that contain approximately 280,000 square feet of office space. Our Company and State Auto Mutual also own and lease other office facilities in numerous locations throughout the State Auto Group’s geographical areas of operation.
We use the statutory net premiums written to surplus ratio as there is no comparable GAAP measure. This ratio, also called the leverage ratio, measures our statutory surplus available to absorb losses.
State Auto P&C, Milbank, Farmers and SA Ohio (“STFC Pooled Companies”) participate in a quota share reinsurance pooling arrangement (the “Pooling Arrangement”) with State Auto Mutual, SA Florida, SA Wisconsin, Meridian Security, Meridian Citizens Mutual, Beacon National, Patrons Mutual and Litchfield, which together with STFC Pooled Companies are referred to as the “Pooled Companies.” The Pooled Companies provide a broad line of property and casualty insurance, such as standard personal and commercial automobile, homeowners and farmowners, commercial multi-peril, workers’ compensation, general liability and property insurance. SA National, which is not included in the Pooling Arrangement, provides nonstandard personal automobile insurance. Our Pooled Companies and SA National are rated A+ (Superior) by the A.M. Best Company.
As of January 1, 2008, the Pooling Arrangement was changed (the “Pooling Change”) to add Beacon National, Patrons Mutual and Litchfield as participants and the middle market business written by companies in the State Auto Group to the Pooling Arrangement (collectively referred to as the “New Pool Business”). Concurrently with the addition of Patrons Mutual, Litchfield and Beacon National, the participating percentages of certain participants were adjusted as presented in the table below; however the STFC Pooled Companies continue to maintain an overall share of the pool at 80% and State Auto Mutual and its subsidiaries and affiliates continue to maintain 20%. In conjunction with this modification, the STFC Pooled Companies received approximately $92.0 million in cash from State Auto Mutual and its subsidiaries and affiliates for net liabilities assumed on this date.
The following table sets forth a chronology of the participants and participation percentages for the Pooling Arrangement:
Reflecting the manner in which we manage our business and report our results internally to our principal operating decision makers, our significant reportable segments are personal insurance, business insurance (collectively the “insurance segments” or “our insurance segments”) and investment operations. The insurance segments distribute their products through the independent agency system across 33 states. Each is managed separately based on the type of customers served, products provided or services offered. The personal insurance segment provides primarily personal auto (standard and nonstandard) and homeowners to the personal insurance market. The business insurance segment provides primarily commercial auto, commercial multi-peril, fire and allied lines, other and product liability and workers’ compensation insurance to small to medium sized businesses within the commercial insurance market. The investment operations segment, managed by Stateco, provides investment services for our Company’s invested assets.
Investment Strategy: We have a disciplined approach to our investment strategy that emphasizes the quality of our fixed maturity portfolio, which comprised 91.3% of our total portfolio at fair value at December 31, 2008, and includes primarily investment grade securities. The majority of our fixed maturity portfolio is invested in municipal bonds to recognize the tax advantages available from municipal bond income. In addition, we believe that our credit risk exposure is reduced by investing in high quality municipal bonds that are diversified by issuer and state. Our internally managed equity portfolio, which comprised 6.7% of our total portfolio at fair value at December 31, 2008, emphasizes large-cap, dividend-paying companies selected based upon their potential for appreciation as well as ability to continue paying dividends. During 2007, we began to diversify our equity portfolio and utilize outside managers to invest in U.S. small-cap equities and international funds. Diversifying our portfolio into small-cap equities and international funds was designed to achieve a greater total return with reduced volatility. In 2008 almost all of the asset classes experienced a decline in fair value, and our portfolio was not immune to this broad-based decline. We believe that in most market cycles diversification of our portfolio will be beneficial to us and we plan to continue to maintain a diversified portfolio.
Loss Reserves: We maintain reserves for the eventual payment of losses and loss expenses for both reported claims and incurred claims that have not yet been reported. Loss reserves are management’s best estimate at a given point in time of what we expect to pay to settle all claims incurred as of the end of the accounting period, based on facts, circumstances and historical trends then known. Although
Innovate SA: In the last two quarters of 2008, we launched a formal company-wide plan called Innovate SA, which is intended to reduce expenses, enhance revenues and improve margins. Innovate SA is comprised of various initiatives, including changes to our field structure, business processes and product changes. Innovate SA began with an idea generation phase that involved our 2000+ associates and was followed by an evaluation phase that was led by senior managers in our business units. The idea generation and evaluation phases were completed for the most part in the fourth quarter of 2008, and 480 separate actions have been approved for implementation. Our expectation is that implementation will take place over the next three fiscal years.
Our significant accounting policies are more fully described in Note 1 of the Notes to our Consolidated Financial Statements included in Item 8 of this Form 10-K. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the period then ended and the financial entries in the accompanying notes to the financial statements. Such estimates and assumptions could change in the future, as more information becomes known which could impact the amounts reported and disclosed in this Item 7. We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations.
the near term. When a security in our investment portfolio has been determined to have a decline in fair value that is other-than-temporary we adjust the cost basis of the security to fair value. This results in a charge to earnings as a realized loss, which is not reversed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other-than-temporary, are included in other comprehensive income or loss.
On January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which was issued by the Financial Accounting Standards Board (“FASB”) in September 2006. For financial statement elements currently required to be measured at fair value, SFAS 157 defines fair value, establishes a framework for measuring fair value under GAAP and enhances disclosures about fair value measurements. The new definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (“exit price”) regardless of whether an observable liquid market price exists. An exit price valuation includes margins for risk even if the margins are not observable.
Level 2 includes observable inputs for assets or liabilities other than quoted prices included in Level 1 and it includes valuation techniques which use prices for similar assets and liabilities.
losses incurred, and subtract all amounts already paid or held as formula or case reserves. Although we use many internal and external resources, as well as multiple established methodologies to calculate IBNR, there is no method for determining the exact ultimate liability. For a further discussion regarding our losses and loss expense reserves and our reserving methods see “Other-Loss and Loss Expense Reserves” included in this Item 7.
The following table summarizes certain key performance indicators used to manage our operations for the years ended December 31, 2008, 2007 and 2006, respectively:
The “SAP Loss and LAE Ratio” is losses and loss expenses as a percentage of net earned premiums. The “SAP Expense Ratio” is statutory underwriting expenses and miscellaneous expenses offset by miscellaneous income (“underwriting expenses”) as a percentage of net written premiums. The “SAP Combined Ratio” is the sum of the SAP Loss and LAE Ratio and the SAP Expense Ratio.
We use the statutory net premiums written to surplus ratio because there is no comparable GAAP measure. This ratio, also called the leverage ratio, measures our statutory surplus available to absorb losses.
During 2008, we recognized $39.3 million of OTTI on our investment portfolio compared to $1.9 million in 2007. See the “Investment Operations Segment” section included in this Item 7.
We measure our top-line growth for our insurance segments based on net written premiums, which represent the premiums on the policies we have issued for a period, net of reinsurance. Net written premiums provide us with an indication of how well we are doing in terms of revenue growth before it is actually earned. Our policies provide a fixed amount of coverage for a stated period of time, often referred to as “the policy term.” As such, our written premiums are recognized as earned ratably over the policy term. The unearned portion of written premiums, called unearned premiums, is reflected on our balance sheet as a liability and represents our obligation to provide coverage for the unexpired terms of the policies.
Our third party excess of loss catastrophe reinsurance program, which renewed July 1, 2008 (coverage period July 1, 2008 through June 30, 2009), incorporates a reinstatement provision should a loss occurrence exceed our retention. Under this provision, our original reinsurance coverage limits are automatically restored in consideration of an additional reinstatement premium (“Reinstatement Premium”). The estimated direct ultimate loss resulting from Hurricane Ike exceeded our retention, thereby causing two premium transactions to occur: 1) an acceleration of the recognition of the original annual premium to the date of loss occurrence in proportion to the reinsurance coverage exhausted and 2) the recognition of the Reinstatement Premium from the date of the loss occurrence to the end of the coverage period (June 30, 2009). Additionally, during the 2008 fourth quarter we entered into a separate property catastrophe excess of loss reinsurance agreement (“Third Event Agreement”), which provides additional coverage in excess of our retention through our remaining coverage period
(June 30, 2009). The incremental impact of the acceleration of the original annual premium plus the recognition Reinstatement Premium plus the premium paid in connection with the Third Event Agreement resulted in $3.5 million less net written and earned premiums within our property lines when compared to the same 2007 period. The incremental impact has the most significant effect on our property lines. See detailed discussion of our reinsurance programs in the “Liquidity and Capital Resources-Reinsurance Arrangements” section included in this Item 7.
The following table provides a summary of written and earned premium, net of reinsurance, by major product line of business for our personal insurance segment for the years ended December 31, 2008 and 2007. The one-time impact of the Pooling Change has been excluded from 2008 to present net written premiums on a comparative basis (see Net Written Premium Reconciliation Table above):
Standard personal auto net written premiums increased 10.3% from 2007. The New Pool Business contributed 3.9% for 2008, while Organic Growth increased 6.4% from 2007. The primary product contributing to our increase in Organic Growth in standard personal auto is our CustomFitSM product which uses a multivariate rating approach that broadens the underwriting and eligibility guidelines for new and existing customers. Since introducing the first generation of the CustomFit product in 2005, we now offer this product in most of our operating states and have seen significant improvement in our net written premiums production trends for new business in these states. In late 2007, we began introducing the second generation of CustomFit and during 2008 we continued migrating CustomFit states to the second generation product which increases the number of pricing points significantly.
We believe independent agents value ease of doing business and make it an important factor in their choice of insurance companies when quoting personal auto products to their customers. To assist in this area, in early 2007, we began implementing comparative rating tools which allow agents to receive rate quotes from multiple insurance companies by entering the rating information only one time. To date, we have implemented 65 different integration points to our personal lines rating engine thus eliminating duplicate entry for agents. We believe agents will quote and write more personal standard and nonstandard auto and homeowners insurance with us as a result of a more efficient quoting process combined with more competitive rates resulting from the ongoing introduction of CustomFit for standard auto and refined pricing for nonstandard auto.
Homeowners net written premium increased 17.1% from 2007. The New Pool Business contributed 12.4% while Organic Growth increased 4.7% from 2007. We have undertaken new homeowners pricing and product initiatives, such as various new home discounts that complement our CustomFit automobile rollout, in order to improve our premium growth. During 2008, we experienced premium growth in most of our states.
We focus our business insurance sales on small to medium sized exposures and offer a broad range of both property and liability coverages such as commercial auto, commercial multi-peril, fire and allied lines, products liability and workers’ compensation. The following table provides a summary of written and earned premium, net of reinsurance, by major product line of business for our business insurance segment for the years ended December 31, 2008 and 2007. The one-time impact of the Pooling Change has been excluded from 2008 to present net written premiums on a comparative basis (see Net Written Premium Reconciliation Table above):
We also continue to improve our back office systems, such as enhancements to our insurance policy administration system, to make it easier for agents to quote and submit business insurance policies to us. Our system now allows transactions to be processed throughout the day using real-time and straight through
We are working to expand the scope of this technology for new products and additional lines of business including workers’ compensation. We believe this technology investment should better position us for revenue growth opportunities in the future and start to drive efficiencies into our business model much like we have seen in personal insurance. The majority of all transactions in business insurance utilize the straight through processing technology. This has resulted in faster delivery of policies to our agents and their insureds for new business and endorsements.
See discussion regarding the 2007 calendar year development at “2007 Compared to 2006-Losses and Expenses” section included in this Item 7. See additional discussion regarding loss and loss expense reserves at the “Other-Loss and Loss Expense Reserves” section included in this Item 7.
Catastrophe losses for 2008 totaled $156.1 million (13.9 loss ratio points) compared to $37.1 million (3.7 loss ratio points) for 2007. The discussion of catastrophe losses includes those which have been designated as such by ISO’s Property Claim Services (“PCS”) unit, a nationally recognized industry service. PCS defines catastrophes as events resulting in $25.0 million or more in insured losses industry wide and affecting significant numbers of insureds and insurers. During 2008, we were impacted by losses from 35 of the 37 storms that were classified as numbered catastrophes by PCS as compared to 18 of the 26 PCS 2007 classified storms. The losses from these catastrophes have had a significant impact on both our personal and business insurance property lines.
The personal insurance segment non-cat loss ratio was 4.6 points higher in 2008 than in 2007. Standard and non-standard auto’s SAP Loss and LAE Ratio increases were attributed primarily to an increase in the severity of bodily injury claims and uninsured motorists’ claims as well as to an increase in claim frequency for these lines of business. In addition, in 2008, competitive market conditions limited our ability to obtain price increases in standard auto. As mentioned above, rate actions taken in our non-standard line of business in early 2008 will not be fully realized until 2009. The non-cat ratio for homeowners remained relatively flat when compared to 2007.
The business insurance segment’s non-cat loss ratio for 2008 was 9.9 points higher than in 2007. The intense competition in the business insurance segment continues to impact our ability to implement price increases, and contributed significantly to the increase in our non-cat loss ratio. For commercial auto, rate decreases were the primary drivers of the increase in our non-cat loss ratio. For other & products liability, the increase in loss ratio was driven by development of losses from prior accident years and, to a lesser extent, rate decreases. For fire & allied lines and workers’ compensation, the increase in loss ratio was primarily due to an increase in the severity of current year claims.
Loss and loss expenses payable by major line of business as of December 31, 2008 and 2007 and at January 1, 2008 as a result of the Pooling Change, are shown in the following table:
Calculated based on December 31, 2008 change from January 1, 2008.
As shown in the table above, there was a $71.6 million increase in total loss and loss expense reserves during 2008. The increase relates primarily to higher levels of reserves for catastrophe losses largely related to Hurricane Ike and an increase in reserves corresponding to our Organic Growth. We conduct periodic reviews of loss development reports and make judgments in determining the reserves for ultimate losses and loss expenses payable. Several factors are considered by us when estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, accounting projections, exposure changes, anticipated inflation, current business conditions, catastrophe developments, late reported claims, and other reasonableness tests.
Our GAAP expense ratio was 34.6% in 2008 compared to 34.4% in 2007. The 2008 GAAP expense ratio was negatively impacted by approximately 0.7 points related to our launching of Innovate SA, previously discussed, and the actions we took to reduce headcount. In addition, during the 2008 fourth quarter we offered eligible associates an early retirement option as well as reducing staff by almost 50 people. See “Other-Benefit Plans” section included in this Item 7 for further discussion regarding our early retirement option. Combining the early retirement option, 2008 reduction in staff and not replacing open positions, we plan to reduce our headcount by approximately 150 positions by the end of the 2009 second quarter. The 2008 GAAP expense ratio was positively impacted from 2007 by a decrease in our variable compensation programs for both our associates and agents. These programs are directly related to our loss experience which, as previously discussed, was worse in 2008 when compared to 2007.
portfolio was not immune to this broad-based decline. We believe that in most market cycles, diversification of the portfolio will be beneficial to us and we plan to continue to maintain a diversified portfolio.
As funds become available, either through cash flow from operations, maturities or sales of investments, our objective is to allocate funds to help us achieve our targeted asset allocations over the long term. The following table provides a breakdown of our investment portfolio relative to our targeted allocated percentages at December 31, 2008. As concerns began to arise in the market place in the last half of 2008 we took a more conservative approach to preserve higher cash balances than our targeted allocation. As we observed markets weakening, we began holding higher cash balances to avoid selling assets at depressed prices for any cash needs that might arise in the course of business, which included settling the claim activity associated with the catastrophes previously discussed. Consequently, cash balances at year-end were somewhat higher than the target. Additionally, approximately $22.3 million is held at the holding company level for State Auto Financial obligations and will remain in short-term funds. See “Liquidity and Capital Resources” included in this Item 7. We measure our investment portfolio allocation with fixed maturities at amortized cost and equities and other invested assets at fair value.
The chart below shows the industry sector breakdown of our large-cap equity portfolio versus the S&P 500 Index based on fair value as of December 31, 2008.
Our primary market risk exposures are to changes in market prices for equity securities and changes in interest rates and credit ratings for fixed maturity securities. Our fixed maturity securities are subject to interest rate risk whereby the value of the securities varies as market interest rates change. We manage this risk by closely monitoring the duration of the fixed maturity portfolio. The duration of the fixed maturity portfolio was approximately 6.26 and 5.10 as of December 31, 2008 and 2007, respectively. The table below summarizes our interest rate risk and shows the effects of a parallel change in interest rates on the fair value of the fixed maturity portfolio (excluding other debt securities) as of December 31, 2008:
This table summarizes only the effects that a parallel change in interest rates could have on the fixed maturity portfolio. This change in rates would also change the value of our liabilities and possibly other financial assets. We caution the reader that this analysis does not take into account nonparallel changes in interest rates. It is likely that some rates would increase or decrease more than others depending upon market conditions at the time of the change. This nonparallel change would alter the value of the fixed maturity portfolio. The analysis is also limited in that it does not take into account any actions that might be taken by us in response to these changes. As a result, the actual impact of a change in interest rates and the resulting fixed maturity values may differ significantly from what is shown in the table.
We have no direct exposure to Lehman Brothers Holdings Inc. or its subsidiaries, American International Group Inc., and no exposure to the common or preferred shares of Federal Home Loan Mortgage Corporation (“Freddie Mac”), or Federal National Mortgage Associations (“Fannie Mae”). Our exposure to Freddie Mac and Fannie Mae is limited to senior debt issues and mortgage-backed pools, which amount to less than 4% of invested assets, with no impairments anticipated as a result.
We have no asset-backed securities in our fixed maturity portfolio which may be labeled sub-prime mortgage-backed securities. We only invest in conventional mortgage backed securities issued by a federal agency or that are U.S. Government guaranteed. Specifically, approximately $180.3 million or 9.3% of our available-for-sale investment portfolio as of December 31, 2008, were in either Ginnie Mae pools, which are guaranteed by the full faith and credit of the U.S. Government, or Fannie Mae or Freddie Mac pools. In 2008 both Fannie Mae and Freddie Mac received additional U.S. Government backing when they were placed into conservatorship.
As of December 31, 2008, our large-cap equity portfolio had a beta of 0.94 using the S&P 500 Index as a benchmark. Beta estimates the degree the portfolio’s price will fluctuate based on a given movement in the market index. The table below reflects what changes might occur in the value of the large-cap equity portfolio given a change in the S&P 500 Index:
The above analysis does not take into account any actions that might be taken by the portfolio managers in response to these changes. As a result, the actual impact of a change in international equity market prices and the resulting international equity values may differ significantly from what is shown in the tables above.
The table below shows our investments measured at fair value by level at December 31, 2008:
The effective tax rate for 2008 was a benefit of 58.6% compared to an expense rate of 23.3% for 2007. Included in our 2008 loss before federal income taxes are tax-exempt earnings related to our investment portfolio which is the significant contributing differential between the actual 58.6% and the expected statutory rate of 35.0%.
Income before federal income tax decreased $6.4 million (4.0%) to $155.3 million from 2006. The most significant factors contributing to this decrease related to a decline in our revenues, specifically our premiums, and an increase in our loss and loss expenses. Our GAAP Loss and Loss Expense Ratio for 2007 was 58.4% compared to 57.4% in 2006.
Our personal insurance segment consists primarily of auto (standard and nonstandard) and homeowners’ products, with personal auto representing approximately 40% of our total consolidated net written premium in 2007 and 2006. The following table provides a summary of written and earned premium, net of reinsurance, by major product line of business for our personal insurance segment for the years ended December 31, 2007 and 2006:
Net written premiums for our standard auto products decreased 0.1% in 2007 compared to 2006. The competitive marketplace combined with some rate reductions in 2007 contributed to this result. However, we have seen increasing new business production related to the introduction of our CustomFit product into new states. CustomFit uses a multi-variate rating approach that broadens the underwriting eligibility for new customers. In 2007, we began introducing the second generation of CustomFit, which further improves our rating sophistication.
During 2007, we continued to enhance our personal lines point of sale portal, netXpress, by adding several new integration options with a variety of third party tools used by our independent agents including a joint credit ordering tool, integrated report ordering, and the comparative rating tools mentioned above. We also have added a number of internal integration points through the use of web services technology. One example of this is real time integration with our enterprise billing system to provide accurate installment information via netXpress. The goal of these technology investments is to streamline quoting and policy issuance for our agents. We strive to be their carrier of choice and ease of doing business is a major driver toward that goal.
In 2007, we began offering our business products in two new states-Colorado and Texas-and increased the number of business products offered in Arizona.
We also continue to enhance our back office systems which enable us to more effectively support our independent agents. We recently implemented the technology to provide real time functionality in our business insurance policy administration systems for quote and issuance transactions. Also known as straight through processing (“STP”), our associates are now able to more effectively and accurately handle typical business insurance processing. The policy service time has been greatly reduced as a result of this new technology.
To make it easier for our agents to submit business insurance accounts, in 2007, we introduced bizXpress, our web-based quote and issuance system, to agents in all of our operating states except Florida. We currently utilize bizXpress for businessowners policies. We are working to expand bizXpress functionality to our business auto products in the first half of 2008, while we develop the same functionality for workers’ compensation business for introduction at a later date. This has been a highly collaborative initiative that has included agent focus group input throughout the project lifecycle. It also leverages the STP technology investment mentioned above. We believe this technology investment should better position us for revenue growth opportunities in the future and start to drive efficiencies into our business model much like we have seen in personal insurance.
reserves by accident year, as they move up or down in relation to carried loss reserves. Since reserves decreased for the prior accident years, the expense reserves declined in a similar fashion. (Allocated loss adjustment expenses (“ALAE”) are those costs that can be related to a specific claim, which may include attorney fees, external claims adjusters and investigation costs, among others. Unallocated loss adjustment expenses (“ULAE”) are those costs incurred in settling claims, such as in-house processing costs, for which no identification can be made to specific claims. “Adjusting and other expenses” are the components of ALAE and ULAE that relate to costs other than defense, litigation, and medical cost containment.)
Favorable catastrophe loss development of approximately $4.6 million is attributable to the 2006 accident year. This development occurred primarily within our homeowners, other personal and commercial multi-peril lines of business.
The following tables provide our insurance segments’ SAP Loss and LAE ratios (“loss ratios”) by major line of business for 2007 and 2006 with the catastrophe (“Cat”) and non-catastrophe (“Non-Cat”) impact shown:
The personal insurance segment loss ratio was 1.3 points lower in 2007 than in 2006. Catastrophes accounted for 5.0 loss ratio points in 2007 compared to 11.9 points in 2006. Excluding the impact of catastrophes, the personal lines loss ratio in 2007 was 5.5 points higher than in 2006. The increase in both the standard and nonstandard auto loss ratios can be attributed partially to rate reductions taken in 2006 and 2007. The improvement in the homeowners loss ratio can be attributed primarily to the reduction of catastrophe losses. In 2007, catastrophes added 14.2 points to the homeowners loss ratio compared to 32.2 points in 2006.
Our equity portfolio consists primarily of large-cap value-oriented stocks, with a small allocation to small-cap equities. Therefore, when large-cap stocks and/or value-oriented stocks perform well our equity
In November 2006, the Committee approved a $50.0 million repositioning of the then-current taxable and tax-exempt holdings to reach our targeted percentage at a quicker pace than if we just used new monies. Based on this action, the sale of approximately $50.0 million of taxable securities was completed by December 31, 2006. Reinvestment into tax-exempt securities of the proceeds from these actions was completed during the first quarter 2007.
During the Committee’s March 2007 meeting, the allocation status was reviewed and the Committee approved an additional $100.0 million repositioning of the then-current taxable and tax-exempt holdings. Based on this action, the sale of approximately $100.0 million of taxable securities was completed by March 31, 2007. Reinvestment into tax-exempt securities of the proceeds from these actions was completed during the 2007 second quarter. After completion of the targeted rebalancing, we assessed the securities held and confirmed our intent to hold the remaining securities until either recovery of fair value or maturity.
Net investment income for 2007 was $84.7 million compared to $83.1 million in 2006. In 2007 our average invested assets increased due to our insurance segments’ favorable underwriting cash flows. However, our pre-tax return on investments declined slightly as provided in the table below due largely to rebalancing our fixed maturity portfolio as described above toward tax-exempt bonds, which have a lower yield on a pre-tax basis. After tax, our net investment income for 2007 was $73.6 million (13.2% effective tax rate) compared to $69.8 million (16.1% effective tax rate) for 2006.
Most of the realized gains in 2007 were derived from the equity segment of the portfolio. Equity sales were executed for various reasons, including the achievement of our price target and raising funds within two of our insurance subsidiaries to fund cash dividends to State Auto Financial. (See “Other Capital Transactions” section below.) The realized gains on the fixed maturity portfolio were achieved by selling shorter-term tax-exempt securities and subsequently reinvesting those funds into longer-term tax-exempt securities as well as selling taxable securities to reinvest the proceeds into the tax-exempt securities as described above. For the year ended December 31, 2007, realized losses of $1.3 million on the fixed maturities related primarily to selling taxable securities to support our shift into tax-exempt securities. Realized losses of $7.1 million on equity securities related primarily to the sale of equity positions where changes in government policy or business conditions, in our opinion, greatly diminished future business prospects.
The following table provides detailed information on our available-for-sale investment portfolio for our gross unrealized gains and losses at December 31, 2007:
Interest expense on our debt was $7.6 million and $7.4 million for the years ended December 31, 2007 and 2006, respectively.
Net cash provided by operating activities was $183.5 million, $121.6 million and $93.5 million for 2008, 2007 and 2006, respectively. Significant sources of operating cash flows are derived from underwriting operations and net investment income. In addition, 2008 benefited from the $92.0 million of cash received by the STFC Pooled Companies in connection with the Pooling Change. There is also a corresponding ongoing impact of adding the New Pool Business which is reflected in the premiums, losses and expenses excluding the one-time Pooling Change. In addition, losses were higher in 2008 than 2007 due to the increased level of catastrophes previously discussed. The table below is a proforma of the direct method of our operating cash flows.
The decline in 2008 versus 2007 was principally the result of an increase in the accumulation of cash for future claims settlements and intercompany payments to affiliates and to pay stockholder dividends.
Dividends paid to shareholders totaled $23.9 million, $20.5 million and $15.4 million for 2008, 2007 and 2006, respectively. The increase in dividends paid between 2008, 2007 and 2006 was due to increasing the amount of dividends paid per common share. Dividends paid per common share were $0.60 in 2008, $0.50 in 2007 and $0.38 in 2006.
Cash used to repurchase common shares under our stock repurchase program was $33.2 million and $22.1 million for 2008 and 2007, respectively. See “Other Capital Transactions” below.
On November 7, 2008, the Board of Directors of State Auto Financial declared a cash dividend of $0.15 per share. The dividend was payable on December 31, 2008, to shareholders of record on December 15, 2008. On March 6, 2009, the Board of Directors of State Auto Financial declared a quarterly cash dividend of $0.15 per share. The dividend is payable on March 31, 2009, to shareholders of record on March 17, 2009. This is the 71st consecutive quarterly cash dividend declared by State Auto Financial’s Board since we had our initial public offering of common stock on June 28, 1991.
To fund capital transactions and provide additional working capital to State Auto Financial, in 2008 State Auto P&C, Milbank, Farmers, and State Auto National Insurance Company (“SA National”) declared cash dividends of $14.0 million, $14.0 million, $4.0 million and $7.0 million, respectively. The cash transfer of dividends was completed in 2008. The dividends from State Auto P&C, Milbank, Farmers and SA National were paid from unassigned statutory surplus and were not considered to be extraordinary for regulatory purposes.
The following provides an overview of our borrowing arrangements during 2008 and outstanding at December 31, 2008:
In 2003, State Auto Financial issued $100.0 million of unsecured Senior Notes due November 2013. The Senior Notes bear interest at a fixed rate of 6.25% per annum, which is payable each May 15 and November 15. The Senior Notes are general unsecured obligations ranking senior to all existing and future subordinated indebtedness and equal with all existing and future senior indebtedness. The Senior Notes are not guaranteed by any of our subsidiaries and thereby are effectively subordinated to all our subsidiaries’ existing and future indebtedness. As of December 31, 2008, we were in compliance with all covenants related to the Senior Notes.
State Auto Financial’s Delaware business trust subsidiary (the “Capital Trust”) issued $15.0 million liquidation amount of capital securities in 2003, due 2033. In connection with the Capital Trust’s issuance of the capital securities and the related purchase by State Auto Financial of all of the Capital Trust’s common securities (liquidation amount of $0.5 million), State Auto Financial issued to the Capital Trust $15.5 million aggregate principal amount of unsecured Floating Rate Junior Subordinated Debt Securities due 2033 (the “Subordinated Debentures”). The sole assets of the Capital Trust are the Subordinated Debentures and any interest accrued thereon. Interest on the Capital Trust’s capital and common securities is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly. The applicable interest rates for the periods January 2006 through December 31, 2008 ranged from 6.38% to 9.78%.
Related to our notes payable, our primary market risk exposure is to the change in interest rates and our credit rating. For a discussion regarding our credit ratings see “Credit and Financial Strength Ratings” included in this Item 7. Based upon the notes payable carrying value at December 31, 2008, we had $15.5 million notes payable with variable interest and $102.1 million notes payable with interest fixed at 6.25%, which equated to approximately 13.1% variable interest debt and 86.9% fixed interest debt. Our decision to obtain fixed versus variable interest rate debt is influenced primarily by the following factors: (a) current market interest rates (b) anticipated future market interest rates (c) availability of fixed versus variable interest instruments and (d) our currently existing notes payable fixed and variable interest rate position. See our contractual obligations table included in “Contractual Obligations”.
The casualty excess of loss reinsurance agreement provides that each company in the State Auto Group is responsible for the first $2.0 million of a covered loss. The reinsurers are responsible for 100% of the excess over $2.0 million up to $5.0 million of covered loss. Also, certain unusual claim situations involving bodily injury liability, property damage, uninsured motorist and personal injury protection are covered by an arrangement that provides for $10.0 million of coverage in excess of $5.0 million retention for each loss occurrence. This layer of reinsurance sits above the $3.0 million excess of $2.0 million arrangement. The rates for this reinsurance are negotiated annually.
In addition to the workers’ compensation reinsurance described above, each company in the State Auto Group is party to an agreement which provides an additional layer of reinsurance for workers’ compensation losses involving multiple workers. Subject to $10.0 million of retention, reinsurers are responsible for 100% of the excess over $10.0 million up to $20.0 million of covered loss. This coverage is subject to a “Maximum Any
One Life” limitation of $10.0 million. This limitation means that losses associated with each worker may contribute no more than $10.0 million to covered loss under this agreement. The rates for this reinsurance are negotiated annually.
The terms of the property catastrophe excess of loss reinsurance agreement described above provide that if coverage is exhausted, coverage may be reinstated upon payment of an additional premium. By this reinstatement provision, the property catastrophe reinsurance agreement effectively provides two sets of limits that may be used to cover multiple events. In September 2008, Hurricane Ike produced losses to the members of the State Auto Group that exceeded the $55.0 million retention layer, and were expected to exhaust the first $25.0 million layer of reinsurance coverage. On October 23, 2008, members of the State Auto Group entered into a separate property catastrophe excess of loss reinsurance agreement (the “Third Event Agreement”) which provided an additional $25.0 million of coverage in excess of our $55.0 million retention layer. Under the Third Event Agreement, the members of the State Auto Group, on a combined basis, retain the first $55.0 million of catastrophe loss, each occurrence, with a 5% co-participation on the next $25.0 million of covered loss, each occurrence. The reinsurers are responsible for 95% of the excess over $55.0 million up to $80.0 million of covered losses, each occurrence. The Third Event Agreement does not include a provision to reinstate coverage if exhausted.
Prior to July 1, 2008, members of the State Auto Group participated in an intercompany catastrophe excess of loss reinsurance agreement (the “Catastrophe Assumption Agreement”) under which State Auto P&C acted as the catastrophe reinsurer for the State Auto Group. Under the Catastrophe Assumption Agreement State Auto P&C was responsible for up to $100.0 million of covered losses in excess of the $135.0 million of covered losses under the catastrophe reinsurance arrangement described above. The Catastrophe Assumption Agreement was not renewed and expired on July 1, 2008. There had been no losses assumed under the Catastrophe Assumption Agreement during 2008, 2007 and 2006.
Our significant contractual obligations as of December 31, 2008, were as follows:
Interest on the subordinated debentures was calculated using an interest rate equal to the three-month LIBOR rate at December 31, 2008 of 1.4250% plus 4.20%, or 5.6250%.
These amounts are estimates of ERISA minimum funding levels based on adjustments to prior year assumptions for our defined benefit pension plan and do not represent an estimate of our expected contributions. Funding levels generally are not determined until later in the year with respect to the contribution year. See Note 9, “Pension and Postretirement Benefits Plans” to our Consolidated Financial Statements included in Item 8 of this Form 10-K for a tabular presentation of expected benefit payments from the State Auto Group’s defined benefit pension plan.
At December 31, 2008, 2007 and 2006, each of our insurance subsidiaries was in compliance with statutory requirements relating to capital adequacy.
As shown below the leverage ratios increased from 2007 to 2008. Net written premiums increased primarily due to a combination of increased Organic Growth and the impact of the Pooling Change along with our insurance subsidiaries’ statutory surplus decreasing mostly due to underwriting losses coupled with realized and unrealized losses on investments. The statutory leverage ratios for our insurance subsidiaries at December 31, 2008, 2007 and 2006 were as follows:
Table excludes the one-time impact on net written premiums of $53.6 million that occurred in conjunction with the Pooling Change.
State Auto Financial’s insurance subsidiaries are subject to regulation and supervision by the states in which they do business. The NAIC has developed Risk-Based Capital (“RBC”) requirements. RBC attempts to relate an individual insurance company’s statutory surplus to the risk inherent in its overall operations. RBC requires the
The State Auto Group has a defined benefit pension plan and a postretirement health care plan covering substantially all employees (collectively “the benefit plans”). Several factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the benefit plans. Key factors include assumptions about the expected rates of return on plan assets, discount rates, and health care cost trend rates. We consider market conditions, including changes in investment returns and interest rates, in making these
In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (“SFAS 158”) which requires employers with defined benefit pension and other postretirement benefit plans, such as health care, to recognize the funded status of its benefit plans on its balance sheet and measure the fair value of plan assets and benefit obligations as of the date of the fiscal year-end balance sheet date thereby eliminating the use of an earlier measurement date and to provide additional disclosures. Adopting SFAS 158 required us to recognize the funded status (i.e. the difference between the fair value of plan assets and the benefit obligations) on our balance sheet, with a corresponding adjustment to accumulated other comprehensive income, net of tax. The adoption of SFAS 158 at December 31, 2006 had the impact of decreasing accumulated comprehensive income by $63.9 million, net of tax.
Our funding status on our pension plan went from a $2.1 million asset at January 1, 2008, to a $73.2 million liability at December 31, 2008. The decline in interest rates over the course of the year and the difference between expected and actual return on assets held by our pension plan had the effect of increasing our liability and cumulative unrecognized actuarial loss, a component of accumulated comprehensive loss in our equity. The factors influencing these increases are as follows: (1) the selected discount rate of 6.0% decreased 0.50 points from the 6.50% rate used at January 1, 2008, which had the effect of increasing the 2008 PBO and related unrecognized actuarial loss approximately $16.6 million, and (2) the actual return on our plan assets was a loss of $40.9 million compared to an expected return of $19.4 million for a net increase to our liability and unrecognized actuarial loss of approximately $60.3 million. In addition to the discount rate and expected to actual return on plan assets, unrecognized gains and losses arise from several factors including expected to actual demographic changes, such as retirement age, mortality, turnover, and rate of compensation increases. The cumulative unrecognized actuarial loss is systematically recognized as an increase in net periodic cost over the average future service period of active participants.
The accumulated benefit obligation (“ABO”) of a defined benefit plan represents the actuarial present value of benefits attributed by the pension benefit formula to employee service rendered prior to the measurement date and based on current and past compensation levels, while the PBO is the ABO plus a factor for future compensation levels. The ABO, which considers current compensations level only, provides information about
the obligation an employer would have if the plan were discontinued at the date of measurement date. At December 31, 2008, the ABO and PBO were $215.2 million and $245.9 million, respectively. At December 31, 2008 the fair value of the assets of our defined benefit pension plan was $172.7 million, which resulted in an underfunding status within our balance sheet of $73.2 million. The State Auto Group has consistently targeted contributions to our defined benefit pension plan with the objective of maintaining a fully funded status on an ABO basis. Historically our plan assets have exceeded our ABO. Given the recent significant decline in the pension plan’s asset we are reviewing the options available to us from a funding perspective. Currently we are anticipating a minimum cash contribution in 2009 of $15.0 million.
Our loss and loss expense reserves reflect all unpaid amounts for claims that have been reported as well as for claims that have been incurred but not reported (“IBNR”). Our loss and loss expense reserves are not discounted to present value.
Reserve ranges provide a quantification of the variability in the reserve projections. The primary determinant in estimating the reserve range boundaries are the variances measured within the historical reserving data for the various lines of business. Property lines typically have smaller variances, while liability lines can experience significant variability. MBE of loss reserves considers the expected variation to establish an appropriate position within a range. MBE Loss and ALAE Reserves for SA National and the STFC Pooled Companies’ share of the Pooled Companies’ reserves at December 31, 2008 was $851.8 million, within a projected range of $784.4 million to $869.0 million. (These values presented are on a direct basis, gross of salvage and subrogation recoverable, and before reinsurance, except for the STFC Pooled Companies’ participation in the inter-company Pooling Arrangement. Therefore, these values cannot be compared to many of the other loss and loss expenses payable tables included elsewhere within this Form 10-K.)
An important assumption underlying the reserve estimation methods for the major casualty lines is that the loss cost trends implicitly built into the loss and ALAE patterns will continue into the future. To estimate the sensitivity of reserves to an unexpected change in inflation, projected calendar year payment patterns were applied to the December 31, 2008, other & product liability Loss and ALAE Reserve 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 10% 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, social inflation, and other inflationary changes in costs beyond assumed levels.
The estimated cumulative impact that this additional, unexpected 10% increase in the loss cost trend would have on our results of operations over the lifetime of the underlying claims in other & product liability is an increase of $61.8 million on reserves, or a $40.2 million reduction to net income, assuming a tax rate of 35%. Inflation changes have much more impact on the longer tail commercial lines like other & product liability and workers’ compensation, and much less impact on the shorter tail personal lines’ reserves.
The following table provides a reconciliation of MBE of our direct Loss and ALAE Reserve to our net loss and loss expenses payable at December 31, 2008 and 2007, respectively. The STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement for the years ended December 31, 2008 and 2007, respectively, has been reflected in the table below as assumed by STFC Pooled Companies:
The following tables present the loss and loss expenses payable by major line of business at December 31, 2008 and 2007, respectively:
See discussion in “Results of Operations 2008 Compared to 2007-Losses and Expenses” section included in this Item 7.
The property and casualty industry has experienced significant loss from claims related to asbestos, environmental remediation, product liability, mold and other mass torts. Asbestos reserves are $3.4 million, and environmental reserves are $7.7 million, for a total of $11.1 million, or 1.4% of net losses and loss expenses payable. Asbestos reserves increased $0.2 million and environmental reserves decreased $0.2 million from 2007. Because we have insured primarily product retailers and distributors, we do not expect to incur the same level of liability, particularly related to asbestos, as companies that have insured manufacturing risks.
In January 2009, the Financial Accounting Standards Board (“FASB”) issued FSP EITF 99-20-1, “Amendments to the Impairment and Interest Income Measurement Guidance of EITF Issue No. 99-20 Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests that Continue to be held by a Transferor in Securitized Financial Assets.” This FSP was issued to achieve consistent determination of whether an OTTI has occurred. This amendment aligns the impairment guidance with FAS 115 “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”). The FSP is effective for interim and annual reporting periods ending after December 15, 2008. The Company adopted this guidance effective December 31, 2008 and there was no impact on the Company’s financial statements.
On December 30, 2008, the FASB issued FSP FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets.” This FSP provides disclosures about the types of assets held in defined benefits and postretirement benefit plans including employers’ investment strategies, major categories of plan assets, concentrations of risk within plan assets, and valuation techniques used to measure the fair value of the plan assets. The FSP includes disclosures about fair value measurements similar to those required by SFAS 157 (defined above). The FSP is effective for fiscal years ending after December 15, 2009 with early adoption permitted.
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedules listed in the Index at Item 15(a)(2). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for defined benefit pension and other postretirement plans as of December 31, 2006, to adopt Financial Accounting Standards Board Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.”
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), State Auto Financial Corporation’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 12, 2009 expressed an unqualified opinion thereon.
We have audited State Auto Financial Corporation’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). State Auto Financial Corporation’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
The consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles, which vary in certain respects from statutory-basis accounting principles followed by State Auto P&C, Milbank, Farmers, SA Ohio and SA National that are prescribed or permitted by the Departments.
Certain amounts in prior years’ financial statements and related footnotes have been reclassified to conform to 2008 presentation. The December 31, 2007 amounts reflected on the consolidated balance sheets include a reclassification of $0.5 million of other invested assets at fair value to other invested assets. Such reclassifications had no effect on the Company’s net income, stockholders’ equity or cash flows.
The Company regularly monitors its investments that have fair values less than cost or amortized cost for signs of other-than-temporary impairment. Among the factors that management considers are market conditions, the amount and length of decline in fair value, events impacting the issuer and the Company’s positive intent and ability to hold the security until anticipated recovery or maturity. For declines in value that are not solely attributable to interest rate movements, the Company considers positive evidence indicating that the cost of the investment is recoverable within a reasonable period of time and evidence to the contrary in considering the severity and duration of the impairment in relation to the anticipated market price recovery. When a decline in fair value is deemed to be other-than-temporary, the investment cost is written down to fair value on the date the determination is made and a realized loss is recorded. The cost is not adjusted for any subsequent recovery in fair value.
Income taxes are accounted for using the liability method. Under this method, deferred tax assets and 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.
See Note 12-Share-Based Compensation regarding the Company’s adoption of SFAS 123(R) “Share-Based Payment” (SFAS 123(R)) on January 1, 2006. The Company’s share-based compensation plans authorize the granting of various equity-based incentives including stock options, restricted stock and restricted share units to employees and non-employee directors and agents. The expense for these equity-based incentives is based on their fair value at date of grant and amortized over their vesting period. The fair value of each stock option is estimated on the date of grant using the Black-Scholes closed-form pricing model. The pricing model requires assumptions such as the expected life of the option and expected volatility of the Company’s stock over the expected life of the option, which significantly impacts the assumed fair value. The Company uses historical data to determine these assumptions and if these assumptions change significantly for future grants, share-based compensation expense will fluctuate in future periods.
In January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment and Interest Income Measurement Guidance of EITF Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests that Continue to be held by a Transferor in Securitized Financial Assets.” This FSP was issued to achieve consistent determination of whether an other-than-temporary impairment has occurred. This amendment aligns the impairment guidance with FAS 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”). The FSP is effective for interim and annual reporting periods ending after December 15, 2008. The Company adopted this guidance effective December 31, 2008 and there was no material impact on the Company’s financial statements.
In June 2007, the FASB issued EITF 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards” (“EITF 06-11”). EITF 06-11 addresses how a company should recognize the income tax benefit received on dividends that are (a) paid to employees holding equity-classified non-vested shares, equity-
Fixed maturities with fair values of approximately $56.0 million and $55.1 million were on deposit with insurance regulators as required by law at December 31, 2008 and 2007, respectively.
Proceeds on sales of available-for-sale securities in 2008, 2007, and 2006 were $231.6 million, $262.2 million and $275.2 million, respectively.
On January 1, 2008, the Company adopted SFAS No. 157. For financial statement elements currently required to be measured at fair value, SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. SFAS 157’s definition of fair value focuses on the price that would be received to sell an asset or paid to transfer a liability (exit price) regardless of whether an observable liquid market price exists. An exit price valuation will include margins for risk even if they are not observable.
The Company utilizes a pricing service and employs other processes and control procedures in developing its fair value estimates. The Company’s processes and control procedures are designed to ensure the values are accurately recorded, that the data and the valuation methods utilized are appropriate and consistently applied and that the assumptions are reasonable and representative of fair value.
For investments that have quoted market prices in active markets, the Company uses quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. The Company receives quoted market prices from a nationally recognized third party pricing service. When quoted market prices are unavailable, the pricing service consolidates market transactions and other key valuation model inputs from multiple sources and provides pricing information in the form of a single fair value for each security. The fair value estimates provided from the pricing service are included in the amount disclosed in Level 2 of the hierarchy. If market inputs are unavailable, then no fair value is provided by the pricing service. For these securities, fair value is determined either by requesting brokers who are knowledgeable about these securities to provide a quote; or the Company internally determines the fair values by employing widely accepted pricing valuation models, and depending on the level of observable market inputs, renders the fair value estimate as Level 2 or Level 3.
The following sections describe the valuation methods used by the Company for each type of financial instrument it holds that are carried at fair value:
proprietary pricing applications (matrix pricing) when quoted prices in active markets for identical assets are not available. Most fixed maturities do not have a quoted price available since they do not trade on a daily basis. Inputs to the applications include but are not limited to, market prices from recently completed transactions and transactions of comparable securities, interest rate yield curves, credit spreads, and other market-observable information. The pricing service will only produce an estimate of fair value if there is objectively verifiable information to produce a valuation. If this information is not available, the Company would be required to produce an estimate of fair value using some of the same methodologies as the pricing service. However, the Company would also have to make assumptions for market-based inputs that are unavailable due to market conditions.
The fair value estimates of most fixed maturity investments are determined by evaluations that are based on observable market information rather than market quotes. All estimates of fair value for fixed maturities priced by the pricing service are included in the amounts disclosed in Level 2 of the hierarchy.
The Company holds one fixed maturity security for which the Company estimates the fair value of this security using the present value of the future cash flows. Due to the limited amount of observable market information, the Company includes the fair value estimates for this security in Level 3.
For assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during 2008, a reconciliation of the beginning and ending balances, separately for each major category of assets is as follows:
The following provides a summary of the reinsurance transactions on the Company’s balance sheets and income statements for the Pooling Arrangement between the STFC Pooled Companies and State Auto Mutual:
In May 2003, State Auto Financial formed a Delaware business trust (the “Capital Trust) that issued $15.0 million mandatorily redeemable preferred capital securities to a third party and $0.5 million of its common securities representing all outstanding common securities to State Auto Financial (collectively, the capital and common securities are referred to as the “Trust Securities”). The Capital Trust loaned $15.5 million in proceeds from the issuance of its Trust Securities to State Auto Financial in the form of a Floating Rate Junior Subordinated Debt Securities due in 2033 (the “Subordinated Debentures”). The Subordinated Debentures are the Capital Trust’s only assets along with any interest accrued thereon. Interest on the Trust Securities are payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20% adjusted quarterly (total 6.38% at December 31, 2008). Prior to May 2008, the interest rate could not exceed 12.5% per annum. The interest rate and interest payment dates on the Subordinated Debentures are the same as the interest rate and interest payment
Stateco provides State Auto Mutual and its affiliates investment management services. Investment management income is recognized quarterly based on a percentage of the average fair value of investable assets and the equity portfolio performance of each company managed. Revenue related to these services amounted to $2.5 million, $2.8 million and $2.5 million in 2008, 2007 and 2006, respectively, and is included in other income (affiliates).
In 2003, State Auto Financial issued $100.0 million of unsecured Senior Notes due November 2013. The Senior Notes bear interest at a fixed rate of 6.25% per annum, which is payable each May 15 and November 15. The Senior Notes are general unsecured obligations ranking senior to all existing and future subordinated indebtedness and equal with all existing and future senior indebtedness. The Senior Notes are not guaranteed by any of State Auto Financial’s subsidiaries and thereby are effectively subordinated to all subsidiaries’ existing and future indebtedness. As of December 31, 2008, State Auto Financial was in compliance with all covenants related to the Senior Notes. State Auto Financial incurred $1.5 million in issuance costs related to the Senior Notes, which is recorded in other assets and is being amortized into interest expense ($0.1 million each for 2008, 2007 and 2008) as the underlying interest expense is recognized on the Senior Notes.
State Auto Financial has a credit agreement (“Credit Agreement”) with a syndicate of lenders which provides for a $200.0 million five-year unsecured revolving credit facility (“Credit Facility”). During the term of the Credit Facility, the Company has the right to increase the total facility to a maximum total facility amount of $250.0 million, provided that no event of default has occurred and is continuing. The Credit Facility will be available for general corporate purposes, including working capital, acquisitions and liquidity purposes. The Credit Facility provides for interest-only payments during its term, with principal due in full at maturity. Interest is based on either a London interbank market rate or a base rate plus a calculated margin amount. The Credit Agreement contains certain covenants, including financial covenants that require the Company to maintain a minimum net worth and not exceed a certain debt to capitalization ratio. As of December 31, 2008, State Auto Financial had not made any borrowings and was in compliance with all of the covenants under the Credit Agreement. State Auto Financial incurred $0.5 million in issuance costs related to the Credit Agreement, which is recorded in other assets and is being amortized into expense ($0.1 million for 2008 and 2007) over the life of the Credit Agreement.
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities as of December 31 are presented below:
At December 31, 2008, the Company established a valuation allowance of $3.1 million for the portion of the deferred tax asset that management believes will not be realized. The valuation allowance was allocated $0.5 million to deferred tax expense associated with realized investment losses recognized in the income statement and $2.6 million against the unrealized holding losses on equity securities recognized through accumulated other comprehensive loss, a component of equity. In the opinion of management, it is more likely than not that the Company will realize the benefits of the net deferred tax assets. No valuation allowance was held at December 31, 2007.
Effective January 1, 2008, the Company adopted the measurement date requirement under transition alternative method one, as defined in SFAS 158, moving from a September 30 measurement date to a December 31 date for measuring its benefit plan obligations. This transition method resulted in a one-time adjustment that decreased beginning retained earnings by $2.4 million, net of tax. The combined impact of the measurement date transition and re-measurement of plan assets and obligations on January 1, 2008, increased beginning accumulated comprehensive income by $3.5 million, net of tax.
Information regarding the Company’s pension and postretirement benefit plans’ change in benefit obligation, plan assets and funded status as of December 31 are as follows:
Information regarding the State Auto Group’s pension and postretirement benefit plans’ components of net periodic cost for the year ended December 31 is as follows:
The assumed health care cost trend rates have a significant effect on the amounts reported for the postretirement plan. A one percentage point change in assumed health care cost trend rates would have the following effects for the year ended December 31, 2008:
Reconciliations of statutory capital and surplus and net income, as determined using statutory accounting principles, to the amounts included in the accompanying consolidated financial statements as of December 31 are as follows:
The Company maintains share-based compensation plans for key employees and outside, or non-employee, directors. The share-based compensation plan for key employees is the Amended and Restated Equity Incentive Compensation Plan (the “Equity Plan”). The stock-based compensation plan for outside directors is the Outside Directors Restricted Share Unit Plan (the “RSU Plan”).
The Equity Plan provides for the award of qualified and nonqualified stock options, restricted shares, performance shares, performance units and other stock-based awards. The Company has reserved 3.5 million common shares under the Equity Plan. As of December 31, 2008, a total of 0.7 million common shares are available for issuance under the Equity Plan. The Equity Plan provides that (i) no more than 33% of the common shares authorized for issuance under the Equity Plan may be granted in the form of awards other than stock options, (ii) the maximum number of common shares subject to awards of stock options, restricted shares and performance shares that may be granted in any calendar year is equal to 1.5% of the total number of common shares of the Company outstanding as of December 31 of the prior year, and (iii) the maximum number of common shares subject to awards of stock options, restricted shares and performance shares that may be granted in any calendar year to any one individual is 250,000 shares. The Equity Plan automatically terminates on July 1, 2010.
The Equity Plan provides that qualified stock options may be granted at an option price not less than the fair market value of the common shares at the date of grant and that nonqualified stock options may be granted at any price determined by the Compensation Committee of the Board of Directors. Options granted generally vest over a three-year period, with one-third of the options vesting on each anniversary of the grant date, and must be exercised no later than ten years from the date of grant. Stock options granted under the Equity Plan for 2008, 2007 and 2006 were 0.4 million, 0.4 million and 0.3 million, respectively.
A summary of the status of the Company’s non-vested restricted shares and changes for the year ended December 31 is as follows:
As of December 31, 2008, there was $0.6 million of total unrecognized compensation cost related to non-vested restricted share compensation arrangements. The remaining cost is expected to be recognized over a period of 1.75 years. No shares vested during the years ended December 31, 2008 and 2007.
The RSU Plan is an unfunded deferred compensation plan which provides each outside director with an award of 1,400 restricted share units (the “RSU award”) following each annual meeting of shareholders, however, the amount of the award may change from year to year, based on the provision described below. The RSU awards are fully vested upon grant. RSU awards are not common shares of the Company and, as such, no participant has any rights as a holder of common shares under the RSU Plan. RSU awards represent the right to receive an amount, payable in cash or common shares of the Company, as previously elected by the outside director, equal to the value of a specified number of common shares of the Company at the end of the restricted period. Such election may be changed within the constraints set forth in the RSU Plan. The restricted period for the RSU awards begins on the date of grant and expires on the date the outside director retires from or otherwise terminates service as a director of the Company. During the restricted period, outside directors are credited with dividends, equivalent in value to those declared and paid on the Company’s common shares, on all RSU awards granted to them. At the end of the restricted period, outside directors receive distributions of their RSU awards either (i) in a single lump sum payment, or (ii) in annual installment payments over a five- or ten-year period, as previously elected by the outside director. The administrative committee for the RSU Plan (currently the Company’s Compensation Committee) retains the right to increase the annual number of RSU awards granted to each outside director to as many as 5,000 or to decrease such annual number to not less than 500, without seeking shareholder approval, if such increase or decrease is deemed appropriate by the administrative committee to maintain director compensation at appropriate levels. The RSU Plan automatically terminates on May 31, 2015. The Company accounts for the RSU Plan as a liability plan. There were 11,200 RSUs granted in both 2008 and 2007 and 9,800 RSUs granted in 2006.
The Company had a stock option incentive plan for certain designated independent insurance agencies (“Agent Stock Option Plan”) that represent the Company and its affiliates. The Agent Stock Option Plan expired May 2008. The plan provided that the options become exercisable on the first day of the calendar year following the agency’s achievement of specific production and profitability requirements over a period not greater than two calendar years from the date of grant or a portion thereof in the first calendar year in which an agency commences participation under the plan. Options granted under this plan have a ten-year term. Options granted for the years 2008, 2007 and 2006 were 15,208, 15,862 and 16,452, respectively.
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, 2008, 2007 and 2006, the total intrinsic value of stock options exercised was $3.3 million, $2.6 million and $11.9 million, respectively. The tax benefit for tax deductions from share-based awards totaled $0.8 million, $0.7 million and $3.2 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Compensation expense recognized during 2008, 2007 and 2006 was $5.5 million, $6.0 million and $7.0 million, respectively. Share-based compensation is recognized as a component of loss and loss adjustment expense and acquisition and operating expense in a manner consistent with other employee compensation. As of December 31, 2008, there was $4.2 million of total unrecognized compensation cost related to option-based compensation arrangements granted under the plans. The remaining cost is expected to be recognized over a period of three years.
The following options to purchase shares of common stock were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price or their inclusion would have been antidilutive for the year ended December 31:
A reconciliation of each component of comprehensive (loss) income and the related federal income tax effect for the year ended December 31 is as follows:
The Company evaluates the performance of its insurance segments using industry financial measurements based on Statutory Accounting Principles (“SAP”), which include loss and loss adjustment expense ratios, underwriting expense ratios, combined ratios, statutory underwriting gain (loss), net premiums earned and net written premiums. One of the most significant differences between SAP and GAAP is that SAP requires all underwriting expenses to be expensed immediately and not deferred and amortized over the same period the premium is earned. The investment operations segment is evaluated based on investment returns of assets managed by Stateco.