(1) Adjusted for a July 1998 2-for-1 common stock split as well as a July 1996 3-for-2 common stock split effected in the form of a stock dividend. (2) The earnings per share amounts prior to 1997 have been restated as required to comply with SFAS No. 128. (3) Preliminary industry information for 2002 from A.M. Best.
* Reflects change in Pooling Arrangement, effective October 1, 2001, January 1, 2000, 1999, 1998 and 1995.
"Management's Discussion and Analysis of Financial Condition and Results of Operations" is as follows:
Mutual's wholly-owned subsidiaries are State Auto Insurance Company of Wisconsin, formerly Midwest Security Insurance Company ("SA Wisconsin"), State Auto Florida Insurance Company ("SA Florida") and Meridian Insurance Group, Inc. ("MIGI"). MIGI's subsidiaries are Meridian Security Insurance Company ("Meridian Security"), Meridian Citizens Security Insurance Company ("Meridian Citizens") and Insurance Company of Ohio ("ICO"). ICO ceased insurance operations on October 1, 2002 and was dissolved on January 15, 2003. MIGI is also party to an affiliation agreement with Meridian Citizens Mutual Insurance Company ("Meridian Citizens Mutual"). Meridian Security, Meridian Citizens, ICO and Meridian Citizens Mutual are collectively referred herein as the "MIGI Insurers."
The following table sets forth a chronology of the participant changes that have occurred in the Pooling Arrangement since January 1, 1999:
On January 1, 2003, the Pooling Arrangement was amended to add SA Florida as a participant. The Company's aggregate pooling participation percentage remained at 80%. At December 31, 2002, SA Florida had not commenced insurance operations; consequently, there was no impact on the Company's books at January 1, 2003 relating to the Pooling Arrangement amendment.
Non-insurance subsidiaries of the Company include Stateco Financial Services, Inc. ("Stateco"), which provides investment management services to affiliated companies and Strategic Insurance Software, Inc. ("S.I.S."), which develops and sells software for the processing of insurance transactions, database management systems for insurance agents and electronic interfacing of information between insurance companies and agents. S.I.S. sells its services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies. 518 Property Management and Leasing, LLC ("518 PML") is engaged in the business of owning and leasing real and personal property to affiliated companies. The members of 518 PML are State Auto P&C and Stateco. The results of operations of S.I.S. and 518 PML are not material to the total operations of the Company.
The following is a summary of several transactions that occurred in the second half of 2001 that will assist in the discussion of the Company's current period financial results:
As the former Meridian Mutual standard and nonstandard business continues to be written and processed through the Meridian underwriting and claims system platform, management has monitored this business as separate segments from the State Auto standard and nonstandard processed business. Monitoring of these segments separately has been necessary in order to facilitate the integration of the business as it migrates through new policies and renewals to the State Auto systems platform in which State Auto policies, pricing, underwriting, and claims philosophies are fully reflected. Over time, it is anticipated that the Meridian operating segments will decrease and eventually disappear as they become fully integrated on to the State Auto systems platform. With the addition of the former Meridian Mutual business to the Pooling Arrangement, 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 that business consisting of the business known formerly as the Meridian Mutual business to be the "Meridian standard segment" and "Meridian nonstandard segment." Due to the integration efforts that occurred within the Meridian nonstandard segment during 2001 and 2002, beginning with the first quarter of 2003, the Meridian nonstandard business will be included in the State Auto nonstandard segment.
Losses and loss expenses payable are management's best estimates 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 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 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 that have not yet been reported are estimated based on many variables including historical and statistical information, inflation, legal developments, storm loss estimates, and
The Company regularly monitors its investment portfolio for declines in value that are other than temporary, an assessment which requires significant management judgment. Among the factors management considers are market conditions, the amount, timing and length of decline in fair value, and events impacting the issuer. When a security in the Company's investment portfolio has a decline in fair value which 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.
Net income for the Company increased by $16.4 million (79.5%) in 2002. Contributing to this increase was a 4.6 point improvement in the Company's GAAP combined ratio and, as more fully described above, changes made to the Company's participation in the Pooling Arrangement in the second half of 2001. Additionally, net investment income increased due to the Pooling Arrangement changes in 2001, which was offset by a decrease in the Company's management and operations service income.
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 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 will be included in the State Auto nonstandard segment category.
Net investment income increased by $12.3 million (26.0%) in 2002. Contributing to the increase over the previous year was an increase in invested assets due to a transfer of $354.6 million in cash and fixed maturity securities from Mutual to the Pooled Subsidiaries in the second half of 2001. This transfer was made in conjunction with the changes made to the Pooled Subsidiaries participation in the Pooling Arrangement, as more fully described above. Total cost of invested assets at December 31, 2002 and 2001, was $1,303.0 million and $1,150.3 million, respectively. Reflecting a decline in the interest rate environment, the investment yields, based on cash equivalents, fixed and equity securities at cost were 4.9% and 5.4% for the annual periods ending 2002 and 2001, respectively. See further discussion regarding investments at the "Liquidity and Capital Resources", "Investments" and "Market Risk" sections, included herein.
Management services income, including investment management fees, decreased by $12.9 million (83.1%) in 2002. This decrease was attributable to the termination of the fee element of the 2000 Management Agreement. The service fee under the 2000 Management Agreement paid by Mutual in 2001 was $12.5 million. See "Liquidity and Capital Resources" included herein, for discussion of the overall impact of the loss of the management and operations service fee on the Company's cash flow and operations.
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%,
For discussion purposes, the following table provides comparative GAAP loss and LAE ratios for the Company's insurance operating segments for the 2002 and 2001 periods, respectively, except for the Meridian segments for 2001, which is for the six month period ended December 31, 2001:
The Meridian standard segment GAAP loss and LAE ratio for 2002 was 85.9 compared to 139.3 for the six month period ended December 31, 2001. Comparison of the overall results of 2002 with those of 2001 is affected by the reserve strengthening that occurred during the second half of 2001 within this segment. Catastrophe losses represent approximately 7.0 points of this segment's loss results for both the 2002 and 2001 periods. While the Meridian standard business continues to produce loss results worse than the State Auto book of business, management believes there has been improvement in this segment due to the necessary and continued efforts that began in 2001, e.g. seeking adequate cost-based rates, re-underwriting commercial renewals to be certain that risks written are within the State Auto underwriting guidelines and discontinuing the Group Advantage(R) Program.
The Meridian non-standard segment GAAP loss ratio for 2002 was 51.9 compared to 168.2 for the six month period ended December 31, 2001. This segment was also significantly impacted by case reserve strengthening that occurred during the second half of 2001. Similar to the Meridian standard segment, largely contributing to the current year loss results has been the substantial rate increases the Company implemented in 2001 and 2002.
Acquisition and operating expenses, as a percentage of earned premiums (the "GAAP expense ratio"), were 29.5% and 30.1% for the years 2002 and 2001, respectively. Management continually focuses its attention on improving its GAAP expense ratio, which is especially critical during a period of substantial top line growth.
The 2002 underwriting improvement, coupled with net investment income being largely comprised of tax-exempt income, produced an effective tax expense rate in 2002 of 2.1% versus an effective tax benefit of 15% in 2001. For additional clarification, see the reconciliation between actual federal income taxes and the amount computed at the statutory rate as detailed in footnote 8 in the notes to the Company's consolidated financial statements.
Net income for the Company decreased $27.1 million (56.8%) in 2001. Contributing to this decease was an increase in the Company's GAAP combined ratio to 107.0% from 98.4% in 2000. Negatively impacting the Company's insurance operations in 2001 were the loss results of the former Meridian Mutual business, assumed by the Pooled Subsidiaries beginning in July 2001, and a decrease in the Company's management and operations service fee income.
Consolidated earned premiums increased $157.2 million (39.5%). This increase was principally the result of the addition of the former Meridian Mutual business to the Pooling Arrangement, effective July 1, 2001, and a change in the Pooled Subsidiaries' aggregate pooling participation percentage from 53% to 80%, effective October 1, 2001. These actions increased consolidated earned premiums 30.9%. The internal growth of the State Auto standard segment's earned premiums increased consolidated earned premiums 6.8%. This increase has been largely driven by growth in commercial lines of business over the last twelve months; however, during the last half of the calendar year, personal lines of business began to experience sales increases. Management believes the personal lines sales increases are due to changes in the market place and to its establishing the position of Personal Lines Sales Specialist. The internal growth of the State Auto nonstandard segment earned premiums increased consolidated earned premiums 2.0%. Production levels in this segment continued to improve during 2001 as a result of improved processing routines for agents and the easing of competitive pricing pressures it had felt from certain market leaders in the first half of 2000. The internal growth of both the Meridian standard and nonstandard segment on consolidated earned premium was flat. See discussion below regarding management's action during 2001 on the Group Advantage(R) Program as well as management's
Losses and loss expenses increased $154.9 million (56.9%) and as a percentage of earned premiums (the "GAAP loss and LAE ratio"), were 76.9%% and 68.4% for the years 2001 and 2000, respectively. During the fourth quarter of 2001, the Pooled Subsidiaries produced a loss ratio under the Stop Loss (described above) that exceeded the 80% threshold, thereby recovering the full layer of $6.2 million from Mutual. Adversely impacting the current year results were the loss results of the former Meridian Mutual business assumed by the Pooled Subsidiaries.
The Company's State Auto standard segment reflected an improvement in its GAAP loss and LAE ratio in 2001 to 65.9 from 67.4 in 2000. This segment's largest line of business, automobile, reflected a 1.5 point improvement in 2001 from 2000. This segment's next largest line of business, homeowners, has experienced some deterioration in its GAAP loss and LAE ratio over the last several years. Management has been monitoring this line of business and has taken some corrective action through rate increases and improved underwriting techniques such as credit scoring.
The Company's State Auto nonstandard segment experienced an improvement in its GAAP loss and LAE ratio in 2001 to 77.3 from 81.4 in 2000. In 2000, this segment began experiencing some volatility in loss activity in those states where National began operations in 1999. Consequently, management began monitoring the premium rate adequacy in these new states and reacted accordingly throughout 2000 and 2001 by increasing rates in these new states. Additionally, this segment has implemented a number of underwriting tools, including "point-of-sale" underwriting as well as the use of credit scoring. Management believes these two tools have contributed to this segment's profit improvement.
The former Meridian Mutual business has historically produced poorer loss results than the State Auto book. Through the integration process, several areas within the Meridian Mutual book are being strengthened that should produce improved long term results. The most notable improvement was management's focus on reviewing the Meridian segments' case reserves during the second half of 2001 to ensure that the claims were reserved in a manner consistent with State Auto practices. During the review, it became apparent that case reserves on the Meridian segments for claims occurring in prior accident periods were not reserved consistently with historic State Auto adequacy levels. Nearly 14,000 open claims were reviewed, adding approximately $36 million to known case reserves on claims occurring in prior periods. Irrespective of this reserve strengthening, the Meridian segments' business continues to produce results that are not acceptable to management.
During 2001, management also focused on strengthening the Meridian standard segment's adherence to underwriting guidelines in a manner consistent with State Auto practices, as well as analyzing the adequacy of prices relative to risks written. Consequently, management is in the process of re-underwriting 100% of the commercial renewals to be certain they fall within the State Auto guidelines. State Auto also has a practice of reviewing the rate level for each line of business in each operating state each year. Concurrent with these reviews, the Meridian standard segment's rate levels on its commercial book of business are being adjusted to the State Auto rate level. Implementing the Company's underwriting and pricing discipline within the Meridian standard segment is anticipated to have an adverse effect on top line growth of the Meridian standard segment. This may be partially offset by new business being written within the State Auto standard segment by those agencies previously representing the former Meridian Mutual but not State Auto.
Acquisition and operating expenses, as a percentage of earned premiums (the "GAAP expense ratio"), were 30.1% and 30.0% for the years 2001 and 2000, respectively. Impacting the current year expenses was approximately $1.3 million (0.2%) related to the Company's estimate of its future guaranty fund assessments related to the Reliance Insurance Company insolvency that was announced during the fourth quarter of 2001.
The decrease in the Company's 2002 profit within the State Auto standard insurance segment is primarily due to an increase in this segment's current year loss experience as discussed at "2002 Compared to 2001" in "Results of Operations." Increased top line growth, as well as an increase in the State Auto nonstandard segment's net investment income, despite deterioration in its loss results, contributed positively to this segment's profit in 2002. Improvement in the Company's 2001 segment profit within the State Auto standard and nonstandard insurance segments was primarily due to an improvement in these segments' loss experience and management's response to premium rate inadequacy as discussed at "2001 Compared to 2000" in "Results of Operations." As discussed above, management continually monitors these segments' premium rate adequacy and seeks adequate cost-based rates.
Comparison of the segment profit (loss) results of 2002 with that of 2001 for the Meridian segments was affected by the reserve strengthening that occurred during the second half of 2001. While management recognizes that the Meridian standard business continues to produce loss results poorer than the State Auto standard segment, it believes its integration efforts that began in 2001, as discussed at "2001 Compared to 2000," has improved this segment's results.
The increase in segment profit of the investment management segment in 2002 and 2001 was the result of this segment providing its services to the Meridian Insurers beginning June 1, 2001. This segment's revenue is based on the average fair value of the portfolio of the companies managed, which is largely comprised of fixed maturities. During 2002 and 2001, the investment management segment profit increased as managed invested assets increased.
Cash provided by financing activities consists of proceeds from issuance of debt and common stock and cash used to acquire treasury shares and pay dividends to shareholders. Overall net cash provided by financing activities was $25.0 million in 2002, $0.5 million in 2001 and $10,000 in 2000. Net cash provided by financing activities increased during 2002 primarily due to net proceeds from issuance of debt (see discussion below), partly offset by payments to re-purchase Company common shares. During 2001 net cash provided by financing activities increased due to an increase in net proceeds from issuance of common stock over 2000.
Mutual, whose ownership in State Auto Financial is approximately 67%, 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 Independent Committee of the board of directors of Mutual. It met and determined that it would review dividend waiver
Effective September 30, 2002, Milbank 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 is September 30, 2012. The interest rate is equal to the U.S. Treasury ten-year note yield at September 30, 2002 plus 100 basis points (4.59%) and is 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 is 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. Interest is scheduled to be paid semiannually in arrears beginning March 30, 2003.
Effective December 23, 2002, State Auto Financial entered into a 364 day $15.0 million term loan note agreement with a bank. Interest adjusts quarterly and accrues based on LIBOR plus 75 basis points (2.15% at December 31, 2002). Interest on the note is 2.15% through March 23, 2003 and 2.027% for the period March 24, 2003 through September 23, 2003. The purpose of this term loan note was to contribute additional capital to State Auto P&C to improve this company's leverage ratio. The reason for the increase in State Auto P&C's leverage ratio is similar to that of Milbank's, which is described above. State Auto P&C's pooling percentage increased from 39% to 59%, effective October 1, 2001. At December 31, 2002, State Auto P&C's leverage ratio is 2.6 to 1.
At December 31, 2002, National's leverage ratio is 4.4 to 1 compared to 2.0 to 1 at December 31, 2001. The increase in the 2002 leverage ratio is the result of this company's substantial current year net written premium growth. Management believes the leverage ratios for Milbank, State Auto P&C and National are higher than is optimal. Management is in the process of considering alternatives and developing a plan to improve these ratios. It is likely there will be a cost to the Company attendant to generating additional surplus within these three insurance subsidiaries, but no details are known at this time.
The National Association of Insurance Commissioners ("NAIC") maintains risk-based capital requirements for property and casualty insurers. Risk-based capital is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy and other business factors. Applying the risk-based capital requirements as of December 31, 2002, each of the State Auto Insurance Companies surpassed all standards established by the formula.
The State Auto Insurance Companies are participants in a catastrophe reinsurance program. The amount retained by the State Auto Insurance Companies 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. State Auto P&C assumes catastrophe reinsurance from Mutual, Milbank, SA Wisconsin, Farmers Casualty, SA Ohio, National, Mid-Plains and the Meridian Insurers, in the amount of $100 million excess of $120 million. This layer of $100 million in excess of $120 million has been excluded from the Pooling Arrangement. There have been no losses assumed under this agreement.
To provide funding if the State Auto Insurance Companies were to incur catastrophe losses in excess of $120.0 million, State Auto Financial has continued a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the "Lenders") to provide up to $100.0 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. State Auto Financial would then contribute to State Auto P&C the funds received from the sale of its preferred shares. State Auto P&C would use the contributed capital to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC (which would repay the Lenders) by redeeming the preferred shares over a five-year period. In the event of a default by State Auto Financial, the obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to either purchase the preferred shares from the SPC or repay the SPC for the loan(s) outstanding.
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 December 31, 1990 liability, if any, is to be reimbursed by Mutual to State Auto P&C in conformance with pooling percentages in place at that time. As of December 31, 2002, there has been no adverse development of the liability.
The maximum amount of dividends that may be paid to State Auto Financial during 2003 by its insurance subsidiaries without prior approval under current law is limited to $35.3 million. The Company is required to notify the insurance subsidiaries' respective State Insurance Commissioner within five business days after declaration of all dividends and at least ten days prior to payment. Additionally, the domiciliary Commissioner of each insurer subsidiary has the authority to limit a dividend when the Commissioner determines, based on factors set forth in the law, that an insurer's surplus is not reasonable in relation to the insurer's outstanding liabilities and adequate to its financial needs. Such restrictions are not expected to limit the capacity of State Auto Financial to meet its cash obligations.
As discussed above, there was particular emphasis throughout 2002 and 2001 on improving the former Meridian Mutual book of business, which is expected to continue in 2003. The Company believes its underwriting and pricing discipline, as well as its commitment to delivering its products as effectively and efficiently as possible, have been key factors in the Company's underwriting results over the last several years. The Company remains active in the personal and commercial markets, developing new products to enhance its product portfolio; appointing new agents in its operating territories; and refining its pricing levels for the markets and lines of business it believes offer the most profit potential.
Stateco performs investment management services (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 primary investment objectives of the Company are to generate income, preserve capital and maintain adequate liquidity for the payment of claims. Fixed maturities that may be sold due to changing investment strategies are categorized as available for sale and are carried at fair value. At December 31, 2002, the Company had no fixed maturity investments rated below investment grade, nor any mortgage loans. The following table provides information regarding the quality distribution of the Company's fixed maturity portfolio at December 31, 2002:
Despite the volatility in the equity market during 2002, the Company continued its direction of moderately increasing its equity portfolio investments to enhance growth of statutory surplus over the long term. Gains and losses on the sale of equity securities are computed using the first-in, first-out method. The Company's current investment strategy does not rely on the use of derivative financial instruments.
At December 31, 2002 all investments in fixed maturity and equity securities were held as available for sale and therefore are carried at fair value. Other invested assets are comprised of limited liability partnership investments that are carried at fair value, and as presented in the table below, represent approximately 0.2% of the Company's overall investment portfolio. 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, and therefore other comprehensive income of $0.8 million, net of deferred taxes, was recognized.
The following table provides the composition of the Company's investment portfolio at December 31, 2002 and 2001, respectively:
The Company regularly monitors its investment portfolio for declines in value that are other than temporary, an assessment which requires significant management judgment. 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 a security in the Company's investment portfolio has a decline in fair value which 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 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, 2002:
The securities sold during 2002, were sold to either recognize the gain available, to dispose of the security because of the Company's opportunity to invest in securities with greater potential return considering capital preservation, and as discussed above, to reposition the taxable/tax-exempt fixed maturity position of the Company. Realized gains and losses are summarized as follows:
The fixed maturity portfolio is managed in a laddered-maturity style and considers business mix and liability payout patterns to ensure adequate cash flow to meet claims as they are presented. At
The Company's investment portfolio grew 17.1% during 2002 to $1,368.3 million at December 31, 2002 from $1.168.7 million at December 31, 2001. This growth was generated primarily from cash flow provided by operations and an increase in the unrealized gains of fixed maturities, partly offset by a decline in the overall equity market.
The equity markets declined during 2002 and 2001, the first time since the 1973 and 1974 bear markets in which the market also declined two years in a row. During 2002, the Company's equity portfolio decreased $11.6 million to a cumulative unrealized loss of $2.1 million at December 31, 2002 from a cumulative unrealized gain position of $9.5 million at December 31, 2001.
During 2002 the fixed maturity fair values increased as the interest rate environment decreased. The Company's fixed maturity portfolio cumulative unrealized gains increased $58.5 million to $67.4 million at December 31, 2002 from $8.9 million in cumulative unrealized gains at December 31, 2001.
The preceding paragraphs briefly describe certain factors management considers in estimating the ultimate liability for losses and loss expenses. With respect to the auto line of business, which represents almost half of the Company's total reserves, the most significant external variable is legal developments. As discussed in "Impact of Significant External Factors" below, court decisions have a significant impact on the property and casualty insurance industry. Some of these decisions have a more prospective effect as, for example, when contract provisions relating to third party coverages are construed in ways not anticipated by the Company. Other court decisions have more of a retroactive effect, in particular in the auto insurance line. Auto insurance tends to be a line of business more regulated by statutes; consequently, the courts tend to have more of an opportunity to construe these statutes and apply their interpretations to existing contracts. Uninsured motorists and underinsured motorists (collectively "UM") are statutory coverages in almost every state
The following table presents the loss and loss expenses payable by major line of business at December 31, 2002 and 2001, respectively:
Overall 2002 total net losses and loss expenses payable increased 16% from 2001. This increase is primarily driven by an increase in claim submissions, as the policy count base grew significantly during the year. As shown in the table, the "other commercial lines" payable percentage increase is greater than the average increase for all lines. We believe this is due to higher than average growth in commercial lines, and several unusually large claims incurred during 2002. Overall, management does not believe there is a significant change in the total book of business at December 31, 2002 compared to December 31, 2001.
net loss and loss expense payable). The current year development of the prior years' ultimate liability does not reflect any changes in the Company's fundamental claims reserving practices.
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 over the last few years. We continue to adjust our pricing projections as loss cost trends change to ensure premiums keep pace with inflation in all lines of business.
The Company considers inflation when estimating liabilities for losses and loss expenses, particularly for claims having a long period between occurrence and settlement. The liabilities for losses and loss expenses are management's best estimates of the ultimate net cost of underlying claims and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on investment income may partially offset potentially higher claims and expenses.
The Company is also affected by court decisions. Premiums 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.
Probably the most significant piece of legislation to affect the Company in 2002 was the Federal Sarbanes-Oxley Act of 2002,("Sarbanes Oxley") which took effect in July 2002. While this law does not affect the Company's insurance operations, it has and will continue to have an effect on the Company. Sarbarnes Oxley was the response of the Congress to the corporate scandals of the last two years. Sarbanes Oxley imposes significant new rules on the Company's corporate governance, its financial and reporting processes and its relationship with its independent auditor. Sarbanes Oxley will require the Company to incur additional costs through an increase in its internal staff functions to ensure that it adequately documents compliance with these new legal requirements.
Statements contained in this Form 10-K or any other reports or documents prepared by the Company or made by management may be "forward-looking" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to certain risks and uncertainties that could cause the Company's actual results to differ materially from those projected. Forward-looking statements may be identified, preceded by, followed by, or otherwise include, without limitation, words such as "plans," "believes," "expects," "anticipates," "intends," "estimates," or similar expressions. The following factors, among others, in some cases have affected and in the future could affect the Company's actual financial performance.
- In addition to the acquisition of the Meridian Insurers and Mutual's merger with Meridian Mutual as discussed elsewhere in this Form 10-K, during the past several years, Mutual and the Company have acquired other insurance companies, such as Milbank, Farmers Casualty, and SA Wisconsin, 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 laws of the various states establish insurance departments with broad regulatory powers relative to approving intercompany arrangements, such as management, pooling, and investment management agreements, granting and revoking licenses to transact business, regulating trade practices, licensing agents, approving policy forms, setting reserve requirements, determining the form and content of required statutory financial statements, prescribing the types and amount of investments permitted and requiring minimum levels of statutory capital and surplus. In addition, although premium rate regulation varies among states and lines of insurance, such regulations generally require approval of the regulatory authority prior to any changes in rates. Furthermore, all of the states in which the State Auto Group transacts business have enacted laws which restrict these companies' underwriting discretion. Examples of these laws include restrictions on agency terminations and laws
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements 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, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States.
- State Auto Property and Casualty Insurance Company (State Auto P&C), a South Carolina corporation - Milbank Insurance Company (Milbank), a South Dakota corporation - Farmers Casualty Insurance Company (Farmers Casualty), an Iowa corporation - State Auto Insurance Company of Ohio (SA Ohio), an Ohio corporation (formerly State Auto Insurance Company) - State Auto National Insurance Company (National), an Ohio corporation - Stateco Financial Services, Inc. (Stateco), an Ohio corporation - Strategic Insurance Software, Inc. (S.I.S.), an Ohio corporation.
Mid-Plains Insurance Company (Mid-Plains), an Iowa corporation, is a wholly-owned subsidiary of Farmers Casualty. 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.
State Auto Financial, an Ohio corporation, is a majority-owned subsidiary of State Automobile Mutual Insurance Company (Mutual), an Ohio corporation. State Auto Financial and subsidiaries are referred to herein as "the Companies" or "the Company." All significant intercompany balances and transactions have been eliminated in consolidation.
The Company, through State Auto P&C, Milbank, Farmers Casualty and SA Ohio, provides standard personal and commercial insurance to its policyholders. Their principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. National and Mid-Plains provide nonstandard automobile insurance. State Auto P&C, Milbank, Farmers Casualty, SA Ohio, National, and Mid-Plains operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. State Auto P&C, Milbank, Farmers Casualty, SA Ohio, National and Mid-Plains are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota, Iowa, Ohio (SA Ohio and National) and Iowa, 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.
At December 31, 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 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 $19,095,000, $20,369,000 and $1,274,000, respectively, and therefore other comprehensive income of $828,000, net of deferred taxes of $446,000 was recognized. Gains and losses on the sale of equity securities 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 considered are market conditions, amount, timing and length of decline in fair market 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 2002, included in net realized gain on investments was $2,221,000 of realized losses recognized due to other than temporary impairments.
Premiums are recognized as earned using the monthly pro rata method over the contract period.
Management services income includes income for management and operations services provided by State Auto P&C employees and income for investment management services provided by Stateco. See note 6(d) regarding the Company's resolution of its disagreement with the Ohio Department of Insurance (ODI) regarding its recognition of management and operations service fee revenue paid by Mutual in 2001. Management and operations services income, to the extent certain operational ratios were achieved, was recognized quarterly based on a percentage of the three year average of each managed company's adjusted surplus or equity. State Auto Insurance Company of Wisconsin (SA Wisconsin), formerly Midwest Security Insurance Company, a wholly-owned subsidiary of Mutual, is an exception to this, calculating its fee based on a percentage of quarterly direct premiums written. Effective July 1, 2002, the Meridian Insurers, defined below, pay State Auto P&C a predetermined percentage of their allocated share of State Auto P&C's employee-related costs in exchange for the services of those employees, in addition to reimbursing State Auto P&C for the actual costs of such services. Investment management income is recognized quarterly based on a percentage of the average fair value of investable assets and the performance of the equity portfolio of each company managed.
S.I.S. recognizes revenue from software license fees on a straight-line basis over the license agreement term specified in the contract. Cash payments received at the signing of the license agreement are deferred and recognized as revenue on a straight-line basis over the agreement term, typically three years. Service fees are also recognized as revenue on a straight-line basis over the license agreement term specified in the contract. Other fees are recognized as revenue upon substantial performance by the Company and customer acceptance. Costs of developing and testing new or enhanced software products are capitalized and are amortized on a product-by-product basis utilizing the straight-line method over a period not to exceed three years. Unamortized software development costs of $225,000 and $186,000 are included in accrued investment income and other assets at December 31, 2002 and 2001, respectively. Software amortization, included in other expenses, was $186,000, $440,000 and $622,000 in 2002, 2001 and 2000 respectively.
liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Certain items in the 2001 and 2000 consolidated financial statements have been reclassified to conform to the 2002 presentation.
Deferred federal income taxes on the net unrealized holding gain for available for sale investments was $22,891,000 and $6,478,000 at December 31, 2002 and 2001, 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. The fair value of other invested assets is based on Generally Accepted Accounting Principles equity.
NOTES PAYABLE: The carrying amounts reported in the balance sheets for these instruments approximate their fair value because their interest rates adjust regularly.
The increase of $12,414,000 in 2002 for claims occurring in prior years is well within normal expectations for reserve development and claim settlement uncertainty. The increase of $60,726,000 in 2001 for claims occurring in prior years is primarily the result of reserve strengthening on the former Meridian Mutual Insurance Company (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. The decrease in calendar year losses from prior years in 2000 of $5,638,000 is within normal expectation of reserve variation.
Mutual, State Auto P&C, Milbank, SA Wisconsin, Farmers Casualty, SA Ohio, National, Mid Plains, and, effective June 1, 2001, the Meridian Insurers, are participants in a catastrophe reinsurance program. Collectively, these participants in the catastrophe reinsurance program are referred to as the "State Auto Insurance Companies." State Auto P&C assumed catastrophe reinsurance from Mutual, Milbank, SA Wisconsin, Farmers Casualty, SA Ohio, National, Mid-Plains and the Meridian Insurers in the amount of $115 million excess of $120 million. Effective November 2002, the catastrophe reinsurance program was renegotiated whereby State Auto P&C assumed $100 million excess of $120 million. Under this agreement, the Company has assumed from Mutual and its affiliate premiums written and earned of $2,914,000, $3,021,000 and $3,129,000 for 2002, 2001 and 2000, 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.
National and Mid-Plains each have ceding reinsurance agreements with Mutual, that include excess of loss and quota share coverages. Through Mutual's participation in the Pooling Arrangement, the effects of these agreements with National and Mid-Plains are indirectly subject to the Pooling Arrangement between Mutual and the pooled subsididaries.
Pursuant to the Pooling Arrangement, Mutual is responsible for the collection of premiums and payment of losses, loss expenses and underwriting expenses of the Pooled Subsidiaries. Unpaid balances are reflected in due to or due from affiliates in the accompanying consolidated balance sheets. Settlements of the intercompany account are made quarterly. No interest is paid on this account. All premium balance receivables and reinsurance recoverable on paid losses from unaffiliated reinsurers are carried by Mutual. The Company had off-balance-sheet credit risk of approximately $167 million and $123 million related to premium balances due to Mutual from agents and insureds at December 31, 2002 and 2001, respectively, which is collateralized by the unearned premium from the respective policies.
Effective January 1, 2000, State Auto P&C began providing management and operation services to Mutual and its insurance affiliates. Revenue relating to these services amount to $553,000, $12,621,000 and $14,654,000 in 2002, 2001 and 2000, respectively. Stateco provides Mutual and its affiliate investment management services. Revenue related to these services amount to $2,085,000, $2,965,000 and $2,940,000 in 2002, 2001, and 2000, respectively.
Effective October 1, 2001, the management agreement between State Auto P&C and certain affiliate companies, including Mutual, was amended to eliminate the management and operations service fee charged by State Auto P&C. The management agreement continues to allocate costs and apportion those costs among the parties to the agreement in accordance with terms outlined therein. As a result of the loss of the management and operations services income under this management agreement, substantially all of State Auto P&C's services income has been eliminated, effective October 1, 2001. See note 15. The management agreement between State Auto P&C and SA Wisconsin was not affected by the disagreement or resolution with the ODI.
S.I.S. provides insurance software products and services to Mutual and its affiliate. Revenue relating to these services amount to $225,000, $692,000 and $900,000 in 2002, 2001 and 2000, respectively, and is included in other income. 518 PML leases assets to Mutual and its affiliate. Revenue relating to these services amount to $376,000, $758,000 and $646,000 in 2002, 2001 and 2000, respectively and is included in other income.
