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 June 30, 1999
-------------------------------------------------
( ) 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
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Ohio 31-1324304
- ------------------------------- --------------------------------------
(State or other (I.R.S. Employer Identification No.)
jurisdiction of incorporation)
518 East Broad Street, Columbus, Ohio 43215-3976
- --------------------------------------------------------------------------------
(Address of principal executive offices) (zip code)
(614) 464-5000
- --------------------------------------------------------------------------------
Registrant's telephone number, including area code
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
(X) Yes ( ) No
Indicate 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 40,565,812
- -------------------------------- ------------------------
(CLASS) (OUTSTANDING ON 8/06/99)
2
INDEX
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed consolidated balance sheets - June 30, 1999 and
December 31, 1998
Condensed consolidated statements of income - Three months
ended June 30, 1999 and 1998
Condensed consolidated statements of income - Six months ended
June 30, 1999 and 1998
Condensed consolidated statements of cash flows - Six months
ended June 30, 1999 and 1998
Notes to condensed consolidated financial statements -
June 30, 1999
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 3. Quantitative and Qualitative Disclosure of Market Risk
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
3
PART I. Financial Information
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
(unaudited)
June 30 December 31
ASSETS 1999 1998
--------- -----------
Fixed maturities:
Held for investment, at amortized cost
(fair value $47,775 and $57,826, respectively) $ 46,913 $ 55,926
Available for sale, at fair value
(amortized cost $508,088 and $464,008, respectively) 507,600 481,844
Equity securities, at fair value (cost $34,684 and $29,233, respectively) 50,427 42,196
--------- ---------
Total investments 604,940 579,966
Cash and cash equivalents 38,316 32,605
Surplus note receivable -- 9,000
Deferred policy acquisition costs 28,299 24,799
Accrued investment income and other assets 18,661 19,542
Net prepaid pension expense 17,776 16,378
Reinsurance receivable 18,012 13,667
Prepaid reinsurance premiums 3,727 4,014
Property and equipment, net 10,997 7,927
Due from affiliates 6,120 --
Current federal income taxes 997 --
Goodwill 2,658 1,880
--------- ---------
Total assets $ 750,503 $ 709,778
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable $ 247,082 $ 218,701
Unearned premiums 144,885 135,088
Note payable 16,000 --
Current federal income taxes -- 2,608
Deferred federal income taxes 2,311 8,095
Due to affiliates -- 884
Other liabilities 4,179 3,578
--------- ---------
Total liabilities 414,457 368,954
--------- ---------
STOCKHOLDERS' EQUITY
Common stock, without par value. Authorized 100,000,000 shares;
42,210,337 and 42,039,892 shares issued, respectively, at stated value
of $2.50 per share 105,526 105,100
Less 1,330,525 and 13,212 treasury shares, respectively (16,568) (167)
Additional paid-in capital 42,285 41,539
Accumulated comprehensive income 10,111 20,276
Retained earnings 194,692 174,076
--------- ---------
Stockholders' equity 336,046 340,824
--------- ---------
Total liabilities and stockholders' equity $ 750,503 $ 709,778
========= =========
See accompanying notes to condensed consolidated financial statements.
4
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Three Months Ended June 30, 1999 and 1998
(dollars in thousands, except per share amounts)
(unaudited)
1999 1998
-------- --------
(Restated -
See Note 1)
Earned premiums (net of ceded earned premiums of
$3,116 and $3,758, respectively) $ 98,853 $ 88,884
Net investment income 8,357 8,112
Management services income 2,192 1,987
Net realized gains on investments 872 324
Other income 912 516
-------- --------
Total revenues 111,186 99,823
-------- --------
Losses and loss expenses (net of ceded losses and loss
expenses of $4,616 and $2,624, respectively) 67,972 69,282
Acquisition and operating expenses 27,824 25,829
Interest expense 67 --
Other expense 1,556 1,416
-------- --------
Total expenses 97,419 96,527
-------- --------
Income before federal income taxes 13,767 3,296
Federal income tax expense (benefit):
Current 3,200 940
Deferred 198 (424)
-------- --------
Total federal income taxes 3,398 516
-------- --------
Net income $ 10,369 $ 2,780
======== ========
Earnings per share:
- basic $ 0.25 $ 0.07
======== ========
- diluted $ 0.25 $ 0.06
======== ========
Dividends paid per common share $ 0.025 $ 0.023
======== ========
See accompanying notes to condensed consolidated financial statements.
5
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Six Months Ended June 30, 1999 and 1998
(dollars in thousands, except per share amounts)
(unaudited)
1999 1998
--------- ---------
(Restated -
See Note 1)
Earned premiums (net of ceded earned premiums of
$6,750 and $7,253, respectively) $ 197,329 $ 177,026
Net investment income 16,808 16,123
Management services income 4,376 3,959
Net realized gains on investments 1,926 1,050
Other income 1,678 1,025
--------- ---------
Total revenues 222,117 199,183
--------- ---------
Losses and loss expenses (net of ceded losses and loss
expenses of $6,255 and $3,997, respectively) 134,464 125,273
Acquisition and operating expenses 56,034 52,036
Interest expense 67 --
Other expense, net 3,124 2,705
--------- ---------
Total expenses 193,689 180,014
--------- ---------
Income before federal income taxes 28,428 19,169
Federal income tax expense (benefit):
Current 6,589 5,485
Deferred 590 (627)
--------- ---------
Total federal income taxes 7,179 4,858
--------- ---------
Net income $ 21,249 $ 14,311
========= =========
Net earnings per share:
- basic $ 0.50 $ 0.34
========= =========
- diluted $ 0.50 $ 0.33
========= =========
Dividends paid per common share $ 0.050 $ 0.046
========= =========
See accompanying notes to condensed consolidated financial statements
6
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Six Months Ended June 30, 1999 and 1998
(in thousands)
(unaudited)
1999 1998
--------- ---------
(Restated -
See Note 1)
Cash flows from operating activities:
Net income $ 21,249 $ 14,311
Adjustments to reconcile net earnings to net cash provided by operating
activities:
Depreciation and amortization, net 1,412 1,103
Net realized gains on investments (1,926) (1,050)
Changes in operating assets and liabilities:
Deferred policy acquisition costs (1,522) (633)
Accrued investment income and other assets 931 (1,951)
Net prepaid pension expense (961) (385)
Other liabilities and due to/from affiliate, net (7,233) 3,753
Reinsurance receivable and prepaid reinsurance premiums (1,505) (1,095)
Losses and loss expenses payable 5,606 7,011
Unearned premiums (1,131) 2,317
Federal income taxes (2,255) (2,849)
--------- ---------
12,665 20,532
Cash provided from the change in the reinsurance pool
participation percentage 11,418 19,708
--------- ---------
Net cash provided by operating activities 24,083 40,240
--------- ---------
Cash flows from investing activities:
Purchase of fixed maturities - available for sale (119,866) (120,887)
Purchase of equity securities (12,269) (5,885)
Maturities, calls and principal reductions of fixed maturities -
held to maturity 8,900 9,330
Maturities, calls and principal reductions of fixed maturities -
available for sale 15,913 13,147
Sale of fixed maturities - available for sale 71,701 62,839
Sale of equity securities 8,394 2,392
Net cash acquired on acquisiton of Farmers Casualty
Insurance Company and subsidiary 11,568 --
Net additions of property and equipment (2,839) (552)
--------- ---------
Net cash used in investing activities (18,498) (39,616)
--------- ---------
Cash flows from financing activities:
Proceeds from issuance of debt 16,000 --
Net proceeds from sale of common stock 1,172 742
Payments to acquire treasury stock (16,401) --
Payment of dividends (645) (575)
--------- ---------
Net cash provided by financing activities 126 167
--------- ---------
Net increase in cash and cash equivalents 5,711 791
Cash and cash equivalents at beginning of period 32,605 30,931
--------- ---------
Cash and cash equivalents at end of period $ 38,316 $ 31,722
========= =========
Supplemental disclosures:
Federal income taxes paid $ 9,500 $ 7,650
========= =========
See accompanying notes to condensed consolidated financial statements.
7
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
June 30, 1999
(in thousands, except per share data)
(unaudited)
1. BASIS OF PRESENTATION
The accompanying condensed consolidated 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.
The balance sheet at December 31, 1998 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.
These financial statements should be read in conjunction with the financial
statements and notes thereto for the year ended December 31, 1998 included in
the Company's 1998 Form 10-K filed with the Securities and Exchange Commission.
In July 1998 the Company acquired the outstanding shares of Milbank Insurance
Company ("Milbank") from State Automobile Mutual Insurance Company ("Mutual"),
an affiliated company. The transaction was effected through an exchange with
Mutual of approximately 5.1 million Company common shares for all of the issued
and outstanding capital stock of Milbank. Since the transaction was a
combination of entities under common control it has been accounted for similar
to a pooling-of-interest. The June 30, 1998 financial information has been
restated to include the financial position and operations of Milbank.
Effective January 1, 1999, the Company purchased Farmers Casualty Insurance
Company ("Farmers Casualty"), an Iowa domiciled standard property casualty
insurer, for approximately $9.0 million. In addition, Farmers Casualty owns 100%
of the outstanding shares of Mid-Plains Insurance Company ("Mid-Plains"), an
Iowa domiciled property casualty insurer, which principally writes nonstandard
auto insurance. This transaction has been accounted for using the purchase
method of accounting. In conjunction with the acquisition, liabilities assumed
were as follows:
Fair value of assets acquired $28,040
Cash paid for the common stock (9,000)
-------
Liabilities assumed $19,040
=======
Also on January 1, 1999, the pooling arrangement was amended to include all of
the property and casualty business of Farmers Casualty. With the inclusion of
Farmers Casualty in the pool, the pooling participation percentages were amended
to allocate 37% to State Auto Property & Casualty ("State Auto P&C"), a wholly
owned subsidiary of the Company, 49% to Mutual, 10% to Milbank, 1% to Midwest
Security Insurance Company, a wholly owned subsidiary of Mutual, and 3% to
Farmers Casualty. State Auto P&C, Milbank and Farmers Casualty received
approximately $11.4 million to cover their increased share of pool liabilities.
8
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
June 30, 1999
(in thousands, except per share data)
(unaudited)
2. COMPREHENSIVE INCOME
The components of comprehensive income, net of related tax, are as follows:
Three months ended Six months ended
June 30 June 30
------- -------
1999 1998 1999 1998
---- ---- ---- ----
(Restated - (Restated -
See Note 1) See Note 1)
Net income $ 10,369 $ 2,780 $ 21,249 $ 14,311
Unrealized holding gains
(losses), net of tax (7,758) 781 (10,165) 1,766
-------------------------- --------------------------
Comprehensive income $ 62,611 $ 3,561 $ 11,084 $ 16,077
========================== ==========================
The components of accumulated other comprehensive income, net of related tax,
included in stockholders' equity at June 30, 1999 and December 31, 1998 include
only unrealized holding gains, net of tax.
3. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted earnings per
common share:
Three months ended Six months ended
June 30 June 30
------- -------
1999 1998 1999 1998
---- ---- ---- ----
(Restated - (Restated -
See Note 1) See Note 1)
Numerator:
Net income for basic and diluted
Earnings per share $ 10,369 $ 2,780 $ 21,249 $ 14,311
------------------------- -------------------------
Denominator
Weighted average shares for
Basic earnings per share 41,642 41,859 41,847 41,843
Effect of dilutive stock options 768 1,089 781 1,072
------------------------- -------------------------
Adjusted weighted average shares
For diluted earnings per share 42,410 42,948 42,628 42,915
------------------------- -------------------------
Basic earnings per share $ 0.25 $ 0.07 $ 0.50 $ 0.34
------------------------- -------------------------
Diluted earnings per share $ 0.25 $ 0.06 $ 0.50 $ 0.33
------------------------- -------------------------
9
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
June 30, 1999
(In thousands, except per share data)
(unaudited)
4. SEGMENT INFORMATION
Three months ended Six months ended
June 30 June 30
------- -------
1999 1998 1999 1998
---- ---- ---- ----
(Restated - (Restated -
See Note 1) See Note 1)
Revenues from external customers:
Standard insurance $ 99,904 $ 91,087 $ 199,605 $ 181,767
Nonstandard insurance 8,554 6,936 16,946 13,441
Investment management services 829 825 1,694 1,637
All other 958 676 1,832 1,294
------------------------- -------------------------
Total revenues from external customers $ 110,245 $ 99,524 $ 220,077 $ 198,139
========================= =========================
Intersegment revenues:
Standard insurance $ 93 $ 66 $ 186 $ 131
Nonstandard insurance (30) (23) (60) (45)
Investment management services 644 591 1,290 1,159
All other 375 283 715 525
------------------------- -------------------------
Total intersegment revenues $ 1,082 $ 917 $ 2,131 $ 1,770
========================= =========================
Segment profit (loss):
Standard insurance $ 11,398 $ 1,919 $ 23,661 $ 15,884
Nonstandard insurance 30 19 (188) 60
Investment management services 1,325 1,198 2,635 2,408
All other 412 329 959 560
------------------------- -------------------------
Total segment profit 13,165 3,465 27,067 18,912
Reconciling items:
Corporate expenses (261) (480) (515) (777)
Net realized gains 872 324 1,926 1,050
Miscellaneous adjustments (9) (13) (50) (16)
------------------------- -------------------------
Total consolidated income before taxes $ 13,767 $ 3,296 $ 28,428 $ 19,169
========================= =========================
Segment assets:
Standard insurance $ 672,592 $ 630,003
Nonstandard insurance 47,137 38,638
Investment management services 5,864 6,057
All other 15,386 14,044
--------------------------
Total segment assets $ 740,979 $ 688,742
==========================
The standard insurance segment's assets increased about $31.0 million at June
30, 1999 from the amount reported at December 31, 1998 because of the
acquisition of Farmers Casualty and the concurrent change in the pooling
arrangement, as discussed above in Note 1. The nonstandard insurance segment's
assets increased about $9.0 million from the amount reported at December 31,
1998, because Mid-Plains, which is a wholly owned subsidiary of Farmers
Casualty, is a part of the nonstandard insurance segment.
10
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
June 30, 1999
(in thousands, except per share data)
(unaudited)
5. DEBT
During the second quarter of 1999, State Auto Financial's Board of Directors
approved a plan to repurchase up to 4.0 million shares of its common stock until
December 31, 2000. Since the repurchase began in the second quarter of 1999,
State Auto Financial has repurchased 1,312,000 shares, 915,500 from Mutual and
396,500 from the public. Repurchases are transacted to maintain the same
ownership ratios, with 70% of the repurchased stock from Mutual and 30% from the
public.
In conjunction with the stock repurchase plan State Auto Financial entered into
a line of credit agreement with Mutual whereby State Auto Financial may draw up
to $30.0 million, at an interest rate of 6.0%, to be used specifically to
repurchase shares of the Company's stock. To date, State Auto Financial has
drawn on $16.0 million of the $30.0 million line of credit. Repayment of
principal shall begin no later than 2001.
6. RECLASSIFICATIONS
Certain items in the 1998 condensed consolidated financial statements have been
reclassified to conform with the 1999 presentation.
11
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Results of Operations
- ---------------------
Income before federal income taxes increased $10.5 million to $13.8 million and
$9.3 million to $28.4 million for the three months and six months ended June 30,
1999, respectively, from the same 1998 periods. A decrease in the level of
catastrophes of approximately $13.3 million and $9.8 million for the three
months and six months ended June 30, 1999, respectively, from the same 1998
periods contributed significantly to the improvement in income.
1999 was also impacted by the acquisition of Farmers Casualty Insurance Company
("Farmers Casualty") and an amendment to the Company's pooling arrangement. On
January 1, 1999, the Company acquired Farmers Casualty and its subsidiary
Mid-Plains Insurance Company ("Mid-Plains"), both Iowa domiciled insurers.
Farmers Casualty is a standard property and casualty insurer while Mid-Plains
writes principally nonstandard auto insurance. This transaction was accounted
for under the purchase method of accounting. During 1998, the Company's standard
insurance subsidiaries, State Auto Property & Casualty Insurance Company ("State
Auto P&C") and Milbank Insurance Company ("Milbank") participated in a pooling
arrangement with State Automobile Mutual Insurance Company ("Mutual"), a
majority shareholder of the Company and Midwest Security Insurance Company
("Midwest Security"), a wholly owned subsidiary of Mutual. State Auto P&C
assumed 37% of the pooled business, Milbank 10%, Mutual 52% and Midwest Security
1%. Effective January 1, 1999, the Company amended its pooling arrangement to
include all of the property and casualty insurance business of Farmers Casualty.
With the inclusion of Farmers Casualty in the pool, the pooling participation
percentages were amended to allocate 37% to State Auto P&C, 49% to Mutual, 10%
to Milbank, 1% to Midwest Security and 3% to Farmers Casualty (collectively,
these companies are referred to as the "Pooled Companies"). In connection with
the January 1, 1999 pooling changes, the Company received approximately $11.4
million to cover its increased share of the pooled liabilities.
Consolidated earned premiums during the quarter ended June 30, 1999, increased
$9.9 million (11.2%) to $98.9 million from the same 1998 period. The 11.2%
increase was derived from four sources. The impact of the change in allocation
percentages of the Company's pooling arrangement, as well as the addition of
Farmers Casualty to the pool increased consolidated earned premiums 8.6%. The
growth in the standard insurance segment (State Auto P&C, Milbank and Farmers
Casualty), excluding the impact of the changes in the pooling arrangement,
increased consolidated earned premiums about 1.0%, while the impact of the
addition of Mid-Plains to the nonstandard insurance segment increased
consolidated earned premiums 2.0%. The nonstandard insurance segment continued
to experience a slight decrease in its earned premiums during the three months
ended June 30, 1999.
Consolidated earned premiums for the six months ended June 30, 1999, increased
$20.3 million (11.5%) to $197.3 million from the same 1998 period. The impact of
the change in allocation percentages of the Company's pooling arrangement, as
well as the addition of Farmers Casualty to the pool increased consolidated
earned premiums 6.6%. The growth in the standard insurance segment (State Auto
P&C, Milbank and Farmers Casualty), excluding the impact of the changes in the
pooling arrangement, increased consolidated earned premiums 1.0%. The impact of
the addition of Mid-Plains to the nonstandard insurance segment increased
consolidated earned premiums 4.0%. Nevertheless, the nonstandard insurance
segment experienced a decrease in its earned premiums for the six months ended
June 30, 1999.
During 1999 the Company has continued to experience minimal internal growth in
its standard insurance segment. While commercial lines pricing remained soft,
the Company did experience an increase in new business during the second
quarter. Competition for private passenger auto continues to be very intense,
particularly from the direct response companies. This adversely affected the
Pooled Companies ability to generate new private passenger business because
management continued to stress responsible pricing and diligent underwriting.
12
The nonstandard insurance segment experienced a decrease in its earned premiums.
This was the continuing result of significant auto physical damage rate
increases and a more restrictive underwriting posture the Company implemented in
this segment throughout most of its operating states during 1998 as well as
increased competition in this market segment during 1999. While these management
actions have resulted in a decrease in the volume of business over the last
several reporting periods, this segment's statutory loss experience continues to
improve over comparative prior periods.
Net investment income increased $0.2 million (3.0%) to $8.4 million and $0.7
million (4.2%) to $16.8 million for the three months and six months ended June
30, 1999, respectively, from the same 1998 periods. Contributing to these
increases was the transfer to the Company of approximately $11.4 million in
conjunction with the change in the pooling arrangement, the addition of Farmers
Casualty and Mid-Plains to the Company's operations and a general increase in
investable assets over the previous 1998 period. Total cost of investable assets
at June 30, 1999 was $628.0 million compared to $575.4 million at June 30, 1998.
The investment yield, based on fixed and equity securities at cost, decreased to
5.3% and 5.4% for the three months and six months ended June 30, 1999,
respectively, from 5.7% for the same 1998 comparable periods.
Losses and loss expenses, as a percentage of earned premiums, decreased to 68.8%
for the three months ended June 30, 1999 from 77.9% for the same 1998 period and
for the six months ended June 30, 1999, decreased to 68.1% from 70.8% for the
same 1998 period. The decrease in losses and loss expense percentages were
largely due to a decrease in the level of catastrophe losses experienced by the
Company compared to the same 1998 period. During the second quarter of 1998 the
Company experienced storm-related catastrophe claims in nearly all operating
states. The improvement in the level of catastrophe claims in 1999 compared to
1998 contributed to a 15 percentage point decrease in the GAAP loss ratio in the
current quarter and approximately 6 percentage points for the six months ended
June 30, 1999. Offsetting the improvement in the 1999 catastrophe levels (as
well as the GAAP loss ratio) was an unusually high number of large commercial
claims impacting the current quarterly operations. Despite these unusually large
losses management believes the Company's core business remains stable.
Acquisition and operating expenses, as a percentage of earned premiums (the
"expense ratio"), decreased to 28.1% for the quarter ended June 30, 1999 from
29.1% for the same 1998 period and for the six months ended June 30, 1999,
decreased to 28.4% from 29.4% for the 1998 period. These decreases are
attributable to an improvement in a number of expense items of the Company and
not any one specific item.
Interest expense relates to the line of credit agreement State Auto Financial
commenced with Mutual during the second quarter of 1999 to assist in the funding
of its repurchase program as discussed in the Liquidity and Capital Resources
section below.
The effective Federal tax rate was 24.7% and 25.3% for the three months and six
months ended June 30, 1999, respectively, compared to 15.7% and 25.3% for the
same 1998 periods, respectively. The fluctuation in the effective rates for the
quarterly periods is largely the result of the differences in the level of
catastrophe losses experienced by the Company in 1998 compared to the current
1999 quarter.
Liquidity and Capital Resources
- -------------------------------
In 1999, net cash provided by operating activities decreased to $24.1 million
($40.2 million in 1998). On January 1, 1998 the Company amended its pooling
arrangement to include the insurance operations of Midwest Security as well as
change its allocation percentages. In connection with the January 1, 1998
pooling change, the Company received approximately $19.7 million to cover its
increased share of the pooled liabilities whereas for the January 1, 1999
pooling change the Company received $11.4 million. Absent these cash transfers,
net cash provided by operating activities decreased to $12.7 million at June 30,
1999 ($20.5 million in 1998). Pursuant to the pooling arrangement, Mutual is
responsible for the payment of losses and loss expenses and receipt of premiums
for the pooled companies. Quarterly unpaid incurred pooled balances are
reflected in "due to or due from affiliates" in the accompanying condensed
consolidated balance sheets. Settlements of the intercompany accounts are made
in the month following the end of the quarter.
13
Overall, net cash used in investing activities decreased to $18.5 million ($39.6
million in 1998). Contributing to this decrease was an increase of $11.6 million
in net cash acquired by the Company on the acquisition of Farmers Casualty and
its subsidiary Mid-Plains. The balance is due to $8.3 million less in cash
provided from the change in the reinsurance pool participation percentages
between 1999 and 1998.
Net cash provided by financing activities for the six months ended June 30, 1999
remained comparable to the same period in 1998. During the second quarter of
1999, State Auto Financial's Board of Directors approved a plan to repurchase up
to 4.0 million shares of its common stock over a period ending December 31,
2000. Since the repurchase began in the second quarter of 1999, State Auto
Financial has repurchased 1,312,000 shares, 915,500 from Mutual and 396,500 from
the public. Repurchases are transacted to maintain the same ownership ratios,
with 70% of the repurchased stock from Mutual and 30% from the public.
In conjunction with the stock repurchase plan State Auto Financial entered into
a line of credit agreement with Mutual whereby State Auto Financial may draw up
to $30.0 million, at an interest rate of 6.0%, to be used specifically to
repurchase shares of the Company's stock. To date, State Auto Financial has
drawn on $16.0 million of the $30.0 million line of credit. Repayment of
principal shall begin no later than 2001.
As of June 30, 1999, funds consisting of cash and cash equivalents were $38.3
million versus $31.7 million at June 30, 1998. At June 30, 1999 approximately
$5.8 million had been allocated to an escrow account for the additional
capitalization of State Auto Insurance Company, with the balance allocated to
fund general operations.
Market Risk
- -----------
With respect to Market Risk, see the discussion regarding this subject in the
Company's December 31, 1998 Management's Discussion and Analysis of Financial
Condition and Results of Operations, included in the December 31, 1998 Form
10-K. There have been no material changes from the information reported
regarding Market Risk in the 1998 Form 10-K.
Year 2000
- ---------
Description of the Year 2000 Issues Affecting the Company
- ---------------------------------------------------------
The Company and its affiliates (all of which are sometimes collectively referred
to hereafter as "State Auto") 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 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. In March 1999, the company conducted another successful Y2K test at
an off-site computer facility, which was geared specifically to Leap Day,
February 29, 2000 and March 1, 2000. An additional test is planned for
September. Additionally, all internal test systems run with advanced dates
giving the Company the opportunity to identify Y2K issues early enough to react
to them. Testing has already begun with policies that renew with effective dates
beyond January 1, 2000.
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
14
to ensure that no material problems arise from the policy processing systems
used by the Company the Company plans to continue simulated Year 2000 testing
throughout 1999.
State Auto's Y2K project team has, through June 1999, completed its efforts on
approximately 99% of State Auto's applications software. That means that
approximately 99% 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 99% are the systems that address policy
issuance, premium billing and collection and claims processing at State Auto.
The remaining 1% 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 during the third quarter 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 whom have automated agency management systems in
place.
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 are Y2K compliant. If upload and download are disrupted by Y2K issues, it
will likely affect the efficiency with which the Company operates its business.
The Company has surveyed all State Auto Agencies that currently upload data
electronically to State Auto and verified that every one of these agencies has a
Y2K compliant agency vendor system. For those agencies that only receive a
download of policy information from State Auto, current information on the Y2K
compliance status of their systems available to State Auto indicates that the
majority of them are Y2K compliant. In the event that any of these agencies
encounters any difficulty with download, State Auto is prepared to suspend the
electronic transfer and turn back on the generation of policy documents of which
an agency would need to maintain records manually.
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 would 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 1999. State Auto
expects to have third party vendor products then in use Y2K compliant by the end
of the 3rd quarter of 1999.
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's Costs to Address Year 2000 Issues
- ----------------------------------------------
State Auto's Y2K compliance expense to date for resources has been $ 4.2 million
dollars of a projected $5.0 million dollars. This estimate is subject to change
depending on future, presently unforeseen developments, which could affect the
cost of Y2K compliance for State Auto. The 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 $0.5 million spent by State
Auto 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
15
resources for other systems projects has generated an additional expense to
State Auto of approximately $2.8 million over the last two years.
State Auto's Risks Due to Year 2000 Issues
- ------------------------------------------
As a property casualty insurer, State Auto faces the additional risk of insured
or allegedly insured losses to its policyholders 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 is making progress in the development of a formal Y2K contingency
plan. Each internal department has responded to a survey relating to its use of
external systems, which might be subject to disruption. The company is also
utilizing some previously developed Business Recovery documents as part of this
contingency plan. 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, product offerings, National's
premium receivable collections effort, the Year 2000 discussion, the statements
relating to the new insurer to be created, State Auto Insurance Company, the
legislative and regulatory environment and sales forecasts. 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.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
The information called for by this item is provided under the caption "Market
Risk" under Item 2 - Management's Discussion and Analysis of Financial Condition
and Results of Operations.
16
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART II. OTHER INFORMATION
Item 1. Legal Proceedings - None
Item 2. Changes in Securities and Use of Proceeds - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders
The annual meeting of shareholders of State Auto Financial Corporation
was held on Thursday, May 27, 1999. The total shares represented at the meeting
were 38,737,952. This constituted 92.0% of the Company's 42,057,917 shares
outstanding. At the meeting, the shareholders voted on one resolution; the
election of Robert L. Bailey, William J. Lhota and David J. D'Antoni as Class II
Directors, each to hold office until the 2002 annual meeting of shareholders and
until a successor is elected and qualified, with each director nominee receiving
the votes indicated:
NUMBER OF VOTES
---------------
FOR WITHHELD
--- --------
Robert L. Bailey 38,467,232 270,720
William J. Lhota 37,466,792 271,160
David J. D'Antoni 37,467,972 269,980
On the basis of this vote, Robert L. Bailey, William J. Lhota and David
J. D'Antoni were elected as Class II Directors to serve until the 2002 annual
meeting and until a successor is elected and qualified.
Item 5. Other Information - None
17
INDEX TO EXHIBITS
Item 6. a. Exhibits
Exhibit No. Description of Exhibits
----------- -----------------------
10(LL) Credit Agreement dated as of June 1, 1999
between State Auto Financial Corporation and
State Automobile Mutual Insurance Company
27 Financial data schedules
b. Reports on Form 8-K - None
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: AUGUST 13, 1999 /s/ Steven J. Johnston
----------------- ----------------------------------------
Steven J. Johnston
Treasurer and Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)