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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[x] Annual Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 1997
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 (no fee required)
For the transition period from ___________ to _____________
Commission File Number 0-19289
STATE AUTO FINANCIAL CORPORATION
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(exact name of Registrant as specified in its charter)
Ohio 31-1324304
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
518 East Broad Street, Columbus, Ohio 43215-3976
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(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (614) 464-5000
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Shares, without par value
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(Title of class)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
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Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
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On March 18, 1998, the aggregate market value (based on the closing
sales price on that date) of the voting stock held by non-affiliates of the
Registrant was $223,002,710.
On March 18, 1998, the Registrant had 18,347,882 Common Shares
outstanding.
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DOCUMENTS INCORPORATED BY REFERENCE
1. Portions of the Registrant's Proxy Statement relating to the annual
meeting of shareholders to be held May 28, 1998, which Proxy Statement
will be filed within 120 days of December 31, 1997, are incorporated by
reference in Part III, Items 10, 11, 12 and 13 of this report.
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PART I
ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS
State Auto Financial Corporation, an Ohio corporation formed April 18,
1990 ("State Auto Financial" or "STFC"), is an insurance holding company
headquartered in Columbus, Ohio, which engages, through its subsidiaries,
primarily in the property and casualty insurance business. State Auto Financial
is approximately 65% owned by State Automobile Mutual Insurance Company, an Ohio
property and casualty insurance company formed in 1921 ("Mutual").
State Auto Financial's principal subsidiary is State Auto Property and
Casualty Insurance Company, a South Carolina corporation formed in 1950 ("State
Auto P&C"). State Auto P&C is a regional insurer engaged primarily in writing
personal and commercial automobile, homeowners, commercial multi-peril, workers'
compensation and fire insurance. State Auto P&C markets its insurance products
through approximately 11,300 independent insurance agents associated with
approximately 2,000 agencies in 24 states. Wisconsin was added as a new
operating territory in 1997. State Auto P&C's products are marketed primarily in
the central and eastern part of the United States, excluding New York, New
Jersey and the New England States.
Another subsidiary of State Auto Financial, Stateco Financial Services,
Inc., an Ohio corporation formed in 1962 ("Stateco"), provides investment
management services to affiliated companies and insurance premium finance
services to customers of State Auto P&C, Mutual and Milbank Insurance Company
("Milbank"), a wholly-owned subsidiary of Mutual.
State Auto P&C, Mutual, Milbank and Midwest Security (defined below)
are collectively referred to hereafter as the ("Pooled Companies"). The Pooled
Companies and National, defined below, are collectively referred to as the
("State Auto Group"). See "Business - Insurance Premium Finance Services" and
"Investment Management Services."
On May 16, 1991, Mutual contributed all of the stock of State Auto P&C,
which it had owned since 1958, and all of the stock of Stateco, which it had
owned since 1962, to State Auto Financial in exchange for all of the outstanding
common shares of State Auto Financial. State Auto P&C and Stateco thereby became
wholly-owned subsidiaries of State Auto Financial and State Auto Financial
continued as a wholly-owned subsidiary of Mutual.
On June 28, 1991, State Auto Financial completed an initial public
offering of 5,490,000 (adjusted to reflect a two-for-one stock split effected in
the form of a stock dividend declared in March 1993, and a three-for-two stock
split effected in the form of a stock dividend declared in May 1996 of its
common shares, which reduced Mutual's ownership interest in State Auto Financial
to approximately 68%.
On October 4, 1991, State Auto Financial formed an Ohio subsidiary,
State Auto National Insurance Company ("National"), which in February 1992 began
writing personal automobile insurance for non-standard risks.
Strategic Insurance Software, Inc. ("SIS") is an Ohio corporation
formed by State Auto Financial on January 12, 1995, which began operations in
July 1995. SIS develops and sells software for the processing of insurance
transactions, management of insurance policy data and electronic interfacing of
insurance policy information between insurance companies and agencies.
SIS is a majority-owned subsidiary of State Auto Financial.
On December 15, 1997, the Articles of Organization of 518 Property
Management and Leasing, LLC ("518 PML") were filed with the Ohio Secretary of
State. 518 PML is an Ohio limited liability company formed to engage in the
business of owning and leasing real and personal property to Mutual and its
affiliates. The members of 518 PML are State Auto P&C and Stateco.
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State Auto Financial and its subsidiaries, State Auto P&C, Stateco,
National, SIS, and 518 PML are collectively referred to as the ("Company").
Effective July 1, 1993, Mutual acquired Milbank, a South Dakota
domiciled property and casualty insurance company. In connection with the
closing of this purchase, on August 20, 1993, Mutual and State Auto Financial
entered into an Option Agreement whereby, subject to the approval of the South
Dakota Insurance Division, State Auto Financial may purchase Milbank from Mutual
at any time over the option term of five years for a price determined pursuant
to a formula set forth in the Option Agreement. On March 6, 1998, State Auto
Financial's Board of Directors approved a resolution affirming STFC's intent to
exercise this option and commenced the steps necessary to effect the transfer of
ownership of Milbank from Mutual to State Auto Financial. Following the closing
of State Auto Financial's acquisition of Milbank, which the parties anticipate
occurring effective July 1, 1998, Milbank will become a wholly-owned subsidiary
of State Auto Financial.
In March 1997, Mutual acquired 100% of the outstanding shares of
Midwest Security Insurance Company ("Midwest Security"), a Wisconsin domiciled
personal lines property and casualty insurer. Pursuant to the terms of the stock
purchase agreement, the transaction was effective as of January 1, 1997. In
connection with this transaction, Mutual and State Auto Financial entered into
an Option Agreement whereby, subject to the approval of the Office of the
Insurance Commissioner of the State of Wisconsin, State Auto Financial may
purchase Midwest Security at any time over the option term of five years at a
price calculated pursuant to a formula set forth in the Option Agreement. With
the acquisition of Midwest Security, the State Auto Group entered its 24th
state.
Since January 1, 1987, State Auto P&C has participated in an
underwriting pooling arrangement with Mutual. Under this arrangement, State Auto
P&C cedes to Mutual all of its property and casualty insurance business and
assumes from Mutual a portion of the combined property and casualty insurance
business of both State Auto P&C and Mutual. From January 1987 through December
1991, State Auto P&C assumed 20% of the combined business. Effective January 1,
1992, State Auto P&C's participation in the pool was increased to 30%. Effective
January 1, 1995, the pooling arrangement was amended to include all of the
property and casualty business of Milbank and the participation percentages were
changed to: Mutual 55%, State Auto P&C 35% and Milbank 10%. Effective July 1,
1996, the pooling arrangement was amended to exclude from the scope of such
arrangements catastrophe losses and premiums attributable thereto in excess of
$120,000,000 up to $220,000,000. See "Reinsurance." Subject to regulatory
approval of the domicilary insurance regulator of each of the pool participants,
pursuant to an Amended and Restated Reinsurance Pooling Agreement dated
effective as of January 1, 1998 Midwest Security has been added to the pooling
arrangement and concurrently the pooling percentages have been adjusted as
follows: Mutual 52%, State Auto P&C 37%, Milbank 10%, and Midwest Security 1%.
See "Pooling Arrangement."
Pursuant to an Amended and Restated Management Agreement and the
Midwest Management Agreement (defined below), State Auto P&C provides executive
management services for Mutual and its insurance subsidiaries. Mutual provides
non-executive employees and facilities for such entities. See "Management
Agreement."
(b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS.
The Company is of the opinion that all of its operations are within one
industry segment and that no information as to industry segments is required
pursuant to Statement of Financial Accounting Standards ("SFAS") No. 14 or
Regulation S-K. In June 1997, the Financial Accounting Standards Board issued
SFAS No. 131, "Disclosures about Segments of an Enterprise and Related
Information," which is effective for fiscal years beginning after December 15,
1997. SFAS No. 131 changes the way public companies report segment information
in annual financial statements and also requires those companies to report
selected segment information in interim financial reports to shareholders. The
Company has not yet determined the reporting changes required by SFAS No. 131.
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(c) SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM
ACT OF 1995.
Statements contained herein expressing the beliefs of management and
the other statements which are not historical facts contained in this report are
forward looking statements that involve risks and uncertainties. These risks and
uncertainties include but are not limited to: legislative, judicial, and
regulatory changes, the impact of competitive products and pricing, product
development, geographic spread of risk, weather and weather-related events,
other types of catastrophic events, fluctuations of securities markets, economic
conditions, and technological difficulties and advancements.
(d) NARRATIVE DESCRIPTION OF BUSINESS.
PROPERTY AND CASUALTY UNDERWRITING
The Company writes personal and commercial property and casualty
insurance lines, including automobile, homeowners, commercial multi-peril,
workers' compensation, liability, fire and other lines of business. Independent
insurance agencies constitute the Company's sales force.
The following table sets forth for each of the last three fiscal years
the amount of the Company's net premiums earned by line of insurance:
Net Premiums Earned (1)(2)
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Year Ended December 31
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1997 1996 1995
---- ---- ----
(in thousands)
Automobile.............................. $151,886 $141,486 $136,825
Homeowners and farmowners............... 40,689 40,184 40,043
Commercial multi-peril.................. 15,471 14,207 13,297
Workers' compensation................... 9,804 11,572 13,548
Fire and allied lines................... 16,756 15,341 14,200
Other commercial liability.............. 11,950 10,483 8,731
Other personal lines.................... 7,191 6,194 5,101
Other commercial lines.................. 935 878 779
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Total................................. $254,682 $240,345 $232,524
======== ======== ========
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(1) The Company earns premiums ratably over the life of an insurance
policy. Net premiums earned are the portion of net premiums written in
both the year in question and prior years, which are applicable to the
expired period of policies.
(2) This reflects net premiums earned by State Auto P&C, after giving
effect to reinsurance and to the pooling arrangement, plus the net
premiums earned by National, the only other insurance subsidiary of
State Auto Financial.
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As mentioned above, the insurance business of Mutual, State Auto P&C,
Milbank and as of January 1, 1998, (subject to regulatory approval) Midwest
Security is combined through the pooling arrangement giving each company an
identical mix of personal and commercial business as written by all three
insurers. The Pooled Companies products' sales are predominantly personal lines.
However, the Pooled Companies are putting greater emphasis on expanding
penetration into the commercial lines market. Commercial lines are being
introduced in Wisconsin in the second quarter of 1998, approximately one year
after closing on the purchase of Midwest Security.
The insurance business of National, with the exception of amounts
reinsured with Mutual, is not included in the pooling arrangement and,
therefore, remains 100% in the Company. See "Pooling
6
Arrangement." National's products are personal lines auto insurance products
written for non-standard risks, with less restrictive underwriting criteria and
higher rates than those applicable to standard risks.
The Company uses computer-based underwriting procedures for personal
lines business. Under such procedures, applications for such business may be
accepted or rejected based upon established underwriting guidelines.
Applications that do not meet guidelines for automated acceptance are referred
to personal lines specialists who review the applications and assess exposure.
During the underwriting process, risks are also reviewed to determine whether or
not they are acceptable as submitted by the independent agents as preferred,
standard or non-standard risks. Personal lines specialists continue to have
significant responsibility for encouraging the Company's agency force to sell
its personal lines products.
POOLING ARRANGEMENT
Since January 1987, State Auto P&C and Mutual have participated in an
intercompany pooling arrangement. Under the terms of the pooling arrangement,
State Auto P&C ceded all of its insurance business to Mutual. All of Mutual's
property and casualty insurance business was also included in the pooled
business. Mutual then ceded a percentage of the pooled business to State Auto
P&C and retained the balance. From January 1987 through December 31, 1991, State
Auto P&C assumed 20% of the pooled business. Effective January 1, 1992, State
Auto P&C increased its percentage of the pool to 30%. Effective January 1, 1995,
the pooling arrangement was amended to include all of the property and casualty
business of Milbank. Concurrently with the inclusion of Milbank, the
participation percentages were amended as follows: Mutual 55%, State Auto P&C
35% and Milbank 10%. Subject to regulatory approval, effective January 1, 1998,
Midwest Security has been added to the pooling arrangement pursuant to an
Amended and Restated Reinsurance Pooling Agreement dated January 1, 1998 (the
"98 Pooling Agreement") which agreement also amended the participation
percentages as follows: Mutual 52%, State auto P&C 37%, Milbank 10%, and Midwest
Security 1%.
The pooling percentages are reviewed by management at least annually,
and more often if deemed appropriate by management or the Board of Directors of
each company, to determine whether any adjustments should be made. Future
adjustments in the pooling percentages are expected to be based on the
performance of the insurance operations of Mutual, State Auto P&C, Milbank and
Midwest Security, the growth in direct premiums written of each company as it
relates to the pooling percentages, the combined ratio of the pooled business
and the net premiums written of the pooled business in relation to the statutory
capital and surplus of Mutual, State Auto P&C, Milbank, and Midwest Security
respectively, among other factors. Management of each of the Pooled Companies
makes recommendations to a four-member coordinating committee consisting of two
members of Mutual's Board of Directors and two members of State Auto Financial's
Board of Directors. The coordinating committee reviews and evaluates various
factors relevant to the pooling percentages and recommends any appropriate
pooling change to the Boards of both Mutual and State Auto Financial. See
"Management Agreement." The pooling arrangement is terminable by any party on 90
days notice or by mutual agreement of the parties. Neither Mutual, State Auto
P&C, Milbank, nor Midwest Security currently intends to terminate the pooling
arrangement.
The pooling arrangement is designed to produce more uniform and stable
underwriting results for State Auto P&C, Mutual, Milbank and Midwest Security
than any one company would experience individually, by spreading the risk among
each of the participants. Under the terms of the pooling arrangement, all
premiums, incurred losses, loss expenses and other underwriting expenses are
prorated among the companies on the basis of their participation in the pool.
One effect of the pooling arrangement is to give State Auto P&C, Mutual, Milbank
and Midwest Security an identical mix of property and casualty insurance
business on a net basis.
The terms of the pooling arrangement were amended in December 1993 to
clarify that certain liabilities created by FASB 106 (post-retirement health
care benefits liability) and FASB 112 (post employment benefits liability) which
did not exist when the pooling arrangement was initiated are to be carried by
Mutual and not pooled except for those liabilities associated with the transfer
of certain executives to State Auto P&C. See "Management Agreement."
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An Amended and Restated Reinsurance Pooling Agreement was executed to
be effective as of July 1, 1996 as a consequence of a reinsurance transaction
entered into by State Auto P&C. The sole substantive change effected by this
agreement was to exclude from the scope of the pooling arrangement catastrophic
loss claims and loss adjustment expenses insured by State Auto P&C, Mutual and
Milbank in the amount of $100,000,000 in excess of $120,000,000 but less than
$220,000,000 and the premium for such exposures. State Auto P&C has become the
reinsurer for each member of the State Auto Group of property casualty companies
(except Midwest Security) for this layer of reinsurance under a Catastrophe
Assumption Agreement. See "Reinsurance."
The following table sets forth the loss ratios by line of insurance and
the combined ratios for the Company, prepared in accordance with accounting
practices prescribed or permitted by state insurance authorities, for the
periods indicated. The loss ratio is the ratio of incurred losses and associated
expenses to net earned premiums ("loss ratio"). The combined ratio is a
traditional measure of underwriting profitability. The combined ratio is the sum
of (a) the loss ratio; and (b) the ratio of expenses incurred for commissions,
premium taxes, administrative and other underwriting expenses, to net written
premium ("expense ratio"). When the combined ratio is under 100%, underwriting
results are generally considered profitable. Conversely, when the combined ratio
is over 100%, underwriting results are generally considered unprofitable. The
combined ratio does not reflect investment income or federal income taxes. The
Company's operating income depends on income from underwriting operations,
investments and management fees.
Year Ended December 31(1)
-------------------------
1997 1996 1995
---- ---- ----
Loss ratios:
Automobile................................. 65.5% 69.5% 74.1%
Homeowners and Farmowners.................. 71.0% 101.7% 73.1%
Commercial multi-peril..................... 72.5% 70.1% 66.6%
Workers' compensation...................... 64.3% 46.8% 38.6%
Fire and allied lines...................... 58.6% 76.4% 49.4%
Other commercial liability................. 64.9% 56.5% 69.7%
Other personal lines....................... 34.2% 34.9% 32.5%
Other commercial lines..................... 17.0% 11.0% 13.0%
----- ------ -----
Total loss ratio................................ 65.2% 72.6% 68.6%
Expense ratio................................... 27.9% 26.4% 30.1%
===== ====== =====
Combined ratio.................................. 93.1% 99.0% 98.7%
===== ====== =====
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(1) This reflects a combination of the loss ratios of State Auto P&C and
National, after giving effect to reinsurance and the pooling
arrangement as amended effective July 1, 1996.
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NON-STANDARD AUTOMOBILE INSURANCE
In October 1991, State Auto Financial formed National, to write
personal automobile insurance for nonstandard risks. National began writing
insurance in Ohio in February 1992. It began writing in West Virginia in October
1993, Tennessee and Mississippi during August 1994 and Kentucky during March
1995. It entered Arkansas and Georgia in December 1996, Minnesota in February
1997. Later in 1997, it began to do business in Alabama, Illinois and Missouri.
Currently licensed in seven (7) additional states and seeking certificates of
authority in at least three more, National presently anticipates beginning
operations in at least five (5) of these states during 1998. Nonstandard
automobile products provide insurance for private passenger automobile risks
that are typically rejected or canceled by standard market companies because
insureds have poor loss experience or a history of late payments of premium.
Nonstandard products are priced to account for the additional risk and expenses
normally associated with this market.
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MARKETING
The Company entered Wisconsin in 1997, its 24th state of operations. In
its twenty-four states, it markets its products through approximately 11,300
insurance agents associated with approximately 2,000 independent insurance
agencies. Neither the Company, Mutual, Milbank, nor Midwest Security has any
contracts with managing general agencies. National is also marketing its
non-standard products through the Company's existing network of independent
agents in its states of operation.
Because independent insurance agents have significant influence over
which insurance company will be selected to write insurance policies for their
customers, management views the State Auto Group's independent insurance agents
as the primary customers of the Company. Management strongly supports the
independent agency system and believes that maintenance of a strong agency
system is essential for the Company's present and future success. Programs and
procedures have been implemented and are continually being developed to enhance
agency relationships. Senior management and branch office staff regularly travel
to states in which the Company does business to meet with agents. The Company
has instituted training programs which involve both products training and sales
training on how to market insurance products with disciplined follow up and
coaching. The Company is actively involved in promoting single entry
multi-company electronic interface which creates efficiencies for both agencies
and the Company. The use of electronic interface is growing among the Company's
agencies. Several software tools to facilitate this process are available,
including software called Semci Partner(R) developed and marketed by SIS. The
Company and Mutual are actively encouraging their agencies to utilize Semci
Partner(R). Also, the Company provides agents with certain travel and cash
incentives if they achieve certain sales and underwriting profit levels. As a
further incentive, the Company recognizes its very top agencies as Inner Circle
Agents and distinguishes them with various additional trip and financial
incentives including bonus commissions for those Inner Circle Agents who
participate in the agent stock purchase plan described below. Finally, the
Company shares with selected agencies the cost of certain approved advertising.
In an effort to strengthen agency commitment to producing profitable
business and further develop its relationships with its agency force, the
Company has a plan whereby agents can apply a portion of their commission income
towards purchasing stock of the Company on a monthly basis. The plan is
administered by the Company's transfer agent which uses commission dollars
assigned by agents to purchase shares through a broker on a monthly basis. As of
year end 1997, there were 384 agents participating in this agent stock purchase
plan.
Under the Company's agency agreements with independent insurance
agents, each agent is authorized to sell and bind insurance coverages in
accordance with established procedures and to collect and remit premiums. The
authority of agents to bind an insurance company is common practice in the
property and casualty insurance industry. The risk to the Company is minimized
because it has the right to terminate coverage on a risk or policy bound by the
agent. In addition, the Company does not grant binding authority to agents on
risks it considers to present a greater than normal exposure to loss. Each agent
receives a percentage of direct premiums written as a commission and a share of
the underwriting profits generated by insurance placed by them as bonus
compensation subject to certain qualifying conditions as set forth in the agency
agreement.
The Company receives premiums on products marketed in Alabama,
Arkansas, Florida, Georgia, Illinois, Indiana, Kentucky, Maryland, Michigan,
Minnesota, Mississippi, Missouri, North Carolina, North Dakota, Ohio, Oklahoma,
Pennsylvania, South Carolina, South Dakota, Tennessee, Utah, Virginia, West
Virginia and Wisconsin. For the year ended December 31, 1997, the seven states
that contributed the greatest percentage of direct premiums written to the State
Auto Group were Ohio (21.3%), Kentucky (10.4%), Tennessee (8.8%), South Carolina
(5.4%), North Carolina (5.2%), Maryland (5.2%), and Minnesota (4.7%).
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CLAIMS
Insurance claims on policies written by the Company are usually
investigated and settled by staff claims adjusters. The Company's claims policy
emphasizes timely investigation of claims, settlement of meritorious claims for
equitable amounts, maintenance of adequate reserves for claims, and control of
external claims adjustment expenses. This claims policy is designed to support
the Company's marketing efforts by providing agents and policyholders with
prompt service.
Claim settlement authority levels are established for each adjuster,
supervisor and manager based on his or her level of expertise and experience.
Upon receipt, each claim is reviewed and assigned to an adjuster based upon its
type, severity and class of insurance. The claims department is responsible for
reviewing the claim, obtaining necessary documentation and establishing loss and
expense reserves of certain claims. Any property or casualty claims estimated to
reach $100,000 or above are sent to the home office to be supervised by claims
department specialists. In territories in which there is not sufficient volume
to justify having full-time adjusters, the Company uses independent appraisers
and adjusters to evaluate and settle claims under the supervision of claims
department personnel.
The Company attempts to minimize claims costs by using its internal
claims staff to settle as many claims as possible, and, if possible, by settling
disputes regarding automobile physical damage and property insurance claims
(first party claims) through arbitration. In addition, selected agents have
authority to settle small first party claims which improves claims service. The
Company's in-house trial counsel operation created in Cleveland, Ohio in 1993 to
represent insureds in third party claim litigation has achieved its objectives
of reducing the cost of defending claims. A third attorney was added to the
Cleveland Office in 1997 and a fourth is planned for 1998. Presently, the
Company also has a two lawyer in-house trial counsel's office in Baltimore,
Maryland. It has no immediate plans to add in-house trial counsel in any other
territories where it operates.
The third party proprietary software installed in 1996 to assist claims
adjusters in evaluating bodily injury claims, except for the most severe injury
cases, continues to be a valuable tool in assisting adjusters in negotiating
bodily injury settlements more effectively.
INVESTMENT MANAGEMENT SERVICES
Stateco has been providing investment management services since April
1, 1993. These services are provided to all insurance companies affiliated with
the Company or Mutual, including Mutual, Milbank, Midwest Security, State Auto
P&C and National. Stateco has entered into an Investment Management Agreement
with each of these entities, pursuant to which Stateco manages the investment
portfolios of these companies and receives an investment management fee based on
performance and the size of the portfolio managed for each affiliate. Stateco
has presented proposals to other potential clients although Stateco has not yet
reached an agreement to engage in investment management services on behalf of a
non-affiliated company.
INSURANCE PREMIUM FINANCE SERVICES
Through Stateco, the Company provides insurance premium finance
services to certain policyholders of Mutual, State Auto P&C and Milbank.
Premiums for property and casualty insurance are typically payable at the time a
policy is placed in force or renewed. On certain large commercial policies, the
premium cost may be difficult for a policyholder to pay in one sum. Stateco
makes loans to commercial insurance policyholders for the term of an insurance
policy to enable them to pay the insurance premium in installments over the term
of the policy, and retains a contractual right to cancel the insurance policy if
the loan installment is not paid on a timely basis. As of December 31, 1997,
Stateco had a net loan receivable balance from policyholders of these companies
of approximately $728,000.
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INSURANCE SOFTWARE BUSINESS
SIS is developing and selling software used by insurance companies and
agencies to allow more efficient and effective electronic management and
communication of policyholder data from insurers to agents (download) and from
agents to insurers (upload). SIS' principal product, Semci Partner(R), is an
alternative to significantly more costly agency management systems which SIS
believes will be attractive to a substantial segment of independent insurance
agencies. While SIS' principal customer is Mutual, it has sold and continues to
sell Semci Partner(R) directly to agents, including agents who do not
represent the State Auto Group. In addition, in 1997 it introduced a new product
called Partner Plus which includes insurance agency accounting software in
addition to the regular features of Semci Partner(R). SIS' revenue from Semci
Partner(R) and other SIS software sales is not material to the Company at
this time.
PROPERTY LEASING BUSINESS
As noted above, the Company formed 518 PML, an Ohio limited liability
company in December 1997. The initial members of 518 PML are Stateco and State
Auto P&C. Stateco contributed $7,000,000 in cash and a parcel of real property
located in Goodlettsville, Tennessee, while State Auto P&C contributed real
property located in Greer, South Carolina. 518 PML plans to develop an office
building on the real estate in Goodlettsville which it expects to lease to
Mutual for Mutual's Nashville Regional Office facility commencing in the summer
of 1999. 518 PML has leased the Greer property to Mutual to use as its Southern
Regional Office facility. Revenue from 518 PML is not material to the Company at
this time.
MANAGEMENT AGREEMENT
The Company operates and manages its business in conjunction with
Mutual and Milbank under a management agreement which was restructured pursuant
to an Amended and Restated Management Agreement effective April 1, 1994. Under
this agreement, State Auto P&C provides executive management services for
Mutual, Milbank, and National, overseeing the insurance operations of all these
companies all of which are parties to the agreement. State Auto P&C does not
provide investment management services, because these services are provided by
Stateco. See "Investment Management Services." A management fee is paid by
Mutual, Milbank, and National for the services provided by State Auto P&C equal
to 2% of the five year average of annual statutory statement "surplus as regards
policyholders", less valuations for managed subsidiaries, of each managed
company. (State Auto Life Insurance Company ("State Auto Life") paid such a
management fee; however, Mutual sold State Auto Life in July 1997). The Amended
and Restated Management Agreement also imposes a performance standard which
could result in State Auto P&C not being entitled to the fee for a particular
quarter if a managed company's performance does not meet the standard
incorporated in the agreement. Management believes that the amount of the
management fee charged is fair and reasonable. In 1997, the managed companies
paid a management fee of $5,416,000 to State Auto P&C.
In addition to the above-described Amended and Restated Management
Agreement, the Company and Mutual entered into a Management Agreement with
Midwest Security effective as of January 1, 1997 (the "Midwest Management
Agreement"). Mutual is providing clerical and non-executive employees to Midwest
Security. The Company provides executive management services to Midwest Security
in return for a management fee. Under this agreement, the Company's management
fee is based on direct written premium of Midwest Security. The fee set for 1997
was 0.75% of direct written premium of Midwest Security and it includes a
performance standard, as well. In 1997, Midwest Security paid a management fee
of $162,000 to State Auto P&C.
Under the Amended and Restated Management Agreement, Mutual provides
the Company with the facilities, clerical personnel and other non-executive
employees necessary to run its day-to-day operations. All costs incurred by
Mutual with respect to underwriting expenses and loss expenses incurred on
behalf of Mutual, State Auto P&C, Milbank, and from January 1998 forward,
Midwest Security, continue to be shared pro rata between Mutual, State Auto P&C,
Milbank, and Midwest Security through the pooling arrangement. "See Pooling
Arrangement." For companies not participating in the pooling arrangement, like
National, expenses directly attributable to a particular company continue to be
charged
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to that company and expenses of personnel who are not dedicated entirely to work
for a particular company are allocated among the companies based on an estimate
of time devoted by such personnel to each company for which services are
rendered. Mutual also charges rent, which is determined under statutory
accounting principles, to each company which has dedicated space within Mutual's
facilities (currently National and Stateco).
The Amended and Restated Management Agreement and the Midwest
Management Agreement set forth procedures for potential conflicts of interest.
Generally, business opportunities presented to the common officers of the
companies, other than business opportunities that meet certain criteria, must be
presented to a four-member coordinating committee consisting of two directors of
Mutual, who represent the interests of Mutual and its subsidiaries, and two
directors of the Company, who represent the interests of the Company and its
subsidiaries. This committee reviews and evaluates the business opportunity
using such factors as it considers relevant. Based upon such review and
evaluation, this committee then makes recommendations to the respective boards
of directors as to whether or not such business opportunity should be pursued
and if so, by which company. The boards of directors of Mutual and of the
Company and, when appropriate, a subsidiary, must then act on the recommendation
of the committee after considering all other factors they deem relevant.
The Amended and Restated Management Agreement has a ten year term
ending March 31, 2004, and automatically renews for an additional ten year term
unless any of the managed companies terminates its participation, or the
manager, State Auto P&C, terminates the agreement upon not less than two years
advance written notice of nonrenewal. The Midwest Management Agreement also has
a ten year term ending December 31, 2006 and automatically renews for an
additional ten year term unless sooner terminated in accordance with its
provisions. The Amended and Restated Management Agreement may also be terminated
by any of the managed companies upon events constituting a change of control or
potential change of control (as defined in the Amended and Restated Management
Agreement) of the Company, upon agreement between a managed company and State
Auto P&C and, the agreement is terminated automatically with respect to a party
if it is subject to insolvency proceedings. Milbank may terminate its
participation in the Amended and Restated Management Agreement upon 120 days
notice. If the Amended and Restated Management Agreement is terminated for any
reason, the Company would have to locate facilities, personnel and management to
continue its operations.
RESERVES
Loss reserves are estimates at a given point in time of what an insurer
expects to pay to claimants, based on facts, circumstances and historical trends
then known. It can be expected that the ultimate liability will exceed or be
less than such estimates. During the loss settlement period, additional facts
regarding individual claims may become known, and consequently it often becomes
necessary to refine and adjust the estimates of liability.
The Company maintains reserves for the eventual payment of losses and
loss expenses for both reported claims and incurred claims that have not yet
been reported. Loss expense reserves are intended to cover the ultimate costs of
settling all losses, including investigation and litigation costs from such
losses.
Reserves for reported losses are established on either a case-by-case
or formula basis depending on the type and circumstances of the loss. The
case-by-case reserve amounts are determined based on the Company's reserving
practices, which take into account the type of risk, the circumstances
surrounding each claim and policy provisions relating to types of loss. The
formula reserves are based on historical paid loss data for similar claims with
provisions for trend changes caused by inflation. Loss and loss expense reserves
for incurred claims that have not yet been reported are estimated based on many
variables including historical and statistical information, inflation, legal
developments, storm loss estimates, and economic conditions. Loss reserves are
reviewed on a regular basis and as new data becomes available, estimates are
updated resulting in adjustments to loss reserves. Although management uses many
resources to calculate reserves, there is no precise method for determining the
ultimate liability. The Company does not discount loss reserves for financial
statement purposes.
12
Mutual has guaranteed the adequacy of State Auto P&C's loss and loss
expense reserves as of December 31, 1990. Pursuant to the guarantee, Mutual has
agreed to reimburse State Auto P&C for any losses and loss expenses in excess of
State Auto P&C's December 31, 1990 reserves ($65,464,000) that may develop from
claims that have occurred on or prior to that date. This guarantee ensures that
any deficiency in the reserves of State Auto P&C as of December 31, 1990, under
the pooling arrangement percentages effective on December 31, 1990, will be
reimbursed by Mutual. As of December 31, 1997, there has been no adverse
development of these reserves. In the event Mutual becomes financially impaired,
and subject to regulatory restrictions, it may be unable to make any such
reimbursement.
The following table presents one year development information on
changes in the reserve for loss and loss expenses of the Company for the three
years ended December 31, 1997:
Year Ended December 31
-------------------------------------------------
1997 1996 1995
---- ---- ----
(in thousands)
Reserve for losses and loss expenses
at beginning of year(1) $156,184 $161,297 $126,742
-------- -------- --------
Provision for losses and loss
expenses occurring:
Current year 179,295 194,568 171,449
Prior years(2) (13,505) (21,028) (12,536)
-------- -------- --------
Total 165,790 173,540 158,913
-------- -------- --------
Loss and loss expense payments
for claims occurring during:
Current year 107,537 116,983 95,011
Prior years 61,862 61,670 62,248
-------- -------- --------
Total 169,399 178,653 157,259
-------- -------- --------
Impact of pooling change 1/1/95 -- -- 32,901
-------- -------- --------
Reserve for losses and loss expenses
at end of year (1) $152,575 $156,184 $161,297
======== ======== ========
- ---------------
(1) This line item is net of reinsurance receivable on losses and loss
expenses payable of approximately $9,871,000, $9,691,000, and
$9,278,000, for the years 1997, 1996 and 1995, respectively.
(2) This line item shows redundancies in the provision for losses and loss
expenses attributable to prior years in the amounts of approximately
$13,505,000, $21,028,000, and $12,536,000, for the years 1997, 1996 and
1995, respectively. These decreases have resulted primarily from
moderating trends in the frequency and severity of losses and loss
expenses due to lower inflation. This along with fundamental
improvements primarily in the auto liability line of business resulted
in incurred losses and loss expenses developing favorably.
- ----------------
The following table sets forth the development of reserves for losses
and loss expenses from 1987 through 1997 for the Company. "Net liability for
losses and loss expenses payable" sets forth the estimated liability for unpaid
losses and loss expenses recorded at the balance sheet date, net of reinsurance
recoverables, for each of the indicated years. This liability represents the
estimated amount of losses and loss expenses for claims arising in the current
and all prior years that are unpaid at the balance sheet date, including losses
incurred but not reported to the Company.
The lower portion of the table shows the re-estimated amounts of the
previously reported reserve based on experience as of the end of each succeeding
year. The estimate is increased or decreased as more information becomes known
about the claims incurred.
13
The upper section of the table shows the cumulative amounts paid with
respect to the previously reported reserve as of the end of each succeeding
year. For example, through December 31, 1997, the Company had paid 86.5% of the
currently estimated losses and loss expenses that had been incurred, but not
paid, as of December 31, 1988.
The amounts on the "cumulative redundancy (deficiency)" line represent
the aggregate change in the estimates over all prior years. For example, the
1987 reserve has developed a $2,381,000 redundancy over ten years. That amount
has been included in operations over the ten years and did not have a
significant effect on income of any one year. The effects on income caused by
changes in estimates of the reserves for losses and loss expenses for the most
recent three years are shown in the foregoing three-year loss development table.
In evaluating the information in the table, it should be noted that
each amount includes the effects of all changes in amounts for prior periods.
For example, the amount of the redundancy related to losses settled in 1990, but
incurred in 1987, will be included in the cumulative redundancy amount for years
1987, 1988 and 1989. The table does not present accident or policy year
development data, which readers may be more accustomed to analyzing. Conditions
and trends that have affected the development of the liability in the past may
not necessarily occur in the future. Accordingly, it may not be appropriate to
extrapolate future redundancies or deficiencies based on this table.
Participation in the pooling arrangement is reflected beginning in
1987. On January 1, 1987, as a result of the reinsurance pooling arrangement
commencing on that date, State Auto P&C's obligation for unpaid losses and loss
expenses was redefined from its former obligation to 20% of the obligations of
State Auto P&C and Mutual combined. The result of initial pooling increased
State Auto P&C's liability for losses and loss expenses. This is reflected in
the first line of the 1987 column. Effective, January 1, 1992, the pooling
percentage was changed whereby State Auto P&C increased its share in the pooled
losses and loss expenses from 20% to 30%. This increase is reflected in the 1992
column. Effective January 1, 1995, the pooling percentage was again changed
adding Milbank to the pool and increasing State Auto P&C's share in the pooled
losses and loss expenses from 30% to 35%. This increase is reflected in the 1995
column. An amount of assets equal to the increase in net liabilities was
transferred to State Auto P&C from Mutual in 1987, 1992 and 1995 in conjunction
with each year's respective pooling change. The amount of the assets transferred
from Mutual in 1992 and 1995 has been netted against and has reduced the
cumulative amounts paid for years prior to 1992 for the January 1, 1992 pooling
change and for years prior to 1995 for the January 1, 1995 pooling change.
[See table on following page.]
14
State Auto Financial Corp.
Years Ended December 31
-------------------------------------------------------------------------------------------------
1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
(Dollars in Thousands)
Net liability for losses
and loss expenses payable $45,771 $51,142 $58,203 $65,464 $71,139 $119,044 $123,337 $126,743 $161,298 $156,184 $152,575
Paid (cumulative)
as of:
One year later 47.8% 47.7% 48.1% 43.3% 12.2% 41.3% 42.2% 23.2% 38.2% 39.6% --
Two years later 68.6% 65.7% 68.8% 46.1% 43.0% 60.9% 52.9% 44.6% 55.5%
Three years later 78.1% 76.0% 70.9% 62.9% 58.7% 67.3% 64.0% 56.6%
Four years later 82.6% 76.1% 79.9% 71.8% 64.4% 73.0% 70.9%
Five years later 81.7% 80.8% 84.4% 75.7% 68.7% 76.0%
Six years later 84.3% 83.0% 85.9% 78.3% 71.5%
Seven years later 85.8% 83.8% 88.0% 80.0%
Eight years later 86.4% 85.4% 89.3%
Nine years later 87.6% 86.5%
Ten years later 88.7%
Net liability re-estimate
as of:
One year later 94.1% 93.7% 98.0% 95.4% 91.2% 92.7% 93.7% 90.1% 87.0% 91.4% --
Two years later 93.2% 91.6% 97.4% 92.1% 87.2% 90.5% 90.8% 82.1% 86.4%
Three years later 92.2% 91.3% 95.9% 89.7% 85.4% 88.2% 86.9% 82.0%
Four years later 92.1% 90.4% 95.4% 88.1% 84.7% 86.6% 87.9%
Five years later 91.2% 90.6% 95.0% 89.3% 83.0% 88.0%
Six years later 91.6% 89.9% 95.9% 88.3% 86.4%
Seven years later 90.8% 91.5% 95.4% 92.1%
Eight years later 93.2% 91.3% 99.0%
Nine years later 93.1% 94.1%
Ten years later 94.8%
Cumulative redundancy
(deficiency) $2,381 $3,006 $590 $5,185 $9,651 $14,256 $14,905 $22,826 $21,900 $13,505 --
Cumulative redundancy
(deficiency) 5.2% 5.9% 1.0% 7.9% 13.6% 12.0% 12.1% 18.0% 13.6% 8.6% --
Gross* liability - end of year $165,875 $162,446
Reinsurance receivable $9,691 $9,871
Net liability - end of year $156,184 $152,575
Gross liability re-estimated - latest 92.8%
Reinsurance receivable re-estimated -latest 116.4%
Net liability re-estimated - latest 91.4%
* Gross liability includes: Direct & assumed losses & loss expenses payable.
15
The following table is a reconciliation as of each December 31 of
losses and loss expenses payable, computed under generally accepted accounting
principles ("GAAP"), to losses and loss expenses payable, computed under
statutory accounting principles used by insurance companies for reporting to
state insurance regulators ("STAT"):
1997 1996 1995
---- ---- ----
(in thousands)
GAAP losses and loss
expenses payable $162,446 $165,875 $170,575
Less: reinsurance receivable
on losses 9,871 9,691 9,278
Add: salvage and subrogation
recoverable 8,487 8,265 7,378
-------- -------- --------
STAT losses and loss
expenses payable $161,062 $164,449 $168,675
======== ======== ========
INVESTMENTS
The Company's investment portfolio is managed to provide growth of
statutory surplus in order to facilitate increased premium writings over the
long term while maintaining the ability to service current insurance operations.
The primary objectives are to generate income, preserve capital and maintain
liquidity. The Company's investment portfolio is managed separately from that of
Mutual and its affiliates and investment results are not shared by Mutual, State
Auto P&C, Milbank, and Midwest Security through the pooling arrangement. The
Company has investment policy guidelines with respect to purchasing fixed income
investments which preclude investments in bonds that are rated below investment
grade by a recognized rating service. The maximum investment in any single note
or bond is limited to 2.0% of assets, other than obligations of the U.S.
government or government agencies, for which there is no limit. 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 investment management
services on behalf of the Company and Mutual and its subsidiaries are performed
by Stateco, although investment policies to be implemented by Stateco continue
to be set for each company through the Investment Committee of its Board of
Directors. See "Investment Management Services."
Strategies as to specific investments can change depending on the
Company's current federal tax position, market interest rates and general market
conditions. Consequently, pursuant to the Statement of Financial Accounting
Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," adopted effective December 31, 1993, the Company segregates a
portion of its fixed maturity investments for the purpose of providing greater
flexibility in the investment portfolio. Fixed maturities that are purchased
with the intention and ability of holding them until maturity are categorized as
held-to-maturity and carried at amortized cost. Fixed maturities that may be
sold, thereby providing the Company the flexibity noted above, are categorized
as available-for-sale and are carried at fair value. Fixed maturities
available-for-sale totaled $320.3 million and $294.1 million at December 31,
1997 and 1996, respectively.
During 1997, the Company began a program to build an equity portfolio
to enhance growth of surplus over the long term. At December 31, 1997, the
equity portfolio totaled $4.6 million.
16
The table below provides information about the quality of the Company's fixed
maturity portfolio
Bond Portfolio Quality
Investment Grade Corporates 62.1%
and Municipals
U.S. Governments 24.3%
U.S. Government Agencies 13.6%
The following table sets forth the Company's investment results for the periods
indicated:
Year Ended December 31
---------------------------------------------------
1997 1996 1995
---- ---- ----
(Dollars in thousands)
Average invested assets (1) $399,628 $376,280 $348,515
Net investment income (2) $25,078 $23,879 $22,617
Average yield 6.24% 6.35% 6.49%
- --------------
(1) Average of the aggregate invested assets at the beginning and end of
each period. Invested assets include fixed maturities at amortized
cost, equity securities at cost and cash equivalents.
(2) Net investment income is net of investment expenses and does not
include realized or unrealized investment gains or losses or provision
for income taxes.
- --------------
REGULATION
The Company. Most states have enacted legislation that regulates
insurance holding company systems. Ohio, the domiciliary state of Mutual and
National, has adopted legislation regulating the activities of those companies.
South Carolina has adopted legislation regulating the activities of State Auto
P&C as the South Carolina domiciled member of the holding company system, as
have South Dakota and Wisconsin which are the domiciliary regulators of Milbank
and Midwest Security, respectively. Each insurance company in the holding
company system is required to register with the insurance supervisory agency of
its state of domicile and furnish information concerning the operations of
companies within the holding company system that may materially affect the
operations, management or financial condition of the insurers within the system.
Pursuant to these laws, the respective insurance departments may examine Mutual,
State Auto P&C, National, Milbank and Midwest Security at any time, require
disclosure of material transactions involving insurer members of the holding
company system and require prior notice and an opportunity to disapprove of
certain "extraordinary" transactions, including, but not limited to,
extraordinary dividends from State Auto P&C and National to State Auto
Financial. Pursuant to these laws, all transactions within the holding company
system affecting Mutual, State Auto P&C, National, Milbank and Midwest Security
must be fair and equitable. In addition, approval of the applicable Insurance
Commissioner is required prior to the consummation of transactions affecting the
control of an insurer.
South Carolina insurance law provides that no person may acquire direct
or indirect control of State Auto P&C unless it has obtained the prior written
approval of the Chief Insurance Commissioner of South Carolina for such
acquisition. Any purchaser of 10% or more of the outstanding Common Shares would
be presumed to have acquired control of State Auto P&C, unless such presumption
is rebutted. Ohio law has similar provisions in place which would be applicable
to National, as does South Dakota for Milbank and Wisconsin for Midwest
Security.
17
In addition to being regulated by the insurance department of its state
of domicile, each insurance company is subject to supervision and regulation in
the states in which it transacts business, and such supervision and regulation
relate to numerous aspects of an insurance company's business and financial
condition. The primary purpose of such supervision and regulation is to ensure
financial stability of insurance companies for the protection of policyholders.
The laws of the various states establish insurance departments with broad
regulatory powers relative to granting and revoking licenses to transact
business, regulating trade practices, licensing agents, approving policy forms,
setting reserve requirements, determining the form and content of required
statutory financial statements, prescribing the types and amount of investments
permitted and requiring minimum levels of statutory capital and surplus.
Although premium rate regulation varies among states and lines of insurance,
such regulations generally require approval of the regulatory authority prior to
any changes in rates. In addition, all of the states in which State Auto P&C,
Mutual, National, Milbank and Midwest Security transact business have enacted
laws which restrict their underwriting discretion. Examples of these laws
include restrictions on policy terminations, restrictions on agency terminations
and laws requiring companies to accept any applicant for automobile insurance.
These laws adversely affect the ability of the foregoing companies to earn a
profit on their underwriting operations.
Insurance companies are required to file detailed annual reports with
the supervisory agencies in each of the states in which they do business, and
their business and accounts are subject to examination by such agencies at any
time.
There can be no assurance that such regulatory requirements will not
become more stringent in the future and have an adverse effect on the operations
of National or the insurers participating in the pooling arrangement.
Dividends. State Auto P&C and National are subject to regulations and
restrictions under which payment of non-extraordinary dividends from statutory
surplus can be made to State Auto Financial during the year without prior
approval of regulatory authorities.
The National Association of Insurance Commissioners, an association of
the chief insurance regulators from the fifty states, the District of Columbia
and U.S. Territories ("NAIC"), has created a certification process for state
insurance departments in an effort to bolster state regulation of insurers'
solvency. One element of the certification process includes a requirement that a
state has in place a variety of "model" laws and regulations which, in the
NAIC's view, enhance the ability of the state regulators to effectively regulate
insurance company solvency. Both the South Carolina Insurance Department and the
Ohio Insurance Department, the domiciliary regulator for State Auto P&C and
National respectively, have been certified by the NAIC.
Insurers are permitted to pay dividends without prior approval from the
domiciliary insurance department unless the dividend is an "extraordinary
dividend." In South Carolina, an extraordinary dividend is one which, when
considered with all other dividends paid in the last 12 months, is an amount
more than the greater of 10% of the insurer's statutory surplus as regards
policyholders as of the preceding December 31, or the statutory net income not
including net realized capital gains or losses for the previous year ended
December 31. In Ohio, the definition is substantially the same as in South
Carolina except that net income does not exclude net realized capital gains and
losses. Both South Carolina and Ohio require notice of all dividends within five
business days after declaration and at least ten days prior to payment. In
addition, the law in both Ohio and South Carolina gives the Commissioner the
authority to limit a non-extraordinary dividend when the Commissioner
determines, based on factors set forth in the law, that an insurer's surplus as
regards policyholders is not reasonable in relation to the insurer's outstanding
liabilities and adequate to its financial needs, provided the Commissioner acts
within the ten calendar days prior to payment. Pursuant to these rules, $28.9
million is available for payment to State Auto Financial as a dividend from
State Auto P&C and National during 1998 without prior approval under current
law.
Rate and Related Regulation. The Company is not aware of any adverse
legislation or regulation that has been adopted by any state where the Company
did business during 1997 which would present
18
material obstacles to the Company's overall business. On the federal level,
however, there remains the possibility that the Department of Housing and Urban
Development ("HUD") will seek to regulate homeowner underwriting practices under
the authority of the Fair Housing Act. Court decisions in the federal courts
have generally upheld HUD's right to regulate homeowner insurance underwriting
practices. If HUD regulations are promulgated, and these include a disparate
impact standard for the determination of illegal discrimination, such
regulations could present a significant underwriting challenge to the Company.
In an attempt to make capital and surplus requirements more accurately
reflect the underwriting risk of different lines of insurance as well as
investment risks that attend insurers operations, the NAIC created what it calls
risk-based capital requirements. The NAIC imposed on property and casualty
insurers a risk-based capital requirement to be applicable as of year end 1994.
Each insurer affiliated with the Company exceeded all standards tested by the
formula applying risk-based capital requirements as of year-end 1997.
The property and casualty insurance industry is also affected by court
decisions. Premium rates are actuarially determined to enable an insurance
company to generate an underwriting profit. These rates contemplate a certain
level of risk. The courts may modify the level of risk which insurers had
expected to assume in a number of ways, including eliminating exclusions,
multiplying limits of coverage, creating rights for policyholders not intended
to be included in the contract and interpreting applicable statutes expansively
to create obligations on insurers not originally considered when the statute was
passed. Courts have also undone legal reforms passed by legislatures, which
reforms were intended to reduce a litigant's rights of action or amounts
recoverable and so reduce the costs borne by insurance mechanism. These court
decisions can adversely affect an insurer's profitability. They also create
pressure on rates charged for coverages adversely affected and this can cause a
legislative response resulting in rate suppression that can adversely affect an
insurer.
One state with a particularly adverse judicial climate is West
Virginia. For example, this state is one of two in the United States in which
the courts have permitted third party claimants to bring bad faith actions
against the insurers of the tort feasors, based on violations of the state's
Unfair Claim Practice law. This state of the law makes claims handling more
problematic in West Virginia than other jurisdictions in which the State Auto
Group operates.
REINSURANCE
The Company, Mutual, Milbank and Midwest Security follow the customary
industry practice of reinsuring a portion of their exposures and paying to the
reinsurers a portion of the premiums received on all policies. Insurance is
ceded principally to reduce net liability on individual risks or for individual
loss occurrences, including catastrophic losses. Effective January 1, 1998,
reinsurance premiums and reimbursements are allocated between State Auto P&C,
Milbank, Mutual, and Midwest Security according to their relative pooling
percentages. National does not directly participate in the pooling arrangement.
Although reinsurance does not legally discharge State Auto P&C, Mutual,
National, Milbank, or Midwest Security from primary liability for the full
amount of their policies, it does make the assuming reinsurer liable to the
extent of the reinsurance ceded.
Each member of the State Auto Group has separate working reinsurance
treaties for property and casualty lines with several reinsurers arranged
through a reinsurance broker. Under the property excess of loss treaty, each
member of the State Auto Group is responsible for the first $2,000,000 of each
defined loss and the reinsurers are responsible for 100% of the excess over
$2,000,000 up to $10,000,000 of such defined loss, depending upon the nature of
the injury or damage. The rates for this reinsurance are negotiated annually.
The terms of the casualty excess of loss program provide that each
company in the State Auto Group is responsible for the first $2,000,000 of a
covered loss. The reinsurers are responsible for 100% of the loss excess of
$2,000,000 and up to $5,000,000. Also, certain unusual claim situations
involving bodily injury liability, property damage liability, uninsured
motorist, personal injury protection and workers' compensation insurance are
covered by an arrangement which provides for $10,000,000 of coverage
19
above a $5,000,000 retention for each loss occurrence. This layer of reinsurance
sits above the $3,000,000 excess of $2,000,000 arrangement.
In addition, the State Auto Group has secured other reinsurance to
limit the net cost of large loss events for certain types of coverages. Included
are umbrella liability losses which are reinsured up to a limit of $15,000,000
above a maximum $500,000 retention. The companies also make use of the
facultative market for unique risk situations and participate in involuntary
pools and associations in certain states.
Catastrophe reinsurance has been arranged for property business,
including automobile physical damage. Effective July 1, 1997, the Company and
Mutual renewed both the traditional and structured financing pieces of their
reinsurance program, originally placed in July 1996, exactly duplicating last
year's program. State Auto P&C, Mutual, Milbank, and National retain the first
$40 million of each occurrence. Eighty million of traditional reinsurance is
available above the $40 million retention with a co-participation of 5%. In the
event the State Auto Group incurs catastrophe losses in excess of $120.0
million, State Auto Financial has continued its structured contingent financing
transaction with Chase Manhattan Bank ("Chase") to provide up to $100.0 million
to be used to cover such catastrophe losses. Under this arrangement, in the
event of such a loss, State Auto Financial would issue and 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 "Lenders"). State Auto Financial will contribute
to State Auto P&C the proceeds from the sale of its preferred shares. State Auto
P&C has assumed catastrophe reinsurance from Mutual, Milbank and National
pursuant to a Catastrophe Assumption Agreement in the amount of $100.0 million
excess of $120.0 million. State Auto P&C will use the contributed capital to pay
its direct catastrophe losses and losses assumed under the Catastrophe
Assumption Agreement. State Auto Financial is obligated to repay SPC (which will
repay the lenders) by redeeming the preferred shares over a six year period.
This layer of $100.0 million in excess of $120.0 million has been excluded from
the pooling arrangement as well by virtue of an Amended and Restated Reinsurance
Pooling Agreement. See "Pooling Arrangement." In addition, State Auto
Financial's obligation to repay SPC has been secured by a Put Agreement among
State Auto Financial, Mutual and the Lenders, under which, in the event of a
default by State Auto Financial 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.
National has entered into a reinsurance agreement with Mutual. Pursuant
to the agreement, on an excess of loss basis, Mutual assumes all liability
losses in excess of National's $50,000 retention; on a quota share basis, Mutual
assumes 20% of all liability losses - and premiums - within National's $50,000
retention. The excess of loss coverage is intended to insulate National from
shock losses while the quota share arrangement is intended to slow the drain on
statutory surplus which can normally be expected with a rapid increase in
premium writings. The quota share portion of the agreement may be extended to
physical damage coverages in 1998.
Midwest Security has also entered into reinsurance agreements with
Mutual. Under an umbrella quota share agreement, Mutual reinsures on a per risk
basis, 100% of the first and second $1,000,000 in umbrella coverage written by
Midwest Security. Mutual also has a property catastrophe excess of loss
agreement with Midwest Security under which Mutual is liable for 100% of
$5,000,000 of losses excess a $100,000 retention in three different layers.
Mutual also has written a property casualty multiple line excess of loss
agreement with Midwest Security under which Midwest Security bears the first
$50,000 of each loss (except for $25,000 in case of private passenger auto
physical damage) with Mutual bearing the excess over the retention, subject to a
limit of $500,000 in casualty and $1,000,000 in property. Mutual also wrote for
Midwest Security a second casualty excess of loss agreement for $1.5 million in
excess of $500,000 for liability coverages referenced under the first multiple
line excess of loss agreement. Management believes the premiums charged to
Midwest Security for these reinsurance agreements are comparable to those that
would be charged by a third party reinsurer. The premiums and losses assumed
under these reinsurance agreements are pooled by Mutual pursuant to the pooling
arrangement. These agreements were in effect only until December 31, 1997
because Midwest Security is being included in the pooling arrangement effective
as of January 1, 1998.
20
YEAR 2000
See discussion included in Part II - Item 7 Management's Discussion and
Analysis of Financial Condition and Results of Operations.
COMPETITION
The property and casualty insurance industry is highly competitive.
Price competition has been particularly intense during recent years. This has
been particularly true in regards to commercial lines in 1997. The Company
competes with numerous insurance companies, many of which are substantially
larger and have considerably greater financial resources. In addition, because
the Company's products are marketed exclusively through independent insurance
agencies, most of which represent more than one company, the Company faces
competition within each agency. See "Marketing." The Company competes through
underwriting criteria, appropriate pricing, and quality service to the
policyholder and the agent and through a fully developed agency relations
program.
EMPLOYEES
As of March 6, 1998, the Company had 45 employees. See "Management
Agreement." All of the other personnel providing services to State Auto
Financial and its subsidiaries are employed by Mutual and made available under
the terms of the Amended and Restated Management Agreement. See "Management
Agreement." At December 31, 1997, Mutual had approximately 1,300 full-time
employees. Employees of the Company and of Mutual are not covered by any
collective bargaining agreement. Management of Mutual and of the Company
consider their relationship with the employees to be excellent.
EXECUTIVE OFFICERS OF THE REGISTRANT
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company (1)(2) Age During the Past Five Years of the Company Since
- ------------------------------- --- -------------------------- --------------------
Robert L. Bailey, 64 Chairman of the Board of STFC 3/93 to 1991
Chairman of the Board, present; Chief Executive Officer of
and Chief Executive Officer STFC 5/91 to present; President of
STFC, 5/91 to 5/96; Chairman of the
Board of Mutual 3/93 to present; Chief
Executive Officer of Mutual, 5/89 to
present; President of Mutual, 1983 to
5/96;
Robert H. Moone, 54 President and Chief Operating Officer 1991
President and of STFC, 5/96 to present; Executive
Chief Operating Officer Vice President, 11/93 to 5/96 and prior
thereto Vice President of STFC;
President and Chief Operating Officer
of Mutual and National, 5/96 to
present; Executive Vice President,
11/93 to 5/96 and prior thereto,
Senior Vice President of Mutual
Steven J. Johnston, 39 Vice President, Treasurer and Chief 1994
Vice President, Financial Officer of STFC and Mutual
Treasurer and Chief 4/97 to present; Vice President of STFC
Financial Officer and Mutual 5/95 to 4/97; Assistant Vice
President of Mutual 8/92 to 5/95
John R. Lowther, 47 Vice President, Secretary and General 1991
Vice President, Secretary Counsel of STFC, 5/91 to present; Vice
and General Counsel President, Secretary and General
Counsel of Mutual, 8/89 to present;
21
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company (1)(2) Age During the Past Five Years of the Company Since
- ------------------------------- --- -------------------------- --------------------
Michael F. Dodd, 60 Senior Vice President of STFC, 5/91 to 1991
Senior Vice President present; Senior Vice President of
Mutual 2/89 to present
Terrence L. Bowshier, 45 Vice President and Comptroller of STFC 1991
Vice President and and Mutual 5/91 to present;
Comptroller
James E. Duemey, 51 Vice President and Investment Officer 1991
Vice President and of STFC and Mutual 5/91 to present;
Investment Officer
Terrence P. Higerd, 53 Vice President of STFC, 5/91 to 1991
Vice President present; Vice President of Mutual 6/87
to present
Noreen W. Johnson 49 Vice President of STFC and Mutual 3/98 1998
Vice President to present; Assistant Vice President of
Mutual 3/97 to 3/98; employee of Mutual
from 9/92 to 3/97
Robert A. Lett 59 Vice President of STFC 3/98 to present; 1994
Vice President Vice President of Mutual 2/88 to present
John B. Melvin 48 Vice President of STFC 3/98 to present; 1994
Vice President Vice President of Mutual 11/93 to
present; and prior thereto an officer
of Mutual
Cathy B. Miley(3) 48 Vice President of STFC 3/98 to present; 1995
Vice President Vice President of Mutual 3/95 to
present; Assistant Vice President of
Mutual 8/92 to 3/95
Richard L. Miley(3) 44 Vice President of STFC 3/98 to present; 1995
Vice President Vice President of Mutual 5/95 to
present; Assistant Vice President of
Mutual 8/87 to 5/95
Gary L. Huber 56 Vice President of STFC 3/98 to present; 1997
Vice President Vice President of Mutual 5/97 to
present; Chief Operating Officer United
Fire and Casualty Insurance Company,
Des Moines, Iowa for more than five
years prior to his joining Mutual
(1) Except for Mr. Bailey, each of the executive officers is elected by the
respective company's Board of Directors for an indefinite term. Mr. Bailey has
executed an employment agreement effective January 1, 1996, which is for a five
year term.
(2) Each of the foregoing executive officers has been designated by the
Company's Board of Directors as an officer for purposes of Section 16 of the
Securities Exchange Act of 1934.
(3) Cathy B. Miley and Richard L. Miley are husband and wife.
ITEM 2. PROPERTIES
Because the operations of the Company and Mutual are integrated with
one another pursuant to the terms of the Amended and Restated Management
Agreement, the Company and Mutual share their operating facilities. See Item 1,
"Management Agreement." The Company's and Mutual's corporate headquarters are
located in Columbus, Ohio in buildings owned by Mutual that contain
approximately 270,000 square feet of office space. The Company and Mutual also
have regional underwriting and
22
claims office facilities which they share through the Management Agreement.
These facilities include a 53,500 square foot regional office in Greer, South
Carolina, a 6,600 square foot branch office in Cleveland, Ohio owned by Mutual,
and a 29,000 square foot branch office in Cincinnati, Ohio owned by Mutual. In
addition, Mutual currently leases a 22,800 square foot regional office in
Nashville, Tennessee pursuant to a 10-year lease. In the first quarter of 1998,
518 PML acquired land in Goodlettsville, Tennessee on which it is constructing
an office building which the Company expects to become Mutual's Nashville
Regional Office following expiration of the current lease in June 1999. Milbank
owns an office facility in Milbank, South Dakota where Mutual employees provide
services to Milbank agents and policyholders. Midwest Security leases an office
facility in Onalaska, Wisconsin where Mutual employees service Midwest
Security's agents and policyholders. Mutual also leases a number of small
offices throughout its operating area for the claims operations of Mutual and
the Company.
ITEM 3. LEGAL PROCEEDINGS
The Company is a party to a number of lawsuits arising in the ordinary
course of its insurance business. Management of the Company believes that the
ultimate resolution of these lawsuits will not, individually or in the
aggregate, have a material, adverse effect on the financial condition of the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON SHARES AND RELATED SHAREHOLDER
MATTERS
STOCK TRADING
Common shares are traded in the Nasdaq National Market System under the
symbol STFC. As of March 9, 1998, there were 826 shareholders of record of the
Company's common shares.
MARKET PRICE RANGE, COMMON STOCK(1)
Initial Public Offering -- June 28, 1991, $4.50. The high and low sale
prices for each quarterly period for the past two years as reported by Nasdaq
are:
1996 High Low Dividend
---- ---- --- -------
First Quarter $17.50 $14.00 $.037
Second Quarter 16.67 15.00 .037
Third Quarter 16.17 13.00 .04
Fourth Quarter 18.50 13.25 .04
1997
----
First Quarter 19.00 16.75 .040
Second Quarter 23.00 16.75 .040
Third Quarter 23.875 20.25 .045
Fourth Quarter 32.25 23.25 .045
(1)Adjusted for a March 1993 two-for-one and a July 1996
three-for-two common stock split effected in the form of a
stock dividend, respectively.
Additionally, see Liquidity and Capital Resources section of
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included in Item 7 of this Form 10-K Annual Report.
23
ITEM 6. SELECTED FINANCIAL DATA
"Selected Consolidated Financial Data" is as follows:
24
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
SELECTED CONSOLIDATED FINANCIAL DATA
YEAR ENDED DECEMBER 31
----------------------
1997 1996 1995* 1994 1993
---- ---- ----- ---- ----
STATEMENTS OF EARNINGS DATA: (Dollars in thousands, except per share data)
Earned premiums $ 254,682 240,345 232,524 175,587 169,610
Net investment income $ 25,078 23,879 22,617 17,756 17,222
Management services income $ 8,705 8,020 7,574 6,078 2,155
Net realized gains on investments $ 543 1,401 1,201 1,506 718
----------------------------------------------------------------
Total revenues $ 289,008 273,645 263,916 200,927 189,705
----------------------------------------------------------------
Earnings before federal income taxes $ 47,084 30,148 35,339 19,105 16,849
----------------------------------------------------------------
Net earnings before cumulative effect of change in
accounting for income taxes $ 33,959 22,602 25,542 14,662 13,646
----------------------------------------------------------------
Net earnings $ 33,959 22,602 25,542 14,662 13,729
----------------------------------------------------------------
Net earnings per common share before cumulative
effect adjustment(1)(2):
Basic $ 1.86 1.25 1.42 .82 .76
----------------------------------------------------------------
Diluted $ 1.82 1.23 1.41 .82 .76
----------------------------------------------------------------
Net earnings per common share(1)(2):
Basic $ 1.86 1.25 1.42 .82 .77
----------------------------------------------------------------
Diluted $ 1.82 1.23 1.41 .82 .77
----------------------------------------------------------------
Cash dividends per common share(1) $ .17 .15 .14 .13 .11
----------------------------------------------------------------
BALANCE SHEET DATA AT YEAR END:
Total investments $ 404,179 384,307 369,847 273,226 273,753
Total assets $ 493,151 453,120 434,496 334,796 320,203
Total stockholders' equity $ 225,479 186,461 168,252 130,186 124,332
Book value per common share(1) $ 12.29 10.28 9.33 7.27 6.99
STATUTORY RATIOS:
Loss ratio 65.2% 72.6 68.6 75.1 73.5
Expense ratio 27.9% 26.4 30.1 25.9 29.1
Combined ratio(3) 93.1% 99.0 98.7 101.0 102.6
Industry combined ratio(4) 101.6% 105.9 106.4 108.5 106.9
Ratio of net premiums written to statutory capital and surplus 1.87 2.08 2.32 1.85 2.02
(1) Adjusted for a July 1996 3-for-2 common stock split effected in the form of a stock dividend.
(2) The net earnings per share amounts prior to 1997 have been restated as required to comply with SFAS No. 128.
(3) Derived from combined statutory financial statements on a pooled basis, including State Auto National.
(4) Preliminary industry information for 1997 from A.M. Best Co.
* Reflects change in pooling arrangement, effective January 1, 1995.
25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
"Management's Discussion and Analysis of Financial Condition and
Results of Operations" is as follows:
26
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
State Auto Financial Corporation (State Auto Financial), through its
principal insurance subsidiary State Auto Property and Casualty Insurance
Company (State Auto P&C), provides personal and commercial insurance primarily
in the central and eastern parts of the United States, excluding New York, New
Jersey, and the New England states. State Auto P&C's principal lines of business
include personal and commercial automobile, homeowners, commercial multi-peril,
workers' compensation, general liability and fire insurance. Another insurance
subsidiary, State Auto National Insurance Company (National), writes personal
automobile insurance for non-standard risks. In 1997 National wrote insurance in
eleven states. State Auto P&C and National's products are marketed through
independent agents.
State Auto P&C provides executive management services to oversee the
insurance operations of all the State Auto Insurance Companies, which include
National and State Automobile Mutual Insurance Company (Mutual), a majority
shareholder of State Auto Financial, and Mutual's wholly-owned subsidiaries,
Milbank Insurance Company (Milbank), Midwest Security Insurance Company (Midwest
Security) (Midwest Security was acquired by Mutual effective January 1, 1997)
and until June 30, 1997, State Auto Life Insurance Company (State Auto Life was
sold by Mutual effective July, 1997). Stateco Financial Services, Inc.
(Stateco), a wholly-owned subsidiary of State Auto Financial, provides
investment management services to affiliated companies and also provides
insurance premium finance services to customers of State Auto P&C, Mutual and
Milbank.
Strategic Insurance Software, Inc. (SIS), a majority owned subsidiary,
develops and sells software for the processing of insurance transactions,
database management for insurance agents and electronic interfacing of
information between insurance companies and agents. SIS sells services and
products to affiliated companies and their agents and markets similar services
and products to nonaffiliated insurers and their agencies. State Auto Financial
and its subsidiaries, State Auto P&C, National, Stateco and SIS are referred to
collectively as the Company.
Since 1987 State Auto P&C has participated in a reinsurance pooling
arrangement (the Arrangement) with Mutual. The Arrangement provides that all
premiums, losses, loss expenses and underwriting expenses of each company be
pooled and then allocated back to each company based on percentages outlined in
the Arrangement. Effective January 1, 1995, the Arrangement was amended to
include all of the property and casualty business of Milbank. Concurrently with
the inclusion of Milbank, the pooling participation percentages were amended to
allocate 35% to State Auto P&C, 55% to Mutual and 10% to Milbank. Effective
January 1, 1998, subject to regulatory approval, the arrangement was amended 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. The change in the Arrangement did not
affect a prior agreement between State Auto P&C and Mutual whereby Mutual agreed
to reimburse State Auto P&C for the development of any losses or loss expenses
on claims occurring on or prior to December 31, 1990, that is in excess of State
Auto P&C's reserves on that date. As of December 31, 1997, there has been no
adverse development of the liability.
Effective July 1, 1993, Mutual acquired Milbank. In connection with this
purchase, Mutual and State Auto Financial entered into an Option Agreement
granting State Auto Financial the right to acquire Milbank from Mutual within
five years at a price determined by a formula set out in the Option Agreement.
On March 6, 1998, the Board of Directors of State Auto Financial adopted a
resolution authorizing the officers of State Auto Financial to take such steps
as are necessary to effect the exercise of State Auto Financial's option to
acquire Milbank from Mutual. State Auto Financial's acquisition of Milbank is
subject to procedural matters contemplated by the Option Agreement, as approved
by the directors of Mutual and State Auto Financial, being completed and
regulatory approval in Ohio and South Dakota. The proposed effective date of
transfer is third quarter 1998.
State Auto P&C, National, Mutual, Milbank and
27
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
Midwest Security are referred to collectively as the State Auto Insurance
Companies, while State Auto P&C, Mutual and Milbank are referred to as the
Pooled Companies.
1997 Compared to 1996
---------------------
Net earnings for the Company increased 50% over 1996. The Company's statutory
combined ratio decreased to 93.1% in 1997 from 99.0% in 1996, reflecting
improvements in almost all major lines of insurance.
State Auto P&C increased its earned premium approximately 2.9% from the same
1996 period. During the 1997 year, the Pooled Companies' experienced minimal
growth in direct written premiums on its personal lines of business of
approximately 1.0%, while commercial lines reflected an increase of
approximately 8.3% from the same 1996 period. Commercial lines growth decreased
from 1996 levels due primarily to a substantial reduction in workers'
compensation loss costs as promulgated by the National Council on Compensation
Insurance that began approximately one year ago. As a result of these lower loss
costs, workers' compensation direct written premiums decreased approximately
6.6% from 1996. The workers' compensation line of business represents
approximately 12% of the Pooled Companies' commercial business. National's
earned premium increased 56.8% from the same 1996 period. Contributing to this
increase was National's entry into the states of Arkansas and Georgia in
December 1996, Minnesota in February 1997 and in the later half of 1997,
Alabama, Illinois and Missouri. Currently licensed in six additional states and
seeking certificates of authority in at least three others, National anticipates
beginning operations in at least six of these states during 1998. Total earned
premiums for the Company increased $14.3 million or 6.0% to $254.7 million.
Net investment income increased $1.2 million or 5.0% to $25.1 million. An
increase in invested assets over the same 1996 period contributed to this
increase. Total cost of invested assets at December 31, 1997 was $391.1 million
compared to $377.0 million at December 31, 1996. During the last half of 1997,
the Company began a program to build an equity portfolio to enhance growth of
statutory surplus over the long term. At December 31, 1997, the equity portfolio
totaled $4.6 million. The investment yield, based on fixed and equity securities
at cost, decreased to 6.2% from 6.4% in 1996.
Management services income, which includes income generated from investment
and executive management services provided by Stateco and State Auto P&C,
respectively increased $0.7 million or 8.5% to $8.7 million.
Losses and loss expenses, as a percentage of earned premiums, decreased to
65.1% from 72.2% in 1996. The decrease in this ratio is due to a reduction in
the level of catastrophe losses experienced by the Company as compared to the
same period in 1996 and continuing improvement in the Company's core
underwriting operations. Homeowners' line of business, which comprises
approximately 16.0% of the Company's earned premiums, reflected a substantial
improvement in its statutory loss ratio of 71.0%, down from 101.7% in 1996.
Additionally, automobile, the Company's largest line of business (approximately
60% of the Company's earned premiums), also reflected an improvement in its
statutory loss ratio of 65.5%, down from 69.5% in 1996.
Acquisition and operating expenses, as a percentage of earned premiums,
increased to 29.1% from 28.1% in 1996. The increase in this percentage is due to
the amortization of software expenses, the Quality Performance Bonus (the Bonus)
and the amount of bonus compensation earned by the Company's agents. Beginning
with the first quarter of 1997, the State Auto Insurance Companies began
amortizing costs associated with the development of its claims and billing
processing system that began a little over two years ago. The amortization
period of these costs will be approximately three years. Additionally, there was
an increase over the same periods in 1996 of the Bonus earned by nearly all
permanent employees. Performance is measured quarterly and the Bonus is earned
if the State Auto Insurance Companies' quarterly direct statutory combined ratio
is better than predetermined targets set at the beginning of each fiscal year.
A Bonus has been
28
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
paid in each of the 1997 quarterly periods. Also contributing to this increase
was an increase over 1996 of the amount of bonus compensation earned by the
Company's agents. Each agent shares in the underwriting profits generated by
insurance placed by them. Thus, the improvement in the underwriting operations
of the Company is shared with the agents who produced the profitable business.
Currently, approximately 20% of the Company's policy transactions are now sent
electronically from the agent to the Company, thereby enhancing the efficiency
of the Company's operations and which is expected to have a long-term positive
impact on the Company's expenses.
Decrease in other expenses of $0.6 million to $1.9 million is primarily due
to the State Auto Insurance Companies changing the catastrophe portion of its
reinsurance program beginning July 1, 1996, that prior to this period was
accounted for as deposit reinsurance (See Liquidity and Capital Resources).
Expenses associated with the catastrophe portion of the program accounted for as
deposit reinsurance were included in Other Expenses.
Federal income taxes increased $5.6 million to $13.1 million. This increase
is due to the increase in taxable income as a result of the improvement in
insurance operations in 1997 compared to the same period in 1996. The tax
benefit from tax exempt securities for 1997 remained comparable to the 1996
level. See footnote (7) to consolidated financial statements of State Auto
Financial Corporation and Subsidiaries.
1996 Compared to 1995
---------------------
Net earnings for the Company decreased 11.5% due primarily to numerous
storm-related catastrophe claims in the first three quarters of the year.
Despite these significant losses, the Company was able to produce a statutory
combined ratio of 99.0% bettering industry results for the year of 105.9%.
Earned premiums increased $7.8 million or 3.4% to $240.3 million. Direct
written premiums for commercial business increased approximately 10.9% from the
same 1995 period. Except for National, the Company's personal lines experienced
no growth in 1996. Contributing to the results in personal lines, was the
introduction of the PRIME of LIFE personal auto and homeowners plan beginning on
a state-by-state basis in late 1995 (the Plan). The Plan focuses on the 50 and
older segment of the personal lines market, a group that has generally produced
more favorable underwriting and retention results for the industry than any
other segment of the personal lines market. The Plan offers a combination of
auto and homeowners discounts and enhances coverages. As a consequence of moving
existing eligible policyholders to the Plan and reflecting the actuarially
justified discounts, along with conservative underwriting and newer agency
appointments of more commercial lines oriented agencies, personal lines written
premium was flat. The Company remains committed to profitable premium growth as
it is continually reviewing current strategies and developing new programs in
both commercial and personal lines sales. Positively contributing to both
commercial and personal lines sales in 1996, was the Company's entry into its
23rd state of operation, Oklahoma. National, which began operations in the
non-standard personal auto market in 1992, recorded an increase in its direct
written premiums of approximately 43%. During the fourth quarter of 1996,
National began writing business in Arkansas and Georgia and wrote its first
policy in the state of Minnesota in February of 1997 bringing the total number
of its operating states to eight. It began operations in three additional states
during 1997.
Net investment income increased $1.3 million or 5.6% to $23.9 million. An
increase in invested assets over the same 1995 period contributed to this
increase. Total amortized cost of invested assets at December 31, 1996 was
$377.0 million compared to $355.4 million at December 31, 1995. The investment
yield decreased to 6.4% from 6.5% in 1995.
Management services income, which includes income generated from investment
and executive management services provided by Stateco and State Auto P&C,
respectively, increased $0.4 million or 5.9% to $8.0 million.
Losses and loss expenses, as a percentage of earned premiums, increased to
72.2% from 68.3% in
29
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
1995. During 1996, the Company experienced several significant weather related
catastrophes. Severe winter weather in January and February, tornado and
hailstorms in the Louisville, Kentucky area in May and storm losses in Raleigh,
North Carolina resulting from Hurricane Fran moving inland in September,
increased losses and loss expenses by approximately $16.0 million. The impact of
these storms increased this loss and loss expense ratio 6.7 points. Despite
these significant losses, the Company continued to record improvements in its
underlying book of business. Automobile, the Company's largest line of business,
showed an improvement in its statutory loss ratio of 69.5%, down from 74.1% in
1995.
Acquisition and operating expenses, as a percentage of earned premiums,
decreased to 28.1% from 29.0% in 1995. The decrease in the ratio for 1996 is due
primarily to the decrease in the amount of Quality Performance Bonus earned by
nearly all permanent employees of the State Auto Companies in 1996 compared to
the same periods in 1995.
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.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity refers to the ability of a company to generate adequate amounts of
cash to meet its needs for both long and short-term cash obligations as they
come due. The Company's significant sources of cash are premiums, investment
income and investments as they mature. The Company continually monitors its
investment and reinsurance programs to ensure they are appropriately structured
to enable the insurance subsidiaries to meet anticipated and unanticipated short
and long-term cash requirements without the need to sell fixed income
investments to meet fluctuations in claim payments.
Net cash provided by operating activities increased to $24.9 million from
$22.4 million in the same 1996 period. Net cash used in investing activities
decreased to $15.3 million from $21.2 million from the same 1996 period. Net
cash provided by financing activities increased to $1.4 million from $0.4
million in the same 1996 period. As of December 31, 1997, funds consisting of
cash and cash equivalents for general operations were $23.9 million compared to
$12.9 million at December 31, 1996. No long-term fixed maturies were required to
be sold to meet financial obligations in 1997.
Effective July 1, 1996, the State Auto Insurance Companies negotiated a
change in their catastrophe reinsurance program. The amount retained by the
State Auto Insurance Companies is $40.0 million for each occurrence, an increase
of $20.0 million over the prior program. For up to $80.0 million in losses,
excess of $40.0 million, traditional reinsurance coverage is provided. To
provide funding if the State Auto Insurance Companies were to incur catastrophe
losses in excess of $120.0 million, State Auto Financial entered into a
structured contingent financing transaction with Chase Manhattan Bank (Chase) to
provide up to $100.0 million for reinsurance purposes. Under this arrangement,
in the event of such a loss, State Auto Financial 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. State Auto Financial will contribute to State Auto
P&C the proceeds from the sale of its preferred shares. State Auto P&C has
assumed catastrophe reinsurance from Mutual, Milbank and National pursuant to a
catastrophe reinsurance agreement in the amount of $100.0 million excess of
$120.0 million. State Auto P&C will use the contributed capital to pay its
direct catastrophe losses and losses assumed under the catastrophe reinsurance
agreement. State Auto Financial is obligated to repay SPC (which will repay the
lenders) by redeeming the preferred shares over a six year period. This layer of
$100.0 million in excess of $120.0 has been excluded from the pooling agreement
as well by virtue of an Amended and Restated Reinsurance Pooling Agreement.
In addition, State Auto Financial's obligation to repay SPC has been secured
by a Put Agreement among State Auto Financial, Mutual and the Lenders, under
which, in the event of a default by State Auto Financial as described in the
Credit Agreement or in
30
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
the Put Agreement, Mutual would be obligated to put either the preferred shares
or the loan(s) outstanding.
On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest
Security, effective as of January 1, 1997. In connection with this purchase,
Mutual and State Auto Financial entered into an Option Agreement granting State
Auto Financial the right to purchase Midwest Security from Mutual within five
years at a price determined by a formula set out in the Option Agreement. As of
March 16, 1998, State Auto Financial has not exercised its right to acquire
Midwest Security.
Effective January 1, 1998, 518 Property Management and Leasing, LLC (518 PML)
was created. The initial members of 518 PML are Stateco and State Auto P&C.
Stateco contributed $7.0 million in cash and real property located in
Goodlettsville, Tennessee, while State Auto P&C contributed real property
located in Greer, South Carolina. 518 PML plans to develop an office building on
the real property in Goodlettsville which it expects to lease to Mutual in 1999
for Mutual's use as its Nashville Regional Office. 518 PML has leased the Greer
property to Mutual for use as Mutual's Southern Regional Office facility.
Operations from 518 PML are not material to the Company at this time.
On March 6, 1998, the Board of Directors of State Auto Financial declared a
quarterly cash dividend of $0.045 per common share, payable on March 31, 1998,
to shareholders of record on March 17, 1998. Additionally, the Board also
declared a two-for-one stock split to be distributed July 8, 1998, to
shareholders of record on June 18, 1998. The split is contingent upon
shareholder approval of a proposal to increase the number of authorized common
shares, without par value, from 30 million to 100 million at the Company's
Annual Meeting of Shareholders on May 28, 1998.
The maximum amount of dividends that may be paid to State Auto Financial
during 1998 by its insurance subsidiaries as a non-extraordinary dividend is
limited to $28.9 million, without prior approval under current law. The Company
is required to notify the insurance subsidiaries' respective State Insurance
Commissioner within five business days after declaration of all dividends and at
least ten days prior to payment. Additionally, the domiciliary Commissioner of
each insurer subsidiary has the authority to limit a non-extraordinary dividend
when the Commissioner determines, based on factors set forth in the law, that an
insurer's surplus is not reasonable in relation to the insurer's outstanding
liabilities and adequate to its financial needs. Such restrictions are not
expected to limit the capacity of State Auto Financial to meet its cash
obligations.
The National Association of Insurance Commissioners (NAIC) adopted risk-based
capital requirements for property and casualty insurers effective December 31,
1994. Risk-based capital is a formula that attempts to evaluate the adequacy of
statutory capital and surplus in relation to investment and insurance risks such
as asset quality, loss reserve adequacy and other business factors. Applying the
risk-based capital requirements as of December 31, 1997, each of the State Auto
Insurance Companies exceeded all standards tested by the formula.
YEAR 2000
The Year 2000 Issue is the result of computer programs having been written
using two digits rather than four to define the applicable year. Any of the
computer programs used by State Auto Financial and Mutual and their respective
subsidiaries (all of which are collectively, referred to as "State Auto" for the
purposes of this section) that have time-sensitive software may recognize a date
using "00" as the year 1900 rather than the year 2000. This could result in a
system failure or miscalculations causing disruptions of uncertain duration in
State Auto's operations, including, among other things, an inability to process
transactions, send invoices, or engage in similar normal business activities.
Based on an analysis of its systems software, management determined that it
is required to modify or replace significant portions of State Auto's software
so that its computer systems will function properly with respect to dates in the
year 2000 and thereafter. Management presently believes that with modifications
to existing software and conversions to new software, the Year 2000 Issue will
not pose significant
31
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CONTINUED
operational problems for State Auto. However, if such modifications and
conversions are not made, or are not completed timely, the Year 2000 Issue could
adversely affect the operations of State Auto.
To address the Year 2000 issue in a timely and effective manner, management
purchased software from a third party vendor to assist in diagnosing and
correcting certain of State Auto's major policy processing software systems. In
addition, management is utilizing State Auto's internal resources to reprogram,
or replace, and test the balance of its software for necessary Year 2000
modifications. Management presently anticipates completing the Year 2000
modifications on State Auto's critical business applications software by October
1998 and its remaining non-critical business applications software during 1999.
Management expects to have these changes completed prior to the Year 2000 Issue
having an adverse impact on State Auto's operations and operating systems. The
total cost of the Year 2000 project for State Auto Financial is estimated at
$1.5 million and is being funded through cash flows. To date, State Auto
Financial's incurred cost is approx