(3) Earnings per share (EPS) adjusted for 1998 2-for-1 and 1996 3-for-2 common stock split effected in the form of a stock dividend.
(6) The industry combined ratios are from A.M. Best. The 2003 industry combined ratio is preliminary.
(7) The Company uses the statutory net premiums written to surplus ratio as there is no comparable GAAP measure. This ratio, also called the leverage ratio, measures the Company's statutory surplus available to absorb losses.
State Auto Financial Corporation ("State Auto Financial" or "STFC") and its wholly owned subsidiaries are collectively referred to herein as the "Company." The Company is a member of the State Auto Group, (defined below), that writes personal and commercial insurance through approximately 22,400 independent insurance agents associated with approximately 3,400 agencies in 26 states and the District of Columbia. The State Auto Group operates primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states. State Auto Financial is a majority-owned subsidiary of State Automobile Mutual Insurance Company ("Mutual"), an Ohio domiciled property and casualty insurer and member of the State Auto Group. Mutual is one of only 15 companies in the United States that has received A.M. Best's A+ or higher rating every year since 1954.
State Auto Financial provides personal and commercial insurance to the standard insurance market through the following principal wholly owned insurance subsidiaries, collectively referred to as the "STFC Pooled Companies":
The companies below are collectively referred to as the "Affiliates." Collectively, the Company and the Affiliates make up the "State Auto Group."
Meridian Security, Meridian Citizens and Meridian Citizens Mutual are collectively referred to herein as the "Meridian Insurers."
The STFC Pooled Companies participate in a quota share reinsurance pooling arrangement (the "Pooling Arrangement") with Mutual, SA Wisconsin and SA Florida (collectively the "Mutual Pooled Companies"). The Pooling Arrangement provides that the STFC Pooled Companies and the Mutual Pooled Companies cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation percentages as outlined in the Pooling Arrangement.
The following table sets forth a chronology of the participant and participant percentage changes that have occurred in the Pooling Arrangement since January 1, 2001:
State Auto P&C provides employees to the Company and the Affiliates. This is contractually provided for under the following management and/or cost sharing agreements: 1) the "2000 Management Agreement" effective January 1, 2000, to which State Auto P&C, Mutual, SA National, Milbank, and SA Ohio are parties. After October 1, 2001, the 2000 Management Agreement became a pure cost sharing agreement, but prior thereto, this agreement provided for a management fee based on surplus which was paid by each managed company to State Auto P&C ; 2) the "Midwest Management Agreement" effective January 1, 2000 to which State Auto P&C, Mutual and SA Wisconsin are parties. This agreement provides for a management fee based on a percentage of direct written premiums collected by the Company for the services State Auto P&C provides; 3) the "MIGI Management Agreement," effective July 1, 2002, to which State Auto P&C, Meridian Security, Meridian Citizens, and Meridian Citizens Mutual are parties. This agreement provides for a management fee equal to a percentage of the allocable employee expenses attributable to the operations of these companies paid to the Company for the services State Auto P&C provides. Each of the foregoing management or cost sharing agreements also apportions among the parties the actual costs of the services provided. Effective January 1, 2002, all employees of MIGI became employees of State Auto P&C. In conjunction with this transaction, approximately $3.6 million in net plan benefit liabilities were transferred from MIGI to State Auto P&C.
Effective June 1, 2001, Mutual merged with Meridian Mutual Insurance Company ("Meridian Mutual"), with Mutual continuing as the surviving corporation, and acquired MIGI. Effective July 1, 2001, the insurance business of the former
Meridian Mutual became part of the Pooling Arrangement and the STFC Pooled Companies assumed 53% of the Meridian Mutual business on this same date. Concurrent with this transaction, the STFC Pooled Companies received cash of $6.4 million and fixed maturities totaling $109.7 million, which related to the additional net insurance liabilities assumed by the STFC Pooled Companies on July 1, 2001. The business of the former Meridian Mutual includes both standard and nonstandard personal lines and standard commercial lines. The principal lines of business include standard personal and commercial automobile, nonstandard personal automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance.
As the former Meridian Mutual standard and nonstandard business was written and processed through the Meridian underwriting and claims system platform, management monitored this business as a separate segment from the State Auto standard and nonstandard business. Monitoring of these segments separately was necessary in order to facilitate the integration of the business as these new policies and renewals were converted to the State Auto systems platform through which State Auto contract forms, pricing, underwriting, and claims philosophies were fully implemented. With the addition of the former Meridian Mutual business to the Pooling Arrangement in 2001, the Company renamed the two insurance segments that existed prior to 2001 to be the "State Auto standard segment" and the "State Auto nonstandard segment" and the former Meridian Mutual business to be the "Meridian standard segment" and the "Meridian nonstandard segment." Due to the integration efforts by management, along with the Meridian nonstandard segment no longer meeting the quantitative thresholds for segment reporting, beginning with the first quarter of 2003, this segment's business was included in the State Auto nonstandard segment. The 2002 and 2001 disclosures have been revised to reflect this change. Likewise, the Meridian standard business, beginning with the first quarter of 2004, will be included in the State Auto standard segment.
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.
On May 22, 2003, STFC Capital Trust I, State Auto Financial's Delaware business trust subsidiary ("Capital Trust"), issued $15.0 million liquidation amount of its capital securities to a third party. In connection with the Capital Trust's issuance of the capital securities and the related purchase by State Auto Financial of all of the Capital Trust's common securities (liquidation amount of $464,000), State Auto Financial issued to the Capital Trust $15.5 million aggregate principal amount of Floating Rate Junior Subordinated Debt Securities due 2033. On November 13, 2003 State Auto Financial issued $100.0 million unsecured 6.25% senior notes. State Auto Financial used the proceeds from these debt instruments to contribute additional paid in capital to its insurance subsidiaries as follows: $39.0 million to State Auto P&C, $30.0 million to SA National and $15.0 million to Milbank. Milbank used the $15.0 million additional paid in capital contribution to repay its $15.0 million surplus note with Meridian Security. State Auto Financial also used these proceeds to repay $15.0 million of its bank debt and invested the remaining amount in fixed maturity and equity securities.
Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses relating to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed for computing the acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned. These amounts are based on estimates, and accordingly, the actual realizable value may vary from the estimated realizable value.
Pension and postretirement benefit obligations are long term in nature and require significant 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 among other factors. Because these obligations are based upon significant management estimates which could change given available information, the ultimate benefit obligation could be different than the amount estimated.
The Company regularly monitors its investment portfolio for declines in value that are other than temporary, an assessment that requires significant management judgment. Among the factors management considers are the nature of the investment, severity and length of decline in fair value, events impacting the issuer, and overall market conditions. When a security in the Company's investment portfolio has been determined to have a decline in fair value that is other than temporary, the Company adjusts the cost basis of the security to fair value. This results in a charge to earnings as a realized loss, which is not changed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other than temporary, are included in other comprehensive income.
The following table summarizes for the years ended December 31, 2003, 2002 and 2001 certain key performance indicators used to manage the operations of the Company:
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULT OF OPERATIONS, CONTINUED - --------------------------------------------------------------------------------
position for support of continued premium growth and for general corporate purposes. See below for additional discussion of the Company's operations.
Net income before federal income taxes for the Company increased $45.5 million (120.0%) to $83.3 million in 2003 from 2002. The most significant factors contributing to this increase were an improvement in the Company's loss experience from 2002 along with growth in earned premium. The Company's GAAP loss and LAE ratio (defined below) reflected a 5.1 point improvement in 2003 from 2002, despite the largest catastrophe loss event in Company history occurring in May 2003. While all insurance segments reflected an improvement in underwriting results from 2002, the most significant improvement was within the Meridian standard segment.
As reflected in the table above, earned premiums increased from year to year across almost all lines of business, with the exception of workers' compensation. Overall the composition of the Company's book of business did not change significantly from year to year, with the standard auto - personal line continuing to be the Company's most significant line of business.
In the past 18-24 months, the Company took necessary and in some cases significant rate increases, particularly within the Meridian book, in almost all lines of business. The Company expects to be able to implement smaller rate increases in 2004 than it had implemented during 2001 and 2003. This is expected to affect earned premium growth in the years following the implementation of these increases. In fact, within the last year, the industry has been experiencing a leveling of rate increases and in some cases certain lines have experienced modest rate decreases. Management continues to emphasize that it will not compromise profitability for top line growth and will continue to focus on maintaining its underwriting consistency through all industry cycles.
Net investment income increased $4.9 million (8.3%) to $64.6 million in 2003 from 2002. This increase was the result of an increase in invested assets generated by cash flow provided from operations and financing, partly offset by a decline in the investment yield. Total cost of invested assets at December 31, 2003 and 2002 was $1,529.7 million and $1,302.0 million, respectively. Invested assets are comprised of total investments and cash equivalents. Reflecting a decline in the interest rate environment, the annualized investment yields based on average invested assets at cost decreased to 4.6% in 2003 from 4.9% in 2002. The Company manages its investment portfolio to maximize after tax profits. With the Company's improving loss experience throughout 2003, management began allocating a higher proportion of new monies to tax exempt securities in the fourth quarter of 2003. This reallocation of new monies is expected to result in lower pre-tax investment yields but higher after tax investment income than if the Company continued with the portfolio allocation of 2003. See further discussion regarding investments at the "Liquidity and Capital Resources," "Investments" and "Market Risk" sections, included herein.
As noted in the above table, all lines of business contributed to the 5.1 GAAP loss and LAE improvement in 2003 from 2002, except for workers' compensation and fire and allied lines which combined represent 10% of total earned premiums in 2003. Company management monitors all lines of business paying particular attention to auto - personal, homeowners and workers' compensation due to the significance these lines have on the profitability of the Company. The auto - personal line continues to be the most significant line of business and therefore has the greatest influence on net income. The homeowners line of business is the Company's second largest (see earned premium table above). The loss experience in this line was adversely affected in the last two years by the increased severity of storms; however, due to management's efforts, its GAAP loss and LAE ratio improved by 10.1 points in 2003 from 2002. Workers' compensation continues to be the Company's most volatile line of business due to the risks insured. Workers' compensation results have been volatile both for the Company and the industry and can have a significant adverse impact on earnings. The Company manages this exposure with conservative underwriting and rate levels that are based on National Council of Compensation Insurance loss costs. As a result of management's conservative approach, workers' compensation represents 3% of total earned premium. Management continually monitors these lines in an effort to obtain adequate cost based rates and write the risks that it believes are more likely to produce an underwriting profit for the Company.
During the year 2003 this segment continued to improve from 2002 despite experiencing several large commercial multi-peril and other liability losses. Note that the "other and products liability" line is approximately 1.5% of this segment's 2003 book of business - see earned premium table above. These continued improvements are a direct result of management's efforts that began in 2001 to obtain adequate cost based rates, re-underwrite the business applying the State Auto underwriting guidelines and terminate unprofitable programs. The Meridian integration is proceeding according to plan. The business written on the historic Meridian platform is being systematically renewed on the State Auto platform. Management is striving to retain the risks that it believes have the greatest profit potential for the Company. Due to the integration efforts by management, along with this segment no longer meeting the quantitative thresholds for separate
Acquisition and operating expenses, as a percentage of earned premiums (the "GAAP expense ratio"), were 30.4% and 29.5% for the years 2003 and 2002, respectively. One factor contributing to the 0.9 point increase is the Company cession of earned premium under the Stop Loss, which was $12.8 million and $1.4 million in 2003 and 2002, respectively. These earned premium cessions under the Stop Loss increased the Company's GAAP expense ratio by 0.4 point and less than 0.1 point for the years 2003 and 2002, respectively. The Stop Loss agreement terminated December 31, 2003 and was not renewed. Certain significant variable expenses that are tied directly to the Company's insurance operation's profitability also contributed to the increased GAAP expense ratio. These are the Company's profit sharing plans, the Quality Performance Bonus ("QPB") that covers substantially all employees and the Quality Performance Agreement or contingent commission agreement ("QPA") which is available to substantially all the Company's agents. QPA was 1.6 points and 1.2 points within the GAAP expense ratio in 2003 and 2002, respectively. QPB was 0.8 point and 0.2 point within the GAAP expense ratio in 2003 and 2002, respectively. Excluding the Stop Loss, QPA and QPB effects, the GAAP expense ratio would have been 27.6% and 28.0% for the years 2003 and 2002, respectively. Management reviews the QPB plan and the QPA annually to determine the appropriateness of each bonus' formula. Any increase in the expense ratio is difficult to accept, but the fact is, that the increase seen this year is largely the result of the Company's profitable underwriting operations, as discussed above. Notwithstanding these directly profit driven expense increases, expense control has been and remains one of the critical elements of the Company's success, and the importance of this is regularly communicated to all employees.
Other expense, as a percentage of earned premiums, was 1.2% and 1.1% for the years 2003 and 2002, respectively. The increase in 2003 other expense is primarily attributable to the legal and other related costs incurred by the Company related to the tender offer initiated by Gregory M. Shepard and his wholly owned company, and other proposals from Mr. Shepard that preceded the tender offer. See Part I, Item 3. Legal Proceedings included within this Form 10-K.
The effective tax expense rate for the years 2003 and 2002 were 23.8% and 2.1%, respectively. Improvement in the Company's 2003 underwriting results along with an increase in net realized gains on investments and the gradual shift in increasing the fixed maturity portfolio from tax-exempt to taxable securities from 2002 contributed to the tax expense rate increase. Management believes the existing level of pre-tax earnings is sufficient to generate future taxable income to realize the deferred tax assets.
The internal decline of the Meridian standard and nonstandard segments decreased consolidated earned premiums 4.2%. This decrease was expected, given the corrective actions taken by management in both these segments, which actions included appropriate and necessary rate increases in almost every line of business. Additionally, one of the more significant actions taken within the Meridian standard segment was the discontinuance in late 2000 of the Group Advantage(R) Program which had generated substantial underwriting losses for Meridian Mutual. The last Group Advantage(R) policy on the books terminated January 2003. Regarding the Meridian nonstandard segment, in addition to taking significant corrective rate action, beginning in late 2001, the Company implemented an integration plan to write all new nonstandard auto business produced by the former Meridian Mutual agents through the State Auto nonstandard segment, specifically through National on the National system platform utilizing a more appropriate rating structure as well as credit scoring (as permitted by local law) and "point-of-sale" underwriting tools. The order of integration had been prioritized such that the states with the most need for profit improvement migrated to National first. All Meridian nonstandard auto new business is now being written through the State Auto nonstandard segment. The business that remains within the Meridian nonstandard segment is expected to decrease given this segment's historically low retention rate as well as the Company's continuing to take appropriate rate increases. Fourth quarter 2002 earned premiums for the Meridian nonstandard segment comprised 0.5% of total consolidated earned premiums versus 1.8% in the same 2001 period. Consequently, beginning with the first quarter 2003, the Meridian nonstandard auto business was included in the State Auto nonstandard segment category.
During the quarters ended September 30, 2002 and June 30, 2002, the Pooled Companies produced a Pool loss and LAE ratio under the Stop Loss (described above) that exceeded the 70.75% threshold, thereby recovering from Mutual $2.4 million and $6.4 million in losses, respectively (total of $8.8 million for the year ended December 31, 2002). In the quarters ended December 31, 2002 and March 31, 2002, the Pooled Companies' Pool loss and LAE ratio was less than 69.25%, but more than 59.99%, thereby ceding to Mutual, under the Stop Loss $1.0 million and $0.4 million in earned premiums, respectively (total of $1.4 million for the year ended December 31, 2002). The cession activity through the Stop Loss had the effect of lowering the GAAP loss and LAE ratio by 0.9 and 1.1 points in 2002 and 2001, respectively.
The year 2002 was the worst catastrophe year in the history of the Company on a dollar loss basis and third worst in terms of GAAP loss and LAE ratio points. During the second quarter of 2002, a series of tornadoes and hailstorms went through several of the Company's operating states, including an tornado in La Plata, Maryland. This storm was the largest single catastrophe event for the Company in 2002, accounting for 3.1 GAAP loss and LAE ratio points. Overall, catastrophe losses in 2002 were 1.2 GAAP loss and LAE ratio points higher than in 2001.
The State Auto nonstandard segment, which now includes the former Meridian nonstandard segment, GAAP loss and LAE ratio improved in 2002 to 77.8 from 91.4 in 2001. This segment was significantly impacted by the former Meridian nonstandard segment case reserve strengthening that occurred during the second half of 2001. Also largely contributing to the current year loss results improvement were the substantial policy rate increases the Company implemented in 2001 and 2002 in the former Meridian nonstandard segment. This segment experienced more volatility in 2002, especially in those states experiencing substantial premium growth due to policy count increases. As described above, contributing to this growth has been the addition of National's product to agents who wrote the former Meridian Mutual's nonstandard auto business. While nonstandard automobile tends to be a more volatile line of business than standard automobile, management continually monitors this segment's premium rate adequacy. Management has been paying particular attention to the adequacy of these rates in these growth states, as well as risks written in certain agencies, and is reacting accordingly by increasing rates and working with those agencies regarding risk selection.
Interest expense relates to the $45.5 million line of credit agreement the Company entered into with Mutual in 1999 and the $15.0 million surplus note agreement entered into with an affiliate on September 30, 2002. See additional discussion in the "Liquidity and Capital Resources" section included herein.
The increase in segment profit of the 2003 all other category is due to an increase in the State Auto P&C management fee earned from management agreements that are described at "Overview." The management fee increased because of the increase in direct written premiums collected under the Midwest Management Agreement and the increase of allocable employee expenses under the MIGI Management Agreement. Beginning with the first quarter of 2002, the former management and operations services segment is now included in the all other category for segment reporting as the results of this segment no longer meet the quantitative thresholds for separate presentation as a reportable segment. All other segment profits, including management and operations services, decreased in 2002 and 2001. The termination of the service fee under the 2000 Management Agreement was due to the resolution of the disagreement between the Company and Ohio Department of Insurance regarding the service fee paid by Mutual to the Company in 2001. See discussion at "significant transactions" and "2002 Compared to 2001" in "Results of Operations." For additional information on the Company's reportable segments, see footnote 15 on "Reportable Segments" in the Company's consolidated financial statements.
Liquidity refers to the ability of the Company to generate adequate amounts of cash to meet its needs for both long and short-term cash obligations as they come due. The Company's significant sources of cash are premiums, investment income, sales of investments and the maturity of fixed maturity investments. 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.
Overall net cash provided by operating activities was $138.0 million in 2003, $126.6 million in 2002 and $63.5 million in 2001. The increase in 2003 is attributable to improved underwriting cash flow, partly offset by an increase in cash paid on estimated federal income taxes and a cash contribution to the Companies defined benefit pension plan (the "Plan") (see discussion below). The increase in 2002 is largely attributable to the prior year changes to the Pooled Subsidiaries participation in the Pooling Arrangement. In the second half of 2001, the Pooled Subsidiaries received cash of $8.6 million and fixed maturities of $346 million from Mutual as a result of adding the Meridian Mutual business to the Pooling Arrangement and changing the pooling participation percentage of the Pooled Subsidiaries from 53% to 80%. Over the last three years, operating cash flows have been sufficient to meet the operating needs of the Company while providing increased opportunities for investment.
Total net cash used in investing activities was $280.2 million during 2003, $85.6 million during 2002 and $55.3 million in 2001. The 2003 cash used in investing activities reflects the increase in cash flow provided by improved operating activities and the increase in cash flow provided by financing activities discussed below. The 2002 and 2001 years' investing activity was reflective of the cash flow generated from operations discussed above. During 2002 the Company experienced fluctuating activity within its fixed maturity portfolio. Call activity in 2002 continued in response to the declines in the interest rate environment. While the Company continued to focus its attention on improving the loss results of the Meridian book of business, which has put upward pressure on the Company's overall loss experience in recent years, the Company increased
its sale activity of its fixed maturities in an effort to increase its taxable position in its investment portfolio. Monies generated from the call and sale activity have been reinvested at lower yielding rates.
Overall net cash provided by financing activities was $86.2 million in 2003, $25.0 million in 2002 and $0.5 million in 2001. Net cash provided by financing activities increased during 2003 and 2002 primarily due to net proceeds from issuance of debt (see discussion below), partly offset by payments of dividends and to re-purchase Company common shares.
Mutual, whose ownership in State Auto Financial is approximately 66%, has waived its right to receipt of the dividends declared by State Auto Financial since 1994 in an effort to enhance the statutory surplus of the insurance subsidiaries of State Auto Financial for use in support of underwriting operations which in turn is expected to increase the statutory surplus of Mutual. In years before 2002, prior to the declaration of each dividend by State Auto Financial, Mutual's directors reviewed the facts and circumstances then present in deciding whether to waive such dividend. Beginning in 2002, the issue of the waiver of Mutual's dividend on its shares of State Auto Financial was referred to the standing Independent Committee of the Board of Directors of Mutual (the "Standing Independent Committee"). It met and determined that it would review dividend waiver decisions on an annual basis. For the years 2002 and 2003, the Standing Independent Committee decided to waive Mutual's dividends that might be declared by the Board of Directors of State Auto Financial in order to take better advantage of the investment opportunity State Auto Financial represents for Mutual. At March 8, 2004, the Standing Independent Committee had not made a determination regarding whether or not it will waive Mutual's right to receipt of State Auto Financial dividends for 2004. The timing for this determination has been moved from March to August to coincide with the timing of the historical dividend increase date. At a board meeting on March 5, 2004, the Board of Directors of Mutual extended the dividend waiver decision made by the Standing Independent Committee in March of 2003 to apply to dividends that may be declared in March and May of 2004. The Standing Independent Committee intends to complete its analysis of the dividend waiver for the period of August 2004 to August 2005 prior to the board meeting in August of 2004.
In conjunction with a 1999 Repurchase Plan, State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million. The interest rate is adjustable annually on each January 1 to reflect adjustments in the then current prime lending rate less 1.75 points, as well as State Auto Financial's current financial position. The interest rate was 2.5%, 3.0% and 7.75% for 2003, 2002 and 2001, respectively. Beginning January 1, 2004, the interest rate on this credit agreement is 2.25%. Principal is due upon demand, with final payment to be received on or prior to December 31, 2005.
The Subordinated Debentures are unsecured and subordinated to all of the Company's existing and future senior indebtedness. As sponsor of the Capital Trust, State Auto Financial incurred security issuance cost related to the Trust Preferred Capital Securities and Subordinated Debentures of $535,000. In July 2003, State Auto Financial used the proceeds from the Subordinated Debentures to make a $15.0 million cash capital contribution to SA National (see discussion below).
Milbank used the $15.0 million additional paid in capital contribution from State Auto Financial to repay its surplus note. On September 30, 2002, Milbank had entered into a $15.0 million surplus contribution note with Meridian Security. Subject to the condition described below and other terms of the note, the maturity date was September 30, 2012. The interest rate was equal to the U.S. Treasury ten-year note yield at September 30, 2002 plus 100 basis points (4.59%) and was adjustable October 1, 2007, to the then current U.S. Treasury ten-year note yield plus 100 basis points for the remaining term of the note. Interest was accrued, but all payments of principal or interest may be made only with the prior written approval of the South Dakota Director of Insurance, Milbank's domiciliary state. Upon receipt of written approval by the South Dakota Director of Insurance, Milbank repaid its surplus note, including interest, in December 2003.
As discussed above, State Auto Financial used proceeds from the senior notes to repay its $15.0 million bank debt in December 2003. On December 23, 2002, State Auto Financial entered into a 364 day $15.0 million term loan note agreement with a bank. Interest adjusted quarterly and accrued based on LIBOR plus 75 basis points (2.15% at December 31, 2002).
The statutory leverage ratios for the Company at December 31, 2003 and 2002 are as follows:
These improvements are due to a combination of the capital contributions made by State Auto Financial (State Auto P&C $39.0 million and SA National $30.0 million) from proceeds of the debt securities issued in 2003, improvement in the underwriting operations for the year 2003 of each company, as well as effective January 1, 2003, the reserving process for statutory reporting began anticipating salvage and subrogation recoverable for each company. Under generally accepted accounting principles, the reserving process has historically anticipated salvage and subrogation recoverable. Management believes these leverage ratios at December 31, 2003 indicate the financial strength of the Company and its position to support future premium growth.
The State Auto Group companies are participants in a catastrophe reinsurance program. The amount retained by the State Auto Group is $40.0 million for each occurrence. For up to $80.0 million in losses, excess of $40.0 million, traditional reinsurance coverage is provided.
The following table provides information regarding the quality distribution of the Company's fixed maturity portfolio at December 31, 2003:
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, 2003:
Included in the 2003 realized losses of equity securities below, was $289,000 recognized related to other than temporary impairment on four equity positions, of which all four equity positions were held at December 31, 2003. Included in the 2002 realized losses of equity securities below, was $2.2 million ($329,000 on equity securities sold and $1.9 million on equity securities held at December 31, 2002) recognized related to other than temporary impairment on five equity positions. The decline in the amount of other than temporary impairments from 2002 reflects the stock market recovery in 2003 and the Company's conservative investment strategy to invest for return while managing its principal loss risk. There were no individually material equity securities for which the Company recognized other than temporary impairments in 2003 and 2002. There was no other than temporary impairment of fixed maturities for 2003 and 2002. The individual circumstances impacting the other than temporary impairments recognized in 2003 and 2002 did not impact other investments.
At December 31, 2003 total investments at fair value comprise approximately 86% of the Company's total assets. Of the total investments, 90% are invested in fixed maturities, 9% in equity securities, 1% in other invested assets. Cash and cash equivalents represent approximately 2% of the Company's total assets at December 31, 2003.
The equity markets increased in 2003 after declining during 2002 and 2001, the first two year decline since the 1973 and 1974 bear markets. The Company's equity portfolio net unrealized gain increased $20.3 million to $18.2 million net unrealized gain at December 31, 2003 from a net unrealized loss position of $2.1 million at December 31, 2002.
During 2003 the fixed maturity fair values decreased as the interest rate environment fluctuated. The Company's fixed maturity portfolio net unrealized gain decreased $5.6 million to $61.8 million net unrealized gain at December 31, 2003 from $67.4 million net unrealized gain at December 31, 2002.
The Company's management conducts periodic reviews of loss development reports and makes judgments in determining the reserves for ultimate losses and loss expenses payable. Several factors are considered by management 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, late reported claims, entry errors, and other reasonableness tests.
Management's best estimate ("MBE") for SA National, Mid-Plains and the STFC Pooled Companies share of the Pooled Companies loss and allocated loss adjustment expense reserve ("Loss and ALAE Reserve") at December 31, 2003, is $654 million compared with an actuarial point estimate of $647 million that is within a projected range of $617 million to $678 million. The actuarial point estimate and MBE are not materially different. These values presented are on a direct basis, gross of salvage and subrogation recoverable, and before reinsurance, except for the STFC Pooled Companies participation in the inter-company Pooling Arrangement. Therefore these values cannot be compared to other loss and loss
expenses payable tables included elsewhere within the Company's Form 10-K. Ranges provide a quantification of the variability in the reserve projections, while the point estimates establish a mean, or expected value for the ultimate reserve. The MBE of loss reserves considers the actuary's point estimate, or expected value, to be a reasonable and appropriate position within the range. The following table provides a reconciliation of MBE of the Company's direct Loss and ALAE Reserve to the Company's net loss and loss expenses payable at December 31, 2003. The STFC Pooled Companies net additional share of transactions assumed from Mutual through the Pooling Arrangement for the year 2003 has been reflected in the table below as Assumed by STFC Pooled Companies:
The risks and uncertainties inherent in the estimates include, but are not limited to, actual settlement experience being different from historical data and 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. The Company's 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.
MAGAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, CONTINUED - --------------------------------------------------------------------------------
At December 31, 2003, the Company had the following contractual obligations:
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of SFAS Statement No. 123 Accounting for Stock-Based Compensation. This Statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, this Statement requires more prominent disclosures in both the annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has adopted the disclosure provisions of this Statement and will adopt a transition method at the time when the FASB issues final guidance that is required to be adopted.
a VIE when it has equity investors who lack the characteristics of having a controlling financial interest, or its capital is insufficient to permit it to finance its activities without additional subordinated financial support. Consolidation of a VIE by an investor is required when it is determined that the investor will absorb a majority of the VIE's expected losses if they occur, receive a majority of the entity's expected residual returns if they occur, or both. As a result of the Company adopting FIN 46, effective July 1, 2003, the financial operations of STFC Capital Trust I, the Company's Delaware business trust subsidiary (see "Liquidity and Capital Resource" above), are no longer consolidated within the accompanying financial statements of the Company. The net impact of the adoption of FIN 46, effective July 1, 2003, was a reclassification adjustment to eliminate the Capital Trust's capital securities of $15.0 million from notes payable and include State Auto Financial's investment of $464,000 in the common securities of Capital Trust in other invested assets and include $15.5 million principal amount of Floating Rate Junior Subordinated Debt Securities issued to the Capital Trust in notes payable.
Inflation can have a significant impact on property and casualty insurers because premium rates are established before the amount of losses and loss expenses are known. When establishing rates, the Company attempts to anticipate increases from inflation subject to the limitations of modeling economic variables. General inflation, as measured by the CPI, has been relatively modest over the last several years; however, price inflation on the goods and services purchased by insurance companies in settling claims has been steadily increasing. In particular, repair costs for homes, autos, and commercial buildings, and medical care costs, have risen disproportionately over the last few years. The Company continues to adjust its pricing projections as loss cost trends change in order to ensure premiums keep pace with inflation in all lines of business.
The impact of Sarbanes Oxley Act of 2002 is continuing to be felt, as the Securities and Exchange Commission ("SEC") implements regulatory changes to meet the obligations imposed on it by Congress. Certain deadlines have been extended by the SEC which may mitigate the cost of compliance to a limited extent. In addition to complying with the SEC and Congressional mandates, State Auto Financial also has to comply with new listing standards of the National Association of Securities Dealers ("NASD") recently approved by the SEC, which will contribute to an increase in expenses.
The Terrorism Risk Insurance Act of 2002 (the "Terrorism Act") established a temporary federal program that provides for a system of shared public and private compensation for insured losses resulting from acts of terrorism committed by or on behalf of a foreign interest. In order for a loss to be covered under the Terrorism Act, it must be the result of an event that is certified as an act of terrorism by the U.S. Secretary of Treasury ("subject losses"). In the case of a war declared by Congress, only workers' compensation losses are covered by the Terrorism Act. The Terrorism Insurance Program (the "Program") generally requires that all commercial property casualty insurers licensed in the U.S. participate in the Program. The amount of compensation paid to participating insurers under the Program is 90% of subject losses, after an insurer deductible, subject to an annual cap that limits the amount of subject losses to $100 billion aggregate per program year. The Company's deductible under this federal Program is approximately $22.3 million for 2004, subject to final rules to be established by the U.S. Treasury. Under the Terrorism Act, commercial property and casualty insurers must offer their commercial policyholders coverage against certified acts of terrorism, but the policyholders may choose to reject this coverage. If the policyholder rejects coverage for certified acts of terrorism, the Company intends, subject to the approval of the state regulators, to cover only such acts of terrorism that are not certified acts under the Terrorism Act and that do not arise out of nuclear, biological or chemical agents.
Company management has identified certain trends and uncertainties that have the potential to significantly affect the Company and the property and casualty insurance industry:
- New and changing insurance risks such as asbestos, mold, silica and acts of terrorism
Company management considers these trends and uncertainties, and others, in the management of the Company operations. Increasing price competition can have the effect of decreasing the rate of growth of earned premiums, if not decreasing earned premiums, as the Company's underwriting philosophy does not permit risk selection at a price below which management believes is adequate. The declining investment rate of return can decrease the rate of growth of, investment income as well as decrease, investment income and net income, as the Company invests for an adequate return with a focus on principal preservation risk. The volatile investment market and related investment valuation can affect the insurers' statutory surplus as the fair value of investments fluctuate. The increasing frequency and severity of storm losses and increasing health care costs can have the effect of increasing losses and decreasing operating profits. Management considers these trends and uncertainties in the writing and pricing of policies. Because of the Company's growth and planned greater geographic dispersion of risk, the loss ratio point impact of recent catastrophes has not been as severe as catastrophe losses several years ago that had fewer loss dollars associated with them. There continues to be consolidation within the property and casualty insurance industry which can increase competition by creating insurance companies with more resources and capital. As demonstrated over the years, the Company has acquired and successfully integrated insurance companies in the past and considers acquisition opportunities as they arise. The Company believes acquisitions MD&A 28
will be an important part of its growth strategies. Company management also monitors the changing product distribution channels, along with its changing relationships with agencies and consolidation occurring within the agency distribution system itself. The Company remains committed to cultivating strong relationships with its agencies and to selling insurance products through the independent agency system. The Company considers the expanding scope of insurance risks, such as asbestos, mold, silica and acts of terrorism, in its pricing, writing of policies and drafting policy forms. The Company established a business continuity plan to ensure the continuation of core business operations in the event that normal business operations could not be performed. Management will continue to assess the business continuity plan to ensure it meets the Company's changing core business operations needs. Overall, the Company considers one of its key strengths to be its core values which are to (i) fairly price and ethically sell useful insurance products; (ii) treat every transaction with absolute honesty and integrity; (iii) extend dignity and respect to everyone; (iv) encourage innovation; and (v) fully utilize every person's talents. These core values, which reflect the "tone at the top," serve the interests of all the Company's constituencies.
- The Company uses reinsurance to help manage its exposure to insurance risks. The availability and cost of reinsurance are subject to prevailing market conditions, both in terms of price and available capacity, which can affect the Company's business volume and profitability. Although the reinsurer is liable to the Company to the extent of the ceded reinsurance, the Company remains liable as the direct insurer on all risks reinsured. As a result, ceded reinsurance arrangements do not eliminate the Company's obligation to pay claims. The Company is subject to credit risk with respect to the Company's ability to recover amounts due from reinsurers. Reinsurance may not be adequate to protect the Company against losses and may not be available to the Company in the future at commercially reasonable rates. In addition, the magnitude of losses in the reinsurance industry resulting from catastrophes may adversely affect the financial strength of certain reinsurers, which may result in the Company's inability to collect or recover reinsurance.
- Mutual and the Company have acquired other insurance companies and it is anticipated that Mutual and the Company will continue to pursue acquisitions of other insurance companies in the future. Acquisitions involve numerous risks and uncertainties, including the following: obtaining necessary regulatory approvals of the acquisition may prove to be more difficult than anticipated; integrating the acquired business may prove to be more costly or difficult than anticipated; integrating the acquired business without material disruption to existing operations may prove to be more difficult than anticipated; anticipated cost savings may not be fully realized (or not realized within the anticipated time frame) or additional or unexpected costs may be incurred; loss results of the Company acquired may be worse than expected; and retaining key employees of the acquired business may prove to be more difficult than anticipated. In addition, other companies in the insurance industry have similar acquisition strategies. There can be no assurance that any future acquisitions will be successfully integrated into the Company's operations, that competition for acquisitions will not intensify or that the Company will be able to complete such acquisitions on acceptable terms and conditions. In addition, the costs of unsuccessful acquisition efforts may adversely affect the Company's financial performance.
- The Company's operations are subject to changes occurring in the legislative, regulatory and judicial environment. Risks and uncertainties related to the legislative, regulatory, and judicial environment include, but are not limited to, legislative changes at both the state and federal level; state and federal regulatory rulemaking promulgations and adjudications that may affect the Company specifically, its affiliates or the industry generally; class action and other litigation involving the Company, its affiliates, or the insurance industry generally; and judicial decisions affecting claims, policy coverages and the general costs of doing business. Many of these changes are beyond the Company's control.
- The property and casualty insurance industry is highly competitive. While prices have generally increased in some lines, the rate of increase has moderated and competition continues to be intense. The Company competes with numerous insurance companies, many of which are substantially larger and have considerably greater financial resources. The Company competes through underwriting criteria, appropriate pricing, and quality service to the policyholder and the agent and through a fully developed agency relations program. See "Marketing" in the "Narrative Description of Business" in Item 1 of the Company's Form 10-K.
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, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. 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.
The consolidated financial statements include State Auto Financial Corporation (State Auto Financial) and its wholly-owned subsidiaries:
- State Auto Insurance Company of Ohio (SA Ohio), an Ohio corporation
Mid-Plains Insurance Company (Mid-Plains), an Iowa corporation, is a wholly-owned subsidiary of Farmers. The financial statements also include the operations and financial position of 518 Property Management and Leasing, LLC (518 PML), whose members are State Auto P&C and Stateco.
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which vary in certain respects from statutory accounting practices followed by State Auto P&C, Milbank, Farmers, SA Ohio, SA National and Mid-Plains that are prescribed or permitted by the Departments.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of losses and loss expenses payable. In connection with the determination of this estimate, management uses historical data and current business conditions to formulate estimates including assumptions related to the ultimate cost to settle claims.
These estimates by their nature are subject to uncertainties for various reasons. The Company's results of operations and financial condition could be impacted in the future should the ultimate payments required to settle claims vary from the amount of the liability currently provided.
At December 31, 2003 and 2002 all investments in fixed maturity and equity securities are held as available for sale and therefore are carried at fair value. Other invested assets are comprised of limited liability partnership and other investments that 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. Effective December 31, 2002, the Company transferred all of its investments previously classified as held to maturity to the available for sale category to align the investment portfolio with management's investment policy. For fixed maturities classified as held to maturity, unrealized holding gains or losses were not reflected in the accompanying consolidated financial statements, rather they were carried at amortized cost. Upon transfer of the held to maturity investments to available for sale at December 31, 2002, the held to maturity investments' amortized cost, fair value and net unrealized gain were $19.1 million, $20.4 million and $1.3 million, respectively. Other comprehensive income of $828,000 net of deferred taxes of $446,000 was recognized upon transfer. Gains and losses on the sale of investments are computed using the first-in, first-out method. The Company regularly monitors its investments that have fair value less than the carrying amount for signs of other than temporary impairment. Among the factors that management considers are market conditions, the amount, timing and length of decline in fair value, and events impacting the issuer. When other than temporary impairment is recognized, the investment cost is written down to fair value and a realized loss is recorded. The cost is not adjusted for any subsequent recovery in fair value. For 2003 and 2002, included in net realized gain on investments was $289,000 and $2.2 million, respectively, of realized losses recognized due to other than temporary impairments.
The Company files a consolidated federal income tax return, and pursuant to an agreement, each entity within the consolidated group pays its share of federal income taxes based on separate return calculations.
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 income. Other comprehensive income includes all other non-owner related changes to equity and represents net unrealized gains and losses on available-for-sale fixed maturities, equity securities, other invested assets, and derivative instruments.
At the time a derivative contract is entered into, the Company formally documents and designates the derivative as either a hedge of the fair value of a recognized asset or liability (fair value hedge) or a hedge of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge). The Company does not have any derivative contracts hedging foreign currencies or derivative contracts held for speculative purposes. The Company formally assesses, both at the hedge's inception and on an ongoing basis, whether the derivatives used for hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. When it is determined that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting prospectively.
provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, this Statement requires more prominent disclosures in both the annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company has adopted the disclosure provisions of this Statement and will adopt a transition method at the time when a consistent fair value measurement and recognition provision is determined by the FASB and is required to be adopted.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities ("FIN 46"), which requires the consolidation of certain entities considered to be variable interest entities ("VIEs"). An entity is considered to be a VIE when it has equity investors who lack the characteristics of having a controlling financial interest, or its capital is insufficient to permit it to finance its activities without additional subordinated financial support. Consolidation of a VIE by an investor is required when it is determined that the investor will absorb a majority of the VIE's expected losses if they occur, receive a majority of the entity's expected residual returns if they occur, or both. As a result of the Company adopting FIN 46, effective July 1, 2003, the financial operations of STFC Capital Trust I, (the "Capital Trust") the Company's Delaware business trust subsidiary (described in Note 7 below), are no longer consolidated within the accompanying financial statements of the Company. The net impact of the adoption of FIN 46, effective July 1, 2003, was a reclassification adjustment to eliminate the Capital Trust's capital securities of $15.0 million from notes payable and include State Auto Financial's investment of $464,000 in the common securities of Capital Trust in other invested assets and $15.5 million principal amount of Floating Rate Junior Subordinated Debt Securities issued to the Capital Trust in notes payable.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with the Characteristics of Both Liabilities and Equity, effective for reporting periods after July 1, 2003. This Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. The Company adopted this statement effective July 1, 2003 with no significant impact to the consolidated financial statements.
Certain items in the 2002 and 2001 consolidated financial statements have been reclassified to conform to the 2003 presentation.
Deferred federal income taxes on the net unrealized holding gain for available for sale investments was $28.1 million and $22.9 million at December 31, 2003 and 2002, respectively.
The following table shows the Company's investments gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2003:
Expected maturities may differ from contractual maturities because the issuers may have the right to call or prepay the obligations with or without call or prepayment penalties. Fixed maturities with carrying values of approximately $49.4 million and $45.3 million were on deposit with regulators as required by law or specific escrow agreement at December 31, 2003 and 2002, respectively. Components of net investment income are summarized as follows:
The decrease of $1.8 million in 2003 and the increase of $12.4 million in 2002, for claims occurring in prior years is well within normal expectations for reserve development and claim settlement uncertainty. The increase of $60.7 million in 2001 for claims occurring in prior years is primarily the result of reserve strengthening on the former Meridian Mutual business in order to bring these claim reserves in line with historic State Auto adequacy levels as well as ongoing analysis of recent loss development trends.
In the ordinary course of business, the Company assumes and cedes reinsurance with other insurers and reinsurers and is a member in various pools and associations. See Note 6(a) for discussion of reinsurance with affiliates. The voluntary arrangements provide greater diversification of business and limit the maximum net loss potential arising from large risks and catastrophes. Most of the ceded reinsurance is effected under reinsurance contracts known as treaties; some is by negotiation on individual risks. Although the ceding of reinsurance does not discharge the original insurer from its primary liability to its policyholder, the insurance company that assumes the coverage assumes the related liability.
Prior to the reinsurance transaction with Mutual under the Pooling Arrangement, as discussed in note 6(a), the effect of the Company's reinsurance on its balance sheets and income statements, is as follows:
Effective with the June 1, 2001 merger transaction of Meridian Mutual into Mutual, Mutual also acquired all of the outstanding shares of Meridian Insurance Group, Inc. (MIGI), an Indiana domiciled insurance holding company. MIGI's wholly-owned insurance subsidiaries are Meridian Security Insurance Company (Meridian Security), an Indiana domiciled property and casualty insurer, and Meridian Citizens Security Insurance Company, an Indiana domiciled property and casualty insurer. MIGI is also party to an affiliation agreement with Meridian Citizens Mutual Insurance Company, an Indiana domiciled property and casualty insurer. Collectively, the MIGI insurer subsidiaries and affiliate are hereafter collectively referred to as the "Meridian Insurers." The STFC Pooled Companies, SA National, Mid-Plains, Mutual, SA Wisconsin, SA Florida and the Meridian Insurers are collectively referred to as the "State Auto Group."
To protect against a catastrophe loss event in which the State Auto Group would incur catastrophe losses in excess of $120 million, State Auto Financial entered into a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the Lender) to provide up to $100 million for reinsurance purposes. In the event of such a loss, this arrangement provides that State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which would borrow the money necessary for such purchase from the Lenders. This
The following provides a summary of the ceding reinsurance transactions on the Company's balance sheets and income statement for the reinsurance agreements between SA National and Mutual and Mid-Plains and Mutual:
Upon receipt of the written approval of the South Dakota Director of Insurance, in the fourth quarter of 2003 Milbank repaid the $15.0 million surplus contribution note to Meridian Security that was entered into on September 30, 2002. Subject to the condition described below and the other terms of the note, the maturity date was September 30, 2012. The interest rate was equal to the U.S. Treasury ten-year note yield at September 30, 2002 plus 100 basis points (total 4.59%) and was adjustable October 1, 2007 to the then current U.S. Treasury ten-year note yield plus 100 basis points for the remaining term of the note. Interest was accrued, but all payments of principal or interest could be made only with the prior written approval of the South Dakota Director of Insurance.
Stateco provides Mutual and its affiliates investment management services. Investment management income is recognized quarterly based on a percentage of the average fair value of investable assets and the equity portfolio performance of each company managed. Revenue related to these services amounted to $2.2 million, $2.1 million and $3.0 million in 2003, 2002 and 2001, respectively, and is included in other income (affiliates).
State Auto Financial has the right, at any time, to defer payments of interest on the Subordinated Debentures for up to 20 consecutive quarterly payment periods. Consequently, distributions on the Trust Securities would be deferred (though such distributions would continue to accrue with interest since interest would accrue on the Subordinated Debentures during any such extended interest payment period). In no case may the deferral of payments and distributions extend beyond the stated maturity dates of the respective securities. During such deferments, State Auto Financial may not declare or pay any dividends on, or purchase any of, its capital stock, make any principal or interest payments on debt securities that rank in all respects equally with or subordinated to the Subordinated Debentures, or make any payment under guarantees that rank in all respects equally with or subordinated to State Auto Financial's guaranty of the Trust Securities.
The Subordinated Debentures are unsecured and subordinated to all of the Company's existing and future senior indebtedness. As sponsor of the Capital Trust, State Auto Financial incurred security issuance costs related to the Trust Preferred Capital Securities and Subordinated Debentures of $535,000, which is recorded in other assets and is being amortized into interest expense ($13,000 for 2003) as the underlying interest expense is recognized on the Trust Securities.
On October 1, 2003 State Auto Financial entered into an interest rate swap contract for a notional amount of $25.0 million as a hedge on the ten year treasury rate in connection with the forecasted issuance of the Senior Notes. The swap contract was designated as a cash flow hedge and settled on November 6, 2003, the pricing date of the Senior Notes, with the Company receiving $811,000. The gain has been recorded in accumulated other comprehensive income and is being accreted as an offset to interest expense ($7,000 in 2003) as the underlying interest expense is recognized for the Senior Notes. Management estimates $61,000 will be accreted as an offset to interest expense in 2004.
swap was $485,000 of which $229,000 related to net accrued interest to be received and reduce reported interest expense in the period. The amount of hedge ineffectiveness was not material.
Total cash paid for interest was $3.1 million, $2.2 million and $2.3 million in 2003, 2002 and 2001. See discussion of affiliate notes payable at note 6 (c). Notes payable at December 31, 2003 and 2002 consisted of the following:
The Company provides a pension benefit plan for its eligible employees. Substantially all Company employees become eligible to participate the year after becoming 20 years of age and vest with 5 years of credited service or attain age 65.
The Company's policy is to fund pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Benefits are determined by applying factors specified in the plan to a participant's defined average annual compensation.
Effective January 1, 2002, employees of MIGI, a subsidiary of the former Meridian Mutual, became employees of State Auto P&C. In conjunction with this transaction approximately $3.6 million in net pension plan benefit liabilities were transferred from MIGI to the Company.
The Company used September 30, 2003, 2002 and 2001, respectively, to determine the pension and postretirement benefit measurements. Information regarding the Company's pension and postretirement benefit plans change in benefit obligation, plan assets and funded status are as follows:
The Company had no additional minimum liability included in other comprehensive income for the Pension and Postretirement plans for 2003, 2002 and 2001.
The Company's defined benefit plan obligations are long-term in nature and consequently the investment strategies have a long-term time horizon. In establishing the long term rate of return assumption on plan assets, management, along with its pension consulting actuary, reviews the historical performance of the plan assets and the stability in mix of investment portfolio. The expected inflation rate and expected real rates of return of applicable asset classes are then determined to assist in setting appropriate assumptions. The relatively stable investment strategy between fixed maturities and equity securities has produced a 10 year average rate of return on plan assets through September 30, 2003 of 10.1%.
The assumed health care cost trend rates used for the years ended December 31, 2003, 2002 and 2001 are as follows:
The Company's pension and postretirement benefit plans weighted average asset allocations by asset category at the Plans' measurement date of September 30, 2003 and 2002, respectively, are as follows:
The following table summarizes the Plans' asset allocation exposure range as a percent of total assets fair market value:
The Company expects to contribute approximately $4.0 million to its pension plan in 2004.
Also, the Company has a supplemental executive retirement plan (SERP) for which the accrued obligation at December 31, 2003 and 2002 was $4.2 million and $2.6 million, respectively, that is included in the balance sheet postretirement benefit liabilities amount.
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 $2.1 million, $2.0 million and $1.1 million for the years 2003, 2002 and 2001, 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 438,023 shares from the public under this plan of which 45,000 and 393,023 shares were purchased during 2003 and 2002, respectively. In May 2000, State Auto Financial's Board of Directors approved a plan to repurchase up to 1.0 million shares of its common stock from the public over a period ending December 31, 2001. Through December 31, 2001, State Auto Financial repurchased 50,522 shares from the public. Repurchases during 2003, 2002 and 2001 were funded through dividends from subsidiaries.
The Company follows Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock incentive plans using the intrinsic value method to account for stock-based compensation. Compensation cost charged against operations in 2003 and 2002 were $0, and $14,000 in 2001 for those employee stock options granted where the exercise price was less than the market price of the underlying stock on the date of grant. 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 No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123), the Company's pro forma net earnings and net earnings per share information would have been as follows:
The fair value of options granted to employees and directors in 2003, 2002 and 2001 were estimated at the date of grant using the Black-Scholes option-pricing model.
The Company has stock option plans for certain directors and key employees. The Nonemployee Directors' Plan provides each nonemployee director an option to purchase 4,200 and 1,500 for 2003 and 2002, respectively, shares of common stock following each annual meeting of the shareholders at an option price equal to the fair market value at the close of business on the last trading day prior to the day of the annual meeting. The Company has reserved 300,000 shares of common stock under this plan. These options are exercisable at issuance to 10 years from date of grant. The Key Employee's Plan provides that qualified stock options may be granted at an option price not less than fair market value at date of grant and that nonqualified stock options may be granted at any price determined by the options committee of the Board of Directors. The Company has reserved 5.0 million shares of common stock under this plan. These options are exercisable at such time or times as may be determined by a committee of the Company's Board of Directors. Normally, these options are exercisable from 1 to 10 years from date of grant.
The following table sets forth the compilation of basic and diluted net earnings per common share:
Effective July 1, 2001, with the STFC Pooled Companies assumption of the former Meridian Mutual business through the Pooling Arrangement, as more fully described in note 6(a), the Company established the Meridian standard and Meridian nonstandard insurance segments. While these Meridian segments offer similar products and services and operate in the same geographical locations within the United States as the State Auto segments, they differ within their operating measures, more specifically within their loss and profitability results. Monitoring the performance of the Meridian segments allows management to review the results of its integration efforts of these segments while this business continues to be processed through the Meridian systems platform. Due to the integration efforts by management, along with this segment no longer meeting the quantitative thresholds for segment reporting within the Meridian nonstandard business, beginning with the first quarter of 2003, the Meridian nonstandard business was included in the State Auto nonstandard segment. The 2002 and 2001 disclosures have been revised to reflect this change. Likewise, the Meridian standard business, beginning with the first quarter of 2004, will be included in the State Auto standard segment.