentage the $1.0 million we retain bears to the total policy limit. Also under Section B, if we write a non-lead excess policy and also write the primary policy for the same insured, there is a separate $1.0 million retention for the primary policy. Under Section C, with respect to policies at $1.0 million or less, we retain the first $1.25 million of Extra Contractual Obligations/Excess of Policy Limits (“ECO/XPL”) and LAE coverage for policies with limits of $1.0 million or less, and the reinsurers are responsible for 90.0% of ECO/XPL and LAE coverage in excess of $1.25 million up to $4.0 million. The rates for these reinsurance agreements are negotiated annually.
The following table sets forth our significant contractual obligations at December 31, 2015:
Leases and other purchase obligations of State Auto Mutual are allocated to us through the Pooling Arrangement.
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, 2015, the ratio of total adjusted statutory capital to authorized control level of State Auto Financial’s insurance subsidiaries ranged from 453.7% to 8,151.7%.
We also consider the following factors when assessing our fixed maturity investments for OTTI: (i) the financial condition of the issuer including receipt of scheduled principal and interest cash flows; (ii) our intent to sell; and (iii) if it is more likely than not that we will be required to sell the investments before recovery. When a fixed maturity has been determined to have an other-than-temporary impairment, the impairment charge is separated into an amount representing the credit loss, which is recognized in earnings as a realized loss, and the amount related to non-credit factors, which is recognized in other comprehensive (loss) income. Future increases or decreases in fair value, if not other-than-temporary, are included in other comprehensive (loss) income.
acquisition costs, the excess is reported as a deferred liability and is included in other liabilities in our consolidated balance sheet. Excess ceding commissions are amortized in proportion to net revenue recognized on the underlying policies resulting in excess ceding commissions being recognized as a reduction of acquisition and operating expenses.
Our loss reserves reflect all unpaid amounts for claims that have been reported, as well as for IBNR claims. Our loss reserves are not discounted to present value.
Loss reserves are management’s best estimates (“MBE”) at a given point in time of what we expect to pay to settle all claims incurred as of that date based on known facts, circumstances and historical trends. Loss reserves at the individual claim level are established on either a case reserve basis or formula reserve basis depending on the type and circumstances of the loss. The case reserve amounts are determined by claims adjusters based on our reserving practices, which take into account the type of risk, the circumstances surrounding each claim and applicable policy provisions. The formula reserves are based on historical data for similar claims with provision for changes caused by inflation. Case reserves and formula reserves are reviewed on a regular basis, and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis and not settled after six months are case reserved at that time. The process for calculating the IBNR component of the loss reserve is to develop an estimate of the ultimate losses and allocated loss expenses incurred, and subtract all amounts already paid or held as case or formula reserves.
We use a number of different methodologies to estimate the IBNR component of our loss reserves. Our loss reserves include amounts related to short tail and long tail lines of business. “Tail” refers to the time period between the occurrence of a loss and the settlement of the claim. In general, the longer the time span between the incidence of a loss and the settlement of the claim, the more the ultimate settlement amount can vary. The reserving methods and strengths and weaknesses of each are described below.
Long-Tail Business: For long-tail business, a material portion of claims may not be settled within five years. Reserve estimates for long-tail business use the same methods listed above along with several other methods as determined by the actuary. For example, premium-based methods may be used in developing ultimate loss estimates, including the Expected Loss Ratio, Bornhuetter-Ferguson, and Least-Squares techniques as described below. We may also use statistical models when the historical patterns can be reasonably approximated.
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 following tables set forth the loss and loss expenses payable by major line of business at December 31, 2015 and 2014:
Asbestos reserves are $1.2 million, and environmental reserves are $11.3 million, for a total of $12.5 million, or 1.2% of net losses and loss expenses payable. Asbestos reserves decreased $0.2 million and environmental reserves increased $0.8 million from 2014.
MP-2014 improvement scale with indefinite improvement was used to project future mortality rates. For the December 31, 2015 valuation, the Adjusted RP-2014 mortality table was used as a baseline for the mortality assumption and to project future mortality rates. The January 1, 2016 actuarial reports of the benefit plans included these revised mortality assumptions.
As a result of revised mortality assumptions and the change in the discount rate, the benefit plan’s liability decreased $6.5 million for the year ended December 31, 2015 and increased $52.6 million for the year ended December 31, 2014.
The following table sets forth an illustration of variability with respect to the discount rate on our share of the State Auto Group’s December 31, 2015 benefit obligation and expected net periodic benefit cost for the year ending December 31, 2016, along with the variability of the expected return on plan assets to our expected net periodic benefit cost for the year ending December 31, 2016. Holding all other assumptions constant, sensitivity to changes in any one of our key assumptions are as follows:
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 due to the magnitude
The following table sets forth the components of our federal income tax expense for the years ended December 31, 2015 and 2014:
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, 2015 and 2014, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2015, 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.
Among the factors that management considers for equity securities and other invested assets are the length of time and/or the significance of decline below cost, the Company’s ability and intent to hold these securities through their recovery periods, the current financial condition of the issuer and its future business prospects, and the ability of the market value to recover to cost 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, the cost basis of the security is adjusted 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 other comprehensive income.
Comprehensive income is defined as all changes in an enterprise’s equity during a period other than those resulting from investments by owners and distributions to owners. Comprehensive income includes net income and other comprehensive (loss) income. Other comprehensive (loss) income includes all other non-owner related changes to equity and includes net unrealized gains and losses on available-for-sale investments, derivative instruments and unrecognized benefit plan obligations, adjusted for deferred federal income taxes.
The Company reviewed its investments at December 31, 2015, and determined no additional other-than-temporary impairment exists in the gross unrealized holding losses.
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, 2015 and 2014.
The remainder of the Company’s other invested assets consist of holdings in publicly-traded mutual funds. The Company believes that its prices for these publicly-traded mutual funds, based on an observable market price for an identical asset in an active market, reflect their fair values and consequently these securities have been disclosed in Level 1.
Included in other invested assets are the FHLB membership common stock (“FHLB common stock”), purchased when State Auto P&C joined the FHLB in 2013, and the Trust Securities (as defined in Note 6b). The Trust Securities and FHLB common stock are carried at cost, which approximates fair value. The fair value of the FHLB common stock at December 31, 2015 was $4.8 million and the fair value of the Trust Securities were $0.5 million. Both investments have been placed in Level 3 of the fair value hierarchy.
On December 31, 2011, the State Auto Group entered into the Homeowners Quota Share Arrangement, which was a three-year quota share agreement covering its homeowners line of business. Under the arrangement, the State Auto Group ceded to reinsurers 75% of its homeowners business under policies in force at the effective date and new and renewal policies thereafter issued during the term of the agreement. The arrangement expired on December 31, 2014. The Company received $89.5 million of unearned premiums related to the expiration of this arrangement. Subject to the terms and conditions of the arrangement, the participating reinsurers’ margin was capped at 9.0%, with any excess returned to the Company in the form of profit commission. For the years ended December 31, 2015 and 2014, the Company recognized profit commission of $4.2 million and $19.0 million, respectively, reflected as a reduction in acquisition and operating expenses on the consolidated statements of income. The amount of ceding commission earned was limited to the amount of deferred acquisition costs that would have been deferred if not for entering in the arrangement. As a result of the expiration of the HO QS Arrangement, the Company recognized $8.1 million of excess ceding commission that had previously been deferred, reflected as a reduction in acquisition and operating expenses on the consolidated statements of income for the year ended December 31, 2014.
The following table sets forth the effect of the Company’s external reinsurance on its balance sheets at December 31, 2015 and 2014, prior to the reinsurance transaction with State Auto Mutual under the Pooling Arrangement, as discussed in Note 6a:
The following table sets forth the effect of the Company’s external reinsurance on its income statements for the years ended December 31, 2015, 2014 and 2013, prior to the reinsurance transaction with State Auto Mutual under the Pooling Arrangement, as discussed in Note 6a:
Pursuant to the Pooling Arrangement, State Auto Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and then settles the intercompany balances generated by these transactions with the participating companies on a quarterly basis within 60 days following each quarter end. No interest is paid on this balance. When settling the intercompany balances, State Auto Mutual provides the pool participants with full credit for the premiums written and net losses paid during the quarter and retains all receivable amounts from insureds and agents and reinsurance recoverable on paid losses from unaffiliated reinsurers. Any receivable amounts that are ultimately deemed to be uncollectible are charged-off by State Auto Mutual and allocated to the pool members on the basis of pool participation. As a result, the Company has an off-balance sheet credit risk related to the balances due to State Auto Mutual from insurers, agents and reinsurers, which are offset by the unearned premium from the respective policies. The Company’s share of the premium balances due to State Auto Mutual from agents and insureds at December 31, 2015 and 2014 is approximately $294.7 million and $297.0 million, respectively.
State Auto Financial’s subsidiary, State Auto P&C, is a member of the Federal Home Loan Bank of Cincinnati (the “FHLB”) and has a term loan with the FHLB in the principal amount of $85.0 million (the “FHLB Loan”). 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.
On July 15, 2013, State Auto Financial redeemed all $100.0 million of its outstanding Senior Notes. The redemption price of $103.0 million was calculated in accordance with the terms of the Senior Notes and included principal plus a make-whole amount. The redemption price was funded by proceeds from the FHLB Loan and cash on hand.
As of December 31, 2015, 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 expense (benefit) and the amount computed at the indicated statutory rate for the years ended December 31, 2015, 2014 and 2013:
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. The Company periodically evaluates its deferred tax assets, which requires significant judgment, to determine if they are realizable based upon weighing all available evidence, both positive and negative, 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. In making such judgments, significant weight is given to evidence that can be objectively verified.
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 valuation allowance was reversed at December 31, 2014. With the reversal of the valuation allowance at December 31, 2014, the Company recorded an income tax benefit of $82.6 million.
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 including the Pooling Arrangement for insurance subsidiaries and affiliates party to this agreement.
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, 2015 and 2014:
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, 2015 and 2014:
The following table sets forth information regarding the Company’s share of pension and postretirement benefit plans’ components of net periodic cost for the years ended December 31, 2015, 2014 and 2013:
The following table sets forth the weighted average assumptions used to determine the benefit plans’ obligations at December 31, 2015 and 2014:
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 2016 is approximately $13.0 million.
The following tables set forth the changes in the Company’s accumulated other comprehensive income component (AOCI), net of tax, for the years ended December 31, 2015, 2014 and 2013:
State Auto P&C, Milbank and SA Ohio are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Under the insurance regulations of Iowa and Ohio (the states of domicile), the maximum amount of dividends that the Company may pay out of earned surplus to shareholders within a twelve month period without prior approval of the Department is limited to the greater of 10% of the most recent year-end policyholders’ surplus or net income for the twelve month period ending the 31st day of December of the previous year-end. Pursuant to these rules, approximately $81.4 million is available for payment to State Auto Financial from its insurance subsidiaries in 2016 without prior approval. State Auto Financial received dividends from its insurance subsidiaries in the amount of $15.0 million, $20.0 million and $10.0 million in 2015, 2014 and 2013, respectively.
The Company’s share-based compensation plans authorize the granting of various equity-based incentives including stock options, restricted stock and restricted share units to employees and non-employee directors and agents. The expense for these equity-based incentives is based on their fair value at the date of grant and amortized over their vesting period. The fair value of each stock option is estimated on the date of grant using the Black-Scholes closed-form pricing model. The pricing model requires assumptions such as the expected life of the option and expected volatility of the Company’s stock over the expected life of the option, which significantly impacts the assumed fair value. The Company uses historical data to determine these assumptions and if these assumptions change significantly for future grants, share-based compensation expense will fluctuate in future periods.
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 3.0 million common shares under the Equity Plan. As of December 31, 2015, a total of 0.5 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 following table sets forth the status of the Company’s non-vested and vested restricted shares and changes for the years ended December 31, 2015, 2014 and 2013:
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 3.7 million common shares under this plan. As of December 31, 2015, a total of 3.3 million common shares have been purchased under this plan. This plan remains in effect until terminated by the Board of Directors.
The RSU Plan is an unfunded deferred compensation plan which currently provides each outside director with an award of 1,400 restricted share units (the “RSU award”) following each annual meeting of shareholders. The amount of the award may change from year to year, based on the provision described below. The RSU awards are fully vested six months after the date of grant. RSU awards are not common shares of the Company and, as such, no participant has any rights as a holder of common shares under the RSU Plan. RSU awards represent the right to receive an amount, payable in cash or common shares of the Company, as previously elected by the outside director, equal to the value of a specified number of common shares of the Company at the end of the restricted period. Such election may be changed within the constraints set forth in the RSU Plan. The restricted period 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 terminated on May 31, 2015. It is the Company’s intent to seek shareholder approval for renewal of this plan with similar terms, in the 2016 Proxy Statement. The Company accounts for the RSU Plan as a liability plan. There were 26,184 RSUs, 25,960 RSUs, and 33,712 RSUs granted in 2015, 2014 and 2013, respectively.
The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes closed-form pricing model. The following tables present the weighted-average assumptions used in the option pricing model for options granted to employees during 2015, 2014 and 2013. The expected life of the options for employees represents the period of time the options are expected to be outstanding and is based on historical trends. For non-employees the expected life of the option approximates the remaining contractual term of the option. The expected stock price volatility is based on the historical volatility of the Company’s stock for a period approximating the expected life and the expected dividend yield is based on the Company’s most recent period’s dividend payout. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant and has a term approximating the expected life of the option.
The fair value of share-based awards granted to employees was estimated at the date of grant using the Black-Scholes option-pricing model. The following table sets forth the weighted average fair values and related assumptions for options granted for the years ended December 31, 2015, 2014 and 2013:
The following table sets forth the Company’s total stock option activity and related information for these plans for the years ended December 31, 2015, 2014 and 2013:
The following table sets forth information pertaining to the total options outstanding and exercisable at December 31, 2015:
Aggregate intrinsic value for total options outstanding at December 31, 2015 was $13.5 million. Aggregate intrinsic value for total options exercisable at December 31, 2015 was $6.2 million.
The following table sets forth the compilation of basic and diluted net earnings per common share for the years ended December 31, 2015, 2014 and 2013:
The following table sets forth financial information regarding the Company’s reportable segments for the years ended December 31, 2015, 2014 and 2013:
The following table sets forth financial information regarding the Company’s reportable segments at December 31, 2015 and 2014:
The following tables set forth quarterly financial data for 2015 and 2014: