Capitalized terms used in this Item 7 and not otherwise defined have the meanings ascribed to such terms under the caption “Important Defined Terms Used in this Form 10-K” which immediately precedes Part I of this Form 10-K. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Form 10-K and the narrative description of our business contained in Item 1 of this Form 10-K. For information regarding our financial results for the fiscal year ended December 31, 2018, please see the discussion included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019.
State Auto Financial is a property and casualty insurance holding company. Our insurance subsidiaries are part of the State Auto Group and Pooling Arrangement described below. The State Auto Group markets its insurance products throughout the United States primarily through independent agencies, which include retail agencies and brokers. The State Auto Group is rated A- (Excellent) by A.M. Best.
State Auto Financial’s principal subsidiaries are State Auto P&C, Milbank and SA Ohio, each of which is a property and casualty insurance company, and Stateco, which provides investment management services to affiliated insurance companies.
Our focus in 2020 was on personal auto profitability and, although our results fell far short of our expectations, we are pleased with the progress we made. We introduced a new private passenger auto pricing model in 2020, addressed additional underwriting issues with the product and fixed the stability of our digital-only platform, State Auto Connect. We believe that these efforts will return personal auto to profitable growth in 2021. Our homeowners business, now our largest line of business, saw improvements in both the non-catastrophe ratio and expense ratio while producing strong premium growth of 23.6%. Commercial lines achieved both profit and growth while completing the rollout of products on State Auto Connect, with the launch of farm and ranch, middle market commercial and workers’ compensation.
The impact of COVID-19 on our results included a decline in auto accidents due to fewer miles driven by insureds. We experienced an increase in workers’ compensation claims, primarily from nursing homes and other medical facilities. And we, along with the rest of the insurance industry, are facing legal challenges with respect to business interruption claims related to COVID-19.
Our success in navigating the challenges of 2020 was a result of the decisions made in recent years in transforming our company. We have built a technology platform that will grow efficiently as our company grows, and our products can adapt more quickly to the expectations of our customers and the marketplace. Our service organizations are striving to meet and exceed customer expectations and our sales teams are working to build even stronger relationships with independent agents, leading to continued exceptional sales growth.
While our 2020 profit goal was not met, we enter 2021 as a much stronger organization.
of premiums, losses and expenses based on each of the Pooled Companies’ respective pooling percentages. State Auto Mutual then retains the balance of the pooled business.
The following table sets forth the participants and their participation percentages in the Pooling Arrangement. There were no changes to the participants or to their participation percentages during 2020.
The following table sets forth certain key performance indicators we use to monitor our operations for the years ended December 31, 2020 and 2019:
Beginning in March 2020, the global COVID-19 pandemic has impacted our results of operations. For the year ended December 31, 2020, the impact on the non-cat loss and ALAE current accident year included:
•Net investment gain was $27.3 million which included $31.8 million of recognized net losses on equity securities sold during the year. During the third quarter, we completed the exit of our investments in the Master Limited Partnership Exchange Traded Funds ("MLP ETF's") equity security asset class and recognized net investment losses of $35.1 million. The decline in the fair value of the investments in the MLP ETFs during 2020 was in part
due to the market volatility caused by the COVID-19 pandemic. Net investment gain for 2020 included $59.3 million of unrealized gains from equity securities and other invested assets still held at the end of 2020.
•Earned premiums were $1,380.9 million and reflected new business growth and rate increases in our personal and commercial segments. State Auto Connect, our fully digital quote and issue platform that incorporates advanced data analytics and updated pricing models, is now live for all of our products and is driving our new business growth.
•The SAP non-cat loss and ALAE ratio was 49.9%, or $688.6 million.
◦The current accident year non-cat loss and ALAE ratio was impacted by (i) the COVID-19 pandemic discussed above, (ii) non-cat weather losses, primarily wind and hail, and (iii) an elevated level of large commercial losses, including fires.
•Earned premiums were $1,250.2 million and reflected new business growth in the personal insurance segment and the exit of the specialty business.
•The SAP non-cat loss and ALAE ratio was 53.7%, or $669.7 million. Non-catastrophe losses and ALAE included 5.8 points of favorable development relating to prior years, or $72.4 million, primarily from the commercial insurance segment which contributed $58.8 million. The 2019 current accident year non-cat loss and ALAE was primarily impacted by non-cat weather losses and large losses, including fires.
The following table sets forth certain key performance indicators for our insurance segments for the years ended December 31, 2020 and 2019:
The following tables set forth certain key performance indicators by major product line of business for our personal insurance segment for the years ended December 31, 2020 and 2019:
The personal insurance segment's net written premiums for the year ended December 31, 2020 increased 9.4% compared to 2019 (Tables 1 - 2), primarily driven by new business growth and increased rates in homeowners and other personal. The new business growth resulted in higher levels of policies in force for homeowners for the year ended December 31, 2020 compared to the same 2019 period. Partially offsetting the 2020 net written premium growth was a decrease in personal auto net written premiums, which was driven by a decline in new business primarily attributable to cumulative rate and underwriting actions taken during the fourth quarter of 2019 and throughout 2020 to address personal auto profitability.
