1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
(X) Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the quarterly period ended September 30, 1998
-------------------------------------------------
( ) Transition report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the Transition period from to
-------------------- ---------------------------
State Auto Financial Corporation
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(Exact name of registrant as specified in its charter)
Ohio 31-1324304
- ---------------------------- ------------------------------------
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation)
518 East Broad Street, Columbus, Ohio 43215-3976
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(Address of principal executive offices) (zip code)
(614) 464-5000
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Registrant's telephone number, including area code
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
(X) Yes ( ) No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
Common shares, without par value 41,937,909
- -------------------------------- -------------------------
(Class) (Outstanding on 11/09/98)
2
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
(unaudited)
September 30 December 31
ASSETS 1998 1997
---- ----
Fixed maturities:
Held for investment, at amortized cost
(fair value $63,294 and $81,571, respectively) $ 60,985 $ 79,300
Available for sale, at fair value
(amortized cost $463,649 and $405,815, respectively) 485,132 420,994
Equity securities, at fair value (cost $24,561 and $19,120, respectively) 31,205 26,069
--------- ---------
Total investments 577,322 526,363
Cash and cash equivalents 27,554 30,931
Surplus note receivable 9,000 --
Deferred policy acquisition costs 24,600 22,440
Accrued investment income and other assets 18,825 17,983
Net prepaid pension expense 15,927 14,608
Reinsurance recoverable 15,496 12,095
Prepaid reinsurance premiums 4,242 4,199
Due from affiliates 6,485 5,315
Current federal income taxes -- 2,811
Property and equipment, net 1,930 2,078
--------- ---------
Total assets $ 701,381 $ 638,823
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable $ 224,515 $ 206,250
Unearned premiums 137,607 125,033
Current federal income taxes 2,434 2,278
Deferred federal income taxes 6,995 5,287
Due to affiliates 790 --
Other liabilities 3,078 2,717
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Total liabilities 375,419 341,565
--------- ---------
STOCKHOLDERS' EQUITY
Common stock, without par value. Authorized 100,000,000 and 30,000,000
shares, respectively; 41,933,409 and 41,828,845 shares issued and
outstanding, respectively, at stated value of $2.50 per share 104,834 104,572
Additional paid-in capital 40,941 40,210
Accumulated comprehensive income 18,567 14,761
Retained earnings 161,773 137,805
Treasury stock (12,063 and 8,118 shares, respectively), at cost (153) (90)
--------- ---------
Stockholders' equity 325,962 297,258
--------- ---------
Total liabilities and stockholders' equity $ 701,381 $ 638,823
========= =========
See accompanying notes to condensed consolidated financial statements.
3
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Three Months Ended September 30, 1998 and 1997
(dollars in thousands, except per share amounts)
(unaudited)
1998 1997
-------- --------
Earned premiums (net of ceded earned premiums of
$3,556 and $3,529, respectively) $ 90,096 $ 80,257
Net investment income 8,349 7,696
Management services income 1,986 1,846
Net realized gains on investments 1,115 902
-------- --------
Total revenues 101,546 90,701
-------- --------
Losses and loss expenses (net of ceded losses and loss
expenses of $1,456 and $1,485, respectively) 59,657 52,385
Acquisition and operating expenses 27,441 24,098
Other expense, net 980 589
-------- --------
Total expenses 88,078 77,072
-------- --------
Income before federal income taxes 13,468 13,629
Federal income tax expense:
Current 2,632 3,696
Deferred 284 187
-------- --------
Total federal income taxes 2,916 3,883
-------- --------
Net income $ 10,552 $ 9,746
======== ========
Net income per share:
- basic $ 0.25 $ 0.23
======== ========
- diluted $ 0.25 $ 0.23
======== ========
Dividends paid per common share $ 0.025 $ 0.023
======== ========
See accompanying notes to condensed consolidated financial statements.
4
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Nine Months Ended September 30, 1998 and 1997
(dollars in thousands, except per share amounts)
(unaudited)
1998 1997
--------- ---------
Earned premiums (net of ceded earned premiums of
$10,810 and $10,462, respectively) $ 267,122 $ 238,748
Net investment income 24,488 23,118
Management services income 5,945 5,542
Net realized gains on investments 2,165 2,091
--------- ---------
Total revenues 299,720 269,499
--------- ---------
Losses and loss expenses (net of ceded losses and loss
expenses of $5,454 and $5,460, respectively) 184,930 157,363
Acquisition and operating expenses 79,477 71,374
Other expense, net 2,675 1,706
--------- ---------
Total expenses 267,082 230,443
--------- ---------
Income before federal income taxes 32,638 39,056
Federal income tax expense (benefit):
Current 8,118 10,043
Deferred (343) 715
--------- ---------
Total federal income taxes 7,775 10,758
--------- ---------
Net income $ 24,863 $ 28,298
========= =========
Net income per share:
- basic $ 0.59 $ 0.68
========= =========
- diluted $ 0.58 $ 0.67
========= =========
Dividends paid per common share $ 0.070 $ 0.063
========= =========
See accompanying notes to condensed consolidated financial statements.
5
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended September 30, 1998 and 1997
(in thousands)
(unaudited)
1998 1997
--------- ---------
Cash flows from operating activities:
Net income $ 24,863 $ 28,298
Adjustments to reconcile net income to net cash provided by operating
activities:
Depreciation and amortization, net 1,247 1,412
Net realized gains on investments (2,165) (2,091)
Changes in operating assets and liabilities:
Deferred policy acquisition costs (951) (1,756)
Accrued investment income and other assets (842) (2,349)
Net prepaid pension expense (578) (1,233)
Other liabilities and due to/from affiliate, net 3,958 (4,817)
Reinsurance recoverable and prepaid reinsurance premiums (927) 130
Losses and loss expenses payable 2,414 (2,761)
Unearned premiums 4,252 6,724
Federal income taxes (185) (45)
--------- ---------
31,086 21,512
Cash provided from the change in the reinsurance pool
participation percentage 19,708 --
--------- ---------
Net cash provided by operating activities 50,794 21,512
--------- ---------
Cash flows from investing activities:
Purchase of fixed maturities - available for sale (164,156) (104,925)
Purchase of equity securities (8,428) (9,668)
Maturities, calls and principal reductions of fixed maturities -
held to maturity 18,130 8,773
Maturities, calls and principal reductions of fixed maturities -
available for sale 18,362 15,203
Sale of fixed maturities - available for sale 88,255 79,507
Sale of equity securities 3,944 6,129
Purchase of surplus note receivable (9,000) --
Net additions of property and equipment (1,313) (852)
--------- ---------
Net cash used in investing activities (54,206) (5,833)
--------- ---------
Cash flows from financing activities:
Net proceeds from sale of common stock 930 729
Payment of dividends (895) (774)
--------- ---------
Net cash provided by (used in) financing activities 35 (45)
--------- ---------
Net increase (decrease) in cash and cash equivalents (3,377) 15,634
Cash and cash equivalents at beginning of period 30,931 15,845
--------- ---------
Cash and cash equivalents at end of period $ 27,554 $ 31,479
========= =========
Supplemental disclosures:
Federal income taxes paid $ 7,768 $ 10,804
========= =========
See accompanying notes to condensed consolidated financial statements.
6
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 1998
(unaudited)
1. BASIS OF PRESENTATION
The financial statements for the interim periods included herein have been
prepared by State Auto Financial Corporation (the "Company" or "State Auto
Financial") without audit; however, such information reflects all adjustments
(consisting of normal recurring adjustments) which are, in the opinion of
management, necessary for a fair presentation of the financial position, results
of operations and cash flows for the interim periods. Certain information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles have been condensed or
omitted. These financial statements should be read in conjunction with the
financial statements and notes thereto for the year ended December 31, 1997
included in the Company's 1997 Form 10-K filed with the Securities and Exchange
Commission.
On July 7, 1998, the Company completed the exercise of its option pursuant to
the Option Agreement dated August 20, 1993, with State Automobile Mutual
Insurance Company ("Mutual") by acquiring the outstanding shares of Milbank
Insurance Company ("Milbank"). Milbank had been a wholly-owned subsidiary of
Mutual since July 1, 1993, but as a result of this transaction, Milbank is now a
wholly owned subsidiary of the Company. The purchase price of Milbank was
approximately $81.9 million. The transaction was effected through an exchange
with Mutual of approximately 5.1 million State Auto Financial common shares for
all the issued and outstanding shares of capital stock of Milbank. The
transaction has been accounted for under the pooling-of-interest method of
accounting. The prior year's financial information has been restated to include
the financial position and operations of Milbank.
The results of operations for the interim periods presented are not necessarily
indicative of the operating results that may be expected for the full fiscal
year ending December 31, 1998.
2. STOCK SPLIT
On March 6, 1998, the Board of Directors of the Company authorized a two-for-one
stock split to be distributed July 8, 1998, to shareholders of record on June
18, 1998. The split was contingent upon shareholder approval of a proposal to
increase the number of authorized common shares, without par value, from 30
million to 100 million. At the Company's annual meeting of shareholders on May
28, 1998, the shareholders approved the increase of such authorized common
shares. Common shares issued and outstanding, weighted average shares and per
share data have been restated to reflect the two-for-one stock split for periods
presented in the accompanying condensed consolidated financial statements.
3. NET INCOME PER COMMON SHARE
The following table sets forth the compilation of basic and diluted net income
per common share:
Three months ended
September 30
1998 1997
------- -------
(in thousands, except per share amounts)
Numerator:
Net income for basic and diluted income
per common share $10,552 $ 9,746
------- -------
Denominator:
Weighted average shares for basic net
income per common share 41,906 41,560
Effect of dilutive stock options 988 949
Adjusted weighted average shares for
diluted net income per common share 42,894 42,509
------- -------
Basic net income per common share $ 0.25 $ 0.23
------- -------
Diluted net income per common share $ 0.25 $ 0.23
------- -------
7
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
September 30, 1998
(unaudited)
3. NET INCOME PER COMMON SHARE - CONTINUED
Nine months ended
September 30
1998 1997
------- -------
(in thousands, except per share amounts)
Numerator:
Net income for basic and diluted income
per common share $24,863 $28,298
------- -------
Denominator:
Weighted average shares for basic net
income per common share 41,865 41,491
Effect of dilutive stock options 1,045 863
Adjusted weighted average shares for
diluted net income per common share 42,910 42,354
------- -------
Basic net income per common share $ 0.59 $ 0.68
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Diluted net income per common share $ 0.58 $ 0.67
------- -------
4. COMPREHENSIVE INCOME
As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting
Comprehensive Income." SFAS No. 130 establishes new rules for the reporting and
display of comprehensive income and its components; however, the adoption of
SFAS No. 130 had no impact on the Company's net income or shareholders' equity.
SFAS No. 130 requires unrealized gains or losses on the Company's
available-for-sale securities, which prior to adoption were reported separately
in shareholders' equity, to be included in other comprehensive income. Prior
year financial statements have been reclassified to conform to the requirements
of SFAS No. 130.
The components of comprehensive income, net of related tax, for the three-month
and nine-month periods ended September 30, 1998 and 1997 are as follows:
Three months ended Nine months ended
September 30 September 30
1998 1997 1998 1997
---- ---- ---- ----
(in thousands) (in thousands)
Net income $10,552 $9,746 $24,863 $28,298
Unrealized holding gains, net of tax 2,039 4,034 3,806 5,078
------- ------- ------- -------
Comprehensive income $12,591 $13,780 $28,669 $33,376
======= ======= ======= =======
The components of accumulated other comprehensive income, net of related tax,
included in stockholders' equity at September 30, 1998 and December 31, 1997
include only unrealized holding gains, net of tax.
8
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
September 30, 1998
(unaudited)
5. SURPLUS NOTE RECEIVABLE
On August 18, 1998, the Company purchased $9.0 million of surplus notes from
Farmers Casualty Company Mutual ("Farmers Casualty") of West Des Moines, Iowa.
At the August 18, 1998 meeting of the Farmers Casualty board, four individuals
designated by the Company were appointed to the seven-member Farmers Casualty
board. A plan to convert Farmers Casualty into a stock insurance company was
approved by the board of Farmers Casualty and by the policyholders as required
by Iowa law. Completion of the plan of conversion is pending regulatory approval
from the Iowa Division of Insurance. The plan contemplates that the newly issued
shares of the company, to be named Farmers Casualty Insurance Company, will be
acquired by the Company in exchange for the redemption of the surplus notes. The
plan of conversion is expected to be effective January 1, 1999.
6. NEW ACCOUNTING STANDARDS
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information," which is effective for fiscal years
beginning after December 15, 1997, but is not required to be applied to interim
period financial statements in the year of adoption. SFAS No. 131 changes the
way public companies report segment information in annual financial statements
and also requires those companies to report selected segment information in
interim financial reports to shareholders. The Company has not yet determined
the reporting changes required by SFAS No. 131 to segment information.
7. RECLASSIFICATIONS
Certain items in the 1997 condensed consolidated financial statements have been
reclassified to conform with the 1998 presentation.
9
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
On July 7, 1998, the State Auto Financial Corporation ("the Company" or "State
Auto Financial") completed the exercise of its option, pursuant to the Option
Agreement dated August 20, 1993, with State Automobile Mutual Insurance Company
("Mutual") by acquiring the outstanding shares of Milbank Insurance Company
("Milbank"). Milbank had been a wholly-owned subsidiary of Mutual since July 1,
1993, but as a result of this transaction, Milbank is now a wholly owned
subsidiary of the Company. The purchase price of Milbank was approximately $81.9
million. The transaction was effected through an exchange with Mutual of
approximately 5.1 million State Auto Financial common shares for all the issued
and outstanding capital stock of Milbank. This exchange of Milbank shares for
the Company's common shares increased Mutual's ownership of the Company to
approximately 70% of its issued and outstanding shares. This transaction has
been accounted for under the pooling-of-interest method of accounting. The prior
year's financial information has been restated to include the financial position
and operations of Milbank.
Results of Operations
- ---------------------
Income before federal income taxes decreased $161,000 to $13.5 million and $6.4
million to $32.6 million for the three months and nine months ended September
30, 1998, respectively, from the same 1997 periods. These decreases are
primarily due to an increase in the level of storm-related catastrophe claims
over the comparable 1997 periods. Also impacting the Company's operations was an
amendment to the pooling arrangement with the Company's insurance subsidiaries,
State Auto Property & Casualty Insurance Company (State Auto P&C) and Milbank.
From 1995 through 1997, State Auto P&C and Milbank participated in a pooling
arrangement with Mutual, whereby State Auto P&C assumed 35% of the pooled
business, Milbank 10% and Mutual 55%. Effective January 1, 1998, the pooling
arrangement was amended to include the insurance operations of Midwest Security
Insurance Company (Midwest), a wholly-owned subsidiary of Mutual. Concurrent
with the addition of Midwest to the pool, the pooling participation percentages
were amended to allocate 37% to State Auto P&C, 52% to Mutual, 10% to Milbank
and 1% to Midwest. In connection with the January 1, 1998 pooling changes, State
Auto P&C and Milbank received approximately $19.7 million to cover its increased
share of the pooled liabilities.
During the quarter ended September 30, 1998, earned premiums increased $9.8
million to $90.1 million from the same 1997 period. The $9.8 million increase
has three sources: $5.7 million is attributable to the pooling change described
above; $3.2 million is State Auto P&C's and Milbank's share of earned premium
growth of the pool during the quarter; and $0.9 million is earned premium growth
of State Auto National Insurance Company ("National"), the Company's
non-standard auto insurer subsidiary. For the nine months ended September 30,
1998, earned premiums increased $28.4 million to $267.1 million from the same
1997 period. Of the $28.4 million increase, $24.9 million was due to an increase
in earned premiums of State Auto P&C & Milbank, of which $17.1 million was due
to the impact of the change in the pooling arrangement with the remaining
portion of the increase due to State Auto P&C's and Milbank's share of the
overall growth of the pool. The remaining $3.5 million of the $28.4 million nine
month increase was due to the earned premium growth of National. National's
premium growth has slowed compared to prior year levels for both quarter and
year-to-date due to aggressive underwriting action designed to improve
profitability in Tennessee, National's largest state, a more restrictive
underwriting posture with several larger producers in its other states, and rate
increases implemented during 1997 in several of its operating states. While
these activities have resulted in a decrease in growth over prior year levels,
National's statutory loss experience has improved over comparative prior
periods. See discussion below. National will begin operations in four new states
in the fourth quarter: Indiana, Pennsylvania, Utah and Wisconsin.
Net investment income increased $0.6 million to $8.3 million for the three
months ended September 30, 1998 and $1.4 million to $24.5 million for the nine
months ended September 30, 1998, from the same
10
1997 periods. Contributing to these increases, was the transfer to State Auto
P&C & Milbank of approximately $19.7 million in conjunction with the change in
the pooling arrangement and a general increase in investable assets over the
same 1997 periods. Total cost of investable assets at September 30, 1998 was
$576.7 million compared to $525.7 million at September 30, 1997. The investment
yield, based on fixed and equity securities at cost, decreased to 5.7% and 5.8%
for the three months and nine months ended September 30, 1998, respectively,
from 5.9% and 6.0% for the 1997 comparable periods, respectively. Contributing
to the decrease in the investment yields has been a decline in fixed maturity
interest rates over the 1997 comparable periods as well as a gradual shift in
the composition of the fixed maturity portfolio from taxables to tax-exempt
securities. At June 30, 1998, approximately 68.5% of the investment portfolio
was comprised of tax-exempt securities whereas at December 31, 1997, tax exempts
comprised 58.9% of the portfolio.
Losses and loss expenses, as a percentage of earned premiums, increased to 66.2%
for the three months ended September 30, 1998, from 65.3% for the same 1997
period and increased to 69.2% for the nine months ended September 30, 1998, from
65.9% for the same 1997 period. As previously discussed, the Company experienced
an increase in storm-related catastrophe claims over 1997 levels for both the
three month and nine month reporting periods. During the third quarter 1998, the
Company was adversely affected by several Midwest wind and hail storms and by
adverse development on catastrophe claims that occurred in nearly all of the
Company's operating states during the second quarter of 1998. The impact of
these catastrophe claims amounted to $6.2 million or 6.8 GAAP loss ratio points
whereas for the same 1997 period, catastrophe claims totaled approximately $2.0
million or 2.5 GAAP loss ratio points. Despite the higher level of catastrophe
claims as compared to the same periods in 1997, the Company did not experience
any significant claim activity from hurricanes Bonnie, Earl and Georges. For the
nine months ended September 1998, the 1998 catastrophe claim related activity
exceeded 1997 levels by $20.8 million increasing the 1998 nine month ratio by
approximately 7.8 GAAP loss ratio points. Absent catastrophes, the Company's
underlying book of business remained stable. Additionally, National produced a
decrease in its statutory loss ratios to 67.1% and 76.1% for the three months
and nine months ending September 30, 1998, respectively, from 70.8% and 82.8%
for the 1997 periods, respectively.
Acquisition and operating expenses, as a percentage of earned premiums (the
expense ratio), increased slightly to 30.5% for the three months ended September
30, 1998 from 30.0% for the same 1997 period and for the nine months ended
September 30, 1998, decreased to 29.8% from 29.9% for the same 1997 period. The
slight increase in the three month ratio can be attributed to the Company's
portion of its guaranty fund assessment accrual due to the insolvency of PIE
Mutual Insurance Company, an Ohio domiciled medical malpractice insurer as well
as an increase in the 1998 accrual for the amount of bonus compensation earned
by the Company's agents.
Other expense for the three months ending September 30, 1998 increased $0.4
million to $0.9 million and for the nine months ending September 30, 1998
increased $0.9 million to $2.7 million. These increases are largely due to an
increase in write-offs of premiums receivable during 1998, primarily in
National. National has sought to improve its premium receivable collections by
retaining the services of a third party whose business is receivables
collection.
Federal income taxes decreased $0.9 million to $2.9 million for the three months
ended September 30, 1998 and $3.0 million to $7.8 million for the nine months
ended September 30, 1998 from the same 1997 periods. These decreases are due to
lower taxable income as a result of the storm related catastrophes experienced
by the company during the 1998 periods as well as a shift in the investment
portfolio from taxable to tax exempt securities. The effective tax rate
decreased to 21.6% and 23.8% for the three months and nine months ending
September 30, 1998 from 28.5% and 27.5% for the 1997 periods, respectively. See
discussion above regarding the shift from taxables to tax exempts within the
investment portfolio.
11
Liquidity and Capital Resources
- -------------------------------
Net cash provided by operating activities increased to $50.8 million for the
nine months ended September 30, 1998 from $21.5 million for the same 1997
period. This increase is due primarily to the transfer of $19.7 million to State
Auto P&C & Milbank in connection with the amended pooling arrangement, as
discussed above. Net cash used in investing activities increased to $54.2
million for the nine months ended September 30, 1998 from $5.8 million for the
same 1997 period. This increase is due to the investing of the cash associated
with the transfer of the $19.7 million, purchase of $9.0 million in surplus
notes, as discussed below, as well as cash generated from insurance operations.
Net cash used in financing activities for the nine months ended September 30,
1998 remained comparable to the same period in 1997. As of September 30, 1998,
funds consisting of cash and cash equivalents available for general operations
were $27.6 million compared to $31.5 million at September 30, 1997. No long-term
fixed maturities were required to be sold to meet obligations during the first
nine months of 1998.
On August 18, 1998, the Company purchased $9.0 million of surplus notes from
Farmers Casualty Company Mutual ("Farmers Casualty") of West Des Moines, Iowa. A
plan to convert Farmers Casualty into a stock insurance company was approved by
the board of Farmers Casualty at its August 18, 1998 board meeting and received
positive votes from more than 2/3 of the policyholders voting at a special
policyholder's meeting held on October 29, 1998. The effectiveness of the plan
of conversion now depends on regulatory approval from the Iowa Division of
Insurance. The plan contemplates that the newly issued shares of the company, to
be named Farmers Casualty Insurance Company, will be acquired by the Company in
exchange for the redemption of the surplus notes. At the August 18, 1998 meeting
of the Farmers Casualty board, four individuals designated by State Auto
Financial Corporation were appointed to the seven-member Farmers Casualty board.
The plan of conversion is expected to be effective January 1, 1999.
The Board declared a two-for-one stock split to be distributed July 8, 1998, to
shareholders of record on June 18, 1998. The split was contingent upon
shareholder approval of a proposal to increase the number of authorized common
shares, without par value, from 30 million to 100 million. At the Company's
annual meeting of shareholders on May 28, 1998, the shareholders approved the
increase of authorized common shares, without par value. The impact of this
stock split has been appropriately reflected in the accompanying condensed
consolidated financial statements.
Year 2000 Discussion Disclosure
- -------------------------------
Description of the Year 2000 Issues Affecting the Company
- ---------------------------------------------------------
The Company commenced work on its Year 2000 ("Y2K") issues in the fall of 1996.
At that time, one of its first tasks was to perform an inventory of all software
systems. As a result of this inventory, it identified approximately 5 million
lines of in house maintained program code in its various software systems.
Following this inventory the Company set priorities as to system remediation
based on the role each system played in the Company's being able to carry on its
insurance operations or meet its general business needs. The Company's
applications software must support certain essential functions: issuing
insurance policies, collecting policy premiums and paying claims and premium
refunds. In addition, there is other applications software used by the Company
in the general operation and management of its business.
Following months of intensive remediation effort, in April 1998, the Company
conducted its first major test of one of its major insurance policy processing
systems. The results of that test were positive. The Company conducted a second
comprehensive Millennium test at an off-site computer facility in August 1998.
All major insurance policy processing systems were tested as if it were the Year
2000. Testing also included Leap Day, February 29, 2000. This test was also
successful.
12
At this time, one hundred percent (100%) of the Company's in-force insurance
policies are being processed on a Y2K compliant system, based on the test
results mentioned above. However, in an effort to ensure that no material
problems arise from the policy processing systems used by the Company and its
affiliates or subsidiaries (all of which are sometimes collectively referred to
hereafter as "State Auto") the Company plans to continue simulated Year 2000
testing throughout 1999.
State Auto's Y2K project team has, through November 3, 1998, completed its
efforts on approximately 84% of State Auto's applications software. That means
that approximately 84% of the software systems State Auto uses in its insurance
operations or in meeting its general business needs has been through Y2K
remediation, testing, and has been introduced back into the Company's production
environment. Included within this 84% are the systems that address policy
issuance, premium billing and collection and claims processing at State Auto.
The remaining 16% of applications software code that is not presently Y2K
compliant involves applications that are not "mission critical", such as certain
management reports and other similar tools. Some of this remaining code may well
be determined to be obsolete. State Auto plans to have 100% of its non-obsolete
applications software Y2K compliant by mid-year 1999.
In addition to addressing its own applications software Y2K problems, State Auto
may be affected by the Y2K issues of third parties with which it has a material
relationship. This includes the independent insurance agents who sell the
Company's products, many of which have automated agency management systems in
place. State Auto is currently surveying its agencies which have automated to
determine the readiness of their systems for the new Millennium. An agency's
management system failing, due to not being Y2K compliant, would likely impair
the business efficiency of such agency.
In addition, a number of State Auto agencies and the Company are able to
communicate policy data electronically. There are several agency management
systems that permit this so-called upload and download of information but not
all of them are Y2K compliant. Mutual has encouraged State Auto agencies to
upgrade to Y2K compliant systems that permit upload and download. If upload and
download is disrupted by Y2K issues, it will likely affect the efficiency with
which the Company operates its business. The consequences of the disruption
would depend on the extent to which State Auto's various lines of business may
be uploaded and downloaded at the time the disruption were to occur and the
duration of the disruption. Thus, it is not possible to reasonably estimate the
financial impact of such reduced efficiency.
There are certain other vendors which have a material relationship with the
company by virtue of the fact that they provide a product or service that State
Auto uses in the ordinary course of its business, such as underwriting
information providers, task specific software or hardware product vendors, and
financial institutions. Y2K compliance by third party vendors will continue to
be one of State Auto's focal points throughout the remainder of 1998 and all of
1999. State Auto expects to have third party vendor products then in use Y2K
compliant by the end of the 3rd quarter of 1999.
13
Stateco Financial Services, Inc. ("Stateco"), a wholly-owned subsidiary of State
Auto Financial which provides investment management services to each of the
State Auto insurers, has had in place a third party vendor investment management
system which is represented by the vendor to be Y2K compliant. Based on its
present use of this system, Stateco does not expect its services to be disrupted
by Y2K issues affecting it, although Stateco will be included in the contingency
planning discussed below should some unanticipated system failure arise.
State Auto Financial's Costs to Address Year 2000 Issues
- --------------------------------------------------------
State Auto Financial's Y2K compliance expense to date for resources has been
$1.6 million dollars of a projected $2.4 million dollars, which is an increase
from its earlier estimate of $1.9 million. This estimate is subject to change
depending on future, presently unforeseen developments which could affect the
cost of Y2K compliance for State Auto. This money spent to date is virtually all
payroll costs attributable to the State Auto employees on the Y2K project team.
The foregoing expense does not include approximately $0.2 million spent by State
Auto Financial on accelerated technology purchases for systems or equipment to
ensure Y2K compliance for such system or equipment. Also, an outsourcing
agreement with State Auto's primary third party software vendor to provide
additional resources for other systems projects has generated an additional
expense to State Auto Financial of approximately $0.9 million over the last two
years.
State Auto's Risks Due to Year 2000 Issues
- ------------------------------------------
The majority of State Auto's Y2K compliance efforts to date have concentrated on
its internal systems. Based on where the project stands today (84% complete),
State Auto believes it has made substantial progress in addressing its own Y2K
issues. This is not to say that State Auto is immune from disruptions to its
business. A systems malfunction is possible, despite the efforts made to date
and the testing that will continue. While it believes that its remediation
efforts have been careful and thorough and that it is positioned to address a
malfunction, were one to occur, without creating a material disruption to its
business, it cannot guarantee the outcome of its Y2K project or that the Y2K
problem will not have a materially adverse impact on the Company.
Another source for unanticipated disruptions and expense would be disruptions
that are external in nature, something over which State Auto has relatively
little opportunity to prevent. Its focus in this scenario is to mitigate the
harm of such an event.
Significant disruptions among the utilities that serve the Company or the
financial institutions with which it interacts would probably make it more
difficult for State Auto to deliver its services to its customers and sell its
products. But, State Auto does not believe that these disruptions would prevent
it from operating its business for an extended period of time. These kinds of
disruptions will be considered in a contingency plan as discussed below.
Clearly, if Y2K issues create material difficulties in the broad based economy,
that could have an adverse impact on the Company, however it cannot anticipate
the consequences of such an event, let alone reasonably estimate its financial
impact.
14
As a property casualty insurer, State Auto faces the additional risk of insured
or allegedly insured losses to its customers from the Y2K exposure. State Auto
has clarified certain commercial liability insurance policies with respect to
this exposure. It is too early to know the nature and extent of insured losses
that might arise from the Y2K problem, be they from information systems failures
or embedded chip processing failures.
State Auto does not expect a material adverse impact from Y2K issues arising
from embedded chip processing failures occurring on site. Those embedded chip
issues which the Company has some opportunity to control or address that have
been identified to date have been generally facilities related or involving
small business equipment (i.e. fax machines). Upgrades and equipment replacement
are being coordinated by a variety of business managers responsible for such
equipment.
State Auto's Year 2000 Contingency Plans
- ----------------------------------------
State Auto has not yet created a formal Y2K contingency plan. Discussions and
communications have begun in regards to this. The Company expects to have a
contingency plan in place by the 4th quarter 1999. Some of the issues that the
plan would likely contemplate would be manual processing alternatives,
non-electronic forms of information distribution, assurance of adequate
supplies, and mitigation of the impact of utilities and financial institution
disruptions.
State Auto continues to work with its business recovery service provider. State
Auto is following a program developed by that provider that requires a
comprehensive Y2K preparation approach. Conforming to this allows State Auto to
take advantage of its provider's facilities for business recovery in the event
that an external Y2K issue that was addressed does happen to fail.
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. Such statements
include, without limitation, those pertaining to the weather related
catastrophes impacting the Company's losses, National's premium receivable
collections effort, the conversion of Farmers Casualty, and the Year 2000
discussion. These risks and uncertainties include but are not limited to:
legislative changes, judicial and regulatory decisions, the impact of
competitive products and pricing, product development, geographic spread of
risk, weather and weather-related events, other types of catastrophic events,
fluctuations of securities markets, economic conditions, technological
difficulties and advancements, availability of labor and materials in storm hit
areas, late reported claims, previously undisclosed damage, utilities and
financial institution disruptions, shortages of programmers, and regulatory or
governmental systems breakdowns.
15
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART II. OTHER INFORMATION
Item 1. Legal Proceedings - None
Item 2. Changes in Securities - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Securities Holders - None
Item 5. Other Information
If a stockholder who plans to present a matter at the 1999 Annual
Meeting of Stockholders fails to provide notice of the matter to the Secretary
of the Company by March 8, 1999, it is the intention of the Company that,
pursuant to CFR Section 240.14 a-4(c)(1), the persons authorized under
management proxies will have discretionary authority to vote and act according
to their best judgment on said matter.
INDEX TO EXHIBITS
Item 6. a. Exhibits
Exhibit No. Description of Exhibits
----------- -----------------------
27 Financial data schedules
b. Reports on Form 8-K
Form 8-K filed on July 7, 1998 providing information regarding
State Auto Financial Corporation's exercise of its option with State Automobile
Mutual Insurance Company to acquire 100% of the outstanding shares of Milbank
Insurance Company, pursuant to Item 2 of Form 8-K.
Form 8-K/A filed on September 16, 1998 providing financial
information on Milbank Insurance Company and pro forma financial information,
pursuant to Item 7 on Form 8-K.
16
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
State Auto Financial Corporation
Date: NOVEMBER 13, 1998 /s/ Steven J. Johnston
----------------- -------------------------------------
Steven J. Johnston
Treasurer and Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)