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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[x] Annual Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 1996
or
[ ] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 (no fee required)
For the transition period from ___________ to _____________
Commission File Number 0-19289
STATE AUTO FINANCIAL CORPORATION
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(exact name of Registrant as specified in its charter)
Ohio 31-1324304
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(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
518 East Broad Street, Columbus, Ohio 43215-3976
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(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (614) 464-5000
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Shares, without par value
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(Title of class)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
-- --
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
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On March 4, 1997, the aggregate market value (based on the closing
sales price on that date) of the voting stock held by non-affiliates of the
Registrant was $112,931,372.
On March 4, 1997, the Registrant had 18,145,925 Common Shares
outstanding.
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DOCUMENTS INCORPORATED BY REFERENCE
1. Portions of the Registrant's Proxy Statement relating to the annual
meeting of shareholders to be held May 29, 1997, which Proxy Statement
will be filed within 120 days of December 31, 1996, are incorporated by
reference in Part III, Items 10, 11, 12 and 13 of this report.
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PART I
ITEM 1. BUSINESS
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(A) GENERAL DEVELOPMENT OF BUSINESS
State Auto Financial Corporation, an Ohio corporation formed April 18,
1990 ("State Auto Financial" or "STFC"), is an insurance holding company
headquartered in Columbus, Ohio, which engages, through its subsidiaries,
primarily in the property and casualty insurance business. State Auto Financial
is approximately 66% owned by State Automobile Mutual Insurance Company, an Ohio
property and casualty insurance company formed in 1921 ("Mutual").
State Auto Financial's principal subsidiary, State Auto Property and
Casualty Insurance Company, a South Carolina corporation formed in 1950 ("State
Auto P&C"), is a regional insurer engaged primarily in writing personal and
commercial automobile, homeowners, commercial multi-peril, workers' compensation
and fire insurance. State Auto P&C markets its insurance products through
approximately 10,600 independent insurance agents associated with approximately
1,760 agencies in 23 states. Oklahoma was added as a new operating territory in
1996. State Auto P&C's products are marketed primarily in the central and
eastern part of the United States, excluding New York, New Jersey and the New
England States.
Another subsidiary of State Auto Financial, Stateco Financial Services
Inc., an Ohio corporation formed in 1962 ("Stateco"), provides investment
management services to affiliated companies and insurance premium finance
services to customers of State Auto P&C, Mutual and Milbank Insurance Company
("Milbank"), a wholly-owned subsidiary of Mutual.
State Auto P&C, Mutual and Milbank, defined below, are collectively
referred to hereafter as the ("Pooled Companies"). The Pooled Companies and
National, defined below, are collectively referred to as the ("State Auto
Group"). See "Business - Insurance Premium Finance Services" and "Investment
Management Services."
On May 16, 1991, Mutual contributed all of the stock of State Auto P&C,
which it had owned since 1958, and all of the stock of Stateco, which it had
owned since 1962, to State Auto Financial in exchange for all of the outstanding
common shares of State Auto Financial. State Auto P&C and Stateco thereby became
wholly-owned subsidiaries of State Auto Financial and State Auto Financial
continued as a wholly-owned subsidiary of Mutual.
On June 28, 1991, State Auto Financial completed an initial public
offering of 5,490,000 (adjusted to reflect a two-for-one stock split effected in
the form of a stock dividend declared in March 1993, and a three-for-two stock
split effected in the form of a stock dividend declared in May 1996 and paid on
July 8, 1996) of its common shares, which reduced Mutual's ownership interest in
State Auto Financial to approximately 68%.
On October 4, 1991, State Auto Financial formed an Ohio subsidiary,
State Auto National Insurance Company ("National"), which in February 1992 began
writing personal automobile insurance for non-standard risks.
Strategic Insurance Software, Inc. ("SIS"), is an Ohio corporation
formed by State Auto Financial on January 12, 1995, which began operations in
July 1995. SIS develops and sells software for the processing of insurance
transactions, management of insurance policy data and electronic interfacing of
insurance policy information between insurance companies and agencies. SIS is a
majority-owned subsidiary of State Auto Financial.
State Auto Financial and its subsidiaries, State Auto P&C, Stateco,
National and SIS are collectively referred to as the ("Company").
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Effective July 1, 1993, Mutual acquired Milbank, a South Dakota
domiciled property and casualty insurance company. In connection with the
closing of this purchase, on August 20, 1993, Mutual and State Auto Financial
entered into an Option Agreement whereby, subject to the approval of the South
Dakota Insurance Division, State Auto Financial may purchase Milbank from Mutual
at any time over the option term of five years for a price determined pursuant
to a formula set forth in the Option Agreement.
At a closing on March 11, 1997, Mutual acquired 100% of the outstanding
shares of Midwest Security Insurance Company ("Midwest Security") a Wisconsin
domiciled personal lines property and casualty insurer. Pursuant to the terms of
the stock purchase agreement, the transaction was effective as of January 1,
1997. In connection with this transaction, Mutual and State Auto Financial
entered into an Option Agreement whereby, subject to the approval of the Office
of the Insurance Commissioner of the State of Wisconsin, State Auto Financial
may purchase Midwest Security at any time over the option term of five years at
a price calculated pursuant to a formula set forth in the Option Agreement. With
the acquisition of Midwest Security, the State Auto Group has entered its 24th
state, although the Company will not see a direct impact of any underwriting
results until Midwest Security participates in the pooling arrangement, which is
contemplated, but not likely, until 1998 at the earliest.
Since January 1, 1987, State Auto P&C has participated in an
underwriting pooling arrangement with Mutual. Under this arrangement, State Auto
P&C cedes to Mutual all of its property and casualty insurance business and
assumes from Mutual a portion of the combined property and casualty insurance
business of both State Auto P&C and Mutual. From January 1987 through December
1991, State Auto P&C assumed 20% of the combined business. Effective January 1,
1992, State Auto P&C's participation in the pool was increased to 30%. Effective
January 1, 1995, the pooling arrangement was amended to include all of the
property and casualty business of Milbank and the participation percentages were
changed to: Mutual 55%, State Auto P&C 35% and Milbank 10%. See "Pooling
Arrangement."
Effective July 1, 1996, the pooling arrangement was amended to exclude
from the scope of such arrangements catastrophe losses and premiums attributable
thereto in excess of $120,000,000 up to $220,000,000.
See "Reinsurance."
Pursuant to an Amended and Restated Management Agreement, State Auto
P&C provides executive management services for Mutual and its insurance
subsidiaries. Mutual provides non-executive employees and facilities for such
entities. See "Management Agreement."
(B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS.
The Company is of the opinion that all of its operations are within one
industry segment and that no information as to industry segments is required
pursuant to Statement of Financial Accounting Standards No. 14 or Regulation
S-K.
(C) SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM
ACT OF 1995.
Statements contained herein expressing the beliefs of management and
the other statements which are not historical facts contained in this report are
forward looking statements that involve risks and uncertainties. These risks and
uncertainties include but are not limited to: legislative, judicial, and
regulatory changes, the impact of competitive products and pricing, product
development, geographic spread of risk, weather and weather-related events,
other types of catastrophic events, fluctuations of securities markets, and
technological difficulties and advancements.
(D) NARRATIVE DESCRIPTION OF BUSINESS.
PROPERTY AND CASUALTY UNDERWRITING
The Company writes personal and commercial property and casualty
insurance lines, including automobile, homeowners, commercial multi-peril,
workers' compensation, liability, fire and other lines of business.
Independent insurance agencies constitute the Company's sales force.
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The following table sets forth for each of the last three fiscal years
the amount of the Company's net premiums earned by line of insurance:
Net Premiums Earned(1)(2)
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Year Ended December 31
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1996 1995 1994
(in thousands)
Automobile ............... $141,486 $136,825 $102,697
Homeowners and farmowners 40,184 40,043 29,384
Commercial ............... 14,207 13,297 10,276
multi-peril
Workers' compensation .... 11,572 13,548 11,668
Fire and allied lines .... 15,341 14,200 10,522
Other commercial liability 10,483 8,731 6,525
Other personal lines ..... 6,194 5,101 3,933
Other commercial lines ... 878 779 583
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Total $240,345 $232,524 $175,588
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<FN>
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(1) The Company earns premiums ratably over the life of an insurance
policy. Net premiums earned are the portion of net premiums written in
both the year in question and prior years, which are applicable to the
expired period of policies.
(2) This reflects net premiums earned by State Auto P&C, after giving
effect to reinsurance and to the pooling arrangement, plus the net
premiums earned by National, the only other insurance subsidiary of
State Auto Financial.
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As mentioned above, the insurance business of Mutual, State Auto P&C
and Milbank is combined through the pooling arrangement giving each company an
identical mix of personal and commercial business as written by all three
insurers. The Pooled Companies products' sales are predominantly personal lines.
However, the Pooled Companies are putting greater emphasis on expanding
penetration into the commercial lines market. The insurance business of
National, with the exception of amounts reinsured with Mutual, is not included
in the pooling arrangement and, therefore, remains 100% in the Company. See
"Pooling Arrangement." National's products are personal lines auto insurance
products written for non-standard risks, with less restrictive underwriting
criteria and higher rates than those applicable to standard risks.
The Company uses computer-based underwriting procedures for personal
lines business. Under such procedures, applications for such business may be
accepted or rejected based upon established underwriting guidelines.
Applications that do not meet guidelines for automated acceptance are referred
to personal lines specialists who review the applications and assess exposure.
During the underwriting process, risks are also reviewed to determine whether or
not they are acceptable as submitted by the independent agents as preferred,
standard or non-standard risks. As a result of the commercial lines
reorganization, personal lines specialists have more responsibility than in the
past for encouraging the Company's agency force to sell its personal lines
products.
POOLING ARRANGEMENT
Beginning in January 1987, State Auto P&C and Mutual participated in an
intercompany pooling arrangement. Under the terms of the pooling arrangement,
State Auto P&C ceded all of its insurance business to Mutual. All of Mutual's
property and casualty insurance business was also included in the pooled
business. Mutual then ceded a percentage of the pooled business to State Auto
P&C and retained the balance. From January 1987 through December 31, 1991, State
Auto P&C assumed 20% of the pooled business. Effective January 1, 1992, State
Auto P&C increased its percentage of the pool to 30%. Effective January 1, 1995,
the pooling arrangement was amended to include all of the property and
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casualty business of Milbank. Concurrently with the inclusion of Milbank, the
participation percentages were amended as follows: Mutual 55%, State Auto P&C
35% and Milbank 10%.
The pooling percentages are reviewed by management at least annually,
and more often if deemed appropriate by management or the Board of Directors of
each company, to determine whether any adjustments should be made. Future
adjustments in the pooling percentages are expected to be based on the
performance of the insurance operations of Mutual, State Auto P&C and Milbank,
the growth in direct premiums written of each company as it relates to the
pooling percentages, the combined ratio of the pooled business and the net
premiums written of the pooled business in relation to the statutory capital and
surplus of Mutual, State Auto P&C and Milbank, respectively, among other
factors. Management of Mutual, State Auto P&C and Milbank make recommendations
to a four-member coordinating committee consisting of two members of Mutual's
Board of Directors and two members of State Auto Financial's Board of Directors.
The coordinating committee reviews and evaluates various factors relevant to the
pooling percentages and recommends any appropriate pooling change to the Boards
of both Mutual and State Auto Financial. See "Management Agreement." The pooling
arrangement is terminable by any party on 90 days notice or by mutual agreement
of the parties. Neither Mutual, State Auto P&C, nor Milbank currently intends to
terminate the pooling arrangement.
As noted above, with the addition of Midwest Security to the State Auto
Group, as a wholly-owned subsidiary of Mutual, the pooling arrangement
adjustments to be considered by the Coordinating Committee in the future will
likely not only deal with the pooling percentages but also the possible addition
of Midwest Security to the pooling arrangements, perhaps in 1998.
The pooling arrangement is designed to produce more uniform and stable
underwriting results for State Auto P&C, Mutual and Milbank than any one company
would experience individually, by spreading the risk among each of the
participants. Under the terms of the pooling arrangement, all premiums, incurred
losses, loss expenses and other underwriting expenses are prorated among the
companies on the basis of their participation in the pool. One effect of the
pooling arrangement is to give State Auto P&C, Mutual and Milbank an identical
mix of property and casualty insurance business on a net basis.
The terms of the pooling arrangement were amended in December 1993 to
clarify that certain liabilities created by FASB 106 (post-retirement health
care benefits liability) and FASB 112 (post employment benefits liability) which
did not exist when the pooling arrangement was initiated are to be carried by
Mutual and not pooled except for those liabilities associated with the transfer
of certain executives to State Auto P&C. See "Management Agreement."
An Amended and Restated Reinsurance Pooling Agreement was executed to
be effective as of July 1, 1996 as a consequence of a reinsurance transaction
entered into by State Auto P&C. The sole substantive change effected by this
agreement was to exclude from the scope of the pooling arrangement catastrophic
loss claims and loss adjustment expenses insured by State Auto P&C, Mutual and
Milbank in the amount of $100,000,000 in excess of $120,000,000 but less than
$220,000,000 and the premium for such exposures. State Auto P&C has become the
reinsurer for the State Auto Group of property casualty companies for this layer
of reinsurance under a Catastrophe Assumption Agreement. See "Reinsurance."
The following table sets forth the loss ratios by line of insurance and
the combined ratios for the Company, prepared in accordance with accounting
practices prescribed or permitted by state insurance authorities, for the
periods indicated. The loss ratio is the ratio of incurred losses and associated
expenses to net earned premiums ("loss ratio"). The combined ratio is a
traditional measure of underwriting profitability. The combined ratio is the sum
of (a) the loss ratio; and (b) the ratio of expenses incurred for commissions,
premium taxes, administrative and other underwriting expenses, to net written
premium ("expense ratio"). When the combined ratio is under 100%, underwriting
results are generally considered profitable. Conversely, when the combined ratio
is over 100%, underwriting results are generally considered unprofitable. The
combined ratio does not reflect investment income or federal income taxes. The
Company's operating income depends on income from underwriting operations,
investments and management fees.
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Year Ended December 31(1)
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1996 1995 1994
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Loss ratios:
Automobile ............... 69.5% 74.1% 76.6%
Homeowners and Farmowners 101.7% 73.1% 89.1%
Commercial multi-peril ... 70.1% 66.6% 78.3%
Workers' compensation .... 46.8% 38.6% 53.6%
Fire and allied lines .... 76.4% 49.4% 71.2%
Other commercial liability 56.5% 69.7% 60.2%
Other personal lines ..... 34.9% 32.5% 35.4%
Other commercial lines ... 11.0% 13.0% 12.2%
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Total loss ratio .............. 72.6% 68.6% 75.1%
Expense ratio ................. 26.4% 30.1% 25.9%
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Combined ratio ................ 99.0% 98.7% 101.0%
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<FN>
(1) This reflects a combination of the loss ratios of State Auto P&C and
National, after giving effect to reinsurance and the pooling
arrangement as amended effective July 1, 1996.
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NON-STANDARD AUTOMOBILE INSURANCE
In October 1991, State Auto Financial formed a new subsidiary,
National, to write personal automobile insurance for nonstandard risks. National
began writing insurance in Ohio in February 1992. It began writing in West
Virginia in October 1993, Tennessee and Mississippi during August 1994 and
Kentucky during March 1995. It entered Arkansas and Georgia in December 1996 and
Minnesota in February 1997. Currently licensed in eight (8) additional states,
National presently anticipates beginning operations in three (3) of these states
during 1997. It is also seeking certificates of authority in several additional
states to facilitate further expansion as management determines. Nonstandard
automobile products provide insurance for private passenger automobile risks
that are typically rejected or canceled by standard market companies because
insureds have poor loss experience or a history of late payments of premium.
Nonstandard products are priced to account for the additional risk and expenses
normally associated with this market.
MARKETING
The Company entered Oklahoma in 1996, its 23rd state of operations. In
its twenty-three states, it markets its products through approximately 10,600
insurance agents associated with approximately 1,760 independent insurance
agencies. Neither the Company, Mutual, nor Milbank has any contracts with
managing general agencies. National is also marketing its non-standard products
through the Company's existing network of independent agents in its states of
operation.
Because independent insurance agents have significant influence over
which insurance company will be selected to write insurance policies for their
customers, management views the independent insurance agent as the primary
customers of the Company. Management strongly supports the independent agency
system and believes that maintenance of a strong agency system is essential for
the Company's present and future success. Programs and procedures have been
implemented and are continually being developed to enhance agency relationships.
Senior management and branch office staff regularly travel to states in which
the Company does business to meet with agents. The Company has instituted
training programs which involve both products training and sales training on how
to market insurance products with disciplined follow up and coaching. The
Company is actively involved in promoting single entry multi-company electronic
interface which creates efficiencies for both agencies and the Company. The use
of electronic interface is growing among the Company's agencies. Several
software tools to facilitate this process are available, including software
called Semci Partner(R) developed and marketed by SIS. The Company and Mutual
are actively encouraging their agencies to utilize Semci
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Partner(R), including offering various incentives. Also, the Company provides
agents with certain travel and cash incentives if they achieve certain sales and
underwriting profit levels. As a further incentive, the Company recognizes its
very top agencies and distinguishes them with various additional trip and
financial incentives. Finally, the Company shares with selected agencies the
cost of certain approved advertising.
In an effort to strengthen agency commitment to producing profitable
business and further develop its relationships with its agency force, the
Company has a plan whereby agents can apply a portion of their commission income
towards purchasing stock of the Company on a monthly basis. The plan is
administered by the Company's transfer agent which uses commission dollars
assigned by agents to purchase shares through a broker on a monthly basis. As of
year end 1996, there were 315 agents participating in this agent stock purchase
plan.
Under the Company's agency agreements with independent insurance
agents, each agent is authorized to sell and bind insurance coverages in
accordance with established procedures and to collect and remit premiums. The
authority of agents to bind an insurance company is common practice in the
property and casualty insurance industry. The risk to the Company is minimized
because it has the right to terminate coverage on a risk or policy bound by the
agent. In addition, the Company does not grant binding authority to agents on
risks it considers to present a greater than normal exposure to loss. Each agent
receives a percentage of direct premiums written as a commission and a share of
the underwriting profits generated by insurance placed by them as bonus
compensation subject to certain qualifying conditions as set forth in the agency
agreement.
The Company receives premiums on products marketed in Alabama,
Arkansas, Florida, Georgia, Illinois, Indiana, Kentucky, Maryland, Michigan,
Minnesota, Mississippi, Missouri, North Carolina, North Dakota, Ohio, Oklahoma,
Pennsylvania, South Carolina, South Dakota, Tennessee, Utah, Virginia and West
Virginia. For the year ended December 31, 1996, the seven states that
contributed the greatest percentage of direct premiums written to the Company,
Milbank and Mutual were Ohio (23%), Kentucky (10.8%), Tennessee (7.0%), Maryland
(5.9%), North Carolina (5.7%), South Carolina (5.6%),and Minnesota (5.1%).
CLAIMS
Insurance claims on policies written by the Company are usually
investigated and settled by staff claims adjusters. The Company's claims policy
emphasizes timely investigation of claims, settlement of meritorious claims for
equitable amounts, maintenance of adequate reserves for claims, and control of
external claims adjustment expenses. This claims policy is designed to support
the Company's marketing efforts by providing agents and policyholders with
prompt service.
Claim settlement authority levels are established for each adjuster,
supervisor and manager based on his or her level of expertise and experience.
Upon receipt, each claim is reviewed and assigned to an adjuster based upon its
type, its severity and class of insurance. The claims department is responsible
for reviewing the claim, obtaining necessary documentation and establishing loss
and expense reserves of certain claims. Any property or casualty claims
estimated to reach $100,000 or above are sent to the home office to be
supervised by claims department specialists. In territories in which there is
not sufficient volume to justify having full-time adjusters, the Company uses
independent appraisers and adjusters to evaluate and settle claims under the
supervision of claims department personnel.
The Company attempts to minimize claims costs by using its internal
claims staff to settle as many claims as possible, and, if possible, by settling
disputes regarding automobile physical damage and property insurance claims
(first party claims) through arbitration. In addition, selected agents have
authority to settle small first party claims which improves claims service. The
Company's in-house trial counsel operation created in Cleveland, Ohio in 1993 to
represent insureds in third party claim litigation has achieved its objectives
of reducing the cost of defending claims. The Company's review of its operations
to determine where in-house trial counsel operations could be economically
feasible to implement, resulted in the opening of a second in-house trial
counsel's office in Baltimore, Maryland in August 1995 and a second lawyer was
added in that Baltimore office in 1996.
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In 1996, the Company and Mutual installed third party proprietary
software to assist claims adjusters in evaluating bodily injury claims, except
for the most severe injury cases. The software has proven to be a valuable tool
in helping adjusters negotiate bodily injury settlements more effectively.
INVESTMENT MANAGEMENT SERVICES
Stateco has been providing investment management services since April
1, 1993. These services are provided to all insurance companies affiliated with
the Company or Mutual, including Mutual, Milbank, State Auto Life Insurance
Company (a subsidiary of Mutual), State Auto P&C and National. Stateco has
entered into an Investment Management Agreement with each of these entities,
pursuant to which Stateco manages the investment portfolios of these companies
and receives an investment management fee based on performance and the size of
the portfolio managed for each affiliate. In addition, with the acquisition of
Midwest Security (see "General Development of Business"), Stateco has entered
into an Investment Management Agreement with Midwest Security, effective as of
January 1, 1997. Stateco has presented proposals to other potential clients
although Stateco has not yet reached an agreement to engage in investment
management services on behalf of a non-affiliated company.
INSURANCE PREMIUM FINANCE SERVICES
Through Stateco, the Company provides insurance premium finance
services to certain policyholders of Mutual, State Auto P&C and Milbank.
Premiums for property and casualty insurance are typically payable at the time a
policy is placed in force or renewed. On certain large commercial policies, the
premium cost may be difficult for a policyholder to pay in one sum. Stateco
makes loans to commercial insurance policyholders for the term of an insurance
policy to enable them to pay the insurance premium in installments over the term
of the policy, and retains a contractual right to cancel the insurance policy if
the loan installment is not paid on a timely basis. As of December 31, 1996,
Stateco had a net loan receivable balance from policyholders of these companies
of approximately $923,000.
INSURANCE SOFTWARE BUSINESS
SIS is developing and selling software used by insurance companies and
agencies to allow more efficient and effective electronic management and
communication of policyholder data from insurers to agents (download) and from
agents to insurers (upload). SIS' principal product, Semci Partner(R), is an
alternative to significantly more costly agency management systems which SIS
believes will be attractive to a substantial segment of independent insurance
agencies. SIS' principal customer is Mutual, but it is engaged in pilot programs
with other insurers to show the value of Semci Partner(R) to those insurers
and their agents. In addition, it has sold copies of Semci Partner(R)
directly to agents. SIS' revenue from Semci Partner(R) and other SIS software
sales is not material to the Company at this time.
MANAGEMENT AGREEMENT
The Company operates and manages its business in conjunction with
Mutual and Milbank under a management agreement which was restructured pursuant
to an Amended and Restated Management Agreement effective April 1, 1994. Under
this agreement, State Auto P&C provides executive management services for
Mutual, Milbank, State Auto Life, and National, overseeing the insurance
operations of all these companies all of which are parties to the agreement.
State Auto P&C does not provide investment management services, because these
services are provided by Stateco. See "Investment Management Services." A
management fee is paid by Mutual, Milbank, State Auto Life and National for the
services provided by State Auto P&C equal to 2% of the five year average of
annual statutory statement "surplus as regards policyholders", less valuations
for managed subsidiaries, of each managed company. The Amended and Restated
Management Agreement also imposes a performance standard which could result in
State Auto P&C not being entitled to the fee for a particular quarter if a
managed company's performance does not meet the standard incorporated in the
agreement. Management believes that the amount of the management fee charged is
fair and reasonable. In 1996, the managed companies paid a management fee of
$5,083,000 to State Auto P&C.
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In addition to the above-described Amended and Restated Management
Agreement, the Company and Mutual entered into a Management Agreement with
Midwest Security, which agreement was effective January 1, 1997 (the "Midwest
Management Agreement"). Mutual is providing clerical and non-executive employees
to Midwest Security. The Company provides executive management services to
Midwest Security in return for a management fee. Under this agreement, the
Company's management fee is based on direct written premium of Midwest Security.
The fee set for 1997 is 0.75% of direct written premium of Midwest Security and
it includes a performance standard, as well. At this time, Midwest Security is
not participating in the pooling arrangement.
Under the Amended and Restated Management Agreement, Mutual provides
the Company with the facilities, clerical personnel and other non-executive
employees necessary to run its day-to-day operations. All costs incurred by
Mutual with respect to underwriting expenses and loss expenses incurred on
behalf of Mutual, State Auto P&C and Milbank continue to be shared pro rata
between Mutual, State Auto P&C and Milbank through the pooling arrangement. "See
Pooling Arrangement." For companies not participating in the pooling
arrangement, like National and Midwest Security, expenses directly attributable
to a particular company continue to be charged to that company and expenses of
personnel who are not dedicated entirely to work for a particular company are
allocated among the companies based on an estimate of time devoted by such
personnel to each company for which services are rendered. Mutual also charges
rent, which is determined under statutory accounting principles, to each company
which has dedicated space within Mutual's facilities (currently National,
Stateco and State Auto Life).
The Amended and Restated Management Agreement and the Midwest
Management Agreement set forth procedures for potential conflicts of interest.
Generally, business opportunities presented to the common officers of the
companies, other than business opportunities that meet certain criteria, must be
presented to a four-member coordinating committee consisting of two directors of
Mutual, who represent the interests of Mutual and its subsidiaries, and two
directors of the Company, who represent the interests of the Company. This
committee reviews and evaluates the business opportunity using such factors as
it considers relevant. Based upon such review and evaluation, this committee
then makes recommendations to the respective boards of directors as to whether
or not such business opportunity should be pursued and if so, by which company.
The boards of directors of Mutual and of the Company and, when appropriate, a
subsidiary, must then act on the recommendation of the committee after
considering all other factors they deem relevant.
The Amended and Restated Management Agreement has a ten year term
ending March 31, 2004, and automatically renews for an additional ten year term
unless any of the managed companies terminates its participation, or the
manager, State Auto P&C, terminates the agreement upon not less than two years
advance written notice of nonrenewal. The Midwest Management Agreement also has
a ten year term ending December 31, 2006 and automatically renews for an
additional ten year term unless sooner terminated in accordance with its
provisions. The Amended and Restated Management Agreement may also be terminated
by any of the managed companies upon events constituting a change of control or
potential change of control (as defined in the Amended and Restated Management
Agreement) of the Company, upon agreement between a managed company and State
Auto P&C and, the agreement is terminated automatically with respect to a party
if it is subject to insolvency proceedings. Milbank may terminate its
participation in the Amended and Restated Management Agreement upon 120 days
notice. If the Amended and Restated Management Agreement is terminated for any
reason, the Company would have to locate facilities, personnel and management to
continue its operations. Mutual and State Auto P&C have jointly developed or
paid for all accounting, mainframe processing and insurance marketing systems
used in their businesses.
RESERVES
Loss reserves are estimates at a given point in time of what an insurer
expects to pay to claimants, based on facts, circumstances and historical trends
then known. It can be expected that the ultimate liability will exceed or be
less than such estimates. During the loss settlement period, additional facts
regarding individual claims may become known, and consequently it often becomes
necessary to refine and adjust the estimates of liability.
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The Company maintains reserves for the eventual payment of losses and
loss expenses for both reported claims and incurred claims that have not yet
been reported. Loss expense reserves are intended to cover the ultimate costs of
settling all losses, including investigation and litigation costs from such
losses.
Reserves for reported losses are established on either a case-by-case
or formula basis depending on the type and circumstances of the loss. The
case-by-case reserve amounts are determined based on the Company's reserving
practices, which take into account the type of risk, the circumstances
surrounding each claim and policy provisions relating to types of loss. The
formula reserves are based on historical paid loss data for similar claims with
provisions for trend changes caused by inflation. Loss and loss expense reserves
for incurred claims that have not yet been reported are estimated based on many
variables including historical and statistical information, inflation, legal
developments, storm loss estimates, and economic conditions. Loss reserves are
reviewed on a regular basis and as new data becomes available, estimates are
updated resulting in adjustments to loss reserves. Although management uses many
resources to calculate reserves, there is no precise method for determining the
ultimate liability. The Company does not discount loss reserves for financial
statement purposes.
Mutual has guaranteed the adequacy of State Auto P&C's loss and loss
expense reserves as of December 31, 1990. Pursuant to the guarantee, Mutual has
agreed to reimburse State Auto P&C for any losses and loss expenses in excess of
State Auto P&C's December 31, 1990 reserves ($65,464,000) that may develop from
claims that have occurred on or prior to that date. This guarantee ensures that
any deficiency in the reserves of State Auto P&C as of December 31, 1990, under
the pooling arrangement percentages effective on December 31, 1990, will be
reimbursed by Mutual. As of December 31, 1996, there has been no adverse
development of these reserves. In the event Mutual becomes financially impaired,
and subject to regulatory restrictions, it may be unable to make any such
reimbursement.
The following table presents one year development information on
changes in the reserve for loss and loss expenses of the Company for the three
years ended December 31, 1996:
Year Ended December 31
-------------------------------------------------
1996 1995 1994
(in thousands)
Reserve for losses and loss expenses
at beginning of year(1) $161,297 $126,742 $123,337
--------- --------- ---------
Provision for losses and loss
expenses occurring:
Current year 194,568 171,449 139,211
Prior years(2) (21,028) (12,536) (7,748)
--------- --------- ---------
Total 173,540 158,913 131,463
--------- --------- ---------
Loss and loss expense payments
for claims occurring during:
Current year 116,983 95,011 75,977
Prior years 61,670 62,248 52,081
--------- --------- ---------
Total 178,653 157,259 128,058
--------- --------- ---------
Impact of pooling change 1/1/95 -- 32,901 --
--------- --------- ---------
Reserve for losses and loss expenses
--------- --------- ---------
at end of year (1) $156,184 $161,297 $126,742
========= ========= =========
<FN>
- ---------------
(1) This line item is net of reinsurance receivable on losses and loss
expenses payable of approximately $9,691,000, $9,278,000, and
$7,007,000, for the years 1996, 1995 and 1994, respectively.
(2) This line item shows redundancies in the provision for losses and loss
expenses attributable to prior years in the amounts of approximately
$21,028,000, $12,536,000, and $7,748,000, for the
12
years 1996, 1995 and 1994, respectively. These decreases have resulted
primarily from moderating trends in the frequency and severity of
losses and loss expenses due to lower inflation. This along with
fundamental improvements primarily in the auto liability and workers'
compensation lines of business resulted in incurred losses and loss
expenses developing favorably.
- ----------------
The following table sets forth the development of reserves for losses
and loss expenses from 1986 through 1996 for the Company. "Net liability for
losses and loss expenses payable" sets forth the estimated liability for unpaid
losses and loss expenses recorded at the balance sheet date, net of reinsurance
recoverables, for each of the indicated years. This liability represents the
estimated amount of losses and loss expenses for claims arising in the current
and all prior years that are unpaid at the balance sheet date, including losses
incurred but not reported to the Company.
The lower portion of the table shows the re-estimated amounts of the
previously reported reserve based on experience as of the end of each succeeding
year. The estimate is increased or decreased as more information becomes known
about the claims incurred.
The upper section of the table shows the cumulative amounts paid with
respect to the previously reported reserve as of the end of each succeeding
year. For example, through December 31, 1996, the Company had paid 87.6% of the
currently estimated losses and loss expenses that had been incurred, but not
paid, as of December 31, 1987.
The amounts on the "cumulative redundancy (deficiency)" line represent
the aggregate change in the estimates over all prior years. For example, the
1986 reserve has developed a $330,000 redundancy over ten years. That amount has
been included in operations over the ten years and did not have a significant
effect on income of any one year. The effects on income caused by changes in
estimates of the reserves for losses and loss expenses for the most recent three
years are shown in the foregoing three-year loss development table.
In evaluating the information in the table, it should be noted that
each amount includes the effects of all changes in amounts for prior periods.
For example, the amount of the redundancy related to losses settled in 1989, but
incurred in 1986, will be included in the cumulative redundancy amount for years
1986, 1987 and 1988. The table does not present accident or policy year
development data, which readers may be more accustomed to analyzing. Conditions
and trends that have affected the development of the liability in the past may
not necessarily occur in the future. Accordingly, it may not be appropriate to
extrapolate future redundancies or deficiencies based on this table.
Participation in the pooling arrangement is reflected beginning in
1987. On January 1, 1987, as a result of the reinsurance pooling arrangement
commencing on that date, State Auto P&C's obligation for unpaid losses and loss
expenses was redefined from its former obligation to 20% of the obligations of
State Auto P&C and Mutual combined. The result of initial pooling increased
State Auto P&C's liability for losses and loss expenses. This is reflected in
the first line of the 1987 column. Effective, January 1, 1992, the pooling
percentage was changed whereby State Auto P&C increased its share in the pooled
losses and loss expenses from 20% to 30%. This increase is reflected in the 1992
column. Effective January 1, 1995, the pooling percentage was again changed
adding Milbank to the pool and increasing State Auto P&C's share in the pooled
losses and loss expenses from 30% to 35%. This increase is reflected in the 1995
column. An amount of assets equal to the increase in net liabilities was
transferred to State Auto P&C from Mutual in 1987, 1992 and 1995 in conjunction
with each year's respective pooling change. The amount of the assets transferred
from Mutual in 1987, 1992 and 1995 has been netted against and has reduced the
cumulative amounts paid for years prior to 1987 for the January 1, 1987 initial
pooling arrangement, for years prior to 1992 for the January 1, 1992 pooling
change and for years prior to 1995 for the January 1, 1995 pooling change.
[See table on following page.]
13
State Auto Financial Corp.
Years Ended December 31
1986 1987 1988 1989 1990 1991
(Dollars in Thousands)
Net liability for losses
and loss expenses payable $29,680 $45,771 $51,142 $58,203 $65,464 $71,139
Paid (cumulative)
as of:
One year later 34.9% 47.8% 47.7% 48.1% 43.3% 12.2%
Two years later 63.3% 68.6% 65.7% 68.8% 46.1% 43.0%
Three years later 78.1% 78.1% 76.0% 70.9% 62.9% 58.7%
Four years later 85.3% 82.6% 76.1% 79.9% 71.8% 64.4%
Five years later 87.5% 81.7% 80.8% 84.4% 75.7% 68.7%
Six years later 86.1% 84.3% 83.0% 85.9% 78.3%
Seven years later 88.6% 85.8% 83.8% 88.0%
Eight years later 90.0% 86.4% 85.4%
Nine years later 91.1% 87.6%
Ten years later 92.6%
Net liability re-estimate
as of:
One year later 99.2% 94.1% 93.7% 98.0% 95.4% 91.2%
Two years later 98.2% 93.2% 91.6% 97.4% 92.1% 87.2%
Three years later 97.2% 92.2% 91.3% 95.9% 89.7% 85.4%
Four years later 96.6% 92.1% 90.4% 95.4% 88.1% 84.7%
Five years later 96.4% 91.2% 90.6% 95.0% 89.3% 83.0%
Six years later 95.5% 91.6% 89.9% 95.9% 88.3%
Seven years later 96.2% 90.8% 91.5% 95.4%
Eight years later 95.3% 93.2% 91.3%
Nine years later 99.0% 93.1%
Ten years later 98.9%
Cumulative redundancy (deficiency) $330 $3,177 $4,438 $2,697 $7,662 $12,119
Cumulative redundancy (deficiency) 1.1% 6.9% 8.7% 4.6% 11.7% 17.0%
Gross* liability - end of year
Reinsurance receivable
Net liability - end of year
Gross liability re-estimated - latest
Reinsurance receivable re-estimated - latest
Net liability re-estimated - latest
(Continued)
1992 1993 1994 1995 1996
Net liability for losses
and loss expenses payable $119,044 $123,337 $126,743 $161,298 $156,184
Paid (cumulative)
as of:
One year later 41.3% 42.2% 23.2% 38.2% --
Two years later 60.9% 52.9% 44.6%
Three years later 67.3% 64.0%
Four years later 73.0%
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Net liability re-estimate
as of:
One year later 92.7% 93.7% 90.1% 87.0% --
Two years later 90.5% 90.8% 82.1%
Three years later 88.2% 86.9%
Four years later 86.6%
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Cumulative redundancy (deficiency) $15,896 $16,179 $22,733 $21,028 --
Cumulative redundancy (deficiency) 13.4% 13.1% 17.9% 13.0% --
Gross* liability - end of year $170,578 $165,875
Reinsurance receivable $9,280 $9,691
Net liability - end of year $161,298 $156,184
Gross liability re-estimated - latest 87.6%
Reinsurance receivable re-estimated - latest 99.0%
Net liability re-estimated - latest 87.0%
* Gross liability includes: Direct & assumed losses & loss expenses payable.
14
The following table is a reconciliation as of each December 31 of
losses and loss expenses payable, computed under generally accepted accounting
principles ("GAAP"), to losses and loss expenses payable, computed under
statutory accounting principles used by insurance companies for reporting to
state insurance regulators ("STAT"):
1996 1995 1994
---- ---- ----
(in thousands)
GAAP losses and loss
expenses payable $165,875 $170,575 $133,750
Less: reinsurance receivable
on losses 9,691 9,278 7,007
Add: salvage and subrogation
recoverable 8,265 7,378 5,136
-------- -------- --------
STAT losses and loss
expenses payable $164,449 $168,675 $131,879
======== ======== ========
INVESTMENTS
The Company's investment portfolio is managed to provide growth of
statutory surplus in order to facilitate increased premium writings over the
long term while maintaining the ability to service current insurance operations.
The primary objectives are to generate income, preserve capital and maintain
liquidity. The Company's investment portfolio is managed separately from that of
Mutual and its affiliates and investment results are not shared by Mutual, State
Auto P&C and Milbank through the pooling arrangement. The Company has investment
policy guidelines with respect to purchasing fixed income investments which
preclude investments in bonds that are rated below investment grade by a
recognized rating service. The maximum investment in any single note or bond is
limited to 2.0% of assets, other than obligations of the U.S. government or
government agencies, for which there is no limit. The Company's decision to make
a specific investment is influenced primarily by the following factors: (a)
investment risks; (b) general market conditions; (c) relative valuations of
investment vehicles; (d) general market interest rates; (e) the Company's
liquidity requirements at any given time; and (f) the Company's current federal
income tax position and relative spread between after tax yields on tax-exempt
and taxable fixed income investments. The investment management services on
behalf of the Company and Mutual and its subsidiaries are performed by Stateco,
although investment policies to be implemented by Stateco continue to be set for
each company through the Investment Committee of its Board of Directors. See
"Investment Management Services."
Strategies as to specific investments can change depending on the
current federal tax position, market interest rates and general market
conditons. Consequently, pursuant to the Statement of Financial Accounting
Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity
Securities", adopted effective December 31, 1993, the Company segregates a
portion of its fixed maturity investments for the purpose of providing greater
flexibility in the investment portfolio. Fixed maturities that are purchased
with the intention and ability of holding them until maturity are categorized as
held-to-maturity and carried at amortized cost. Fixed maturities that may be
sold, thereby providing the Company the flexibity noted above, are categorized
as available-for-sale and are carried at fair value. In December 1995, the
Company reclassified from the held-to-maturity category to the
available-for-sale category fixed maturities with an amortized cost of $84.6
million. This reclassification was performed in accordance with the Financial
Accounting Standards Board Special Report, "A Guide to Implementation of
Statement 115 on Accounting for Certain Investments in Debt and Equity
Securities." Fixed maturities available-for-sale totaled $294.1 million and
$278.3 million at December 31, 1996 and 1995, respectively.
During the fourth quarter of 1994, the Company converted its equity
securities portfolio to fixed maturities in an effort to generate additional
investment income and increase the effective yield on the investment portfolio.
During 1996, the Company continued this investment strategy.
15
The table below provides information about the quality of the Company's
fixed maturity portfolio
Bond Portfolio Quality
Investment Grade Corporates
and Municipals 59.6%
U.S. Governments 24.1%
U.S. Government Agencies 16.3%
The following table sets forth the Company's investment results for the
periods indicated:
Year Ended December 31
-----------------------------------------------
1996 1995 1994
---- ---- ----
(Dollars in thousands)
Average invested assets (1) $387,579 $354,346 $279,344
Net investment income (2) $23,879 $22,617 $17,756
Average yield 6.16% 6.38% 6.36%
<FN>
- --------------
(1) Average of the aggregate invested assets at the beginning and end of
each period. Invested assets include fixed maturities, equity
securities and cash equivalents.
(2) Net investment income is net of investment expenses and does not
include realized or unrealized investment gains or losses or provision
for income taxes.
- --------------
REGULATION
The Company. Most states have enacted legislation that regulates
insurance holding company systems. Ohio, the domiciliary state of Mutual and
National, has adopted legislation regulating the activities of those companies.
South Carolina has adopted legislation regulating the activities of State Auto
P&C as the South Carolina domiciled member of the holding company system, as has
South Dakota which is the domiciliary regulator of Milbank. Each insurance
company in the holding company system is required to register with the insurance
supervisory agency of its state of domicile and furnish information concerning
the operations of companies within the holding company system that may
materially affect the operations, management or financial condition of the
insurers within the system. Pursuant to these laws, the respective insurance
departments may examine Mutual, State Auto P&C, National and Milbank at any
time, require disclosure of material transactions involving insurer members of
the holding company system and require prior notice and an opportunity to
disapprove of certain "extraordinary" transactions, including, but not limited
to, extraordinary dividends from State Auto P&C and National to State Auto
Financial. Pursuant to these laws, all transactions within the holding company
system affecting Mutual, State Auto P&C, National and Milbank must be fair and
equitable. In addition, approval of the applicable Insurance Commissioner is
required prior to the consummation of transactions affecting the control of an
insurer.
South Carolina insurance law provides that no person may acquire direct
or indirect control of State Auto P&C unless it has obtained the prior written
approval of the Chief Insurance Commissioner of South Carolina for such
acquisition. Any purchaser of 10% or more of the outstanding Common Shares would
be presumed to have acquired control of State Auto P&C, unless such presumption
is rebutted. Ohio law has similar provisions in place which would be applicable
to National.
In addition to being regulated by the insurance department of its state
of domicile, each insurance company is subject to supervision and regulation in
the states in which it transacts business, and such
16
supervision and regulation relate to numerous aspects of an insurance company's
business and financial condition. The primary purpose of such supervision and
regulation is to ensure financial stability of insurance companies for the
protection of policyholders. The laws of the various states establish insurance
departments with broad regulatory powers relative to granting and revoking
licenses to transact business, regulating trade practices, licensing agents,
approving policy forms, setting reserve requirements, determining the form and
content of required statutory financial statements, prescribing the types and
amount of investments permitted and requiring minimum levels of statutory
capital and surplus. Although premium rate regulation varies among states and
lines of insurance, such regulations generally require approval of the
regulatory authority prior to any changes in rates. In addition, all of the
states in which State Auto P&C, Mutual, National and Milbank transact business
have enacted laws which restrict their underwriting discretion. Examples of
these laws include restrictions on policy terminations, restrictions on agency
terminations and laws requiring companies to accept any applicant for automobile
insurance. These laws adversely affect the ability of the foregoing companies to
earn a profit on their underwriting operations.
Insurance companies are required to file detailed annual reports with
the supervisory agencies in each of the states in which they do business, and
their business and accounts are subject to examination by such agencies at any
time.
There can be no assurance that such regulatory requirements will not
become more stringent in the future and have an adverse effect on the operations
of National or the insurers participating in the pooling arrangement.
Dividends. State Auto P&C and National are subject to regulations and
restrictions under which payment of non-extraordinary dividends from statutory
surplus can be made to State Auto Financial during the year without prior
approval of regulatory authorities.
The National Association of Insurance Commissioners, an association of
the chief insurance regulators from the fifty states, the District of Columbia
and U.S. Territories ("NAIC"), has created a certification process for state
insurance departments in an effort to bolster state regulation of insurers'
solvency. One element of the certification process includes a requirement that a
state has in place a variety of "model" laws and regulations which, in the
NAIC's view, enhance the ability of the state regulators to effectively regulate
insurance company solvency. Both the South Carolina Insurance Department and the
Ohio Insurance Department, the domiciliary regulator for State Auto P&C and
National respectively, have been certified by the NAIC.
Insurers are permitted to pay dividends without prior approval from the
domiciliary insurance department unless the dividend is an "extraordinary
dividend." In South Carolina, an extraordinary dividend is one which, when
considered with all other dividends paid in the last 12 months, is an amount
more than the greater of 10% of the insurer's statutory surplus as regards
policyholders as of the preceding December 31, or the statutory net income not
including net realized capital gains or losses for the previous year ended
December 31. In Ohio, the definition is substantialy the same as in South
Carolina except that net income does not exclude net realized capital gains and
losses. Both South Carolina and Ohio require notice of all dividends within five
business days after declaration and at least ten days prior to payment. In
addition, the law in both Ohio and South Carolina gives the Commissioner the
authority to limit a non-extraordinary dividend when the Commissioner
determines, based on factors set forth in the law, that an insurer's surplus as
regards policyholders is not reasonable in relation to the insurer's outstanding
liabilities and adequate to its financial needs, provided the Commissioner acts
within the ten calendar days prior to payment. Pursuant to these rules, $12.3
million is available for payment to State Auto Financial as a dividend from
State Auto P&C and National during 1997 without prior approval under current
law.
Rate and Related Regulation. The Company is not aware of any adverse
legislation or regulation that has been adopted by any state where the Company
did business during 1996 which would present material obstacles to the Company's
overall business. On the federal level, however, there is still the possibility
that the Department of Housing and Urban Development ("HUD") will seek to
regulate homeowner underwriting practices under the authority of the Fair
Housing Act. Court decisions in the
17
federal courts have generally upheld HUD's right to regulate homeowner insurance
underwriting practices. If HUD regulations are promulgated, and these include a
disparate impact standard for the determination of illegal discrimination, such
regulations could present a significant underwriting challenge to the Company.
In an attempt to make capital and surplus requirements more accurately
reflect the underwriting risk of different lines of insurance as well as
investment risks that attend insurers operations, the NAIC created what it calls
risk-based capital requirements. The NAIC imposed on property and casualty
insurers a risk-based capital requirement to be applicable as of year end 1994.
Each insurer affiliated with the Company exceeded all standards tested by the
formula applying risk-based capital requirements as of year-end 1996.
The property and casualty insurance industry is also affected by court
decisions. Premium rates are actuarially determined to enable an insurance
company to generate an underwriting profit. These rates contemplate a certain
level of risk. The courts may modify the level of risk which insurers had
expected to assume in a number of ways, including eliminating exclusions,
multiplying limits of coverage, creating rights for policyholders not intended
to be included in the contract and interpreting applicable statutes expansively
to create obligations on insurers not originally considered when the statute was
passed. Courts have also undone legal reforms passed by legislatures, which
reforms were intended to reduce a litigant's rights of action or amounts
recoverable and so reduce the costs borne by insurance mechanism. These court
decisions can adversely affect an insurer's profitability. They also create
pressure on rates charged for coverages adversely affected and this can cause a
legislative response resulting in rate suppression that can adversely affect an
insurer.
REINSURANCE
The Company, Mutual, and Milbank follow the customary industry practice
of reinsuring a portion of their exposures and paying to the reinsurers a
portion of the premiums received on all policies. Insurance is ceded principally
to reduce net liability on individual risks or for individual loss occurrences,
including catastrophic losses. Effective January 1, 1995, reinsurance premiums
and reimbursements are allocated between State Auto P&C, Milbank and Mutual
according to their relative pooling percentages. National does not directly
participate in the pooling arrangement. Although reinsurance does not legally
discharge State Auto P&C, Mutual, National, or Milbank from primary liability
for the full amount of their policies, it does make the assuming reinsurer
liable to the extent of the reinsurance ceded.
State Auto P&C, Milbank, National and Mutual have separate working
reinsurance treaties for property and casualty lines with several reinsurers
arranged through a reinsurance broker. Under the property excess of loss treaty,
State Auto P&C, Milbank, National and Mutual are responsible for the first
$1,000,000 of each defined loss and the reinsurers are responsible for 100% of
the excess over $1,000,000 up to $5,000,000 of such defined loss, depending upon
the nature of the injury or damage. The rates for this reinsurance are
negotiated annually.
The terms of the casualty excess of loss program provide for State Auto
P&C, Milbank, Mutual, and National to be responsible for the first $2,000,000 of
a covered loss. The reinsurers are responsible for 100% of the loss excess of
$2,000,000 and up to $5,000,000. Also, certain unusual claim situations
involving bodily injury liability, property damage liabillity, uninsured
motorist, personal injury protection and workers' compensation insurance are
covered by arrangements which provide for $10,000,000 of coverage in two
$5,000,000 layers, above a $5,000,000 retention for each loss occurrence. These
two layers of reinsurance sit above the $3,000,000 excess of $2,000,000
arrangement.
In addition, State Auto P&C, Mutual, and Milbank have secured other
reinsurance to limit the net cost of large loss events for certain types of
coverages. Included are umbrella liability losses which are reinsured up to a
limit of $15,000,000 above a maximum $500,000 retention. The companies also make
use of the facultative market for unique risk situations and participate in
involuntary pools and associations in certain states.
18
Catastrophe reinsurance has been arranged for property business,
including automobile physical damage. Effective July 1, 1996, the Company and
Mutual negotiated a change in their catastrophe reinsurance program. The amount
retained by State Auto P&C, Mutual, Milbank and National is $40.0 million for
each occurrence, an increase of $20.0 million over the retention in the prior
program. For up to $80.0 million in losses, excess of the $40.0 million
retention, traditional reinsurance coverage is provided with a 5%
co-participation on each layer of the $80.0 million of total traditional
reinsurance coverage. In the event the State Auto Group incurs catastrophe
losses in excess of $120.0 million, State Auto Financial has entered into a
structured contingent financing transaction with Chase Manhattan Bank ("Chase")
to provide up to $100.0 million to be used to cover such catastrophe losses.
Under this arrangement, in the event of such a loss, State Auto Financial would
issue and sell redeemable preferred shares to SAF Funding Corporation, a special
purpose company ("SPC"), which will borrow the money necessary for such purchase
from Chase and a syndicate of other lenders (the "Lenders"). State Auto
Financial will contribute to State Auto P&C the proceeds from the sale of its
preferred shares. State Auto P&C has assumed catastrophe reinsurance from
Mutual, Milbank and National pursuant to a Catastrophe Assumption Agreement in
the amount of $100.0 million excess of $120.0 million. State Auto P&C will use
the contributed capital to pay its direct catastrophe losses and losses assumed
under the Catastrophe Assumption Agreement. State Auto Financial is obligated to
repay SPC (which will repay the lenders) by redeeming the preferred shares over
a six year period. This layer of $100.0 million in excess of $120.0 million has
been excluded from the pooling arrangement as well by virtue of an Amended and
Restated Reinsurance Pooling Agreement. See "Pooling Arrangement." In addition,
State Auto Financial's obligation to repay SPC has been secured by a Put
Agreement among State Auto Financial, Mutual and the Lenders, under which, in
the event of a default by State Auto Financial as described in the Credit
Agreement or in the Put Agreement, Mutual would be obligated to put either the
preferred shares or the loan(s) outstanding.
National has entered into a reinsurance agreement with Mutual. Pursuant
to the agreement, on an excess of loss basis, Mutual assumes all liability
losses in excess of National's $50,000 retention; on a quota share basis, Mutual
assumes 20% of all losses - and premiums - within National's $50,000 retention.
The excess of loss coverage is intended to insulate National from shock losses
while the quota share arrangement is intended to slow the drain on statutory
surplus which can normally be expected with a rapid increase in premium
writings.
Midwest Security has also entered into reinsurance agreements with
Mutual. Under an umbrella quota share agreement, Mutual reinsures on a per risk
basis, 100% of the first and second $1,000,000 in umbrella coverage written by
Midwest Security. Mutual also has a property catastrophe excess of loss
agreement with Midwest Security under which Mutual is liable for 100% of
$5,000,000 of losses excess a $100,000 retention in three different layers.
Mutual also has written a property casualty multiple line excess of loss
agreement with Midwest Security under which Midwest Security bears the first
$50,000 of each loss (except for $25,000 in case of private passenger auto
physical damage) with Mutual bearing the excess over the retention, subject to a
limit of $500,000 in casualty and $1,000,000 in property. Mutual also wrote for
Midwest Security a second casualty excess of loss agreement for $1.5 million in
excess of $500,000 for liability coverages referenced under the first multiple
line excess of loss agreement. Management believes the premiums charged to
Midwest Security for these reinsurance agreements are comparable to those that
would be charged by a third party reinsurer. The premiums and losses assumed
under these reinsurance agreements are pooled by Mutual pursuant to the pooling
arrangement.
COMPETITION
The property and casualty insurance industry is highly competitive.
Price competition has been particularly intense during recent years. The Company
competes with numerous insurance companies, many of which are substantially
larger and have considerably greater financial resources. In addition, because
the Company's products are marketed exclusively through independent insurance
agencies, most of which represent more than one company, the Company faces
competition within each agency. See "Marketing." The Company competes through
underwriting criteria, appropriate pricing, and quality service to the
policyholder and the agent and through a fully developed agency relations
program.
19
EMPLOYEES
As of March 4, 1997, the Company had 39 employees. See "Management
Agreement." All of the other personnel providing services to State Auto
Financial and its subsidiaries are employed by Mutual and made available under
the terms of the Amended and Restated Management Agreement. See "Management
Agreement." At December 31, 1996, Mutual had approximately 1,300 full-time
employees. Employees of the Company and of Mutual are not covered by any
collective bargaining agreement. Management of Mutual and of the Company
consider their relationship with the employees to be excellent.
EXECUTIVE OFFICERS OF THE REGISTRANT
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company (1)(2) Age During the Past Five Years of the Company Since
- ------------------------------- --- -------------------------- --------------------
Robert L. Bailey, 63 Chairman of the Board of STFC 3/93 to 1991
Chairman of the Board, present; Chief Executive Officer of
and Chief Executive Officer STFC 5/91 to present; President of
STFC, 5/91 to 5/96; Chairman of the
Board of State Auto P&C and Mutual
3/93 to present; Chief Executive
Officer of State Auto P&C and Mutual,
5/89 to present; President of State
Auto P&C and Mutual, 5/89 to 5/96;
Chairman of the Board of National
3/93 to present; Chief Executive
Officer of National 10/91 to present;
President of National 10/91 to 5/96;
Chairman of the Board of Stateco 3/93
to present; Chief Executive Officer
of Stateco 5/89 to present; President
of Stateco 5/89 to 5/96; Chairman of
the Board and Chief Executive Officer
of SIS 7/95 to present
Robert H. Moone, 53 President and Chief Operating Officer 1991
President and of STFC, 5/96 to present; Executive
Chief Operating Officer Vice President, 11/93 to 5/96 and prior
thereto Vice President of STFC;
President and Chief Operating Officer
of State Auto P&C, Mutual and
National, 5/96 to present; Executive
Vice President, 11/93 to 5/96 and
prior thereto, Senior Vice President
of State Auto P&C, Mutual and
National; President and Chief
Operating Officer of Stateco, 5/96 to
present
Urlin G. Harris, Jr., 60 Executive Vice President, Treasurer, 1991
Executive Vice President, and Chief Financial Officer of STFC,
Treasurer and Chief 11/93 to present, and prior thereto
Financial Officer Senior Vice President, Treasurer, and
Chief Financial Officer of STFC; and
Executive Vice President, Chief
Financial Officer and Treasurer,
11/93 to present, and prior thereto,
Senior Vice President and Treasurer
of State Auto P&C, Mutual and
National; Vice President and Chief
Financial Officer of Stateco 5/89 to
present; Vice Chairman and Treasurer
of SIS 7/95 to present
John R. Lowther, 46 Vice President, Secretary and General 1991
Vice President, Secretary Counsel of STFC, 5/91 to present; Vice
and General Counsel President, Secretary and General
Counsel of State Auto P&C and Mutual,
8/89 to present; Vice President,
Secretary and General Counsel of
National 10/91 to present; Secretary
of Stateco 5/89 to present; Vice
President, Secretary and General
Counsel of SIS 7/95 to present
20
Name of Executive Officer and Principal Occupation(s) An Executive Officer
Position(s) with Company (1)(2) Age During the Past Five Years of the Company Since
------------------------------- --- -------------------------- --------------------
Michael F. Dodd, 59 Senior Vice President of STFC, 5/91 to 1991
Senior Vice President present; Senior Vice President of State
Auto P&C and Mutual 2/89 to present;
Senior Vice President of National 10/91
to present
Terrence L. Bowshier, 44 Vice President and Comptroller of STFC, 1991
Vice President and State Auto P&C, and Mutual 5/91 to
Comptroller present; Vice President and Comptroller
of National 10/91 to present; Treasurer
and Comptroller of Stateco 5/84 to
present; Vice President and Comptroller
of SIS, 7/95 to present
James E. Duemey, 50 Vice President and Investment Officer 1991
Vice President and of STFC, State Auto P&C and Mutual 5/91
Investment Officer to present; Vice President and Investment
Officer of National 10/91 to present;
Vice President of Stateco 3/93 to present
Terrence P. Higerd, 52 Vice President of STFC, 5/91 to 1991
Vice President present; Vice President of State Auto P&C
and Mutual 6/87 to present; Vice
President of National 10/91 to present
Steven J. Johnston, 38 Vice President of STFC, Mutual, State 1994
Vice President Auto P&C, and National, 5/95 to
present; Assistant Vice President of
Mutual, State Auto P&C and National 8/92
to 5/95; Assistant Secretary of Mutual
and State Auto P&C, 5/91 to 8/92
Robert A. Lett 58 Vice President of Mutual and State Auto 1994
P&C 2/88 to present; Vice President of
National 10/91 to present
John B. Melvin 47 Vice President of Mutual, State Auto 1994
P&C and National 11/93 to present; and
prior thereto an officer of Mutual and
State Auto P&C
Cathy B. Miley 47 Vice President of Mutual, State Auto 1995
P&C and National 3/95 to present;
Assistant Vice President of Mutual, State
Auto P&C and National 8/92 to 3/95;
Assistant Secretary of Mutual and State
Auto P&C 5/91 to 8/92
Richard L. Miley 43 Vice President of Mutual, State Auto 1995
P&C and National 5/95 to present;
Assistant Vice President of Mutual and
State Auto P&C, 8/87 to 5/95
Donald F. Moshgat 62 Vice President of Mutual, State Auto 1995
P&C and National 8/95 to present;
Assistant Vice President of Mutual and
State Auto P&C, 3/91 to 8/95
<FN>
(1) Except for Mr. Bailey, each of the executive officers is elected by the
respective company's Board of Directors for an indefinite term. Mr. Bailey has
executed an employment agreement effective January 1, 1996, which is for a five year
term.
(2) Each of the foregoing executive officers has been designated by the Company's
Board of Directors as an officer for purposes of Section 16 of the Securities
Exchange Act of 1934.
21
ITEM 2. PROPERTIES
- ------- ----------
Because the operations of the Company and Mutual are integrated with
one another pursuant to the terms of the Amended and Restated Management
Agreement, the Company and Mutual share their operating facilities. See Item 1,
"Management Agreement." The Company's and Mutual's corporate headquarters are
located in Columbus, Ohio in buildings owned by Mutual that contain
approximately 270,000 square feet of office space. The Company and Mutual also
have regional underwriting and claims office facilities which they share through
the Management Agreement. These facilities include a 53,500 square foot regional
office in Greer, South Carolina, which is owned by State Auto P&C, a 22,800
square foot regional office in Nashville, Tennessee which is leased by Mutual
from a third party pursuant to a 10-year lease, a 6,600 square foot branch
office in Cleveland, Ohio owned by Mutual, and a 29,000 square foot branch
office in Cincinnati, Ohio owned by Mutual. Milbank owns an office facility in
Milbank, South Dakota where Mutual employees provide services to Milbank agents
and policyholders. Midwest Security leases an office facility in Onalaska,
Wisconsin where Mutual employees service Midwest Security's agents and
policyholders. Mutual also leases a number of small offices throughout its
operating area for the claims operations of Mutual and the Company. Each company
maintains the facilities owned or leased by it and, because the facilities are
used in common and shared, does not charge rent to the other State Auto
Companies using those facilities except with respect to space within a facility
dedicated to the exclusive use of a particular company. With respect to the
Tennessee location, the Board of Directors of State Auto Financial and Mutual
have authorized State Auto Financial to purchase land and develop an office
building for Mutual to occupy as a tenant of State Auto Financial when the lease
in Nashville expires in 1999.
ITEM 3. LEGAL PROCEEDINGS
- ------- -----------------
The Company is a party to a number of lawsuits arising in the ordinary
course of its insurance business. Management of the Company believes that the
ultimate resolution of these lawsuits will not, individually or in the
aggregate, have a material, adverse effect on the financial condition of the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ------- ---------------------------------------------------
Not applicable.
22
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON SHARES AND RELATED SHAREHOLDER
- ------- -----------------------------------------------------------------
MATTERS
-------
STOCK TRADING
Common shares are traded in the Nasdaq National Market System under the
symbol STFC. As of March 5, 1997, there were 824 shareholders of record of the
Company's common shares.
MARKET PRICE RANGE, COMMON STOCK(1)
Initial Public Offering -- June 28, 1991, $4.50. The high and low sale
prices for each quarterly period for the past two years as reported by Nasdaq
are:
1995 HIGH LOW DIVIDEND
---- ---- --- --------
First Quarter $11.33 $9.17 $.033
Second Quarter 12.83 10.75 .033
Third Quarter 15.67 12.50 .037
Fourth Quarter 17.50 14.50 .037
1996
First Quarter $17.50 $14.00 $.037
Second Quarter 16.67 15.00 .037
Third Quarter 16.17 13.00 .04
Fourth Quarter 18.50 13.25 .04
<FN>
(1) Adjusted for a March 1993 two-for-one and a July 1996
three-for-two common stock split effected in the form of a
stock dividend, respectively.
Additionally, see Liquidity and Capital Resources section of
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included in Item 7 of this Form 10-K Annual Report.
ITEM 6. SELECTED FINANCIAL DATA
- ------- -----------------------
"Selected Consolidated Financial Data" is as follows:
23
SELECTED CONSOLIDATED FINANCIAL DATA
Year ended December 31
----------------------
1996 1995* 1994 1993 1992
---- ----- ---- ---- ----
Statements of Earnings Data: (Dollars in thousands, except per share data)
Earned premiums $240,345 232,524 175,587 169,610 162,158
Net investment income $ 23,879 22,617 17,756 17,222 16,912
Management services income $ 8,020 7,574 6,078 2,155 --
Net realized gains on investments $ 1,401 1,201 1,506 718 1,512
-------------------------------------------------
Total revenues $273,645 263,916 200,927 189,705 180,582
-------------------------------------------------
Earnings before federal income taxes $ 30,148 35,339 19,105 16,849 11,450
-------------------------------------------------
Net earnings before cumulative effect of change in
accounting for income taxes $ 22,602 25,542 14,662 13,646 9,296
-------------------------------------------------
Net earnings $ 22,602 25,542 14,662 13,729 9,296
-------------------------------------------------
Net earnings per common share before cumulative
effect adjustment $ 1.25 1.42 0.82 0.76 0.53
-------------------------------------------------
Net earnings per common share(1) $ 1.25 1.42 0.82 0.77 0.53
-------------------------------------------------
Cash dividends per common share(1) $ 0.15 0.14 0.13 0.11 0.10
-------------------------------------------------
Balance Sheet Data at Year End:
Total investments(3) $384,307 369,847 273,226 273,753 250,470
Total assets(2) $453,120 434,496 334,796 320,203 298,426
Total stockholders' equity $186,461 168,252 130,186 124,332 105,399
Book value per common share(1) $ 10.28 9.33 7.27 6.99 5.96
Statutory Ratios:
Loss ratio 72.6% 68.6 75.1 73.5 75.5
Expense ratio 26.4% 30.1 25.9 29.1 29.6
Combined ratio(4) 99.0% 98.7 101.0 102.6 105.1
Industry combined ratio(5) 107.0% 106.4 108.5 106.9 115.8
Ratio of net premiums written to statutory capital and surplus 2.08 2.32 1.85 2.02 2.14
<FN>
(1) Adjusted for a March 1993 2-for-1 and a July 1996 3-for-2 common stock split effected in the form of a stock
dividend, respectively.
(2) The Company adopted SFASNo. 113 in 1993. Prior year information has been restated to conform to the 1993
presentation.
(3) The Company adopted SFASNo. 115, effective December 31, 1993. Prior year information has not been restated.
(4) Derived from combined statutory financial statements on a pooled basis, including State Auto National.
(5) Preliminary industry information for 1996 from A.M. Best Co.
* Reflects change in pooling arrangement, effective January 1, 1995.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
- ------- -----------------------------------------------------------------------
OF OPERATIONS
-------------
"Management's Discussion and Analysis of Financial Condition and
Results of Operations" is as follows:
24
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
OVERVIEW
State Auto Financial Corporation (State Auto Financial), through its
principal insurance subsidiary State Auto Property and Casualty Insurance
Company (State Auto P&C) provides personal and commercial insurance primarily in
the eastern half of the United States, excluding New York, New Jersey, and the
New England states. State Auto P&C's principal lines of business include
personal and commercial automobile, homeowners, commercial multiple peril,
workers' compensation, general liability and fire insurance. Another insurance
subsidiary, State Auto National Insurance Company (National), writes personal
automobile insurance for non-standard risks. In 1996 National wrote insurance in
seven states. State Auto P&C and National's products are marketed through
independent agents.
Effective April 1, 1994, State Auto P&C began providing executive management
services to oversee the insurance operations of all the State Auto Insurance
Companies, which include National and State Automobile Mutual Insurance Company
(Mutual), a majority shareholder of State Auto Financial, and Mutual's
wholly-owned subsidiaries Milbank Insurance Company (Milbank) and State Auto
Life Insurance Company. Stateco Financial Services, Inc. (Stateco), another
subsidiary of State Auto Financial, provides investment management services to
affiliated companies and also provides insurance premium finance services to
customers of State Auto P&C, Mutual and Milbank.
New to State Auto Financial in 1995 was Strategic Insurance Software, Inc.
(SIS), a majority owned subsidiary. In July 1995, SIS began developing and
selling software for the processing of insurance transactions, database
management for insurance agents and electronic interfacing of information
between insurance companies and agents. SIS sells services and products to
affiliated companies and their agents and markets similar services and products
to nonaffiliated insurers and their agencies. State Auto Financial and its
subsidiaries, State Auto P&C, National, Stateco and SIS are referred to
collectively as the Company.
Since 1987 State Auto P&C has participated in a reinsurance pooling
arrangement (the Arrangement) with Mutual. The Arrangement provides that all
premiums, losses, loss expenses and underwriting expenses of each company be
pooled and then allocated back to each company based on percentages outlined in
the Arrangement. During 1994, State Auto P&C assumed 30% of the pooled business
with 70% retained by Mutual. Effective January 1, 1995, the Arrangement was
amended to include all of the property and casualty business of Milbank.
Concurrently with the inclusion of Milbank, the pooling participation
percentages were amended to allocate 35% to State Auto P&C, 55% to Mutual and
10% to Milbank. In connection with the January 1, 1995 change in pooling
percentages, State Auto P&C received cash of approximately $46 million to cover
its increased share of pool liabilities. The change in the Arrangement did not
affect a prior agreement between State Auto P&C and Mutual whereby Mutual agreed
to reimburse State Auto P&C for the development of any losses or loss expenses
on claims occurring on or prior to December 31, 1990, that are in excess of
State Auto P&C's reserves on that date. As of December 31, 1996, there has been
no adverse development of the liability. State Auto P&C, National, Mutual, and
Milbank are referred to collectively as the State Auto Insurance Companies.
1996 Compared to 1995
- --------------------------------------------------------------------------------
Net earnings for the Company decreased 11.5% due primarily to numerous
storm-related catastrophe claims in the first three quarters of the year.
Despite these significant losses, the Company was able to produce a statutory
combined ratio of 99.0% bettering preliminary industry expectations for the year
of 107%.
25
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Continued
Earned premiums increased $7.8 million or 3.4% to $240.3 million. Direct
written premiums for commercial business increased approximately 10.9% from the
same 1995 period. Except for National, the Company's personal lines experienced
no growth in 1996. Contributing to the results in personal lines, was the
introduction of the PRIME of LIFE personal auto and homeowners plan beginning on
a state-by-state basis in late 1995 (the Plan). The Plan focuses on the 50 and
older segment of the personal lines market, a group that has generally produced
more favorable underwriting and retention results for the industry than any
other segment of the personal lines market. The Plan offers a combination of
auto and homeowners discounts and enhanced coverages. As a consequence of moving
existing eligible policyholders to the Plan and reflecting the actuarially
justified discounts, along with conservative underwriting and newer agency
appointments of more commercial lines oriented agencies, personal lines written
premium was flat. The Company remains committed to profitable premium growth as
it is continually reviewing current strategies and developing new programs in
both commercial and personal lines sales. Positively contributing to both
commercial and personal lines sales in 1996, was the Company's entry into its
23rd state of operation, Oklahoma. National, which began operations in the
non-standard personal auto market in 1992, recorded an increase in its direct
written premiums of approximately 43%. During the fourth quarter of 1996,
National began writing business in Arkansas and Georgia and wrote its first
policy in the state of Minnesota in February of 1997 bringing the total number
of its operating states to eight. It anticipates beginning operations in two to
three additional states during 1997.
Net investment income increased $1.3 million or 5.6% to $23.9 million. An
increase in invested assets over the same 1995 period contributed to this
increase. Total amortized cost of invested assets at December 31, 1996 was
$377.0 million compared to $355.4 million at December 31, 1995. The investment
yield decreased to 6.16% from 6.38% in 1995.
Management services income, which includes income generated from investment
and executive management services provided by Stateco and State Auto P&C,
respectively, increased $0.4 million or 5.9% to $8.0 million.
Losses and loss expenses, as a percentage of earned premiums, increased to
72.2% from 68.3% in 1995. During 1996, the Company experienced several
significant weather related catastrophes. Severe winter weather in January and
February, tornado and hailstorms in the Louisville, Kentucky area in May and
storm losses in Raleigh, North Carolina resulting from Hurricane Fran moving
inland in September, increased losses and loss expenses by approximately $16.0
million. The impact of these storms increased this losses and loss expense ratio
6.7 points. Despite these significant losses, the Company continued to record
improvements in its underlying book of business. Automobile, the Company's
largest line of business, showed an improvement in its statutory loss ratio of
69.5%, down from 74.1% in 1995.
Acquisition and operating expenses, as a percentage of earned premiums,
decreased to 28.1% from 29.0% in 1995. The decrease in the ratio for 1996 is due
primarily to the decrease in the amount of Quality Performance Bonus earned by
nearly all permanent employees of the State Auto Companies in 1996 compared to
the same periods in 1995.
Federal income taxes decreased $2.3 million to $7.5 million. This decrease is
reflective of the lower taxable income experienced by the Company in the current
year. The effective tax rate decreased to 25% from 28% in 1995.
26
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Continued
1995 Compared to 1994
- --------------------------------------------------------------------------------
The Company recorded a 74.2% increase in net earnings in 1995 reflecting
substantial improvements in its insurance operations as well as the change in
the pooling percentages. All major lines of insurance experienced an improvement
operationally. The Company produced a statutory combined ratio of 98.7% compared
to industry experience for the year of 106.4%.
Earnings before federal income taxes increased $16.2 million or 85% to $35.3
million. As previously discussed, this improvement in operations reflects the
positive underwriting results and the effect of the change in the pooling
percentages.
Earned premiums increased $56.9 million or 32.4% to $232.5 million primarily
as a result of the change in the pooling arrangement. Absent the impact of this
change, earned premiums increased $10.9 million or 4.9%. Direct written premiums
for commercial lines of business increased approximately 11% from the same
period in 1994. Management believes this increase is attributable to changes in
the structure of the sales organization and an increase in emphasis on
commercial lines of business.
Personal lines of business, except for National's non-standard auto products,
are currently experiencing a period of no real growth. Management believes this
is caused by several factors, including price competition and underwriting
actions taken to both reduce the Company's exposure to natural catastrophes and
to maintain the quality of what it believes to be an improved book of personal
lines business. Management has been emphasizing sales of personal lines by
encouraging personal lines specialists to contact agents directly about personal
lines sales opportunities, reviewing pricing levels, seeking new agency
appointments and introducing new products. For example, in 1995 the Company
appointed 109 new agents and during the fourth quarter launched its PRIME of
LIFE Plan in Ohio, Indiana, Tennessee, and Arkansas. The Plan is designed to
focus on the 50 and older age market by offering a combination of auto and
homeowners discounts and enhanced coverages. The Plan will be introduced in most
of the Company's other operating states in 1996. National began operations in
Kentucky in mid-1995, bringing the total number of states it currently operates
in to five. It anticipates beginning operations in at least two additional
states during 1996.
Net investment income increased $4.9 million or 27.4% to $22.6 million,
primarily due to an increase in invested assets. The increase in invested assets
resulted from the $46.0 million cash transfer to State Auto P&C in connection
with the pooling change and an increase in cash flow from operations. The
investment yield increased slightly to 6.38% from 6.36% for 1994.
Management services income, which includes income generated from investment
and executive services provided by Stateco and State Auto P&C, respectively,
increased $1.5 million or 24.6% to $7.6 million. Services income for 1995
reflects four quarters of income for State Auto P&C, while 1994 reflects only
three quarters as State Auto P&C commenced executive management services April
1, 1994.
Losses and loss expenses, as a percentage of earned premiums, decreased to
68.3% from 74.9% in 1994. The extent of this improvement in the underwriting
operations in its major lines of business is apparent when one considers that
1995 catastrophe losses were only slightly lower than 1994 catastrophe losses.
The Company recorded an improvement in its statutory loss ratio in its largest
line of business, automobile. The statutory loss ratio for automobile in 1995
was 74.1%, down from 76.6% in 1994. The Company's second largest line,
homeowners, produced its best statutory loss ratio in 1995, since going public
in 1991. The statutory loss ratio for homeowners in 1995 was
27
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Continued
73.1% compared to 89.1% for the same period in 1994. Management believes the
improvement in underwriting operations in 1995 is due to the Company's
continuing commitment to sound underwriting and pricing policies.
Acquisition and operating expenses, as a percentage of earned premiums,
increased to 29.0% from 28.4% in 1994. Most of the increase in this percentage
was the increase over 1994 of the amount of Quality Performance Bonus (the
Bonus) that was earned by nearly all permanent employees of the State Auto
Companies in 1995. Performance is measured quarterly and the Bonus is earned if
the State Auto Insurance Company's direct statutory combined ratio is better
than predetermined targets set at the beginning of each fiscal year. The State
Auto Insurance Companies performed better than the targets for each quarter of
1995 whereas in 1994 performance exceeded the targets for only two quarters.
Also contributing to this increase was an increase over 1994 of the amount of
bonus compensation earned by the Company's agents. Each agent shares in the
underwriting profits generated by insurance placed by them. Thus, the
improvement in the underwriting operations of the Company is shared with the
agents who produced the profitable business.
Federal income taxes increased $5.4 million to $9.8 million. This increase is
reflective of higher taxable income experienced by the Company in the current
year. The effective tax rate increased to 28% from 23% in 1994.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity refers to the ability of a company to generate adequate amounts of
cash to meet its needs for both long and short-term cash obligations as they
come due. The Company's significant sources of cash are premiums, investment
income and investments as they mature. The Company continually monitors its
investment and reinsurance programs to ensure they are appropriately structured
to enable the insurance subsidiaries to meet anticipated and unanticipated short
and long-term cash requirements without the need to sell fixed income
investments to meet fluctuations in claim payments.
Net cash provided by operating activities was $22.4 million and $76.4 million
for 1996 and 1995, respectively. This decrease is primarily due to the fact that
on January 1, 1995, $46.0 million was transferred to State Auto P&C, in
connection with the amended pooling arrangement. Also contributing to this
decrease was that in 1996 the Company experienced an increase in its losses and
loss expense payments compared to the same time period in 1995 due to the
significant weather related catastrophes discussed above. Net cash used in
investing activities decreased to $21.2 million from $77.3 million in 1995. This
change is due to the investing of the $46.0 million associated with the pooling
change in 1995. As of December 31, 1996, funds consisting of cash and cash
equivalents available for general operations were $12.9 million compared to
$11.2 million at December 31, 1995.
Effective July 1, 1996, the State Auto Insurance Companies negotiated a
change in their catastrophe reinsurance program. The amount retained by the
State Auto Insurance Companies is $40.0 million for each occurrence, an increase
of $20.0 million over the prior program. For up to $80.0 million in losses,
excess of $40.0 million, traditional reinsurance coverage is provided. To
provide funding if the State Auto Insurance Companies were to incur catastrophe
losses in excess of $120.0 million, State Auto Financial entered into a
structured contingent financing transaction with Chase Manhattan Bank (Chase) to
provide up to $100.0 million for reinsurance purposes. Under this arrangement,
in the event of such a loss, State Auto Financial would sell redeemable
preferred shares to SAF Funding Corporation, a special purpose company (SPC),
which will borrow the money necessary for such
28
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Continued
purchase from Chase and a syndicate of other lenders. State Auto Financial will
contribute to State Auto P&C the proceeds from the sale of its preferred shares.
State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank and
National pursuant to a catastrophe reinsurance agreement in the amount of $100.0
million excess of $120.0 million. State Auto P&C will use the contributed
capital to pay its direct catastrophe losses and losses assumed under the
catastrophe reinsurance agreement. State Auto Financial is obligated to repay
SPC (which will repay the lenders) by redeeming the preferred shares over a six
year period. This layer of $100.0 million in excess of $120.0 million has been
excluded from the pooling agreement as well by virtue of an Amended and Restated
Reinsurance Pooling Agreement.
In addition, State Auto Financial's obligation to repay SPC has been secured
by a Put Agreement among State Auto Financial, Mutual and the Lenders, under
which, in the event of a default by State Auto Financial as described in the
Credit Agreement or in the Put Agreement, Mutual would be obligated to put
either the preferred shares or the loan(s) outstanding.
Effective July 1, 1993, Mutual acquired Milbank. In connection with this
purchase, Mutual and State Auto Financial entered into an Option Agreement
granting State Auto Financial the right to purchase Milbank from Mutual within
five years at a price determined by a formula set out in the Option Agreement.
As of March 4, 1997, State Auto Financial has not exercised its right to acquire
Milbank.
On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest
Security, effective January 1, 1997. In connection with this purchase, Mutual
and State Auto Financial entered into an Option Agreement granting State Auto
Financial the right to purchase Midwest Security from Mutual within five years
at a price determined by a formula set out in the Option Agreement.
The State Auto Insurance Companies' Tennessee office location is currently
leased by Mutual from a third party pursuant to a 10-year lease which expires in
1999. The Boards of Directors of State Auto Financial and Mutual have authorized
State Auto Financial to purchase land and develop an office building for Mutual
to occupy as a tenant of State Auto Financial when the lease expires. No
commitment has been made to acquire land as of March 4, 1997.
The maximum amount of dividends that may be paid to State Auto Financial
during 1997 by its insurance subsidiaries as a non-extraordinary dividend is
limited to $12.3 million, without prior approval under current law. The Company
is required to notify the insurance subsidiaries' respective State Insurance
Commissioner within five business days after declaration of all dividends and at
least ten days prior to payment. Additionally, the domiciliary Commissioner of
each insurer subsidiary has the authority to limit a non-extraordinary dividend
when the Commissioner determines, based on factors set forth in the law, that an
insurer's surplus is not reasonable in relation to the insurer's outstanding
liabilities and adequate to its financial needs. Such restrictions are not
expected to limit the capacity of State Auto Financial to meet its cash
obligations.
The National Association of Insurance Commissioners (NAIC) adopted risk-based
capital requirements for property and casualty insurers effective December 31,
1994. Risk-based capital is a formula that attempts to evaluate the adequacy of
statutory capital and surplus in relation to investment and insurance risks such
as asset quality, loss reserve adequacy and other business factors. Applying the
risk-based capital requirements as of December 31, 1996, each member of the
State Auto Insurance Companies exceeded all standards tested by the formula.
29
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Continued
INVESTMENTS
Stateco performs investment management services on behalf of the Company and
Mutual and its subsidiaries. Investment policies followed by Stateco are set by
each company's Investment Committee of its Board of Directors.
The primary investment objectives are to generate income, preserve capital
and maintain adequate liquidity for the payment of claims. Fixed maturities that
are purchased with the intention and ability of holding them until maturity are
categorized as held to maturity and are carried at amortized cost. Fixed
maturities that may be sold due to changing investment strategies, are
categorized as available for sale and are carried at fair value.
In December 1995, the Company reclassified $84.6 million in fixed maturities
from the held to maturity category to available for sale. This reclassification
was performed in accordance with the Financial Accounting Standards Board (FASB)
Special Report - " A Guide to Implementation of Statement 115 on Accounting for
Certain Investments in Debt and Equity Securities." As of December 31, 1996, the
Company had fixed maturities with a fair value of $294.1 million designated as
available for sale compared to $278.3 million at December 31, 1995.
The Company's investable assets as of December 31, 1996 and 1995 were $397.2
million and $381.0 million, respectively. At December 31, 1996, 96.8% of the
investable assets were in fixed maturities with the remaining 3.2% allocated to
cash and cash equivalents.
As of December 31, 1996, the Company had no fixed maturity investments rated
below investment grade, nor any mortgage loans. The Company does not intend to
change its investment policy on the quality of its fixed maturity investments.
IMPACT OF SIGNIFICANT EXTERNAL CONDITIONS
Inflation can have a significant impact on property and casualty insurers
because premium rates are established before the amounts of losses and loss
expenses are known. When establishing rates, the Company attempts to anticipate
increases from inflation subject to limitations imposed for competitive pricing.
The Company considers inflation when estimating liabilities for losses and
loss expenses, particularly for claims having a long period between occurrence
and settlement. The liabilities for losses and loss expenses are management's
estimates of the ultimate net cost of underlying claims and expenses and are not
discounted for the time value of money. In times of high inflation, the normally
higher yields on investment income may partially offset potentially higher
claims and expenses.
30
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ------- -------------------------------------------
The Consolidated Financial Statements, including the Notes to
Consolidated Financial Statements and the Report of Independent Auditors are as
follows:
31
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
State Auto Financial Corporation
We have audited the accompanying consolidated balance sheets of State Auto
Financial Corporation and subsidiaries as of December 31, 1996 and 1995, and the
related consolidated statements of earnings, stockholders' equity and cash flows
for each of the three years in the period ended December 31, 1996. Our audits
also included the financial statement schedules listed in the Index at Item
14(a)(2). These financial statements and schedules are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and schedules based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of State
Auto Financial Corporation and subsidiaries as of December 31, 1996 and 1995,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 1996, in conformity with
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedules, when considered in relation to the basic
financial statements taken as a whole, present fairly in all material respects
the information set forth therein.
/s/ Ernst and Young LLP
Columbus, Ohio
February 21, 1997
32
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
December 31
-----------
1996 1995
---- ----
Assets (dollars in thousands,
except share data)
Fixed maturities (notes 2 and 3):
Held to maturity, at amortized cost (fair value $91,058 and $93,940,
respectively) ........................................................... $ 90,251 91,529
Available for sale, at fair value (amortized cost $286,790 and $263,821,
respectively) ........................................................... 294,056 278,318
-------- -------
Total investments ............................................................. 384,307 369,847
Cash and cash equivalents ..................................................... 12,868 11,227
Deferred policy acquisition costs ............................................. 15,711 15,866
Accrued investment income and other assets .................................... 13,845 13,168
Net prepaid pension expense (note 8) .......................................... 10,623 9,385
Reinsurance recoverable on losses and loss expenses payable (note 5) .......... 9,691 9,278
Prepaid reinsurance premiums (note 5) ......................................... 3,380 3,170
Property and equipment, at cost, net of accumulated depreciation of $1,265
and $1,164, respectively ................................................... 2,541 2,555
Deferred federal income taxes (note 7) ........................................ 154 --
-------- -------
Total assets .................................................................. $453,120 434,496
-------- -------
- ----------------------------------------------------------------------------------------------------------
Liabilities and Stockholders' Equity
Losses and loss expenses payable (note 4) ..................................... $165,875 170,575
Unearned premiums (note 5) .................................................... 93,884 90,108
Federal income taxes (note 7):
Current .................................................................... 2,076 565
Deferred ................................................................... -- 2,334
Other liabilities ............................................................. 2,903 1,866
Due to affiliates ............................................................. 1,921 796
-------- -------
Total liabilities ............................................................. 266,659 266,244
-------- -------
Commitments and contingencies (notes 5 and 13)
Stockholders' equity (notes 9, 10, and 11):
Class A Preferred stock (nonvoting), 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 30,000,000 shares; 18,135,526
and 18,025,375 shares issued and outstanding, respectively, at stated value
of $5 per share ......................................................... 90,678 90,127
Additional paid-in capital .................................................... 1,456 681
Net unrealized holding gains (note 2) ......................................... 5,179 9,965
Retained earnings ............................................................. 89,148 67,479
-------- -------
Total stockholders' equity .................................................... 186,461 168,252
-------- -------
Total liabilities and stockholders' equity .................................... $453,120 434,496
-------- -------
See accompanying notes to consolidated financial statements.
33
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF EARNINGS
- --------------------------------------------------------------------------------
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands,
except per share amount)
Earned premiums (net of ceded earned premiums of $11,079,
$11,273 and $9,822, respectively) (note 5) .................... $240,345 232,524 175,587
Net investment income (note 2) ................................... 23,879 22,617 17,756
Management services income (note 6) .............................. 8,020 7,574 6,078
Net realized gains on investments (note 2) ....................... 1,401 1,201 1,506
----------------------------------
Total revenues ................................................... 273,645 263,916 200,927
----------------------------------
Losses and loss expenses (net of ceded losses and loss expenses of
$5,429, $4,745 and $4,881, respectively) (notes 4 and 5) ...... 173,540 158,913 131,463
Acquisition and operating expenses ............................... 67,447 67,348 49,834
Other expense, net ............................................... 2,510 2,316 525
----------------------------------
Total expenses ................................................... 243,497 228,577 181,822
----------------------------------
Earnings before federal income taxes ............................. 30,148 35,339 19,105
----------------------------------
Federal income tax expense (benefit) (note 7):
Current ....................................................... 7,457 10,542 3,393
Deferred ...................................................... 89 (745) 1,050
----------------------------------
Total federal income taxes ....................................... 7,546 9,797 4,443
----------------------------------
Net earnings ..................................................... $ 22,602 25,542 14,662
----------------------------------
Weighted average common shares outstanding (note 9a) ............. 18,070 17,956 17,833
----------------------------------
Net earnings per common share (note 9a) .......................... $ 1.25 1.42 .82
----------------------------------
Dividends paid per common share (note 9a) ........................ $ .15 .14 .13
----------------------------------
See accompanying notes to consolidated financial statements.
34
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
- --------------------------------------------------------------------------------
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(in thousands)
Common stock shares (note 9a):
Beginning of year ................................................ 18,025 17,905 17,794
Issuance of common stock ......................................... 110 120 111
-------------------------------------------
End of year ...................................................... 18,135 18,025 17,905
-------------------------------------------
Class A preferred stock:
Beginning and end of year ........................................ $ -- -- --
-------------------------------------------
Class B preferred stock:
Beginning and end of year ........................................ -- -- --
-------------------------------------------
Common stock (note 9a):
Beginning of year ................................................ 90,127 89,523 89,968
Issuance of common stock ......................................... 551 604 555
-------------------------------------------
End of year ...................................................... 90,678 90,127 89,523
-------------------------------------------
Additional paid-in capital (note 9a):
Beginning of year ................................................ 681 273 --
Issuance of common stock ......................................... 775 408 273
-------------------------------------------
End of year ...................................................... 1,456 681 273
-------------------------------------------
Net unrealized holding gains (losses):
Beginning of year ................................................ 9,965 (2,384) 6,511
Change in net unrealized holding gains (losses) (note 2) ......... (4,786) 12,349 (8,895)
-------------------------------------------
End of year ...................................................... 5,179 9,965 (2,384)
-------------------------------------------
Retained earnings (note 9a):
Beginning of year ................................................ 67,479 42,774 28,853
Cash dividends paid .............................................. (933) (837) (741)
Net earnings ..................................................... 22,602 25,542 14,662
-------------------------------------------
End of year ...................................................... 89,148 67,479 42,774
-------------------------------------------
-------------------------------------------
Total stockholders' equity .......................................... $186,461 168,252 130,186
-------------------------------------------
See accompanying notes to consolidated financial statements.
35
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(in thousands)
Cash flows from operating activities:
Net earnings ............................................................. $ 22,602 25,542 14,662
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Depreciation and amortization, net .................................... 764 557 556
Net realized gains on investments ..................................... (1,401) (1,201) (1,506)
Changes in operating assets and liabilities:
Deferred policy acquisition costs .................................. 155 126 1,022
Accrued investment income and other assets ......................... (677) (3,624) (1,980)
Net prepaid pension expense ........................................ (1,238) (894) (1,266)
Reinsurance receivable on losses and loss
expenses payable and prepaid reinsurance premiums ................ (623) 63 126
Other liabilities and due to affiliates, net ...................... 2,162 5,120 (3,544)
Losses and loss expenses payable ................................... (4,700) 1,623 3,193
Unearned premiums .................................................. 3,776 4,558 4,061
Federal income taxes ............................................... 1,600 (1,574) 2,200
-----------------------------------
22,420 30,296 17,524
Cash provided from the change in the reinsurance pool
participation percentage .......................................... -- 46,061 --
-----------------------------------
Net cash provided by operating activities ................................... 22,420 76,357 17,524
-----------------------------------
Cash flows from investing activities:
Purchase of fixed maturities - held to maturity .......................... (9,074) (18,478) (17,469)
Purchase of fixed maturities - available for sale ........................ (124,954) (134,082) (60,650)
Purchase of equity securities ............................................ -- -- (9,379)
Maturities, calls and principal reductions of fixed maturities - held
to maturity ............................................................. 10,111 4,367 11,387
Maturities, calls and principal reductions of fixed maturities - available
for sale ................................................................ 3,624 3,152 6,190
Sale of fixed maturities - available for sale ............................ 99,220 68,158 40,278
Sale of equity securities ................................................ -- -- 17,536
Net additions of property and equipment .................................. (99) (377) (173)
-----------------------------------
Net cash used in investing activities ....................................... (21,172) (77,260) (12,280)
-----------------------------------
Cash flows from financing activities:
Net proceeds from issuance of common stock ............................... 1,326 1,012 828
Payment of dividends ..................................................... (933) (837) (741)
-----------------------------------
Net cash provided by financing activities ................................... 393 175 87
-----------------------------------
Net increase (decrease) in cash and cash equivalents ........................ 1,641 (728) 5,331
-----------------------------------
Cash and cash equivalents at beginning of year .............................. 11,227 11,955 6,624
-----------------------------------
Cash and cash equivalents at end of year .................................... $ 12,868 11,227 11,955
-----------------------------------
See accompanying notes to consolidated financial statements.
36
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of State Auto
Financial Corporation (the Company) and its wholly-owned subsidiaries State Auto
Property and Casualty Insurance Company (State Auto P&C), State Auto National
Insurance Company (National) and Stateco Financial Services, Inc. (Stateco) and
majority-owned subsidiary Strategic Insurance Software, Inc. (SIS). State Auto
Financial Corporation and subsidiaries are referred to herein as "the
Companies." The Company, an Ohio corporation, is a majority-owned subsidiary of
State Automobile Mutual Insurance Company (Mutual). All significant intercompany
balances and transactions have been eliminated in consolidation.
(B) DESCRIPTION OF BUSINESS
The Company, through State Auto P&C, a South Carolina corporation, and
National, an Ohio corporation, provides personal and commercial insurance to its
policyholders, primarily in the eastern half of the United States, excluding New
York, New Jersey, and the New England states through an independent insurance
agency system. The Company's principal lines of business include personal and
commercial automobile, homeowners, commercial multi-peril, workers'
compensation, general liability and fire insurance. State Auto P&C and National
are chartered and licensed as property and casualty insurers in the states of
South Carolina and Ohio, respectively, and are licensed in various other states.
As such, they are subject to the regulations of the Departments of Insurance of
the states of South Carolina and Ohio (collectively, the Departments) and the
regulations of each state in which they operate. State Auto P&C and National
undergo periodic financial examination by the Departments and insurance
regulatory agencies of the states that choose to participate. Through State Auto
P&C, the Company also provides executive management services to its affiliated
insurance companies.
Through Stateco, the Company provides investment management services to
affiliated companies and also provides insurance premium finance services to
customers of State Auto P&C, Mutual and Milbank Insurance Company (Milbank), a
wholly-owned subsidiary of Mutual.
Beginning in July 1995, the Company, through SIS, began developing and selling
software for the processing of insurance transactions, database management for
insurance agents and electronic interfacing of information between insurance
companies and agencies. SIS sells services and products to affiliated companies
and their agents and markets similar services and products to nonaffiliated
insurers and their agencies.
(C) BASIS OF PRESENTATION
The consolidated financial statements have been prepared in conformity with
generally accepted accounting principles, which vary in certain respects from
statutory accounting practices followed by State Auto P&C and National that are
prescribed or permitted by the Departments.
The National Association of Insurance Commissioners (NAIC) currently has a
project to codify statutory accounting practices, the result of which is
expected to constitute the only source of prescribed statutory accounting
practices. Accordingly, that project, expected to be completed in 1998, will
likely change the definitions of what comprises prescribed versus permitted
statutory accounting practices, and may result in changes to the accounting
policies that insurance companies use to prepare their statutory financial
statements.
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the balance sheet, revenues and expenses for the
period then ended and the accompanying notes to the financial statements. Such
estimates and assumptions could change in the future as more information becomes
known which could impact the amounts reported and disclosed herein.
Material estimates that are particularly susceptible to significant change in
the near term relate to the determination of losses and loss expenses payable
and the recoverability of deferred policy acquisition costs. In connection with
the determination of these items, management uses historical data and current
business conditions to formulate estimates including assumptions related to the
ultimate cost to settle claims. These estimates by their nature are subject to
uncertainties for various reasons. The Company's results of operations and
financial condition could be impacted in the future should the ultimate payments
required to settle claims vary from the liability currently provided.
37
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(D) PREMIUM REVENUES
Premiums are recognized as earned using the monthly pro rata method over the
contract period.
(E) DEFERRED POLICY ACQUISITION COSTS
Acquisition costs, consisting of commissions, premium taxes, and certain
underwriting expenses related to the production of property and casualty
business, are deferred and amortized ratably over the contract period. The
method followed in computing deferred policy acquisition costs limits the amount
of such deferred costs to their estimated realizable value. In determining
estimated realizable value, the computation gives effect to the premium to be
earned, losses and loss expenses to be incurred, and certain other costs
expected to be incurred as premium is earned, without credit for anticipated
investment income. These amounts are based on estimates and accordingly, the
actual realizable value may vary from the estimated realizable value. Net
deferred policy acquisition costs were:
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands)
Balance,
beginning of
year................ $15,866 12,521 13,543
Acquisition costs
deferred............ 57,752 57,229 41,430
Amortized to
expense during
the year............ (57,907) (53,884) (42,452)
-----------------------------------
Balance, end
of year............. $15,711 15,866 12,521
-----------------------------------
(F) LOSSES AND LOSS EXPENSES PAYABLE
Losses and loss expenses payable are based on formula and case-basis
estimates for reported claims, and on estimates, based on experience, for
unreported claims and loss expenses. The liability for unpaid losses and loss
expenses, net of estimated salvage and subrogation recoverable of $8,265,000 and
$7,378,000 at December 31, 1996 and 1995, respectively, has been established to
cover the estimated ultimate cost of insured losses. The amounts are necessarily
based on estimates of future rates of inflation and other factors, and
accordingly there can be no assurance that the ultimate liability will not vary
from such estimates. The estimates are continually reviewed and adjusted as
necessary; such adjustments are included in current operations (see note 4).
Salvage and subrogation recoverables are estimated using historical experience.
(G) INVESTMENTS
Investments in fixed maturities, where the Companies have the ability and
intent to hold to maturity, are carried at amortized cost. Accordingly,
unrealized holding gains or losses are not reflected in the accompanying
consolidated financial statements. Investments in fixed maturities held as
available for sale are carried at fair value. The net unrealized holding gains
or losses, net of applicable deferred taxes, are shown as a separate component
of stockholders' equity, and are not included in the determination of net
earnings.
(H) MANAGEMENT SERVICES INCOME
Management services income includes income for executive management services
provided by State Auto P&C and income for investment management services
provided by Stateco. Executive management income is recognized quarterly based
on a percentage of the average adjusted annual statutory surplus of each company
managed. Investment management income is recognized quarterly based on a
percentage of the average fair value of investable assets and the performance of
the equity portfolio of each company managed.
(I) SOFTWARE REVENUE RECOGNITION
SIS recognizes revenue from license fees when the product is delivered and
service revenue when services are performed. Costs of developing and testing new
or enhanced software products are capitalized and are amortized on a
product-by-product basis utilizing the straight-line method over a period not to
exceed three years. Unamortized software development costs of $1,055,000 and
$1,190,000 are included in accrued investment income and other assets at
December 31, 1996 and 1995, respectively. Software amortization, included in
other expenses, was $394,000 and zero in 1996 and 1995, respectively.
38
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(J) FEDERAL INCOME TAXES
The Companies file a consolidated federal income tax return and pursuant to
an agreement, each entity within the consolidated group pays its share of
federal income taxes based on separate return calculations.
Income taxes are accounted for using the liability method. Using this method,
deferred tax assets and liabilities are determined based on differences between
financial reporting and tax bases of assets and liabilities and are measured
using the enacted tax rates and laws that will be in effect when the differences
are expected to reverse.
(K) CASH EQUIVALENTS
For purposes of the statements of cash flows, the Company considers all
highly liquid debt instruments with a maturity of three months or less to be
cash equivalents.
(L) NET EARNINGS PER COMMON SHARE
Net earnings per common share is computed on the basis of the weighted
average number of common shares outstanding during each period. The dilutive
effect of stock options is not material to the computation of net earnings per
common share.
(2) INVESTMENTS
Realized and unrealized gains and losses are summarized as follows:
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands)
Realized gains:
Fixed maturities available for sale .................................. $ 1,793 1,226 980
Equity securities .................................................... -- -- 1,326
---------------------------------
Total realized gains .................................................... 1,793 1,226 2,306
---------------------------------
Realized losses:
Fixed maturities available for sale .................................. $ 392 25 --
Equity securities .................................................... -- -- 800
---------------------------------
Total realized losses ................................................... 392 25 800
---------------------------------
Net realized gains on investments ....................................... $ 1,401 1,201 1,506
---------------------------------
Increase (decrease) in unrealized holding gains or losses -- Fixed
maturities held to maturity .......................................... $(1,604) 5,561 (11,331)
---------------------------------
Decrease in unrealized holding gains or losses -- Equity
securities............................................................ $ -- -- (704)
Increase (decrease) in unrealized holding gains or losses -- Fixed
maturities available for sale at fair value .......................... (7,231) 18,166 (12,981)
Change in deferred unrealized gain ...................................... (132) 833 --
Deferred federal income taxes thereon ................................... 2,577 (6,650) 4,790
---------------------------------
Increase (decrease) in net unrealized holding gains or losses ........... $(4,786) 12,349 (8,895)
---------------------------------
39
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The Company's investments in held to maturity securities and available for sale
securities are summarized as follows:
Gross Gross
Held to maturity at December 31, 1996: Amortized unrealized unrealized Fair
cost holding gains holding losses value
---- ------------- -------------- -----
(dollars in thousands)
U.S. Treasury securities and obligations of U.S.
government corporations and agencies ........ $ 6,728 6 36 6,698
Obligations of states and political subdivisions 7,081 223 12 7,292
Mortgage-backed securities ..................... 76,442 1,167 541 77,068
-----------------------------------------------
Total .......................................... $ 90,251 1,396 589 91,058
-----------------------------------------------
Available for sale at December 31, 1996:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies ........ $ 86,349 1,662 660 87,351
Obligations of states and political subdivisions 188,296 6,415 404 194,307
Corporate securities ........................... 10,133 428 202 10,359
Mortgage-backed securities ..................... 2,012 27 -- 2,039
-----------------------------------------------
Total .......................................... $286,790 8,532 1,266 294,056
-----------------------------------------------
Deferred federal income taxes on the net unrealized holding gain was $2,788,000
at December 31, 1996.
Held to maturity at December 31, 1995:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies ........ $ 4,860 117 -- 4,977
Obligations of states and political subdivisions 7,093 299 -- 7,392
Mortgage-backed securities ..................... 79,576 2,040 45 81,571
-----------------------------------------------
Total .......................................... $ 91,529 2,455 45 93,940
-----------------------------------------------
Available for sale at December 31, 1995:
U.S. Treasury securities and obligations of U.S.
government corporations and agencies ........ $ 82,319 4,041 78 86,282
Obligations of states and political subdivisions 169,431 9,757 28 179,160
Corporate securities ........................... 12,071 817 12 12,876
-----------------------------------------------
Total .......................................... $263,821 14,616 118 278,318
-----------------------------------------------
Deferred federal income taxes on the net unrealized holding gain was $5,366,000
at December 31, 1995.
In December 1995, the Company reclassified from the held to maturity category to
available for sale fixed maturities with an amortized cost of $84,573,000. On
the date of reclassification there was a related unrealized holding gain of
$4,081,000 included in stockholders' equity. This reclassification was recorded
in accordance with the FASB Special Report, "A Guide to Implementation of
Statement 115 on Accounting for Certain Investments in Debt and Equity
Securities."
40
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The amortized cost and fair value of fixed maturities segregated by held to
maturity and available for sale, at December 31, 1996, by contractual maturity,
are summarized as follows:
Held to maturity Available for sale
---------------- ------------------
Amortized Fair Amortized Fair
cost value cost value
---- ----- ---- -----
(dollars in thousands)
Due after 1 year or less........................... $ -- -- 3,513 3,550
Due after 1 year through 5 years................... 2,680 2,665 29,222 30,446
Due after 5 years through 10 years................. 5,041 5,062 164,222 168,119
Due after 10 years................................. 6,088 6,263 87,821 89,902
----------------------------------------------------------
13,809 13,990 284,778 292,017
Mortgage-backed securities......................... 76,442 77,068 2,012 2,039
----------------------------------------------------------
$90,251 91,058 286,790 294,056
----------------------------------------------------------
Expected maturities may differ from contractual maturities because the issuers
may have the right to call or prepay the obligations with or without call or
prepayment penalties.
Fixed maturities with carrying values of approximately $3,890,000 and $5,454,000
were on deposit as required by law or specific escrow agreement at December 31,
1996 and 1995, respectively.
Components of net investment income are summarized as follows:
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands)
Fixed maturities............................................................. $23,578 22,275 17,519
Equity securities............................................................ -- -- 233
Cash and cash equivalents.................................................... 814 850 351
-----------------------------------------
Investment income............................................................ 24,392 23,125 18,103
-----------------------------------------
Investment expenses.......................................................... 513 508 347
-----------------------------------------
Net investment income........................................................ $23,879 22,617 17,756
-----------------------------------------
(3) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in estimating
its fair value disclosures for financial instruments.
Cash and cash equivalents: The carrying amounts reported in the balance
sheet for these instruments approximate their fair value.
Investment securities: Fair values for investments in fixed maturities are
based on quoted market prices, where available. For fixed maturities not
actively traded, fair values are estimated using values obtained from
independent pricing services.
See note 2 for additional fair value disclosures.
41
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(4) LOSSES AND LOSS EXPENSES PAYABLE
Activity in the liability for losses and loss expenses is summarized as
follows:
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands)
Losses and loss expenses payable, net of reinsurance receivables,
at beginning of year......................................................... $161,297 126,742 123,337
Incurred related to:
Current year................................................................. 194,568 171,449 139,211
Prior years.................................................................. (21,028) (12,536) (7,748)
----------------------------------------
Total incurred.................................................................. 173,540 158,913 131,463
----------------------------------------
Paid related to:
Current year................................................................. 116,983 95,011 75,977
Prior years.................................................................. 61,670 62,248 52,081
----------------------------------------
Total paid...................................................................... 178,653 157,259 128,058
----------------------------------------
Impact of pooling change, January 1, 1995 (note 5).............................. -- 32,901 --
----------------------------------------
Losses and loss expenses payable, net of reinsurance receivables,
at end of year............................................................... $156,184 161,297 126,742
----------------------------------------
The liability for losses and loss expenses decreased by $21,028,000 in 1996,
$12,536,000 in 1995 and $7,748,000 in 1994, for claims that had occurred in
prior years. These decreases have resulted primarily from moderating trends in
the frequency and severity of losses and loss expenses due to lower inflation.
This along with fundamental improvements primarily in the auto liability and
workers' compensation lines of business resulted in incurred losses and loss
expenses developing favorably. Because of the nature of the business written
over the years, the Company's management believes that the Company has limited
exposure to environmental claim liabilities.
(5) REINSURANCE
In the ordinary course of business, State Auto P&C assumes and cedes
reinsurance with other insurers and reinsurers and is a member in various pools
and associations. The voluntary arrangements provide greater diversification of
business and limit the maximum net loss potential arising from large risks and
catastrophes. Most of the ceded reinsurance is effected under reinsurance
contracts known as treaties; some is by negotiation on individual risks.
Although the ceding of reinsurance does not discharge the original insurer from
its primary liability to its policyholder, the insurance company that assumes
the coverage assumes the related liability.
Amounts recoverable from reinsurers are estimated in a manner consistent with
the claim liability associated with the reinsured business. The recoverability
of these assets depends on the reinsurers' ability to perform under the
reinsurance agreements. The Company evaluates and monitors the financial
condition and concentrations of credit risk associated with its reinsurers under
voluntary reinsurance arrangements to minimize its exposure to significant
losses from reinsurer insolvencies.
Since January 1, 1987, State Auto P&C has participated in a reinsurance
pooling arrangement with Mutual. The arrangement provides that all premiums,
losses, loss expenses, underwriting expenses, premiums in course of collection
and reinsurance recoverable on loss payments (all transactions and balances in
the underwriting accounts) of the companies be pooled and then allocated to each
company based on percentages outlined in the agreement. During 1994, State Auto
P&C assumed 30% of the pool with 70% retained by Mutual. Effective January 1,
1995, the arrangement was amended to include all of the property and casualty
business of Milbank. Concurrently, with the inclusion of Milbank, the pooling
participation percentages were amended to allocate 35% to State Auto P&C, 55% to
Mutual and 10% to Milbank. In connec-
42
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
tion with the January 1, 1995 change in pooling percentages, State Auto P&C
received approximately $46 million to cover its increased share of pool
liabilities.
Pursuant to the pooling arrangement, Mutual is responsible for the collection
of premiums and payment of losses, loss expenses and underwriting expenses of
the pooled companies. Unpaid balances are reflected in due to or due from
affiliates in the accompanying consolidated balance sheets. Settlements of the
intercompany account are made quarterly. No interest is paid on this account.
All premium balances receivable and reinsurance recoverable on paid losses from
unaffiliated reinsurers are carried by Mutual.
Effective July 1, 1996, the State Auto Insurance Companies (State Auto P&C,
Mutual, Milbank and National) negotiated a change in their catastrophe
reinsurance program. State Auto P&C has assumed catastrophe reinsurance from
Mutual, Milbank and National pursuant to a catastrophe reinsurance agreement in
the amount of $100.0 million excess of $120.0 million. To protect against a
catastrophe loss event in which the State Auto Insurance Companies would incur
catastrophe losses in excess of $120.0 million, the Company entered into a
structured contingent financing transaction with Chase Manhattan Bank (Chase) to
provide up to $100.0 million of additional reinsurance protection. Under this
arrangement, in the event of such a loss, the Company would sell redeemable
preferred shares to SAF Funding Corporation, a special purpose company (SPC),
which will borrow the money necessary for such purchase from Chase and a
syndicate of other lenders. The Company will contribute to State Auto P&C the
proceeds from the sale of its preferred shares. State Auto P&C will use the
contributed capital to pay its direct catastrophe losses and losses assumed
under the catastrophe reinsurance agreement. The Company is obligated to repay
SPC by redeeming the preferred shares over a six year period. This layer of
$100.0 million in excess of $120.0 million has been excluded from the pooling
arrangement pursuant to the terms of the Amended and Restated Reinsurance
Pooling Agreement, also effective July 1996.
In addition, the Company's obligation to repay SPC has been secured by a Put
Agreement among the Company, Mutual and the Lenders, under which, in the event
of a default by the Company, as described in the Credit Agreement or in the Put
Agreement, Mutual would be obligated to put either the preferred shares or the
loan(s) outstanding.
The Company has reported ceded losses and loss expenses payable and prepaid
reinsurance premiums as assets. The amounts reported represent State Auto P&C's
pooling percentage of the total amounts ceded to unaffiliated reinsurers and
National's ceded amounts. All contracts providing indemnification against loss
or liability relating to insurance risk have been accounted for as reinsurance.
Contracts for which it is not clear that the treaty results in the reasonable
possibility that the reinsurer may realize a significant loss from the insurance
risk assumed have been accounted for as deposits.
43
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
The following table summarizes State Auto P&C's direct business, amounts
contributed to the pool and State Auto P&C's participation in the pool:
December 31
-----------
1996 1995
---- ----
(dollars in thousands)
Losses and loss expenses payable:
Direct.................................................................. $161,458 156,624
Assumed (excluding intercompany pooling)................................ 12,734 12,605
Ceded (excluding intercompany pooling).................................. (10,919) (9,432)
-----------------------------
Net amount contributed to the pool................................... 163,273 159,797
-----------------------------
Direct and assumed (intercompany pooling)............................... 160,478 166,512
Ceded (intercompany pooling)............................................ (8,538) (8,508)
-----------------------------
Net participation in the pool........................................ $151,940 158,004
-----------------------------
Unearned premiums:
Direct.................................................................. $101,224 96,726
Assumed (excluding intercompany pooling)................................ 5,236 5,625
Ceded (excluding intercompany pooling).................................. (3,547) (3,907)
-----------------------------
Net amount contributed to the pool................................... 102,913 98,445
-----------------------------
Direct and assumed (intercompany pooling)............................... 86,325 84,684
Ceded (intercompany pooling)............................................ (2,117) (2,241)
-----------------------------
Net participation in the pool........................................ $ 84,208 82,443
-----------------------------
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands)
Earned premiums:
Direct.................................................... $271,435 260,288 247,084
Assumed (excluding intercompany pooling).................. 17,804 22,132 19,209
Ceded (excluding intercompany pooling).................... (14,822) (16,548) (16,848)
-------------------------------------------
Net amount contributed to the pool..................... 274,417 265,872 249,445
-------------------------------------------
Direct and assumed (intercompany pooling)................. 233,560 232,907 180,667
Ceded (intercompany pooling).............................. (8,379) (9,467) (8,994)
-------------------------------------------
Net participation in the pool.......................... 225,181 223,440 171,673
Assumed from affiliates (excluding intercompany pooling).. 1,470 -- --
-------------------------------------------
Total.................................................. $226,651 223,440 171,673
-------------------------------------------
Losses and loss expenses incurred:
Direct.................................................... $210,077 182,975 197,658
Assumed (excluding intercompany pooling).................. 19,673 20,205 17,479
Ceded (excluding intercompany pooling).................... (9,672) (10,404) (10,066)
-------------------------------------------
Net amount contributed to the pool..................... 220,078 192,776 205,071
-------------------------------------------
Direct and assumed (intercompany pooling)................. 167,036 156,299 133,012
Ceded (intercompany pooling).............................. (3,962) (3,855) (4,460)
-------------------------------------------
Net participation in the pool.......................... $163,074 152,444 128,552
-------------------------------------------
44
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
National has a reinsurance agreement with Mutual to cede 20% of its premiums
written and losses and loss expenses incurred to Mutual for liability lines. The
agreement also has a provision for excess of loss coverage, whereby Mutual will
reinsure National for all losses over a prescribed limit for each individual
occurrence. Through Mutual's participation, the effects of the reinsurance
agreement are indirectly subject to the pooling agreement between Mutual and
State Auto P&C.
Amounts related to National's reinsurance agreement that are reported as
assets in the accompanying consolidated balance sheets are summarized as
follows:
December 31
-----------
1996 1995
---- ----
(dollars in thousands)
Losses and loss expenses payable.......................... $1,153 769
Unearned premiums......................................... 1,263 928
The effects of the agreement on the indicated income and expense accounts are
summarized as follows:
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands)
Earned premiums............................... $2,700 1,806 828
Losses and loss expenses incurred............. 1,467 890 421
(6) TRANSACTIONS WITH MUTUAL
A management fee was paid to Mutual by the Company pursuant to a management
agreement. Such fee amounted to $40,000 in 1994, which is included in
acquisition and operating expenses in the accompanying consolidated statements
of earnings.
Effective April 1, 1994, State Auto P&C began providing Mutual and its
insurance affiliates executive management services to oversee the insurance
operations of these companies. Fees relating to these services amounted to
$4,956,000 in 1996, $4,662,000 in 1995 and $3,221,000 in 1994.
Stateco provides Mutual and its affiliates investment management services.
Fees related to these services amounted to $3,064,000 in 1996, $2,912,000 in
1995 and $2,857,000 in 1994.
Effective July 1, 1995, SIS began providing insurance software products and
services to Mutual and its affiliates. Fees relating to these services amounted
to $1,015,000 in 1996 and $423,000 in 1995 and is included in other income.
State Auto P&C's December 31, 1990 liability for losses and loss expenses of
$65,464,000 has been guaranteed by Mutual. Pursuant to the guaranty agreement,
all ultimate adverse development of the December 31, 1990 liability, if any, is
to be reimbursed by Mutual to State Auto P&C. As of December 31, 1996, there has
been no adverse development of the liability.
45
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(7) FEDERAL INCOME TAXES
A reconciliation between actual federal income taxes and the amount computed
at the indicated statutory rate is as follows:
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
Amount % Amount % Amount %
------ - ------ - ------ -
(dollars in thousands, except percentages)
Amount at statutory rate................................... $10,552 35 12,369 35 6,687 35
Tax-free interest and dividends received deduction......... (3,051) (10) (2,812) (8) (2,265) (12)
Other, net................................................. 45 -- 240 1 21 --
---------------------------------------------------------------
Effective tax rate......................................... $7,546 25 9,797 28 4,443 23
---------------------------------------------------------------
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and deferred tax liabilities at December 31,
1996 and 1995 are presented below:
1996 1995
---- ----
(dollars in thousands)
Deferred tax assets:
Unearned premiums not deductible........................................................... $ 6,336 6,086
Losses and loss expenses payable discounting............................................... 5,686 5,923
Other...................................................................................... 871 804
--------------------------
Total deferred tax assets.............................................................. 12,893 12,813
--------------------------
Deferred tax liabilities:
Deferral of policy acquisition costs....................................................... 5,499 5,553
Net pension expense........................................................................ 3,718 3,284
Unrealized holding gain on investments..................................................... 2,788 5,366
Other...................................................................................... 734 944
--------------------------
Total deferred tax liabilities......................................................... 12,739 15,147
--------------------------
Net deferred tax assets (liabilities)..................................................$ 154 (2,334)
--------------------------
The Company is required to establish a valuation allowance for any portion of
the deferred tax asset that management believes will not be realized. In the
opinion of management, it is more likely than not that the Company will realize
the benefit of the deferred tax assets, and, therefore, no such valuation
allowance has been established.
Federal income taxes paid during 1996, 1995 and 1994 were $5,883,000,
$11,371,000 and $2,200,000, respectively.
46
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(8) BENEFIT PLANS
State Auto P&C, Stateco and SIS, pursuant to an intercompany agreement, are
participants, together with Mutual, in a defined benefit pension plan that
covers substantially all employees of Mutual, State Auto P&C, Stateco and SIS.
The assets of the plan are represented primarily by U.S. government and agency
obligations, bonds, and common stocks. Mutual, State Auto P&C, Stateco and SIS's
policy is to fund pension costs in accordance with the requirements of the
Employee Retirement Income Security Act of 1974. Benefits are determined by
applying factors specified in the plan to a participant's defined average annual
compensation.
Information regarding the funded status and net periodic pension cost for State
Auto P&C, Stateco and SIS's participation in the plan is as follows:
December 31
-----------
1996 1995
---- ----
(dollars in thousands)
Accumulated benefit obligation:
Vested.............................................................. $(30,473) (28,190)
Nonvested........................................................... (237) (247)
---------------------------
$(30,710) (28,437)
---------------------------
Projected benefit obligation (PBO) for services rendered to date....... $(31,049) (29,352)
Plan assets at fair value.............................................. 43,963 38,653
---------------------------
Plan assets in excess of PBO........................................... 12,914 9,301
Unrecognized net gain.................................................. (2,775) (394)
Unrecognized net assets at end of period............................... (1,330) (1,450)
Unrecognized prior service cost........................................ 1,814 1,928
---------------------------
Net prepaid pension expense............................................ $ 10,623 9,385
---------------------------
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands)
Net periodic pension cost consists of the following:
Service cost (benefits earned during the period) ................... $ 1,191 952 905
Interest cost on PBO ............................................... 2,116 2,059 1,468
Actual return on plan assets ....................................... (3,334) (2,907) (2,359)
Net amortization and deferral ...................................... (7) (7) (65)
--------------------------------------
Net periodic pension (benefit) expense ................................ $ (34) 97 (51)
--------------------------------------
The actuarial assumptions used in these calculations are as follows:
1996 1995 1994
---- ---- ----
Weighted average discount rate ........................................ 7.25% 7.25% 8.50%
Rates of increase in compensation levels .............................. 4.50% 4.50% 5.50%
Expected long-term rate of return on assets ........................... 9.00% 9.00% 9.00%
State Auto P&C, Stateco and SIS are also participants with Mutual in a
defined contribution plan that covers substantially all employees of Mutual,
State Auto P&C, Stateco and SIS. Contributions to the plan are based on employee
contributions and the level of Company match. State Auto P&C, Stateco and SIS's
share of the expense under the plan totaled $534,000, $496,000 and $371,000 for
the years 1996, 1995 and 1994, respectively.
47
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(9) STOCKHOLDERS' EQUITY
(A) STOCK SPLIT
On May 30, 1996, the Board of Directors approved a three-for-two common stock
split to be effected in the form of a stock dividend, which has been given
retroactive effect. Fractional shares were paid in cash.
(B) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION
State Auto P&C and National are subject to regulations and restrictions under
which payment of dividends from statutory surplus can be made to the Company
during the year without prior approval of regulatory authorities. Pursuant to
these rules, approximately $12.3 million is available for payment to the Company
in 1997 without prior approval.
Reconciliations of statutory capital and surplus and net income or loss, as
determined using statutory accounting practices, to the amounts included in the
accompanying consolidated financial statements are as follows:
December 31
-----------
1996 1995
---- ----
(dollars in thousands)
Statutory capital and surplus of insurance subsidiaries....................................... $126,742 107,858
Net assets of noninsurance parent and affiliate............................................... 11,870 8,872
--------------------------
138,612 116,730
Add (subtract) cumulative effect of adjustments:
Deferred policy acquisition costs.......................................................... 15,711 15,866
Losses and loss expenses payable........................................................... 8,265 7,378
Net prepaid pension expense................................................................ 10,583 9,330
Deferred federal income taxes.............................................................. 205 (2,265)
Excess of statutory loss liabilities over case basis amounts............................... 4,199 5,283
Fixed maturities at fair value............................................................. 7,978 15,192
Other, net................................................................................. 908 738
--------------------------
Stockholders' equity per accompanying consolidated
financial statements................................................................... $186,461 168,252
--------------------------
Year ended December 31
----------------------
1996 1995 1994
---- ---- ----
(dollars in thousands)
Statutory net income of insurance subsidiaries............................... $18,336 14,652 13,113
Net earnings of noninsurance parent and affiliate............................ 2,301 2,406 2,255
--------------------------------------------
20,637 17,058 15,368
Increases (decreases):
Deferred policy acquisition costs......................................... (155) 3,345 (1,022)
Losses and loss expenses payable.......................................... 887 2,242 365
Net prepaid pension expense............................................... 1,253 2,012 851
Deferred federal income taxes............................................. (56) 782 (1,058)
Other, net................................................................ 36 103 158
--------------------------------------------
Net earnings per accompanying consolidated
financial statements................................................... $22,602 25,542 14,662
--------------------------------------------
48
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(10) PREFERRED STOCK
The Company has authorized two classes of preferred stock. For both classes,
upon issuance, the Board of Directors has authority to fix and determine the
significant features of the shares issued, including, among other things, the
dividend rate, redemption price, redemption rights, conversion features and
liquidation price payable in the event of any liquidation, dissolution, or
winding up of the affairs of the Company.
The Class A preferred stock is not entitled to voting rights until, for any
period, dividends are in arrears in the amount of six or more quarterly
dividends.
(11) STOCK INCENTIVE PLANS
The Company follows Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees" (APB 25), and related Interpretations in
accounting for its stock incentive plans. Under APB 25, because the exercise
price of the Company's employee stock options equals the market price of the
underlying stock on the date of grant, no compensation expense is recognized.
Had compensation cost for the Company's plans been determined based on the fair
values at the grant dates consistent with the method of SFAS No. 123,
"Accounting for Stock-Based Compensation," (SFAS No. 123), the Company's pro
forma net earnings and net earnings per share information would have been as
follows:
1996 1995
---- ----
(in thousands, except
per share figures)
Pro forma net earnings ......................... $ 21,760 $ 24,533
Pro forma net earnings per share ............... $ 1.20 $ 1.37
The Company has stock option plans for certain directors and key employees of
Mutual, State Auto P&C, Stateco and SIS. The nonemployee directors' plan
provides each nonemployee director an option to purchase 1,000 shares of common
stock following each annual meeting of the shareholders at an option price equal
to the fair market value at the last business day prior to the annual meeting.
The Company has reserved 150,000 shares of common stock under this plan. These
options are exercisable at issuance to 10 years from date of grant. The key
employee's plan provides that qualified stock options may be granted at an
option price not less than fair market value at date of grant and that
nonqualified stock options may be granted at any price determined by the options
committee of the Board of Directors. The Company has reserved 1,800,000 shares
of common stock under this plan. These options are exercisable from 1 to 10
years from date of grant.
The fair value of these options utilized in the pro forma information above
were estimated at the date of grant using the Black-Scholes option-pricing model
with the following weighted-average assumptions for 1996 and 1995, respectively:
dividend yield of 1.0% for both years; expected volatility factors of .23 and
.22; risk-free interest rates of 6.6% and 7.3%; and expected life of the option
of 8 for both years.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
49
A summary of the Company's stock option activity and related information for
these plans for the years ended December 31, 1996, 1995 and 1994, follows:
1996 1995 1994
---------------------------- -------------------------------- -----------------------------
Weighted - Average Weighted - Average Weighted - Average
Options Exercise Price Options Exercise Price Options Exercise Price
------- -------------- ------- -------------- ------- --------------
(numbers in thousands, except per share figures)
Outstanding, beginning
of year 950 $8.33 684 $7.12 674 $7.09
Granted 217 14.72 292 11.03 10 9.34
Exercised (36) 7.76 (23) 6.64 -- --
Cancelled -- -- (3) 8.83 -- --
----- --- ---
Outstanding, end of year 1,131 $9.57 950 $8.33 684 $7.12
----- --- ---
Weighted - average fair
value of options granted
during the year: $5.81 $4.52 N/A
A summary of information pertaining to options outstanding and exercisable as of
December 31, 1996 follows:
Options Outstanding Options Exercisable
----------------------------------------------------- ------------------------------
Weighted - Average
Remaining Weighted - Average Weighted - Average
Range of Exercise Prices Number Contractual Life Exercise Price Number Exercise Price
------------------------ ------ ---------------- -------------- ------ --------------
(numbers in thousands, except per share figures)
Less than $8.50 263 4.9 years $ 4.74 263 $4.74
Greater than $8.50 868 7.7 11.04 664 9.95
----- ---
1,131 927
----- ---
The Company has an employee stock purchase plan with a dividend reinvestment
feature, under which employees of Mutual, State Auto P&C, Stateco and SIS 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 1,200,000 shares of
common stock under this plan. At December 31, 1996, 568,652 shares have been
purchased under this plan. Compensation expense is recognized for the fair value
of the employee's purchase rights, which was estimated using the Black-Scholes
model with the following weighted-average assumptions for 1996 and 1995,
respectively: dividend yield of 1.0% for both years; expected volatility of .24
for both years; risk-free interest rates of 6.5% and 6.4%; and expected lives of
6 months for both years. The weighted-average fair value of those purchase
rights granted in 1996 and 1995 was $3.52 and $2.92, respectively.
50
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
(12) QUARTERLY FINANCIAL DATA (UNAUDITED)
For three months ended
----------------------
March 31, June 30, September 30, December 31,
--------- -------- ------------- ------------
1996
----
(dollars in thousands, except per share amounts)
Total revenues.......................................... $67,332 68,375 68,491 69,447
Earnings before federal income taxes.................... 7,681 6,667 4,530 11,270
Net earnings ........................................... 5,607 4,850 3,660 8,485
Net earnings per common share (note 9a)................. .31 .27 .20 .47
---------------------------------------------------------------
For three months ended
----------------------
March 31, June 30, September 30, December 31,
--------- -------- ------------- ------------
1995
----
(dollars in thousands, except per share amounts)
Total revenues.......................................... $64,447 66,363 66,430 66,676
Earnings before federal income taxes.................... 9,403 8,895 8,289 8,752
Net earnings ........................................... 6,891 6,234 6,459 5,958
Net earnings per common share (note 9a)................. .38 .35 .36 .33
---------------------------------------------------------------
(13) CONTINGENCIES
State Auto P&C and National are involved in litigation and may become
involved in potential litigation arising in the ordinary course of business. In
the opinion of management, the effects, if any, of such litigation are not
expected to be material to the consolidated financial statements.
51
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
- ------- ---------------------------------------------------------------
FINANCIAL DISCLOSURE
--------------------
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
- -------- --------------------------------------------------
Information required under this Item with respect to directors will be
contained in the Company's proxy statement to be filed within 120 days of
December 31, 1996, and is hereby incorporated herein by reference.
Information required under this Item with respect to executive officers
is contained under the heading "Executive Officers of the Registrant" in Item 1
of this Form 10-K report.
ITEM 11. EXECUTIVE COMPENSATION
- -------- ----------------------
Information required under this Item will be contained in the Company's
proxy statement to be filed within 120 days of December 31, 1996, and is hereby
incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
- -------- --------------------------------------------------------------
Information required under this Item will be contained in the Company's
proxy statement to be filed within 120 days of December 31, 1996, and is hereby
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- -------- ----------------------------------------------
Information required under this Item will be contained in the Company's
proxy statement to be filed within 120 days of December 31, 1996, and is hereby
incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
- -------- ---------------------------------------------------------------
(a)(1) LISTING OF FINANCIAL STATEMENTS
-------------------------------
The following consolidated financial statements of the Company, are
filed as part of this Form 10-K Report and are included in Item 8:
Report of Independent Auditors
Consolidated Balance Sheets as of
December 31, 1996 and 1995
Consolidated Statements of Earnings for
each of the three years in the
period ended December 31, 1996
Consolidated Statements of Stockholders' Equity for each of
the three years in the period ended December 31, 1996
Consolidated Statements of Cash Flows for each of the three
years in the period ended December 31, 1996
Notes to Consolidated Financial Statements
52
(a)(2) LISTING OF FINANCIAL STATEMENT SCHEDULES
----------------------------------------
The following financial statement schedules of the Company for the
years 1996, 1995, and 1994 are included in Item 14(d), following
the signatures, and should be read in conjunction with the
consolidated financial statements contained in this Form 10-K
Annual Report.
Schedule
Number Schedule
- ------ --------
I. Summary of Investments - Other Than
Investments in Related Parties
II. Condensed Financial Information of Registrant
IV. Reinsurance
VI. Supplemental Information Concerning Property -
Casualty Insurance Operations
Independent Auditors' Consent (filed as Exhibit 23).
All other schedules are omitted because they are not applicable or
the required information is included in the consolidated financial
statements or notes thereto.
53
(a)(3) LISTING OF EXHIBITS
-------------------
If incorporated by reference document
which Exhibit was previously filed
Exhibit No. Description of Exhibit with SEC
- ----------- ---------------------- -------------------------------------
3(A)(1) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No.
Articles of Incorporation 33-40643 on Form S-1 (see Exhibit 3(a)
therein)
3(A)(2) State Auto Financial Corporation's Amendment to the 1933 Act Registration Statement No.
Amended and Restated Articles of Incorporation 33-89400 on Form S-8 (see Exhibit 4(b)
therein)
3(B) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No.
Code of Regulations 33-40643 on Form S-1 (see Exhibit 3(b)
therein)
4 State Auto Financial Corporation's Amended and Restated See Exhibit 3(A) and 3(B)
Articles of Incorporation, and Articles 1, 3, 5 and 9 of
the Company's Amended and Restated Code of Regulations
10(A) Reinsurance Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and Southern Home Insurance Company, 33-40643 on Form S-1 (see Exhibit 10(a)
now known as State Auto Property and Casualty Insurance therein)
Company, dated January 1, 1987
10(B) Amendment Number 1 effective January 1, 1992 to Form 10-K Annual Report for the year
Reinsurance Agreement between State Automobile Mutual ended December 31, 1991 (see Exhibit 10
Insurance Company and State Auto Property and Casualty (B) therein)
insurance Company formerly known as Southern Home
Insurance Company, effective as of January 1, 1987
10(C) Amendment Number 2 dated as of December 1, 1993 to the Form 10-K Annual Report for the year
Reinsurance Agreement between State Automobile Mutual ended December 31, 1993 (see Exhibit 10
Insurance Company and State Auto Property and Casualty (C) therein)
Insurance Company formerly known as Southern Home
Insurance Company, effective as of January 1, 1987
10(D) Amendment Number 3 dated as of December 1, 1994 Form 10-K Annual Report for the year
effective as of January 1, 1995 to the Reinsurance ended December 31, 1994 (see Exhibit
Agreement between State Automobile Mutual Insurance 10(D) therein)
Company and State Auto Property and Casualty Insurance
Company
10(E)* Amended and Restated Management Agreement among State Form 10-K Annual Report for the year
Automobile Mutual Insurance Company, State Auto Property ended December 31, 1994 (see Exhibit
and Casualty Insurance Company, State Auto National 10(E) therein)
Insurance Company, State Auto Financial Corporation, State
Auto Life Insurance Company, and Milbank effective April
1, 1994 as approved by insurance regulatory officials in
Ohio, South Carolina and South Dakota
10(F)* Amendment Number 1-A to the Amended and Restated Form 10-K Annual Report for the year
Management Agreement among State Automobile Mutual ended December 31, 1994 (see Exhibit
Insurance Company, State Auto Property and Casualty 10(F) therein)
Insurance Company, State Auto National Insurance Company,
State Auto Financial Corporation, State Auto Life
Insurance Company and Milbank Insurance Company effective
as of January 1, 1995
10(G) Guaranty Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and State Auto Property and Casualty 33-40643 on Form S-1 (see Exhibit 10(d)
Insurance Company dated as of May 16, 1991 therein)
<FN>
- ---------------------------------
*Constitutes either a management contract or a compensatory plan or arrangement
required to be filed as an Exhibit
54
10(H) Form of Indemnification Agreement between State Auto 1933 Act Registration Statement No.
Financial Corporation and each of its directors 33-40643 on Form S-1 (see Exhibit 10
(e) therein)
10(I)* State Auto 1991 Quality Performance Bonus Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10 (f)
therein)
10(J)* Non-Qualified Deferred Compensation Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10 (g)
therein)
10(K)* 1991 Stock Option Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10 (h)
therein)
10(L)* Amendment Number 1 to the 1991 Stock Option Plan 1933 Act Registration Statement No.
33-89400 on Form S-8 (see Exhibit 4 (a)
therein)
10(M)* 1991 Directors' Stock Option Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10 (i)
therein)
10(N) Lease Agreement between Longhollow Associates Limited 1933 Act Registration Statement No.
Partnership and State Automobile Mutual Insurance 33-40643 on Form S-1 (see Exhibit 10
Company dated July 8, 1988, as amended (j) therein)
10(O) License Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and Policy Management Systems 33-40643 on Form S-1 (see Exhibit 10
Corporation dated December 28, 1984 (k) therein)
10(P) Investment Management Agreement between Stateco Form 10-K Annual Report for the year
Financial Services, Inc. and State Automobile Mutual ended December 31, 1992 (see Exhibit 10
Insurance Company, effective April 1, 1993 (N) therein
10(Q) Option Agreement between State Automobile Mutual Form 10-K Annual Report for year ended
insurance Company and State Auto Financial Corporation December 31, 1993 (see Exhibit 10(R)
dated as of August 20, 1993 therein)
10(R)* Supplemental Executive Retirement Income Plan effective Form 10-K Annual Report for the year
December 1, 1992 ended December 31, 1992 (see Exhibit
10(O) therein)
10(S)* State Auto Insurance Companies Directors' Deferred Form 10-K Annual Report for year ended
Compensation Plan December 31, 1995 (see Exhibit 10(S)
therein)
10(T)* State Auto Insurance Companies Non-Qualified Incentive Form 10-K Annual Report for year ended
Deferred Compensation Plan December 31, 1995 (see Exhibit 10(T)
therein)
10(U)* Strategic Insurance Software, Inc. 1995 Stock Option Plan Form 10-K Annual Report for year ended
December 31, 1995 (see Exhibit 10(U)
therein)
10(V)* Strategic Insurance Software, Inc. Warrant to purchase Form 10-K Annual Report for year ended
common stock December 31, 1995 (see Exhibit 10(V)
therein)
10(W* Strategic Insurance Software, Inc. Shareholder's Form 10-K Annual Report for year ended
Agreement December 31, 1995 (see Exhibit 10(W)
therein)
10(X)* Robert L. Bailey Employment Contract Form 10-K Annual Report for year ended
December 31, 1995 (see Exhibit 10(X)
therein)
<FN>
- ---------------------------
*Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit
55
10(Y) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended
between State Automobile Mutual Insurance Company, State September 30, 1996 (see Exhibit 10(Y)
Auto Property and Casualty Insurance Company and Milbank therein)
Insurance Company effective July 1, 1996
10(Z) Property Catastrophe Overlying Excess of Loss Form 10-Q for the period ended
Reinsurance Contract between State Automobile Mutual September 30, 1996 (see Exhibit 10(Z)
Insurance Company, Milbank Insurance Company, State Auto therein)
National Insurance Company and State Auto Property and
Casualty Insurance Company dated July 1,1996
10(AA) Credit Agreement between SAF Funding Corporation and Form 10-Q for the period ended
The Chase Manhattan Bank dated August 16, 1996 September 30, 1996
(see Exhibit 10(AA) therein)
10(BB) Put Agreement between State Automobile Mutual Insurance Form 10-Q for the period ended
Company, State Auto Financial Corporation and The Chase September 30, 1996 (see Exhibit 10(BB)
Manhattan Bank dated August 16, 1996 therein)
10(CC) Standby Purchase Agreement between State Auto Financial Form 10-Q for the period ended
Corporation and SAF Funding Corporation dated August 16, September 30, 1996 (see Exhibit 10(CC)
1996
therein)
10(DD)* Amendment Number 2 to the 1991 Stock Option Plan Included Herein
10(EE)* Amendment Number 1 to the 1991 Directors' Stock Option Included Herein
Plan
10(FF) Option Agreement between State Auto Mutual and State Included Herein
Auto Financial dated March 11, 1997.
11 Statement regarding computation of earnings per share Form 10-K Annual Report for the year ended
December 31, 1995 (see Exhibit 11
therein)
21 List of Subsidiaries of State Auto Financial Corporation Form 10-K Annual Report for the year ended
December 31, 1995 (see Exhibit 22
therein)
23 Consent of Independent Auditors Included Herein
24 Powers of Attorney - John R. Lowther, David L. Form 10-K Annual Report for the year
Bickelhaupt, Paul W. Huesman, George R. Manser and ended December 31, 1991 (see Exhibit 25
Robert J. Murchake therein)
24(A) Power of Attorney - William J. Lhota Form 10-K Annual Report for the year
ended December 31, 1994 (see Exhibit
25(A) therein)
24(B) Power of Attorney - David J. D'Antoni Form 10-K Annual Report for the year
ended December 31, 1995 (see Exhibit
25(B) therein)
27 Financial Data Schedule Included Herein
<FN>
- ------------------
* Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit
No other exhibits are required to be filed herewith pursuant
to Item 601 of regulation S-K.
(b) REPORTS ON FORM 8-K
-------------------
The Company did not file any Form 8-K current reports during
the fourth quarter of the Company's fiscal year ended December
31, 1996.
56
(c) EXHIBITS
--------
The exhibits have been submitted as a separate section of this
report following the financial statement schedules.
(d) FINANCIAL STATEMENT SCHEDULES
-----------------------------
The financial statement schedules have been submitted as a
separate section of this report following the signatures.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
STATE AUTO FINANCIAL CORPORATION
Dated: March 28, 1997 /s/Robert L. Bailey
----------------------------------------
Robert L. Bailey, Chairman
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed by the following persons on behalf of the Registrant
and in the capacities and on the dates indicated.
Name Title Date
---- ----- ----
/s/ Robert L. Bailey Chairman of the Board March 28, 1997
- ----------------------- Chief Executive Officer
Robert L. Bailey and Director (principal
executive officer)
/s/ Urlin G. Harris, Jr. Chief Financial Officer, March 28, 1997
- ----------------------- Executive Vice President,
Urlin G. Harris, Jr. Treasurer and Director
(principal financial officer
and principal accounting
officer)
John R. Lowther* Secretary and Director March 28, 1997
- -----------------------
John R. Lowther
David L. Bickelhaupt* Director March 28, 1997
- -----------------------
David L. Bickelhaupt
Paul W. Huesman* Director March 28, 1997
- -----------------------
Paul W. Huesman
57
George R. Manser* Director March 28, 1997
- -----------------------
George R. Manser
Robert J. Murchake* Director March 28, 1997
- -----------------------
Robert J. Murchake
William J. Lhota* Director March 28, 1997
- -----------------------
William J. Lhota
David J. D'Antoni* Director March 28, 1997
- -----------------------
David J. D'Antoni
*Urlin G. Harris, Jr., by signing his name hereto, does sign this
document on behalf of the person indicated above pursuant to a Power of Attorney
duly executed by such person.
/s/ Urlin G. Harris, Jr. March 28, 1997
- -----------------------
Urlin G. Harris, Jr.,
Attorney in Fact
58
Item 14(d)
Financial Statement Schedules
59
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I(a) - SUMMARY OF INVESTMENTS - OTHER THAN
INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1996
Column A Column B Column C Column D
-------- -------- -------- --------
Held to maturity Amount at
which shown
in the
Type of Investment Cost Value balance sheet
------------------ ---- ----- -------------
(in thousands)
Fixed maturities:
Bonds:
United States Government and
government agencies and authorities $83,170 $83,766 $83,170
States, municipalities and
political subdivisions 7,081 7,292 7,081
------- ------- -------
Total fixed maturities $90,251 $91,058 $90,251
======= ======= =======
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE I(b) - SUMMARY OF INVESTMENTS - OTHER THAN
INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 1996
Column A Column B Column C Column D
-------- -------- -------- --------
Available for sale Amount at
which shown
in the
Type of Investment Cost Value balance sheet
------------------ ---- ----- -------------
(in thousands)
Fixed maturities:
Bonds:
United States Government and
government agencies and authorities $88,361 $89,390 $89,390
States, municipalities and
political subdivisions 188,296 194,307 194,307
Public utilities 8,094 8,126 8,126
All other corporate bonds 2,039 2,233 2,233
======== ======== ========
Total fixed maturities $286,790 $294,056 $294,056
======== ======== ========
60
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
Condensed Balance Sheets
December 31
------------------------------------
ASSETS 1996 1995
(dollars in thousands)
Investments in common stock of subsidiaries
(equity method) $184,787 $167,734
Cash 731 361
Other assets 755 461
Federal income tax benefit 461 158
-------- --------
Total assets $186,734 $168,714
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Due to affiliates $173 $413
Accrued expenses 100 49
-------- --------
Total liabilities 273 462
STOCKHOLDERS' EQUITY
Class A Preferred stock (nonvoting), 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
30,000,000 shares; issued and outstanding
18,135,526 and 18,025,375 shares issued
and outstanding, respectively, at stated
value of $5 per share 90,678 90,127
Additional paid-in capital 1,456 681
Net unrealized holding gains of subsidiaries 5,179 9,965
Retained earnings 89,148 67,479
-------- --------
Total stockholders' equity 186,461 168,252
-------- --------
Total liabilities and stockholders' equity $186,734 $168,714
======== ========
61
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT, CONTINUED
Condensed Statements of Earnings
Year ended December 31
----------------------------------------------
1996 1995 1994
---- ---- ----
(in thousands)
Investment income $30 $16 $12
-------- -------- --------
Total revenue 30 16 12
-------- -------- --------
Total operating expenses 1,074 475 393
-------- -------- --------
Earnings before federal income taxes (1,044) (459) (381)
Federal income tax benefit (405) (147) (133)
Net earnings before equity in undistributed
-------- -------- --------
net earnings of subsidiaries (639) (312) (248)
Equity in undistributed net earnings of subsidiaries 23,241 25,854 14,910
======== ======== ========
Net earnings $22,602 $25,542 $14,662
======== ======== ========
62
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT, CONTINUED
Condensed Statements of Cash Flows
Year Ended December 31
------------------------------------
1996 1995 994
(in thousands)
Cash flows from operating activities:
Net earnings $22,602 $25,542 $14,662
-------- -------- --------
Adjustments to reconcile net earnings to
net cash used in operating activities:
Equity in undistributed earnings of subsidiaries (23,241) (25,854) (14,910)
Change in accrued expenses and due to affiliates (188) 403 (10)
Change in other assets (294) (391) 20
Change in federal income taxes (303) (25) 22
-------- -------- --------
Net cash used in operating activities (1,424) (325) (216)
-------- -------- --------
Cash flows from investing activities:
Capitalization of subsidiary (5,000) (952) --
Dividends received from subsidiaries 6,402 1,000 --
-------- -------- --------
Net cash provided by investing activities 1,402 48 0
-------- -------- --------
Cash flows from financing activities:
Net proceeds from issuance of common stock 1,325 1,012 829
Payment of dividends (933) (837) (741)
-------- -------- --------
Net cash provided by (used in) financing activities 392 175 88
-------- -------- --------
Net increase (decrease) in cash and invested cash 370 (102) (129)
-------- -------- --------
Cash and cash equivalents at beginning of year 361 463 592
-------- -------- --------
Cash and cash equivalents at end of year $731 $361 $463
======== ======== ========
Supplemental Disclosures:
- -------------------------
Federal income taxes received ($165) ($123) ($155)
======== ======== ========
63
STATE AUTO FINANCIAL CORPORATION
SCHEDULE IV - REINSURANCE
Years Ended December 31, 1996, 1995 and 1994
(in thousands, except percentages)
Column A Column B Column C Column D Column E Column F
-------- -------- -------- -------- -------- --------
Percentage
Ceded to Assumed from of amount
Outside Affiliated Outside Affiliated assumed
Gross Amount Companies Companies(1) Companies Companies(1) Net Amount to net(2)
------------ --------- ------------ --------- ------------ ---------- ---------
Year ended 12-31-96
property-casualty earned premiums $287,828 $14,822 $277,116 $17,804 $226,651 $240,345 7.4%
Year ended 12-31-95
property-casualty earned premiums $271,177 $16,548 $267,677 $22,132 $223,440 $232,524 9.5%
Year ended 12-31-94
property-casualty earned premiums $251,828 $16,849 $250,274 $19,209 $171,673 $175,588 10.9%
<FN>
- --------------
(1) These columns include the effect of intercompany pooling.
(2) Calculated as earned premiums assumed from outside companies to net amount.
64
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
SCHEDULE VI - SUPPLEMENTAL INFORMATION CONCERNING
PROPERTY-CASUALTY INSURANCE OPERATIONS
Years Ended December 31, 1996, 1995 and 1994
(in thousands)
Column A Column B Column C Column D Column E Column F
-------- -------- -------- -------- -------- --------
Deferred Policy Losses and Discount, if
Acquisition Loss Expense any, deducted Unearned Earned
Affiliation with Registrant Cost Payable in Column C Premiums Premiums
--------------------------- ---- ------- ----------- -------- --------
Consolidated
Property-Casualty Subsidiary
Year Ended:
December 31, 1996 * * n/a * *
December 31, 1995 * * n/a * *
December 31, 1994 * * n/a * *
Column H Column I Column J Column K
-------- -------- -------- --------
Losses and Loss Amortization
Expenses Incurred of Paid Losses
Related to Acquisition and Loss Premiums
Current Year Prior Years Costs Expenses Written
------------ ----------- ----- -------- -------
Year Ended:
December 31, 1996 * * * * $243,911
December 31, 1995 * * * * $253,468
December 31, 1994 * * * * $179,563
<FN>
- ------------
* Information included in consolidated financial statements or accompanying notes thereto.
65
Item 14(c)
Exhibit Index
If incorporated by reference document
Exhibit No. Description of Exhibit with which Exhibit was previously filed with SEC
- ----------- ---------------------- ------------------------------------------------
3(A)(1) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No.
Articles of Incorporation 33-40643 on Form S-1 (see Exhibit 3(a)
therein)
3(A)(2) State Auto Financial Corporation's Amendment to the 1933 Act Registration Statement No.
Amended and Restated Articles of Incorporation 33-89400 on Form S-8 (see Exhibit 4(b)
therein)
3(B) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No.
Code of Regulations 33-40643 on Form S-1 (see Exhibit 3(b)
therein)
4 State Auto Financial Corporation's Amended and Restated See Exhibit 3(A) and 3(B)
Articles of Incorporation, and Articles 1, 3, 5 and 9 of
the Company's Amended and Restated Code of Regulations
10(A) Reinsurance Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and Southern Home Insurance Company, 33-40643 on Form S-1 (see Exhibit 10(a)
now known as State Auto Property and Casualty Insurance therein)
Company, dated January 1, 1987
10(B) Amendment Number 1 effective January 1, 1992 to Form 10-K Annual Report for the year
Reinsurance Agreement between State Automobile Mutual ended December 31, 1991 (see Exhibit 10
Insurance Company and State Auto Property and Casualty (B) therein)
insurance Company formerly known as Southern Home
Insurance Company, effective as of January 1, 1987
10(C) Amendment Number 2 dated as of December 1, 1993 to the Form 10-K Annual Report for the year
Reinsurance Agreement between State Automobile Mutual ended December 31, 1993 (see Exhibit 10
Insurance Company and State Auto Property and Casualty (C) therein)
Insurance Company formerly known as Southern Home
Insurance Company, effective as of January 1, 1987
10(D) Amendment Number 3 dated as of December 1, 1994 Form 10-K Annual Report for the year
effective as of January 1, 1995 to the Reinsurance ended December 31, 1994 (see Exhibit
Agreement between State Automobile Mutual Insurance 10(D) therein)
Company and State Auto Property and Casualty Insurance
Company
10(E)* Amended and Restated Management Agreement among State Form 10-K Annual Report for the year
Automobile Mutual Insurance Company, State Auto Property ended December 31, 1994 (see Exhibit
and Casualty Insurance Company, State Auto National 10(E) therein)
Insurance Company, State Auto Financial Corporation,
State Auto Life Insurance Company, and Milbank effective
April 1, 1994 as approved by insurance regulatory
officials in Ohio, South Carolina and South Dakota
<FN>
- --------------
*Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit
66
10(F)* Amendment Number 1-A to the Amended and Restated Form 10-K Annual Report for the year
Management Agreement among State Automobile Mutual ended December 31, 1994 (see Exhibit
Insurance Company, State Auto Property and Casualty 10(F) therein)
Insurance Company, State Auto National Insurance
Company, State Auto Financial Corporation, State Auto
Life Insurance Company and Milbank Insurance Company
effective as of January 1, 1995
10(G) Guaranty Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and State Auto Property and Casualty 33-40643 on Form S-1 (see Exhibit 10
Insurance Company dated as of May 16, 1991 (d) therein)
10(H) Form of Indemnification Agreement between State Auto 1933 Act Registration Statement No.
Financial Corporation and each of its directors 33-40643 on Form S-1 (see Exhibit 10
(e) therein)
10(I)* State Auto 1991 Quality Performance Bonus Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10
(f) therein)
10(J)* Non-Qualified Deferred Compensation Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10
(g) therein)
10(K)* 1991 Stock Option Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10
(h) therein)
10(L)* Amendment Number 1 to the 1991 Stock Option Plan 1933 Act Registration Statement No.
33-89400 on Form S-8 (see Exhibit 4 (a)
therein)
10(M)* 1991 Directors' Stock Option Plan 1933 Act Registration Statement No.
33-40643 on Form S-1 (see Exhibit 10
(i) therein)
10(N) Lease Agreement between Longhollow Associates Limited 1933 Act Registration Statement No.
Partnership and State Automobile Mutual Insurance 33-40643 on Form S-1 (see Exhibit 10
Company dated July 8, 1988, as amended (j) therein)
10(O) License Agreement between State Automobile Mutual 1933 Act Registration Statement No.
Insurance Company and Policy Management Systems 33-40643 on Form S-1 (see Exhibit 10
Corporation dated December 28, 1984 (k) therein)
10(P) Investment Management Agreement between Stateco Form 10-K Annual Report for the year
Financial Services, Inc. and State Automobile Mutual ended December 31, 1992 (see Exhibit 10
Insurance Company, effective April 1, 1993 (N) therein
10(Q) Option Agreement between State Automobile Mutual Form 10-K Annual Report for year ended
insurance Company and State Auto Financial Corporation December 31, 1993 (see Exhibit 10 (R)
dated as of August 20, 1993 therein)
10(R)* Supplemental Executive Retirement Income Plan effective Form 10-K Annual Report for the year
December 1, 1992 ended December 31, 1992 (see Exhibit
10(O) therein)
10(S)* State Auto Insurance Companies Directors' Deferred Form 10-K Annual Report for year ended
Compensation Plan December 31, 1995 (see Exhibit 10(S)
therein)
<FN>
- --------------
*Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit
67
10(T)* State Auto Insurance Companies Non-Qualified Incentive Form 10-K Annual Report for year ended
Deferred Compensation Plan December 31, 1995 (see Exhibit 10(T)
therein)
10(U)* Strategic Insurance Software, Inc. 1995 Stock Option Plan Form 10-K Annual Report for year ended
December 31, 1995 (see Exhibit 10(U)
therein)
10(V) Strategic Insurance Software, Inc. Warrant to purchase Form 10-K Annual Report for year ended
common stock December 31, 1995 (see Exhibit 10(V)
therein)
10(W* Strategic Insurance Software, Inc. Shareholder's Form 10-K Annual Report for year ended
Agreement December 31, 1995 (see Exhibit 10(W)
therein)
10(X)* Robert L. Bailey Employment Contract Form 10-K Annual Report for year ended
December 31, 1995 (see Exhibit 10(X)
therein)
10(Y) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended
between State Automobile Mutual Insurance Company, State September 30, 1996 (see Exhibit 10(Y)
Auto Property and Casualty Insurance Company and Milbank therein)
Insurance Company effective July 1, 1996
10(Z) Property Catastrophe Overlying Excess of Loss Form 10-Q for the period ended
Reinsurance Contract between State Automobile Mutual September 30, 1996 (see Exhibit 10(Z)
Insurance Company, Milbank Insurance Company, State Auto therein)
National Insurance Company and State Auto Property and
Casualty Insurance Company dated July 1,1996
10(AA) Credit Agreement between SAF Funding Corporation and Form 10-Q for the period ended
The Chase Manhattan Bank dated August 16, 1996 September 30, 1996 (see Exhibit 10(AA)
therein)
10(BB) Put Agreement between State Automobile Mutual Insurance Form 10-Q for the period ended
Company, State Auto Financial Corporation and The Chase September 30, 1996 (see Exhibit 10(BB)
Manhattan Bank dated August 16, 1996 therein)
10(CC) Standby Purchase Agreement between State Auto Financial Form 10-Q for the period ended
Corporation and SAF Funding Corporation dated August 16, September 30, 1996 (see Exhibit 10(CC)
1996 therein)
10(DD)* Amendment Number 2 to the 1991 Stock Option Plan Included Herein
10(EE)* Amendment Number 1 to the 1991 Directors' Stock Option Included Herein
Plan
10(FF) Option Agreement between State Auto Mutual and State Included Herein
Auto Financial dated March 11, 1997.
11 Statement regarding computation of earnings per share Form 10-K Annual Report for the year
ended December 31, 1995 (see Exhibit 11
therein)
21 List of Subsidiaries of State Auto Financial Corporation Form 10-K Annual Report for the year
ended December 31, 1995 (see Exhibit 22
therein)
23 Consent of Independent Auditors Included Herein
<FN>
- --------------
*Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit
68
24 Powers of Attorney - John R. Lowther, David L. Form 10-K Annual Report for the year
Bickelhaupt, Paul W. Huesman, George R. Manser and ended December 31, 1991 (see Exhibit 25
Robert J. Murchake therein)
24(A) Power of Attorney - William J. Lhota Form 10-K Annual Report for the year
ended December 31, 1994 (see Exhibit
25(A) therein)
24(B) Power of Attorney - David J. D'Antoni Form 10-K Annual Report for the year
ended December 31, 1995 (see Exhibit
25(B) therein)
27 Financial Data Schedule Included Herein