We share our operating facilities with State Auto Mutual pursuant to the terms of the 2005 Management Agreement. Our corporate headquarters are located in Columbus, Ohio, in buildings owned by State Auto Mutual that contain approximately 280,000 square feet of office space. We 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 evaluate the performance of our insurance segments using industry financial measurements determined under SAP and certain measures determined under GAAP. We evaluate our investment operations segment based on investment returns of assets managed. Financial information about our segments for 2016 is set forth in this Item 7 and in Note 16 to our consolidated financial statements included in Item 8 of this Form 10-K.
•Rebuilt pricing and underwriting models for our personal and commercial products
•Telematics, or usage-based insurance offerings for our personal and commercial auto products
Personal insurance segment: During the first half of 2016, we increased the number of agency appointments for our personal lines products and implemented pricing changes to improve our overall competitiveness. Increasing bodily injury severity trends negatively impacted the insurance industry during 2016, and our personal auto results reflect the higher trends. We continued efforts begun in 2015 to address the profitability of our personal auto business including the implementation of a number of rating actions and improvements aimed at reducing underwriting and claims leakage. The actions we’ve taken began to show measurable impact in 2016, as personal auto new business premiums and policy counts increased compared to 2015. In 2016, our homeowners line was again profitable and new business increased both in policies-in-force and written premiums.
Business insurance segment: Our business insurance results improved in 2016 compared to 2015, reflecting our actions to address issues that were negatively impacting underwriting results. The largest improvement came in our commercial auto line of business which, like personal auto, has been impacted by increasing bodily injury severity trends. Throughout 2016, we took a number of actions focused on improving commercial auto underwriting results, including identification and fixing of underwriting gaps, better risk classifications, improving modeling capabilities and addressing rate needs. The combination of these actions and our decision to exit our large account solutions impacted our ability to grow our business insurance net written premiums.
In the fourth quarter of 2016, we successfully launched our new technology platform in five states for auto and home, providing our agents with cutting-edge, fully digital technology for underwriting and servicing new business policies. In addition to only issuing policies digitally, insureds can only make premium payments electronically, further improving efficiencies and eliminating the use of paper files. The new platform also incorporates new products and rates with advanced data analytics, enhancing our analytical capabilities and providing us with data and knowledge to improve our ability to profitably underwrite business across all of our lines of business. We expect to complete the roll-out of our new technology platform in our remaining states for personal lines by the end of 2017 and plan to launch the same platform for small business and commercial auto by mid-2017. Our workers compensation, umbrella and farm and ranch products will follow, most likely in 2018.
We remain a company focused on the property and casualty insurance business and are steadfast in our commitment to distributing our products through independent agents. The insurance industry is undergoing significant and unprecedented change, the pace of which can swiftly and dramatically change the manner in which property and casualty products are bought and sold. We plan on being at the forefront of that change and our parent company, State Auto Mutual, has created State Auto Labs as a vehicle for identifying, evaluating and investing in new technologies we believe will transform the property and casualty insurance industry.
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 2016.
Under the terms of the Pooling Arrangement, all subject premiums, incurred losses, loss expenses and other underwriting expenses are prorated among our Pooled Companies on the basis of their participation in the pool. By spreading the underwriting risk, the Pooling Arrangement is designed to produce more uniform and stable underwriting results for each of our Pooled Companies than any one company would experience individually. This has the effect of providing each of our Pooled Companies with a similar mix of pooled property and casualty insurance business on a net basis.
Earned premiums in 2016 were $1,291.9 million compared to $1,270.5 million and $1,074.1 million in 2015 and 2014, respectively. Earned premium growth in 2016 was due to new business growth in the specialty insurance segment. Earned premium growth in 2015 was due to (i) the termination of the HO QS Arrangement (as defined below) and (ii) new business growth in workers’ compensation and the specialty insurance segment.
The SAP cat loss and ALAE ratio for 2016 was 6.3% compared to 4.0% and 3.0% for 2015 and 2014, respectively. The 2016 cat loss ratio increased when compared to the same 2015 and 2014 periods primarily driven by an increase in storm activity including wind and hail storms in Texas, Hurricane Matthew and wildfires in Tennessee.
We measure our top-line growth for our insurance segments based on net written premiums, which 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 term of the policies.
In the following discussion of the results of our insurance segments, we sometimes refer to GAAP financial measures in the context of “as reported” and to non-GAAP financial measures in the context of “pro forma.” These pro forma, or non-GAAP financial measures, may exclude the impact of the HO QS Arrangement cession for the year ended December 31, 2014 and exclude the one-time impact of the unearned premium transfer associated with the termination of the HO QS Arrangement at December 31, 2014. We believe the use of these non-GAAP financial measures enable investors to (a) better understand the impact of the reinsurance arrangement cession on our reported results for the year ended December 31, 2014, and (b) perform a meaningful comparison of our results of operations for the years ended December 31, 2016, 2015 and 2014. We have also included Reconciliation Tables 1-4 and Tables 1-6 for readers to better understand the use and calculation of these non-GAAP financial measures.
The following table sets forth, on a SAP and pro forma basis, certain of our key performance indicators before and after the impact of the HO QS Arrangement cession for the year ended December 31, 2014.
See additional pro forma reconciliation tables for the HO QS Arrangement cession on our homeowners line of business at Reconciliation Tables 3-4.
The following table sets forth certain key performance indicators for our insurance segments for the years ended December 31, 2016, 2015 and 2014:
The following table sets forth the net written premiums by major product line of business for our personal insurance segment for the years ended December 31, 2016, 2015 and 2014.
The following table sets forth the SAP loss and ALAE ratios by major product line of business for our personal insurance segment with the catastrophe and non-catastrophe impact shown separately for the years ended December 31, 2016, 2015 and 2014:
The personal insurance segment’s net written premiums for the year ended December 31, 2015 increased 9.6% when compared to 2014 (Table 1). Net written premiums for the year ended December 31, 2014 reflect the expiration of the HO QS Arrangement, effective December 31, 2014, which resulted in a return of $89.5 million of unearned premium previously ceded under the arrangement. Excluding the impact of the homeowners cession and the expiration of the HO QS Arrangement, net written premiums for the year ended December 31, 2015 for the homeowners line of business and the personal insurance segment decreased 6.1%(1) and 5.3%(1), respectively, when compared to 2014. In addition, personal auto net written premiums for the year ended December 31, 2015 decreased 5.6% when compared to 2014 (Table 1). The 2015 change was primarily the result of a reduction in personal auto and homeowners new business policy counts when compared to 2014, primarily due to Company actions to improve profitability.
The personal insurance segment’s SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2016 was 58.1%, compared to 54.7% in 2015 and the pro forma SAP non-catastrophe loss and ALAE ratio of 52.3% in 2014 (Table 2 and Reconciliation Table 4). The SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2016 increased 3.4 points, when compared to the same 2015 period (Table 2) primarily due to personal auto. Personal auto results for the year were impacted by increasing level of bodily injury severity trends that resulted in increases in ultimate loss and ALAE estimates for
The following table sets forth the net written premiums by major product line of business for our business insurance segment for the years ended December 31, 2016, 2015 and 2014.
Net written premiums for the business insurance segment for the year ended December 31, 2016 decreased 5.4% when compared to 2015 (Table 3). The 2016 decrease was primarily due to (i) our decision to exit our large account business, (ii) rate and underwriting actions to improve profitability in commercial auto, and (iii) changes made to our regional sales teams during the first quarter of 2016, including staff reductions and reassignment of agency relationships among the remaining staff. Net written premiums for the year ended December 31, 2015 increased 1.4% when compared to 2014 (Table 3) primarily due to growth in mono-line workers’ compensation business.
Underwriting Improvements - During 2016, we implemented a number of changes within our business insurance segment, including (i) the decision to exit our large account solutions business; (ii) the restructuring of our regional sales teams; (iii) redefining our underwriting appetite for commercial exposures; (iv) pricing reviews designed to improve commercial auto profitability, and (v) expanding and strengthening relationships with our agency force.
The business insurance segment’s SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2016 was 58.7% compared to 60.6% and 52.8% in 2015 and 2014, respectively (Table 4). The 1.9 point improvement in the 2016 ratio when compared to 2015 (Table 4) was primarily due to commercial auto and commercial multi-peril lines ratio improvements of 4.2 points and 7.6 points, respectively (Table 4). The improvement in the commercial auto ratio was primarily due to less adverse development of prior accident year losses as a result of revising our previous estimates for accident years 2014 and 2015, slightly offset by increases in the current accident year loss and ALAE estimates that reflect the impact of increasing bodily injury severity trends. Commercial multi-peril improved when compared to 2015 primarily as a result of underwriting actions taken to improve production and profitability. Slightly offsetting the improvement was a 5.8 point increase in the fire & allied loss ratio when compared to 2015 (Table 4) primarily due to three large fire losses that occurred during the second half of 2016.
The following table sets forth the net written premiums by unit for our specialty insurance segment for the years ended December 31, 2016, 2015 and 2014.
The following table sets forth the SAP loss and LAE ratios for our specialty insurance segment with the catastrophe and non-catastrophe impact shown separately for the years ended December 31, 2016, 2015 and 2014:
Net written premiums for the specialty insurance segment for the year ended December 31, 2016 increased 21.7% when compared to 2015 (Table 5). E&S casualty net written premiums increased 41.3% compared to 2015 primarily due to (i) continued organic growth within our general liability and umbrella lines, which comprised the majority of the increase, (ii) changes to the reinsurance treaty covering casualty risks within the specialty insurance segment, including an increase in our retention per loss occurrence (see “Liquidity and Capital Resources - Reinsurance Arrangements" in this Item 7 for further information), and (iii) the impact of the reinsurance correction recorded in the second quarter of 2015, which reduced E&S casualty net written premiums by $7.2 million. Programs unit net written premiums increased 17.4% compared to 2015 due to new programs added during the second half of 2015 and growth of existing programs. As discussed further below, during the third quarter of 2016, management made the decision to exit the programs business. E&S property net written premiums were flat compared to the same 2015 period as a result of continuing competitiveness of the catastrophe-exposed property market. During the fourth quarter of 2016, we hired an internal E&S property underwriting team that we believe will strengthen our broker relationships and further diversify our book of business with respect to (i) the mix between catastrophe and non-catastrophe and (ii) geographic spread of risk.
Net written premiums for the year ended December 31, 2015 increased 11.6% when compared to 2014 (Table 5). The increase in premiums was primarily due to (i) the Partners General Agency acquisition in 2014, (ii) new programs added during the second half of 2014, and (iii) growth in general liability and umbrella policies in the E&S casualty unit. Partially offsetting the 2015 growth was a decline in the E&S property unit premiums due to continued intense competition within the catastrophe-exposed property marketplace, which has contributed to less favorable pricing opportunities.
liability coverage of our Florida package business. E&S casualty increased 7.4 points when compared to 2015 (Table 6) driven by (i) increases in the ultimate loss and ALAE estimates for the current and prior accident years for our healthcare line, which was placed in run-off during the first quarter of 2016, and (ii) an increase in the ultimate loss and ALAE estimates for the current accident year in our general liability line due to increased severity. Programs increased 4.9 points when compared to 2015 (Table 6) primarily driven by elevated severity trends within programs with commercial auto exposures which contributed to (i) higher 2016 accident year loss and ALAE ratios and (ii) adverse development of prior accident year losses.
The specialty insurance segment’s SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2015 was 59.7% compared to 104.0% in 2014 (Table 6). The improvement in 2015 when compared to 2014 (Table 6) was due to RED reserve strengthening during 2014.
The programs unit 2015 SAP non-catastrophe loss and ALAE ratio improved 133.4 points when compared to 2014 (Table 6) as a result of RED reserve strengthening in 2014 which added 148.3 points to the 2014 ratio. Excluding RED reserve strengthening, the ratio increased 14.9 points when compared to pro forma 2014, primarily due to higher current accident year losses due to increased severity in three programs with commercial auto exposures. In addition, prior accident year losses developed adversely for certain programs, including those in runoff.
The following table sets forth a tabular presentation of the development of the ultimate liability of prior accident years by line of business for the years ended December 31, 2016, 2015 and 2014:
The following table sets forth a tabular presentation of the development of the ultimate liability by accident year for the year ended December 31, 2016:
The personal insurance segment non-catastrophe loss and ALAE reserves contributed $7.8 million of the adverse development, driven by personal auto which contributed $7.9 million of adverse development, primarily due to higher than anticipated bodily injury severity from the prior two accident years.
ULAE was $12.5 million lower than anticipated in the reserves at December 31, 2013.
The Investment Committee (the “Committee”) of our Board of Directors establishes the investment policies to be followed by Stateco. Our primary investment objectives are to maintain adequate liquidity and capital to meet our responsibilities to policyholders, grow long term economic surplus to increase our capital position, maintain a consistent level of income to support operations and manage investment risk. Our current investment strategy does not rely on the use of derivative financial instruments.
At December 31, 2016, our investments in fixed maturities, equity securities and certain other invested assets were held as available-for-sale and carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are included as a separate component of stockholders’ equity as accumulated other comprehensive income (loss) and as such are not included in the determination of net income.
At December 31, 2016, our equity portfolio consisted of approximately 44 different large-cap stocks, 73 small-cap stocks and 11 mutual and exchange traded funds. The largest single fund holding was 12.7% of the equity portfolio based on fair value and the top ten positions accounted for 45.5% of the equity portfolio. At December 31, 2015, our equity portfolio consisted of approximately 56 different large-cap stock, 69 small-cap stocks and nine mutual and exchange traded funds. The largest single fund holding was 13.0% of the equity portfolio based on fair value, and the top ten positions accounted for 34.1% of the equity portfolio.
We believe our Muni Portfolio is well diversified by issuer and state. We have 13.8% invested in securities which have been either pre-refunded or escrowed to maturity bonds. No single issuer comprises more than 5.0% of our Muni Portfolio. For the bonds that are not in the pre-refunded category, no more than 13.0% 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 54.6% of our Muni Portfolio and state and local government general obligation bonds make up 17.5% 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, 2016, we have one international fund, Fund 1, which is included in other invested assets available-for-sale. Fund 1 had a beta of 0.70 using the MSCI EAFE Index as a benchmark. The following table sets forth what changes might occur in the value of Funds 1 given a change in the MSCI EAFE Index at December 31, 2016:
Net realized gains increased $11.8 million and $15.8 million, respectively, when compared to the same 2015 and 2014 periods. During the fourth quarter of 2016, we redeemed a limited partnership investment in international equities that had been classified as other invested assets. The redemption proceeds were reinvested in an international equity mutual fund classified as an equity security. The Company recognized a gain of $12.0 million on the redemption. Out of the total proceeds related to this redemption and reinvestment, $44.0 million was non-cash and therefore excluded from net cash used in investing activities in the consolidated statements of cash flows. 2015 net realized gains increased $4.0 million when compared to 2014 partially driven by an increase in realized gains in the fixed income portfolio 2015 as a result of reducing our TIPS position due to our inflation outlook.
When a fixed maturity security has been determined to have an other-than-temporary decline in fair value, the impairment charge is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to non-credit factors, which is recognized in accumulated other comprehensive income. See “Critical Accounting Policies - Investments” included in this Item 7 for OTTI impairment indicators. Future increases or decreases in fair value, if not other-than-temporary, are included in accumulated other comprehensive income (loss). We recognized $2.3 million of OTTI on our fixed maturity portfolio for the year ended December 31, 2016. We did not recognize any impairments on our fixed maturity portfolio during 2015 or 2014.
Based upon our review of our investment portfolio at December 31, 2016, 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, 2016:
The following table sets forth our unrealized holding gains by investment type, net of deferred tax that was included as a component of accumulated comprehensive income at December 31, 2016 and 2015, and the change in unrealized holding gains, net of deferred tax, for the year ended December 31, 2016:
Our insurance subsidiaries must have adequate liquidity to ensure that their cash obligations are met. However, as discussed below, the STFC Pooled Companies do not have the day-to-day liquidity concerns normally associated with an insurance company due to their participation in, and the terms of, the Pooling Arrangement. In addition, State Auto P&C’s $100.0 million credit facility is available for general corporate purposes such as funding liquidity needs. See “Liquidity and Capital Resources - Borrowing Arrangements - Credit Facility” included in this Item 7.
We generally manage our cash flows through current operational activity and maturing investments, without a need to liquidate any of our other investments. However, should our written premiums decline or paid losses increase significantly, or a combination thereof, our cash flows from operations could be impacted requiring us to liquidate investments. This action was not necessary in 2016, 2015 or 2014.
We maintain a portion of our investment portfolio in relatively short-term and highly liquid investments to ensure the immediate availability of funds to pay claims and expenses. At December 31, 2016 and 2015, we had $51.1 million and $58.1 million, respectively, in cash and cash equivalents, and $2,537.2 million and 2,396.4 million, respectively, of total available-for-sale investments. Included in our fixed maturities available-for-sale were $9.2 million and $8.8 million, respectively, of securities on deposit with insurance regulators, as required by law, at December 31, 2016 and 2015. In addition, substantially all of our fixed
Net cash used in investing was $127.6 million and $167.7 million and $56.5 million in 2016, 2015 and 2014, respectively. The change from 2016 compared to 2015 and 2014 was primarily due to the reinvestment of proceeds received from the expiration of the HO QS Arrangement along with the reduction of our average cash on hand balances through additional fixed income and equity purchases.
In September 2016, State Auto P&C entered into a new term loan with the FHLB in the principal amount of $21.5 million (the “2016 FHLB Loan”). The 2016 FHLB Loan is a five-year term loan and may be called (prepaid) after three years with no prepayment penalty. The 2016 FHLB Loan 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 1.73%. The 2016 FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C. Proceeds from the loan were contributed to the pension plan to reduce the Company's future pension costs. For the year ended December 31, 2016, the Company contributed $34.5 million to its pension plan.
In addition, State Auto P&C has outstanding an $85.0 million loan ("2013 FHLB Loan") from the FHLB. The 2013 FHLB Loan is a 20-year term loan that may be currently called (prepaid) at any time with no prepayment penalty. The interest rate is fixed over the term of the loan at 5.03%.
State Auto Financial’s Delaware business trust subsidiary (the “Capital Trust”) has outstanding $15.0 million liquidation amount of capital securities, 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 has 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 December 31, 2016 and 2015 were 5.13% and 4.61%, respectively.
The following table sets forth our notes payable at December 31, 2016:
To minimize the risk of reinsurer default, the State Auto Group cedes only to third-party reinsurers who are rated A- or better by A.M. Best or Standard & Poor’s and also utilizes both domestic and international markets to diversify its credit risk. We utilize reinsurance to limit our loss exposure and contribute to our liquidity and capital resources.
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. As of June 1, 2016, this property catastrophe reinsurance agreement renewed. Under this reinsurance agreement, we retain the first $55.0 million of catastrophe loss, each occurrence, with a 5.0% co-participation on the next $285.0 million of covered loss, each occurrence. The reinsurers are responsible for 95.0% of the excess over $55.0 million up to $340.0 million of covered losses, each occurrence. Under this reinsurance agreement, the State Auto Group is responsible for losses above $340.0 million.
The State Auto Group also maintains a separate property catastrophe excess of loss reinsurance agreement covering the specialty insurance segment's E&S property and programs units catastrophe related events affecting at least two risks. Under this reinsurance agreement, the State Auto Group retains the $30.0 million of catastrophe loss, each occurrence, with no co-participation on the next $25.0 million of covered loss, each occurrence.
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 $30.0 million of coverage in excess of $10.0 million retention for each loss occurrence. This reinsurance coverage sits above the $8.0 million excess of $2.0 million arrangement. Policies underwritten by the E&S casualty and programs units are not subject to this casualty excess of loss reinsurance agreement.
In addition, each company in the State Auto Group is party to a workers’ compensation catastrophe reinsurance agreement that provides additional reinsurance coverage for workers’ compensation losses involving multiple workers. Subject to $10.0 million of retention, reinsurers are responsible for 100.0% of the excess over $10.0 million up to $30.0 million of covered loss. For loss amounts over $30.0 million, the casualty excess of loss reinsurance agreement provides $20.0 million coverage in excess of $30.0 million. Workers’ compensation catastrophe 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 these agreements.
As of July 1, 2016, the State Auto Group restructured its reinsurance coverage for E&S casualty and programs units casualty risks. Under this reinsurance agreement, the State Auto Group is responsible for the first $2.0 million of losses. This reinsurance agreement provides 100.0% coverage up to $9.0 million excess of $2.0 million for any one insured, all policies, and $14.0 million excess of $11.0 million for Clash only coverage. This reinsurance arrangement is placed on a loss occurrence basis, while the expired treaty was placed on a risk-attaching basis. As a result of this change, the 2015 reinsurance treaty was terminated on a cut-off basis, resulting in the return of $5.1 million of ceded unearned premium from the reinsurers to the Company.
The following table sets forth the statutory leverage ratios for our insurance subsidiaries at December 31, 2016, 2015 and 2014:
As of February 26, 2016, the State Auto Group’s financial strength rating from A.M. Best was A- (Excellent) with a stable outlook and its credit rating from A.M. Best was bbb- with a stable outlook.
The determination of ultimate losses integrates information and analysis provided by several disciplines within our Company, including claims, actuarial and accounting. This assessment requires considerable judgment in understanding how claims mature, which lines of business are the most volatile, and how trends change over time. Loss reserves represent an estimate at a given point in time based on many variables including historical and statistical information, inflation, legal developments, storm loss estimates and economic conditions. Although we consider many different sources of information, as well as a number of actuarial methodologies to estimate our loss reserves, there is no single method for determining the exact ultimate liability.
Incurred Loss Development Method: The Incurred Loss Development Method is probably the most common actuarial method used in projecting indicated IBNR reserves. This method uses paid loss experience as well as the outstanding estimates
Reserve ranges provide a quantification of the variability in the loss reserve projections. The primary determinant in estimating the loss reserve range boundaries are the variances measured within the historical reserving data for the various lines of business. MBE of loss reserves considers the expected variation to establish an appropriate position within a range. At December 31, 2016, MBE of our direct loss and ALAE reserves for the STFC Pooled Companies’ share of the Pooled Companies’ reserves were $1,180.7 million, within an estimated range of $1,010.7 million to $1,218.8 million.
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, 2016 and 2015. The STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement for the years ended December 31, 2016 and 2015, respectively, has been reflected in the table below as assumed by STFC Pooled Companies.
Asbestos reserves are $1.1 million, and environmental reserves are $15.1 million, for a total of $16.2 million, or 1.4% of net losses and loss expenses payable. Asbestos reserves decreased $0.1 million and environmental reserves increased $3.8 million from 2015.
The State Auto Group has a defined benefit pension plan covering substantially all employees hired prior to January 1, 2010 and a postretirement healthcare plan covering certain associates and retirees (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 assumptions. The actuarial assumptions used by us in determining benefit obligations may differ materially from actual results due to changing market and economic conditions, higher or lower turnover and retirement rates, or longer or shorter life spans 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.
MP-2014 improvement scale with indefinite improvement was used to project future mortality rates. For the December 31, 2016 and 2015 valuations, the Adjusted RP-2014 mortality table was used as a baseline for the mortality assumption and to project future mortality rates. The January 1, 2017 and 2016 actuarial reports of the benefit plans included these revised mortality assumptions.
To calculate the State Auto Group’s December 31, 2016 benefit obligation for each of the benefit plans, we used a discount rate of 4.00% based on an evaluation of the expected future benefit cash flows of our benefit plans used in conjunction with the Citigroup Pension Discount Curve at the measurement date. A lower discount rate results in, all else being equal, a higher present value of the benefit obligation. To calculate our benefit obligation at December 31, 2016 and net periodic benefit cost for the year ended December 31, 2017, a discount rate of 4.00% and an expected long-term rate of return on plan assets of 7.00% were used. We selected an expected long-term rate of return on our plan assets by considering the mix of investments and stability of investment portfolio along with actual investment experience during the lifetime of the plans. Our assumptions regarding the discount rate and expected return on plan assets could have a significant effect on the amounts related to our benefit obligations and net periodic benefit cost depending on the degree of change between reporting periods.
As a result of revised mortality assumptions and the change in the discount rate, the benefit plan’s liability increased $2.9 million for the year ended December 31, 2016 and decreased $6.5 million for the year ended December 31, 2015.
2014 was primarily due to the reversal of our deferred tax asset valuation allowance, which resulted in an income tax benefit of $82.6 million.
The principal positive evidence that led us to determine at December 31, 2014 that the valuation allowance against our net deferred tax assets was no longer necessary included (i) three consecutive years of pre-tax income; (ii) cumulative three-year pre-tax income of $98.7 million through December 31, 2014; and (iii) expected future pre-tax income. Since the establishment of the valuation allowance in the second quarter of 2011, our homeowners line underwriting results, a key contributor to the initial establishment of the valuation allowance, have significantly improved. The improvement in our homeowners underwriting results is attributable to actions undertaken by management, including rate increases, deductible expansion, and changes in the geographic mix, among others. See the “Results of Operations - Insurance Segments - Personal Insurance Segment” discussion included in this Item 7 for further information. Since 2011, underwriting results have also been impacted by our RED underwriting results, which included reserve strengthening in 2012, 2013 and 2014. Due to the actions taken in 2014, including the reserve strengthening and the placement of the ADC reinsurance agreement, which provides $40.0 million of adverse development cover over carried Loss and LAE reserves for the RED restaurant program, along with the fact that the RED program business has been terminated and is in run-off, future underwriting results are not expected to be materially impacted by RED underwriting results. See the “Results of Operations - Insurance Segments - Specialty Insurance Segment” discussion included in this Item 7 for further information.
Management anticipates generating taxable income over the next three years that will allow for the realization of all of our net operating loss (“NOL”) carryforwards prior to the end of 2019. The NOL carryforwards do not begin to expire until 2030 and will not fully expire until 2036.
The following table sets forth the components of our federal income tax expense for the years ended December 31, 2016, 2015 and 2014:
See Note 9, “Federal Income Taxes,” to our consolidated financial statements included in Item 8 of this Form 10-K for further disclosures regarding our income tax matters.
The Board of Directors and Stockholders of State Auto Financial Corporation
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. 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.
The following table sets forth net deferred acquisition costs for the years ended December 31, 2016, 2015 and 2014:
Comprehensive income is defined as all changes in an enterprise’s equity during a period other than those resulting from investments by owners and distributions to owners. Comprehensive income includes net income and other comprehensive (loss) income. Other comprehensive (loss) income includes all other non-owner related changes to equity and includes net unrealized gains and losses on available-for-sale investments and unrecognized benefit plan obligations, adjusted for deferred federal income taxes.
Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent)
In May 2014, the FASB issued guidance that requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods and services. Insurance contracts do not fall within the scope of this new guidance. The guidance is effective for annual reporting periods beginning after December 15, 2017, with early adoption permitted. The guidance has not yet been adopted; however, there is not expected to be a material impact on the Company’s results of operations and consolidated financial position.
financial assets and liabilities by measurement category and form on the balance sheet or the notes to the financial statements, and (vii) clarifies that the need for a valuation allowance on a deferred tax asset related to an available for sale security should be evaluated with other deferred tax assets. The guidance is effective beginning January 1, 2018 and the Company is currently evaluating the impact on its results of operations and consolidated financial position.
In February 2016, the FASB issued guidance that amended previous guidance on lease accounting. The new guidance requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The guidance is effective beginning January 1, 2019 and the Company is currently evaluating the impact on its results of operations and consolidated financial position; however, it is not expected to have a material impact on the Company’s results of operations, consolidated financial position or cash flows.
In March 2016, the FASB issued guidance that simplifies the accounting for share-based payment award transactions including: income tax consequences, classification of awards as either equity or liabilities, classification of excess tax benefits, and classification on the statement of cash flows. The guidance is effective beginning January 1, 2017 and it is not expected to have a material impact on the Company’s results of operations, consolidated financial position or cash flows.
The following tables set forth the cost or amortized cost and fair value of available-for-sale securities by lot at December 31, 2016 and 2015:
The following table sets forth the amortized cost and fair value of available-for-sale fixed maturities by contractual maturity at December 31, 2016:
Transfers between levels may occur due to changes in the availability of market observable inputs. Transfers in and out of levels are reported as having occurred at the beginning of the quarter in which the transfer occurred. There were no transfers between levels during the years ended December 31, 2016 and 2015.
The fair value estimate of the Company’s fixed maturity investments are determined by evaluations that are based on observable market information rather than market quotes. Inputs to the evaluations 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 fixed maturity portfolio pricing obtained from the pricing service is reviewed for reasonableness. Regularly, samples of security prices are referred back to the pricing service for more detailed explanation as to how the pricing service arrived at that particular price. The explanations are reviewed for reasonableness by the portfolio manager or investment officer. Additionally, the prices and assumptions are verified against an alternative pricing source for reasonableness and accuracy. Any discrepancies with the pricing are returned to the pricing service for further explanation and if necessary, adjustments are made. To date, the Company has not identified any significant discrepancies in the pricing provided by its third party pricing service. Investments valued using these inputs include U.S. treasury securities and obligations of U.S. government agencies, obligations of states and political subdivisions, corporate securities (except for a security discussed below), and U.S. government agencies mortgage-backed securities. All unadjusted estimates of fair value for fixed maturities priced by the pricing service are included in the amounts 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 Company holds one fixed maturity corporate security included in Level 3 and estimates its fair value using the present value of the future cash flows.
In accordance with Accounting Standard Codification 820-10, since the investments are measured at fair value using the net asset value per share practical expedient they have not been classified in the fair value hierarchy. Fair values presented here are intended to permit reconciliation of the fair value hierarchy to the amounts presented in the consolidated balance sheets.
The following tables set forth the Company’s available-for-sale investments within the fair value hierarchy at December 31, 2016 and 2015:
For assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3), the following tables set forth a reconciliation of the beginning and ending balances for 2016 and 2015, separately for each major category of assets:
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 7b). 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, 2016 was $4.9 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.
Included in notes payable are the FHLB Loans, consisting of the 2013 FHLB Loan and the 2016 FHLB Loan (as defined in Note 8) and Subordinated Debentures. The Company estimates the fair value of the FHLB Loans by discounting cash flows using a borrowing rate currently available to the Company for a loan with similar terms. The FHLB Loans have been placed in Level 3 of the fair value hierarchy. The carrying amount of the Subordinated Debentures approximates its fair value as the interest rate adjusts quarterly and has been disclosed in Level 3.
Favorable development of unallocated loss adjustment expenses contributed approximately $12.5 million of the 2014 development, while favorable development of catastrophe reserves was approximately $5.2 million, which was slightly lower than 2013. The personal and business insurance segments non-catastrophe loss and ALAE reserves accounted for $28.7 million of
favorable development. The personal insurance segment contributed $6.4 million of favorable development, primarily from accident year 2013. The business insurance segment contributed $22.3 million of favorable development, driven by the other & product liability, workers’ compensation and commercial auto lines with $11.9 million, $5.6 million and $5.3 million of favorable development, respectively. The favorable development in these lines was driven by the emergence of lower than anticipated claim severity from accident years 2013 and prior. Somewhat offsetting the favorable development was adverse development of $2.1 million in the commercial multi-peril line, driven by third party liability coverage. The specialty insurance segment non-catastrophe loss and ALAE reserves accounted for $91.5 million of adverse development, driven by RED reserve strengthening of $96.7 million related to a large restaurant program and a commercial auto trucking program. Somewhat offsetting the adverse development was favorable development of $3.9 million in the E&S property unit and $3.1 million in the E&S casualty unit. Favorable development in these lines was driven by better than anticipated severity emerging from the 2012 and 2013 accident years.
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, Bornhuetter-Ferguson, and Least-Squares techniques as described in the "Losses and Loss Expenses Payable" section of "Critical Accounting Policies" included in Item 7 of this Form10-K. Statistical models may also be used when the historical patterns can be reasonably approximated.
The change in incurred losses and loss adjustment expenses for prior accident years was caused by lower than expected loss emergence during 2016 in our other & product liability and workers’ compensation lines of business. The unanticipated emergence in the other & product liability line was driven by much lower than expected severity in accident years 2013 and 2015. The unanticipated emergence in the workers’ compensation line was driven by lower than expected severity in accident year 2014.
The change in incurred losses and loss adjustment expenses for prior accident years was caused by greater than expected loss emergence during 2016 in our Programs line of business. The unanticipated emergence in the Programs line was driven by higher than expected severity in accident year 2015 for programs with commercial auto exposure. The changes in incurred losses and loss adjustment expenses for accident years 2012 and 2013 for the years ended December 31, 2013, 2014 and 2015 are primarily attributable to our Programs line of business, including RED.
The change in incurred loss and loss adjustment expenses for prior accident years was caused by greater than expected loss emergence during 2016, driven by higher than anticipated severity in accident years 2014 and 2015 for our healthcare product.
On December 31, 2011, the State Auto Group entered into the Homeowners Quota Share Arrangement, which was a three-year quota share agreement covering its homeowners line of business. Under the arrangement, the State Auto Group ceded to reinsurers 75% of its homeowners business under policies in force at the effective date and new and renewal policies thereafter issued during the term of the agreement. The arrangement expired on December 31, 2014. The Company received $89.5 million of unearned premiums related to the expiration of this arrangement. Subject to the terms and conditions of the arrangement, the participating reinsurers’ margin was capped at 9.0%, with any excess returned to the Company in the form of profit commission. For the years ended December 31, 2016, 2015 and 2014, the Company recognized profit commission of $1.9 million, $4.2 million, and $19.0 million, respectively, reflected as a reduction in acquisition and operating expenses on the consolidated statements of income. The amount of ceding commission earned was limited to the amount of deferred acquisition costs that would have been deferred if not for entering in the arrangement. As a result of the expiration of the HO QS Arrangement, the Company recognized $8.1 million of excess ceding commission that had previously been deferred, reflected as a reduction in acquisition and operating expenses on the consolidated statements of income for the year ended December 31, 2014.
The following table sets forth the effect of the Company’s external reinsurance on its income statements for the years ended December 31, 2016, 2015 and 2014, prior to the reinsurance transaction with State Auto Mutual under the Pooling Arrangement, as discussed in Note 7a:
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, 2016 and 2015:
Pursuant to the Pooling Arrangement, State Auto Mutual receives all premiums and pays all losses and expenses associated with the insurance business produced by the pool participants and then settles the intercompany balances generated by these transactions with the participating companies on a quarterly basis within 60 days following each quarter end. No interest is paid on this balance. When settling the intercompany balances, State Auto Mutual provides the pool participants with full credit for the premiums written and net losses paid during the quarter and retains all receivable amounts from insureds and agents and reinsurance recoverable on paid losses from unaffiliated reinsurers. Any receivable amounts that are ultimately deemed to be uncollectible are charged-off by State Auto Mutual and allocated to the pool members on the basis of pool participation. As a result, the Company has an off-balance sheet credit risk related to the balances due to State Auto Mutual from insurers, agents and reinsurers, which are offset by the unearned premium from the respective policies. The Company’s share of the premium balances due to State Auto Mutual from agents and insureds at December 31, 2016 and 2015 is approximately $310.5 million and $294.7 million, respectively.
Under these agreements, the Company earned interest of $4.9 million for each of the three years ended December 31, 2016, 2015 and 2014, respectively. See Note 3 for the notes receivable fair value discussion.
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 $1.9 million, $1.8 million and $1.5 million in 2016, 2015 and 2014, respectively, and is included in other income (affiliates) on the consolidated statements of income.
As of December 31, 2016, State Auto P&C had not made any borrowings and both State Auto P&C and State Auto Financial were in compliance with all covenants and requirements of the SPC Credit Facility.
The following table sets forth the tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 2016 and 2015:
During 2011, the Company determined that a valuation allowance should be established due to the magnitude of the catastrophe losses from unprecedented storms experienced industry wide. As part of its assessment of the appropriateness of the deferred tax asset valuation allowance at December 31, 2014, management considered the following positive evidence: (i) three-year cumulative pre-tax income of $98.7 million, (ii) three consecutive years of pre-tax income, (iii) the expiration of the HO QS Arrangement under which we ceded 75% of our homeowners line underwriting results to the participating reinsurers, (iv) the actions the Company took (including reserve strengthening and entering into an ADC reinsurance agreement protecting against the risk of further adverse development for one of the programs) with respect to the terminated RED program business, which significantly reduced the Company’s reported financial results since 2011, (v) more adequate pricing, which has contributed to improved underwriting margins, and (vi) profitable growth within the specialty insurance segment, excluding the terminated RED program business. Management concluded that this positive evidence outweighed available negative evidence and further
concluded that a valuation allowance against the Company’s net deferred tax assets was no longer appropriate. As a result, the valuation allowance was reversed at December 31, 2014. With the reversal of the valuation allowance at December 31, 2014, the Company recorded an income tax benefit of $82.6 million.
At December 31, 2016, the Company carried no balance for uncertain tax positions. The Company had no accrual for the payment of interest and penalties at December 31, 2016 or 2015.
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, 2016 and 2015:
The following table sets forth the Company’s share of the amounts included in accumulated other comprehensive income (loss) that have not been recognized in net periodic cost at December 31, 2016 and 2015:
The following table sets forth the weighted average assumptions used to determine the benefit plans’ net periodic cost for the years ended December 31, 2016, 2015 and 2014:
The actuarially prepared funding amount to the pension plan ranges from the minimum amount the Company would be required to contribute to the maximum amount that would be deductible for tax purposes. Contributed amounts in excess of the minimum amounts are deemed voluntary. Amounts in excess of the maximum amount would be subject to an excise tax and may not be deductible for tax purposes. The Company’s share of expected contributions during 2017 is approximately $13.0 million.
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 $6.3 million, $5.1 million and $5.1 million for 2016, 2015 and 2014, respectively.
The following tables set forth the changes in the Company’s accumulated other comprehensive income component (AOCI), net of tax, for the years ended December 31, 2016, 2015 and 2014:
The following tables set forth the reclassifications out of accumulated other comprehensive income, by component, to the Company’s consolidated statement of income for the years ended December 31, 2016, 2015 and 2014:
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
The Company’s 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. As of December 31, 2016, each of the Company’s insurance subsidiaries maintained adjusted statutory surplus in excess of 400% of the authorized control level RBC.
The RSU Plan is an unfunded deferred compensation plan which currently provides each outside director with an award of 1,400 restricted share units (the “RSU award”) following each annual meeting of shareholders. The amount of the award may change from year to year, based on the provision described below. The RSU awards are fully vested six months after the date of 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 cash or common share 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 10,000 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, 2026. The Company accounts for the RSU Plan as a liability plan. There were 22,832 RSUs, 26,184 RSUs, and 25,960 RSUs granted in 2016, 2015 and 2014, respectively.
During 2016 and 2015, common shares valued at approximately $753,000 and $567,000, respectively, were distributed by the Company under the RSU Plan.
The fair value of share-based awards granted to employees was estimated at the date of grant using the Black-Scholes option-pricing model. The following table sets forth the weighted average fair values and related assumptions for options granted for the years ended December 31, 2016, 2015 and 2014:
Compensation expense recognized during 2016, 2015 and 2014 was $3.7 million, $4.5 million and $3.6 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, 2016, there was $2.2 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 2.25 years.
The following table sets forth the compilation of basic and diluted net earnings per common share for the years ended December 31, 2016, 2015 and 2014:
The following table sets forth the options to purchase shares of common stock and the restricted share units (“RSU award”) provided to each outside director of the Company, that were not included in the computation of diluted earnings per common share because the exercise price of the options, or awards, was greater than the average market price or their inclusion would have been antidilutive for the years ended December 31, 2016, 2015 and 2014:
Commercial Insurance Segment - commercial auto, small commercial package, middle market commercial, workers’ compensation and other commercial
The following table sets forth financial information regarding the Company’s reportable segments at December 31, 2016 and 2015: