ITEM 1. BUSINESS
(a) GENERAL DEVELOPMENT OF BUSINESS
State Auto Financial Corporation ("State Auto Financial" or "STFC") is an insurance holding company formed in 1990 and headquartered in Columbus, Ohio. STFC engages primarily in the property and casualty insurance business through its wholly-owned subsidiaries, State Auto Property and Casualty Insurance Company ("State Auto P&C"), Milbank Insurance Company ("Milbank"), Farmers Casualty Insurance Company ("Farmers Casualty"), State Auto Insurance Company of Ohio ("SA Ohio"), and State Auto National Insurance Company ("National"). Farmers Casualty owns 100% of the outstanding common shares of the property-casualty insurer, Mid-Plains Insurance Company ("Mid-Plains").
Approximately 67% of State Auto Financial's outstanding common shares are owned by State Automobile Mutual Insurance Company ("Mutual"), an Ohio mutual property and casualty insurance company organized in 1921. Mutual owns 100% of the outstanding common shares of property-casualty insurers, State Auto Florida Insurance Company ("SA Florida") and State Auto Insurance Company of Wisconsin ("SA Wisconsin"), formerly named Midwest Security Insurance Company. Mutual is also the sole owner of Meridian Insurance Group, Inc. ("MIGI"), an insurance holding company with two wholly-owned property and casualty insurance subsidiaries: Meridian Security Insurance Company ("Meridian Security") and Meridian Citizens Security Insurance Company ("Meridian Citizens"). In 2001, Mutual merged with Meridian Mutual Insurance Company ("Meridian Mutual"), with Mutual continuing as the surviving corporation, and in a substantially concurrent transaction Mutual acquired the outstanding shares of MIGI. Another of MIGI's insurance subsidiaries, Insurance Company of Ohio ("ICO"), was dissolved effective January 15, 2003. MIGI is also a party to an affiliation agreement with the property-casualty insurer, Meridian Citizens Mutual Insurance Company ("Meridian Citizens Mutual"). Meridian Security, Meridian Citizens, ICO and Meridian Citizens Mutual are hereafter referred to collectively as the "Meridian Insurers," and together with MIGI, they are hereafter referred to collectively as the "Meridian Companies."
Another wholly-owned subsidiary of STFC is Stateco Financial Services, Inc. ("Stateco"), which provides investment management services to affiliated insurance companies. See "Investment Management Services" in the "Narrative Description of Business." STFC also owns Strategic Insurance Software, Inc. ("S.I.S."), a developer and seller of insurance-related software. The limited liability company, 518 Property Management and Leasing, LLC ("518 PML"), whose members are State Auto P&C and Stateco, owns and leases real and personal property to affiliated companies. The results of operations of S.I.S. and 518 PML are insignificant to the total operations of STFC.
State Auto Financial and its subsidiaries, State Auto P&C, Milbank, Farmers Casualty, SA Ohio, National, Mid-Plains, Stateco, S.I.S., and 518 PML, are collectively referred to as the "Company."
State Auto P&C has participated in a quota share reinsurance pooling arrangement with Mutual since 1987 (the "Pooling Arrangement"). The participants in the Pooling Arrangement currently are State Auto P&C, Mutual, Milbank, SA Wisconsin, Farmers Casualty, SA Ohio, and SA Florida, collectively referred to hereafter as the "Pooled Companies." State Auto P&C, Milbank, Farmers Casualty and SA Ohio are collectively referred to hereafter as the "Pooled Subsidiaries." Effective January 1, 2003, the pooling percentages were modified as follows: Mutual (18.3%), State Auto P&C (59%), Milbank (17%), SA Wisconsin (1%), Farmers Casualty (3%), SA Ohio (1%) and becoming party to the agreement on this same date, SA Florida (0.7%). See "Pooling Arrangement" in the "Narrative Description of Business." The Pooled Companies, National, Mid-Plains and the Meridian Insurers are collectively referred to as the "State Auto Group."
The insurers in the State Auto Group write a broad line of property and casualty insurance, including standard personal and commercial automobile; nonstandard personal automobile; homeowners; commercial multi-peril; workers' compensation; general liability and fire insurance through approximately 22,300 independent insurance agents associated with approximately 3,500 agencies in 26 states. The State Auto Group's insurance products are marketed primarily in the central and eastern parts of the United States, excluding New York, New Jersey and the New England States.
(b) FINANCIAL INFORMATION ABOUT SEGMENTS
The Company currently operates in four insurance segments. Prior to 2001, it operated in two segments: the standard insurance segment, consisting of the business operations of the Pooled Subsidiaries, and the nonstandard segment, consisting of the business operations of National and Mid-Plains. With the merger of Meridian Mutual into Mutual and the July 1, 2001, addition of the former Meridian Mutual business to the Pooling Arrangement (see "Pooling Arrangement" in "Narrative Description of Business"), the Company renamed the two existing insurance segments as the "State Auto Standard Segment" and the "State Auto Nonstandard Segment" and added two more insurance segments: the "Meridian Standard Segment," for the standard insurance business of the former Meridian Mutual, and the "Meridian Nonstandard Segment," for the nonstandard insurance business of the former Meridian Mutual. Financial information about all these segments is set forth in Note 15 to the Company's Consolidated Financial Statements, included in Item 8 "Financial Statements and Supplementary Data." Additional information regarding the Company's insurance and non-insurance segments is provided in "Narrative Description of Business."
(c) NARRATIVE DESCRIPTION OF BUSINESS
PROPERTY AND CASUALTY INSURANCE
POOLING ARRANGEMENT
The Pooled Companies are parties to an intercompany Pooling Arrangement under the Reinsurance Pooling Agreement Amended and Restated as of January 1, 2000, as amended by the First, Second, Third and Fourth Amendments (the "2000 Pooling Agreement"). The Pooling Arrangement covers all the property and casualty insurance written by the parties, except voluntary assumed reinsurance written by Mutual and catastrophe inter-company reinsurance written by State Auto P&C. Under the terms of the Pooling Arrangement, each of the Pooled Subsidiaries, SA Wisconsin and SA Florida cede premiums, losses and expenses on all of their business to Mutual; in turn, Mutual cedes to each of the Pooled Subsidiaries, SA Wisconsin and SA Florida a specified portion of premiums, losses and expenses and Mutual retains the balance.
The following table sets forth a chronology of the participant changes that have occurred in the Pooling Arrangement since it became effective on January 1, 1987:
* At this time Milbank was a wholly owned subsidiary of Mutual
** In July, 1998 Milbank became a wholly owned subsidiary of STFC
*** Time period is for the year ended December 31, unless otherwise noted.
The following table sets forth a summary of the Pooling Arrangement participant percentages of STFC and Mutual, aggregating their respective wholly-owned subsidiaries:
*** Time period is for the year ended December 31, unless otherwise noted.
With the June 2001 merger of Meridian Mutual into Mutual, all insurance business written by Meridian Mutual legally became the business of Mutual and was included in the Pooling Arrangement effective July 1, 2001. Representing approximately 20% of the Pooled Companies' business, the former Meridian Mutual business is monitored as standard and nonstandard segments separate from the State Auto standard and nonstandard business. Over time, it is anticipated that the Meridian segments will decrease and eventually disappear as those segments are fully integrated over to the State Auto systems platform. See "Standard Insurance Segment" and "Nonstandard Insurance Segment" in "Narrative Description of Business."
Prior to 2001, the pooling percentages were 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. As a result of the changes made to the pooling percentages in 2001, it is not management's current intention to recommend an adjustment to the Pooled Subsidiaries aggregate participation percentage in the foreseeable future. Under revised procedures, management of each of the Pooled Companies would make recommendations to an independent committee of the Board of each of Mutual and STFC. These independent committees would review and evaluate such factors as they deem relevant and recommend any appropriate pooling change to the Boards of both Mutual and STFC. See "Management Agreement" in the "Narrative Description of Business." The Pooling Arrangement is terminable by any party on 90 days' notice or by mutual agreement of the parties. None of the Pooled Companies currently intends to terminate the Pooling Arrangement.
The Pooling Arrangement is designed to produce more uniform and stable underwriting results for each of the Pooled Companies than any one company would experience individually by spreading the underwriting 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 provide each participant with an identical mix of property and casualty insurance business on a net basis.
The 2000 Pooling Agreement contains a provision excluding catastrophic loss claims and loss adjustment expenses incurred by the parties in the amount of $100 million in excess of $120 million, as well as the premium for such exposures. State Auto P&C reinsures each insurer in the State Auto Group for this layer of reinsurance under a Catastrophe Assumption Agreement. See "Reinsurance" in the "Narrative Description of Business."
The direct business of the Meridian Insurers is not included in the Pooling Arrangement and to that extent is not included in the insurance operations of the Company. If State Auto P&C were required to pay catastrophe losses of the Meridian Insurers under the above referenced Catastrophe Assumption Agreement, those losses would impact the Company's results.
MANAGEMENT AGREEMENT
State Auto P&C's employees provide all organizational, operational and management functions for all insurance affiliates within the State Auto Group through management and cost sharing agreements. For the performance of its services under three of the management agreements, State Auto P&C is paid a quarterly management and operations services fee based on formulas outlined in the agreements, to the extent specified performance standards are achieved. Under the 2000 Midwest Management Agreement among State Auto P&C, Mutual and SA Wisconsin, SA Wisconsin pays 0.75% of direct written premium for management and operation services performed by employees of State Auto P&C. Pursuant to the 2000 Farmers Casualty Management Agreement among Farmers Casualty, Mid-Plains, State Auto P&C, and Mutual, Farmers Casualty and Mid-Plains pay 0.75% of direct written premium for management and operation services performed by State Auto P&C's employees. Under the Management Services Agreement among State Auto P&C, MIGI and the Meridian Insurers (the "MIGI Management Agreement"), each of the Meridian Companies (other than ICO) pays State Auto P&C 10% of all State Auto P&C's employee-related costs in exchange for the services of those employees, in addition to reimbursing State Auto P&C for the actual costs of such services. Mutual provides facilities for all the insurance affiliates under management or cost sharing agreements.
While there had been in place a fee under an agreement between State Auto P&C and Mutual (the "2000 Management Agreement"), as a result of the resolution of a disagreement with the Ohio Department of Insurance, the fee aspect of that agreement was terminated, effective October 1, 2001, and that arrangement continues as a pure cost sharing arrangement. As a result of the loss of the service fee under the 2000 Management Agreement, substantially all of State Auto P&C's insurance operations management fee was eliminated effective October 1, 2001. Consequently, beginning with the first quarter 2002, the management and operations services segment is included in the "other" category for segment reporting as the results of this segment no longer meet the quantitative thresholds for separate presentation as a reportable segment.
Each of the affiliated management and cost sharing agreements, except the MIGI Management Agreement, has a ten-year term and automatically renews for an additional ten-year period unless sooner terminated in accordance with its terms. If the 2000 Management Agreement is terminated for any reason, the Company would have to locate facilities to continue its operations, although the Company does not anticipate such termination.
Investment management services are provided by Stateco. See "Investment Management Services" in the Narrative Description of Business."
STANDARD INSURANCE SEGMENTS
The Company's share of the business written by the Pooled Companies constitutes the Company's State Auto and Meridian standard insurance segments as well as the Meridian nonstandard segment. See "Nonstandard Insurance Segment" in the "Narrative Description of Business." The standard segments include 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 for both the standard segments and the nonstandard segments. Footnote 14 in the Company's Consolidated Financial Statements included herewith sets forth the amount of the Company's net earned premiums by line of insurance for both the State Auto and Meridian standard segments and nonstandard segments.
The following tables set forth the statutory loss and loss adjustment expense ("LAE") ratios by line of insurance and the combined ratio for the standard insurance segments of the Company's business. These tables were prepared in accordance with accounting practices prescribed or permitted by state insurance authorities, for the periods indicated. The loss & LAE ratio is the ratio of incurred losses and loss adjustment expenses, without consideration of salvage and subrogation recoverable, to net earned premiums ("loss & LAE ratio"). The combined ratio is a traditional measure of underwriting profitability. The combined ratio is the sum of (a) the loss & LAE 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 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, although management fee income is substantially reduced after October 1, 2001. See "Management Agreement" in the "Narrative Description of Business."
The following table sets forth the aggregate statutory loss & LAE ratios by line of insurance and the combined ratio for the Company's two standard insurance segments, the State Auto standard insurance segment and beginning July 1, 2001, the Meridian standard insurance segment:
(1) Reflects a combination of the loss experience of the Pooled Subsidiaries after giving effect to reinsurance and the 2000 Pooling Agreement.
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The following tables provide the statutory loss and LAE ratios by line of insurance and the combined ratio for the State Auto and Meridian standard insurance segments, respectively.
(1) Reflects a combination of the loss experience of the Pooled Subsidiaries after giving effect to reinsurance and the 2000 Pooling Agreement.
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(1) Reflects the loss experience of the Meridian standard segment assumed by the Pooled Subsidiaries through the 2000 Pooling Agreement, beginning July 1, 2001.
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NONSTANDARD INSURANCE SEGMENTS
The Company writes personal automobile insurance for nonstandard risks through National and Mid-Plains. National is licensed in 24 states and active in 19 of those states. Mid-Plains operates in Kansas and Iowa.
Existing nonstandard auto risks in the Meridian nonstandard segment will continue to be written by Mutual until such policies terminate. During the fourth quarter of 2001, National's product and system platform began to be introduced on a state by state basis to former Meridian agents, and by the end of 2002 had been rolled out to all Meridian nonstandard states of operations. As a result of the Company's integration efforts that occurred within the Meridian nonstandard segment during 2001 and 2002, the Meridian nonstandard segment will be included in the State Auto nonstandard segment beginning with the first quarter of 2003.
It is envisioned that National will eventually be the principal writer for all nonstandard auto risks within the State Auto Group. Nonstandard automobile products provide insurance for private passenger automobile risks that are typically not acceptable to standard market companies for various reasons, such as an insured's poor loss experience, poor driving record, or history of late payments of premium. Nonstandard products are priced to account for the additional risk and expenses normally associated with this market.
The following table provides the statutory loss & LAE ratios by line of insurance for the Company's nonstandard insurance segments, which includes National and Mid-Plains, and beginning July 1, 2001, the Meridian nonstandard insurance segment:
(1) Reflects the combination of the loss experience of National and Mid-Plains as well as the Meridian nonstandard segment assumed by the Pooled Subsidiaries through the 2000 Pooling Agreement, beginning July 1, 2001.
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The following tables set forth the statutory loss and LAE ratios and combined ratios of National and Mid-Plains, which are engaged in the State Auto nonstandard segment of the business, and beginning July 1, 2001, the Meridian nonstandard segment, respectively:
(1) Reflects the combination of the loss experience of National and Mid-Plains.
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(1) Reflects the loss experience of the Meridian nonstandard segment assumed by the Pooled Subsidiaries through the 2000 Pooling Agreement, beginning July 1, 2001.
MARKETING
In its 26 states of operation, the State Auto Group markets its products through approximately 22,300 insurance agents associated with approximately 3,500 independent insurance agencies. None of the companies in the State Auto Group has any contracts with managing general agencies.
National markets nonstandard products in 19 states exclusively through the Company's network of independent agents. Mid-Plains writes nonstandard auto insurance in Iowa and Kansas through the agency network of Farmers Casualty in those states, and the Mid-Plains business is processed on National's system. The former Meridian Mutual nonstandard products were also marketed through the Meridian independent agency force, as well as agents specializing in nonstandard coverage only. As noted, National's product has been introduced to these "former Meridian agents." See "Nonstandard Automobile Insurance" in the "Narrative Description of Business."
Because independent insurance agents significantly influence which insurance company their customers select, management views the Company's independent insurance agents as its primary customers. 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. As such, the Company continually develops programs and procedures to enhance agency relationships, including the following: regular travel by senior management and branch office staff to meet with agents, in person, in their home states; training opportunities; and an agent stock purchase plan.
The Company actively helps its agencies develop professional sales skills within their staff. The training programs include both products and sales training in concentrated programs in the Company's home office. Further, the training programs include disciplined follow-up and coaching for an extended time.
The Company takes a leadership role in the insurance industry with respect to agency automation, promoting single entry multi-company interface using industry standards, especially through software developed and marketed by S.I.S. (SEMCI Partner(R)). The Company believes that, since agents and their customers realize better service and efficiencies through automation, they value their relationship with the Company. Automation can make it easier for the agent to do business with the Company, which attracts prospective agents and enhances the existing agencies' relationship with the Company.
The Company shares the cost of approved advertising with selected agencies. The Company provides agents with certain travel and cash incentives if they achieve certain sales and underwriting profit levels. Further, the Company recognizes its very top agencies as Inner Circle Agencies. Inner Circle Agencies are rewarded with additional trip and financial incentives, including additional profit sharing bonus and additional contributions to their Inner Circle Agent Stock Purchase Plan, a part of the Agent Stock Purchase Plan described below.
To strengthen agency commitment to producing profitable business and further develop its agency relationships, the Company's Agent Stock Purchase Plan offers its agents the opportunity to use commission income to purchase the Company's stock. The Company's transfer agent administers the plan using commission dollars assigned by the agents to purchase shares on the open market through a broker.
The Company receives premiums on products marketed in Alabama, Arkansas, District of Columbia, Florida, Georgia, Idaho, Illinois, Indiana, Iowa, Kansas, Kentucky, Maryland, Michigan, Minnesota, Mississippi, Missouri, North Carolina, North Dakota, Ohio, Oklahoma, Pennsylvania, South Carolina, South Dakota, Tennessee, Utah, Virginia, Washington, West Virginia and Wisconsin. During 2002, the seven states that contributed the greatest percentage of direct premiums written by the State Auto Group were: Ohio (18.3%), Kentucky (12.0%), Indiana (8.5%), Tennessee (6.8%), Minnesota (6.1%), Pennsylvania (5.3%), and South Carolina (4.1%).
CLAIMS
Insurance claims on policies written by the Company are usually investigated and settled by staff claims adjusters. The Company's claims division 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. Achievement of these goals supports the Company's marketing efforts by providing agents and policyholders with prompt and effective service.
Claim settlement authority levels are established for each adjuster, supervisor and manager based on his or her level of expertise and experience. The claims division is responsible for reviewing the claim, obtaining necessary documentation and establishing loss and expense reserves of certain claims. Generally, property or casualty claims estimated to reach $100,000 or above are sent to the home office to be supervised by claims division specialists. Branches with small volumes of large claims report claims to the home office at a lower dollar threshold. 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 division personnel.
The Company attempts to minimize claims costs by settling as many claims as possible through its internal claims staff 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 third party, proprietary bodily injury evaluation software which claims representatives use to help them value bodily injury claims, except for the most severe injury cases, continues to be a valuable tool for the Company. The Central Claims Department allows the Company to improve claims efficiency and economy by concentrating the handling of smaller, less complex claims in a centralized environment. The claims division also provides 24 hour, 7 days a week claim service through associates in its Contact Center.
RESERVES
Loss reserves are management's best estimates at a given point in time of what the Company expects to pay to claimants, based on facts, circumstances and historical trends then known. 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's results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required to settle claims vary from the liability currently recorded.
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, litigation and in house claims processing costs from such losses.
Reserves for reported losses are initially 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. Case and formula basis loss reserves are reviewed on a regular basis. As new data becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis which have not settled after six months, are case reserved at that time. 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. Additional information regarding the Company's reserves is included in
Item 7 "Management's Discussion and Analysis" in the Losses and Loss Expenses Payable section included therein.
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 ($65.5 million) 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, 2002, 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, 2002:
(1) Includes amounts due from affiliates of $4,286, $8,867 and $2,111, respectively.
(2) Includes net amounts assumed from affiliates of $303,959, $280,011 and $10,126, respectively.
(3) This line item shows increases (decreases) in the current calendar year in the provision for losses and loss expenses attributable to claims occurring in prior years. The increase of $12,414 in 2002 for claims occurring in prior years is well within normal expectations for reserve development and claim settlement uncertainty. The increase of $60,726 in 2001 for claims occurring in prior years is primarily the result of reserve strengthening on the former Meridian Mutual business in order to bring these claim reserves in line with historic State Auto adequacy levels as well as ongoing analysis of recent loss development trends. The decrease in calendar year losses from prior years in 2000 of $5,638 is within a normal expectation of reserve variation.
(4) This line item represents the increase in loss and loss expense reserves due to the Company's change in pooling participation percentages effective October 1, 2001 and January 1, 2000, respectively. See "Pooling Arrangement" in "Narrative Description of Business."
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The following table sets forth the development of reserves for losses and loss expenses from 1992 through 2002 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.
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, 2002, the Company had paid 72.7% of the currently estimated losses and loss expenses that had been incurred, but not paid, as of December 31, 1992.
The amounts on the "cumulative redundancy (deficiency)" line represent the aggregate change in the estimates over all prior years. For example, the 1992 reserve has developed a $17,765 million redundancy through December 31, 2002. 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 1996, but incurred in 1993, will be included in the cumulative redundancy amount for years 1993, 1994 and 1995. 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.
In 1992, 1995, 1998, 1999, 2000 and 2001, the Pooling Arrangement was amended to increase the Company's share of premiums, losses and expenses. An amount of assets equal to the increase in net liabilities was transferred to the Company from Mutual in 1992, 1995, 1998, 1999, 2000 and 2001 in conjunction with each year's respective pooling change. The amount of the assets transferred from Mutual in 1992, 1995, 1998, 1999, 2000 and 2001 has been netted against and has reduced the cumulative amounts paid for years prior to 1992, 1995, 1998, 1999, 2000 and 2001, respectively.
[See table on following page.]
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"):
REINSURANCE
Members of the State Auto Group follow the customary industry practice of reinsuring a portion of their exposures and paying to the reinsurers a portion of the premiums received. Insurance is ceded principally to reduce net liability on individual risks or for individual loss occurrences, including catastrophic losses. Although reinsurance does not legally discharge the individual members of the State Auto Group from primary liability for the full amount of limits applicable under their policies, it does make the assuming reinsurer liable to the extent of the reinsurance ceded.
Each member of the State Auto Group is party to working reinsurance treaties for property, casualty and workers compensation lines with several reinsurers arranged through a reinsurance broker. Under the property per risk excess of loss treaty, each member is responsible for the first $2.0 million of each defined loss, and the reinsurers are responsible for 100% of the excess over $2.0 million up to $10 million of 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 $2.0 million of a covered loss. The reinsurers are responsible for 100% of the excess over $2.0 million up to $5.0 million of covered loss. Also, certain unusual claim situations involving bodily injury liability, property damage, uninsured motorists and personal injury protection are covered by an arrangement that provides for $10.0 million of coverage in excess of a $5.0 million retention for each loss occurrence. This layer of reinsurance sits above the $3.0 million excess of $2.0 million arrangement. The rates for this reinsurance are negotiated annually.
The terms of the workers compensation excess of loss program provide that each company in the State Auto Group is responsible for the first $2.0 million of covered loss. The reinsurers are responsible for 100% of the excess over $2.0 million up to $5.0 million of covered loss, and 95% of the excess over $5.0 million up to $10 million of covered loss. Net retentions under this contract may be submitted to the casualty excess of loss program, subject to a limit of $2 million per loss occurrence.
In addition, the State Auto Group has secured other reinsurance to limit the net cost of large loss events for certain types of coverage. Included are umbrella liability losses which are reinsured up to a limit of $10.0 million above a maximum $600,000 retention. The State Auto Group also makes use of facultative reinsurance for unique risk situations and participates in involuntary pools and associations in certain states.
The members of the State Auto Group combined retain the first $40 million of each property catastrophe occurrence that affects more than two individual risks. Eighty ($80) million dollars of traditional reinsurance is available above the $40 million retention with a co-participation of 5%.
In the event of a catastrophe loss in excess of $120.0 million for the State Auto Group, STFC has implemented a structured contingent financing agreement (the "Credit Agreement") with Bank One and other lenders (the "Lenders") to provide up to $100.0 million. Under the Credit Agreement, in the event of such a loss, STFC 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 the Lenders. STFC 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, SA Wisconsin, National, Farmers Casualty, Mid-Plains, SA Ohio, Meridian Citizens Mutual and Meridian Security pursuant to a Catastrophe Assumption Agreement in the amount of $100.0 million excess $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. STFC is obligated to redeem the preferred shares by making periodic payments to the SPC. The SPC would use these payments to repay the Lenders over a five year period. This layer of $100.0 million excess of $120.0 million is excluded from the Pooling Arrangement. In addition, STFC's obligation to repay the SPC has been secured by a Put Agreement among STFC, Mutual and the Lenders; under which, in the event of a default by STFC as described in the Credit Agreement or in the Put Agreement, Mutual would be obligated to either purchase the preferred shares from the SPC or repay the SPC for the loan(s) outstanding.
National has a reinsurance agreement with Mutual pursuant to which Mutual assumes up to $4,950,000 of each liability loss occurrence in excess of National's $50,000 of retention; and up to $450,000 of each catastrophe loss occurrence in excess of National's $50,000 of retention. Mutual further provides National with an 8.5% quota share within the $50,000 retention on liability coverages, and a 20% quota share on physical damage coverages. Mid-Plains also has a reinsurance agreement with Mutual pursuant to which Mutual assumes up to $450,000 of each liability loss occurrence in excess of Mid-Plains' $50,000 of retention.
For the period October 1, 2001 through December 31, 2003, Mutual entered into a Stop Loss Reinsurance Arrangement (the "Stop Loss") with certain of the Pooled Companies. Under the Stop Loss, Mutual has agreed to participate in the Pooling Arrangement's quarterly underwriting losses and gains, in the manner described. If the Pooling Arrangement loss and LAE ratio(the "Pool loss and LAE ratio") is between 70.75% and 80.00%, Mutual will reinsure certain of the Pooled Companies 27% of the Pooling Arrangement's losses in excess of a Pool loss and LAE ratio of 70.75% up to 80.00%. Certain of the Pooled Companies would be responsible for its share of the Pooling Arrangement's losses over the 80.00% threshold. Also, Mutual will have the right to participate in the profits of the Pooling Arrangement; Mutual will assume 27% of the Pooling Arrangement's underwriting profits attributable to a Pool loss and LAE ratio less than 69.25%, but more than 59.99%. This Stop Loss Reinsurance Arrangement will cease at the end of the fourth quarter, 2003.
See discussion regarding the federal Terrorism Risk Insurance Act of 2002 ("Terrorism Act") at Regulation section and Item 7 "Management's Discussion and Analysis" in the Other External Factors section included therein.
REGULATION
Most states, including all the domiciliary states of the State Auto Group, have enacted legislation that regulates insurance holding company systems. 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 any members of the State Auto Group, 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 to shareholders. Pursuant to these laws, all transactions within the holding company system affecting any members of the State Auto Group 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. The insurance laws of all the domiciliary states of the State Auto Group provide that no person may
acquire direct or indirect control of a domestic insurer without obtaining the prior written approval of the state insurance commissioner for such acquisition.
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. Such supervision and regulation relate to numerous aspects of an insurance company's business operations 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 the State Auto Group transacts business have enacted laws which restrict these companies' 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 may adversely affect the ability of the insurers in the State Auto Group 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 the State Auto Group.
Dividends. STFC's insurance subsidiaries generally are restricted by the insurance laws of their respective states of domicile as to the amount of dividends they may pay to STFC without the prior approval of the respective state regulatory authorities. Generally, the maximum dividend that may be paid by an insurance subsidiary during any year without prior regulatory approval is limited to the greater of a stated percentage of that subsidiary's statutory surplus as of a certain date, or adjusted net income of the subsidiary, for the preceding year. Pursuant to these rules, a total of $35.3 million is available for payment to State Auto Financial as a dividend from State Auto P&C, Milbank, Farmers Casualty, SA Ohio and National during 2003 without prior approval from their domiciliary state insurance departments, under current law.
Rate and Related Regulation. In general, the Company is not aware of the adoption of any adverse legislation or regulation by any state where the Company did business during 2002 which would present material obstacles to the Company's overall business. However, several states where the Company does business have passed or are considering more strict regulation of the use of credit scoring in rating and/or risk selection in personal lines of business. Regulations or laws restricting the use of this information have an adverse impact on the Company because these laws impede the ability of the Company to make optimum use of credit scoring information. Such regulations would limit the ability of the Company, as well as the ability of all other insurance carriers operating in that jurisdiction, to take advantage of this tool.
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 has tested insurer's risk-based capital requirements since 1994. As of December 31, 2002, each insurer affiliated with the Company surpassed all standards tested by the formula applying risk-based capital requirements.
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, in a number of ways, the level of risk which insurers had expected to assume including eliminating exclusions, expanding the terms of the contract, 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 the 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.
The newly enacted Terrorism Act requires the federal government and the insurance industry to share in insured losses up to $100 billion per year resulting from future terrorist attacks within the United States. Under the Terrorism Act, commercial property and casualty insurers must offer their commercial policyholders coverage against certified acts of terrorism, but the policyholders may choose to reject this coverage. If the policyholder rejects coverage for certified acts of terrorism, the Company intends, subject to the approval of the state regulators, to cover only such acts of terrorism that are not certified acts under the Terrorism Act and that do not arise out of nuclear, biological or chemical agents.
Probably the most significant piece of legislation to affect the Company was not a state insurance law, but rather the federal Sarbanes-Oxley Act of 2002 ("Sarbanes Oxley"), which took effect in July 2002. While this law does not affect the Company's insurance operations, it has and will continue to have an effect on the Company. Sarbanes Oxley was the response of the Congress to the corporate scandals of the last two years. Sarbanes Oxley imposes significant new rules on the Company's corporate governance, its financial and reporting processes and its relationship with its independent auditor. Sarbanes Oxley will require the Company to increase the internal staff functions to ensure that it can demonstrate it is complying with these new legal requirements, which can be expected to have an adverse effect on the Company's expense ratio.
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 each of the Pooled Companies through the Pooling Arrangement. Stateco performs investment management services for the Company and Mutual and its subsidiaries, although investment policies implemented by Stateco continue to be set for each company through the Investment Committee of its Board of Directors. See "Investment Management Services" in the "Narrative Description of Business."
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 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 5.0% of assets, other than obligations of the U.S. government or government agencies, for which there is no limit. Investments in equity securities are selected based on their potential for appreciation as well as ability to continue paying dividends. See discussion regarding Market Risk included in Part II - Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Strategies as to specific investments can change depending on the Company's current federal tax position, market interest rates and general market conditions. Prior to year-end 2002, the fixed maturity investments were classified as available for sale and carried at fair market value, or as held-to-maturity and carried at amortized cost according to the Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." As of December 31, 2002, all fixed maturity investments have been classified as available for sale. Fixed maturities classified as available for sale totaled $1,216.7 million and $1,051.4 million at December 31, 2002 and December
31, 2001, respectively. Fixed maturities categorized as hold-to-maturity totaled $-0- and $27.4 million at December 31, 2002 and December 31, 2001, respectively.
At December 31, 2002 and 2001, respectively, the Company's equity portfolio totaled $53.7 million and $59.8 million.
The table below provides information about the quality and the scope of the Company's fixed maturity portfolio as of December 31, 2002:
*As rated by Moody's Investors Service
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The following table sets forth the Company's investment results for the periods indicated:
(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.
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For additional discussion regarding the Company's investments, see Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
INVESTMENT MANAGEMENT SERVICES
Stateco has been providing investment management services since 1993. These services are provided to all insurance companies affiliated with the Company or Mutual. 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. The Investment Committee of each insurer's Board of Directors sets investment policies to be followed by Stateco.
COMPETITION
The property and casualty insurance industry is highly competitive. 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" in the "Narrative Description of Business." The Company competes through underwriting criteria, appropriate pricing, quality service to the policyholder and the agent, and a fully developed agency relations program.
Another underwriting and claims issue the Company is confronting is "toxic mold." This source of loss has received significant publicity in recent months, and indications are that mold claims will increase in the future. The Company believes that, under its insurance policies, the Company is not obligated to cover this kind of commonly occurring condition, particularly when remediation costs are extreme. Hence, to protect its current rate structure, the Company has filed mold limitations and exclusions on homeowner policies and certain commercial policies in all states that will accept such filings.
EMPLOYEES
As of March 13, 2003, the Company had 2,097 employees. This includes 565 employees who had been employees of MIGI until January 1, 2002. Employees of the Company are not covered by any collective bargaining agreement. Management of the Company considers its relationship with its employees to be excellent.
AVAILABLE INFORMATION
STFC's internet website address is www.stfc.com. Through this internet website (found under the "SEC Filings" link), STFC makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after STFC electronically files such material with the Securities and Exchange Commission.
EXECUTIVE OFFICERS OF THE REGISTRANT
(1) Each of the foregoing officers has been designated by the Company's Board of Directors as an executive officer for purposes of Section 16 of the Securities Exchange Act of 1934.
(2) Richard L. Miley and Cathy B. Miley are husband and wife.
ITEM 2.
ITEM 2. PROPERTIES
Because the operations of the Company and Mutual are integrated with one another pursuant to the terms of the 2000 Management Agreement, the Company and Mutual share their operating facilities. See Item 1, "Management Agreement" in the "Narrative Description of Business." 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 claims office facilities that are owned by Mutual, including a 6,600 square foot branch office in Cleveland, Ohio; a 29,000 square foot branch office in Cincinnati, Ohio; and a 205,000 square foot regional office in Indianapolis, Indiana. In addition, 518 PML owns and leases to Mutual regional office facilities in Nashville, Tennessee; Greer, South Carolina; and Des Moines, Iowa. Milbank owns an office facility in Milbank, South Dakota, where Company employees provide services to Milbank agents and policyholders. SA Wisconsin leases an office facility in Onalaska, Wisconsin, where Company employees service SA Wisconsin's agents and policyholders. Mutual also leases space in Columbus, Ohio for a regional office and leases a number of small offices throughout its operating area for the claims operations of Mutual and the Company.
ITEM 3.
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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
STOCK TRADING
Common shares are traded in the Nasdaq National Market System under the symbol STFC. As of March 8, 2003, there were 937 shareholders of record of the Company's common shares.
MARKET PRICE RANGE, COMMON STOCK(1)
Initial Public Offering -- June 28, 1991, $2.25(1). The high and low sale prices for each quarterly period for the past two years as reported by Nasdaq are:
(1) Adjusted for stock splits.
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 for a discussion of regulatory restrictions on the payment of dividends by the Company's insurance subsidiaries.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
"Selected Consolidated Financial Data" is as follows:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
SELECTED CONSOLIDATED FINANCIAL DATA
(1) Adjusted for a July 1998 2-for-1 common stock split as well as a July 1996 3-for-2 common stock split effected in the form of a stock dividend. (2) The earnings per share amounts prior to 1997 have been restated as required to comply with SFAS No. 128. (3) Preliminary industry information for 2002 from A.M. Best.
* Reflects change in Pooling Arrangement, effective October 1, 2001, January 1, 2000, 1999, 1998 and 1995.
ITEM 7.
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:
OVERVIEW
State Auto Financial Corporation ("State Auto Financial"), through its principal insurance subsidiaries, State Auto Property and Casualty Insurance Company ("State Auto P&C"), Milbank Insurance Company ("Milbank"), Farmers Casualty Insurance Company ("Farmers Casualty") and State Auto Insurance Company of Ohio, formerly State Auto Insurance Company ("SA Ohio"), provides personal and commercial insurance for the standard insurance market. State Auto National Insurance Company ("National") and Mid-Plains Insurance Company ("Mid-Plains") write personal automobile insurance for risks in the nonstandard insurance market. These insurance products are marketed through the independent agency system. State Auto Financial is a majority-owned subsidiary of State Automobile Mutual Insurance Company ("Mutual"), an Ohio domiciled property and casualty insurer. State Auto Financial and its subsidiaries are referred to collectively herein as the "Company."
Mutual's wholly-owned subsidiaries are State Auto Insurance Company of Wisconsin, formerly Midwest Security Insurance Company ("SA Wisconsin"), State Auto Florida Insurance Company ("SA Florida") and Meridian Insurance Group, Inc. ("MIGI"). MIGI's subsidiaries are Meridian Security Insurance Company ("Meridian Security"), Meridian Citizens Security Insurance Company ("Meridian Citizens") and Insurance Company of Ohio ("ICO"). ICO ceased insurance operations on October 1, 2002 and was dissolved on January 15, 2003. MIGI is also party to an affiliation agreement with Meridian Citizens Mutual Insurance Company ("Meridian Citizens Mutual"). Meridian Security, Meridian Citizens, ICO and Meridian Citizens Mutual are collectively referred herein as the "MIGI Insurers."
State Auto P&C provides employees to all insurance affiliates, including Mutual and each of its affiliates. This is contractually provided for under the following management and/or cost sharing agreements: 1) the "2000 Management Agreement", to which State Auto P&C, Mutual, National, Milbank, and SA Ohio are parties. After October 1, 2001, the 2000 Management Agreement became a pure cost sharing agreement, but prior thereto, this agreement provided for a management fee based on surplus which was paid by each managed company to State Auto P&C; 2) the "Midwest Management Agreement", to which State Auto P&C, Mutual and SA Wisconsin are parties. This agreement provides for a management fee based on a percentage of direct written premiums collected by the Company for the services State Auto P&C provides; 3) the MIGI Management Agreement, effective July 1, 2002, to which State Auto P&C, Meridian Security, Meridian Citizens, and Meridian Citizens Mutual are parties. This agreement provides for a management fee equal to a percentage of the allocable employee expenses attributable to the operations of these companies paid to the Company for the services State Auto P&C provides. Each of the foregoing management agreements also apportions the actual costs of the services provided among the parties.
Effective January 1, 2002, all employees of MIGI became employees of State Auto P&C. In conjunction with this transaction, approximately $3.6 million in net plan benefit liabilities were transferred from MIGI to State Auto P&C.
State Auto P&C, Milbank, Farmers Casualty and SA Ohio (collectively the "Pooled Subsidiaries"), the insurance subsidiaries comprising the standard insurance segment, participate in a quota share reinsurance pooling arrangement (the "Pooling Arrangement") with Mutual. The Pooling Arrangement provides that the Pooled Subsidiaries cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation percentages as outlined in the Pooling Arrangement.
The following table sets forth a chronology of the participant changes that have occurred in the Pooling Arrangement since January 1, 1999:
* Time period is for the year ended December 31, unless otherwise noted.
On January 1, 2003, the Pooling Arrangement was amended to add SA Florida as a participant. The Company's aggregate pooling participation percentage remained at 80%. At December 31, 2002, SA Florida had not commenced insurance operations; consequently, there was no impact on the Company's books at January 1, 2003 relating to the Pooling Arrangement amendment.
In discussing Results of Operations, State Auto P&C, Milbank, Farmers Casualty, SA Ohio, National, Mid-Plains, Mutual, SA Wisconsin, Meridian Security, Meridian Citizens, ICO and Meridian Citizens Mutual are referred to collectively as the "State Auto Insurance Companies." The Pooled Subsidiaries, Mutual and SA Wisconsin are collectively referred to below as the "Pooled Companies."
Non-insurance subsidiaries of the Company include Stateco Financial Services, Inc. ("Stateco"), which provides investment management services to affiliated companies and Strategic Insurance Software, Inc. ("S.I.S."), which develops and sells software for the processing of insurance transactions, database management systems for insurance agents and electronic interfacing of information between insurance companies and agents. S.I.S. sells its services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies. 518 Property Management and Leasing, LLC ("518 PML") is engaged in the business of owning and leasing real and personal property to affiliated companies. The members of 518 PML are State Auto P&C and Stateco. The results of operations of S.I.S. and 518 PML are not material to the total operations of the Company.
The following is a summary of several transactions that occurred in the second half of 2001 that will assist in the discussion of the Company's current period financial results:
Effective June 1, 2001, Mutual merged with Meridian Mutual Insurance Company ("Meridian Mutual"), with Mutual continuing as the surviving corporation, and acquired MIGI. Effective July 1, 2001, the insurance business of the former Meridian Mutual became part of the Pooling Arrangement and the Pooled Subsidiaries assumed 53% of the Meridian Mutual business on this same date. Concurrent with this transaction, the Pooled Subsidiaries received cash of $6.4 million and fixed maturities totaling $109.7 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on July 1, 2001. The business of the former Meridian Mutual provides both standard and nonstandard personal lines and standard commercial lines to its policyholders. The principal lines of business include standard personal and commercial automobile, nonstandard personal automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. This former Meridian Mutual business assumed by the Pooled Subsidiaries comprises the Company's "Meridian standard" and "Meridian nonstandard" segments.
Effective October 1, 2001, the 2000 Management Agreement was amended to eliminate the management and operations services fee charged by State Auto P&C to participants to the agreement, including Mutual. As a result of the loss of this income, substantially all of State Auto P&C's services income was eliminated at that time. Consequently, beginning with the first quarter
2002, the management and operations services segment is included in the "all other" category for segment reporting, as the results of this segment no longer meet the quantitative thresholds for separate presentation as a reportable segment. See "Reportable Segments" included herein and footnote 15 regarding the Company's operating segments in the consolidated financial statements of the Company.
The Pooling Arrangement was amended, effective October 1, 2001, such that the Pooled Subsidiaries' aggregate participation was increased from 53% to 80%. In conjunction with this change in pool participation, the Pooled Subsidiaries received cash of $2.2 million and fixed maturities totaling $236.3 million from Mutual, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on October 1, 2001.
For the period October 1, 2001 through December 31, 2003, Mutual entered into a stop loss reinsurance arrangement (the "Stop Loss") with the Pooled Subsidiaries. Under the Stop Loss, Mutual has agreed to participate in the Pooling Arrangement's quarterly underwriting losses and gains in the manner described. If the Pooling Arrangement's quarterly statutory loss and loss adjustment expense ratio (the "Pool loss and LAE ratio") is between 70.75% and 80.00% (after the application of all available reinsurance), Mutual will reinsure the Pooled Subsidiaries 27% of the Pooling Arrangement's losses in excess of a Pool loss and LAE ratio of 70.75% up to 80.00%. The Pooled Subsidiaries would be responsible for their share of the Pooling Arrangement's losses over the 80.00% threshold. Also, Mutual will have the right to participate in the profits of the Pooling Arrangement. Mutual will assume 27% of the Pooling Arrangement's underwriting profits attributable to Pool loss and LAE ratios less than 69.25%, but more than 59.99%.
As the former Meridian Mutual standard and nonstandard business continues to be written and processed through the Meridian underwriting and claims system platform, management has monitored this business as separate segments from the State Auto standard and nonstandard processed business. Monitoring of these segments separately has been necessary in order to facilitate the integration of the business as it migrates through new policies and renewals to the State Auto systems platform in which State Auto policies, pricing, underwriting, and claims philosophies are fully reflected. Over time, it is anticipated that the Meridian operating segments will decrease and eventually disappear as they become fully integrated on to the State Auto systems platform. With the addition of the former Meridian Mutual business to the Pooling Arrangement, the Company renamed the two insurance segments that existed prior to 2001 to be the "State Auto standard segment" and the "State Auto nonstandard segment" and that business consisting of the business known formerly as the Meridian Mutual business to be the "Meridian standard segment" and "Meridian nonstandard segment." Due to the integration efforts that occurred within the Meridian nonstandard segment during 2001 and 2002, beginning with the first quarter of 2003, the Meridian nonstandard business will be included in the State Auto nonstandard segment.
CRITICAL ACCOUNTING POLICIES
The Company's significant accounting policies are more fully described in note 1 to the Company's consolidated financial statements. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the period then ended and the financial entries in the accompanying notes to the financial statements. Such estimates and assumptions could change in the future, as more information becomes known which could impact the amounts reported and disclosed therein.
Losses and loss expenses payable are management's best estimates at a given point in time of what the Company expects to pay claimants, based on known facts, circumstances and historical trends. 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 data for similar claims with provision 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. Case and formula basis loss reserves are reviewed on a regular basis and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses that had initially been reserved on a formula basis which have not settled after six months, are case reserved at that time. Although management uses many resources to calculate reserves, there is no precise method for determining the ultimate liability.
Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses relating to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed computing the acquisition costs limit the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned. These amounts are based on estimates, and accordingly, the actual realizable value may vary from the estimated realizable value.
At December 31, 2002, fixed maturity and equity security investments are classified as available for sale and carried at fair value. At December 31, 2001, fixed maturities are classified either as held to maturity and carried at amortized cost, or available for sale and carried at fair value. For investments classified as available for sale, the net unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity as "accumulated other comprehensive income," and as such are not included in the determination of net income. Investment income is recognized when earned, and capital gains and losses are recognized when investments are sold.
The Company regularly monitors its investment portfolio for declines in value that are other than temporary, an assessment which requires significant management judgment. Among the factors management considers are market conditions, the amount, timing and length of decline in fair value, and events impacting the issuer. When a security in the Company's investment portfolio has a decline in fair value which is other than temporary, the Company adjusts the cost basis of the security to fair value. This results in a charge to earnings as a realized loss, which is not changed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other than temporary, are included in other comprehensive income.
See a discussion of other factors that may have an impact on management's best estimates at "Impact of Significant External Factors" included herein.
RESULTS OF OPERATIONS
2002 COMPARED TO 2001
Net income for the Company increased by $16.4 million (79.5%) in 2002. Contributing to this increase was a 4.6 point improvement in the Company's GAAP combined ratio and, as more fully described above, changes made to the Company's participation in the Pooling Arrangement in the second half of 2001. Additionally, net investment income increased due to the Pooling Arrangement changes in 2001, which was offset by a decrease in the Company's management and operations service income.
Consolidated earned premiums increased by $341.4 million (61.5%) in 2002. This increase was the result of the addition of the former Meridian Mutual business to the Pooling Arrangement, effective July 1, 2001, a change in the Pooled Subsidiaries' aggregate pooling participation percentage from 53% to 80%, effective October 1, 2001 and total net internal growth of 16.3%. The addition of the former Meridian Mutual business and the pooling change increased consolidated earned premiums 45.2%. The internal growth of the State Auto standard segment's earned premiums increased consolidated earned premiums 15.1%. This increase was driven by growth in commercial lines of business due to a combination of rate changes as well as increased policy counts. Personal lines of business continued to experience sales increases over prior year due to changes in the marketplace that permitted rate increases, as well as the expansion of the new personal lines sales specialist position that contributed to increased policy counts. The internal growth of the State Auto nonstandard segment earned premiums increased consolidated earned premiums 5.4% due to a combination of rate changes and increased policy counts.
The internal decline of the Meridian standard and nonstandard segments decreased consolidated earned premiums 4.2%. This decrease was expected, given the corrective actions taken by management in both these segments, which actions included appropriate and necessary rate increases in almost every line of business. Additionally, one of the more significant actions taken within the Meridian standard segment was the discontinuance in late 2000 of the Group Advantage(R) Program which had generated substantial underwriting losses for Meridian Mutual. The last Group Advantage(R) policy on the books terminated January 2003. Regarding the Meridian nonstandard segment, in addition to taking significant corrective rate action, beginning in late 2001, the Company implemented an integration plan to write all new nonstandard auto business produced by the former Meridian Mutual agents through the State Auto nonstandard segment, specifically through National on the National system platform utilizing a more appropriate rating structure as well as credit scoring (as permitted by local law) and "point-of-sale" underwriting tools. The order of integration had been prioritized such that the states with the most need for profit improvement migrated to National first. All Meridian nonstandard auto new business is now being written through the State Auto nonstandard segment. The business that remains within the Meridian nonstandard segment is expected to decrease given this segment's historically low retention rate as well as the Company continuing to take appropriate rate increases. Fourth quarter 2002 earned premiums for the Meridian nonstandard segment comprised 0.5% of total consolidated earned premiums versus 1.8% in the same 2001 period. Consequently, beginning with the first quarter 2003, the Meridian nonstandard auto business will be included in the State Auto nonstandard segment category.
Net investment income increased by $12.3 million (26.0%) in 2002. Contributing to the increase over the previous year was an increase in invested assets due to a transfer of $354.6 million in cash and fixed maturity securities from Mutual to the Pooled Subsidiaries in the second half of 2001. This transfer was made in conjunction with the changes made to the Pooled Subsidiaries participation in the Pooling Arrangement, as more fully described above. Total cost of invested assets at December 31, 2002 and 2001, was $1,303.0 million and $1,150.3 million, respectively. Reflecting a decline in the interest rate environment, the investment yields, based on cash equivalents, fixed and equity securities at cost were 4.9% and 5.4% for the annual periods ending 2002 and 2001, respectively. See further discussion regarding investments at the "Liquidity and Capital Resources", "Investments" and "Market Risk" sections, included herein.
Management services income, including investment management fees, decreased by $12.9 million (83.1%) in 2002. This decrease was attributable to the termination of the fee element of the 2000 Management Agreement. The service fee under the 2000 Management Agreement paid by Mutual in 2001 was $12.5 million. See "Liquidity and Capital Resources" included herein, for discussion of the overall impact of the loss of the management and operations service fee on the Company's cash flow and operations.
Consolidated losses and loss adjustment expenses, as a percentage of earned premiums (the "GAAP loss and LAE ratio"), were 72.9% and 76.9% for the years 2002 and 2001, respectively. Comparison of the overall results of 2002 with those of 2001 was affected by the addition of the former Meridian Mutual business to the Pooling Arrangement. Since the former Meridian Mutual business was added to the Pooling Arrangement effective July 1, 2001, it negatively impacted the loss results of the Company only in the second half of 2001. However, in 2002 the results of the former Meridian Mutual business were included in and negatively impacted the results of the Pooling Arrangement for the entire year. Comparison of the overall results of 2002 with those of 2001 is also affected by the reserve strengthening that occurred during the second half of 2001 with respect to the Meridian segments. While the Meridian standard business continues to produce loss results poorer than the State Auto book of business (see table of GAAP loss and LAE ratios operating segments below), management believes there has been improvement in the performance of the Meridian segments due to the continuing efforts to improve pricing and risk selection applicable to these segments during 2002.
During the quarters ended September 30, 2002 and June 30, 2002, the Pooled Companies produced a Pool loss and LAE ratio under the Stop Loss (described above) that exceeded the 70.75% threshold, thereby recovering from Mutual $2.4 million and $6.4 million in losses, respectively (total of $8.8 million for the year ended December 31, 2002). In the quarters ended December 31, 2002 and March 31, 2002, the Pooled Companies' Pool loss and LAE ratio was less than 69.25%, but more than 59.99%,
thereby ceding to Mutual, under the Stop Loss $1.0 million and $0.4 million in earned premiums, respectively (total of $1.4 million for the year ended December 31, 2002). The cession activity through the Stop Loss had the effect of lowering the GAAP loss and LAE ratio by 0.9 and 1.1 points in 2002 and 2001, respectively.
The year 2002 was the worst catastrophe year in the history of the Company on a dollar loss basis and third worst in terms of GAAP loss and LAE ratio points. During the second quarter of 2002, a series of tornadoes and hailstorms went through several of the Company's operating states, including an tornado in La Plata, Maryland. This storm was the largest single catastrophe event for the Company in 2002, accounting for 3.1 GAAP loss and LAE ratio points. Overall, catastrophe losses in 2002 were 1.2 GAAP loss and LAE ratio points higher than in 2001.
For discussion purposes, the following table provides comparative GAAP loss and LAE ratios for the Company's insurance operating segments for the 2002 and 2001 periods, respectively, except for the Meridian segments for 2001, which is for the six month period ended December 31, 2001:
The State Auto standard segment GAAP loss and LAE ratio increased in 2002 to 69.4 from 65.9 in 2001. Catastrophe losses represented 5.7 points of this segment's loss results for 2002 compared to 4.4 points for 2001. With the significant increase in new business policy count came an increase in claim submissions. While general inflation has been relatively modest for the past several years, price inflation on goods and services for which insurance pays, such as medical care and repairs to automobiles and buildings, exceeded the rate of overall inflation and adversely impacted the GAAP loss and LAE ratio. The Company has reacted to this inflationary trend by filing more aggressive, cost-based, rate increases. Also contributing to the current year deterioration in the GAAP loss and LAE ratio was restrictions on the use of credit scoring in some states where the Company does business. To the extent these limitations result in higher loss ratios, the actuarial rate indications will increase resulting in larger rate increases being sought. The Company is also reviewing its credit scoring models to ensure that the premium rate derived from the model continues to accurately reflect the loss experience associated with each particular credit score range.
Representing approximately 42% of this segment's business, personal automobile has over the last five years yielded loss results better than industry average and in fact, has produced combined ratios of less than 100.0%. While the current year results are expected again to better industry average, this line of business did experience deterioration in its current year loss ratio, specifically within the auto liability and no fault lines, which management believes is due at least in part to increasing rates of inflation applicable to the health care sector of the U.S. economy and an increased volume of new business, as noted above. Adverse loss results on workers' compensation, commercial multi peril and other liability lines of business, which collectively represents approximately 18.2% of this segment's business, also contributed to the current year loss result increase. The Company is taking substantial and necessary rate increases in rate per exposure across these lines of business. Workers' compensation continues to be one of the most volatile lines that the Company provides and for this reason the Company has always maintained a particularly conservative posture on pricing in this line.
The State Auto nonstandard segment GAAP loss and LAE ratio increased in 2002 to 81.2 from 77.3 in 2001. This segment experienced more volatility in 2002, especially in those states experiencing substantial premium growth due to policy count increases. As described above, contributing to this growth has been the addition of National's product to agents who wrote the former Meridian Mutual's nonstandard auto business. While nonstandard automobile tends to be a more volatile line of business than standard automobile, management continually monitors this segment's premium rate adequacy. Management has been paying particular attention to the adequacy of these rates in these growth states, as well as risks
written in certain agencies, and is reacting accordingly by increasing rates and working with those agencies regarding risk selection.
The Meridian standard segment GAAP loss and LAE ratio for 2002 was 85.9 compared to 139.3 for the six month period ended December 31, 2001. Comparison of the overall results of 2002 with those of 2001 is affected by the reserve strengthening that occurred during the second half of 2001 within this segment. Catastrophe losses represent approximately 7.0 points of this segment's loss results for both the 2002 and 2001 periods. While the Meridian standard business continues to produce loss results worse than the State Auto book of business, management believes there has been improvement in this segment due to the necessary and continued efforts that began in 2001, e.g. seeking adequate cost-based rates, re-underwriting commercial renewals to be certain that risks written are within the State Auto underwriting guidelines and discontinuing the Group Advantage(R) Program.
The Meridian non-standard segment GAAP loss ratio for 2002 was 51.9 compared to 168.2 for the six month period ended December 31, 2001. This segment was also significantly impacted by case reserve strengthening that occurred during the second half of 2001. Similar to the Meridian standard segment, largely contributing to the current year loss results has been the substantial rate increases the Company implemented in 2001 and 2002.
Acquisition and operating expenses, as a percentage of earned premiums (the "GAAP expense ratio"), were 29.5% and 30.1% for the years 2002 and 2001, respectively. Management continually focuses its attention on improving its GAAP expense ratio, which is especially critical during a period of substantial top line growth.
Interest expense relates to the $45.5 million line of credit agreement the Company entered into with Mutual in 1999 and the $15.0 million surplus note agreement entered into with an affiliate on September 30, 2002. See additional discussion in the "Liquidity and Capital Resources" section included herein.
The 2002 underwriting improvement, coupled with net investment income being largely comprised of tax-exempt income, produced an effective tax expense rate in 2002 of 2.1% versus an effective tax benefit of 15% in 2001. For additional clarification, see the reconciliation between actual federal income taxes and the amount computed at the statutory rate as detailed in footnote 8 in the notes to the Company's consolidated financial statements.
2001 COMPARED TO 2000
Net income for the Company decreased $27.1 million (56.8%) in 2001. Contributing to this decease was an increase in the Company's GAAP combined ratio to 107.0% from 98.4% in 2000. Negatively impacting the Company's insurance operations in 2001 were the loss results of the former Meridian Mutual business, assumed by the Pooled Subsidiaries beginning in July 2001, and a decrease in the Company's management and operations service fee income.
Consolidated earned premiums increased $157.2 million (39.5%). This increase was principally the result of the addition of the former Meridian Mutual business to the Pooling Arrangement, effective July 1, 2001, and a change in the Pooled Subsidiaries' aggregate pooling participation percentage from 53% to 80%, effective October 1, 2001. These actions increased consolidated earned premiums 30.9%. The internal growth of the State Auto standard segment's earned premiums increased consolidated earned premiums 6.8%. This increase has been largely driven by growth in commercial lines of business over the last twelve months; however, during the last half of the calendar year, personal lines of business began to experience sales increases. Management believes the personal lines sales increases are due to changes in the market place and to its establishing the position of Personal Lines Sales Specialist. The internal growth of the State Auto nonstandard segment earned premiums increased consolidated earned premiums 2.0%. Production levels in this segment continued to improve during 2001 as a result of improved processing routines for agents and the easing of competitive pricing pressures it had felt from certain market leaders in the first half of 2000. The internal growth of both the Meridian standard and nonstandard segment on consolidated earned premium was flat. See discussion below regarding management's action during 2001 on the Group Advantage(R) Program as well as management's
response to adequacy of premium rate levels within the standard segment and the Company's plan on integration with regard to the Meridian nonstandard segment.
Net investment income increased $8.5 million (21.7%) in 2001. Contributing to the increase over the previous year was an increase in investable assets due to a transfer of cash and fixed maturity securities from Mutual totaling $354.6 million to the Pooled Subsidiaries in conjunction with the Pooled Subsidiaries assuming 53% of the former Meridian Mutual business on July 1, 2001 and the change in the Pooled Subsidiaries pooling participation percentages, effective October 1, 2001, from 53% to 80%. Total cost of investable assets at December 31, 2001 and 2000, was $1,150.3 million and $741.1 million, respectively.
The investment yields, based on cash equivalents, fixed maturities and equity securities at cost, were 5.4% and 5.5% for the annual periods ending 2001 and 2000, respectively. During 2001, the Company experienced an increase in the number of calls over prior years on higher yielding fixed maturities. Monies from these calls were reinvested at lower rates. See further discussion regarding investments at the "Liquidity and Capital Resources," "Investments" and "Market Risk" sections, included herein.
Management services income, including investment management fees, decreased $2.0 million (11.4%) to $15.6 million for the year ended December 31, 2001. This decrease was attributable to the resolution of the disagreement between the Company and Ohio Department of Insurance regarding the recognition of the service fee paid by Mutual to State Auto P&C. The service fee under the 2000 Management Agreement paid by Mutual in 2001 was $12.5 million down from $14.5 million in 2000. See "Liquidity and Capital Resources" included herein, for discussion of the overall impact of the loss of the management and operations service fee on the Company's cash flow and operations.
Losses and loss expenses increased $154.9 million (56.9%) and as a percentage of earned premiums (the "GAAP loss and LAE ratio"), were 76.9%% and 68.4% for the years 2001 and 2000, respectively. During the fourth quarter of 2001, the Pooled Subsidiaries produced a loss ratio under the Stop Loss (described above) that exceeded the 80% threshold, thereby recovering the full layer of $6.2 million from Mutual. Adversely impacting the current year results were the loss results of the former Meridian Mutual business assumed by the Pooled Subsidiaries.
For discussion purposes, the following table provides comparative GAAP loss and LAE ratios for the Company's insurance operating segments for the 2001 and 2000 periods, respectively, except for the Meridian segments for 2001, which is for the six month period ended December 31, 2001:
The Company's State Auto standard segment reflected an improvement in its GAAP loss and LAE ratio in 2001 to 65.9 from 67.4 in 2000. This segment's largest line of business, automobile, reflected a 1.5 point improvement in 2001 from 2000. This segment's next largest line of business, homeowners, has experienced some deterioration in its GAAP loss and LAE ratio over the last several years. Management has been monitoring this line of business and has taken some corrective action through rate increases and improved underwriting techniques such as credit scoring.
The Company's State Auto nonstandard segment experienced an improvement in its GAAP loss and LAE ratio in 2001 to 77.3 from 81.4 in 2000. In 2000, this segment began experiencing some volatility in loss activity in those states where National began operations in 1999. Consequently, management began monitoring the premium rate adequacy in these new states and reacted accordingly throughout 2000 and 2001 by increasing rates in these new states. Additionally, this segment has implemented a number of underwriting tools, including "point-of-sale" underwriting as well as the use of credit scoring. Management believes these two tools have contributed to this segment's profit improvement.
The former Meridian Mutual business has historically produced poorer loss results than the State Auto book. Through the integration process, several areas within the Meridian Mutual book are being strengthened that should produce improved long term results. The most notable improvement was management's focus on reviewing the Meridian segments' case reserves during the second half of 2001 to ensure that the claims were reserved in a manner consistent with State Auto practices. During the review, it became apparent that case reserves on the Meridian segments for claims occurring in prior accident periods were not reserved consistently with historic State Auto adequacy levels. Nearly 14,000 open claims were reviewed, adding approximately $36 million to known case reserves on claims occurring in prior periods. Irrespective of this reserve strengthening, the Meridian segments' business continues to produce results that are not acceptable to management.
Corrective action is taking place in both the standard and nonstandard segments. Group Advantage(R) was a program within Meridian's standard segment where Meridian made its personal lines products available to Sam's Club members through insurance kiosks located in Sam's Club retail outlets. While this program generated significant premium growth, it consistently failed to meet profitability objectives. As a result, in late 2000, the former Meridian Mutual stopped writing new Group Advantage(R) business and began to terminate existing business as permitted by law. At the end of 2000, there were approximately 15,000 Group Advantage(R) policies in force. At year end 2001, there are approximately 800 of such policies in force. These remaining policies are expected to non-renew over the course of 2002.
During 2001, management also focused on strengthening the Meridian standard segment's adherence to underwriting guidelines in a manner consistent with State Auto practices, as well as analyzing the adequacy of prices relative to risks written. Consequently, management is in the process of re-underwriting 100% of the commercial renewals to be certain they fall within the State Auto guidelines. State Auto also has a practice of reviewing the rate level for each line of business in each operating state each year. Concurrent with these reviews, the Meridian standard segment's rate levels on its commercial book of business are being adjusted to the State Auto rate level. Implementing the Company's underwriting and pricing discipline within the Meridian standard segment is anticipated to have an adverse effect on top line growth of the Meridian standard segment. This may be partially offset by new business being written within the State Auto standard segment by those agencies previously representing the former Meridian Mutual but not State Auto.
The Meridian nonstandard segment produced significant underwriting losses generating a loss ratio for the six months ended December 31, 2001 of 168.2%. An integration plan is currently in place to write all new nonstandard auto business produced by former Meridian agents through National on the National system platform. The National system provides several enhancements that management anticipates will improve the nonstandard loss ratio for new risks written. Most notably, the National system uses credit scoring and "point-of-sale" underwriting tools. The order of integration has been prioritized such that the states with the most need for profit improvement are migrating to National first. New business for six of the 12 states that the Meridian nonstandard segment operates in is currently being written through National, with the remaining six states to follow throughout 2002.
Acquisition and operating expenses, as a percentage of earned premiums (the "GAAP expense ratio"), were 30.1% and 30.0% for the years 2001 and 2000, respectively. Impacting the current year expenses was approximately $1.3 million (0.2%) related to the Company's estimate of its future guaranty fund assessments related to the Reliance Insurance Company insolvency that was announced during the fourth quarter of 2001.
Interest expense relates to the line of credit agreement the Company entered into with Mutual during the second quarter of 1999 to assist in the funding of its stock repurchase program. See additional discussion in the "Liquidity and Capital Resources" section included herein.
Other expense as a percentage of earned premiums, were 1.6% and 1.7% for the year 2001 and 2000, respectively. Other expense for 2000 included $530,000 in interest relating to the return of premiums to the policyholders in the state of North Carolina as a result of settlement of rate litigation with the North Carolina Department of Insurance. Absent this interest charge in 2000, other expense, as a percentage of earned premiums, was comparable between the two time periods.
During 2001, the Company experienced an underwriting loss on its insurance operations, largely due to the loss results of the former Meridian Mutual business assumed by the Pooled Subsidiaries. This underwriting loss, coupled with net investment income being largely comprised of tax-exempt income, produced an effective tax benefit in 2001 of 15% versus an effective tax expense of 22% in 2000. For additional clarification, see the reconciliation between actual federal income taxes and the amount computed at the statutory rate as detailed in footnote 8 in the notes to the Company's consolidated financial statements.
REPORTABLE SEGMENTS
The Company's reportable segments are: State Auto standard insurance, State Auto nonstandard insurance, Meridian standard insurance, Meridian nonstandard insurance, and investment management services. The profits (losses) of these segments are monitored by management on an unconsolidated basis, as reflected in footnote 15, Reportable Segments, in the Company's consolidated financial statements and therefore do not reflect adjustments for transactions with other segments or realized gains or losses on sales of investments. The following table reflects segment profit (loss) for the years ended 2002, 2001, and 2000, except for the Meridian segments for 2001, which is for the six month period ended December 31, 2001:
The decrease in the Company's 2002 profit within the State Auto standard insurance segment is primarily due to an increase in this segment's current year loss experience as discussed at "2002 Compared to 2001" in "Results of Operations." Increased top line growth, as well as an increase in the State Auto nonstandard segment's net investment income, despite deterioration in its loss results, contributed positively to this segment's profit in 2002. Improvement in the Company's 2001 segment profit within the State Auto standard and nonstandard insurance segments was primarily due to an improvement in these segments' loss experience and management's response to premium rate inadequacy as discussed at "2001 Compared to 2000" in "Results of Operations." As discussed above, management continually monitors these segments' premium rate adequacy and seeks adequate cost-based rates.
Comparison of the segment profit (loss) results of 2002 with that of 2001 for the Meridian segments was affected by the reserve strengthening that occurred during the second half of 2001. While management recognizes that the Meridian standard business continues to produce loss results poorer than the State Auto standard segment, it believes its integration efforts that began in 2001, as discussed at "2001 Compared to 2000," has improved this segment's results.
The increase in segment profit of the investment management segment in 2002 and 2001 was the result of this segment providing its services to the Meridian Insurers beginning June 1, 2001. This segment's revenue is based on the average fair value of the portfolio of the companies managed, which is largely comprised of fixed maturities. During 2002 and 2001, the investment management segment profit increased as managed invested assets increased.
As discussed above, beginning with the first quarter of 2002, the management and operations services segment is now included in the "all other" category for segment reporting as the results of this segment no longer meet the quantitative thresholds for separate presentation as a reportable segment. All other segment profits, including management and operations services, decreased in 2002 and 2001. The termination of the service fee under the 2000 Management Agreement was due to the resolution of the disagreement between the Company and Ohio Department of Insurance regarding the service fee
paid by Mutual to the Company in 2001. See discussion at "2002 Compared to 2001" and "2001 Compared to 2000" in "Results of Operations." For additional information on the Company's reportable segments, see footnote 15 on "Reportable Segments" in the Company's consolidated financial statements.
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 short and long-term cash requirements without the need to sell investments to meet fluctuations in claim payments.
Overall net cash provided by operating activities was $126.6 million in 2002, $63.5 million in 2001 and $87.7 million in 2000. The increase in 2002 is largely attributable to the prior year changes to the Pooled Subsidiaries participation in the Pooling Arrangement. In the second half of 2001, the Pooled Subsidiaries received cash of $8.6 million and fixed maturities of $346 million from Mutual as a result of adding the Meridian Mutual business to the Pooling Arrangement and changing the pooling participation percentage of the Pooled Subsidiaries from 53% to 80%. In 2000 there was a cash transfer of $18.6 million to the Pooled Subsidiaries in connection with the 2000 amended Pooling Arrangement, as well as a cash transfer of $28.1 million to State Auto P&C from Mutual relating to the net pension and post-retirement plan liabilities assumed by State Auto P&C relating to the transfer of employees of Mutual as of January 1, 2000. Prior to 2000, State Auto P&C provided only executive management services to all insurance affiliates. Absent the impact of these transactions in 2001 and 2000, net cash provided by operating activities was $54.9 million and $40.9 million, respectively. Over the last three years, operating cash flows have been sufficient to meet the operating needs of the Company while providing opportunities for increased investment and financing needs. The combination of the elimination of the relatively consistent cash flow from the management and operations services fee from Mutual in 2001 along with significantly larger insurance segments is expected to result in more volatility going forward but will also provide opportunity for increased earnings and cash flows from operations.
Overall net cash used in investing activities was $85.6 million during 2002, $55.3 million in 2001 and $90.9 million during 2000. The respective year's investing activity was reflective of the cash flow generated from operations discussed above. During 2002 the Company experienced fluctuating activity within its fixed maturity portfolio. Call activity in 2002 continued in response to the declines in the interest rate environment. While the Company continued to focus its attention on improving the loss results of the Meridian book of business, which has put upward pressure on the Company's overall loss experience in recent years, the Company increased its sale activity of its fixed maturities in an effort to increase its taxable position in its investment portfolio. Monies generated from the call and sale activity have been reinvested at lower yielding rates.
Cash provided by financing activities consists of proceeds from issuance of debt and common stock and cash used to acquire treasury shares and pay dividends to shareholders. Overall net cash provided by financing activities was $25.0 million in 2002, $0.5 million in 2001 and $10,000 in 2000. Net cash provided by financing activities increased during 2002 primarily due to net proceeds from issuance of debt (see discussion below), partly offset by payments to re-purchase Company common shares. During 2001 net cash provided by financing activities increased due to an increase in net proceeds from issuance of common stock over 2000.
Mutual, whose ownership in State Auto Financial is approximately 67%, has waived its right to receipt of the dividends declared by State Auto Financial since 1994 in an effort to enhance the statutory surplus of the insurance subsidiaries of State Auto Financial for use in support of underwriting operations which in turn is expected to increase the statutory surplus of Mutual. In years before 2002, prior to the declaration of each dividend by State Auto Financial, Mutual's directors reviewed the facts and circumstances then present in deciding whether to waive such dividend. Beginning in 2002, the issue of the waiver of Mutual's dividend on its shares of State Auto Financial was referred to the Independent Committee of the board of directors of Mutual. It met and determined that it would review dividend waiver
decisions on an annual basis. For the year 2002, this committee of Mutual's board of directors decided to waive Mutual's dividends that might be declared by the board of directors of State Auto Financial for 2002 in order to take better advantage of the investment opportunity State Auto Financial represents for Mutual. In 2003, once again this matter was referred to the Independent Committee of the Mutual board which determined to waive Mutual's right to receipt of dividends declared by State Auto Financial for the year 2003.
Impacting cash provided by financing activities during 2002, 2001 and 2000 was State Auto Financial's Board of Directors' approving plans to repurchase shares of its common stock from the public. In March 2002, the Board of Directors of State Auto Financial approved a plan to repurchase up to 1.0 million shares of its common stock from the public over a period extending to December 31, 2003. During 2002, the Company repurchased 396,000 shares from the public for a total of $6.3 million. Impacting cash used in financing activities during 2001 and 2000 was a 2000 stock repurchase plan approved to purchase up to 1.0 million of State Auto Financial's common stock from the public ending December 31, 2001 (the "2000 Repurchase Plan"). In 2001 and 2000, the Company repurchased approximately 25,000 shares each year from the public for a total of $0.4 million and $0.3 million, respectively.
In conjunction with a 1999 Repurchase Plan, State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million. The interest rate is adjustable annually on each January 1 to reflect adjustments in the then current prime lending rate as well as State Auto Financial's current financial position. The interest rate was 4.75%, 5.0% and 6.0% for 2002, 2001 and 2000, respectively. Beginning January 1, 2003, the interest rate on this credit agreement will be 4.25%. Commencing in 2001, principal is due upon demand, with final payment to be received on or prior to December 31, 2005
Effective September 30, 2002, Milbank entered into a $15.0 million surplus contribution note with Meridian Security. Subject to the condition described below and other terms of the note, the maturity date is September 30, 2012. The interest rate is equal to the U.S. Treasury ten-year note yield at September 30, 2002 plus 100 basis points (4.59%) and is adjustable October 1, 2007, to the then current U.S. Treasury ten-year note yield plus 100 basis points for the remaining term of the note. Interest is accrued, but all payments of principal or interest may be made only with the prior written approval of the South Dakota Director of Insurance, Milbank's domiciliary state. Interest is scheduled to be paid semiannually in arrears beginning March 30, 2003.
The purpose of this surplus contribution note was to lower Milbank's net written premium to statutory surplus ratio (the "leverage ratio"). The increase in Milbank's leverage ratio resulted from an unusual rate of written premium growth over the last eighteen months due to a combination of increased top line growth and an increase in the Company's pooling participation percentage, effective October 1, 2001 (Milbank's pooling percentage increased from 10% to 17%), as well as the addition of the former Meridian Mutual business to the Pooling Arrangement, effective July 1, 2001. Also affecting its leverage ratio had been the increased losses sustained by the Company during the period of transition of the former Meridian Mutual book of business. At December 31, 2002, Milbank's leverage ratio is 2.4 to 1.
Effective December 23, 2002, State Auto Financial entered into a 364 day $15.0 million term loan note agreement with a bank. Interest adjusts quarterly and accrues based on LIBOR plus 75 basis points (2.15% at December 31, 2002). Interest on the note is 2.15% through March 23, 2003 and 2.027% for the period March 24, 2003 through September 23, 2003. The purpose of this term loan note was to contribute additional capital to State Auto P&C to improve this company's leverage ratio. The reason for the increase in State Auto P&C's leverage ratio is similar to that of Milbank's, which is described above. State Auto P&C's pooling percentage increased from 39% to 59%, effective October 1, 2001. At December 31, 2002, State Auto P&C's leverage ratio is 2.6 to 1.
At December 31, 2002, National's leverage ratio is 4.4 to 1 compared to 2.0 to 1 at December 31, 2001. The increase in the 2002 leverage ratio is the result of this company's substantial current year net written premium growth. Management believes the leverage ratios for Milbank, State Auto P&C and National are higher than is optimal. Management is in the process of considering alternatives and developing a plan to improve these ratios. It is likely there will be a cost to the Company attendant to generating additional surplus within these three insurance subsidiaries, but no details are known at this time.
The National Association of Insurance Commissioners ("NAIC") maintains risk-based capital requirements for property and casualty insurers. 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, 2002, each of the State Auto Insurance Companies surpassed all standards established by the formula.
The State Auto Insurance Companies are participants in a catastrophe reinsurance program. The amount retained by the State Auto Insurance Companies is $40.0 million for each occurrence. For up to $80.0 million in losses, excess of $40.0 million, traditional reinsurance coverage is provided. State Auto P&C assumes catastrophe reinsurance from Mutual, Milbank, SA Wisconsin, Farmers Casualty, SA Ohio, National, Mid-Plains and the Meridian Insurers, in the amount of $100 million excess of $120 million. This layer of $100 million in excess of $120 million has been excluded from the Pooling Arrangement. There have been no losses assumed under this agreement.
To provide funding if the State Auto Insurance Companies were to incur catastrophe losses in excess of $120.0 million, State Auto Financial has continued a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the "Lenders") to provide up to $100.0 million for reinsurance purposes. In the event of such a loss, this arrangement provides that State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company ("SPC"), which would borrow the money necessary for such purchase from the Lenders. State Auto Financial would then contribute to State Auto P&C the funds received from the sale of its preferred shares. State Auto P&C would 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 would repay the Lenders) by redeeming the preferred shares over a five-year period. In the event of a default by State Auto Financial, the obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to either purchase the preferred shares from the SPC or repay the SPC for the loan(s) outstanding.
State Auto P&C's December 31, 1990 liability for losses and loss expenses of $65.5 million has been guaranteed by Mutual. Pursuant to the guaranty agreement, all ultimate adverse development of the December 31, 1990 liability, if any, is to be reimbursed by Mutual to State Auto P&C in conformance with pooling percentages in place at that time. As of December 31, 2002, there has been no adverse development of the liability.
On March 7, 2003, the Board of Directors of State Auto Financial declared a quarterly cash dividend of $0.035 per common share, payable on March 31, 2003, to shareholders of record on March 17, 2003. This is the 47th consecutive cash dividend declared by State Auto Financial's Board since State Auto Financial had its initial public offering of common stock on June 28, 1991. State Auto Financial has increased cash dividends to shareholders for eleven consecutive years.
The maximum amount of dividends that may be paid to State Auto Financial during 2003 by its insurance subsidiaries without prior approval under current law is limited to $35.3 million. 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 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.
As discussed above, there was particular emphasis throughout 2002 and 2001 on improving the former Meridian Mutual book of business, which is expected to continue in 2003. The Company believes its underwriting and pricing discipline, as well as its commitment to delivering its products as effectively and efficiently as possible, have been key factors in the Company's underwriting results over the last several years. The Company remains active in the personal and commercial markets, developing new products to enhance its product portfolio; appointing new agents in its operating territories; and refining its pricing levels for the markets and lines of business it believes offer the most profit potential.
OTHER DISCLOSURES
INVESTMENTS
Stateco performs investment management services (the investment management services segment) on behalf of the Company and Mutual and its subsidiaries. The Investment Committee of each insurer's Board of Directors sets investment policies to be followed by Stateco.
The primary investment objectives of the Company are to generate income, preserve capital and maintain adequate liquidity for the payment of claims. Fixed maturities that may be sold due to changing investment strategies are categorized as available for sale and are carried at fair value. At December 31, 2002, the Company had no fixed maturity investments rated below investment grade, nor any mortgage loans. The following table provides information regarding the quality distribution of the Company's fixed maturity portfolio at December 31, 2002:
(1) As rated by Moody's Investors Service
Despite the volatility in the equity market during 2002, the Company continued its direction of moderately increasing its equity portfolio investments to enhance growth of statutory surplus over the long term. Gains and losses on the sale of equity securities are computed using the first-in, first-out method. The Company's current investment strategy does not rely on the use of derivative financial instruments.
At December 31, 2002 all investments in fixed maturity and equity securities were held as available for sale and therefore are carried at fair value. Other invested assets are comprised of limited liability partnership investments that are carried at fair value, and as presented in the table below, represent approximately 0.2% of the Company's overall investment portfolio. The unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity as "accumulated other comprehensive income" and as such are not included in the determination of net income. Effective December 31, 2002, the Company transferred all of its investments previously classified as held to maturity to the available for sale category to align the investment portfolio with management's investment policy. For fixed maturities classified as held to maturity, unrealized holding gains or losses were not reflected in the accompanying consolidated financial statements; rather they were carried at amortized cost. Upon transfer of the held to maturity investments to available for sale at December 31, 2002, the held to maturity investments' amortized cost, fair value and net unrealized gain were $19.1 million, $20.4 million and $1.3 million, respectively, and therefore other comprehensive income of $0.8 million, net of deferred taxes, was recognized.
The following table provides the composition of the Company's investment portfolio at December 31, 2002 and 2001, respectively:
The Company regularly monitors its investment portfolio for declines in value that are other than temporary, an assessment which requires significant management judgment. Among the factors that management considers are market conditions, the amount, timing and length of decline in fair value, and events impacting the issuer. When a security in the Company's investment portfolio has a decline in fair value which is other than temporary, the Company adjusts the cost basis of the security to fair value. This results in a charge to earnings as a realized loss, which is not changed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other than temporary, are included in other comprehensive income.
The Company reviewed its investments at December 31, 2002, and determined no other than temporary impairment exists in the gross unrealized holding losses, as provided in the table below, due to the evidence that exists indicating temporary impairment which includes, market conditions, amount, timing and length of decline, as well as events impacting the issuer, among other factors. The evaluation of investments for other than temporary impairment requires management to make judgments and estimates regarding the evidence known. Such judgments and estimates could change in the future as more information becomes known which could negatively impact the amounts reported herein. At December 31, 2002, there were no investments reflected in the table below with an unrealized holding loss that had a fair value significantly below cost continually for more than one year. There are no individually material securities with an unrealized holding loss at December 31, 2002.
The following table provides detailed information on the Company's investment portfolio for its gross unrealized gains and losses, adjusted for investments with other than temporary impairment at December 31, 2002:
The amortized cost and fair value of fixed maturities at December 31, 2002, by contractual maturity, are summarized as follows:
Expected maturities may differ from contractual maturities as the issuers may have the right to call or prepay the obligations with or without call or prepayment penalties.
For 2002, included in realized losses of equity securities below, was $2,221,000 ($329,000 on equity securities sold and $1,892,000 on equity securities held at year end) recognized related to other than temporary impairment on 5 equity positions and none for 2001 and 2000. There were no individually material equity securities for which the Company recognized other than temporary impairments in 2002. There was no other than temporary impairment of fixed maturities for 2002, 2001 and 2000. The individual circumstances impacting the other than temporary impairments recognized in 2002 did not impact other investments.
The securities sold during 2002, were sold to either recognize the gain available, to dispose of the security because of the Company's opportunity to invest in securities with greater potential return considering capital preservation, and as discussed above, to reposition the taxable/tax-exempt fixed maturity position of the Company. Realized gains and losses are summarized as follows:
MARKET RISK
Investable assets comprise approximately 85.9% of the Company's total assets. Of the total investable assets, 88.9% are invested in fixed maturities, 3.9% in equity securities and the remaining in cash and cash equivalents.
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 fixed maturity portfolio is managed in a laddered-maturity style and considers business mix and liability payout patterns to ensure adequate cash flow to meet claims as they are presented. At
December 31, 2002, the Company's fixed maturity portfolio had an average maturity of 15.2 years. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 5.0% of statutory assets, other than obligations of the U.S. government or government agencies, for which there is no limit. As indicated in the table above, the fixed maturity portfolio is of high quality with all holdings in either Government obligations, municipal, or corporate obligations. The Company does not intend to change its investment policy on the quality of its fixed maturity investments. Investments in equity securities are selected based on their potential for appreciation as well as ability to continue paying dividends. Additional information regarding the composition of investments, along with maturity schedules regarding investments in fixed maturities at December 31, 2002, is presented in tabular form above.
The Company's primary market risk exposures are to changes in market prices for equity securities and changes in interest rates and credit ratings for fixed maturity securities. The Company has no exposure to foreign currency exchange rate risk nor does it rely on the use of derivative financial instruments. To provide the Company greater flexibility in order to manage its market risk exposures, the Company categorizes its fixed maturities as available for sale. Also, the Company does not maintain a trading portfolio.
The Company's investment portfolio grew 17.1% during 2002 to $1,368.3 million at December 31, 2002 from $1.168.7 million at December 31, 2001. This growth was generated primarily from cash flow provided by operations and an increase in the unrealized gains of fixed maturities, partly offset by a decline in the overall equity market.
The equity markets declined during 2002 and 2001, the first time since the 1973 and 1974 bear markets in which the market also declined two years in a row. During 2002, the Company's equity portfolio decreased $11.6 million to a cumulative unrealized loss of $2.1 million at December 31, 2002 from a cumulative unrealized gain position of $9.5 million at December 31, 2001.
During 2002 the fixed maturity fair values increased as the interest rate environment decreased. The Company's fixed maturity portfolio cumulative unrealized gains increased $58.5 million to $67.4 million at December 31, 2002 from $8.9 million in cumulative unrealized gains at December 31, 2001.
The following table provides information about the Company's fixed maturity investments used for purposes other than trading that are sensitive to changes in interest rates. The table presents principal cash flows from maturities, anticipated calls and estimated prepayments, or pay downs from holdings in asset backed securities. The table also presents the average interest rate for each period presented.
PRINCIPAL AMOUNT MATURING IN: (Dollars in thousands)
LOSSES AND LOSS EXPENSES PAYABLE
The Company's management conducts periodic reviews of loss development reports and makes judgments in determining the reserves for ultimate losses and loss expenses payable. Several factors are considered by management in estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims' settlement practices, recent legal developments, historical data, actuarial projections, accounting projections, exposure growth, current business conditions, catastrophe developments, late reported claims, entry errors, and other reasonableness tests.
Management's best estimate ("MBE") for National, Mid-Plains and the Pooled Subsidiaries share of the Pooled Companies loss and allocated loss adjustment expense reserve ("Loss and ALAE Reserve") at December 31, 2002, is $618,673,000 compared with an actuarial point estimate of $618,302,000 that is within a projected range of $593,156,000 to $644,692,000. The actuarial point estimate and MBE are not materially different. These values presented are on a direct basis, gross of salvage and subrogation recoverable, and before reinsurance, except for the Pooled Subsidiaries participation in the inter-company Pooling Arrangement. Therefore these values cannot be compared to other loss and loss expenses payable tables included elsewhere within the Company's Form 10-K. Ranges provide a quantification of the variability in the reserve projections, while the point estimates establish a mean, or expected value for the ultimate reserve. The MBE of loss reserves considers the Actuary's point estimate, or expected value, to be a reasonable and appropriate position within the range. The following table provides a reconciliation of MBE of the Company's direct Loss and ALAE Reserve to the Company's net loss and loss expenses payable at December 31, 2002. The Pooled Subsidiaries net additional share of transactions assumed from Mutual through the Pooling Arrangement has been reflected in the table below as Assumed by Pooled Subsidiaries:
(1) ALAE are those costs that can be related to a specific claim, which may include attorney fees, external claims adjusters, and investigation costs, among others. ULAE are those costs incurred in settling claims, such as in-house processing costs, for which no identification can be made to specific claims. ALAE and ULAE comprise the loss expense portion of the total loss and loss expenses payable.
The risks and uncertainties inherent in the estimates include, but are not limited to, actual settlement experience different from historical data, trends, changes in business and economic conditions, court decisions creating unanticipated liabilities, ongoing interpretation of policy provisions by the courts, inconsistent decisions in lawsuits regarding coverage and additional information discovered before settlement of claims. The Company's results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required to settle claims vary from the liability currently recorded.
The preceding paragraphs briefly describe certain factors management considers in estimating the ultimate liability for losses and loss expenses. With respect to the auto line of business, which represents almost half of the Company's total reserves, the most significant external variable is legal developments. As discussed in "Impact of Significant External Factors" below, court decisions have a significant impact on the property and casualty insurance industry. Some of these decisions have a more prospective effect as, for example, when contract provisions relating to third party coverages are construed in ways not anticipated by the Company. Other court decisions have more of a retroactive effect, in particular in the auto insurance line. Auto insurance tends to be a line of business more regulated by statutes; consequently, the courts tend to have more of an opportunity to construe these statutes and apply their interpretations to existing contracts. Uninsured motorists and underinsured motorists (collectively "UM") are statutory coverages in almost every state
where the Company does business. When courts construe UM statutes in a manner which is adverse to the Company and the industry, the effect of that decision is typically retroactive, because, legally speaking when the court interprets a statute it is as though the statute was always construed in that manner. This retroactive effect is exacerbated in UM cases (and other first party coverage cases) because the statute of limitations applicable to UM claims and other first party coverages can be as long as 15 years. Claims that had been closed or not even presented, going back as long as 15 years, can be re-born by an adverse court decision. The Company considers the impact of adverse court decisions of which it has become aware when it sets ultimate loss and LAE reserves for auto insurance as well as other lines to the extent those lines may be retroactively affected by such matters.
The effect of court decisions is also apparent in the commercial lines of coverages such as commercial multi-peril and other liability and products liability. Courts can expand coverage or void exclusions which can increase the Company's exposure to claims. Some of these third party claims may still be brought within the statute of limitations applicable to such third party claims and expose the Company to some retroactive liabilities. These liabilities are sought to be addressed by the ultimate loss and LAE reserve that is the Company's estimate of loss and loss expenses payable.
It is not feasible to quantify the impact of judicial decisions by the courts that may have retroactive effect because the Company cannot foresee, among the range of issues that are litigated every day in courts in each state in which the Company does business, which cases will be decided adversely and how such decisions will actually apply to the Company.
The following table presents the loss and loss expenses payable by major line of business at December 31, 2002 and 2001, respectively:
Overall 2002 total net losses and loss expenses payable increased 16% from 2001. This increase is primarily driven by an increase in claim submissions, as the policy count base grew significantly during the year. As shown in the table, the "other commercial lines" payable percentage increase is greater than the average increase for all lines. We believe this is due to higher than average growth in commercial lines, and several unusually large claims incurred during 2002. Overall, management does not believe there is a significant change in the total book of business at December 31, 2002 compared to December 31, 2001.
Unlike 2001, where the Company's loss and loss expenses incurred increased by $60.7 million for claims that occurred in prior years primarily as the result of case reserve strengthening on Meridian claims, in 2002, loss and losses expenses incurred increased $12.4 million (2.4% of December 31, 2001
net loss and loss expense payable). The current year development of the prior years' ultimate liability does not reflect any changes in the Company's fundamental claims reserving practices.
A tabular presentation of the current year $12.4 million development broken down by accident year is shown below derived from the Company's 2001 and 2002, 10 year loss development tables, as presented in the Reserves section of the Company's Form 10-K, "Narrative Description of Business" section. The development is measured in dollars and as a percentage of the total December 31, 2001 net loss and loss expense payable:
In management's opinion, the 2.4% current year development, given the breakdown by accident year, is well within normal expectations for reserve development and claim settlement uncertainty.
NEW ACCOUNTING STANDARDS
In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001 (Statements). Under the new rules, goodwill will no longer be amortized but will be subject to impairment tests in accordance with the Statements. Other intangible assets will continue to be amortized over their useful lives. Effective January 1, 2002, the Company implemented the new rules in accordance with the Statements. As part of the implementation, the Company performed the requisite transitional impairment tests for goodwill. The adoption of the Statements did not materially impact the Company's financial position or results of operations.
IMPACT OF SIGNIFICANT EXTERNAL FACTORS
Inflation can have a significant impact on property and casualty insurers because premium rates are established before the amount of losses and loss expenses are known. When establishing rates, the Company attempts to anticipate increases from inflation subject to the limitations of modeling economic variables. General inflation, as measured by the CPI, has been relatively modest over the last several years, however price inflation on the goods and services purchased by insurance companies in settling claims has been steadily increasing. In particular, repair costs for homes, autos, and commercial buildings, and medical care costs, have risen over the last few years. We continue to adjust our pricing projections as loss cost trends change to ensure premiums keep pace with inflation in all lines of business.
The Company considers inflation when estimating liabilities for losses and loss expenses, particularly for claims having a long period between occurrence and settlement. The liabilities for losses and loss expenses are management's best estimates of the ultimate net cost of underlying claims and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on investment income may partially offset potentially higher claims and expenses.
The Company is also affected by court decisions. Premiums 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, in a number of ways, the level of risk which insurers had expected to assume 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 the 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. The Company may also be adversely affected by regulatory actions on matters within the jurisdiction of the various insurance departments where the Company does business or has entities domiciled.
After credit scoring, the industry's use of which has been limited to varying extents by certain state's laws, the next most predictive underwriting report available to insurers is previous loss information. Third party vendors obtain loss information from insurers based on the insured, the vehicle and/or the property location. As insurers write new business the database is accessed to analyze any loss experience of the insured, vehicle and/or property location. Many times insurer's premium rates will be adjusted to reflect the loss experience accessed from these databases. In some cases the overall acceptability of the insured's application in the standard market may be determined by these reports. During 2002, use of this loss information database product by the insurance industry as a predictive underwriting tool has been challenged by several west coast states and most recently in a few of the Company's states of operation. While it is too soon to determine states' reaction to the utilization of these database systems, any restrictive regulation of the full use of these underwriting reports could have an adverse impact on the Company as it has utilized these database systems for several years as an underwriting tool. Since such regulation is applicable to all companies writing business which utilize these reports the Company does not expect to suffer a competitive disadvantage.
Probably the most significant piece of legislation to affect the Company in 2002 was the Federal Sarbanes-Oxley Act of 2002,("Sarbanes Oxley") which took effect in July 2002. While this law does not affect the Company's insurance operations, it has and will continue to have an effect on the Company. Sarbarnes Oxley was the response of the Congress to the corporate scandals of the last two years. Sarbanes Oxley imposes significant new rules on the Company's corporate governance, its financial and reporting processes and its relationship with its independent auditor. Sarbanes Oxley will require the Company to incur additional costs through an increase in its internal staff functions to ensure that it adequately documents compliance with these new legal requirements.
The Terrorism Risk Insurance Act of 2002 (the "Terrorism Act") established a temporary federal program that provides for a system of shared public and private compensation for insured losses resulting from acts of terrorism committed by or on behalf of a foreign interest. In order for a loss to be covered under the Terrorism Act, it must be the result of an event that is certified as an act of terrorism by the U.S. Secretary of Treasury ("subject losses"). In the case of a war declared by Congress, only workers' compensation losses are covered by the Terrorism Act. The Terrorism Insurance Program (the "Program") generally requires that all commercial property casualty insurers licensed in the U.S. participate in the Program. The amount of compensation paid to participating insurers under the Program is 90% of subject losses, after an insurer deductible, subject to an annual cap that limits the amount of subject losses to $100 billion aggregate per program year. The Company's deductible under this federal Program is approximately $28.0 million for 2003, subject to final rules to be established by the U.S. Treasury. Under the Terrorism Act, commercial property and casualty insurers must offer their commercial policyholders coverage against certified acts of terrorism, but the policyholders may choose to reject this coverage. If the policyholder rejects coverage for certified acts of terrorism, the Company
intends, subject to the approval of the state regulators, to cover only such acts of terrorism that are not certified acts under the Terrorism Act and that do not arise out of nuclear, biological or chemical agents.
FORWARD-LOOKING STATEMENTS; CERTAIN FACTORS AFFECTING FUTURE RESULTS
Statements contained in this Form 10-K or any other reports or documents prepared by the Company or made by management may be "forward-looking" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to certain risks and uncertainties that could cause the Company's actual results to differ materially from those projected. Forward-looking statements may be identified, preceded by, followed by, or otherwise include, without limitation, words such as "plans," "believes," "expects," "anticipates," "intends," "estimates," or similar expressions. The following factors, among others, in some cases have affected and in the future could affect the Company's actual financial performance.
- In addition to the acquisition of the Meridian Insurers and Mutual's merger with Meridian Mutual as discussed elsewhere in this Form 10-K, during the past several years, Mutual and the Company have acquired other insurance companies, such as Milbank, Farmers Casualty, and SA Wisconsin, and it is anticipated that Mutual and the Company will continue to pursue acquisitions of other insurance companies in the future. Acquisitions involve numerous risks and uncertainties, including the following: obtaining necessary regulatory approvals of the acquisition may prove to be more difficult than anticipated; integrating the acquired business may prove to be more costly or difficult than anticipated; integrating the acquired business without material disruption to existing operations may prove to be more difficult than anticipated; anticipated cost savings may not be fully realized (or not realized within the anticipated time frame) or additional or unexpected costs may be incurred; loss results of the Company acquired may be worse than expected; and retaining key employees of the acquired business may prove to be more difficult than anticipated. In addition, other companies in the insurance industry have similar acquisition strategies. There can be no assurance that any future acquisitions will be successfully integrated into the Company's operations, that competition for acquisitions will not intensify or that the Company will be able to complete such acquisitions on acceptable terms and conditions. In addition, the costs of unsuccessful acquisition efforts may adversely affect the Company's financial performance.
- The Company's financial results are subject to the occurrence of weather-related and other types of catastrophic events, none of which are within the Company's control.
- The Company's operations are subject to changes occurring in the legislative, regulatory and judicial environment. Risks and uncertainties related to the legislative, regulatory, and judicial environment include, but are not limited to, legislative changes at both the state and federal level, state and federal regulatory rulemaking promulgations and adjudications that may affect the Company specifically, its affiliates or the industry generally, class action and other litigation involving the Company, its affiliates, or the insurance industry generally and judicial decisions affecting claims, policy coverages and the general costs of doing business. Many of these changes are beyond the Company's control.
- The laws of the various states establish insurance departments with broad regulatory powers relative to approving intercompany arrangements, such as management, pooling, and investment management agreements, 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. In addition, 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. Furthermore, all of the states in which the State Auto Group transacts business have enacted laws which restrict these companies' underwriting discretion. Examples of these laws include restrictions on agency terminations and laws
requiring companies to accept any applicant for automobile insurance and laws regulating underwriting "tools." These laws may adversely affect the ability of the insurers in the State Auto Group to earn a profit on their underwriting operations.
- The property and casualty insurance industry is highly competitive. While prices have generally increased in some lines, price competition continues to be intense. 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. 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. See "Marketing" in the "Narrative Description of Business" in Item 1 of the Company's Form 10-K.
- The Company is subject to numerous other factors which effects its operations, including, without limitation, the development of new insurance products, geographic spread of risk, fluctuations of securities markets, economic conditions, technological difficulties and advancements, availability of labor and materials in storm hit areas, late reported claims, previously undisclosed damage, utilities and financial institution disruptions, and shortages of technical and professional employees and unexpected challenges to the control of the Company by Mutual.
ITEM 7(a). QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
"Qualitative and Quantitative Disclosures About Market Risk" is included in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Market Risk.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Report of Independent Auditors are as follows:
Report of Independent Auditors
The Board of Directors and Stockholders State Auto Financial Corporation
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of State Auto Financial Corporation and subsidiaries at December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States.
Columbus, Ohio /s/ Ernst & Young, LLP February 21, 2003
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED BALANCE SHEETS
See accompanying notes to consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF INCOME
See accompanying notes to consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in thousands)
See accompanying notes to consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes to consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements of State Auto Financial Corporation include State Auto Financial Corporation (State Auto Financial) and its wholly-owned subsidiaries that consist of:
- State Auto Property and Casualty Insurance Company (State Auto P&C), a South Carolina corporation - Milbank Insurance Company (Milbank), a South Dakota corporation - Farmers Casualty Insurance Company (Farmers Casualty), an Iowa corporation - State Auto Insurance Company of Ohio (SA Ohio), an Ohio corporation (formerly State Auto Insurance Company) - State Auto National Insurance Company (National), an Ohio corporation - Stateco Financial Services, Inc. (Stateco), an Ohio corporation - Strategic Insurance Software, Inc. (S.I.S.), an Ohio corporation.
Mid-Plains Insurance Company (Mid-Plains), an Iowa corporation, is a wholly-owned subsidiary of Farmers Casualty. The financial statements also include the operations and financial position of 518 Property Management and Leasing, LLC (518 PML), whose members are State Auto P&C and Stateco.
State Auto Financial, an Ohio corporation, is a majority-owned subsidiary of State Automobile Mutual Insurance Company (Mutual), an Ohio corporation. State Auto Financial and subsidiaries are referred to herein as "the Companies" or "the Company." All significant intercompany balances and transactions have been eliminated in consolidation.
(b) DESCRIPTION OF BUSINESS
The Company, through State Auto P&C, Milbank, Farmers Casualty and SA Ohio, provides standard personal and commercial insurance to its policyholders. Their principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. National and Mid-Plains provide nonstandard automobile insurance. State Auto P&C, Milbank, Farmers Casualty, SA Ohio, National, and Mid-Plains operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. State Auto P&C, Milbank, Farmers Casualty, SA Ohio, National and Mid-Plains are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota, Iowa, Ohio (SA Ohio and National) and Iowa, respectively, and are licensed in various other states. As such, they are subject to the regulations of the applicable Departments of Insurance of their respective states of domicile (the Departments) and the regulations of each state in which they operate. These property and casualty insurance companies undergo periodic financial examination by the Departments and insurance regulatory agencies of the states that choose to participate.
Through State Auto P&C, effective January 1, 2000, the Company provides management and operation services under management agreements for all insurance and non-insurance affiliates. Pursuant to these agreements, the Company received approximately $28.1 million equal to the net pension and postretirement plan benefit liabilities assumed relating to the transfer to the Company of all employees from Mutual and other affiliated companies. Prior to January 1, 2000, the Company, through State Auto P&C, provided executive insurance management services to all insurance affiliates.
Through Stateco, the Company provides investment management services to affiliated companies.
The Company, through S.I.S., develops and sells software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance companies and agencies. S.I.S. sells services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies.
518 PML, an Ohio limited liability company, was formed to engage in the business of owning and leasing real and personal property to affiliated companies.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(c) BASIS OF PRESENTATION
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States, which vary in certain respects from statutory accounting practices followed by State Auto P&C, Milbank, Farmers Casualty, SA Ohio, National and Mid-Plains that are prescribed or permitted by the Departments.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the period then ended and the accompanying notes to the financial statements. Such estimates and assumptions could change in the future as more information becomes known which could impact the amounts reported and disclosed herein.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of losses and loss expenses payable. In connection with the determination of this estimate, management uses historical data and current business conditions to formulate estimates including assumptions related to the ultimate cost to settle claims. These estimates by their nature are subject to uncertainties for various reasons. The Company's results of operations and financial condition could be impacted in the future should the ultimate payments required to settle claims vary from the amount of the liability currently provided.
(d) DEFERRED POLICY ACQUISITION COSTS
Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses related to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned, without credit for anticipated investment income. These amounts are based on estimates and accordingly, the actual realizable value may vary from the estimated realizable value. Net deferred policy acquisition costs were:
(e) INVESTMENTS
At December 31, 2002 all investments in fixed maturity and equity securities are held as available for sale and therefore are carried at fair value. Other invested assets are comprised of limited liability partnership investments that are carried at fair value. The unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity as "accumulated other comprehensive income" and as such are not included in the determination of net income. Effective December 31, 2002, the Company transferred all of its investments previously classified as held to maturity to the available for sale category to align the investment portfolio with management's investment policy. For fixed maturities classified as held to maturity, unrealized holding gains or losses were not reflected in the accompanying consolidated financial statements, rather they were carried at amortized cost. Upon transfer of the held to maturity investments to available for sale at December 31, 2002, the held to maturity investments' amortized cost, fair value and net unrealized gain were $19,095,000, $20,369,000 and $1,274,000, respectively, and therefore other comprehensive income of $828,000, net of deferred taxes of $446,000 was recognized. Gains and losses on the sale of equity securities are computed using the first-in, first-out method. The Company regularly monitors its investments that have fair value less than the carrying amount for signs of other than temporary impairment. Among the factors considered are market conditions, amount, timing and length of decline in fair market value and events impacting the issuer. When other than temporary impairment is recognized, the investment cost is written down to fair value and a realized loss is recorded. The cost is not adjusted for any subsequent recovery in fair value. For 2002, included in net realized gain on investments was $2,221,000 of realized losses recognized due to other than temporary impairments.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(f) GOODWILL
Goodwill included in other assets was $2,012,000, net of $1,864,000 amortization at December 31, 2002 and 2001 which represents the excess of cost of acquisition over the fair value of the net assets acquired. See related goodwill discussion at note 1(n). In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001 (Statements). Under the new rules, goodwill will no longer be amortized but will be subject to impairment tests in accordance with the Statements. The Company evaluated the goodwill and determined that there was no impairment at December 31, 2002.
(g) LOSSES AND LOSS EXPENSES PAYABLE
Losses and loss expenses payable are based on formula and case-basis estimates for reported claims, and on estimates, based on experience and perceived trends, for unreported claims and loss expenses. The liability for unpaid losses and loss expenses, net of estimated salvage and subrogation recoverable of $27,093,000 and $26,216,000 at December 31, 2002 and 2001, respectively, has been established to cover the estimated ultimate cost of insured losses. The amounts are necessarily based on estimates of future rates of inflation and other factors, and accordingly there can be no assurance that the ultimate liability will not vary from such estimates. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations (see note 4). Salvage and subrogation recoverables are estimated using historical experience. As such, losses and loss expenses payable represent management's best estimate of the ultimate liability related to reported and unreported claims.
(h) PREMIUM REVENUES
Premiums are recognized as earned using the monthly pro rata method over the contract period.
(i) MANAGEMENT SERVICES INCOME
Management services income includes income for management and operations services provided by State Auto P&C employees and income for investment management services provided by Stateco. See note 6(d) regarding the Company's resolution of its disagreement with the Ohio Department of Insurance (ODI) regarding its recognition of management and operations service fee revenue paid by Mutual in 2001. Management and operations services income, to the extent certain operational ratios were achieved, was recognized quarterly based on a percentage of the three year average of each managed company's adjusted surplus or equity. State Auto Insurance Company of Wisconsin (SA Wisconsin), formerly Midwest Security Insurance Company, a wholly-owned subsidiary of Mutual, is an exception to this, calculating its fee based on a percentage of quarterly direct premiums written. Effective July 1, 2002, the Meridian Insurers, defined below, pay State Auto P&C a predetermined percentage of their allocated share of State Auto P&C's employee-related costs in exchange for the services of those employees, in addition to reimbursing State Auto P&C for the actual costs of such services. Investment management income is recognized quarterly based on a percentage of the average fair value of investable assets and the performance of the equity portfolio of each company managed.
(j) SOFTWARE REVENUE RECOGNITION
S.I.S. recognizes revenue from software license fees on a straight-line basis over the license agreement term specified in the contract. Cash payments received at the signing of the license agreement are deferred and recognized as revenue on a straight-line basis over the agreement term, typically three years. Service fees are also recognized as revenue on a straight-line basis over the license agreement term specified in the contract. Other fees are recognized as revenue upon substantial performance by the Company and customer acceptance. Costs of developing and testing new or enhanced software products are capitalized and are amortized on a product-by-product basis utilizing the straight-line method over a period not to exceed three years. Unamortized software development costs of $225,000 and $186,000 are included in accrued investment income and other assets at December 31, 2002 and 2001, respectively. Software amortization, included in other expenses, was $186,000, $440,000 and $622,000 in 2002, 2001 and 2000 respectively.
(k) FEDERAL INCOME TAXES
The Company files a consolidated federal income tax return and pursuant to an agreement, each entity within the consolidated group pays its share of federal income taxes based on separate return calculations. Income taxes are accounted for using the liability method. Using this method, deferred tax assets and
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
(l) CASH EQUIVALENTS
The Company considers all highly liquid debt instruments with a maturity of three months or less to be cash equivalents.
(m) OTHER COMPREHENSIVE INCOME
Comprehensive income is defined as all changes in an enterprise's equity during a period other than those resulting from investments by owners and distributions to owners. Comprehensive income includes net income and other comprehensive income. Other comprehensive income includes all other non-owner related changes to equity and represents net unrealized gains and losses on available-for-sale fixed maturities, equity securities and other invested assets.
Separate presentation of the accumulated balance of other comprehensive income within the equity section of the statement of financial position is also required. The Company has presented the required displays of total comprehensive income and its components, within the "Consolidated Statements of Stockholders' Equity." See additional disclosures at note 14.
(n) NEW ACCOUNTING STANDARDS
In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001 (Statements). Under the new rules, goodwill will no longer be amortized but will be subject to impairment tests in accordance with the Statements. Other intangible assets will continue to be amortized over their useful lives. Effective January 1, 2002, the Company implemented the new rules in accordance with the Statements. As part of the implementation, the Company performed the requisite transitional impairment tests for goodwill. The adoption of the Statements did not materially impact the Company's financial position or results of operations.
(o) RECLASSIFICATIONS
Certain items in the 2001 and 2000 consolidated financial statements have been reclassified to conform to the 2002 presentation.
(2) INVESTMENTS
Realized and unrealized gains and losses are summarized as follows:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
See footnote 1(e) regarding investments. The Company's investments are summarized as follows:
Deferred federal income taxes on the net unrealized holding gain for available for sale investments was $22,891,000 and $6,478,000 at December 31, 2002 and 2001, respectively.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The amortized cost and fair value of fixed maturities at December 31, 2002, by contractual maturity, are summarized as follows:
Expected maturities may differ from contractual maturities because the issuers may have the right to call or prepay the obligations with or without call or prepayment penalties.
Fixed maturities with carrying values of approximately $45,256,000 and $27,666,000 were on deposit with regulators as required by law or specific escrow agreement at December 31, 2002 and 2001, respectively.
Components of net investment income are summarized as follows:
The Company's current investment strategy does not rely on the use of derivative financial instruments.
See note 3 for additional fair value disclosures.
(3) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
INVESTMENT SECURITIES: Fair values for investments in fixed maturities are based on quoted market prices, where available. For fixed maturities not actively traded, fair values are estimated using values obtained from independent pricing services. The fair values for equity securities are based on quoted market prices. The fair value of other invested assets is based on Generally Accepted Accounting Principles equity.
CASH AND CASH EQUIVALENTS: The carrying amounts reported in the balance sheets for these instruments approximate their fair value, because of their short-term nature.
NOTES PAYABLE: The carrying amounts reported in the balance sheets for these instruments approximate their fair value because their interest rates adjust regularly.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(4) LOSSES AND LOSS EXPENSES PAYABLE
Activity in the liability for losses and loss expenses is summarized as follows:
The increase of $12,414,000 in 2002 for claims occurring in prior years is well within normal expectations for reserve development and claim settlement uncertainty. The increase of $60,726,000 in 2001 for claims occurring in prior years is primarily the result of reserve strengthening on the former Meridian Mutual Insurance Company (Meridian Mutual) business in order to bring these claim reserves in line with historic State Auto adequacy levels as well as ongoing analysis of recent loss development trends. The decrease in calendar year losses from prior years in 2000 of $5,638,000 is within normal expectation of reserve variation.
(5) REINSURANCE
In the ordinary course of business, the Company assumes and cedes reinsurance with other insurers and reinsurers and is a member in various pools and associations. See Note 6(a) for discussion of reinsurance with affiliates. The voluntary arrangements provide greater diversification of business and limit the maximum net loss potential arising from large risks and catastrophes. Most of the ceded reinsurance is effected under reinsurance contracts known as treaties; some is by negotiation on individual risks. Although the ceding of reinsurance does not discharge the original insurer from its primary liability to its policyholder, the insurance company that assumes the coverage assumes the related liability.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. The recoverability of these assets depends on the reinsurers' ability to perform under the reinsurance agreements. The Company evaluates and monitors the financial condition and concentrations of credit risk associated with its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. The Company has reported ceded losses and loss expenses payable and prepaid reinsurance premiums with other insurers and reinsurers as assets. All reinsurance contracts provide indemnification against loss or liability relating to insurance risk and have been accounted for as reinsurance. Prior to the reinsurance transaction with Mutual under the Pooling Arrangement, as discussed in note 6(a), the effect of the Company's reinsurance on its balance sheets and income statements, is as follows:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(6) TRANSACTIONS WITH AFFILIATES
(a) REINSURANCE
State Auto P&C, Milbank, Farmers Casualty, SA Ohio (the Pooled Subsidiaries) and SA Wisconsin participate in a quota share reinsurance pooling arrangement (the Pooling Arrangement) with Mutual whereby the Pooled Subsidiaries and SA Wisconsin cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation percentages in the Pooling Arrangement. All premiums, losses and loss expenses and underwriting expenses are allocated among the participants on the basis of each company's participation percentage in the Pooling Arrangement. The Pooling Arrangement provides indemnification against loss or liability relating to insurance risk and has been accounted for as reinsurance.
Effective December 31, 1999 State Auto P&C, Milbank, SA Wisconsin and Farmers participation in the Pooling Arrangement was 50%. Effective January 1, 2000, the Pooling Arrangement was amended to make SA Ohio a participant in the Pooling Arrangement and the Pooled Subsidiaries aggregate participation increased to 53%. In conjunction with this change in pool participation, the Pooled Subsidiaries received cash from Mutual of $18.6 million, which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on January 1, 2000. In 2000, Mutual entered into an agreement with Meridian Mutual Insurance Company (Meridian Mutual), an Indiana domiciled property and casualty insurance company, pursuant to which Meridian Mutual would be merged with and into Mutual, with Mutual continuing as the surviving corporation. The effective date of the merger transaction was June 1, 2001. With the merging of Meridian Mutual into Mutual, all insurance business that had been written by Meridian Mutual became, legally, Mutual business. For the period June 1, 2001 through June 30, 2001, the insurance business formerly known as the Meridian Mutual business prior to the June 1 merger transaction was excluded from the Pooling Arrangement. Effective July 1, 2001, the insurance business of the former Meridian Mutual became part of the Pooling Arrangement, and the Pooled Subsidiaries assumed 53% of the former Meridian Mutual business on this same date. Concurrently, with this transaction, the Pooled Subsidiaries received cash of $6.4 million and fixed maturities totaling $109.7 million from Mutual which related to the additional net insurance liabilities assumed by the Pooled Subsidiaries on July 1, 2001. As part of the resolution of the disagreement with the ODI regarding the recognition of the service fee revenue paid by Mutual to State Auto P&C (see note 6(d)), the Pooled Subsidiaries aggregate participation in the Pooling Arrangement was increased to 80%, effective October 1, 2001. In conjunction with this change in pool participation, the Pooled Subsidiaries received cash of $2.2 million and fixed maturities totaling $236.3 million from Mutual, which related to the additional net insurance liabilities assumed on October 1, 2001. All parties that participate in the Pooling Arrangement have an A. M. Best rating of A+ (Superior).
The Pooling Arrangement does not relieve each individual pooled subsidiary of its primary liability as the originating insurer, consequently, there is a concentration of credit risk arising from business ceded to Mutual. As the Pooling Arrangement provides for the right of offset, the Company has reported losses and loss expenses payable and prepaid reinsurance premiums to Mutual as assets only in situations when net amounts ceded to Mutual exceed that assumed. The following provides a summary of the reinsurance transactions on the Company's balance sheets and income statements for the Pooling Arrangement between the Pooled Subsidiaries and Mutual:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
Effective with the June 1, 2001 merger transaction of Meridian Mutual into Mutual, Mutual also acquired all of the outstanding shares of Meridian Insurance Group, Inc. (MIGI), an Indiana domiciled insurance holding company. MIGI's wholly-owned insurance subsidiaries are Meridian Security Insurance Company, (Meridian Security), an Indiana domiciled property and casualty insurer, Meridian Citizens Security Insurance Company, an Indiana domiciled property and casualty insurer, and Insurance Company of Ohio, an Ohio domiciled property and casualty insurer. MIGI is also party to an affiliation agreement with Meridian Citizens Mutual Insurance Company, an Indiana domiciled property and casualty insurer. Collectively, the MIGI insurer subsidiaries and affiliate are hereafter collectively referred to as the "Meridian Insurers".
Mutual, State Auto P&C, Milbank, SA Wisconsin, Farmers Casualty, SA Ohio, National, Mid Plains, and, effective June 1, 2001, the Meridian Insurers, are participants in a catastrophe reinsurance program. Collectively, these participants in the catastrophe reinsurance program are referred to as the "State Auto Insurance Companies." State Auto P&C assumed catastrophe reinsurance from Mutual, Milbank, SA Wisconsin, Farmers Casualty, SA Ohio, National, Mid-Plains and the Meridian Insurers in the amount of $115 million excess of $120 million. Effective November 2002, the catastrophe reinsurance program was renegotiated whereby State Auto P&C assumed $100 million excess of $120 million. Under this agreement, the Company has assumed from Mutual and its affiliate premiums written and earned of $2,914,000, $3,021,000 and $3,129,000 for 2002, 2001 and 2000, respectively. There have been no losses assumed under this agreement. The catastrophe reinsurance program with State Auto P&C has been excluded from the Pooling Arrangement.
To protect against a catastrophe loss event, in which the State Auto Insurance Companies would incur catastrophe losses in excess of $120 million, State Auto Financial entered into a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the Lender) to provide (effective November 2002) up to $100 million for
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
reinsurance purposes. In the event of such a loss, this arrangement provides that State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which would borrow the money necessary for such purchase from the Lenders. This arrangement with the Lenders, SPC and State Auto Financial is a financing arrangement, whereby State Auto Financial would receive cash funding in the event of a catastrophe event as described above. State Auto Financial would then contribute to State Auto P&C the funds received from the sale of its preferred shares. State Auto P&C would use the contributed capital proceeds to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC by redeeming the preferred shares over a five-year period. In the event of a default by State Auto Financial, the obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to either purchase the preferred shares from the SPC or repay the SPC for the loan(s) outstanding.
For the period October 1, 2001 through December 31, 2003, Mutual entered into a stop loss reinsurance arrangement (Stop Loss) with the Pooled Subsidiaries. Under the Stop Loss, Mutual has agreed to participate in the Pooling Arrangement's quarterly underwriting losses and gains in the manner described. If the Pooling Arrangement's statutory loss and loss adjustment expense ratio (loss ratio) is between 70.75% and 80% (after the application of all available reinsurance), Mutual will reinsure the Pooled Subsidiaries 27% of the Pooling Arrangement's losses in excess of a loss ratio of 70.75% up to 80.00%. The Pooled Subsidiaries would be responsible for their share of the Pooling Arrangement's losses over the 80% threshold. Also, Mutual will have the right to participate in the profits of the Pooling Arrangement. Mutual will assume 27% of the Pooling Arrangement's underwriting profits attributable to loss ratios less than 69.25%, but more than 59.99%. During 2002 and 2001, the Pooled Subsidiaries ceded to Mutual, $8,769,000 and $6,177,000 in losses, respectively, and $1,442,000 and $0, respectively, in premiums under the Stop Loss. At December 31, 2001, the $6,177,000 recovery under the stop loss has been reflected in reinsurance recoverable on losses and loss expenses payable.
National and Mid-Plains each have ceding reinsurance agreements with Mutual, that include excess of loss and quota share coverages. Through Mutual's participation in the Pooling Arrangement, the effects of these agreements with National and Mid-Plains are indirectly subject to the Pooling Arrangement between Mutual and the pooled subsididaries.
The following provides a summary of the ceding reinsurance transactions on the Company's balance sheets and income statement for the reinsurance agreements between National and Mutual and Mid-Plains and Mutual:
(b) INTERCOMPANY BALANCES
Pursuant to the Pooling Arrangement, Mutual is responsible for the collection of premiums and payment of losses, loss expenses and underwriting expenses of the Pooled Subsidiaries. Unpaid balances are reflected in due to or due from affiliates in the accompanying consolidated balance sheets. Settlements of the intercompany account are made quarterly. No interest is paid on this account. All premium balance receivables and reinsurance recoverable on paid losses from unaffiliated reinsurers are carried by Mutual. The Company had off-balance-sheet credit risk of approximately $167 million and $123 million related to premium balances due to Mutual from agents and insureds at December 31, 2002 and 2001, respectively, which is collateralized by the unearned premium from the respective policies.
(c) NOTES PAYABLE
In 1999, State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million in conjunction with its stock repurchase program. See related footnote at note 10(a). Principal payment is due on demand after December 31, 2000, with final payment to be received on or prior to December 31,
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
2005. The interest rate is adjustable annually after the year 2000 to reflect adjustments in the then current prime lending rate as well as State Auto Financial's current financial position. Interest rate for the year 2002, 2001 and 2000 is 4.75%, 5.0% and 6.0%, respectively. Interest rate for the year 2003 will be 4.25%. Interest expense on the loan from Mutual was $2,161,000, $2,275,000 and $2,730,000 in 2002, 2001 and 2000, respectively. Total interest expense paid to affiliates during 2002, 2001 and 2000 was $2,333,000, $2,275,000 and $2,730,000, respectively.
Effective September 30, 2002, Milbank, entered into a $15.0 million surplus contribution note agreement with Meridian Security. This note was funded with cash during the fourth quarter of 2002. Subject to the condition described below and the other terms of the note, the maturity date is September 30, 2012. The interest rate is equal to the U.S. Treasury ten-year note yield at September 30, 2002 plus 100 basis points (total 4.59%) and is adjustable October 1, 2007 to the then current U.S. Treasury ten-year note yield plus 100 basis points for the remaining term of the note. Interest is accrued, but all payments of principal or interest may be made only with the prior written approval of the South Dakota Director of Insurance. Interest is scheduled to be paid semiannually in arrears starting March 30, 2003. Interest expense on the loan was $172,000 in 2002.
(d) MANAGEMENT SERVICES
Effective January 1, 2000, State Auto P&C began providing management and operation services to Mutual and its insurance affiliates. Revenue relating to these services amount to $553,000, $12,621,000 and $14,654,000 in 2002, 2001 and 2000, respectively. Stateco provides Mutual and its affiliate investment management services. Revenue related to these services amount to $2,085,000, $2,965,000 and $2,940,000 in 2002, 2001, and 2000, respectively.
During early 2001, the ODI requested that Mutual file an analysis with the ODI on a quarterly basis, starting with the quarter beginning January 1, 2001, that justified the apportionment of the management and operation services fee paid by Mutual to State Auto P&C under the accounting guidance outlined in Statement of Statutory Accounting Principles No. 70 - Allocation of Expenses. The Company believed its accounting for such service fee was consistent with all statutory accounting principles. On October 24, 2001, the board of directors of the Company and Mutual and special committees thereof approved a resolution of the disagreement between the Company and the ODI regarding the service fee paid by Mutual to State Auto P&C. The disagreement with ODI was resolved and ODI expressly did not take issue with Mutual's payment of the service fee to State Auto P&C for the nine-month period ending September 30, 2001 which amounted to $12.5 million, pre-tax, nor with Mutual's accounting for the service fee for this same time period. The ODI also approved regulatory filings, effective October 1, 2001, implementing a revised management agreement, changing the Pooled Subsidiaries pooling participation percentages and implementing a stop loss reinsurance arrangement. See note 6(a) regarding the change in the Pooled Subsidiaries pooling participation percentages and the implementation of a stop loss reinsurance arrangement.
Effective October 1, 2001, the management agreement between State Auto P&C and certain affiliate companies, including Mutual, was amended to eliminate the management and operations service fee charged by State Auto P&C. The management agreement continues to allocate costs and apportion those costs among the parties to the agreement in accordance with terms outlined therein. As a result of the loss of the management and operations services income under this management agreement, substantially all of State Auto P&C's services income has been eliminated, effective October 1, 2001. See note 15. The management agreement between State Auto P&C and SA Wisconsin was not affected by the disagreement or resolution with the ODI.
(e) OTHER TRANSACTIONS
S.I.S. provides insurance software products and services to Mutual and its affiliate. Revenue relating to these services amount to $225,000, $692,000 and $900,000 in 2002, 2001 and 2000, respectively, and is included in other income. 518 PML leases assets to Mutual and its affiliate. Revenue relating to these services amount to $376,000, $758,000 and $646,000 in 2002, 2001 and 2000, respectively and is included in other income.
State Auto P&C's December 31, 1990 liability for losses and loss expenses of $65,464,000 has been guaranteed by Mutual. Pursuant to the guaranty agreement, all ultimate adverse development of the December 31, 1990 liability, if any, is to be reimbursed by Mutual to State Auto P&C in conformance with pooling percentages in place at that time. As of December 31, 2002, there has been no adverse development of the liability.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(7) NOTE PAYABLE TO BANK
Effective December 21, 2002 State Auto Financial entered into a $15,000,000 term loan note agreement with a bank that matures December 21, 2003. Interest adjusts quarterly and accrues at LIBOR plus 75 basis points (2.15% at December 31, 2002) and is payable quarterly. This note agreement has various covenants including financial ratio covenants.
(8) FEDERAL INCOME TAXES
A reconciliation between actual federal income taxes (benefit) and the amount computed at the indicated statutory rate is as follows:
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities are presented below:
The Company is required to establish a valuation allowance for any portion of the deferred tax asset that management believes will not be realized. In the opinion of management, it is more likely than not that the Company will realize the benefit of the deferred tax assets and, therefore, no such valuation allowance has been established.
Federal income taxes paid during 2002, 2001 and 2000 were $6,000,000 $11,500,000 and $12,638,000, respectively.
(9) (a) PENSION BENEFIT PLANS
Effective January 1, 2002, employees of MIGI, a subsidiary of the former Meridian Mutual, became employees of State Auto P&C. In conjunction with this transaction approximately $3.6 million in net plan benefit liabilities were transferred from MIGI to the Company. Effective January 1, 2000, all employees of Mutual, Stateco and S.I.S., became employees of State Auto P&C, under new management agree-
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
ments effective on that same date. See related discussion at Note (1)(b). Pursuant to the new management agreements, the Company paid cash of approximately $14.6 million to Mutual, equal to the net prepaid pension asset received.
The assets of the defined benefit pension plan are represented primarily by U.S. government and agency obligations, bonds, and common stocks. The Company's policy is to fund pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Benefits are determined by applying factors specified in the plan to a participant's defined average annual compensation.
Prior to 2000, State Auto P&C, Stateco and S.I.S. pursuant to an intercompany agreement, were participants, together with Mutual, in a defined benefit pension plan and a defined contribution plan that covered substantially all employees of Mutual and the Company.
Information regarding the funded status and net periodic pension benefit for the Company's participation in the defined benefit pension plan is as follows:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
Effective January 1, 2000, the net prepaid pension expense is carried on the financial statements of the Company and the annual periodic pension benefit or cost is allocated to affiliated companies based on allocations pursuant to intercompany management agreements. The Company's share of the 2002, 2001 and 2000 net periodic benefit was $2.0 million, $4.0 million and $2.6 million, respectively.
The Company maintains a defined contribution plan that covers substantially all employees of the Company. Contributions to the plan are based on employee contributions and the level of Company match. The Company's share of the expense under the plan totaled $1,964,000, $1,120,000 and $890,000 for the years 2002, 2001 and 2000, respectively.
(b) POSTRETIREMENT BENEFITS
In addition to pension benefits, the Company provides certain health care and life insurance benefits for its eligible retired employees. Substantially all of the Company's employees may become eligible for these benefits if they retire between age 55 and 65 with 15 years or more of service or if they retire at age 65 or later with 5 years or more of service. Effective January 1, 2000, all employees of Mutual, Stateco and S.I.S., became employees of State Auto P&C, under new management agreements effective on that same date. See related discussion at Note (1)(b). Pursuant to the new management agreements, the Company received cash of approximately $49.6 million from Mutual, equal to the funded status of the postretirement obligation assumed.
Plan assets are primarily composed of mutual funds and government securities.
Information regarding the funded status and net periodic benefit cost for the Company's participation in the postretirement benefit plan is as follows:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
A 6.75%, 7.5% and 8.0% weighted average discount rate was used for 2002, 2001 and 2000, respectively to determine the accumulated postretirement benefit obligation. A 9.0%, 8.5% and 8.5% weighted average rate was used for 2002, 2001 and 2000, respectively to determine the long-term rate of return on plan assets.
Effective January 1, 2000, the postretirement benefit liability is carried on the financial statements of the Company and the net periodic benefit cost is allocated to affiliated companies based on allocations pursuant to intercompany management agreements. The Company's share of the 2002, 2001 and 2000 net periodic cost was $5.6 million, $3.0 million and $2.6 million, respectively.
The assumed rate of future increases in per capita cost of health care benefits was 10% for the first year and grading down 1% per year to an ultimate rate of 5%. The health care cost trend rate assumption affects the amounts reported. For example, increasing the assumed health care cost trend rate by one percentage point would increase the accumulated postretirement benefit obligation by approximately $10.7 million and would increase the medical service and interest cost by approximately $1.5 million.
The Company also has a supplemental executive retirement plan for which the accrued obligation at December 31, 2002 and 2001 was $2,609,000 and $ 1,709,000, respectively.
(10) STOCKHOLDERS' EQUITY
(a) TREASURY SHARES
On March 1, 2002, the State Auto Financial's Board of Directors approved a plan to repurchase up to 1.0 million shares of common stock from the public over a period extending to and through December 31, 2003. Through December 31, 2002, State Auto Financial repurchased 395,924 shares from the public. Repurchases during 2002 were funded through dividends from subsidiaries.
In May 2000, State Auto Financial's Board of Directors approved a plan to repurchase up to 1.0 million shares of its common stock from the public over a period ending December 31, 2001. Through December 31, 2001, State Auto Financial repurchased 50,522 shares from the public. Repurchases during 2000 and 2001 were funded through dividends from subidiaries.
(b) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION
State Auto P&C, Milbank, Farmers Casualty, SA Ohio and National are subject to regulations and restrictions under which payment of dividends from statutory earned surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Pursuant to these rules, approximately $35.3 million is available for payment to State Auto Financial in 2003 without prior approval. Reconciliations of statutory capital and surplus and
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
net income (loss), as determined using statutory accounting practices, to the amounts included in the accompanying consolidated financial statements are as follows:
In March 1998, the National Association of Insurance Commissioners revised the Accounting Practices and Procedures Manual for insurance companies in a process referred to as Codification. The revised manual became effective January 1, 2001. The revised manual changed, to some extent, prescribed statutory insurance accounting practices and resulted in changes to the accounting practices that the insurance subsidiaries of State Auto Financial use to prepare its statutory-basis financial statements. The cumulative effect of changes in accounting principles adopted to conform to the revised Accounting Practices and Procedures Manual was reported as an adjustment to statutory surplus as of January 1, 2001. The adoption of Codification, as of January 1, 2001, increased statutory surplus of the insurance subsidiaries of State Auto Financial by approximately $19.3 million.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(11) PREFERRED STOCK
State Auto Financial has authorized two classes of preferred stock. For both classes, upon issuance, the Board of Directors has authority to fix and determine the significant features of the shares issued, including, among other things, the dividend rate, redemption price, redemption rights, conversion features and liquidation price payable in the event of any liquidation, dissolution, or winding up of the affairs of State Auto Financial. See note 6 (a) regarding State Auto Financial's obligation to issue redeemable preferred shares to SPC in connection with its catastrophic reinsurance arrangements with a financial institution.
The Class A preferred stock is not entitled to voting rights until, for any period, dividends are in arrears in the amount of six or more quarterly dividends.
(12) STOCK INCENTIVE PLANS
The Company follows Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25) and related Interpretations in accounting for its employee stock incentive plans. Compensation cost charged against operations in 2002, 2001 and 2000 were $0, $14,000 and $31,000, respectively, for those employee stock options granted where the exercise price was less than the market price of the underlying stock on the date of grant. Had compensation cost for the Company's plans been determined based on the fair values at the grant dates consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123), the Company's pro forma net earnings and net earnings per share information would have been as follows:
The fair value of options granted in 2002, 2001 and 2000 were estimated at the date of grant using the Black-Scholes option-pricing model. The weighted average fair values and related assumptions for options granted were as follows:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.
The Company has stock option plans for certain directors and key employees. In May 2000, the Company's 1991 Stock Option Plan and 1991 Directors' Stock Option Plan were replaced with the 2000 Stock Option Plan (Key Employee Plan) and the 2000 Directors Stock Option Plan (Nonemployee Director Plan), respectively, upon approval of shareholders at the 2000 annual meeting of shareholders. The Nonemployee Directors' Plan provides each nonemployee director an option to purchase (1,500 shares for 2002 and 4,200 shares for 2003) shares of common stock following each annual meeting of
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
the shareholders at an option price equal to the fair market value at the close of business on the date of the annual meeting. The Company has reserved 300,000 shares of common stock under this plan. These options are exercisable at issuance to 10 years from date of grant. The Key Employee's Plan provides that qualified stock options may be granted at an option price not less than fair market value at date of grant and that nonqualified stock options may be granted at any price determined by the options committee of the Board of Directors. The Company has reserved 5,000,000 shares of common stock under this plan. These options are exercisable at such time or times as may be determined by a committee of the Company's Board of Directors. Normally, these options are exercisable from 1 to 10 years from date of grant.
The Company has an employee stock purchase plan with a dividend reinvestment feature, under which employees of the Company may choose at two different specified time intervals each year to have up to 6% of their annual base earnings withheld to purchase the Company's common stock. The purchase price of the stock is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 2,400,000 shares of common stock under this plan. At December 31, 2002 and 2001, 1,919,000 and 1,803,000, respectively shares have been purchased under this plan.
The Company has a stock option incentive plan for certain designated independent insurance agencies that represent the Company and its affiliates. The Company has reserved 400,000 shares of common stock under this plan. The plan provides that the options become exercisable on the first day of the calendar year following the agency's achievement of specific production and profitability requirements over a period not greater than two calendar years from date of grant or a portion thereof in the first calendar year in which an agency commences participation under the plan. Options granted and vested under this plan have a 10-year term. The Company has accounted for the plan in its accompanying financial statements at fair value. The fair value of options granted was estimated at the reporting date or vesting date using the Black-Scholes option-pricing model. The weighted average fair value and related assumptions for 2002, 2001 and 2000, respectively, were as follows: fair value of $7.55, $8.04 and $10.91; dividend yield of .87%, .90% and .90%; expected volatility factor of .36, .34 and .32; risk-free interest rate of 4.50%, 5.16% and 5.19%; and expected life of the option of 8.1, 8.7 and 9.0 years. Expense of $165,000, $140,000 and $493,000 associated with this plan was recognized in 2002, 2001 and 2000, respectively.
A summary of the Company's stock option activity and related information for these plans for the years ended December 31, 2002, 2001 and 2000, follows:
Page 71
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
A summary of information pertaining to options outstanding and exercisable as of December 31, 2002 follows:
(13) NET EARNINGS PER COMMON SHARE
The following table sets forth the compilation of basic and diluted net earnings per common share:
The following options to purchase shares of common stock were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price:
(14) OTHER COMPREHENSIVE INCOME
The related federal income tax effects of each component of other comprehensive income (loss) are as follows:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(15) REPORTABLE SEGMENTS
Prior to 2001 the Company had four reportable segments: standard insurance, nonstandard insurance, investment management services and management and operations services. The reportable segments are business units managed separately because of the differences in products or service they offer and type of customer they serve.
The standard insurance segment provides personal and commercial insurance to its policyholders. Its principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. The nonstandard insurance segment provides personal automobile insurance to policyholders that are typically rejected or canceled by standard insurance carriers because of poor loss experience or a history of late payment of premiums. Both the standard and nonstandard insurance segments operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system.
Effective July 1, 2001, with the Pooled Subsidiaries assumption of the former Meridian Mutual business through the Pooling Arrangement, as more fully described in note 6(a), the Company's standard and nonstandard insurance segments have been segregated into four reportable segments. While these segments offer similar products and services and operate in the same geographical locations within the United States, they differ within their operating measures, more specifically within their loss and profitability results. Consequently, the Company has defined the two insurance segments that existed prior to 2001 to be State Auto standard insurance and State Auto nonstandard insurance and the former Meridian Mutual business assumed through the Pooling Arrangement by the Pooled Subsidiaries to be Meridian standard insurance and Meridian nonstandard insurance. Monitoring the performance of the Meridian segments allows management to review the results of its integration efforts of these segments while this business continues to be processed through the Meridian systems platform. As this business begins to migrate through new and renewal policy issuance on the State Auto systems platform where State Auto policies, pricing and underwriting philosophies are fully integrated, it is anticipated that the Meridian segments will decrease. With the transition, during 2002, of the Meridian nonstandard segment to the State Auto systems platform, begining with the first quarter 2003, this segment will be included in the State Auto nonstandard segment.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The investment management services segment manages the investment portfolios of affiliated insurance companies. As a result of the loss of the management and operations services income as described in note 6(d), the management and operations service segment is now in the all other category for segment reporting beginning with the first quarter of 2002 as the results for this segment no longer meet the quantitative thresholds for separate presentation as a reportable segment. The segment disclosures for the year ended December 31, 2001 and 2000 have been restated to reflect this change.
The Company evaluates performance of its reportable segments and allocates resources thereon based on profit or loss from operations, excluding net realized gains on investments on the Company's investment portfolio, before federal income taxes. The Company monitors its assets for the insurance segments on a legal entity basis, which for the Pooled Subsidiaries includes assets of three of the four reportable insurance segments (State Auto standard insurance, Meridian standard insurance and Meridian nonstandard insurance). The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies.
Revenue from segments in the other category is attributable to three other operating segments of the Company; management and operations services segment, an insurance software development and resale segment, and a property management and leasing segment. The insurance software development and resale segment and property management and leasing segment have never met the quantitative thresholds for individual presentation as reportable segments.
The following provides financial information regarding the Company's reportable segments. The 2001 financial information for the Meridian standard and nonstandard segments reflects the business assumed by the pooled subsidiaries, beginning July 1, 2001:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
Revenues from external customers include the following products and services:
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The standard insurance segments and the Meridian nonstandard insurance segment participate in a reinsurance pooling agreement with other standard and nonstandard insurance affiliates. For discussion regarding this arrangement and these segments' contribution to the pool and participation in the pool, see note 6.
Revenues from external customers are derived entirely within the United States. Also, all long-lived assets are located within the United States.
(16) QUARTERLY FINANCIAL DATA (UNAUDITED)
(17) CONTINGENCIES
The Company's insurance subsidiaries are involved in litigation and may become involved in potential litigation arising in the ordinary course of business. Additionally, the insurance subsidiaries may be impacted by adverse regulatory actions and adverse court decisions where insurance coverages are expanded beyond the scope originally contemplated in the policy(ies). In the opinion of management, the effects, if any, of such litigation and published court decicions are not expected to be material to the consolidated financial statements.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required under this Item with respect to directors will be contained in the Company's proxy statement to be filed within 120 days of December 31, 2002, and is hereby incorporated herein by reference.
Information required under this Item with respect to executive officers is contained under the heading "Executive Officers of the Registrant" in Item 1 of this Form 10-K report.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information required under this Item will be contained in the Company's proxy statement to be filed within 120 days of December 31, 2002, and is hereby incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information required under this Item will be contained in the Company's proxy statement to be filed within 120 days of December 31, 2002, and is hereby incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required under this Item will be contained in the Company's proxy statement to be filed within 120 days of December 31, 2002, and is hereby incorporated herein by reference.
ITEM 14.
ITEM 14. CONTROLS AND PROCEDURES
(a) Within the 90 days prior to the date of filing of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the Securities and Exchange Commission.
(b) There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to the date the evaluation described in (a), above, was carried out.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) LISTING OF FINANCIAL STATEMENTS
The following consolidated financial statements of the Company, are filed as part of this Form 10-K Report and are included in Item 8:
Report of Independent Auditors Consolidated Balance Sheets as of December 31, 2002 and 2001 Consolidated Statements of Income for each of the three years in the period ended December 31, 2002 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 2002 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2002 Notes to Consolidated Financial Statements
(a)(2) LISTING OF FINANCIAL STATEMENT SCHEDULES
The following financial statement schedules of the Company for the years 2002, 2001, and 2000, are included in Item 14(d), following the signatures, and should be read in conjunction with the consolidated financial statements contained in this Form 10-K Annual Report.
All other schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements or notes thereto.
(a)(3) LISTING OF EXHIBITS
* Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit.
* Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit.
* Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit.
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*Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit
(b) REPORTS ON FORM 8-K -------------------
The Company did not file any Form 8-K current reports during the fourth quarter of the Company's fiscal year ended December 31, 2002.
(c) EXHIBITS
The exhibits have been submitted as a separate section of this report following the financial statement schedules.
(d) FINANCIAL STATEMENT SCHEDULES
The financial statement schedules have been submitted as a separate section of this report following the signatures and certifications.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
STATE AUTO FINANCIAL CORPORATION
Dated: March 28, 2003 /s/Robert H. Moone -------------------------------- Robert H. Moone Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
*Steven J. Johnston by signing his name hereto, does sign this document on behalf of the person indicated above pursuant to a Power of Attorney duly executed by such person.
/s/Steven J. Johnston March 28, 2003 Steven J. Johnston Attorney in Fact
CERTIFICATION
I, Robert H. Moone, certify that:
1. I have reviewed this annual report on Form 10-K of State Auto Financial Corporation;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
(c) Presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):
(a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 28, 2003 /s/ Robert H. Moone ---------------------------- Robert H. Moone Chief Executive Officer (Principal Executive Officer)
CERTIFICATION
I, Steven J. Johnston, certify that:
1. I have reviewed this annual report on Form 10-K of State Auto Financial Corporation;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
(a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
(b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
(c) Presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function):
(a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 28, 2003 /s/ Steven J. Johnston --------------------------------- Steven J. Johnston Treasurer and Chief Financial Officer (Principal Financial Officer)
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 2002
(1) Original cost of equity securities and, as to fixed maturities, original cost reduced by repayments and adjusted for amortization of premiums or accrual of discounts.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONTINUED CONDENSED STATEMENTS OF INCOME
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONTINUED CONDENSED STATEMENTS OF CASH FLOWS
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONTINUED
NOTE 1 - BASIS OF PRESENTATION
In the parent company-only financial statements, State Auto Financial Corporation's investment in subsidiaries is stated at cost plus equity in undistributed earnings of subsidiaries and net unrealized gains and losses on investments. The parent company-only financial statements should be read in conjunction with the Company's consolidated financial statements.
NOTE 2 - STOCK REPURCHASE PLAN
On March 1, 2002, the Board of Directors of State Auto Financial approved a plan to repurchase up to 1.0 million shares of its common stock over a period extending to and through December 31, 2003. Through December 31, 2002, State Auto Financial repurchased 395,924 shares from the public. Repurchases during 2002 were funded through dividends from subsidiaries.
During 2000, State Auto Financial's Board of Directors approved a plan to repurchase up to 1.0 million shares of its common stock from the public over a period ending December 31, 2001. Through December 31, 2001 State Auto Financial repurchased 50,522 shares. Repurchases during 2001 and 2000 were funded through dividends from subsidiaries.
NOTE 3 - NOTES PAYABLE
In conjunction with the May 1999 stock repurchase plan, State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million, at an interest rate of 6.0%. The interest rate adjusts each January 1 based on a formula set forth in the note. During 2002 and 2001 the interest rate was 4.75% and 5.0%, respectively, and adjusts to 4.25% in 2003. Principal payment is due on demand from Mutual after December 31, 2000, with final payment to be received on or prior to December 31, 2005.
Effective December 23, 2002, State Auto Financial entered into a 364 day $15.0 million term loan note agreement with a bank. Interest adjusts quarterly and accrues based on LIBOR plus 75 basis points (2.15% at December 31, 2002). Interest on the note is 2.15% through March 23, 2003 and 2.027% for the period March 24, 2003 through September 23, 2003.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (in thousands)
STATE AUTO FINANCIAL CORPORATION
SCHEDULE IV - REINSURANCE YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (in thousands, except percentages)
- -------------- (1) These columns include the effect of intercompany pooling. (2) Calculated as earned premiums assumed from outside companies to net amount. ITEM 15(c) EXHIBIT INDEX
(a)(3) LISTING OF EXHIBITS
* Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit.
* Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit.
* Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit.
* Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit.
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*Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit