(5) GAAP ratios are computed using earned premiums for both the loss and LAE ratio and the expense ratio, and include the effect of eliminations in consolidation. The statutory expense ratio is computed using net written premiums. The Company uses the statutory combined ratio to compare its results to the industry statutory combined ratio as there is no industry GAAP combined ratio available.
Wholly owned non-insurance subsidiaries (direct and indirect) of State Auto Financial include:
Consolidated earned premiums increased $64.0 million (7.1%) to $960.6 million in 2003 from 2002. This increase was primarily the result of premium rate increases across all lines of business (see earned premium table below). The State Auto standard segment contributed a 14.0% increase to consolidated earned premiums in 2003 from 2002, while the State Auto non-standard segment contributed a 1.0% increase to consolidated earned premiums in the same period. Contributing also to the State Auto standard segment's increase was the migration of the Meridian standard segment's policies to the State Auto systems platform. These increases in earned premiums were partly offset by two factors: declines in the Meridian standard segment and an increase in premiums ceded to Mutual under the Stop Loss. The Meridian standard segment declined 6.7 points in 2003 from 2002. Contributing to this segment's decrease are the following: re-underwriting the policies migrating on renewal to the State Auto systems platform, as well as the non-renewal of policies due to significant rate increases and underwriting action taken that management believed were necessary to improve the underwriting performance of the Meridian book of business. The integration also includes the migration of Indiana business to affiliate companies outside the Pooled Companies. During the years 2003 and 2002, the STFC Pooled Companies ceded a total of $12.8 million and $1.4 million, respectively, in earned premiums to Mutual in accordance with the Stop Loss arrangement. The effect of the increased premiums ceded reduced consolidated earned premium by 1.2% in 2003 from 2002 (premiums ceded were 1.4% and 0.2% of consolidated earned premium for the years 2003 and 2002, respectively). The Stop Loss arrangement ended on December 31, 2003 and was not renewed. See the Stop Loss discussion below regarding loss and loss adjustment expense cession.
The following table summarizes the State Auto standard segment GAAP loss and LAE ratio by line of business for the years ended December 31, 2003 and 2002, respectively:
The State Auto standard segment GAAP loss and LAE ratio increased in 2002 to 69.4 from 65.9 in 2001. Catastrophe losses represented 5.7 points of this segment's loss results for 2002 compared to 4.4 points for 2001. With the significant increase in new business policy count came an increase in claim submissions. While general inflation has been relatively modest for the past several years, price inflation on goods and services for which insurance pays, such as medical care and repairs to automobiles and buildings, exceeded the rate of overall inflation and adversely impacted the GAAP loss and LAE ratio. The Company has reacted to this inflationary trend by filing more aggressive, cost-based, rate increases. Also contributing to the current year deterioration in the GAAP loss and LAE ratio were restrictions on the use of credit scoring in some states where the Company does business. To the extent these limitations result in higher loss ratios, the actuarial rate indications will increase resulting in larger rate increases being sought. The Company is also reviewing its credit scoring models to ensure that the premium rate derived from the model continues to accurately reflect the loss experience associated with each particular credit score range.
On October 1, 2003 State Auto Financial entered into an interest rate swap contract for a notional amount of $25.0 million as a hedge on the ten year treasury rate in connection with the forecasted issuance of the senior notes. The swap contract was designated as a cash flow hedge and settled on November 6, 2003, the pricing date of the senior notes, with the Company receiving $811,000. The gain has been recorded in accumulated other comprehensive income and is being accreted into interest expense as the underlying interest expense is recognized for the senior notes.
State Auto Financial used the senior notes proceeds to contribute additional paid in capital to its subsidiaries as follows: $39.0 million to State Auto P&C, $15.0 million to National (in addition to the $15.0 million contributed from the Trust Securities mentioned above) and $15.0 million to Milbank. See further discussion below regarding the leverage ratio. State Auto Financial also used the senior notes proceeds to repay $15.0 million of bank debt. See further discussion below regarding bank debt. State Auto Financial retained the balance for general corporate purposes and has since invested these funds in fixed maturities and common stocks.
The Company's decision to make a specific investment is influenced primarily by the following factors: (a) investment risks; (b) general market conditions; (c) relative valuations of investment vehicles; (d) general market interest rates; (e) the Company's liquidity requirements at any given time; and (f) the Company's current federal income tax position and relative spread between after tax yields on tax-exempt and taxable fixed income investments.
The effect of court decisions is also apparent in the commercial lines of coverages such as commercial multi-peril and other liability and products liability. Courts can expand coverage or void exclusions which can increase the Company's exposure to claims. Some of these third party claims may still be brought within the statute of limitations applicable to such third party claims and expose the Company to some retroactive liabilities. These liabilities are sought to be addressed by the ultimate loss and LAE reserve that is the Company's estimate of loss and loss expenses payable.
A tabular presentation of the current year $1.8 million development broken down by accident year is shown below derived from the Company's 2002 and 2003, 10 year loss development tables, as presented in the Reserves section of the Company's Form 10-K, "Narrative Description of Business" section. The development is measured in dollars and as a percentage of the total December 31, 2003 net loss and loss expense payable:
518 PML, an Ohio limited liability company, was formed to engage in the business of owning and leasing real and personal property to the Company's affiliates.
State Auto P&C, Milbank, Farmers, SA Ohio (the "STFC Pooled Companies"), SA Wisconsin and beginning January 1, 2003, SA Florida, participate in a quota share reinsurance pooling arrangement (the Pooling Arrangement) with Mutual whereby the STFC Pooled Companies, SA Wisconsin and SA Florida cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation percentages in the Pooling Arrangement. All premiums, losses and loss expenses and underwriting expenses are allocated among the participants on the basis of each company's participation percentage in the Pooling Arrangement. The Pooling Arrangement provides indemnification against loss or liability relating to insurance risk and has been accounted for as reinsurance.
A reconciliation between actual federal income tax expense (benefit) and the amount computed at the indicated statutory rate is as follows:
The standard insurance segments participate in a reinsurance pooling agreement with other standard insurance affiliates. For discussion regarding this arrangement and these segments' contribution to the pool and participation in the pool, see note 6. Revenues from external customers are derived entirely within the United States. Also, all long-lived assets are located within the United States.