MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTINUED
Federal income taxes decreased $2.3 million to $7.5 million. This decrease is reflective of the lower taxable income experienced by the Company in the current year. The effective tax rate decreased to 25% from 28% in 1995.
(g) INVESTMENTS Investments in fixed maturities, where the Companies have the ability and intent to hold to maturity, are carried at amortized cost. Accordingly, unrealized holding gains or losses are not reflected in the accompanying consolidated financial statements. Investments in fixed maturities and equity securities held as available for sale are carried at fair value. The net unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity, and are not included in the determination of net earnings. Gains and losses on the sale of equity securities are computed using the first-in, first-out method.
(l) NET EARNINGS PER COMMON SHARE In 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings per Share." SFAS No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to SFAS No. 128 presentation. For additional disclosure, see Note 12.
tive as of January 1, 1998, to include all of the property and casualty business of Midwest Security. Concurrently, with the inclusion of Midwest Security, the pooling participation percentages were amended to allocate 37% to State Auto P&C, 52% to Mutual, 10% to Milbank and 1% to Midwest Security. In connection with the January 1, 1998 change in pooling percentages, State Auto P&C received approximately $17.2 million to cover its increased share of pool liabilities. Pursuant to the pooling arrangement, Mutual is responsible for the collection of premiums and payment of losses, loss expenses and underwriting expenses of the pooled companies. Unpaid balances are reflected in due to or due from affiliates in the accompanying consolidated balance sheets. Settlements of the intercompany account are made quarterly. No interest is paid on this account. All premium balances receivable and reinsurance recoverable on paid losses from unaffiliated reinsurers are carried by Mutual. Effective July 1, 1996, the State Auto Insurance Companies (State Auto P&C, Mutual, Milbank and National) negotiated a change in their catastrophe reinsurance program. State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank and National pursuant to a catastrophe reinsurance agreement in the amount of $100 million excess of $120 million. To protect against a catastrophe loss event in which the State Auto Insurance Companies would incur catastrophe losses in excess of $120 million, the Company entered into a structured contingent financing transaction with Chase Manhattan Bank (Chase) to provide up to $100 million of additional reinsurance protection. Under this arrangement, in the event of such a loss, the Company would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which will borrow the money necessary for such purchase from Chase and a syndicate of other lenders. The Company will contribute to State Auto P&C the proceeds from the sale of its preferred shares. State Auto P&C will use the contributed capital to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. The Company is obligated to repay SPC by redeeming the preferred shares over a six year period. This layer of $100 million in excess of $120 million has been excluded from the pooling arrangement pursuant to the terms of the Amended and Restated Reinsurance Pooling Agreement, also effective July 1, 1996. In addition, the Company's obligation to repay SPC has been secured by a Put Agreement among the Company, Mutual and the Lenders, under which, in the event of a default by the Company, as described in the Credit Agreement or in the Put Agreement, Mutual would be obligated to put either the preferred shares or the loan(s) outstanding. The Company has reported ceded losses and loss expenses payable and prepaid reinsurance premiums as assets. The amounts reported represent State Auto P&C's pooling percentage of the total amounts ceded to unaffiliated reinsurers and National's ceded amounts. All contracts providing indemnification against loss or liability relating to insurance risk have been accounted for as reinsurance. Contracts for which it is not clear that the treaty results in the reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed have been accounted for as deposits.
State Auto P&C, Stateco and SIS are also participants with Mutual in a defined contribution plan that covers substantially all employees of Mutual, State Auto P&C, Stateco and SIS. Contributions to the plan are based on employee contributions and the level of Company match. State Auto P&C, Stateco and SIS's share of the expense under the plan totaled $581,000, $534,000 and $496,000 for the years 1997, 1996 and 1995, respectively.