The Company shares its operating facilities with Mutual pursuant to the terms of the 2005 Management Agreement. The Company’s corporate headquarters are located in Columbus, Ohio, in buildings owned by Mutual that contain approximately 280,000 square feet of office space. The Company and Mutual also own and lease other office facilities in numerous locations throughout the State Auto Group’s geographical areas of operation.
(2) Net income less preferred share dividends, if any, divided by average common stockholders’ equity.
(3) GAAP ratios are computed using earned premiums for both the loss and LAE ratio and the expense ratio, and include the effect of eliminations in consolidation. The statutory expense ratio is computed using net written premiums. The Company uses the statutory combined ratio to compare its results to the industry statutory combined ratio as there is no industry GAAP combined ratio available.
State Auto Financial’s subsidiaries are State Auto P&C, Milbank, Farmers, SA Ohio and SA National, each of which is a property and casualty insurance company; Stateco, which provides investment management services to affiliated insurance companies; S.I.S., a developer and seller of insurance-related software; and 518 PML, which owns and leases real and personal property to affiliated companies. State Auto Financial and these subsidiaries are collectively referred to as the “Company.”
The Pooled Companies (defined below) provide a broad line of property and casualty insurance, such as standard personal and commercial automobile, homeowners, commercial multi-peril, workers’ compensation, general liability and fire insurance. SA National provides nonstandard personal automobile insurance to the nonstandard insurance market. The Pooled Companies and SA National are collectively referred to as the “State Auto Group.”
The results of our operations from year-to-year and quarter-to-quarter are primarily driven by our ability to generate revenue through premium growth, price and sell our insurance products at levels which will generate underwriting profits, and establish appropriate loss reserves. In addition, our results are significantly impacted by the occurrence of catastrophic events, which are generally beyond our control.
Claims Service: We believe an important element of our success is our focus on claims service. The role of the claims division is to deliver the promise that we and the independent agent made to the insured - that we will strive to provide prompt and fair claims service. We have the capability of receiving claims 24 hours a day, seven days a week. Claims may be reported to our Claims Contact Center, to the policyholder’s independent agent or via the Internet. We make a pledge to our policyholders to try and make contact with them within two hours once the claim has been assigned to a claims handler (except in catastrophe loss situations).
Investment Strategy: We have a conservative investment strategy that emphasizes the quality of our fixed income portfolio, which comprised 86% of our total portfolio at December 31, 2005, and includes only investment grade securities. We have a disciplined approach to the equity portion of our portfolio, which comprised 13.6% of our total portfolio at December 31, 2005, that emphasizes large capitalization, dividend-paying companies. We select equity investments based on a stock’s potential for appreciation as well as ability to continue paying dividends.
Technology: Recent statistics indicate that approximately 87% of the Company’s personal automobile and homeowners new business applications and 73% of change requests in these lines of business are delivered and processed electronically. This increased utilization, specifically the new business percentage representing a 20 point increase since the 2004 fiscal year, demonstrates our success and focus with respect to competing on an “ease of doing business” factor. Our internet-based point of sale agency portal for personal lines business, netXpress, and an automated intelligent underwriting system, Apollo, are examples of standards-based, user-friendly technology, making it easier for agents to submit personal lines accounts to us. The Apollo system allows us to make consistent underwriting decisions across the standard and non-standard lines of business. In 2005, we continued to rollout this system to additional states, resulting in 171,000 total underwriting decisions rendered. This reflected a 101% increase from 2004 for new business and endorsement transactions handled by our automated underwriting systems. Management’s focus will continue on “ease of doing business” in other ways as well, such as enhancements to our electronic portal for agents, called Agentsite, and creating ways for our internet rating and underwriting systems to “talk” with more agency management systems. In 2005, “Agentsite Dashboard” was added to provide agents with quicker access to customer information and recent transactions. This new functionality helped agents transition following our decision to eliminate the printing and mailing of paper policy declarations to agents for personal lines. We have recently begun work to develop a commercial lines automation system that is intended to build upon the success we have achieved through our netXpress system for personal lines. netXpress allows agents to obtain rates for applicants on-line in real time and secure consumer reports required for rating or underwriting, all of which combined enables the agent to offer a firm quote to a customer in real time at the point of sale. In order to achieve our goal of commercial lines functionality, we will need to make a significant commitment of resources over the next 18 to 36 months. However, we believe developing such an Internet-based system is vitally important to our ability to compete for new commercial lines accounts.
Pension and postretirement benefit obligations are long term in nature and require management judgment in estimating the factors used to determine these amounts. Management, along with its defined benefit consulting actuary, reviews these factors, including the discount rate and expected long term rate of return on plan assets. Because these obligations are based on management estimates which could change, the ultimate benefit obligation could be different from the amount estimated.
The following table summarizes certain key performance indicators used to manage the operations of the Company for the years ended December 31, 2005, 2004 and 2003, respectively:
The investment management services segment reflects management of the investment portfolios of affiliate companies. Its significant source of segment profit is the fee generated from providing this service. This segment’s revenue is based on the average fair value of the portfolios managed. Beginning January 1, 2006, the investment management services segment will be included in the all other category as the results of this segment no longer meets the quantitative thresholds for separate presentation as a reportable segment even with consideration of aggregation of other segments with similar economic characteristics, among other factors.
The following tables provides a summary of the insurance segments’ GAAP underwriting profit (in dollars), GAAP Combined Ratio along with related segment net investment income, for the years 2005, 2004 and 2003, respectively. The tabular information provided is net of adjustments for transactions with other segments.
(1) Includes $24.0 million of unearned premium transferred to the Company in connection with the addition of the Meridian Insurers to the Pooling Arrangement.
The Company’s biggest challenge in 2005 was top line growth in both the standard and nonstandard segments. As a consequence, the Company implemented a number of initiatives to stimulate sales in personal lines new business and is working with its independent agency partners to strengthen personal lines sales techniques and skills. Known by the acronym STAR, this Sales Training for Agency Representatives has now been delivered to over 1,300 agency representatives, exceeding the Company’s goal of at least 1,000 program participants during 2005. Additionally, the Company continually reviews its insurance programs in order to provide insurance to a broader segment in the markets in which it operates. For example, the Company has expanded eligibility requirements for youthful operators within its standard segment and, as noted, is selectively offering higher limits within the nonstandard segment. Most recently the Company began to roll out a new standard private passenger auto multi-variant rating program called CustomFit™-a program that is more responsive to the risk characteristics of each driver, more accurately matching price to risk, and is intended to facilitate the Company’s agency partners’ ability to sell this program to a broader segment of its customer base. The objective is to preserve the Company’s Prime of Life product, which targets the 45 year and older market, while also becoming more attractive to a broader range of personal lines accounts.
In 2005, the Investment Committee of the Company’s Board of Directors approved management’s recommendation to increase its target allocation for equity securities, which typically have an investment yield less than fixed maturities, in an effort to mitigate inflation risk and increase the growth potential of the portfolio. The Company targets those equity securities that demonstrate a history of dividend payment and potential for capital appreciation. During 2005, the Company added $61.4 million, an increase of 37.6% from 2004, of new investments to the equity securities portfolio.
With the shift in the Company’s investment portfolio towards lower yielding securities before tax, the decrease in assets associated with the repayment of the $45.5 million line of credit with Mutual in December 2005 and increased dividend rate expected to be paid per common share in 2006 (discussed below), net investment income in 2006 is not expected to increase at a rate comparable to that experienced in 2005.
In 2005, the Company recorded $5.6 million in net realized investment gains as compared to $7.6 million in 2004. Most of the net realized gains in 2005 were in the fixed income segment of the portfolio. In many cases, taxable bonds were sold at a profit with the proceeds being reinvested in the tax-exempt segment. These transactions helped to further the goal of increasing the tax-exempt portion of the portfolio. In other cases, bonds with lower coupons were sold with the proceeds reinvested in higher coupon bonds in order to increase interest income for the Company. Equity securities were sold due to changing fundamentals, mergers or acquisitions, and
See further discussion regarding investments at the “Liquidity and Capital Resources - Other, Investments” section, included herein.
Acquisition and operating expenses, as a percentage of earned premiums (the “GAAP expense ratio” or “expense ratio points”), were 31.7% and 30.2% in 2005 and 2004, respectively. The 1.5 point increase is largely due to lower than anticipated written premiums in combination with certain fixed expenses increasing.
Interest expense in 2005 was $8.8 million compared to $7.3 million in 2004. The increase in interest expense was due to higher interest rates on variable debt in 2005 and the benefit of interest rate swaps in 2004. See further discussion of the Company’s debt activity in 2005 and 2004 in the section “Liquidity and Capital Resources-Borrowing Arrangements” included herein.
The consolidated effective tax rate is largely affected by the amount of underwriting profit or loss and net realized investment gains or losses that are taxed at approximately 35% relative to the amount of net investment income at its effective tax rate. The 2005 consolidated effective tax rate declined to 26.8% from 27.4% in 2004. This was principally due to a decline in the 2005 effective tax rate on net investment income to approximately 17.3% versus 19.4% in 2004. Contributing to the decline was the decision by the Company to continue to increase in 2005 its holdings of tax-exempt municipal bonds as previously discussed.
Income before federal income taxes for the Company increased $68.3 million (82.0%) to $151.6 million in 2004 from 2003. The most significant factors contributing to this increase were an improvement in the Company’s loss experience from 2003 along with growth in earned premium. The Company’s GAAP loss and LAE ratio reflected a 6.3 point improvement in 2004 from 2003, despite at that time, 2004 being the largest catastrophe (in dollars) loss year in the Company’s history.
The following provides a summary of a stop loss reinsurance arrangement (the “Stop Loss”), which expired on December 31, 2003, that will assist in the discussion of the Company’s related 2003 financial results:
For the period October 1, 2001 through December 31, 2003, Mutual entered into a stop loss reinsurance arrangement (the “Stop Loss”) with the STFC Pooled Companies. Under the Stop Loss, Mutual agreed to participate in the Pooling Arrangement’s quarterly underwriting losses and gains in the manner described. If the Pooling Arrangement’s quarterly statutory loss and loss adjustment expense ratio (the “Pool loss and LAE ratio”) was between 70.75% and 80.00% (after the application of all available reinsurance), Mutual reinsured the STFC Pooled Companies 27% of the Pooling Arrangement’s losses in excess of a Pool loss and LAE ratio of 70.75% up to 80.00%. The STFC Pooled Companies were responsible for their share of the Pooling Arrangement’s losses over the 80.00% threshold. Also, Mutual had the right to participate in the
profits of the Pooling Arrangement. Mutual assumed 27% of the Pooling Arrangement’s underwriting profits attributable to Pool loss and LAE ratios less than 69.25%, but more than 59.99%. The Stop Loss arrangement expired at December 31, 2003, and was not renewed.
The following table summarizes the consolidated earned premiums by segment and by line of business for the years ended December 31, 2004 and 2003:
Consolidated earned premiums increased $46.2 million (4.8%) to $1,006.8 million in 2004 from 2003. The Company’s standard segment contributed a 4.6% increase to consolidated earned premiums in 2004 from 2003, while the nonstandard segment experienced a 1.1% decrease in the same period. The 2003 consolidated earned premiums were affected by the Stop Loss. The STFC Pooled Companies ceded $12.8 million in earned premiums to Mutual in 2003, which reduced the Company’s earned premiums in 2003 by 1.3%. The Stop Loss reinsurance agreement expired December 31, 2003 and was not renewed.
Earned premiums within the standard segment increased $57.0 million (6.5%) in 2004 from 2003. During 2003 and 2002, the Company took necessary and in some cases significant base rate increases, particularly within the Meridian book, in almost all lines of business. The impact of these base rate changes affects earned premium growth in the years following the implementation of these changes. After a number of years of having attained a healthy degree of rate adequacy, during 2004 the Company implemented more moderate base rate changes, which was expected to slow earned premium growth. In an effort to address personal lines growth, the Company introduced programs in 2004 focusing on increasing personal lines applications from its agency partners. Additionally, the Company introduced a specialized training program to its agency partners’ service representatives that focuses specifically on sales techniques.
The GAAP loss and LAE ratios were 61.5% and 67.8% for the years 2004 and 2003, respectively. Losses and loss expenses for a calendar year represents the combined estimated ultimate liability for claims occurring in the current calendar year along with development of claims occurring in prior years. The following table presents the provision for losses and loss expenses for those claims occurring in the current calendar year and prior years, along with the respective impact on the current calendar year GAAP loss and LAE ratio for the years 2004 and 2003, respectively:
For the years 2004 and 2003, catastrophe claims contributed 7.0 and 6.8 points, respectively, to the consolidated GAAP loss and LAE ratio. During 2004, hurricanes Charley, Frances, Jeanne and Ivan contributed a total of $39.6 million in catastrophe losses, or 3.9 GAAP loss and LAE ratio points. In 2003, high winds, tornadoes, hail, lightning and resulting fires from one numbered catastrophe loss caused damage in 17 of the Company’s 26 operating states (“CAT 88”). Claims resulting from CAT 88 totaled $39.6 million or 4.1 GAAP loss and LAE points for the year 2003. In terms of dollars, CAT 88 remains the largest single catastrophe loss event in State Auto history. As discussed below, each of the Company’s insurance operating segments was impacted by these catastrophe losses.
The following table summarizes the consolidated GAAP loss and LAE ratio by segment and by line of business for the years ended December 31, 2004 and 2003, respectively:
Interest expense increased $3.6 million (97.3%) to $7.3 million in 2004 from 2003. This increase was the result of an additional $85.5 million of debt, net of repayments, obtained during the last nine months of 2003. See “Liquidity and Capital Resources-Borrowing Arrangements” for further discussion of the Company’s debt activity in 2004 and 2003.
Liquidity refers to the ability of the Company to generate adequate amounts of cash to meet its needs for both long-term and short-term cash obligations as they come due. The Company’s significant sources of cash are premiums, investment income, investment sales and the maturity of fixed 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 can vary due to uncertainties regarding settlement of large losses or catastrophe events. As a result, the Company continually monitors its 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 Company’s insurance subsidiaries must have adequate liquidity to ensure that their cash obligations are met. However, because the STFC Pooled Subsidiaries participate in the Pooling Arrangement, they do not have the daily liquidity concerns normally associated with an insurance company. This is due to the fact that, under the terms of the Pooling Arrangement, 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 45 days following each quarter end. When settling the intercompany balances, 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
During 2005, 2004 and 2003, as permitted by regulations of the Internal Revenue Service, the Company made cash contributions of $7.5 million, $5.0 million and $4.6 million, respectively, to the Pension Plan on behalf of its employees. The actuarially determined contribution to the Pension Plan ranges from the minimum amount the Company 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 Pension Plan is generally not determined until the second quarter with respect to the contribution year, though the Company currently expects to make a cash contribution of approximately $10.0 million during 2006 to the Pension Plan. See additional discussion regarding the Company’s Pension Plan provided under the “Employee Benefit Plans” section included herein.
the current year increase in cash provided by operating activities as described above.
State Auto Financial’s repayment of its $45.5 million line of credit with Mutual. See further discussion provided under “Borrowing Arrangements” section included herein.
In 1999, State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million in conjunction with its stock repurchase program in effect at that time. The entire principal amount was due no later than December 31, 2005, which State Auto Financial repaid in its entirety on December 27, 2005. This repayment was substantially funded through dividends from State Auto Financial’s insurance subsidiaries. The interest rate under this line of credit was 3.50% and 2.25% for 2005 and 2004, respectively.
In November 2005, State Auto Financial entered into a Credit Agreement (the “Credit Agreement”) with a syndicate of lenders. The Credit Agreement provides for a $100.0 million five-year unsecured revolving credit facility (the “Credit Facility”). During the term of the Credit Facility, State Auto Financial has the right to increase the total facility amount by $25.0 million, up to a maximum total facility amount of $125.0 million, provided that no event of default has occurred and is continuing. The Credit Facility is available for general corporate purposes, including working capital and acquisitions, and for catastrophic loss purposes. At the present time, State Auto Financial intends to use the Credit Facility for catastrophe loss purposes. The Credit Facility provides for interest-only payments during its term, with principal due in full at maturity. Interest is based on a London interbank market rate or a base rate plus a calculated margin amount. In addition to requiring the payment of a monthly fee to maintain availability of funds, the Credit Agreement contains certain covenants, including financial covenants that require State Auto Financial to (i) maintain a minimum net worth, (ii) not exceed a certain debt to capitalization ratio and (iii) not go below a certain fixed charge coverage ratio. State Auto Financial did not borrow any funds under the Credit Agreement in 2005. As of December 31, 2005, State Auto Financial was in compliance with all of its covenants under the Credit Agreement.
At December 31, 2005, the Company’s notes payable are summarized as follows:
Each member of the State Auto Group is party to working reinsurance treaties for property, casualty and workers’ compensation lines with several reinsurers arranged through a reinsurance intermediary. Under the property per risk excess of loss treaty, each member is responsible for the first $2.0 million of each covered loss, and the reinsurers are responsible for 100% of the excess over $2.0 million up to $10.0 million of covered loss. The rates for this reinsurance are negotiated annually.
In addition to the workers’ compensation reinsurance program described above, each company in the State Auto Group is party to an agreement which provides an additional layer of excess of loss reinsurance for workers’ compensation losses involving multiple workers. Subject to $10.0 million of retention, reinsurers are responsible for 100% of the excess over $10.0 million up to $20.0 million of covered loss. This coverage is subject to a “Maximum Any One Life” limit of $10.0 million. The rates for this reinsurance are negotiated annually.
The State Auto Group participates in an intercompany catastrophe reinsurance program. Under this program, the members of the State Auto Group, on a combined basis, retain the first $40.0 million of catastrophe losses that affect at least two individual risks. For catastrophe losses incurred by the State Auto Group up to $80.0 million, in excess of $40.0 million, traditional reinsurance coverage is provided with a co-participation of 5%. For catastrophe losses incurred by the State Auto Group up to $100.0 million, in excess of $120.0 million, in exchange for a premium paid by each reinsured company, State Auto P&C acts as the catastrophe reinsurer for the State Auto Group under the terms of an intercompany catastrophe reinsurance agreement. There have been no losses assumed under this agreement.
Included in the table are the estimated payments to be made with respect to the Company’s notes payable and in the settlement of direct loss and ALAE (defined below) reserves:
(1) The Company’s actuarial department derived expected payment patterns separately for the direct loss and ALAE reserves (ALAE defined below). Amounts include the STFC Pooled Companies net additional share of transactions assumed from Mutual through the Pooling Agreement (see reconciliation of management’s best estimate included in the Loss Reserves section included herein). These patterns were applied to the December 31, 2005, loss and ALAE payable to generate estimated annual incremental loss and ALAE payments for each subsequent calendar year. These amounts are based on historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates.
The National Association of Insurance Commissioners (“NAIC”) utilizes a collection of analytical tools designed to assist state insurance departments with an integrated approach to screening and analyzing the financial condition of insurance companies operating in their respective states. One such set of analytical tools is 12 key financial ratios that are known in the insurance industry as the “IRIS” ratios. IRIS ratios are derived from financial statements prepared on a statutory accounting basis, which are accounting practices prescribed or permitted by the insurance department with regulatory authority over the Company’s insurance subsidiaries. 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 its operating performance on a statutory accounting basis, of which each of the respective insurance subsidiaries operates well within the defined range for the other
measures, the net written premium to statutory surplus ratio (the “leverage ratio”) is monitored to ensure that each of the Company’s insurance subsidiaries continues 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.
The statutory leverage ratios for the Company’s insurance subsidiaries at December 31, 2005, 2004 and 2003 are as follows:
Stateco performs investment management services, which comprise the investment management services segment, on behalf of the Company and Mutual and its subsidiaries. The Investment Committee of each insurer’s Board of Directors sets investment policies to be followed by Stateco.
The Company manages its equity portfolio by investing in a large, but manageable, number of stocks from many different industries. This diversification across companies and industries reduces volatility in the value of the equity portfolio. The Company invests only in stocks that currently pay a dividend. As of December 31, 2005, the Company’s equity portfolio consisted of approximately 100 different stocks. The largest single position was 2.2% of the equity portfolio based on fair value and the top ten positions were equal to approximately 16% of the equity portfolio. The chart below shows the industry sector breakdown of the Company’s equity portfolio versus the S&P 500 Index based on fair value as of December 31, 2005.
The Company’s equity portfolio tends to consist of large cap, value oriented stocks. Therefore, when large cap stocks and/or value stocks perform well the Company’s portfolio typically performs well. Conversely, when growth stocks outperform value and/or small to mid cap stocks outperform large cap, the Company’s portfolio does not perform as well.
The following table provides the composition of the Company’s investment portfolio at December 31, 2005 and 2004, respectively:
The Company reviewed its investments at December 31, 2005, and determined no additional other-than-temporary impairment exists in the gross unrealized holding losses, as provided in the table below, due to the evidence that exists indicating temporary impairment. At December 31, 2005, there were no investments reflected in the table below with an unrealized holding loss that had a fair value significantly below cost continually for more than one year. There are no individually material securities with an unrealized holding loss at December 31, 2005.
The following table provides detailed information on the Company’s investment portfolio for its gross unrealized gains and losses, adjusted for investments with other-than-temporary impairment at December 31, 2005:
At December 31, 2005, total investments at fair value comprise approximately 82.6% of the Company’s total assets. Of the Company’s total investments, 86.0% are invested in fixed maturities, 13.6% in equity securities and 0.4% in other invested assets. Cash and cash equivalents represent approximately 1.3% of the Company’s total assets at December 31, 2005.
The Company’s decision to make a specific investment is influenced primarily by the following factors: (a) investment risks; (b) general market conditions; (c) relative valuations of investment vehicles; (d) general market interest rates; (e) the Company’s liquidity requirements at any given time; and (f) the Company’s current federal income tax position and relative spread between after tax yields on tax-exempt and taxable fixed income investments.
This table summarizes only the effects that a parallel change in interest rates could have on the fixed income portfolio. This change in rates would also change the value of the Company’s liabilities and possibly other financial assets. The Company cautions the reader that this analysis does not take into account nonparallel changes in interest rates. It is likely that some rates would increase or decrease more than others depending upon market conditions at the time of the change. This nonparallel change would alter the value of the fixed income portfolio. The analysis is also limited in that it does not take into account any actions that might be taken by the Company in response to these changes. As a result, the actual impact of a change in interest rates and the resulting fixed income values may differ significantly from what is shown in the table.
As of December 31, 2005, the Company’s equity portfolio had a beta of 0.98 using the S&P 500 Index as a benchmark. Beta estimates the degree the portfolio’s price will fluctuate based on a given movement in the market index. The table below reflects what changes might occur in the value of the equity portfolio given a change in the S&P 500 Index:
Some parameters have been set by the Investment Committee to help manage the risks associated with the investment portfolio. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 5.0% of statutory assets, other than obligations of the U.S. government or government agencies, for which there is no limit. Investments in equity securities are selected based on their potential for appreciation as well as ability to continue paying dividends. The equity portfolio is diversified across industries and concentrations in any one company or industry are limited by parameters established by the Investment Committee of the Company’s Board of Directors. The total holding of a specific stock should not exceed 2% of the outstanding stock and based on market value at the time of purchase, no one equity holding should exceed 5% of the total equity portfolio. Up to 15% of the equity portfolio may deviate from these requirements allowing the Company to invest in timely special situations. Equity investments will normally be targeted to no more than 40% of total assets or 50% of statutory surplus whichever is greater. Additional information regarding the composition of investments, along with maturity schedules regarding investments in fixed maturities at December 31, 2005, is presented in tabular form above.
The Company’s total investments, at fair value, grew approximately 10.6% during 2005 to $1,879.9 million at December 31, 2005, from $1,699.1 million at December 31, 2004. This growth was generated primarily from net cash flows provided by operations, $54.0 million received from the Meridian Insurers and financing activities which were offset by a decline on the cumulative unrealized gains on investments. The net unrealized gain on the Company’s equity portfolio increased $0.6 million to $30.8 million at December 31, 2005, while the Company’s net unrealized gain on its fixed maturity portfolio declined $30.2 million to $20.0 million at December 31, 2005. Unrealized gains related to other invested assets increased $0.6 million to $0.8 million at December 31, 2005.
To calculate the State Auto Group’s pension benefit obligation as of December 31, 2005, the Company used a discount rate of 5.75% based on an evaluation of the expected future benefit cash flows of the Pension Plan used in conjunction with the Citigroup Pension Discount Curve (formerly Salomon Brothers Pension Discount Curve) at the measurement date. A lower discount rate results in, all else equal, a higher present value of the benefit obligation. The Company selected an expected long-term rate of return on its plan assets of 9.0% by considering the mix of investments, stability of investment portfolio along with actual investment experience
The selected discount rate of 5.75% is a reduction of 0.75 points from the 6.50% rate used in the previous year which had the effect of increasing the pension benefit obligation at December 31, 2005 and related unrecognized net loss by approximately $23.2 million. Unrecognized losses of approximately $82.4 million are being recognized over approximately a 12 year period, which represents the average future service period of active participants. Unrecognized gains and losses arise from several factors including expected to actual demographic changes, assumption changes in the obligations and from the difference between expected and actual returns on plan assets. These unrecognized losses will be systematically recognized as an increase in future net periodic pension expense in accordance with FASB Statement 87, “Employers Accounting for Pensions” (“SFAS 87”).
(2) Calculated based on December 31, 2005 change from January 1, 2005.
The Company’s internal actuarial staff conducts quarterly reviews of projected loss development information to assist management in making estimates of reserves for ultimate losses and loss expenses payable. Several factors are considered in estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, accounting projections, exposure growth, current business conditions, catastrophe developments, and late reported claims. In addition, reasonableness tests are performed on measures of claim severity, loss ratio and trend factors, all of which are implicit in the liability estimates.
Losses and loss expenses payable is management’s best estimate (“MBE”) at a given point in time of what the Company expects to pay claimants, based on known facts, circumstances and historical trends. Reserves for reported losses are established by the Company’s claim division on either a case-by-case or formula basis depending on the type and circumstances of the loss. The case-by-case reserve amounts are determined based on the Company’s reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. The objective of the claims division is to establish ultimate case reserves that are sufficient, but not excessive. The formula reserves are based on historical data for similar claims with provision for trend changes caused by inflation. Loss and loss expense reserves for incurred claims
Management establishes a reserve for loss adjustment expenses contemplating functions and costs that are not attributable to a specific claim, which is called Unallocated Loss Adjustment Expense (“ULAE”). Historical ratios of paid ULAE to paid losses are developed, and then imposed on the current outstanding reserves. The method uses a traditional assumption that 50% of the expenses are realized when the claim is open, and the other 50% are incurred as the loss payments are made. The method also assumes that the underlying claims process and mix of business do not change drastically over time.
An important assumption underlying the 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, 2005, other liability loss and ALAE payable 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 two percent 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 jump 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 two percent increase in the loss cost trend would have on our results of operations over the lifetime of the underlying claims in other liability is an increase of $9.3 million on reserves, or a $6.1 million after-tax reduction (assuming a tax rate of 35%) to net income. Inflation changes have much more impact on the longer tail commercial lines like other liability and workers’ compensation, and much less impact on the shorter tail personal lines’ reserves.
The property and casualty industry has had significant loss experience from claims related to asbestos, environmental remediation, product liability, mold and other mass torts. Asbestos reserves are $3.7 million, and environmental reserves are $5.5 million, for a total of $9.2 million, or 1.3% of net losses and loss expenses payable. Because the Company has insured primarily product retailers and distributors, not manufacturers, incurred losses have not been significant from asbestos and environmental claims activity.
The 6.2% current year favorable development is partly explained by normal fluctuations and uncertainty associated with loss reserve development. See related discussion regarding incurred losses and loss expenses included in the “2005 Compared to 2004” section above.
It is not feasible to quantify the impact of judicial decisions that may have retroactive effect because the Company cannot foresee, among the range of issues that are litigated every day in courts in each state in which the Company does business, which cases will be decided adversely and how such decisions will actually apply to the Company.
The reserve estimates do not contemplate substantial loss from any mass torts, including those already listed above, or others not known at this time. In addition, there is no provision in the reserves for a major retroactive expansion of coverage through judicial interpretation. If these assumptions prove to be incorrect, ultimate liabilities could increase substantially. The Company’s Claims, Underwriting and Actuarial staff track separately all claims within the family of mass torts, and respond accordingly as information becomes known.
Premium rates are actuarially determined to enable an insurance company to generate an underwriting profit. These rates contemplate a certain level of risk. The courts may modify, in a number of ways, the level of risk which insurers had expected to assume including eliminating exclusions, multiplying limits of coverage, creating rights for policyholders not intended to be included in the contract and interpreting applicable statutes expansively to create obligations on insurers not originally considered when the statute was passed. Courts have also undone legal reforms passed by legislatures, which reforms were intended to reduce a litigant’s rights of action or amounts recoverable and so reduce the costs borne by the insurance mechanism. These court decisions can adversely affect an insurer’s profitability. They also create pressure on rates charged for coverages adversely affected, and this can cause a legislative response resulting in rate suppression that can adversely affect an insurer. The Company may also be adversely affected by regulatory actions on matters within the jurisdiction of the various insurance departments where the Company does business or has entities domiciled.
See the discussion regarding the federal Terrorism Risk Insurance Act of 2002 (the “TRIA”) and its successor, the Terrorism Risk Insurance Extension Act of 2005 (“TRIEA”) (collectively, the “Terrorism Act”) in the “Regulation” section of Item 1 included herein.
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2005. 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, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of State Auto Financial Corporation’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 1, 2006 expressed an unqualified opinion thereon.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of State Auto Financial Corporation as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2005, and our report dated March 1, 2006 expressed an unqualified opinion thereon.
The Company, through State Auto P&C, Milbank, Farmers and SA Ohio, provides standard personal and commercial insurance to its policyholders. The Company’s principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers’ compensation, general liability and fire insurance. SA National provides nonstandard automobile insurance. State Auto P&C, Milbank, Farmers, SA Ohio and SA National operate primarily in the central and eastern United States, excluding New York, New Jersey and the New England states, through an independent insurance agency system. State Auto P&C, Milbank, Farmers, SA Ohio and SA National are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota, Iowa and Ohio (SA Ohio and SA National), respectively, and are licensed in various other states. 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 Mutual. The nature of the underlying policies and geographical distribution of Mutual’s underwriting activity is similar to the Company.
The Company, through S.I.S., develops and sells software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance
companies and agencies. S.I.S. sells services and products to insurance agencies and nonaffiliated insurers and their agencies. S.I.S. also delivers services and sells products to affiliated entities.
Certain items in the prior period consolidated financial statements have been reclassified to conform to the 2005 presentation.
All investments in fixed maturity and equity securities are classified as available-for-sale and, therefore, are carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders’ equity as “accumulated other comprehensive income” and as such are not included in the determination of net income. Realized gains and losses on the sale of investments are computed using the first-in, first-out method.
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 $27.2 million at December 31, 2005 and 2004, respectively, has been established to cover the estimated ultimate cost of insured losses. The amounts are necessarily based on estimates of future rates of inflation and other factors, and accordingly, there can be no assurance that the ultimate liability will not vary materially from such estimates. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations (see Note 4). Anticipated salvage and subrogation is estimated using historical experience. As such, losses and loss expenses payable represent management’s best estimate of the ultimate liability related to reported and unreported claims.
The Company follows Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related Interpretations in accounting for its employee and director share based awards using the intrinsic value method to account for stock-based compensation. Had compensation cost for the Company’s plans been determined based on the fair values at the grant dates consistent with the method of SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), the Company’s pro-forma net earnings and net earnings per share information would have been as follows:
The fair value of share based awards granted to employees and directors in 2005, 2004 and 2003 were estimated at the date of grant using the Black-Scholes-Merton option-pricing model.
acquisition costs on internal replacements of insurance contracts that are modifications to product features that occur by the exchange of a contract for a new contract. Insurance contracts issued by the Company include nonintegrated contract features as defined in SOP 05-1, or those that provide coverage that is underwritten and priced only for that incremental insurance coverage and do not result in reunderwriting or repricing of other components of the contract. Nonintegrated contract features do not change the existing base contract and do not require further evaluation under SOP 05-1. Given the nature of the policies written, the impact of SOP 05-1 upon implementation is not expected to be material.
In May 2005, the FASB issued FASB Statement 154, “Accounting Changes and Error Corrections” (“SFAS 154”) which replaces APB Opinion 20, “Accounting Changes” (“APB 20”) and FASB Statement 3, “Reporting Accounting Changes in Interim Financial Statements” (“SFAS 3”). SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS 154 applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 requires voluntary changes in accounting principles be recognized retrospectively to prior periods’ financial statements, rather than recognition in the net income of the current period. Retrospective application requires restatement of prior period financial statements as if that accounting principle had always been used. SFAS 154 carries forward without change the guidance contained in APB 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. The provisions of SFAS 154 are effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not believe SFAS 154 will have a material impact on the financial position or results of operation of the Company.
During 2005, the Company recognized realized losses on other-than-temporary impairments of $0.6 million on its fixed maturity portfolio and $1.0 million on its equity security portfolio, and in 2004, $0.2 million on its fixed maturity portfolio. The Company reviewed its investments at December 31, 2005, and determined no additional other-than-temporary impairment exists in the gross unrealized holding losses, as provided in the table below, due to the evidence that exists indicating temporary impairment.
Deferred federal income taxes on the net unrealized holding gains for available-for-sale investments was $18.0 million and $28.2 million at December 31, 2005 and 2004, respectively.
At December 31, 2005 and 2004, there were no investments reflected in the tables below with an unrealized holding loss that had a fair value significantly below cost continually for more than one year. There are no individually material securities with an unrealized holding loss at December 31, 2005 and 2004. The following tables reflect the Company’s gross unrealized losses and fair value on its investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2005 and 2004:
The amortized cost and fair value of available-for-sale fixed maturities at December 31, 2005, by contractual maturity, are summarized as follows:
Fixed maturities with fair values of approximately $52.5 million and $52.3 million were on deposit with regulators as required by law or specific escrow agreement at December 31, 2005 and 2004, respectively.
Investment securities: Fair values for investments in fixed maturities are based on quoted market prices, where available. For fixed maturities not actively traded, fair values are estimated using values obtained from independent pricing services. The fair values for equity securities are based on quoted market prices.
Cash and cash equivalents: The carrying amounts reported in the balance sheets for these instruments approximate their fair value, because of their short-term nature.
The Company recorded favorable loss reserve development in 2005, 2004 and 2003 of $44.3 million, $22.2 million and $1.8 million, respectively. Normal fluctuations and uncertainty associated with loss reserve development and claim settlement contributed to the favorable development in the respective calendar years. Impacting the 2005 development was favorable development of $5.8 million on 2004 and prior catastrophe losses, approximately $14.4 million of changes in ceded claim reserves along with lower cost projections for unallocated loss adjustment expense reserves.
In conjunction with the Pooling Arrangement amendment, the STFC Pooled Companies received $54.0 million in cash from the Meridian Insurers which related to the additional net insurance liabilities assumed on January 1, 2005. The following table presents the impact on the Company’s balance sheet relating to the additional net insurance liabilities assumed on this date:
Under the Pooling Arrangement, the STFC Pooled Companies, SA Wisconsin, SA Florida and the Meridian Insurers cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation percentages in the Pooling Arrangement. The STFC Pooled Companies’ pooling participation percentage remained at 80% under the amended pooling arrangement effective January 1, 2005. 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.
The STFC Pooled Companies, SA National, Mutual, SA Wisconsin, SA Florida and the Meridian Insurers are collectively referred to as the “State Auto Group.”
State Auto P&C assumes catastrophe reinsurance from the State Auto Group in the amount of $100.0 million excess of $120.0 million in exchange for a premium paid by each reinsured company. Under this agreement, the Company has assumed from Mutual and its affiliates premiums written and earned of $2.7 million, $2.7 million and $2.8 million for 2005, 2004 and 2003, respectively. There have been no losses assumed under this agreement. The catastrophe reinsurance program with State Auto P&C has been excluded from the Pooling Arrangement.
Pursuant to the Pooling Arrangement, 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 45 days following each quarter end. No interest is paid on this balance. When settling the intercompany balances, 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 Mutual and allocated to the pool member on the basis of pool participation. As a result, the Company has an off-balance sheet credit-risk related to the balances due to Mutual from insureds, agents and reinsurers, which is offset by the unearned premium from the respective policies. The Company’s share of the premium balances due to Mutual from agents and insureds at December 31, 2005 and 2004 is approximately $255.1 million and $214.2 million, respectively.
State Auto P&C’s December 31, 1990 liability for losses and loss expenses of $65.5 million has been guaranteed by Mutual. Pursuant to the guaranty agreement, all ultimate adverse development of the
In November 2005, State Auto Financial entered into a Credit Agreement (the “Credit Agreement”) with a financial institution and a syndicate of other lenders to provide for a $100.0 million five-year unsecured revolving credit facility (the “Credit Facility”). During the term of the Credit Facility, State Auto Financial has the right to increase the total facility amount by $25.0 million, up to a maximum total facility amount of $125.0 million, provided that no event of default has occurred and is continuing. The Credit Facility is available for general corporate purposes, including working capital and acquisitions, and for catastrophic loss purposes. At the present time, the Company intends to use the Credit Facility for catastrophe loss purposes. The Credit Facility provides for interest-only payments during its term, with principal due in full at maturity. Interest is based on either a London interbank market rate or a base rate plus a calculated margin amount. In addition to paying a quarterly fee to have these funds available, the Credit Agreement contains certain covenants, including financial covenants that require State Auto Financial to (i) maintain a minimum net worth, (ii) not exceed a certain debt to capitalization ratio and (iii) not go below a certain fixed charge coverage ratio. As of December 31, 2005, State Auto Financial had no borrowings under the Credit Agreement and was in compliance with all its covenants.
A reconciliation between actual federal income tax expense (benefit) and the amount computed at the indicated statutory rate for the year ended December 31, is summarized as follows:
In addition to the pension benefit 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
The Company’s pension and postretirement benefit plans’ weighted average asset allocations by asset category at the plans’ measurement date of September 30, 2005 and 2004, respectively, are as follows:
The plan’s investment policy objective is to preserve the investment principal while generating income and appreciation in fair value to meet the plans’ obligations. The plans’ investment strategy and risk tolerance is balanced between meeting cash obligation requirements and a long term relatively high risk tolerance. Since the nature and timing of the plans’ liabilities and cash requirements are predictable, the liquidity requirements are somewhat moderate. Therefore, the Trustees of the plan have authorized that at least 75% of the plans’ assets should be in public marketable securities. Bond investments will normally range from 10 to 20 years in maturity. Debt instruments, convertible debt and preferred stock are rated “A” or better by two major rating services. The equity portfolio is comprised primarily of large capitalization, high quality stocks with a strong earnings growth and dividends payment history. Total holding of a specific stock cannot exceed 2% of the outstanding stock. No one equity holding can be greater than 5% of the total equity portfolio. Total holdings of bonds and stocks of any one corporation cannot exceed 5% of assets.
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. This range is generally not determined until the second quarter with respect to the contribution year. The Company expects to contribute approximately $10.0 million during 2006 to its pension plan, depending on the actuarially calculated funding requirements of such plan. Postretirement and SERP plan payments are deductible for tax purposes when paid.
The postretirement net accrued obligation is also carried on the financial statements of the Company and the annual periodic postretirement benefit or cost is allocated to affiliated companies based on allocations pursuant to intercompany management agreements. The Company’s share of the 2005, 2004 and 2003 net periodic costs were $11.8 million, $8.9 million and $8.2 million, respectively.
The Company maintains a defined contribution plan that covers substantially all employees of the Company. The Company matches the first 2% of contributions of participants’ salary at the rate of 75 cents for each dollar contributed. Participant contributions of 3% to 6% are matched at a rate of 50 cents for each dollar contributed. The Company’s share of the expense under the plan totaled $2.4 million, $2.2 million and $2.1 million for the years 2005, 2004 and 2003, respectively.
On March 1, 2002, the State Auto Financial’s Board of Directors approved a plan to repurchase up to 1.0 million shares of common stock from the public over a period extending to and through December 31, 2003. Through December 31, 2003, State Auto Financial repurchased 0.5 million shares from the public under this plan of which 0.1 million was purchased during 2003. Repurchases during 2003 were funded through dividends from subsidiaries.
During both 2005 and 2004, options to purchase 0.4 million common shares were granted to key employees under the Equity Plan. 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 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 in 2005 and 2004 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.
The Outside Directors RSU Plan is an unfunded deferred compensation plan which provides each outside director with an award of 1,400 restricted share units (the “RSU award”) following each annual meeting of shareholders. In 2005, a total of 9,800 RSU awards were made to outside directors. The RSU awards are fully vested upon 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 Outside Directors 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. 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 Outside Directors 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 Outside Directors RSU Plan automatically terminates on May 31, 2015.
this plan. The plan provides that the options become exercisable on the first day of the calendar year following the agency’s achievement of specific production and profitability requirements over a period not greater than two calendar years from the date of grant or a portion thereof in the first calendar year in which an agency commences participation under the plan. Options granted under this plan have a ten year term. The Company has accounted for this plan in its accompanying financial statements at fair value. Expenses associated with this plan of $0.3 million, $0.2 million and $0.3 million were recognized in 2005, 2004 and 2003, respectively.
The following provides financial information regarding the Company’s reportable segments for the year ended December 31: