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 estimates at a given point in time of what we expect to pay to claimants, based on facts,
The Company’s reportable segments are standard insurance, nonstandard insurance and investment management services. The profits of these segments are monitored by management without consideration of transactions with other segments or realized gains or losses on sales of investments.
The following table summarizes the consolidated earned premiums by segment and by line of business for the years ended December 31, 2005 and 2004:
The Company continues to emphasize that it will not compromise underwriting profitability for top line growth. The Company believes that it can implement periodic rate changes in most states and remain an attractive market to its policyholders and independent agency partners by stressing the strengths it brings to the marketplace. These strengths include stability, financial soundness, prompt and fair claims service, and technology which makes it easier for the agent to do business with State Auto and provide substantial value to their customers. The Company’s Internet-based point of sale agency portal for personal lines business, netXpress, and an automated intelligent underwriting system, Apollo, are examples of standards-based, user-friendly technology, making it easier for agents to submit personal lines accounts to the Company.
The Company is addressing ease of doing business in other ways as well, including enhancements to its electronic portal for agents, called Agentsite, and creating ways for the Company’s internet rating and underwriting systems to “talk” with more agency management systems. In 2005, “Agentsite Dashboard” was added to provide agents with quicker access to customer information and recent transactions. This new functionality helped the agents transition following the Company’s decision to eliminate the printing and mailing of paper policy declarations to agents for personal lines.
For the year 2003, the STFC Pooled Companies ceded a total of $12.8 million in earned premium and $5.6 million in losses and loss adjustment expenses to Mutual under the Stop Loss. The net impact of this cession increased the 2003 GAAP loss and LAE ratio by 0.3 points.
As noted in the above table, all lines of business contributed to the 6.3 point GAAP loss and LAE improvement in 2004 from 2003, except for auto-commercial and other and products liability, which combined represent 17.5% of total earned premiums in 2004. The Company monitors all lines of business paying particular attention to auto-personal, homeowners and workers’ compensation due to the significance these lines have on the profitability of the Company. The auto-personal line continues to be the most significant line of business and therefore has the greatest influence on net income. The homeowners line of business is the Company’s second largest (see earned premium table above) and has been most significantly impacted by weather-related losses in the last two years by the apparent increased severity of storms. Improvement in the loss results in both auto-personal and homeowners is the result of the Company’s efforts to obtain adequate rate increases, maintain effective underwriting guidelines along with the discipline of adhering to these guidelines. Workers’ compensation continues to be the Company’s most volatile line of business due to the risks insured. Workers’ compensation results have been volatile both for the Company and the industry and can have a significant adverse impact on earnings. The Company manages this exposure with conservative underwriting and rate levels that are based on National Council of Compensation Insurance loss costs. As a result of the Company’s conservative approach, workers’ compensation represents 3% of total earned premium.
An increase over 2004 in the Company’s payment of shareholder dividends of $6.3 million. Dividends paid per common share for 2005 increased to $0.27 from $0.17 for the same 2004 period. Also contributing to this increase was the expiration on July 31, 2005, of Mutual’s waiver of dividends that would otherwise have been payable to it by State Auto Financial. Dividends paid by State Auto Financial to Mutual in 2005 were $4.7 million versus none in 2004 and 2003. Beginning in the third quarter of 2005, with the increased dividend rate along with Mutual’s receipt of its dividends, quarterly dividend payments increased approximately $3.0 million.
In addition, the State Auto Group has secured other reinsurance to limit the net cost of large loss events for certain types of coverage. Included are umbrella liability losses which are reinsured up to a limit of $10.0 million with a maximum $0.6 million retention. The State Auto Group also makes use of facultative reinsurance for unique risk situations and participates in involuntary pools and associations in certain states.
The potential impact of loss reserve variability on net income is quantifiable using the range end points and carried reserve amounts listed above. For example, if ultimate losses reach the high point of $763 million, the reserve increase of $15 million is an after-tax decrease of $9.8 million on net income. Likewise, should losses decline to the low end of $681 million, the $67 million reserve decrease would add $43.6 million of after-tax net income.
Currently, under SFAS 123 for pro-forma disclosure, the Company uses the Black-Scholes-Merton formula to estimate the value of stock options granted to employees and will continue to use this acceptable option valuation model upon the required adoption of SFAS 123(R) on January 1, 2006. Under SFAS 123, the Company recognized compensation cost over the explicit service vesting period and will continue to do so for share-based awards granted prior to the adoption of SFAS 123(R). Upon adoption of SFAS 123(R), the compensation cost attributable to an award granted to an employee who becomes eligible to retire prior to the end of the vesting period will be recognized over the period until the earliest date of eligible retirement. Had compensation expense been accelerated due to retirement eligibility, pro-forma stock compensation expense, net of tax would have been $4.2 million, $2.9 million and $2.3 million in 2005, 2004 and 2003, respectively.
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 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 herein.
The Pooling Arrangement does not relieve each individual pooled subsidiary of its primary liability as the originating insurer; consequently, there is a concentration of credit risk arising from business ceded to Mutual. As the Pooling Arrangement provides for the right of offset, the Company has reported losses and loss expenses payable and prepaid reinsurance premiums to Mutual as assets only in situations when net amounts ceded to Mutual exceed that assumed. The STFC Pooled Companies’ participation percentage was 80% for the years 2005, 2004 and 2003. All parties that participate in the Pooling Arrangement have an A.M. Best rating of A+ (Superior).
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was signed into law. The Act expanded Medicare to include, for the first time, coverage for prescription drugs. In May of 2004, the FASB issued FASB Staff Position 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-2”). FSP 106-2 provided guidance on accounting for the effects of the Act for employers that sponsor postretirement health care plans that provide drug benefits. The Company and its actuarial advisors completed a review of its plan provisions and concluded that the benefits provided by its plan are actuarially equivalent to Medicare Part D and will be entitled to the subsidy. The Company determined that the enactment of the Act was not a significant event and incorporated the effect of the Act in the most recent measurement date pursuant to FSP 106-2.
Reconciliations of statutory capital and surplus and net income (loss), as determined using statutory accounting principles, to the amounts included in the accompanying consolidated financial statements as of December 31, are as follows: