UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
(X) Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the quarterly period ended September 30, 2003
or
( ) Transition report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the Transition period from ---------------- to--------------------------
Commission File Number 0-19289
State Auto Financial Corporation
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Ohio 31-1324304
- ------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation)
518 East Broad Street, Columbus, OH 43215-3976
- --------------------------------------------------------------------------------
(Address of principal executive offices) (zip code)
(614) 464-5000
- --------------------------------------------------------------------------------
Registrant's telephone number, including area code
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. (X) Yes ( ) No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). (X) Yes ( ) No
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date:
Common shares, without par value 39,344,009
- -------------------------------- -------------------------
(Class) (Outstanding on 10/20/03)
INDEX
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed consolidated balance sheets - September 30, 2003 and December 31, 2002
Condensed consolidated statements of income - Three months ended September 30, 2003 and 2002
Condensed consolidated statements of income - Nine months ended September 30, 2003 and 2002
Condensed consolidated statements of cash flows - Nine months ended September 30, 2003 and 2002
Notes to condensed consolidated financial statements - September 30, 2003
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosure of Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except per share data)
September 30 December 31
2003 2002
------------- ------------
(unaudited) (see note 1)
ASSETS
Fixed maturities, available for sale, at fair value
(amortized cost $1,294,797 and $1,149,334, respectively) $ 1,361,539 $ 1,216,698
Equity securities, available for sale, at fair value
(cost $93,537 and $55,837, respectively) 100,476 53,710
Other invested assets, at fair value
(cost $8,842 and $1,857, respectively) 8,892 1,908
------------- ------------
Total investments 1,470,907 1,272,316
Cash and cash equivalents 28,170 96,048
Deferred policy acquisition costs 85,816 77,886
Accrued investment income and other assets 53,311 50,788
Due from affiliate 23,442 14,210
Net prepaid pension expense 46,814 46,690
Reinsurance recoverable on losses and loss expenses payable
(ceded to affiliates $5,463 and $4,286, respectively) 13,676 8,825
Prepaid reinsurance premiums
(ceded to affiliates $4,251 and $3,997, respectively) 8,736 7,695
Deferred federal income taxes 1,954 5,796
Property and equipment, at cost, net of accumulated
depreciation of $4,337 and $3,915, respectively 12,699 12,741
------------- ------------
Total assets $ 1,745,525 $ 1,592,995
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable
(net assumed from affiliates $307,458 and $303,960, respectively) $ 645,457 $ 600,958
Unearned premiums
(net assumed from affiliates $128,240 and $133,130, respectively) 411,534 377,990
Notes payable (affiliates $75,964 and $60,500, respectively) 90,964 75,500
Postretirement benefit liabilities 72,182 66,763
Current federal income taxes 94 745
Other liabilities 9,348 7,270
------------- ------------
Total liabilities 1,229,579 1,129,226
------------- ------------
Commitments and contingencies - -
STOCKHOLDERS' EQUITY
Class A Preferred stock (non voting), without par value.
Authorized 2,500,000 shares; none issued - -
Class B Preferred stock, without par value.
Authorized 2,500,000 shares; none issued - -
Common stock, without par value. Authorized 100,000,000 shares;
43,930,183 and 43,525,774 shares issued, respectively, at
stated value of $2.50 per share 109,825 108,815
Less 4,593,674 and 4,524,475 treasury shares, respectively, at cost (55,475) (54,249)
Additional paid-in capital 53,770 50,354
Accumulated other comprehensive income 47,973 42,512
Retained earnings 359,853 316,337
------------- ------------
Total stockholders' equity 515,946 463,769
------------- ------------
Total liabilities and stockholders' equity $ 1,745,525 $ 1,592,995
============= ============
See accompanying notes to condensed consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Three Months Ended September 30, 2003 and 2002
(dollars in thousands, except per share amounts)
(unaudited)
2003 2002
------------ ------------
Earned premiums
(ceded to affiliates $151,021 and $130,016, respectively) $ 246,056 $ 230,059
Net investment income 16,047 14,766
Net realized gains on investments 1,550 700
Other income (includes $935 and $926,
respectively, from affiliates) 1,457 1,437
------------ ------------
Total revenues 265,110 246,962
------------ ------------
Losses and loss expenses
(ceded to affiliates $103,282 and $91,566, respectively) 171,004 170,009
Acquisition and operating expenses 69,222 68,816
Interest expense (includes $676 and $541,
respectively, to affiliates) 753 541
Other expense, net 3,327 2,468
------------ ------------
Total expenses 244,306 241,834
------------ ------------
Income before federal income taxes 20,804 5,128
Federal income tax expense (benefit) 5,224 (757)
------------ ------------
Net income $ 15,580 $ 5,885
============ ============
Earnings per share:
- basic $ 0.40 $ 0.15
============ ============
- diluted $ 0.38 $ 0.15
============ ============
Dividends paid per common share $ 0.040 $ 0.035
============ ============
See accompanying notes to condensed consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Nine Months Ended September 30, 2003 and 2002
(dollars in thousands, except per share amounts)
(unaudited)
2003 2002
------------ ------------
Earned premiums
(ceded to affiliates $441,242 and $370,380, respectively) $ 720,124 $ 664,238
Net investment income 47,587 44,214
Net realized gains on investments 9,568 854
Other income (includes $2,759 and $2,359,
respectively, from affiliates) 4,342 3,838
------------ ------------
Total revenues 781,621 713,144
------------ ------------
Losses and loss expenses
(ceded to affiliates $301,302 and $278,706, respectively) 503,342 493,749
Acquisition and operating expenses 209,074 195,209
Interest expense (includes $2,078 and $1,621,
respectively, to affiliates) 2,320 1,621
Other expense, net 8,608 6,887
------------ ------------
Total expenses 723,344 697,466
------------ ------------
Income before federal income taxes 58,277 15,678
Federal income tax expense (benefit) 13,332 (1,986)
------------ ------------
Net income $ 44,945 $ 17,664
============ ============
Net earnings per share:
- basic $ 1.15 $ 0.45
============ ============
- diluted $ 1.12 $ 0.44
============ ============
Dividends paid per common share $ 0.110 $ 0.100
============ ============
See accompanying notes to condensed consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended September 30, 2003 and 2002
(in thousands)
(unaudited)
2003 2002
----------- ------------
Cash flows from operating activities:
Net income $ 44,945 $ 17,664
Adjustments to reconcile net earnings to net cash
provided by operating activities:
Depreciation and amortization, net 6,224 4,075
Net realized gains on investments (9,568) (854)
Changes in operating assets and liabilities:
Deferred policy acquisition costs (7,930) (10,904)
Accrued investment income and other assets (2,210) (9,554)
Net prepaid pension expense (124) (2,812)
Postretirement health care benefits 5,419 8,032
Other liabilities and due to/from affiliate, net (7,154) (23,542)
Reinsurance receivable and prepaid reinsurance premiums (5,892) 313
Losses and loss expenses payable 44,499 65,916
Unearned premiums 33,544 51,018
Federal income taxes 1,383 (8,031)
----------- ------------
Net cash provided by operating activities 103,136 91,321
----------- ------------
Cash flows from investing activities:
Purchase of fixed maturities - available for sale (436,062) (356,525)
Purchase of equity securities (43,799) (22,130)
Purchase of other invested assets (6,984) (1,549)
Maturities, calls and principal reductions of fixed maturities -
held to maturity - 7,017
Maturities, calls and principal reductions of fixed maturities -
available for sale 65,818 27,715
Sale of fixed maturities - available for sale 230,154 258,241
Sale of equity securities 4,913 9,778
Net additions of property and equipment (383) -
----------- ------------
Net cash used in investing activities (186,343) (77,453)
----------- ------------
Cash flows from financing activities:
Proceeds from issuance of debt 15,464 -
Debt issuance costs (535) -
Net proceeds from the sale of common stock 2,558 1,922
Payment of dividends (1,429) (1,270)
Payments to acquire treasury shares (729) (4,699)
----------- ------------
Net cash provided by (used in) financing activities 15,329 (4,047)
----------- ------------
Net increase (decrease) in cash and cash equivalents (67,878) 9,821
Cash and cash equivalents at beginning of period 96,048 30,016
----------- ------------
Cash and cash equivalents at end of period $ 28,170 $ 39,837
=========== ============
Supplemental disclosures:
Federal Income taxes paid $ 11,950 $ 6,000
=========== ============
Interest paid (affiliates $1,814 and $1,621, respectively) $ 2,051 $ 1,621
=========== ============
See accompanying notes to condensed consolidated financial statements.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements of State
Auto Financial Corporation ("State Auto Financial" or the "Company") have been
prepared in accordance with Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by accounting principles generally accepted in the U.S. for complete financial
statements. In the opinion of management, all adjustments (consisting of normal,
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three and nine month periods ended September
30, 2003 are not necessarily indicative of the results that may be expected for
the year ended December 31, 2003. The balance sheet at December 31, 2002 has
been derived from the audited financial statements at that date but does not
include all of the information and footnotes required by accounting principles
generally accepted in the United States for complete financial statements.
For further information, refer to the consolidated financial statements and
footnotes thereto included in the Registrant Company and Subsidiaries' annual
report on Form 10-K for the year ended December 31, 2002. Capitalized terms used
herein and not otherwise defined shall have the meaning ascribed to them in the
foregoing Form 10-K.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation -Transition and Disclosure, an amendment of SFAS Statement No. 123
Accounting for Stock-Based Compensation. This Statement provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based compensation. In addition, this Statement requires
more prominent disclosures in both the annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The Company has adopted the
disclosure provisions of this Statement and will adopt a transition method at
the time when a consistent fair value measurement and recognition provision is
determined by the FASB and is required to be adopted.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with the Characteristics of Both Liabilities and Equity, effective
for reporting periods after July 1, 2003. This Statement establishes standards
for classifying and measuring as liabilities certain financial instruments that
embody obligations of the issuer and have characteristics of both liabilities
and equity. The Company adopted this statement effective July 1, 2003 with no
significant impact to the consolidated financial statements.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities ("FIN 46"), which requires the consolidation of
certain entities considered to be variable interest entities ("VIEs"). An entity
is considered to be a VIE when it has equity investors who lack the
characteristics of having a controlling financial interest, or its capital is
insufficient to permit it to finance its activities without additional
subordinated financial support. Consolidation of a VIE by an investor is
required when it is determined that the investor will absorb a majority of the
VIE's expected losses if they occur, receive a majority of the entity's expected
residual returns if they occur, or both. As a result of the Company adopting FIN
46, effective July 1, 2003, the financial operations of STFC Capital Trust I,
the Company's Delaware business trust subsidiary (described in Note 7 below),
are no longer consolidated within the accompanying financial statements of the
Company. The net impact of the adoption of FIN 46, effective July 1, 2003, was a
reclassification adjustment to eliminate the Capital Trust's capital securities
of $15.0 million from notes payable and include State Auto Financial's
investment of $464,000 in the common securities of Capital Trust in other
invested assets and $15.5 million principal amount of Floating Rate Junior
Subordinated Debt Securities issued to the Capital Trust in notes payable.
Certain items in the 2002 condensed consolidated financial statements have been
reclassified to conform to the 2003 presentation.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
2. COMPREHENSIVE INCOME
The components of comprehensive income, net of related tax, are as follows:
Three months ended Nine Months ended
September 30 September 30
----------------------- -----------------------
2003 2002 2003 2002
---------- --------- --------- ----------
(in thousands)
--------------
Net income $ 15,580 $ 5,885 $ 44,945 $ 17,664
Unrealized holding gain (loss), net of tax (13,759) 25,225 5,461 37,344
---------- --------- --------- ----------
Comprehensive income $ 1,821 $ 31,110 $ 50,406 $ 55,008
========== ========= ========= ==========
The components of accumulated other comprehensive income, net of related tax,
included in stockholders' equity at September 30, 2003 and 2002 include
unrealized holding gains (losses), net of tax.
3. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted earnings per
common share:
Three months ended Nine months ended
September 30 September 30
------------------------ ----------------------
2003 2002 2003 2002
---------- ---------- --------- ---------
(dollars in thousands, except per share amounts)
------------------------------------------------
Numerator:
Net income for basic and diluted
Earnings per share $ 15,580 $ 5,885 $ 44,945 $ 17,664
========== ========== ========= ========
Denominator:
Weighted average shares outstanding
Basic earnings per share 39,302 38,993 39,193 38,989
Effect of dilutive stock options 1,031 729 844 787
---------- ---------- --------- ---------
Adjusted weighted average shares
For diluted earnings per share 40,333 39,722 40,037 39,776
========== ========== ========= =========
Basic earnings per share $ 0.40 $ 0.15 $ 1.15 $ 0.45
========== ========== ========= =========
Diluted earnings per share $ 0.38 $ 0.15 $ 1.12 $ 0.44
========== ========== ========= =========
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
3. EARNINGS PER COMMON SHARE (CONTINUED)
The following numbers of 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:
Three months ended Nine months ended
September 30 September 30
------------------ -----------------
2003 2002 2003 2002
---- ---- ---- ----
(in thousands)
Number of options - 911 - 911
=== === === ===
4. STOCK BASED COMPENSATION
At September 30, 2003, the company has stock-based employee and non-employee
compensation plans, which are described more fully below. The company accounts
for the employee and non-employee director plans using the intrinsic value
method under the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related Interpretations. No
stock-based employee and director compensation cost is reflected in net income,
as substantially all options granted under these plans have an exercise price
equal to the market value of the underlying common stock on the date of grant.
The company accounts for the remaining non-employee plans using the fair value
method under the recognition and measurement principles of FASB Statement No.
123, Accounting for Stock-Based Compensation, and related interpretations.
Non-employee stock-based compensation cost is reflected in net income. The
following table illustrates the effect on net income and earnings per share if
the company had applied the fair value recognition provisions of FASB Statement
No. 123, Accounting for Stock-Based Compensation, to stock-based employee and
non-employee director compensation.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
4. STOCK BASED COMPENSATION (CONTINUED)
Three months ended Nine months ended
September 30 September 30
-------------------- ---------------------
2003 2002 2003 2002
-------- -------- -------- ---------
(in thousands, except per share amounts)
Net income, as reported $ 15,580 $ 5,885 $ 44,945 $ 17,664
Deduct: Total stock-based employee and non-employee
director compensation expense determined under fair
value based method for all awards, net of related
tax effects (473) (357) (1,293) (1,071)
-------- -------- -------- ---------
Pro forma net income $ 15,107 $ 5,528 $ 43,652 $ 16,593
======== ======== ======== =========
Earnings per share:
Basic--as reported $ 0.40 $ 0.15 $ 1.15 $ 0.45
======== ======== ======== =========
Basic--pro forma $ 0.38 $ 0.14 $ 1.11 $ 0.43
======== ======== ======== =========
Diluted--as reported $ 0.38 $ 0.15 $ 1.12 $ 0.44
======== ======== ======== =========
Diluted--pro forma $ 0.37 $ 0.14 $ 1.07 $ 0.42
======== ======== ======== =========
There were 442,371 and 375,910 options granted to employees and directors during
the nine month periods ended September 30, 2003 and 2002, respectively. There
were no options granted to employees and directors during the three month
periods ended September 30, 2003 and 2002. The fair value of options granted was
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:
Three and nine
months ended
September 30
--------------------
2003 2002
------- -------
Fair value $ 7.57 $ 6.94
Dividend yield .80% .92%
Risk free interest rate 2.89% 4.58%
Expected volatility factor 37.6% 34.8%
Expected life in years 7.8 7.8
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 input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee and director 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 and director stock options.
The Company has stock option plans for certain key employees, all Company
employees, non-employee directors and certain independent insurance agencies.
The Key Employee's Plan provides that qualified stock options may be granted at
an option price not less than common stock fair market value at date of grant
and that nonqualified stock options may be granted at any price determined by
the Compensation Committee of the Board of Directors.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
4. STOCK BASED COMPENSATION (CONTINUED)
The Company has reserved 5 million shares of common stock under this plan. These
options typically vest over a three year period with one-third vesting at each
anniversary date. Normally, these options are exercisable up to ten years from
the 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 2.4 million shares of common stock under
this plan.
The Non-employee Directors' Plan provides each non-employee director of the
Company an option to purchase (4,200 shares for 2003 and 1,500 shares for 2002)
shares of common stock following each annual meeting of the shareholders at an
option price equal to the common stock fair market value at the close of
business on the last trading day immediately prior to the date of the annual
meeting. The Company has reserved 300,000 shares of common stock under this
plan. These options vest upon grant and are exercisable up to 10 years from the
date of grant.
The company accounts for the remaining non-employee plans described below using
the fair value method under the recognition and measurement principles of FASB
Statement No. 123, Accounting for Stock-Based Compensation, and related
interpretations. Non-employee stock-based compensation cost of $106,000 and
$7,000 for the three month periods ended September 30, 2003 and 2002,
respectively, and $239,000 and $101,000 for the nine month periods ended
September 30, 2003 and 2002, respectively, is reflected in net income.
The fair value of non-employee 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 are as follows:
Three and nine
months ended
September 30
----------------
2003 2002
------ ------
Fair value $14.79 $ 6.13
Dividend yield .80% .90%
Risk free interest rate 3.75% 3.60%
Expected volatility factor 36.4% 34.0%
Expected life in years 9.1 9.0
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 the date of
grant or a portion thereof in the first calendar year in which an agency
commences participation under the plan. Options granted under this plan have a
ten year term.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
4. STOCK BASED COMPENSATION (CONTINUED)
A summary of the Company's stock option activity and related information for all
option plans for the three and nine month periods ended September 30, 2003 and
2002 is as follows:
Three months ended Nine months ended
September 30 September 30
-------------------------------------- ---------------------------------------
2003 2002 2003 2002
----------------- ------------------ ------------------ ------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
Exercise Exercise Exercise Exercise
Options Price Options Price Options Price Options Price
------- -------- ------- -------- ------- -------- ------- --------
(numbers in thousands, except per share figures)
Outstanding,
beginning of period 2,906 $ 12.50 2,955 $ 10.64 2,791 $ 10.98 2,797 $ 9.58
Granted - - - - 410 18.71 351 15.98
Exercised (66) 10.83 (90) 4.87 (340) 6.63 (283) 5.22
Cancelled (9) 16.24 - - (30) 16.24 - -
----- ----- ----- -----
Outstanding,
end of period 2,831 $ 12.53 2,865 $ 10.82 2,831 $ 12.53 2,865 $ 10.82
===== ----- ----- =====
A summary of information pertaining to all options outstanding and exercisable
at September 30, 2003 is as follows:
Options Outstanding Options Exercisable
-------------------------------- -------------------
Weighted
Average Weighted Weighted
Remaining Average Average
Contractual Exercise Exercise
Range of Exercise Prices Number Life Price Number Price
- ------------------------ ------ ----------- -------- ------ --------
(numbers in thousands, except per share figures)
Less than $5.00 57 .2 $ 4.14 57 $ 4.14
$5.01 - $10.00 727 2.3 6.65 727 6.65
Greater than $10.01 2,047 7.2 14.86 1,377 13.59
----- -----
2,831 5.8 $12.53 2.161 $ 11.00
===== =====
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
5. REINSURANCE
The following table provides a summary of the Company's reinsurance transactions
with other insurers and reinsurers, as well as reinsurance transactions with
affiliates:
Three months ended Nine months ended
September 30 September 30
---------------------- ------------------------
2003 2002 2003 2002
---------- --------- ---------- -----------
(in thousands)
Premiums earned:
Assumed from other insurers and reinsurers $ 1,174 $ 1,232 $ 3,642 $ 2,864
Assumed under State Auto Pool and
other affiliate arrangements 225,813 212,508 664,396 618,694
Ceded to other insurers and reinsurers 3,471 2,952 9,436 8,185
Ceded under State Auto Pool,
Stop Loss and other affiliate arrangements 151,021 130,016 441,242 370,380
Losses and loss expenses incurred:
Assumed from other insurers and reinsurers 867 747 2,401 1,544
Assumed under State Auto Pool and
other affiliate arrangements 155,395 156,988 461,714 465,165
Ceded to other insurers and reinsurers 983 275 5,524 1,619
Ceded under State Auto Pool,
Stop Loss and other affiliate arrangements $ 103,282 $ 91,566 $ 301,302 $ 278,706
6. SEGMENT INFORMATION
As the former Meridian Mutual Insurance Company ("Meridian") 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 onto the State Auto systems
platform. 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 is included in the State Auto
nonstandard segment. The segment disclosures for the three month and nine month
periods ended September 30, 2002 have been restated to reflect this change.
Interim financial data by segment is as follows:
Three months ended Nine months ended
September 30 September 30
------------------ -----------------
2003 2002 2003 2002
---- ---- ---- ----
(in thousands)
Revenues from external customers:
State Auto standard insurance $ 218,755 $ 184,851 $ 618,512 $ 529,247
State Auto nonstandard insurance 21,476 20,005 65,065 55,550
Meridian standard insurance 21,760 39,915 83,950 123,402
Investment management services 653 581 1,872 1,896
All other 925 902 2,605 2,178
--------- --------- --------- ---------
Total revenues from external customers $ 263,569 $ 246,254 $ 772,004 $ 712,273
========= ========= ========= =========
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
6. SEGMENT INFORMATION (CONTINUED)
Three months ended Nine months ended
September 30 September 30
---------------------- --------------------------
2003 2002 2003 2002
--------- --------- ---------- -----------
(in thousands)
Intersegment revenues:
State Auto standard insurance $ 35 $ 37 $ 110 $ 83
Investment management services 1,486 1,278 4,330 3,675
All other 493 528 1,415 1,664
--------- --------- ---------- -----------
Total intersegment revenues $ 2,014 $ 1,843 $ 5,855 $ 5,422
========= ========= ========== ===========
Segment profit (loss):
State Auto standard insurance $ 17,716 $ 9,244 $ 39,584 $ 23,409
State Auto nonstandard insurance 1,356 (600) 4,308 1,575
Meridian standard insurance (1,048) (5,866) 639 (14,429)
Investment management services 1,927 1,712 5,448 4,967
All other 702 576 1,810 1,292
--------- --------- ---------- -----------
Total segment profit (loss) $ 20,661 $ 5,066 $ 51,789 $ 16,814
Reconciling items:
Corporate expenses $ (1,407) $ (638) $ (3,079) $ (1,990)
Net realized gains 1,550 700 9,568 854
--------- --------- ---------- -----------
Total consolidated income (loss) before
federal income taxes $ 20,804 $ 5,128 $ 58,277 $ 15,678
========= ========= ========== ===========
Segment assets:
Standard insurance $1,576,423 $ 1,415,812
Nonstandard insurance 129,197 96,756
Investment management services 5,857 7,168
All other 15,722 16,636
---------- -----------
Total segment assets $1,727,199 $ 1,536,372
========== ===========
7. SUBORDINATED DEBENTURES
On May 22, 2003, STFC Capital Trust I, State Auto Finanical's Delaware business
trust subsidiary (the "Capital Trust"), issued $15,000,000 liquidation amount of
its capital securities to a third party. In connection with the Capital Trust's
issuance of these capital securities and the related purchase by State Auto
Financial of all of the Capital Trust's common securities (liquidation amount of
$464,000) (the Capital Trust's capital and common securities are hereafter
referred to as the "Trust Securities"), State Auto Financial issued to the
Capital Trust $15.5 million aggregate principal amount of Floating Rate Junior
Subordinated Debt Securities due 2033 (the "Subordinated Debentures"). The sole
assets of the Capital Trust are the Subordinated Debentures and any interest
accrued thereon. Interest on the Trust Securities is payable quarterly at a rate
equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly (5.48% for
the period May 22, 2003 through August 23, 2003, adjusted to 5.34% for the
period August 24, 2003 through November 23, 2003). Prior to May 2008, the
interest rate may not exceed 12.5% per annum. The interest rate and interest
payment dates on the Subordinated Debentures are the same as the interest rate
and interest payment dates on the Trust Securities.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 2003
(unaudited)
7. SUBORDINATED DEBENTURES (CONTINUED)
The Trust Securities are mandatorily redeemable on May 23, 2033, and may be
redeemed at any time on and after May 23, 2008, at 100% of the principal amount
thereof plus unpaid interest. The Trust Securities may be redeemed in whole, but
not in part, at any time within 90 days following the occurrence of a "Tax
Event" or "Investment Company Event" (as defined in the declaration of trust)
(a) if such Tax Event or Investment Company Event occurs on or after May 23,
2008, at a redemption price equal to 100% of the principal amount thereof plus
unpaid interest, and (b) if such Tax Event or Investment Company Event occurs
prior to May 23, 2008, at a redemption price equal to the greater of 100% of the
principal amount thereof plus accrued interest and a "make-whole" amount. The
Subordinated Debentures are subject to these same redemption terms. The
obligations under the Subordinated Debentures and related agreements, taken
together, constitute a full and unconditional guarantee of payments due on the
Trust Securities.
State Auto Financial has the right, at any time, to defer payments of interest
on the Subordinated Debentures for up to 20 consecutive quarterly payment
periods. Consequently, distributions on the Trust Securities would be deferred
(though such distributions would continue to accrue with interest since interest
would accrue on the Subordinated Debentures during any such extended interest
payment period). In no case may the deferral of payments and distributions
extend beyond the stated maturity dates of the respective securities. During
such deferments, State Auto Financial may not declare or pay any dividends on,
or purchase any of its capital stock, make any principal or interest payments on
debt securities that rank in all respects equally with or subordinated to the
Subordinated Debentures, or make any payments under guarantees that rank in all
respects equally with or subordinated to State Auto Financial's guaranty of the
Trust Securities.
In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest
Entities, effective for reporting periods beginning after June 15, 2003. As a
result of the Company adopting FIN 46 effective July 1, 2003, the financial
statements of the Capital Trust are no longer consolidated within the
accompanying financial statements of the Company. State Auto Financial's
investment of $464,000 in the common securities of the Capital Trust is included
in other invested assets and the $15.5 million of Subordinated Debentures is
included in the accompanying financial statements dated September 30, 2003.
8. SUBSEQUENT EVENT
In the fourth quarter 2003, State Auto Financial anticipates issuing up to
$100.0 million principal amount of long-term debt. Net proceeds are expected to
be used to repay certain indebtedness and for general corporate purposes,
including providing additional capital to certain of the Company's insurance
subsidiaries.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
For information regarding the Company's significant accounting policies, as well
as a discussion regarding its critical accounting policies, refer to the
Management's Discussion and Analysis of Financial Condition and Results of
Operations as well as the consolidated financial statements and footnotes
thereto included in the Company's Annual Report on Form 10-K for the year ended
December 31, 2002.
Results of Operations
State Auto Financial Corporation ("State Auto Financial" and, together with its
subsidiaries, the "Company") operates in three insurance segments: (i) State
Auto Financial's wholly owned 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 ("SA Ohio") engage in the State Auto standard
segment of the Company's operations; (ii) State Auto National Insurance Company
("State Auto National"), a wholly owned subsidiary of the Company, and
Mid-Plains Insurance Company ("Mid-Plains"), a wholly owned subsidiary of
Farmers Casualty, engage in the State Auto nonstandard segment of the Company's
operations; and (iii) the Meridian standard segment consists of the standard
insurance business of the former Meridian Mutual Insurance Company ("Meridian
Mutual"), which was acquired and merged into State Automobile Mutual Insurance
Company ("State Auto Mutual") in June 2001. In addition to these segments, the
Company previously operated in a Meridian nonstandard segment. However, due to
the integration efforts that occurred within this segment during 2001 and 2002,
beginning with the first quarter of 2003, the Meridian nonstandard segment was
included in the State Auto nonstandard insurance segment. All prior period
financial information has been reclassified to reflect this segment combination.
An insurance pooling arrangement exists between State Auto P&C, Milbank, Farmers
Casualty, and SA Ohio (collectively referred to as the "Pooled Subsidiaries")
and State Auto Mutual and its subsidiaries, State Auto Insurance Company of
Wisconsin ("SA Wisconsin") and State Auto Florida Insurance Company ("SA
Florida" and, together with the Pooled Subsidiaries, State Auto Mutual, and SA
Wisconsin, the "Pooled Companies" or the "State Auto Pool"). Under this pooling
arrangement, premiums, losses and underwriting expenses are shared by the Pooled
Companies, with the Pooled Subsidiaries receiving 80% in the aggregate of this
underwriting pool and State Auto Mutual and its subsidiaries receiving 20% in
the aggregate of this underwriting pool.
The Pooled Companies, State Auto National, Mid-Plains, State Auto Mutual's
insurance subsidiaries, Meridian Security Insurance Company, Meridian Citizens
Security Insurance Company, and State Auto Mutual's affiliate, Meridian Citizens
Mutual Insurance Company, are collectively referred to herein as the "State Auto
Insurance Companies."
As more fully described in the Company's December 31, 2002 Form 10-K, the
following summary will assist in the discussion of the Company's current period
financial results:
For the period October 1, 2001 through December 31, 2003, State Auto
Mutual entered into a stop loss reinsurance agreement (the "Stop Loss")
with the Pooled Subsidiaries. Under the Stop Loss, if the State Auto
Pool's quarterly statutory loss and loss adjustment expense ratio (the
"Pool loss and LAE ratio") is between 70.75% and 80%, State Auto Mutual
will reinsure the Pooled Subsidiaries 27% of the State Auto Pool's
losses in excess of a Pool loss and LAE ratio of 70.75% to 80%. The
Pooled Subsidiaries would be responsible for their share of the State
Auto Pool's losses over the 80% threshold. State Auto Mutual will have
the right to participate in the profits of the State Auto Pool. State
Auto Mutual will assume 27% of the State Auto Pool's underwriting
profits attributable to a Pool loss and LAE ratio less than 69.25% but
more than 50.99%.
Net income for the Company increased $9.7 million to $15.6 million and $27.3
million to $44.9 million for the three month and nine month periods ended
September 30, 2003, respectively, from the same periods in 2002. Contributing to
these increases was an improvement in the Company's loss experience from
2002 along with increased growth in earned premium. The Company's GAAP loss and
LAE ratio (defined below) reflected a 4.4 point improvement for the three and
nine month periods ended September 30, 2003, respectively, from the same periods
in 2002, despite the nine month results being impacted by the largest
catastrophe loss event in Company history occurring in May 2003. While all
insurance segments, absent catastrophe losses, reflected an improvement in
underwriting results from the same 2002 periods, the most significant
improvement was within the State Auto standard segment.
Consolidated earned premiums increased to $246.1 million and $720.1 million for
the three and nine month periods ended September 30, 2003, respectively. These
totals represent a $16.0 million, or 7.0%, and $55.9 million, or 8.4%, increase
from the same periods in 2002, respectively. These increases were primarily the
result of premium rate and policy count increases across most lines of business.
The State Auto standard segment contributed a 14.3% and 13.6% increase to
consolidated earned premiums for the three month and nine month periods ended
September 30, 2003, respectively, from the same periods in 2002, while the State
Auto non-standard segment contributed a 0.6% and 1.4% increase, respectively,
from the same periods in 2002. Contributing also to the State Auto standard
segment's increases was the migration of the Meridian standard segment's
policies to the State Auto systems platform. The increases in the State Auto
standard and non-standard segments were offset by two factors: declines in the
Meridian standard segment and an increase in premiums ceded to State Auto Mutual
under the Stop Loss. The Meridian standard segment declined 7.8 points and 5.8
points for the three and nine month periods ending September 30, 2003,
respectively. Contributing to this segment's decreases are the following:
policies migrating on renewal to the State Auto systems platform, as well as a
loss of policy count due to significant rate increases taken that management
believed were necessary to improve the underwriting performance of this
segment's book of business. During the three month period ended September 30,
2003, the Pooled Companies ceded $167,000 in earned premiums to State Auto
Mutual under the Stop Loss, reducing earned premiums by 0.1 points from the same
2002 time period. See the Stop Loss discussion below regarding loss and loss
adjustments expense cessions for the three month period ended September 30,
2002. For the nine month periods ended September 30, 2003 and 2002, the Pooled
Companies ceded a total of $5.7 million and $425,000, respectively, in earned
premiums to State Auto Mutual. The effect of this increase in premiums ceded
reduced consolidated earned premium by 0.8 points for the nine months ended
September 30, 2003. See the Stop Loss discussion below regarding loss and loss
adjustment expense cession.
Net investment income increased $1.2 million (8.1%) to $16.0 million and
increased $3.4 million (7.7%) to $47.6 million for the three month and nine
month periods ended September 30, 2003, respectively, from the same periods in
2002. These increases were primarily the result of an increase in invested
assets generated by cash flow provided from operations, partly offset by a
decline in the investment yield. Total cost of invested assets at September 30,
2003 and 2002 was $1,424.2 million and $1,232.7 million, respectively.
Reflecting a decline in the interest rate environment, the annualized investment
yields based on invested assets at cost decreased from 4.9% to 4.6% and from
5.0% to 4.7% for the three month and nine month periods ended September 30,
2003, respectively from the same 2002 periods. See further discussion regarding
investments at the "Liquidity and Capital Resources", "Investments" and "Market
Risk" sections, included herein.
Consolidated losses and loss adjustment expenses, as a percentage of earned
premiums (the "GAAP loss and LAE ratio"), were 69.5% and 73.9%, for the three
month periods ended September 30, 2003 and 2002, respectively, and 69.9% and
74.3% for the nine month periods ended September 30, 2003 and 2002,
respectively. See the Stop Loss discussion above regarding earned premiums
cessions for the three month period ended September 30, 2003, and nine month
periods ended September 30, 2003 and 2002. During the three month period ended
September 30, 2002, the Pooled Companies produced a Pool loss and LAE ratio that
exceeded the 70.75% threshold, specified in the Stop Loss reinsurance contract,
resulting in a cession to State Auto Mutual of $2.4 million in loss and loss
adjustment expenses. For the nine month periods ended September 30, 2003 and
2002, the Pooled Companies ceded a total of $5.6 million and $8.8 million,
respectively, in losses and loss adjustment expenses to State Auto Mutual. The
net effect of these Stop Loss cessions, both earned premiums and loss and loss
adjustment expenses, increased the GAAP loss and LAE ratio by less than 0.1
point for the three months ended September 30, 2003 and decreased 1.0 point for
the same 2002 time period. The net effect of these Stop Loss cessions decreased
the GAAP loss and LAE ratio by 0.9 and 1.3 points, for the nine month periods
ended September 30, 2003 and 2002, respectively.
During the third quarters of 2003 and 2002, catastrophe losses totaled $16.9
million (6.9 GAAP loss and LAE points) and $8.1 million (3.5 GAAP loss and LAE
points), respectively. Catastrophe losses discussed herein, are as designated by
ISO's Property Claim Services ("PCS") unit, a nationally recognized industry
service. PCS defines catastrophes as events resulting in $25.0 million or more
in insured losses industry wide and affecting significant numbers of insureds
and insurers. High winds, tornadoes, hail and lighting resulting from Hurricane
Isabel (CAT 95) that occurred in mid-September 2003 resulted in claims totaling
approximately $6.0 million or 2.4 GAAP loss and LAE points for the three months
ended September 30, 2003.
For the nine months ended September 30, 2003 and 2002, catastrophe claims
contributed 8.9 and 6.5 points, respectively, to the consolidated GAAP loss and
LAE ratio. High winds, tornadoes, hail, lightning and resulting fires caused
damage in 17 of the Company's 26 operating states between May 2 and May 11, 2003
("CAT 88"). Claims resulting from CAT 88 totaled $39.2 million or 5.4 GAAP loss
and LAE points for the nine months ended September 30, 2003, and now ranks as
the mostly costly catastrophe loss event in State Auto history. Hurricane Isabel
contributed 0.8 GAAP loss and LAE points for the nine months ended September 30,
2003. The second most costly catastrophe loss event occurred in the second
quarter of 2002, from a widespread series of storms that included a tornado in
the community of LaPlata, Maryland ("CAT 61"). Claims resulting from CAT 61
totaled $27.9 million or 4.2 GAAP loss and LAE points for the nine months ended
September 30, 2002. As discussed below, each of the Company's insurance
operating segments were impacted by these catastrophe losses.
For discussion purposes, the following table provides comparative GAAP loss and
LAE ratios for the Company's insurance operating segments for the three month
and nine month periods ended September 30, 2003 and 2002, respectively:
Three months ended Nine months ended
September 30 September 30
-------------------------- -----------------------
Change Change
GAAP Loss and LAE Ratio 2003 2002 inc (dec) 2003 2002 inc (dec)
- ----------------------- ---- ---- --------- ---- ---- --------
State Auto standard segment 67.0 69.2 (2.2) 68.1 70.4 (2.3)
State Auto nonstandard segment 76.1 87.4 (11.3) 76.8 81.8 (5.0)
Meridian standard segment 89.0 88.8 0.2 77.5 87.5 (10.0)
---- ---- ----- ---- ---- -----
Total GAAP Loss and LAE Ratio 69.5 73.9 (4.4) 69.9 74.3 (4.4)
==== ==== ===== ==== ==== =====
The State Auto standard segment's GAAP loss and LAE ratios improved 2.2 and 2.3
points for the three month and nine month periods ending September 30, 2003,
respectively, from the same 2002 periods, despite being impacted by the
catastrophe losses described above. Catastrophe losses represent 7.0 and 3.4
points of this segment's GAAP loss and LAE ratio for the three month periods
ending September 30, 2003 and 2002, respectively, of which Hurricane Isabel
accounted for 2.9 points of the 2003 total catastrophe points. For the nine
months ended September 30, 2003 and 2002, catastrophe losses represents 9.7 and
6.4 points, respectively, of which Hurricane Isabel accounted for 1.0 point and
CAT 88 accounted for 5.9 points of the 2003 total catastrophe points and CAT 61
accounted for 4.2 points of the 2002 total catastrophe points. Absent the impact
of catastrophe losses, this segment's GAAP loss and LAE ratio improved for the
three month and nine month periods ending September 30, 2003, 5.8 and 5.6
points, respectively, from the same 2002 time periods. These improvements
reflect the Company's continual emphasis on strict underwriting, which includes
taking necessary and appropriate rate increases across most lines of business.
The Company monitors the underwriting and pricing activity on all lines of
business in this segment, particularly, private passenger auto liability,
homeowners, commercial auto, fire, general liability and workers compensation.
The State Auto nonstandard segment's GAAP loss and LAE ratios improved 11.3
points and 5.0 points for the three month and nine month periods ending
September 30, 2003, respectively, from the same 2002 periods. Catastrophe losses
represent 0.3 and 0.2 points of this segment's GAAP loss and LAE ratio for the
three month periods ending September 30, 2003 and 2002, of which Hurricane
Isabel had minimal impact on this segment's 2003 quarterly and nine month loss
results. For the nine months ended September 30, 2003 and 2002, catastrophe
losses represent 1.7 and 0.9 points, respectively, of which
CAT 88 accounted for 0.9 points and CAT 61 0.5 points of the 2003 and 2002 total
catastrophe points, respectively. Absent the impact of catastrophe losses, this
segment's GAAP loss and LAE ratio improved for the three month and nine month
periods ending September 30, 2003, 11.4 and 5.8 points, respectively, from the
same 2002 time periods. These improvements have been primarily driven by
significant underwriting action and rate level improvement on the former
Meridian nonstandard segment book of business. Management implemented corrective
rate increases on the business that continued to renew on the Meridian systems
platform. In addition, all new nonstandard auto business produced by the former
Meridian Mutual agents is now written through the State Auto 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. Management
continually monitors this segment's underwriting performance, as it is typically
a more volatile line of business than the standard segment, paying particular
attention to rate adequacy and risk selection in states and agencies with
unusually high premium written growth. Kentucky, this segment's largest state of
operation, has experienced significant written premium growth over the last
year. The Company has terminated or suspended eleven fast growing, but extremely
unprofitable, agencies in Kentucky. While this action adversely affected this
segment's premium growth it is expected to improve long term underwriting
results.
The Meridian standard segment's GAAP loss and LAE ratio increased 0.2 points and
improved 10.0 points for the three month and nine month periods ended September
30, 2003, respectively, from the same periods in 2002, despite also being
impacted by the significant catastrophe losses described above. Catastrophe
losses represent 12.1 and 5.6 points of this segment's GAAP loss and LAE ratio
for the three month periods ending September 30, 2003 and 2002, respectively, of
which Hurricane Isabel had minimal impact on this segment's 2003 quarterly and
nine month loss results. For the nine months ended September 30, 2003 and 2002,
catastrophe losses represents 9.3 and 9.1 points, respectively, of which CAT 88
accounted for 5.4 points and CAT 61 5.4 points of the 2003 and 2002 total
catastrophe points, respectively. Absent the impact of catastrophe losses, this
segment's GAAP loss and LAE ratio improved for the three month and nine month
periods ending September 30, 2003, 6.3 and 10.2 points, respectively, from the
same 2002 time periods. During the three month and nine month periods ended
September 30, 2003 this segment experienced several large commercial losses.
Despite these large losses, this segment continued to improve from 2002
comparable periods. These continued improvements are a direct result of
management's efforts that began in 2001 to obtain adequate cost based rates,
re-underwrite the business within the State Auto underwriting guidelines and
terminate unprofitable programs. The Meridian integration is proceeding
according to plan. The business written on the historic Meridian platform is
being systematically renewed on the State Auto platform. Management is striving
to retain the risks that it believes have the greatest profit potential for the
Company. Over time, the historic Meridian segment premium will continue to
decrease to a point where all the business will be included in the State Auto
segment.
Acquisition and operating expenses, as a percentage of earned premiums (the
"GAAP expense ratio"), were 28.1% and 29.9% for the three month periods ended
September 30, 2003 and 2002, respectively, and 29.0% and 29.4% for the nine
month periods ended September 30, 2003 and 2002, respectively. Improvements in
the GAAP expense ratios reflects fixed costs comprising a lesser portion of
earned premiums in 2003 than the same 2002 periods. The Company believes that
the year to date expense ratio better reflects overall performance and
management's efforts to control expenses. As noted above, during the three
months ended September 30, 2003, the Company ceded to State Auto Mutual $167,000
in earned premiums under the Stop Loss, which had minimal impact on the
Company's quarterly GAAP expense ratio. For the nine months ended September 30,
2003, the Company ceded $5.7 million in earned premium under the Stop Loss
versus $425,000 in the same 2002 time period. This increased earned premium
cession under the Stop Loss in 2003 increased the Company's GAAP expense ratio
by 0.2 points for the nine month period ended September 30, 2003.
Interest expense increased to $753,000 from $541,000 and to $2.3 million from
$1.6 million for the three month and nine month periods ended September 30, 2003
from the same periods in 2002. These increases were the result of the additional
$30 million of debt obtained in the last six months of 2002 as well as an
additional $15.5 million of debt issued in May 2003 (see discussion included in
Liquidity and Capital Resources), partly offset by a decline in the interest
rate on the $45.5 million line of credit with State Auto Mutual.
Other expense, as a percentage of total revenues, less net realized gains on
investments, was 1.3% and 1.0% for the three month periods ended September 30,
2003 and 2002, respectively, and 1.1% and 1.0%
for the nine month periods ended September 30, 2003 and 2002, respectively.
Included in other expenses in 2003 are legal and other related costs associated
with the Company and its Board of Directors incurring expenses related to the
tender offer initiated by Gregory M. Shepard and his wholly owned company and
other proposals from Mr. Shepherd that preceded the tender offer. See Part II.
Other Information: Item 1. Legal Proceedings included within this Form 10-Q.
The effective tax expense rate for the three month and nine month periods ended
September 30, 2003 were 25.1% and 22.9%, respectively, as compared to an
effective tax benefit rate of 14.8% and 12.7% for the same 2002 periods,
respectively. Improvement in the Company's 2003 underwriting results along with
an increase in net realized gains on investments and the gradual shift in
increasing the fixed maturity portfolio from tax-exempt to taxable securities
from 2002 contributed to these rate changes.
Liquidity and Capital Resources
For the nine months ended September 30, 2003, net cash provided by operating
activities increased to $103.1 million from $91.3 million for the same 2002
period. The increase in cash flow from operations in 2003 is attributable to
improved underwriting cash flow offset by an increase in cash paid on estimated
federal income taxes from 2002. For the nine months ended September 30, 2003,
net cash used in investing activities increased to $186.3 million from $77.5
million for the same 2002 period. This increase is due to the Company investing
a substantial amount of cash and cash equivalents that existed at December 31,
2002, as well as increased cash flow generated from operating and financing
activities from 2002. For the nine months ended September 30, 2003, net cash
provided by financing activities was $15.3 million in comparison to the same
period in 2002 where $4.0 million was used in financing activities. The increase
in cash provided by financing activities was due to the Company issuing $15.5
million in Subordinated Debentures (as defined below) during May 2003.
In 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 and through December 31, 2003. No shares were repurchased
under this plan during the three months ended September 30, 2003. During the
nine months ended September 30, 2003, 45,000 shares were repurchased for a total
of $727,000. As of September 30, 2003, the cumulative total shares repurchased
were 441,000 for a total of $7.0 million.
On May 22, 2003, STFC Capital Trust I, State Auto Financial's Delaware business
trust subsidiary (the "Capital Trust"), issued $15.0 million liquidation amount
of its capital securities to a third party. In connection with the Capital
Trust's issuance of the capital securities and the related purchase by State
Auto Financial of all of the Capital Trust's common securities (liquidation
amount of $464,000) (the Capital Trust's capital and common securities are
hereafter referred to as the "Trust Securities"), State Auto Financial issued to
the Capital Trust $15.5 million aggregate principal amount of Floating Rate
Junior Subordinated Debt Securities due 2033 (the "Subordinated Debentures").
The sole assets of the Capital Trust are the Subordinated Debentures and any
interest accrued thereon. Interest on the Trust Securities is payable quarterly
at a rate equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly
(5.48% for the period May 22, 2003 through August 23, 2003, adjusted to 5.34%
for the period August 24, 2003 through November 23, 2003). Prior to May 2008,
the interest rate may not exceed 12.5% per annum. The interest rate and interest
payment dates on the Subordinated Debentures are the same as the interest rate
and interest payment dates on the Trust Securities. In January 2003, the FASB
issued FIN 46, Consolidation of Variable Interest Entities, effective for
reporting periods beginning after June 15, 2003. As a result of the Company
adopting FIN 46 effective July 1, 2003, the financial statements of the Capital
Trust are no longer consolidated within the accompanying financial statements of
the Company. See additional discussion below included in New Accounting
Standards.
The Trust Securities are mandatorily redeemable on May 23, 2033, and may be
redeemed at any time on and after May 23, 2008, at 100% of the principal amount
thereof plus unpaid interest. The Trust Securities may be redeemed in whole, but
not in part, at any time within 90 days following the occurrence of a "Tax
Event" or "Investment Company Event" (as defined in the declaration of trust)
(a) if such Tax Event or Investment Company Event occurs on or after May 23,
2008, at a redemption price equal to 100% of the principal amount thereof plus
unpaid interest, and (b) if such Tax Event or Investment Company Event occurs
prior to May 23, 2008, at a redemption price equal to the greater of 100% of the
principal amount thereof plus accrued interest and a "make-whole" amount. The
Subordinated Debentures are subject to these same redemption terms. The
obligations under the Subordinated
Debentures and related agreements, taken together, constitute a full and
unconditional guarantee of payments due on the Trust Securities.
State Auto Financial has the right, at any time, to defer payments of interest
on the Subordinated Debentures for up to 20 consecutive quarterly payment
periods. Consequently, distributions on the Trust Securities would be deferred
(though such distributions would continue to accrue with interest since interest
would accrue on the Subordinated Debentures during any such extended interest
payment period). In no case may the deferral of payments and distributions
extend beyond the stated maturity dates of the respective securities. During
such deferments, State Auto Financial may not declare or pay any dividends on,
or purchase any of, its capital stock, make any principal or interest payments
on debt securities that rank in all respects equally with or subordinated to the
Subordinated Debentures, or make any payment under guarantees that rank in all
respects equally with or subordinated to State Auto Financial's guaranty of the
Trust Securities.
The Subordinated Debentures are unsecured and subordinated to all of the
Company's existing and future senior indebtedness. As sponsor of the Capital
Trust, State Auto Financial incurred security issuance cost related to the Trust
Preferred Capital Securities and Subordinated Debentures of $535,000. In July
2003, State Auto Financial used the proceeds from the Subordinated Debentures to
make a $15.0 million cash capital contribution to State Auto National (see
discussion below).
At September 30, 2003, funds consisting of cash and cash equivalents were $28.2
million versus $39.8 million at September 30, 2002.
In order to provide funding if the State Auto Insurance Companies were to incur
catastrophe losses in excess of $120.0 million, State Auto Financial continued a
structured contingent financing arrangement in 2001 ("2001 Agreement") with a
financial institution and a syndicate of other lenders to provide up to $100.0
million for catastrophic reinsurance purposes. See additional discussion
regarding this arrangement included in the Company's 2002 Form 10-K. State Auto
Financial is currently negotiating a new structured contingent financing
arrangement with a financial institution and syndicate of lenders on terms
substantially similar to the 2001 Agreement, which will expire on November 12,
2003. The Company expects to enter into a new arrangement on or about November
12, 2003; however, there can be no assurance that the Company will be successful
in negotiating a new arrangement.
The Company continues to generate substantial earned premium growth which
requires capital resources. Earned premiums through the State Auto Pool
increased significantly beginning in July 2001 with the addition of the former
Meridian Mutual business. Also increasing earned premiums significantly was the
October 1, 2001 pooling change from 53% to 80%. Earned premiums increased 8.4%
and 92.2% for the nine months ended September 30, 2003 and 2002, respectively,
from the same prior year periods. For the year ended December 31, 2002, earned
premiums increased 61.5% from 2001. At September 30, 2003, all of the Company's
insurance subsidiaries were in compliance with statutory requirements relating
to capital adequacy. Nevertheless, after consideration of this continued growth
in premiums and improvement in its underlying book of business, and despite the
Company experiencing its worst catastrophe loss in State Auto history,
management continues to believe that the Company has sufficient capital, cash
flow and potential capital resources to meet its cash flow requirements.
The National Association of Insurance Commissioners ("NAIC") utilizes a
collection of analytical tools designed to assist state insurance departments
with an integrated approach to screening and analyzing the financial condition
of insurance companies operating in their respective states. One such set of
analytical tools are 12 key financial ratios that have come to be known in the
insurance industry as the "IRIS" ratios. IRIS ratios are derived from financial
statements prepared on a statutory accounting basis, which are accounting
practices prescribed or permitted by the insurance department with regulatory
authority over the Company's insurance subsidiaries. A "defined range" of
results for each ratio has been established by the NAIC for solvency monitoring.
While management utilizes each of these IRIS ratios in monitoring its operating
performance on a statutory accounting basis, the net written premium to
statutory surplus ratio (the "leverage ratio") is monitored to ensure that each
of the Company's insurance subsidiaries continues to operate within the "defined
range" of 3.0 to 1.0. The higher the leverage ratio, the more risk a company
bears in relation to statutory surplus available to absorb losses. In
considering this range, management also considers the distribution of net
premiums between property and liability lines of business. A company with a
larger portion of net premiums from liability lines should generally maintain a
lower leverage ratio. In the case of State Auto National, a nonstandard auto
insurer, which
writes lines of business that are generally short tail in nature and with
generally lower amounts of coverage applicable, there is relatively less loss
exposure to the premium than is generally the case with other lines of business
that are written for higher limits and for which losses develop over long
periods of time, such as workers compensation or other liability. In sum, a
higher premium surplus ratio with a non standard auto insurer is not necessarily
indicative of dangerous financial conditions as might be the case with another
type insurer. The leverage ratios for Milbank, State Auto P&C and State Auto
National improved at September 30, 2003 from December 31, 2002 as follows:
Milbank - 2.1 vs. 2.4 to 1; State Auto P&C - 2.3 vs. 2.6 to 1; State Auto
National 2.2 vs. 4.4 to 1. These improvements are due to a combination of
improvement in the underwriting operations for the nine months ended September
30, 2003 of each company, as well as effective January 1, 2003, the reserving
process for statutory reporting began anticipating salvage and subrogation
recoverable. Under generally accepted accounting principles, the reserving
process has historically anticipated salvage and subrogation recoverable. During
the third quarter of 2003, State Auto Financial made a $15 million cash capital
contribution to State Auto National. Despite these improvements, management
continues to believe these leverage ratios are higher than optimal. In the
fourth quarter 2003, State Auto Financial anticipates issuing up to $100.0
million principal amount of long-term debt. Net proceeds are expected to be used
to repay certain indebtedness and for general corporate purposes, including
providing additional capital to certain of the Company's insurance subsidiaries.
Other Disclosures
Investments
Stateco Financial Services, Inc., the Company's wholly owned subsidiary
("Stateco"), performs investment management services (the investment management
services segment) on behalf of the Company and State Auto Mutual and its
subsidiaries. The Investment Committee of each insurer's Board of Directors sets
investment policies to be followed by Stateco.
At September 30, 2003, 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 September 30, 2003 and December 31, 2003:
September 30 December 31
2003 2002 Quality(1)
------------ ----------- ----------
Corporate and Municipal Bonds 59.0% 72.0% Aa+
U.S. Governments 2.4% 2.8% Aaa
U.S. Government Agencies 38.6% 25.2% Aaa
----- -----
Total 100.0% 100.0%
===== =====
(1) As rated by Moody's Investors Service
During the three month and nine month periods ended September 30, 2003, the
Company increased its equity portfolio investments by investing an additional
$10.1 million and $37.7 million, respectively, to enhance growth of statutory
surplus over the long term. The Company's current investment strategy does not
rely on the use of derivative financial instruments.
At September 30, 2003, 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,
common securities of Capital Trust and trust preferred security 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.
The following table provides the composition of the Company's investment
portfolio at September 30, 2003 and December 31, 2002:
(dollars in thousands) September 30, 2003 December 31, 2002
---------------------- ---------------------- --------------------
Fixed maturities, at fair value $ 1,361,539 92.6% $ 1,216,698 95.6%
Equity securities, at fair value 100,476 6.8% 53,710 4.2%
Other invested assets, at fair value 8,892 0.6% 1,908 0.2%
----------- ----- ----------- -----
Total investments $ 1,470,907 100.0% $ 1,272,316 100.0%
=========== ===== =========== =====
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 September 30, 2003, and, based on the
factors described above, determined no other than temporary impairment existed
in the gross unrealized holding losses, as provided in the table below. This
determination could change in the future as more information becomes known which
could negatively impact the amounts reported herein. At September 30, 2003,
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 September 30, 2003.
The following table provides detailed information on the Company's investment
portfolio for its gross unrealized gains and losses at September 30, 2003:
(dollars in thousands) Gross Gain Gross Loss
Cost or unrealized number unrealized number
September 30, 2003 amortized holding of holding of
Investment Category cost gains positions losses positions Fair value
- ------------------- ----------- ---------- --------- ---------- --------- ----------
Fixed Maturities
U.S. Treasury securities &
obligations $ 326,917 $ 10,849 93 $ 923 12 $ 336,843
States & political subdivisions 640,145 44,531 316 814 20 683,862
Corporate securities 109,987 9,309 51 - - 119,296
Mortgage-backed securities of
U.S. Gov. Agencies 217,748 5,189 62 1,399 19 221,538
----------- ---------- --- ---------- -- ----------
Total fixed maturities 1,294,797 69,878 522 3,136 51 1,361,539
Equity Securities
Consumer 14,901 2,132 9 473 5 16,560
Technologies 9,971 1,205 5 41 2 11,135
Pharmaceuticals 13,587 1,043 5 665 5 13,965
Financial services 25,435 3,040 11 1,044 11 27,431
Manufacturing & other 29,643 3,195 17 1,453 12 31,385
----------- ---------- --- ---------- -- ----------
Total equity securities 93,357 10,615 47 3,676 35 100,476
----------- ---------- --- ---------- -- ----------
Other invested assets 8,842 50 1 - - 8,892
----------- ---------- --- ---------- -- ----------
Total $ 1,397,176 $ 80,543 570 $ 6,812 86 $1,470,907
=========== ========== === ========== == ==========
The amortized cost and fair value of fixed maturities at September 30, 2003, by
contractual maturity, are summarized as follows:
(dollars in thousands) Amortized Fair
September 30, 2003 Cost Value
- ---------------------- ----------- -----------
Due after 1 year through 5 years $ 28,987 $ 31,457
Due after 5 years through 10 years 296,484 312,031
Due after 10 years 758,115 803,229
----------- -----------
Subtotal 1,083,586 1,146,717
Mortgage-backed securities 211,211 214,822
----------- -----------
Total $ 1,294,797 $ 1,361,539
=========== ===========
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.
Included in realized losses of equity securities below, was $35,000 and $289,000
recognized related to other than temporary impairment on one and four equity
positions for the three month and nine month periods ended September 30, 2003,
respectively. The individual circumstances generating the other than temporary
impairments recognized during 2003 did not impact other investments. There were
no individual, material equity securities for which the Company recognized other
than temporary impairment. There were three other than temporary impairments of
equity securities totaling $1.1 million for the same periods in 2002. There were
no other than temporary impairments of fixed maturity securities for the three
month and nine month periods ended September 30, 2003 and 2002.
The securities sold during the three and nine months ended September 30, 2003,
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, or to reposition the
taxable/tax-exempt fixed maturity position of the Company. Realized gains and
losses for the three and nine months ended September 30, 2003 are summarized as
follows:
Three months ended Nine months ended
September 30 September 30
---------------------------- ----------------------------
Realized Fair Value at Realized Fair Value at
(dollars in thousands) Gains/Losses Sale Gains/Losses Sale
---------------------- ------------ ------------- ------------ -------------
Realized gains:
Fixed maturities $ 1,698 $ 48,039 $10,837 $ 224,374
Equity securities 342 1,699 358 1,895
------- ------- ------- ---------
Total realized gains 2,040 49,738 11,195 226,269
Realized losses:
Fixed maturities 54 3,647 83 5,780
Equity securities 436 1,990 1,544 3,018
------- ------- ------- ---------
Total realized losses 490 5,637 1,627 8,798
------- ------- ------- ---------
Net realized gains on investments $ 1,550 $ 55,375 $ 9,568 $ 235,067
======= ======== ======= =========
Loss and Loss Expenses Payable
The following table presents the loss and loss expenses payable by major line of
business at September 30, 2003 and December 31, 2002, respectively:
September 30 December 31
2003 2002 % Change
------------ ----------- ----------
(dollars in thousands)
Automobile - personal (standard) 181,226 $ 181,778 (.3)%
Automobile - personal (nonstandard) 38,665 35,270 9.6%
Automobile - commercial 86,350 72,800 18.6%
Homeowners 51,351 45,850 12.0%
Commercial multi-peril 85,899 77,018 11.5%
Workers' compensation 77,995 77,801 0.2%
Fire and allied lines 19,661 14,416 36.4%
Other/products liability 86,791 80,539 7.8%
Miscellaneous personal/commercial lines 3,843 6,661 (42.3)%
---------- ----------- ----------
Total losses and loss expenses payable, net of
reinsurance recoverable on losses and loss expenses
payable of $13,676 and $8,825, respectively $ 631,781 $ 592,133 6.7%
========== =========== ==========
Total net losses and loss expenses payable increased 6.7% from December 31, 2002
to September 30, 2003. This increase was consistent with that of a growing
company and resulting increased claims activity, as well as the outstanding
catastrophe claim activity relating to CAT 88, along with related third quarter
2003 incurred catastrophe losses (see discussion above). Overall, management
does not believe there was a significant change in the total book of business at
September 30, 2003 compared to December 31, 2002.
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.
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. To provide a measure of sensitivity of pre-tax
income to changes in reserve estimates, for every 1% change in the ultimate
development of the September 30, 2003 total losses and loss expenses payable,
the effect on pre-tax income would be $6.3 million.
New Accounting Standards
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation -Transition and Disclosure, an amendment of SFAS Statement No. 123
Accounting for Stock-Based Compensation. This Statement provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based compensation. In addition, this Statement requires
more prominent disclosures in both the annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The Company has adopted the
disclosure provisions of this Statement and will adopt a transition method at
the time when and if a consistent fair value measurement and recognition
provision is determined by the FASB and is required to be adopted.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with the Characteristics of Both Liabilities and Equity, effective
for reporting periods after July 1, 2003. This Statement establishes standards
for classifying and measuring as liabilities certain financial instruments that
embody obligations of the issuer and have characteristics of both liabilities
and equity. The Company adopted this statement effective July 1, 2003 with no
significant impact to the consolidated financial statements.
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities ("FIN 46"), which requires the consolidation of
certain entities considered to be variable interest entities ("VIEs"). An entity
is considered to be a VIE when it has equity investors who lack the
characteristics of having a controlling financial interest, or its capital is
insufficient to permit it to finance its activities without additional
subordinated financial support. Consolidation of a VIE by an investor is
required when it is determined that the investor will absorb a majority of the
VIE's expected losses if they occur, receive a majority of the entities expected
residual returns if they occur, or both. As a result of the Company adopting FIN
46, effective July 1, 2003, the financial statements of the Capital Trust
(described above) are no longer consolidated within the accompanying financial
operations of the Company. The net impact of the adoption of FIN 46, effective
July 1, 2003, was a reclassification adjustment to eliminate the Capital Trust's
capital securities of $15.0 million from notes payable and include State Auto
Financial's investment of $464,000 in the common securities of Capital Trust in
other invested assets and $15.5 million principal amount of Floating Rate Junior
Subordinated Debt Securities issued to the Capital Trust.
Market Risk
With respect to Market Risk, see the discussion regarding this subject in the
Company's December 31, 2002 Management's Discussion and Analysis of Financial
Condition and Results of Operations, included in the December 31, 2002 Form
10-K. There have been no material changes from the information reported
regarding Market Risk in the 2002 Form 10-K.
FORWARD-LOOKING STATEMENTS; CERTAIN FACTORS AFFECTING FUTURE RESULTS
Statements contained in this Form 10Q 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, have affected and in the future could affect
the Company's actual financial performance.
- In addition to the acquisition of the Meridian Insurers and State
Auto Mutual's merger with Meridian Mutual, during the past several
years, State Auto Mutual and the Company have acquired other insurance
companies, such as Milbank, Farmers Casualty, and SA Wisconsin, and it
is anticipated that State Auto 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,
particularly with respect to price. 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 State Auto Mutual's
control of the Company.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
The information called for by this item is provided under the caption "Market
Risk" under Item 2 - Management's Discussion and Analysis of Financial
Condition.
ITEM 4. CONTROLS AND PROCEDURES
(a) 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 (as
defined in Exchange Act Rule 13a-15 (e)) Based upon that evaluation, the
Company's Chief Executive Officer and Chief Financial Officer concluded that, as
of the end of the period covered by
this report, the Company's disclosure controls and procedures were 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 has been no change in the Company's internal control
over financial reporting that occurred during the Company's most recent fiscal
quarter that has materially affected, or is reasonably likely to materially
affect, the Company's internal control over financial reporting.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On June 30, 2003, State Auto Financial Corporation ("State Auto Financial") and
State Automobile Mutual Insurance Company ("State Auto Mutual") filed a
complaint against Gregory M. Shepard, a 5% shareholder of State Auto Financial,
in the United States District Court, Southern District of Ohio, Eastern
Division, seeking injunctive relief on a variety of claims, including enjoining
Mr. Shepard from making material misrepresentations and omissions in his
Schedule 13D filings with the Securities and Exchange Commission ("SEC") and
from violating federal securities laws. The factual basis for this suit related
to a series of press releases and Schedule 13D filings made by Mr. Shepard
regarding proposals or purported offers to purchase certain amounts of State
Auto Financial's outstanding common shares and to take control of State Auto
Financial and State Auto Mutual. On August 25, 2003, State Auto Financial and
State Auto Mutual amended their original complaint against Mr. Shepard to seek
injunctive relief on additional claims, including enjoining Mr. Shepard from
making material misrepresentations and omissions in connection with the Shepard
tender offer(defined below) and from illegally tipping persons with material,
nonpublic information concerning Mr. Shepard's anticipated tender offer. On
October 16, 2003, State Auto Financial and State Auto Mutual dismissed, without
prejudice, this action against Mr. Shepard in light of the United States
District Court's dismissal of Mr. Shepard's lawsuit against State Auto
Financial, State Auto Mutual and their respective directors, discussed in the
following paragraph.
On August 20, 2003, Mr. Shepard and his wholly owned corporation filed a
Schedule TO with the SEC relating to a proposed tender offer (the "Shepard
tender offer") to purchase 8.0 million of State Auto Financial's outstanding
common shares at a price of $32.00 per share upon the terms and subject to the
conditions set forth in their Schedule TO. On August 21, 2003, Mr. Shepard and
his company filed a complaint against State Auto Financial, State Auto Mutual
and their respective directors in the United States District Court, Southern
District of Ohio, Eastern Division, seeking (i) declaratory relief that State
Auto Financial's directors and State Auto Mutual and its directors violated
their respective fiduciary duties to Mr. Shepard, his company and State Auto
Financial's minority shareholders in their consideration of Mr. Shepard's prior
proposals and were likely to engage in breaches of their respective fiduciary
duties in their consideration of the proposed Shepard tender offer (which tender
offer was not commenced until on or about September 11, 2003), and (ii)
injunctive relief to enjoin State Auto Financial, State Auto Mutual and their
respective directors and employees from taking actions which would have the
effect of impeding or interfering with the Shepard tender offer. On October 15,
2003, the United States District Court dismissed this action against State Auto
Financial, State Auto Mutual and their respective directors based on a finding
that the District Court lacked subject matter jurisdiction.
On October 16, 2003, State Auto Financial, State Auto Mutual and their
respective directors filed a complaint against Mr. Shepard and his company in
the Common Pleas Court of Franklin County, Ohio, seeking (i) declaratory relief
that neither State Auto Financial, State Auto Mutual nor their respective
directors and officers violated any fiduciary duties to Mr. Shepard, his company
or State Auto Financial's minority shareholders in responding to the Shepard
tender offer, (ii) declaratory relief that neither State Auto Financial nor its
respective directors and officers have an obligation to call a meeting of
shareholders under Ohio's Control Share Acquisition statute with respect to the
Shepard tender offer and (iii) compensatory damages from Mr. Shepard and his
company for knowingly making misrepresentations in their Acquiring Person
Statement in violation of Ohio's control bid statute. As of October 24, 2003,
Mr. Shepard and his company had not responded to this complaint.
Item 2. Changes in Securities and Use of Proceeds - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders - None
Item 5. Other Information - None
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits
Exhibit
No. Description of Exhibits
- ------- -----------------------
10.01 Amendment No. 3 to 1991 Stock Option Plan Effective January 1, 2001
10.02 Amendment No. 1 to 2000 Stock Option Plan Effective January 1, 2001
10.03 Addendum No. 1 to Property Catastrophe Overlying Excess of Loss Reinsurance
Contract effective November 16, 2001
10.04 Property catastrophe overlying excess of loss reinsurance contract effective
July 1, 2002
31.1 CEO certification required by Section 302 of Sarbanes Oxley Act of 2002
31.2 CFO certification required by Section 302 of Sarbanes Oxley Act of 2002
32.1 CEO certification required by Section 906 of Sarbanes Oxley Act of 2002
32.2 CFO certification required by Section 906 of Sarbanes Oxley Act of 2002
b. Reports on Form 8-K
On each of July 21, 2003, August 21, 2003, and September 2, 2003, the
Company filed a Form 8-K under Item 5.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
STATE AUTO FINANCIAL CORPORATION
Date: October 29, 2003 /s/ Steven J. Johnston
-------------------------------------
Steven J. Johnston
Treasurer and Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
Exhibit No. Description of Exhibits
- ----------- -----------------------
10.01 Amendment No. 3 to 1991 Stock Option Plan Effective January 1, 2001
10.02 Amendment No. 1 to 2000 Stock Option Plan Effective January 1, 2001
10.03 Addendum No. 1 to Property Catastrophe Overlying Excess of Loss Reinsurance
Contract effective November 16, 2001
10.04 Property catastrophe overlying excess of loss reinsurance contract effective
July 1, 2002
31.1 CEO certification required by Section 302 of Sarbanes Oxley Act of 2002
31.2 CFO certification required by Section 302 of Sarbanes Oxley Act of 2002
32.1 CEO certification required by Section 906 of Sarbanes Oxley Act of 2002
32.2 CFO certification required by Section 906 of Sarbanes Oxley Act of 2002