State Auto P&C's December 31, 1990 liability for losses and loss expenses of $65,464,000 has been guaranteed by Mutual. Pursuant to the guaranty agreement, all ultimate adverse development of the December 31, 1990 liability, if any, is to be reimbursed by Mutual to State Auto P&C in conformance with pooling percentages in place at that time. As of December 31, 2002, there has been no adverse development of the liability.
Effective December 21, 2002 State Auto Financial entered into a $15,000,000 term loan note agreement with a bank that matures December 21, 2003. Interest adjusts quarterly and accrues at LIBOR plus 75 basis points (2.15% at December 31, 2002) and is payable quarterly. This note agreement has various covenants including financial ratio covenants.
A reconciliation between actual federal income taxes (benefit) and the amount computed at the indicated statutory rate is as follows:
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 plan benefit liabilities were transferred from MIGI to the Company. Effective January 1, 2000, all employees of Mutual, Stateco and S.I.S., became employees of State Auto P&C, under new management agree-
ments effective on that same date. See related discussion at Note (1)(b). Pursuant to the new management agreements, the Company paid cash of approximately $14.6 million to Mutual, equal to the net prepaid pension asset received.
The Company maintains a defined contribution plan that covers substantially all employees of the Company. Contributions to the plan are based on employee contributions and the level of Company match. The Company's share of the expense under the plan totaled $1,964,000, $1,120,000 and $890,000 for the years 2002, 2001 and 2000, respectively.
In addition to pension benefits, the Company provides certain health care and life insurance benefits for its eligible retired employees. Substantially all of the Company's employees may become eligible for these benefits if they retire between age 55 and 65 with 15 years or more of service or if they retire at age 65 or later with 5 years or more of service. Effective January 1, 2000, all employees of Mutual, Stateco and S.I.S., became employees of State Auto P&C, under new management agreements effective on that same date. See related discussion at Note (1)(b). Pursuant to the new management agreements, the Company received cash of approximately $49.6 million from Mutual, equal to the funded status of the postretirement obligation assumed.
Information regarding the funded status and net periodic benefit cost for the Company's participation in the postretirement benefit plan is as follows:
net income (loss), as determined using statutory accounting practices, to the amounts included in the accompanying consolidated financial statements are as follows:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
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. Compensation cost charged against operations in 2002, 2001 and 2000 were $0, $14,000 and $31,000, respectively, 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 shareholders at an option price equal to the fair market value at the close of business on the date 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 5,000,000 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 Company has a stock option incentive plan for certain designated independent insurance agencies that represent the Company and its affiliates. The Company has reserved 400,000 shares of common stock under 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 date of grant or a portion thereof in the first calendar year in which an agency commences participation under the plan. Options granted and vested under this plan have a 10-year term. The Company has accounted for the plan in its accompanying financial statements at fair value. The fair value of options granted was estimated at the reporting date or vesting date using the Black-Scholes option-pricing model. The weighted average fair value and related assumptions for 2002, 2001 and 2000, respectively, were as follows: fair value of $7.55, $8.04 and $10.91; dividend yield of .87%, .90% and .90%; expected volatility factor of .36, .34 and .32; risk-free interest rate of 4.50%, 5.16% and 5.19%; and expected life of the option of 8.1, 8.7 and 9.0 years. Expense of $165,000, $140,000 and $493,000 associated with this plan was recognized in 2002, 2001 and 2000, respectively.
The investment management services segment manages the investment portfolios of affiliated insurance companies. As a result of the loss of the management and operations services income as described in note 6(d), the management and operations service segment is now in the all other category for segment reporting beginning with the first quarter of 2002 as the results for this segment no longer meet the quantitative thresholds for separate presentation as a reportable segment. The segment disclosures for the year ended December 31, 2001 and 2000 have been restated to reflect this change.
The Company evaluates performance of its reportable segments and allocates resources thereon based on profit or loss from operations, excluding net realized gains on investments on the Company's investment portfolio, before federal income taxes. The Company monitors its assets for the insurance segments on a legal entity basis, which for the Pooled Subsidiaries includes assets of three of the four reportable insurance segments (State Auto standard insurance, Meridian standard insurance and Meridian nonstandard insurance). The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.
The following provides financial information regarding the Company's reportable segments. The 2001 financial information for the Meridian standard and nonstandard segments reflects the business assumed by the pooled subsidiaries, beginning July 1, 2001:
The Company's insurance subsidiaries are involved in litigation and may become involved in potential litigation arising in the ordinary course of business. Additionally, the insurance subsidiaries may be impacted by adverse regulatory actions and adverse court decisions where insurance coverages are expanded beyond the scope originally contemplated in the policy(ies). In the opinion of management, the effects, if any, of such litigation and published court decicions are not expected to be material to the consolidated financial statements.