The following tables set forth certain key performance indicators by major product line of business for our commercial insurance segment for the years ended December 31, 2020 and 2019:
The commercial auto SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 2.9 points when compared to 2019 (Tables 3 - 4), driven by improvement in the current accident year. The 2020 current accident year was impacted by lower claims frequency, attributable to (i) fewer miles driven due to people working remotely and staying at home more because of COVID-19 concerns, and (ii) reduced business activity due to the impact of COVID-19 concerns. Partially offsetting the 2020 improvement was less favorable development of prior accident year losses when compared to 2019. The 2019 prior accident year favorable development was primarily attributable to lower than anticipated severity from the 2017 accident year.
The small commercial package SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 7.0 points compared to 2019 (Tables 3 - 4), primarily due to greater favorable development of prior accident year losses, driven by lower than expected bodily injury severity from multiple accident years when compared to 2019. The 2020 current accident year ratio was impacted by (i) a decline in claim frequency as a result of reduced business activity caused by COVID-19, and (ii) increased severity of property losses, primarily related to fire. The 2020 current accident year was also impacted by increased legal defense costs from claims related to COVID-19, which added 2.0 points to the non-cat loss ratio. 2019 favorable development of prior accident year losses was attributable to lower than expected bodily injury severity from multiple accident years.
The middle market commercial SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 7.3 points when compared to 2019 (Tables 3 - 4), primarily due to improvement in the current accident year, driven by a decline in claim frequency as a result of reduced business activity caused by the impact of COVID-19, partially offset by increased legal defense costs from claims related to COVID-19, which added 0.6 points to the non-cat loss and ALAE ratio. Greater favorable development of prior accident year losses, driven by lower than expected bodily injury severity from multiple accident years, also contributed to the improvement when compared to 2019. The 2019 non-cat loss and ALAE ratio was impacted by favorable development of prior accident year losses due to lower than expected bodily injury claim severity from multiple accident years. Also impacting 2019 were large fire losses in the 2019 current accident year, including a single large loss that added 2.0 points to the loss ratio.
The farm & ranch SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 0.6 points when compared to 2019. The improvement in the 2020 non-cat loss ratio was primarily due to lower claim frequency in the current accident year.
Losses and loss expenses for a calendar year represent the combined estimated ultimate liability for claims occurring in the current calendar year along with any change in the estimated ultimate liability for claims occurring in prior years. The following table sets forth the provision for losses and loss expenses for those claims occurring in the current and prior years, along with the GAAP loss and LAE ratio for the years ended December 31, 2020 and 2019:
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the more notable items contributing to 2020 development were as follows:
•The personal insurance segment non-catastrophe loss and ALAE reserves contributed $21.7 million of adverse development, primarily from accident year 2019. Personal auto contributed $20.3 million of adverse development primarily driven by higher than expected severity for bodily injury claims from multiple accident years.
•Catastrophe reserves in specialty run-off contributed $12.6 million of adverse development primarily from Hurricane Irma.
•ULAE was $2.5 million higher than anticipated in the reserves at December 31, 2019.
•The personal insurance segment non-catastrophe loss and ALAE reserves contributed $12.5 million of the favorable development, driven by personal auto which contributed $10.7 million of favorable development, primarily due to lower than anticipated bodily injury severity.
The following table sets forth loss and loss expenses payable by major line of business at 2020 and 2019:
Our GAAP acquisition and operating expenses were $481.4 million in 2020 compared to $440.7 million in 2019. The increase in acquisition and operating expenses was driven by (i) amortization of deferred acquisition costs due to growth, (ii) IT expenses, including electronic data processing equipment and software cost amortization and IT consulting, and (iii) variable agent compensation. The shift to State Auto Connect and our digital journey over the last five years continue to drive the increases in IT expenses. Partially offsetting this increase in acquisition and operating expenses was a decrease in estimated variable associate compensation when compared to 2019.
At December 31, 2020, our investments in fixed maturities, equity securities and certain other invested assets were carried at fair value. The unrealized holding gains or losses of our available-for-sale fixed maturities, net of applicable deferred taxes, are included as a separate component of stockholders’ equity as accumulated other comprehensive income and as such are not included in the determination of net income. Changes in the fair value of equity securities and other invested assets are reported in "net investment gain (loss)" in the condensed consolidated statements of income.
The following table sets forth the credit ratings of our municipal securities based on ratings by nationally recognized rating agencies at December 31, 2020:
We believe our Muni Portfolio is well diversified by issuer and state. We have 22.3% invested in securities which have been either pre-refunded or escrowed to maturity bonds. No single issuer comprises more than 8.0% of our Muni Portfolio. For the bonds that are not in the pre-refunded category, no more than 15% is concentrated in any one state. We believe our Muni Portfolio is invested within the strongest sectors of the municipal bond market. Revenue bonds represent 69.9% of our Muni Portfolio and state and local government general obligation bonds make up 24.0% of our Muni Portfolio. Our credit research is an important part of our investment management process, and we continually monitor all holdings for any signs of deterioration. We believe that our municipal holdings will maintain their high credit quality and that the issuers will be able to make all principal and interest payments as they come due.
At December 31, 2020, our large-cap equity portfolio had a weighted beta of 1.02 using the S&P 500 Index as the benchmark. At December 31, 2020, our mutual and exchange traded funds portfolio had a weighted beta of 1.00 using the S&P 500 Index and the CRSP US Small Cap Index as benchmarks. Beta estimates the degree the portfolio’s price will fluctuate based on a given movement in the market index. The following tables set forth what changes might occur in the value of the large-cap equity portfolio and the mutual fund and ETF portfolio given a change in the respective index at December 31, 2020:
When a fixed maturity has been determined to have an impairment, the impairment charge representing the credit loss is recognized in earnings as a realized loss and on the balance sheet as an allowance for credit losses netted with the amortized cost of fixed maturities. Future increases in fair value, if related to credit factors, are recognized through earnings limited to the amount previously recognized as an allowance for credit losses. The amount related to non-credit factors is recognized in accumulated other comprehensive income and future increases or decreases in fair value, if not credit losses, are included in accumulated other comprehensive (loss) income. We reviewed our available-for-sale fixed maturities at December 31, 2020 and determined that no credit impairment existed in the gross unrealized holding losses. See Note 3, “Investments” to our consolidated financial statements included in Item 8 of this Form 10-K for additional information.
Based upon our review of our investment portfolio at December 31, 2020, we determined that there were no individual investments with an unrealized holding loss that had a fair value significantly below cost continually for more than one year. The following table sets forth detailed information on our available-for-sale investment portfolio by lot at fair value for our gross unrealized holding gains (losses) at December 31, 2020:
We have foreign tax credit carryforwards of $0.3 million which will expire in 2021. We believe it is more likely than not that the benefit from these foreign tax credit carryforwards will not be realized. In recognition of this risk, we have provided a valuation allowance of $0.3 million on the deferred tax assets related to these foreign tax credit carryforwards.
Under the terms of the Pooling Arrangement, each period State Auto Mutual collects all premiums from policyholders and pays all losses and expenses associated with the insurance business produced by the STFC Pooled Companies and the other pool participants, and then it settles the intercompany balances generated by these transactions with the pool participants within 60 days following each quarter end. We believe this provides State Auto Mutual with sufficient liquidity to pay losses and expenses of our insurance operations on a timely basis.
On September 2, 2020, State Auto P&C retired its five-year term loan with the FHLB in the amount of $21.5 million and maturing on September 2, 2021 and replaced it with a new ten-year term loan with the FHLB in the amount of $21.5 million (the “2020 FHLB Loan”). The 2020 FHLB Loan is at a fixed rate of interest of 1.37%, provides for interest-only payments during its term, with principal due in full at maturity, and may be prepaid without penalty after five years and each of the
succeeding six months thereafter. The 2020 FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C.
State Auto P&C also has an outstanding term loan with the FHLB in the principal amount of $85.0 million (the "2018 FHLB Loan"). The 2018 FHLB Loan matures in May 2033 and provides for interest-only payments during its term, with principal due in full at maturity. The interest rate is fixed over the term of the loan at 3.96%. Prepayment of the 2018 FHLB Loan would require a prepayment fee. The 2018 FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C.
The State Auto Group has an adverse development reinsurance agreement implemented at the end of 2014, providing $40.0 million of coverage for adverse claims development in excess of carried reserves as of November 30, 2014 for the terminated restaurant program business previously underwritten by a MGU-subsidiary of State Auto Mutual.
Members of the State Auto Group maintain a property catastrophe excess of loss reinsurance agreement, covering property catastrophe related events affecting at least two risks. This property catastrophe reinsurance agreement renewed as of July 1, 2020. Under this reinsurance agreement, we retain the first $90.0 million of catastrophe loss, each occurrence, with a 5.0% co-participation on the next $180.0 million of covered loss, each occurrence which is broken down into two layers of $70.0 million and $110.0 million. The reinsurers are responsible for 95.0% of the catastrophe losses excess of $90.0 million up to $270.0 million, each occurrence. The State Auto Group is responsible for catastrophe losses above $270.0 million. There is also an automatic reinstatement of the limit, for 100% of the deposit premium.
Also, certain unusual claim situations involving extra contractual obligations, excess of policy limits, LAE coverage and multiple policy or coverage loss occurrences arising from bodily injury liability, property damage, uninsured motorist and personal injury protection are covered by a Clash reinsurance agreement that provides for $20.0 million of coverage in excess of $10.0 million retention for each loss occurrence. This Clash reinsurance coverage sits above the $7.0 million excess of $3.0 million arrangement.
The NAIC utilizes a collection of analytical tools designed to assist state insurance departments with an integrated approach to screening and analyzing the financial condition of insurance companies operating in their respective states. One such set of analytical tools is 12 key financial ratios that are known in the insurance industry as the “IRIS” ratios. A “defined range” of results for each ratio has been established by the NAIC for solvency monitoring. While management utilizes each of these IRIS ratios in monitoring our insurance companies’ operating performance on a statutory accounting basis (each of our insurance subsidiaries operates within the defined range for the other measures), the net premiums written to surplus or leverage ratio is monitored to ensure that each of our insurance subsidiaries continue to operate within the “defined range” of 3.0 to 1.0. The higher the leverage ratio, the more risk a company bears in relation to statutory surplus available to absorb losses. In considering this range, management also considers the distribution of net premiums between property and liability lines of business. A company with a larger portion of net premiums from liability lines should generally maintain a lower leverage ratio.
Our insurance subsidiaries are subject to risk-based capital (“RBC”) requirements that have been adopted by individual states. These requirements subject insurers having statutory capital less than that required by the RBC calculation to varying degrees of regulatory action, depending on the level of capital inadequacy. The RBC formulas specify various weighting factors to be applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of total adjusted capital to authorized control level RBC. Generally, no remedial action is required by an insurance company if its adjusted statutory surplus exceeds 200% of the authorized level RBC. At December 31, 2020, the ratio of total adjusted statutory capital to authorized control level of State Auto Financial’s insurance subsidiaries ranged from 489% to 19,110%.
Loss reserves are management’s best estimates (“MBE”) at a given point in time of what we expect to pay to settle all claims incurred as of that date based on known facts, circumstances and historical trends. Loss reserves at the individual claim level are established on either a case reserve basis or formula reserve basis depending on the type and circumstances of the loss. The case reserve amounts are determined by claims adjusters based on our reserving practices, which take into account the type of risk, the circumstances surrounding each claim and applicable policy provisions. The formula reserves are based on historical data for similar claims with provision for changes caused by inflation. Case reserves and formula reserves are reviewed on a regular basis, and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis and not settled after six months are case reserved at that time. The process for calculating the IBNR component of the loss reserve is to develop an estimate of the ultimate losses and allocated loss adjustment expenses incurred, and subtract all amounts already paid or held as case or formula reserves. Note that reference to losses below includes allocated loss adjustment expenses.
For catastrophe losses, within the first month following an event, there is typically insufficient data available to rely on an actuarial analysis using paid loss and case reserve amounts. In those situations management relies on estimates provided by our claims personnel in determining the ultimate losses. When providing such estimates, claims personnel consider a number of factors specific to a given event, including the type of catastrophe event, the severity of the event, the policies in-force that may be affected by the event, the contract provisions of those policies and their knowledge of prior catastrophes. After the first month following an event, there is more data available on which to base an actuarial projection of unreported loss amounts. This projection is based on an estimate of the number of claims yet to be reported and the average amount of each such claim. The actuarial projections and the claims estimates are considered by management when determining the ultimate losses for an event.
Short-Tail Business: For short-tail business, claims are typically settled within five years, and the most common actuarial estimates are based on methods using link ratio projections of incurred losses (paid plus outstanding amounts) and paid losses, and methods projecting claim counts and claim severities. These methods are described below.
Incurred Loss Development Method: The Incurred Loss Development Method is probably the most common actuarial method used in projecting ultimate losses. This method uses incurred losses for claims that have been reported. A pattern of incurred losses is estimated to project ultimate losses for each accident year. An important assumption underlying the Incurred Loss Development Method is that case reserve adequacy remains consistent over time. This method’s primary advantage is its responsiveness to changes in incurred losses, which is particularly valuable for more recent accident years. A disadvantage of the Incurred Loss Development Method is that changes in case reserve adequacy can distort the projections.
Long-Tail Business: : For long-tail business, a significant portion of claims may not be settled within five years. Reserve estimates for long-tail business use the same methods listed above along with several other methods. Premium-based methods may be used in developing ultimate loss estimates, including the Expected Loss Ratio and Bornhuetter-Ferguson methods described below. While these methods are more commonly relied upon for long-tail business, they may be relied upon for short-tail business as well.
Selection Process: In determining which reserving methods to rely on for a particular line of business or accident year, diagnostic tests of loss ratios and severity trends are considered, as well as the historical case reserve adequacy and claim settlement rate. Various reserving methods are considered, along with supplemental information such as open claim counts, open claim severity and prior period development, and the final selection may be a weighted average of multiple methods. For
When management establishes ultimate losses within the actuarial range of reasonable estimates of ultimate losses, the resulting MBE loss reserves fall within the actuarial range of reasonable reserves. Management considers the expected variability of loss reserves described above when establishing an appropriate reserve within the actuarial range. At December 31, 2020, loss and loss expenses payable were $1,026.1 million, within an estimated range of $919.3 million to $1,063.7 million.
An important assumption underlying certain loss reserve methods is that the loss cost trends underlying historical data will continue into the future. To estimate the sensitivity of reserves to an unexpected change in inflation, projected calendar year payment patterns were applied to the December 31, 2020, workers’ compensation loss and ALAE reserve balance to generate estimated annual incremental loss and ALAE payments for each subsequent calendar year. Then, for purposes of sensitivity testing, an additional annual loss cost trend of 5% was added to the trend implicitly embedded in the estimated payment pattern, and revised incremental loss and ALAE payments were calculated. This type of inflationary increase could arise from a variety of sources including tort law changes, development of new medical procedures and social inflation. The estimated cumulative impact that this additional, unexpected 5% increase in the loss cost trend would have on our results of operations over the lifetime of the underlying claims in workers’ compensation is an increase of $86.4 million on reserves, or a $68.3 million reduction to net income, assuming a tax rate of 21%. Inflation changes have much more impact on the longer tail commercial lines like workers’ compensation, and much less impact on the shorter tail personal lines.
The following table sets forth a reconciliation of MBE of our direct loss and LAE reserve to our net losses and loss expenses payable at December 31, 2020 and 2019. The STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement for the years ended December 31, 2020 and 2019, respectively, has been reflected in the table below as assumed by STFC Pooled Companies.
The following tables set forth the net losses and loss expenses payable by major line of business at December 31, 2020 and 2019:
See discussion in “Results of Operations-Loss and LAE Development” section included in this Item 7.
of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect our financial position or results of operations.
As a result of revised mortality assumptions and the change in the discount rate, the benefit plan’s liability increased $27.2 million for the year ended December 31, 2020 and decreased $3.1 million for the year ended December 31, 2019.
The following table sets forth an illustration of variability with respect to the discount rate on the December 31, 2020 benefit obligation and expected net periodic benefit cost for the year ending December 31, 2021, along with the variability of the expected return on plan assets to the expected net periodic benefit cost for the year ending December 31, 2021. Holding all other assumptions constant, sensitivity to changes in any one of our key assumptions are as follows:
We have audited the accompanying consolidated balance sheet of State Auto Financial Corporation and its subsidiaries (the “Company”) as of December 31, 2020, and the related consolidated statements of income, comprehensive income (loss), stockholders' equity and cash flows for the year then ended, including the related notes and schedules of summary of investments - other than investments in related parties as of December 31, 2020, condensed financial information of registrant as of and for the year ended December 31, 2020, and supplementary insurance information and reinsurance for the year ended December 31, 2020 appearing after the signatures page (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Our audit of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
Addressing the matter involved performing procedures and evaluating audit evidence in connection with forming our overall opinion on the consolidated financial statements. These procedures included testing the effectiveness of controls relating to the Company’s valuation of loss reserves, including controls over the various actuarial projection methods and development of significant assumptions. These procedures also included, among others, the involvement of professionals with specialized skill and knowledge to assist in developing an independent estimate of loss reserves for certain lines of business using independently derived assumptions based on historical reporting and settlement patterns and expected loss ratios, and comparing this independent estimate to management’s actuarially determined reserves. Developing the independent estimate also involved testing the completeness and accuracy of data provided by management.
To the Stockholders and Board of Directors of State Auto Financial Corporation
For fixed maturities in an unrealized loss position, management considers the extent to which fair value is less than amortized cost, any changes to the rating of the security by a rating agency, and adverse conditions specifically related to the security, among other factors. If this assessment indicates that a credit loss exists, the present value of cash flows expected to be collected from the security are compared to the amortized cost basis of the security. If the present value of cash flows expected to be collected is less than the amortized cost basis, a credit loss exists and an allowance for credit losses is recorded for the credit loss, limited by the amount that the fair value is less than the amortized cost basis. Any impairment that has not been recorded through an allowance for credit losses is recognized in other comprehensive income.
The Company excludes accrued interest receivable from both the estimated fair value and the amortized cost basis of available-for-sale fixed maturities and includes such amounts within "accrued investment income and other assets" on the Company's condensed consolidated balance sheets. Any uncollectible accrued interest receivable is written off in the period it is deemed uncollectible.
The Company considers all liquid debt instruments with a maturity of three months or less at the time of acquisition to be cash equivalents. The carrying amounts reported approximate their fair value.
The following table sets forth net deferred acquisition costs for the years ended December 31, 2020, 2019 and 2018:
Interest and penalties related to uncertain tax positions are recorded in the balance sheet as other liabilities, and recognized in the income statement as other expenses.
The adoption of this guidance reduced retained earnings by $0.5 million, net of tax, and established an allowance for estimated uncollectible reinsurance as of January 1, 2020. Adoption of ASC 326 for available-for-sale fixed maturities was prospective, and therefore there was no adjustment to retained earnings as of January 1, 2020.
Reference Rate Reform: Facilitation of the Effects of Reference Rate Reform on Financial Reporting
Management identified a number of errors in the Company’s historical financial statements as further described below. In accordance with the guidance set forth in SEC Staff Accounting Bulletin No. 99, Materiality, and SEC Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, management concluded that the errors were not material to the consolidated financial statements as presented in the Company’s quarterly and annual financial statements that had been previously filed in the Company’s Quarterly Reports on Form 10-Q and Annual Reports on Form 10-K. As a result, amendment of such reports is not required. The Company revised the previously issued annual consolidated financial statements for 2019 and 2018 in this Form 10-K to correct these errors as well as other immaterial out of period adjustments previously identified. As periods prior to 2018 were impacted, retained earnings as of January 1, 2018 was decreased by $1.2 million to recognize the cumulative net of tax impact of the correction of the errors as of that date.
The Company corrected a balance sheet classification error at December 31, 2019 to separately present premiums receivable on its consolidated balance sheet. This had no impact on the underwriting results or cash flows of the Company.
The following tables set forth the Company’s gross unrealized losses and fair value on its investments by lot, aggregated by investment category and length of time for individual securities that have been in a continuous unrealized loss position for which an allowance for credit losses was not recorded at December 31, 2020 and 2019:
•U.S. treasury securities and obligations of U.S. government agencies: These securities were issued by the U.S. Treasury Department or Federal government-sponsored entities. The decline in fair values was attributable to changes in interest rates and not credit quality. The Company does not intend to sell these securities and it is likely that it will not do so before their anticipated recovery. Therefore, the Company does not consider these impaired securities.
•U.S. government agencies mortgage-backed securities: Federal government-sponsored entities issued these securities. The decline in fair values was attributable to changes in interest rates and not credit quality. The Company does not intend to sell these securities and it is likely that it will not do so before their anticipated recovery. Therefore, the Company does not consider these impaired securities.
The following table sets forth the amortized cost and fair value of available-for-sale fixed maturities by contractual maturity at December 31, 2020:
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay the obligations with or without call or prepayment penalties.
At December 31, 2020, State Auto P&C had fixed maturity securities, with a carrying value of approximately $106.5 million, that were pledged as collateral for the FHLB Loan (as defined in Note 10). In accordance with the terms of the FHLB Loan, State Auto P&C retains all rights regarding these securities, which are included in the “U.S. government agencies mortgage-backed securities” classification of the Company’s fixed maturity securities portfolio.
At December 31, 2020, State Auto P&C had fixed maturities with fair values of approximately $32.2 million pledged as collateral for the performance obligations under its reinsurance agreement with Home State County Mutual Insurance Company ("Home State") as defined in Note 7. In accordance with the terms of the trust agreement, State Auto P&C retains all rights regarding these securities, which are included in the “U.S. treasury securities and obligations of U.S. government agencies” classification of the Company’s fixed maturity securities portfolio.
Proceeds on sales of investments in 2020, 2019 and 2018 were $351.4 million, $355.5 million, and $197.0 million, respectively.
The following table sets forth the gains (losses) on investments on the Company’s investment portfolio for the years ended December 31, 2020, 2019 and 2018:
The unrealized holding gains (losses) recognized during the reporting period on equity securities still held at December 31, 2020, 2019 and 2018 were $58.5 million, $63.9 million, and $(49.7) million, respectively. The unrealized holding gains (losses) recognized during the reporting period on other invested assets still held at December 31, 2020, 2019 and 2018 were $0.8 million, $9.9 million, and $(7.7) million, respectively.
The Company utilizes a nationally recognized pricing service to estimate the majority of its investment portfolio’s fair value. The Company obtains one price per security. The Company’s processes and control procedures are designed to ensure the price is accurately recorded on an unadjusted basis. Through discussions with the pricing service, the Company obtains an understanding of the methodologies used to price the different types of securities, that the data and the valuation methods utilized are appropriate and consistently applied, and that the assumptions are reasonable and representative of fair value. To validate the reasonableness of the valuations obtained from the pricing service, the Company compares the valuations received to other fair value pricing from other independent pricing sources. At December 31, 2020 and 2019, the Company did not adjust any of the prices received from the pricing service.
The following tables set forth the Company’s investments within the fair value hierarchy at December 31, 2020 and 2019:
Included in other invested assets are common stock of the Federal Home Loan Bank of Cincinnati (the “FHLB”), and the Trust Securities (as defined in Note 9b). The Trust Securities and FHLB common stock are carried at cost, which approximates fair value. The fair value of the FHLB common stock at December 31, 2020 was $11.6 million and the fair value of the Trust Securities were $0.5 million. Both investments have been placed in Level 3 of the fair value hierarchy.
The Company recorded favorable development related to prior years’ loss and loss expense reserves in 2018 of $80.2 million. Favorable development of prior accident years' non-catastrophe loss and ALAE reserves was due to $79.7 million of favorable development in the personal and commercial insurance segments. In the personal insurance segment, personal auto contributed $24.4 million of favorable development primarily driven by lower than anticipated severity emerging from accident years 2016 and 2017, and homeowners contributed favorable development of $7.3 million, spread across several accident years. In the commercial insurance segment, workers' compensation, small commercial package, commercial auto, and middle market commercial contributed $13.3 million, $9.6 million, $8.4 million, and $8.0 million, respectively, of favorable development. Slightly offsetting the favorable development was adverse development in the specialty insurance segment of $3.1 million, primarily driven by E&S casualty and programs with adverse development of $2.7 million and $1.2 million, respectively. The E&S casualty adverse development for prior accident years was due primarily to development within our healthcare and umbrella books of business. The programs adverse development for prior accident years was driven by increased ultimate loss estimates for commercial auto liability and contractors liability coverages. Favorable development of prior years' unallocated loss adjustment expenses was $7.1 million of the 2018 development.
Short-Tail Business: For short-tail business, claims are typically settled within five years, and the most common actuarial estimates are based on methods using link ratio projections of incurred losses (paid plus outstanding amounts) and paid losses, and methods projecting claim counts and claim severities. Separate projections are made for catastrophes based on specific information known through the reporting date.
Long-Tail Business: For long-tail business, a material portion of claims may not be settled within five years. Reserve estimates for long-tail business use the same methods listed above along with several other methods as determined by the actuary. For example, premium-based methods may be used in developing ultimate loss estimates, including the Expected Loss Ratio and Bornhuetter-Ferguson methods.
The change in incurred losses and loss adjustment expenses for prior accident years was due to higher than expected emergence of all personal insurance products. The emergence was primarily attributable to higher severity for bodily injury claims from the 2017, 2018 and 2019 accident years.
The change in incurred losses and loss adjustment expenses for prior accident years was primarily driven by lower than expected emergence for the small commercial package and middle market commercial products. The emergence in these products was driven by lower than expected bodily injury claim severity from multiple accident years.
The change in incurred losses and loss adjustment expenses for prior accident years was primarily related to an adverse court decision relating to an E&S casualty claim from accident year 2016.
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 9a 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; the remainder 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.
The Company is exposed to third-party credit risk both directly through its cessions to reinsurers and indirectly through its participation in the Pooling Arrangement. In addition to exposure to credit risk on reinsurance recoverables, the Company is also exposed to credit risk on amounts due from insureds and agents through the Pooling Arrangement. When settling the intercompany balances, State Auto Mutual provides the STFC Pooled Companies with full credit for the net premiums written and net losses paid during the quarter and retains all receivable amounts from insureds and agents and reinsurance recoverable on paid losses from unaffiliated reinsurers.
At December 31, 2020, the determination of the allowance for credit losses for premiums receivable and reinsurance recoverables included considerations for the potential impacts of the COVID-19 pandemic on the Company's ability to collect balances due from its insureds, agents, and reinsurers.
The following table sets forth the amortized cost of the Company's direct third-party reinsurance recoverables by FSR, net of the allowance for credit losses, at December 31, 2020:
The Pooling Arrangement does not relieve each individual pooled subsidiary of its primary liability as the originating insurer; consequently, there is a concentration of credit risk arising from business ceded to State Auto Mutual. As the Pooling
The following table sets forth the reinsurance transactions on the Company’s balance sheets for the Pooling Arrangement between the STFC Pooled Companies and State Auto Mutual at December 31, 2020 and 2019:
Management utilizes an aging schedule to estimate an allowance for uncollectible amounts relating to the State Auto Group’s premiums receivable balance. Current and historical collection experience along with reasonable and supportable forecasts are used to estimate the percentage of the premiums receivable balance that will be uncollectible. Credit risk is partially mitigated by the State Auto Group's ability to cancel the policy if the policyholder does not pay the premium. Pursuant to the Pooling Arrangement, bad debt expense for uncollectible premiums receivable is allocated to pool members on the basis of pool participation and is included in the quarterly settlement of intercompany balances. This is included in "other expenses" on the condensed consolidated statements of income and reflected in “due to/from affiliates” on the Company's condensed consolidated balance sheets. The Company’s share of the premium balances due to State Auto Mutual from agents and insureds at December 31, 2020 and 2019 is approximately $389.4 million and $371.0 million, respectively, net of the allowance for uncollectible premiums receivable of $7.1 million and $4.3 million, respectively.
In May 2003, State Auto Financial formed a Delaware business trust (the “Capital Trust”) to issue $15.0 million of mandatorily redeemable preferred capital securities to a third party and $0.5 million of common securities to State Auto Financial (the capital and common securities are collectively referred to as the “Trust Securities”). The Capital Trust loaned $15.5 million, the proceeds from the issuance of its Trust Securities, to State Auto Financial in the form of Floating Rate Junior Subordinated Debt Securities due in 2033 (the “Subordinated Debentures”). The Subordinated Debentures and interest accrued thereon are the Capital Trust’s only assets. Interest on the Trust Securities is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20% adjusted quarterly (total 4.43% at December 31, 2020). Because the interest rate and interest payment dates on the Subordinated Debentures are the same as the interest rate and interest payment dates on the Trust Securities, payments from the Subordinated Debentures finance the distributions paid on the Trust Securities. State Auto Financial has the right to redeem the Subordinated Debentures, in whole or in part, on or after May 2008. State Auto Financial has unconditionally and irrevocably guaranteed payment of any required distributions on the capital securities, the redemption price when the capital securities are to be redeemed, and any amounts due if the Capital Trust is liquidated or terminated. State Auto Financial’s equity interest in the Capital Trust is included in other invested assets. In accordance with the Consolidation Topic of the FASB ASC 810, State Auto Financial determined that the business trust is a variable interest entity for which it is not the primary beneficiary and therefore, does not consolidate the Capital Trust with the Company.
On March 19, 2020, State Auto P&C entered into a short-term loan arrangement with the FHLB in the principal amount of $60.0 million. This loan arrangement, known as REPO based advances, was for general corporate purposes and was intended to provide additional liquidity to State Auto P&C. The REPO based advances were repaid in full on September 22, 2020, and this loan arrangement was terminated.
State Auto P&C has an Open Line of Credit Commitment (the "OLC") with the FHLB that provides State Auto P&C with a $100.0 million one-year open line of credit available for general corporate purposes. The OLC matures in April 2021. Draws under the OLC are to be funded at a daily variable rate advance with a term of no more than 180 days with interest payable monthly. All advances under the OLC are to be fully secured by a pledge of specific investment securities of State Auto P&C. As of December 31, 2020, no advances had been made under the OLC.
During 2019, the IRS released Rev. Proc. 2019-31 with final discount factors, which were used in the 2018 tax return filed in 2019. After discounting the January 1, 2018 reserves using these final factors, the impact was $42.7 million on a pretax basis down from the revised estimate of $47.5 million for a tax-effected change of $1.0 million in the impact of the transitional amount.
At December 31, 2020, the Company carried no balance for uncertain tax positions. The Company had no accrual for the payment of interest and penalties at December 31, 2020 or 2019.
State Auto Financial and its subsidiaries file a consolidated U.S. federal income tax return. State Auto Financial and its subsidiaries also file in various state jurisdictions. The Company is no longer subject to U.S. federal or state and local income tax examinations by tax authorities for years before 2017. The Company has no current U.S. federal or state and local income tax examinations on-going at this time.
The following table sets forth information regarding the pension and postretirement benefit plans’ change in benefit obligation, plan assets and funded status at December 31, 2020 and 2019:
The 2020 pension plan actuarial loss was primarily due to (i) a 78-basis-point reduction in the discount rate assumption at December 31, 2020, and (ii) revisions to mortality rate assumptions.
Effective January 1, 2020, the Company changed the funding of its postretirement benefit plan from self-insured to a fully-insured group Medicare advantage program. The group Medicare advantage program is less than half the cost of the self-insured plan. As a result of this funding change, the postretirement benefit plan's liability decreased, and accumulated other comprehensive income (loss) increased by $13.9 million, respectively, for the year ended December 31, 2019.
The following table sets forth information regarding the Company’s share of pension and postretirement benefit plans’ components of net periodic cost for the years ended December 31, 2020, 2019 and 2018:
The following table sets forth the benefit payments, which reflect expected future service, expected to be paid:
The postretirement plan’s gross benefit payments for 2020 were $0.6 million, including the prescription drug benefits. The postretirement plan’s subsidy related to Medicare Prescription Drug Improvement and Modernization Act of 2003 estimates future annual subsidies to be approximately $0.3 million.
Effective January 1, 2014, the Investment Committee approved a change to a liability driven investment (LDI) for the pension plan assets. The primary goal of the LDI strategy is to shift the asset allocation to more closely align with the plan liability, thereby reducing the volatility of the funded status. The implementation of the LDI strategy occurred over time and the actual asset allocation at any point in time is dependent upon the funded status and the level of interest rates. This glide path helps to balance interest rate risk, curve steepness risk, and credit spread risk, as incremental changes are made to the allocation over time. This allocation strategy reduces exposure to equity holdings and increases exposure to long duration fixed maturity holdings. This change resulted in lower volatility for the plan assets. By moving more of the plan’s assets to long duration fixed income, the duration of the assets increased to more closely match the duration of the plan’s liabilities.
See Note 4 for the valuation methods used by the Company for each type of financial instrument the plans hold that are carried at fair value. There were no transfers between level categorizations during the years ended December 31, 2020 and 2019.
The following tables set forth the plan’s investments within the fair value hierarchy at December 31, 2020 and 2019:
The Company maintains a defined contribution plan that covers substantially all employees of the Company. The Company matches the first 1% of contributions of participants’ salary at the rate of one dollar for each dollar contributed. Participant contributions of 2% to 6% are matched at a rate of 50 cents for each dollar contributed. In addition, the Company contributes a percentage of the employee’s annual income for those employees hired on or after January 1, 2010, and for those employees hired prior to January 1, 2010 who chose to freeze their existing accrued pension benefit effective June 30, 2010. The Company’s share of the expense under the plan totaled $7.3 million, $6.4 million and $5.6 million for 2020, 2019 and 2018, respectively.
The following tables set forth the changes in the Company’s accumulated other comprehensive income (loss) component ("AOCI(L)"), net of tax, for the years ended December 31, 2020, 2019 and 2018:
The following tables set forth the reclassifications out of accumulated other comprehensive income (loss), by component, to the Company’s consolidated statement of income for the years ended December 31, 2020, 2019 and 2018:
State Auto P&C, Milbank and SA Ohio are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Under the insurance regulations of Iowa and Ohio (the states of domicile), the maximum amount of dividends that the Company may pay out of earned surplus to shareholders within a twelve month period without prior approval of the Department is limited to the greater of 10% of the most recent year-end policyholders’ surplus or net income for the twelve month period ending the 31st day of December of the previous year-end. Pursuant to these rules, approximately $91.0 million is available for payment to State Auto Financial from its insurance subsidiaries in 2021 without prior approval. State Auto Financial received dividends from its insurance subsidiaries in the amount of $15.0 million, $10.0 million and $10.0 million in 2020, 2019 and 2018, respectively.
The Company's statutory capital and surplus was $910.3 million and $913.3 million at December 31, 2020 and 2019, respectively. The Company's net (loss) income, as determined using SAP, was $(39.1) million, $31.1 million, and $65.1 million for the years ended December 31, 2020, 2019, and 2018, respectively.
The Company’s share-based compensation plans authorize the granting of various equity-based incentives including performance-based stock awards, performance-based unit awards, restricted stock, and other stock based awards to employees and non-employee directors. The expense for these equity-based incentives is based on their fair value at the date of grant and amortized over their vesting period.
As of December 31, 2020, 0.8 million common shares had been issued and 1.6 million common shares were available for issuance under the 2017 LTIP. The 2017 LTIP provides that (i) the maximum value of performance stock awards or performance unit awards settled in cash that may be granted in any calendar year is equal to the excess of the number of awards multiplied by the fair market value of the company’s common shares on the applicable payment or settlement date of the award multiplied by 5 and (ii) the maximum number of common shares subject to awards of performance stock and performance units that may be granted in any calendar year to any one individual is 250,000 shares. The 2017 LTIP remains in effect until terminated by the Board of Directors.
Service-based restricted stock awards granted to employees are subject to a vesting schedule based on the employee’s continued employment (“Restriction Period”), for which vesting is generally on the third anniversary after the date of grant. The
Awards with both service and performance conditions granted to employees are subject to (i) the Restriction Period, and (ii) the achievement of predetermined performance goals within specified time periods. All performance-based awards include a specified number of units that will vest. The number of performance-based awards that are ultimately earned for each grant is dependent upon meeting specified target and performance goals that range from 0% to 500% of the target number of performance units awarded based on the extent to which the Company achieves the performance goals for the performance measures as set forth in a performance matrix established by the Compensation Committee.
The following table sets forth the Company’s total activity and related information for performance unit award activity for the years ended December 31, 2020, 2019 and 2018:
Intrinsic value for stock options is defined as the difference between the current market value and the grant price. For the years ended December 31, 2020, 2019 and 2018, the total intrinsic value of stock options exercised was $1.0 million, $4.5 million and $7.2 million, respectively.
The following table sets forth stock awards and restricted share units ("RSU award") of the Company that were not included in the computation of diluted earnings per common share because the exercise price of the awards was greater than the average market price or their inclusion would have been antidilutive for the year ended December 31, 2018:
•Commercial Insurance Segment - commercial auto, small commercial package, middle market commercial, workers’ compensation, farm & ranch, and other commercial
The following table sets forth financial information regarding the Company’s reportable segments at December 31, 2020 and 2019: