2004
Annual Report
State Auto
Financial Corporation
STATE AUTO®
Insurance Companies
®
Board of Directors
seated, from left: Robert H. Moone, president and CEO, chairman of the board; David J. D’Antoni, retired senior vice president and group operating officer, Ashland, Inc.;
Paul S. Williams, executive vice president, chief legal officer and secretary, Cardinal Health, Inc.; William J. Lhota, president and CEO, Central Ohio
Transit Authority; Richard K. Smith, retired partner, KPMG LLP;
standing, from left: S. Elaine Roberts, president and chief executive officer, Columbus Regional Airport Authority; John R. Lowther, senior vice president, secretary
and general counsel; James E. Kunk, regional president, Huntington National Bank; Paul W. Huesman, consultant and retired president,
Huesman-Schmid Insurance Agency, Inc.
Senior Officers
Robert H. Moone, 61
president and CEO,
chairman of the board
Steven J. Johnston, 45
senior vice president,
treasurer and CFO
John R. Lowther, 54
senior vice president,
secretary and general counsel
Mark A. Blackburn, 53
senior vice president
Douglas E. Allen, 47
vice president
William D. Hansen, 39
vice president
John B. Melvin, 55
vice president
John M. Petrucci, 46
vice president
Terrence L. Bowshier, 52
vice president
Steven R. Hazelbaker, 49
vice president
Cathy B. Miley, 55
vice president
Cynthia A. Powell, 44
vice president
David W. Dalton, 46
vice president
Terrence P. Higerd, 60
vice president
Richard L. Miley, 51
vice president
James E. Duemey, 58
vice president and
investment officer
Noreen W. Johnson, 56
vice president
Paul E. Nordman, 47
vice president
State Auto Financial Corporation
Table of contents
2 Financial highlights
State Auto Financial Corporation
3 Corporate structure
State Automobile Mutual Insurance Company
4 Letter to our shareholders
Robert H. Moone, president, CEO and Chairman of the Board
6 Behind the Numbers
6
Financial
9 Underwriting
Personal Lines
Commercial Lines
1 1 Sales
1 2 Claims
1 4
1 5
Information Technology
R e g i o n a l O p e r a t i o n s
1
Corporate Profile
State Auto Financial Corporation (“STFC” or the
“Company”) is a regional insurance holding company head-
quartered in Columbus, Ohio. STFC, through its five insur-
ance subsidiaries, provides personal and commercial insur-
ance for both the standard and nonstandard insurance mar-
kets. STFC’s principal lines of business include personal and
commercial auto, homeowners, commercial multi-peril, fire
and general liability. Combined, the State Auto companies
market their insurance products through approximately
22,500 independent agents associated with approximately
3,250 agencies in 26 states. STFC and its subsidiaries are
affiliated with State Automobile Mutual Insurance Company
(“Mutual”), which owns approximately 65% of the Company’s
outstanding shares.
STFC’s insurance subsidiaries consist of State Auto
Property and Casualty Insurance Company (“State Auto
P&C”), Milbank Insurance Company (“Milbank”), Farmers
Casualty Insurance Company (“Farmers”), State Auto
Insurance Company of Ohio (“SA Ohio”), and State Auto
National Insurance Company (“SA National”). An insurance
pooling arrangement exists ( the “State Auto Pool”) between
various insurers in the State Auto group by which premiums,
losses and underwriting expenses are shared by the pool
participants. STFC receives 80 percent in the aggregate of
the State Auto Pool, while Mutual receives 20 percent.
STFC also has three non-insurance subsidiaries. Stateco
Financial Services, Inc. (“Stateco”) provides investment
management services to the entire State Auto group of
companies. Strategic Insurance Software, Inc. (“S.I.S.”)
develops and markets software designed to compete in
the insurance agency management system market. 518
Property Management and Leasing, LLC (“518 PML”) owns
and leases real and personal property to STFC and its affili-
ates. STFC and Mutual, together with their insurance sub-
sidiaries, are collectively referred to as "State Auto."
With a commitment to responsible cost-based pricing,
conservative investments and sound underwriting practices,
STFC has maintained a healthy financial record since
becoming a public company in 1991. Combined with its
focus on providing outstanding service to policyholders and
agents, State Auto has earned the reputation as one of the
strongest and best managed regional insurance groups in
the industry. The State Auto Pool has consistently received
A.M. Best Company’s A+(Superior) rating.
State Auto Financial Corporation is traded on the Nasdaq
National Market System under the symbol STFC.
Financial Highlights OF STATE AUTO FINANCIAL CORPORATION
(in millions, except per share data)
2004
2003
2002
2001*
2000*
1999*
GAAP MEASURES
Total revenue $ 1,092.4
Net income $ 110.0
Total assets $ 2,023.7
$ 658.2
Total stockholders' equity
GAAP combined ratio(1)
91.7
PER COMMON SHARE (2)
Basic earnings $ 2.76
Diluted earnings $ 2.70
Book value $ 16.42
1,041.7
63.6
1,836.7
542.3
98.2
1.62
1.58
13.71
967.5
37.0
1,593.0
463.8
102.4
0.95
0.93
11.89
623.3
20.6
1,367.5
400.2
107.0
0.53
0.52
10.28
462.8
47.7
898.1
386.1
98.4
1.24
1.21
10.01
440.9
42.8
759.9
317.7
96.0
1.05
1.03
8.29
NON-GAAP MEASURES
Total operating revenue(3)
Plus net realized gain
on investments
$1,084.8
1,031.1
961.6
621.3
457.5
438.3
$ 7.6
10.6
5.9
2.0
5.3
2.6
GAAP total revenue $1,092.4
1,041.7
967.5
623.3
462.8
440.9
Net income from operations(4) $ 105.1
56.7
33.2
19.3
44.3
41.2
Plus net realized gain
on investments, less applicable
federal income taxes
$ 4.9
GAAP net income $ 110.0
PER COMMON SHARE (2)
$ 2.64
Basic earnings from operations(5)
Diluted earnings from operations(5) $ 2.58
2
6.9
63.6
1.44
1.41
3.8
37.0
0.85
0.83
1.3
20.6
0.50
0.49
3.4
47.7
1.15
1.12
1.6
42.8
1.01
.99
State Auto ® Corporate Structure
State Automobile
Mutual Insurance Company
STATE AUTO FINANCIAL
CORPORATION
State Auto Property and
Casualty Insurance Company
518 Property Management
and Leasing, LLC
Stateco Financial
Services, Inc.
Milbank
Insurance Company
Farmers Casualty
Insurance Company
State Auto
Insurance Company of Ohio
State Auto National
Insurance Company
Strategic Insurance
Software, Inc.
Meridian Citizens Mutual
Insurance Company
Meridian Insurance Group, Inc.
Meridian Security
Insurance Company
State Auto Insurance
Company of Wisconsin
State Auto
Florida Insurance Company
BroadStreet Capital
Partners, Inc.
Pooled Companies within the State Auto Group
as of January 1, 2005.
1998*
1997
402.1
37.5
717.5
340.8
97.3
.89
.87
8.11
363.0
41.0
664.4
297.3
94.6
.99
.97
7.11
1996
345.1
26.4
605.4
247.6
100.5
.64
.63
5.98
1995*
333.5
29.9
579.2
225.8
97.8
.73
.72
5.48
399.1
359.9
342.3
331.7
(1) Combined ratio is the loss and LAE ratio plus the expense
ratio. GAAP ratios are computed using earned premiums
for both the loss and LAE ratio and the expense ratio, and
include the effect of eliminations in consolidation.
(2) Per common share adjusted for 1998 2-for-1 and 1996
3-for-2 common stock split effected in the form of a stock
dividend. Earnings per common share amounts prior to
1998 are restated as required to comply with SFAS No. 128.
(3) Total operating revenue excludes net realized gains and
and losses on investments from total revenue.
(4) Net income from operations excludes net realized gains and
3.0
3.1
2.8
1.8
losses on investments, net of tax, from net income.
(5) Basic and diluted earnings from operations is net income
from operations as defined above divided by the weighted
average basic or diluted shares outstanding for the period,
as applicable.
*Includes pooling changes effective October 1, 2001, January 1,
2000, 1999, 1998 and 1995.
402.1
363.0
345.1
333.5
35.6
39.0
24.6
28.8
1.9
37.5
.85
.83
2.0
41.0
.94
.92
1.8
26.4
.60
.59
1.1
29.9
.70
.69
3
Letter to our shareholders
nature served up a typical dose of wind, hail and ice
throughout most of our operating states. These events
are a part of our business, but we believe the impact of
such storms can be mitigated by appropriate rate action
and controlling exposures in the most loss-prone areas.
We believe the combined ratio number mentioned in the
previous paragraph reflects the Company’s success in
this regard. We will continue to be relentless in the exe-
cution of these underwriting fundamentals that are critical
to success.
As the market softened in 2004, we resisted the exam-
ple set by many competitors that decided to use rampant
rate cutting as a scheme to increase market penetration.
Nonetheless, we believe our rate of premium growth was
quite appropriate, and we are intent on increasing the
sales pace in 2005 using strategies that enhance profit,
not reduce it.
We know that state-of-the-art automation can provide
both a sustainable sales advantage and a decidedly posi-
tive impact on the expense ratio.
On the personal lines side we are convinced our new
“netXpress” Internet product is making an enormous
impact, allowing agency staffers to submit business to us
on a “once and done” basis. Time and again our agency
partners and the customer service representatives who
are so involved in the placement of personal lines policies
tell us that speed, accuracy, convenience - the “ease of
doing business” – are important ways by which they mea-
sure their companies. Over the course of 2005,
netXpress will be introduced for standard personal lines in
all of our operating states and should provide us with a
sales advantage over those companies without such
sophisticated systems. And the change will further widen
our expense ratio advantage over many competitors, mov-
ing us from reliance on company personnel who re-enter
information into the issuance system, since the agency
has already keyed the required data. Our objective for
2005 is to see 80% of new personal lines business com-
ing straight into our system, directly from the agents’
offices.
Additional efficiency and loss ratio enhancement should
flow from the use of our “Apollo intelligent underwriting
system.” This system is expected to improve the numbers
by allowing our current staff of personal lines specialists
to handle substantially more volume, while freeing them
up to concentrate on the examination of entire agency
books of business. The slicing and dicing of data to iden-
tify the most profitable market segments, as well as those
that need rate nourishment, has been pivotal to our
underwriting success. Apollo is critical to the creation and
actuarial analysis of such a huge data warehouse. Such
analysis will allow us to develop sales and pricing pro-
grams designed to identify market segments from which
we expect robust sales and superior profits.
In commercial lines we continue to exploit the advan-
tages inherent in having our underwriters in the field. This
Robert H. Moone, president, CEO, and chairman of the board, is
shown in State Auto’s computer training center. The center reflects
STFC’s commitment to developing and utilizing effective, sophisticat-
ed business automation processes.
As you may recall, your 2003 Annual Report was titled
“By the Numbers.” For 2004 we decided to expand upon
that theme by going “Behind the Numbers” in an effort to
highlight our philosophies, practices and processes so
instrumental in achieving your Company’s results.
Throughout this report many of our key people will be
explaining the philosophies and processes that we believe
are crucial to our sustained success.
As has been our custom for a number of years, we’ll
begin with some figures that demonstrate outstanding
performance over a wide range of metrics. These primary
indicators of success are the combined ratio, the rate of
written premium growth and the expense ratio. Of course,
there are many other measures we watch closely – many
of which will be presented elsewhere in this report – but
we feel these three, high-level figures truly capture the
essence of an insurance company’s performance.
STFC’s GAAP combined ratio was a stellar 91.7% for
2004. Lest we get too giddy over that excellent number,
we must be mindful of the fact that the majority of publicly
traded insurance companies achieved an underwriting
profit last year – although few approached our results.
Insurers made progress moving toward rate adequacy,
paid greater attention to underwriting integrity and benefit-
ed from continuing reductions in loss frequency, resulting
in an estimated 97.6% combined ratio for the industry as
a whole, the best year in decades for this industry. So,
measuring our results on the profit metric is a matter of
degree and STFC, once again, out-performed the industry
by a wide margin. STFC’s profit produced an all time high
in earnings per share for the Company in 2004.
While we are certainly proud of this achievement, it is
even more remarkable given the level of catastrophe loss-
es incurred over the course of the year. Four Florida hur-
ricanes in a single season is not unprecedented, but it
certainly qualifies as a very rare occurrence. In addition,
4
gives them the opportunity to work directly with our
agents, policyholders and prospects in developing the
very “best of class” in terms of risk control, financial stabil-
ity and management expertise. Assessing these metrics
gives them a far better appreciation for pricing options, as
well as policy terms and conditions, as compared to desk-
bound underwriters who are forced to make such determi-
nations based solely on paper or electronic applications.
Our agents regularly comment on the value of this system
in helping them develop new business and retain their
best existing accounts.
While we do not yet enjoy the cost advantages of
Internet-based agent submissions as is the case with per-
sonal lines, we do have a dedicated team working to bring
automated solutions to our commercial products.
We are very pleased with the synergies presented by
each of these “behind the numbers” programs to improve
all three of our major corporate objectives.
It is appropriate for me to comment on two other topical
issues. The first issue is the state of the insurance market
and State Auto’s response to any perceived changes. It is
now clear that the prospect of a single year of underwrit-
ing profit - the first since 1978 - has inspired management
of some insurance companies to devolve into the strategy
of cutting prices as a means of developing market share.
One can only expect that abandoning underwriting
discipline, as manifested by accepting marginal business
in standard programs, will follow.
You can rest assured that your Company has not lost
sight of the mischief that follows sacrificing the bottom line
to achieve top line growth. The chart on page 7 showing
our revenue increases over the years, demonstrates our
resolve, as was the case in 2000, to seek to maintain mar-
ket discipline rather than write new business at an almost
guaranteed loss. While the market has not yet descended
to that level, we will be mindful of our need to improve
shareholder value through underwriting excellence.
Finally, we remind you that your Company distributes its
products exclusively through independent insurance
agents who have been appointed by the Company – not
brokers. This is an extremely important distinction in terms
of understanding the allegations of improper compensation
made by New York Attorney General Elliott Spitzer and
other regulators. Brokers are paid by their customers to
seek out the best insurance coverage value for their firms.
To negotiate and accept payments from both the insured
and the carrier without at least disclosing this may well be
problematic. Contrast that distribution system with inde-
pendent insurance agents who are contracted by the insur-
ance companies they represent and are compensated by
those companies.
It may well be that many state regulators will prefer or
insist upon some degree of agent compensation disclo-
sure, but we do not see this issue as having any funda-
mental impact on our method of doing business. We
believe this is important as the agency system has peren-
nially contributed to our underwriting success and contin-
ues to enjoy dominance in commercial lines market pene-
tration and a resurgence in personal lines.
As always, you have our pledge of continued focus on
executing the sound underwriting fundamentals and con-
servative financial management that have served our con-
stituencies so well.
Robert H. Moone, CPCU
Chairman of the Board
President and Chief Executive Officer
Statutory combined ratio STFC vs Industry
Selected financial data as of 12/31/04
125
115
105
95
85
75
115.9
106.4
105.8
106.0
108.1
110.4
107.4
105.2%
99.6
100.0
101.6
97.8
94.1
96.9
95.5
102.3
100.1
97.6
EST.
98.6
92.2
Industry
STFC
Market price..........................................................$25.85
52-week high-low range.............................$31.83 -22.12
2004 basic/diluted earnings per share...........$2.76/$2.70
P/E ratio.....................................................................9.4x
Market capitalization................................$1,037.0 million
Shares outstanding.........................................40.1 million
Estimated float................................................13.9 million
Book value/share...................................................$16.42
Price/book value.........................................................1.6x
Return on average equity........................................18.3%
Quarterly dividend................................................$0.045
Average daily trading volume....................58,409 shares*
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
*Source: NASDAQ
5
2004 Behind
the
numbers
$2.0 billion...STFC’s total assets;
19.8%...book value increase $2.70...earnings per share;
18.3%...return on equity;
$1,313...today’s value of $100 invested in STFC in 1991.
Book value*
(Per Common Share Outstanding)
*Book Value = Total stockholders’ equity divided by total number of
common shares outstanding
$18
16
14
12
10
8
6
4
16.42
13.71
11.89
10.01
10.28
8.11
8.29
7.11
5.98
5.48
1995 1996 1997 1998
1999
2000
2001
2002
2003
2004
STFC stock performance
STFC
S&P 500
S&P P&C Index
1,137
366
143
1992 1993 1994 1995 1996 1997 1998 1999
2000
2001 2002 2003
2004
The CFO behind the numbers, Steve Johnston, reviews
STFC’s outstanding 2004 results.
Financial
A key objective for State Auto is to grow shareholder
value. Shareholder value can be measured by several
metrics, including stock price appreciation, book value per
share, return on equity and earnings growth. It can be
measured on an absolute basis or on a comparative
basis. By any measurement, STFC added nicely to share-
holder value during 2004 and has consistently done so
since first going public in 1991.
1200
The charts on this page reflect STFC’s history of strong
1000
growth in book value and stock price appreciation. Book
value increased 19.8% during 2004 and has grown at a
compound average annual rate of 14% since 1991.
During this period, STFC has integrated four acquisitions,
experienced hard and soft underwriting cycles, seen bull
and bear stock markets and endured fluctuating interest
rates. Through all of these events, STFC was able to
increase book value each year. Coupled with this is an
outstanding relative performance in STFC’s stock price
when compared to the S&P 500 and the S&P Index of
P&C stocks.
6
800
600
400
200
0
Diluted earnings per share
2.70
.97
.87
1.03
.72
193.6
.63
.93
.52
1.21
1.58
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Total revenue
1092
1042
967
623
345
363
402
441
463
333
193.6
$2.80
2.40
2.00
1.60
1.20
0.80
0.40
0
$1200
1100
1000
900
800
700
600
500
400
300
200
100
0
)
s
n
o
i
l
l
i
m
n
i
(
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Cumulative total shareholder return*
Earnings growth in 2004 soared to new
heights. Diluted earnings per share set a
record at $2.70, increasing 71% from 2003.
While STFC’s diluted earnings per share
have not increased every year, an invest-
ment of $100 in STFC, in the initial public
offering, would be worth more than $1,300
at year end 2004, for an annual return of
21%.
In 2004, STFC established a record for
total revenue of $1,092.4 million. This figure
reflects a 136% increase in this metric since
yearend 2000. The Company is now more
than twice the size, from a revenue stand-
point, that it was just four years ago. While
substantial growth in revenue is important, it
is only half of the story. Much of this growth
has come from the acquisition of the
Meridian Group in 2001 which presented
STFC the challenge of integration. A signifi-
cant amount of hard work was undertaken
to integrate the Meridian companies into the
State Auto family and to restore the return
on equity (ROE) of STFC to historic levels at
12/31/04. STFC achieved success in this
metric by producing an ROE of 18.3% for
2004.
continued on page 8
1,313
1,178
774
800
806
776
598
488
*Value of $100
invested on June 28,
1991 including
reinvested dividends.
* Value of $100 invested on
June 28,1991 including
reinvested dividends.
409
429
169
203
222
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
7
$1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
continued from page 6
Bond Quality
State Auto’s prudent underwriting position
is buttressed by a conservative investment
philosophy. STFC’s high quality investment
portfolio is managed by Stateco Financial
Services, Inc. Stateco’s dedicated staff of
investment professionals continually moni-
tors the mix and composition of the STFC
portfolio to ensure adherence to corporate
investment policy guidelines, consistent
investment return and preservation of capi-
tal. Approximately 84% of the Company’s
total assets are invested in publicly traded,
marketable securities, i.e., stocks and
bonds. Only investment grade bonds and
dividend-paying securities are purchased for
the portfolio. While a more aggressive port-
folio may have produced better results dur-
ing certain market cycles, the relatively con-
servative and consistent nature of the
Company’s portfolio has proven beneficial to
STFC’s performance through the years. The
charts here show the quality and diversifica-
tion of the portfolio.
The cumulative effect of all our philoso-
phies, practices and processes has resulted
in STFC being recognized as a company
with superior financial strength. As a publicly
traded insurance holding company, STFC
operates in a highly regulated environment.
Regulations promulgated by the SEC, FASB,
NAIC, state insurance departments, and
practices of rating agencies, and A.M. Best
Company establish financial guidelines and
standards by which STFC is continually
measured and evaluated for compliance with
each such party’s guidelines and standards.
Examples of these standards would be Risk
Based Capital ratios, BCAR ratios, IRIS
ratios, leverage ratio, debt to capital ratio,
etc. The results of all pricing, underwriting,
marketing, claims paying, investing and
operational decisions made throughout the
Company on a daily basis are ultimately
reflected in the financial statements.
“We are extremely pleased to report that
State Auto has consistently met or exceeded
the financial requirements of each of the
above mentioned standards and has com-
plied with all mandated guidelines. State
Auto Mutual’s achievement of receiving A.M.
Best Company’s A+ (Superior) rating for
fifty-one consecutive years, affirms the
group’s history of long-term financial
strength,” stated Johnston.
8
Aa
29.3%
a
Aa
70.2%
A
0.5%
Investment Portfolio $1.76 billion
Cash &
Equivalents
3.6%
Other 0.5%
Corporate Bonds
2.0%
Equities
11.0%
U.S. Government
Agencies - MBS
12.7%
U.S. Treasury
Securities
18.8%
Municipal
Bonds
51.4%
Return on equity STFC vs Industry
20%
15
10
5
0
-5
14.9%
15.0%
11.0%
11.8%
13.0%
13.6%
11.6%
9.3%
8.7%
8.5%
18.3%
12.6%
11.0%
EST.
8.6%
5.2%
9.7%
6.0%
5.9%
2.2%
-1.2%
As reported
STFC
Industry
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Underwriting
The 2004 annual report looks behind the impressive
personal lines underwriting numbers with director of
Personal Lines Underwriting, Rick Holbein.
91.7...combined ratio for 2004; 600...the approximate number
of characteristics considered in evaluating personal lines risks;
8...the number of years out of the last eight that STFC’s
underwriting results outperformed the industry.
Personal Lines
Personal automobile and homeowners insurance com-
prise just over 60% of STFC’s business. Automobile
alone is responsible for 44% of our total premium. Rick
Holbein, director of personal lines underwriting for the
Companies, has dedicated countless hours of his exis-
tence to tweaking contracts, fine tuning rating programs,
collecting loss data and wondering how Henry Ford’s
incredible invention became such an expensive, irreplace-
able, complicated and very fast piece of machinery.
“For years, insuring automobiles and, more importantly,
the people they transport, has produced the greatest pre-
mium volume for the Company. Fortunately, it has often
been a profitable line, as well.” Holbein knows, of course,
that profitably insuring automobiles as well as homes is
that rare combination of science and art. The science is
knowing repair costs, accident rates - the numbers that
tell you what your liability is likely to add up to; the art is
divining which way the market is going.
“We have always underwritten personal lines - all lines
– with the idea that we wanted to be able to cover our
claims costs with the premiums we collect. To stay true to
that philosophy means some days and in some places
you’re competitive…and some days and in some places
you simply aren’t. At least not on price alone. Our trade-
mark is consistency, excellent service and the best claims
handling in the business.”
Holbein suggests that consistency is underrated.
“Agents want markets they can count on. We will tell our
agents that if they partner with us, they’ll be profitable and
over time they will grow. It’s interesting: the “consistency”
sales pitch is typically not as appealing to your potential
customers as it is to your existing customers. We’re an
insurance company that people become attached to.
“State Auto is an underwriting company, first and fore-
most,” says Holbein. “I know our shareholders probably
wonder if we all stand around chanting that mantra. But
we’re proud of it and it’s made us one of the most suc-
cessful companies in the industry.” State Auto is con-
stantly and doggedly monitoring its underwriting practices,
coverages, rates, forms and rules. “We never stop looking
for tools that will enable us to perfect our processes and
boost our ability to grow with profit,” says Holbein. Many of
these processes take several years to implement from
start to finish. Listed below are just a few tasks State Auto
performs behind the numbers:
Audits – The bi-annual underwriting audit process is
a training tool that assures that our guidelines are
being followed and training needs met. Results are
shared with line operations in the regional offices in
face-to-face meetings. The regional offices respond to
every audit, documenting changes they have adopted
to address any underwriting problems.
(cid:1) Endorsement Forms – An important function of the
underwriting staff, most of whom are located in the
Home Office, is to keep on top of the competition and
developments in the market. You can’t allow the com-
petition, through their offerings, to dictate your prod-
ucts’ coverages and cost, but you would be remiss not
to know what consumers are telling you through their
buying habits. Staff also is paying attention to legal
costs, replacement costs, safety features and changes
in driving habits and environments. The changes that
result are often delivered via policy endorsements.
(cid:1) Automation – The banner automation story for person-
al lines in 2004 was the introduction of a new automat-
ed intelligent underwriting system for private passenger
auto, homeowners and nonstandard auto products.
We named it the Apollo Underwriting System. For the
past couple years, teams of people have been devoted
to the process of creating rules and procedures that
will automate many tasks associated with underwriting.
The Apollo roll out to State Auto’s nonstandard auto
states was completed in December 2004. The results
have been gratifying. Not only does this streamline
and refine the underwriting process, it frees up time for
our field sales and line underwriting representatives to
concentrate on production and profitability issues at
the agency level. Efforts are now focused on rolling out
Apollo for standard auto and homeowner.
(cid:1) Characteristic Analysis – This means we thoroughly
review over 600 characteristics that tell us something
meaningful about the people and products we are
insuring. Ironically, as this analysis leads to more
accurate underwriting and the fairest possible pricing of
risk, consumers become more confused by the terms
continued on page 10
9
and processes employed. There is no such thing as
the perfect underwriting tool, but now there are multiple
tools that we are trying to use together…perfectly. We
are closer than we’ve ever been. Now the challenge is
to be able to explain the process to the people and
risks we apply it to.
(cid:1) Class Accuracy - We are using a new homeowners
underwriting tool that ensures we apply the correct pro-
tection class on homeowners property, dwelling fire
and class rated commercial business. The tool is
invaluable to our loss mitigation and rate process.
Why? Homeowners rates are based in large part on
protection class, which measures the capability of the
local fire department to fight a fire, and almost 50% of
all homeowner losses are caused by the peril of fire.
In three of the last four years, including 2004, State Auto
has made an underwriting profit in commercial lines. Ben
Blackmon, (left), assistant vice president and director of
Commercial Lines Underwriting, and Paul Nordman, vice
president and director of Underwriting, talk about the
Company’s overall approach to underwriting and the effort,
discipline and dedication behind the positive numbers.
Commercial Lines
Paul: There are a number of reasons why we’ve done
well on the commercial lines side. Perhaps right at the top
is our approach to account selection. We’re disciplined
and consistent. We don’t entertain certain risk types in
soft markets, only to abandon them in hard markets. Over
the past four years, however, we have been able to attain
stronger rate levels for our accounts. In fact, we use a
metric that we call premium per exposure (PPE) to monitor
our relative rate strength. Since implementing this mea-
sure, we believe our PPE gains have been significant.
Ben: Establishing our base rates is a shared exercise
that involves our branch and regional office management
10
teams, our Home Office staff areas and our actuaries.
We have been able to deliver both an underwriting profit
and a competitive rate, because of our approach that
combines market intelligence and technical acumen.
Paul: Profit is job number one, of course. Our growth
in commercial lines trailed off a bit in 2004. We grew, just
not as fast as we did in 2003. There’s a good reason for
that. After four consecutive years of meaningful rate
increases, we felt that we had attained a healthy degree
of rate adequacy. That translates into more moderate rate
changes at policy renewal.
Ben: And this is where I need to point out that it takes
more than adequate rate levels to be profitable in com-
mercial lines. Our underwriting teams work very closely
with each other and with our agents to make sure our
selection remains deliberate and our pricing responsible.
In fact, many of our underwriters live and travel in the
regions that they underwrite, giving us a first-hand look at
the risks we're being asked to insure. Also, our underwrit-
ing teams share a common understanding of our under-
writing philosophies, so we see remarkable consistency in
risk treatment throughout our 26 operating states. The
other thing I’d point to is the fact that we always look for
ways to get better at what we do, whether that be learning
more about certain types of operations, sharpening our
knowledge base or sharing success stories. We have a
culture of sharing what works.
Paul: Indeed, relationships are paramount at State
Auto. Our people truly care about the Company and there
is a widely shared desire to make decisions that add
value to it. Also, I think our agents enjoy working with our
underwriters because we listen and try to find solutions
that work for everybody.
Ben: Speaking of agents…I was an agent before I
joined State Auto, so I know that underwriting is more
than just the Company’s responsibility. We constantly
monitor each agency’s business to spot trends that may
lead to unprofitability. The agent is really the front line
underwriter for all of the companies he or she represents,
and we examine the agent’s performance critically. It’s
important to their financial health as well as ours. If we
see characteristics in an agent’s book that will likely lead
to loss problems in the future, we act decisively to
address the situation, so to contain underwriting losses.
Paul: We perform another underwriting task with more
fervor than most: we think we are especially good at ana-
lyzing our commercial and personal lines policy data to
find segments that offer either higher or lower than aver-
age loss potential. Analysis has always been a strength
here and we never stop mining our data for pricing oppor-
tunities.
Ben: Earlier we were talking about sharing information
internally, between departments and offices, and why that
was so important. We have delivered both an underwrit-
ing profit and a competitive rate, because of our approach
that combines market intelligence and technical acumen.
Paul: Underwriters are, by nature, highly analytical and
very particular. There are other words to describe us, but
let’s stick with highly analytical and very particular. We’re
never satisfied because there are always improvements to
be made. Innovation is a deeply ingrained part of our cul-
ture. Whether policy coverages or rating tools or data
management, we are always trying to improve something.
And based on our results, it’s pretty obvious that trying
has led to succeeding.
Sales
John Petrucci, vice president of sales, talks about the
best practices behind a solid year of growth.
14...the number of PaceSetter classes that have graduated
since the training programs inception nine years ago.
73...the number of new agencies apponted in 2004.
$1,092.4 million...total revenues.
3,255...the number of agencies representing the STFC
throughout its 26 states.
STFC finished the year with $1,006,800,000 in earned
premium, representing an increase of $46.2 million, or
4.8%.
This growth was recorded in a market that grew consider-
ably softer as the year wore on. Those who have paid
attention to any of our annual reports over the years can
probably anticipate the next statement: profit comes first;
growth at the expense of profit is unacceptable. Thus, our
2004 sales results are all the more gratifying.
Shareholders want growth, the Company wants growth,
but no short cuts are allowed. No succumbing to tempta-
tions to discount our product or abandon core underwrit-
ing principles. No pricing changes just to keep up with the
competition. No ignoring all the hard market lessons
learned.
We know the marketplace is a dynamic organism.
Consumers are smarter, they expect more and the old
saw, “everyone wants to be sold” doesn’t seem to apply
anymore. It’s incumbent upon us to provide quality training
to our associates in a timely manner, as effectively and
efficiently as possible. To ensure that sales training is
absorbed and put into practice, we continued with our
BEST (Brilliant Execution of Selling Techniques) sales
reviews in 2004. Results again showed marked improve-
ment over the prior year. Our associates are aware that
the tools they have at their disposal can positively impact
sales, and they are becoming much more comfortable
employing these tools. Our corporate culture is built on
the premise that Everybody Sells State Auto. Our sales
training and reviews reinforce that fact every day.
In reality, our associates sell State Auto to our agencies.
Our agencies sell State Auto to our insureds. To help
them in their efforts, we have developed the premier new
agent training program in the industry: PaceSetter. What
makes this program the best? It starts with in-depth, two-
week classroom training -- provided in the Home Office --
over-viewing State Auto’s underwriting philosophy and
sales “best practices.” It ends with the PaceSetter gradu-
ate being assigned a PaceSetter coach for one year. We
don’t know of any other insurance company that offers
this benefit. We expanded our coaching team to three
coaches as we entered the year: two commercial lines
coaches and one personal lines coach. This realignment
allowed us to expand the number of PaceSetters we
could include in each session. Now entering its ninth
year, the PaceSetter program’s 14 graduated classes
have produced in excess of $22 million in new business
for State Auto. We see a bright future for both our
PaceSetter graduates, and our PaceSetter program.
One way to positively impact sales results is to keep
more of our current insureds. While some turnover is
inevitable (insureds sell assets, move out of our operating
territory, and, unfortunately, pass away), much is avoid-
able. A Personal Lines Retention process was fully
deployed in 2004. This automated tool allows our person-
al lines specialists and personal lines sales specialists to
routinely and deliberately work with our agency partners
to increase their retention of State Auto insureds. It was
met with much success during its beta-test period. We
anticipate increased benefits from the process in the
years ahead.
A word about our personal lines sales specialists
(PLSS). This carefully selected and specially trained
team of associates, 31 strong, is now represented in 24 of
our 26 operating states. They give us the ability to work
more closely with those producers in our agents’ offices
who sell personal lines, and the program has paid hand-
some dividends during its four years of existence. In 2004,
the PLSS group finished putting together a detailed sales
training program for their agency representatives. Titled
STAR (Sales Training for Agency Representatives), it is to
be kicked off in early 2005 and will undoubtedly have a
positive impact in helping our agency partners capture
more of the personal lines market. We’ll keep looking for
ways to expand this program – where it makes sense to
do so – in 2005 and beyond.
continued on page 12
11
The Company had a goal to appoint 50 high-quality new
agencies in 2004. We finished the year with 73 appoint-
ments, exceeding the goal by 46%. Yet numbers alone
don’t tell the whole story. State Auto conducts one of the
more thorough agency appointment processes in the
industry. We want to ensure the agencies we partner with
are financially secure, profit-driven sales organizations.
We want them to be well-balanced between companies
and lines of business. We want to feel confident the own-
ers and principals understand the business of insurance
and are competent to lead their respective organizations.
We pick our agencies for a long-term relationship, never
for short-term gain. In the end, this selectivity has
brought us together with many of the better agencies in
the business. That is important. After all, our results are
simply their results, no more, no less. To all of our over
3,250 agents, new and old, we say thank you for an
excellent year, thank you for being the finest partners a
Company can have.
Claims
The 2004 claims stories behind the numbers were dra-
matic, heroic and, ultimately, gratifying. John Melvin, vice
president of Claims, talked about the year of the hurricane
and more.
$37.2 million...the estimated savings in claims costs
produced by innovative cost management programs
$536.0 million...2004 direct claims paid
$30.9 million...direct claims paid for hurricane losses in
Florida alone
This was a year when you were constantly reminded
why this business is so important to the economy of the
country. And why, ultimately, it’s about helping people.
Unless you were living on a butte in Montana, you are
probably aware that the weather story of 2004 was written
by four nasty characters: Charlie, Frances, Jeanne and
Ivan. Thirteen of our 26 states were affected by these
hurricanes, with damage ranging as far north as Ohio and
12
Pennsylvania and as far west as Mississippi. The hurri-
cane losses for the State Auto companies exceeded $52
million - $30 million came out of Florida and approximate-
ly $6 million from Alabama. Lives were lost, homes were
destroyed, communities were literally turned upside down.
In these situations, insurance companies and their claim
reps have to react quickly and compassionately. Ours is a
business that, day in and day out, garners little attention
from the consumer or the public at large. A catastrophe
changes all of that. Suddenly, we’re the “go to” guys,
we’re the first responders. Suddenly, the contract that has
been gathering dust in the roll top desk or the glove com-
partment is must reading (if you still have a desk). You
will find out quickly if your agent is truly value added and
if your insurance company is ready to deliver on its
promise. Companies that can’t rise to meet a challenge
such as that presented by the hurricanes of 2004 are in
the wrong business.
At the peak we sent in 17 State Auto claims staff associ-
ates, two State Auto retirees, and approximately 50 inde-
pendent adjusters to assist claims offices in Orlando and
Birmingham. Some did duty in both states. Three corpo-
rate staff members helped coordinate the effort in
Alabama and Florida. Nineteen Indianapolis Regional
Office (IRO) associates and four Home Office-based
property examiners assisted the Florida and Alabama
offices with directing the work of the independent
adjusters. Meanwhile, from their locations in Columbus
and Des Moines, the Claims Contact Centers handled
claims from all areas hammered by the hurricanes.
Our Orlando office lost power twice and had to move to
temporary quarters both times. Our local Orlando claim
supervisor was kind and generous enough to turn her
house into those temporary quarters. There were a lot of
people – employees, independent adjusters – coming and
going through her living room and kitchen. But the com-
mitment to the common cause, bringing claims service to
our insureds in the area, carried the day. The cama-
raderie was something to behold. No one wants to have
to perform catastrophe duty because it means confronting
large scale suffering and very difficult duty, but many
claims reps will tell you that participating in the recovery
effort was the most uplifting, gratifying experience of their
careers.
***
On the other hand, I wouldn’t want shareholders or poli-
cyholders to think it takes a catastrophe to bring out the
best in our claims service. I am extremely proud of State
Auto’s tradition of claims excellence. For years it has
been suggested that we are the Companies’ best sales
tool. I judge the claims division’s success in several ways:
comments, written and oral, from insureds and claimants;
the number of complaints we receive through official and
unofficial channels; timely response and settlement, and
our ability to manage claims costs. This last point is often
overlooked in the grand scheme of evaluating claims per-
formance. The cost of servicing claims includes associate
salaries, travel, legal fees, office space, furniture, equip-
ment and so on. Not only should an insurance company
do its utmost to control these costs (without sacrificing
service), it must find ways to recoup damages from at-
fault parties, recover claims salvage, develop efficiencies
in home and auto repair services, and participate in man-
aged health care appropriate to workers comp or personal
injury protection coverages. Altogether, our claims cost
management programs saved the Company over $37 mil-
lion in 2004, savings that benefited our insureds, our
agents and the bottom line.
***
I commented earlier that 2004 was ultimately about peo-
ple helping people. I am asked on occasion about the
growth of our centralized claims function, what we call our
Claims Contact Center. We actually have two centers,
one in Columbus at the Home Office and one in our Des
Moines Branch Office. For business continuity purposes,
each office is designed to perform as a redundant service
facility to the other. All claims that come to the centers
are handled over the phone. Only claims of a certain size
and type are adjusted this way, but it’s now just over 30%
of our claims. Larger, more complicated claims are still
handled by one or more specialists in the field. The con-
cern is that claims handled over the phone deny us the
opportunity to meet face-to-face with the insured or
claimant and somehow depersonalizes the process.
Nothing could be further from the truth. The move to a
more centralized claims function has everything to do with
speed and efficiency. But, it’s still a human being the
insured or claimant is working with. The fact is, the
majority of our claims are not complicated. (Some are
very complicated, but they won’t be processed in the
Contact Centers.) Once we’ve established that the policy-
holder has coverage under the contract, the settlement
can move along smartly. We want to settle claims quickly
and fairly…but guess what most insureds care about the
most? The “quickly” part. That’s the world we live in, and
our Claims Contact Centers provide fast and cost effec-
tive service. Our customers seem quite pleased with the
centralized claims approach. But if we thought for a
minute that fast and effective was getting in the way of
customer satisfaction and fair claims handling, the centers
would be gone.
***
We could never complain that there are no challenges left
in this business. Here are a few from the claims perspec-
tive.
(cid:1) We need to get serious about tort reform. On behalf of
consumers, insureds, claimants and shareholders, we
must find fair remedies for injuries and settlements that
cover rather than dwarf the loss.
(cid:1) As an industry, we need to continue to look for ways to
mitigate losses. We try to collect enough premium to
cover anticipated losses. Wouldn’t it be great if we had
fewer losses and had to collect less premium? State Auto
has created a Special Investigative Unit and we have an
expanded staff of safety engineers who work with
accounts and insureds to reduce risk.
(cid:1) We would like to see insurance fraud become a more
important topic for legislators and regulators. Some
states are working hard on this, some are not. If we could
significantly reduce insurance fraud, we could reduce the
price of our product.
Information Technology
Doug Allen, director of Information Technology, comments
on the role and performance of IT at State Auto.
2...the number of prestigious awards received by State
Auto’s Information Technology division
$27 million...State Auto’s 2004 investment in Information
technology
1,973,516... the number of hits on AgentSite, State Auto’s
Internet portal for agents
(cid:1) Some of us remember the movie, The Graduate. This
guy pulls Ben (Dustin Hoffman) aside and tells him to
remember one word: “Plastics.” When agents pull us
aside today, they’re whispering “ease of doing business.”
Compared to a few years ago, virtually every company in
this industry can boast about its improved automation.
We’re all faster, we’re all smarter, we’re all about more
data, better data. But the key to really making your
Company easier to do business with is effectively orches-
trating how all the various technologies work together so
that each agency transaction is effectively and profession-
ally handled.
continued on page 14
13
Dec Stop Agents
AgentSite Logins
2500
2000
1500
1000
500
0
1190
741
+77%
2106
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
+81%
1,973,516
1,091,025
228,294
2002
2003
2004
2002
2003
2004
(cid:1) State Auto was named the ACORD® organization’s
upload company of the year again in 2004. This is the
third consecutive year and fourth time in seven years
State Auto has received this prestigious award at
ACORD’s annual technology conference. That means
we have consistently been making it pretty easy for our
agents to send their business to us in a “digital” fashion.
We now measure policy issuance in a matter of hours, not
days and typically weeks. We are on a mission to mea-
sure these same business processes in minutes and sec-
onds. If we keep doing this, agents – our first customer –
will love us. It’s all about the ease of doing business.
(cid:1) Another award we received recently was for our docu-
ment imaging and customer service. Mobius, one our key
technology partners, recently awarded State Auto its 2005
Customer Achievement Award for “Best Application –
Improving Customer Service.” Over 325 million business
documents are now one mouse click away for agents and
associates. Both the ACORD and Mobius awards repre-
sent nationally acclaimed accomplishments.
(cid:1) The Internet has transformed the way our industry
conducts business. AgentSite is our Internet portal for
agents. AgentSite has effectively reduced the time it
takes agents to provide key services to their clients like
answering billing inquiries, checking on claims status,
accepting premium payments, reviewing policy docu-
ments, and ordering marketing materials. In 2003, we
had 1,091,025 logins on AgentSite. In 2004, that number
jumped by 81% to nearly 2,000,000 logins. We are espe-
cially proud of the newest component, netXpress, our on-
line personal lines quote and issuance tool. Total personal
lines upload grew at a record pace last year from 48% in
December of 2003 to 68% as of December 2004. And
beginning late in 2004 we rolled out the 24x7 version of
netXpress. I would hope there isn’t a big demand to
quote business at midnight, but if our agents want to do
that, now they can. Allowing agents to access and view
14
policy documents off AgentSite has probably saved a
small rain forest in Brazil. We call this service Dec Stop
(a “dec” is the first page of the policy that includes virtual-
ly all of the contract’s pertinent coverage information).
Sixty-two percent of our agency force (2,106 agencies) no
longer receives a hard copy of the insured’s personal
lines policy from us; it is stored electronically and can be
accessed on-line when the agent needs it. That percent-
age will reach 100% in the next year as we build more
functionality into AgentSite.
(cid:1) One thing our shareholders and consumers need to
understand about State Auto’s commitment to automation:
business continuity and security must be addressed. So
much so that we’ve probably driven a few our colleagues
crazy during the design phase of some of our systems.
The challenge now and for the foreseeable future is keep-
ing our systems available, tamper proof, and secure with-
out negatively impacting the ease of doing business. On
the horizon is making much of this same information
available to customers. This is all the more reason to
institutionalize these disciplines into our design. There
are industries that figured out how to automate the sales
side before they mastered the availability and security
pieces. Our industry simply can’t take that tack.
(cid:1) When I’m asked to name the greatest challenge in
front of IT, I say, “Staying ahead of the curve.” You have to
be willing to take some risks, not with the product but with
the investment. Things change so fast that you can liter-
ally be six months into a project and then realize, darn,
someone has devised a better way to do this. But you
can’t let the prospect of failure paralyze you. Rest
assured, our best IT technicians have their fingers on the
pulse of the business, working closely with line and staff
operations. We are continually working to find the next
“best way” to service and deliver our products.
(cid:1) We used to say it was easier to find an underwriter will-
ing to program than a programmer capable of underwrit-
ing. The point is, our IT technicians have to work closely
with the people who know this business. Having said
that, this business is turning to automation at every level
and in every aspect. To me, our intelligent underwriting
system for personal lines, which we call Apollo, is the ulti-
mate example. We expect to be underwriting 80% or
more of our personal lines business soon using the com-
puter. Should that concern the shareholder? I don’t think
so. Remember, our underwriting experts were in on the
ground floor of this technology, and they had to approve it
before it was released.
(cid:1) It’s true that most of our efforts are directed at making
the agent’s business life easier, producing the finest prod-
ucts, and bringing these products to market quickly and
cost effectively. But there’s another column on our “to do”
list, and it’s headed “Internal Clients.” We collect, store
and organize information and we also push it out to the
knowledge workers. We need to do this pushing part
faster and faster. I was talking to a colleague the other
day about a particular work management feature in our
Company and he had never heard of it. It dawned on me
that there are now so many of these tools that it’s almost
impossible for one person to be well-versed on all of
them. Yet each tool has its own special audience, some
of whom are absolutely dependent on it in order to do
their jobs. IT needs to be sure that all of these data man-
agement and processing systems are accurate, reliable,
and scalable. Our IT infrastructure absolutely must be ser-
vice-oriented so that new and improved components can
be added when our business partners need them.
Regional
Operations
1,400... employees of who report to regional and
branch offices
100%... percentage of STFC premium generated by regional
and branch operations
State Auto is comprised of ten regional offices. It is
within these offices that most of the Companies’ sales,
service and underwriting activities are performed. Cathy
Miley and Steve Hazelbaker are the vice presidents of
regional operations. The Southern Regional Office (SRO)
in Greer, S.C., Nashville Regional Office (NRO), Milbank
Regional Office (MRO) in Milbank, S.D. and the
Indianapolis Regional Office (IRO) report to Cathy; the
Des Moines Branch Office (DBO), the La Crosse Branch
Office (LBO) in La Crosse, Wis., the Eastern Regional
Office (ERO) and Central Regional Office (CRO), both
located in Columbus, and the Cincinnati Branch Office
report to Steve. We asked them to look behind the num-
bers and tell us why the regional office concept works so
well for us.
Steve: There are lots of reasons to recommend the
regional office approach. Decision making is in the field,
closer to our customers. And the competitive environment
varies greatly from one part of the country to the next.
The legislative environment varies. What works in
Michigan might not have a chance in Mississippi. Your
toughest competition in Alabama may not even write in
Arkansas.
Cathy: Our regional and branch offices also epitomize
the stability and reliability of the Company. When we com-
mit to a territory, that commitment manifests itself in peo-
ple, products and facilities. Steve and I were listing the
years of service for each of our branch and regional office
managers and it’s pretty impressive. Agents and employ-
ees become friends. They develop a trust that comes
with time and shared hard work.
Steve: I’m newer to this role than Cathy, but one of the
first things I observed is that the regional office approach
promotes creativity and independent problem solving.
And when something works, other branches are willing to
try it. It doesn’t always translate, of course, but imagine
having ten problem solvers tackling the same challenge.
Each branch can probably take credit for a universally
successful sales or underwriting or claims technique that
has worked throughout the Company.
Cathy: By the same token, the Company can ask one
branch to try a new approach to conducting operations.
Or the branch can suggest it. If it works, we can consider
trying it elsewhere. If it doesn’t work, we have at least
benefited from the experience. STFC shareholders should
also know that our branches have helped us solve larger
corporate processing and service challenges. For exam-
ple, Meridian Center houses the Indianapolis Regional
Office as well as members of corporate staff, a commer-
cial lines processing unit and specialized claims units.
DBO was recently remodeled and now it has a full service
branch working next to a Claims Contact Center. The
Central Regional Office (CRO) shares space with State
Auto Mutual’s new Middle Market Insurance unit.
continued on page 16
15
continued from page 15
Steve: This makes an important point. The regional con-
cept fosters flexibility, independence and even healthy
competition among offices, but the corporate common
good is a preeminent consideration in the development of
any branch goals or practice.
Cathy: Steve and I work pretty hard at conveying a con-
sistent message to the branches. Our job is not to tell
them what to do or how to do it, but we are responsible
for making certain they understand the corporate goals
and expectations. We’re also communication liaisons,
which means we take messages back the other direction.
Steve: I guess if I had to pinpoint the biggest challenge
Cathy and I face, it’s helping the Company work through
those infrequent situations when it’s unclear whether a
decision should be made at the local or corporate level.
But the regional office concept as State Auto practices it
is the best of both worlds. We embrace the regional
office’s autonomy but know that it can and will make good
use of Home Office resources.
Cathy: In our recent trips to the branch and regional
offices with CEO Bob Moone, he commented that the vis-
its “energized” him. He was struck by the enthusiasm,
positive attitudes and energy found in each office. The
branches were in the midst of setting goals and he was
impressed with the thoroughness of the process and how
involved everyone was. Our corporate goals are actually
the sum of our regional goals.
Steve: The fact is, if each office works to optimize its
results and never falters in that effort, we are destined to
be successful as a corporation. It’s more than just the
spread of risk or the law of large numbers. We have ten
well-managed, focused, territory-attuned operations. One
or even two regions might get hammered by storms or hit
an unexpected run of loss frequency or severity problems,
but if all ten “stay the course” as Bob (Moone) likes to say,
we will come out on top.
Cathy: I guess that point was never better illustrated
than in 2004. Four major hurricanes ravaged several of
our states and took down the numbers in two of our
offices, but our corporate combined ratio was exceptional.
Branch and regional offices
# employees
2004 loss ratio
2004 premium
volume (in millions)2
Central Regional
Cincinnati Branch
Cleveland Branch
Des Moines Branch
Eastern Regional
Indianapolis Regional
La Crosse Branch
Milbank Regional
Nashville Regional
Southern Regional
121
63
54
40
106
581
33
92
130
160
55.1
47.1
52.0
36.0
58.6
50.4
60.3
40.8
52.0
81.6
$157.5
120.4
71.7
31.8
147.2
116.6
43.2
127.4
220.9
199.2
(1) This number does not include a claims staff. IRO claims are handled by the corporate claims staff.
(2) State Auto group figures excluding Non-Standard, Farm, Facility.
16
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[x]
Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
[ ]
Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2004
or
For the transition period from ___________ to _____________
Commission File Number 0-19289
STATE AUTO FINANCIAL CORPORATION
(exact name of Registrant as specified in its charter)
Ohio
(State or other jurisdiction of
incorporation or organization)
31-1324304
(I.R.S. Employer Identification No.)
518 East Broad Street, Columbus, Ohio
(Address of principal executive office)
43215-3976
(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
(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. ______
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes _X__ No _____
As of June 30, 2004, the last business day of the Registrant’s most recently completed second fiscal quarter,
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 $348,077,023.
DOCUMENTS INCORPORATED BY REFERENCE
1.
Portions of the Registrant's Proxy Statement relating to the annual meeting of shareholders to be held May
11, 2005 (the “2005 Proxy Statement”), which will be filed within 120 days of December 31, 2004, are
incorporated by reference into Part III of this Form 10-K.
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Index to Form 10-K Annual Report for the year ended December 31, 2004
Form 10-K
_______________________________________________________________________________________________
Description ........................................................................................ Page
Item
Part I
Part II
Part III
1
2
3
4
5
6
7
7A
8
9
9A
9B
10
11
12
13
14
Business ..................................................................................................1
Executive Officers of the Registrant ......................................................... 13
Properties .............................................................................................. 14
Legal Proceedings .................................................................................. 14
Submission of Matters to a Vote of Security Holders ................................. 15
Market for the Registrant’s Common Equity, Related Shareholder Matters
And Issuer Purchases of Equity Securities .............................................. 15
Selected Financial Data........................................................................... 16
Management’s Discussion and Analysis of Financial Condition and Results
of Operations ....................................................................................... 17
Qualitative and Quantitative Disclosures about Market Risk....................... 40
Financial Statements and Supplementary Data......................................... 40
Report of Independent Registered Public Accounting Firm ................... 41-42
Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures............................................................................. 70
Controls and Procedures ......................................................................... 70
Other Information .................................................................................. 70
Directors and Executive Officers of the Registrant .................................... 70
Executive Compensation ......................................................................... 71
Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters ................................................................. 71
Certain Relationships and Related Transactions........................................ 71
Principal Accountant Fees and Services.................................................... 71
Part IV
15(1)
Exhibits and Financial Statement Schedules ............................................. 71
Signatures ............................................................................................. 78
Exhibits(1)
Consent of Independent Auditors ............................................................ 79
Certifications .......................................................................................... 80
(1) Exhibits as noted at item 15(c), other than those exhibits identified in this Index, and the financial statement
schedules at item 15(d) have been omitted from the reproduction of this From 10-K. For the omitted exhibits and
schedules, see our Form 10-K Annual Report for the year ended December 31, 2004, as filed with the Securities and
Exchange Commission, a copy of which is available on the SEC’s website at www.sec.gov. Copies of the omitted
exhibits and schedules are also available on our website at www.stfc.com under “SEC Filings.”
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
IMPORTANT INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
All statements, other than statements of historical facts, included in this Annual Report on Form 10-K (this “Form 10-K”) of
State Auto Financial Corporation (“State Auto Financial” or “STFC”) or incorporated herein by reference, including, without limitation,
statements regarding State Auto Financial’s future financial position, business strategy, budgets, projected costs, goals and plans
and objectives of management for future operations, are forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of forward-looking terminology
such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “believe” or “continue” or the negative thereof or
variations thereon or similar terminology. Forward-looking statements speak only as the date the statements were made. Although
State Auto Financial believes that the expectations reflected in forward-looking statements have a reasonable basis, it can give no
assurance that these expectations will prove to be correct. Forward-looking statements are subject to risks and uncertainties that
could cause actual events or results to differ materially from those expressed in or implied by the statements. For a discussion of
the most significant risks and uncertainties that could cause State Auto Financial’s actual results to differ materially from those
projected, see “Forward-Looking Statements; Certain Factors Affecting Future Results” in Item 7 “Management’s Discussion and
Analysis of Financial Condition and Results of Operations.” Except to the limited extent required by applicable law, State Auto
Financial undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information,
future events, or otherwise.
Item 1. Business
(a) General Development of Business
PART I
State Auto Financial is an insurance holding company formed in 1990 and headquartered in Columbus, Ohio. STFC
engages primarily in the property and casualty insurance business through its 100% owned subsidiaries, State Auto Property and
Casualty Insurance Company (“State Auto P&C”), Milbank Insurance Company (“Milbank”), Farmers Casualty Insurance Company
(“Farmers”), State Auto Insurance Company of Ohio (“SA Ohio”), and State Auto National Insurance Company (“SA National”).
Farmers formerly owned 100% of the outstanding common shares of Mid-Plains Insurance Company (“Mid-Plains”), a property-
casualty insurer. Mid-Plains was dissolved in December 2004 and its insurance liabilities were assumed by SA National pursuant to
an assumption reinsurance agreement.
Approximately 65% of State Auto Financial’s outstanding common shares are owned by State Automobile Mutual
Insurance Company (“Mutual”), an Ohio mutual property and casualty insurance company organized in 1921. Mutual owns 100% of
State Auto Florida Insurance Company (“SA Florida”) and State Auto Insurance Company of Wisconsin (“SA Wisconsin”), property-
casualty insurers. Mutual also owns 100% of Meridian Insurance Group, Inc. (“MIGI”), an insurance holding company. MIGI owns
100% of Meridian Security Insurance Company (“Meridian Security”), a property-casualty insurer. In 2001, Mutual merged with
Meridian Mutual Insurance Company (“Meridian Mutual”), with Mutual continuing as the surviving corporation, and in a substantially
concurrent transaction Mutual acquired the outstanding shares of MIGI. MIGI is also a party to an affiliation agreement with
Meridian Citizens Mutual Insurance Company (“Meridian Citizens Mutual”), a property-casualty insurer. Meridian Security and
Meridian Citizens Mutual are hereafter referred to collectively as the “MIGI Insurers,” and together with MIGI, the “MIGI
Companies.”
STFC owns 100% of Stateco Financial Services, Inc. (“Stateco”), which provides investment management services to
affiliated insurance companies. STFC also owns 100% of Strategic Insurance Software, Inc. (“S.I.S.”), a developer and seller of
insurance-related software. 518 Property Management and Leasing, LLC (“518 PML”), whose members are State Auto P&C and
Stateco, owns and leases real and personal property to affiliated companies. The results of the operations of S.I.S. and 518 PML
are not material to the total operations of STFC.
State Auto Financial, State Auto P&C, Milbank, Farmers, SA Ohio, SA National, Mid-Plains, Stateco, S.I.S., and 518 PML are
hereafter referred to collectively as the “Company.”
State Auto P&C has participated in a quota share reinsurance pooling arrangement with Mutual since 1987 (the “Pooling
Arrangement”). At year end, the participants in the Pooling Arrangement were State Auto P&C, Mutual, Milbank, SA Wisconsin,
Farmers, SA Ohio and SA Florida. As of January 1, 2005, Meridian Security and Meridian Citizens Mutual were added to the Pooling
Arrangement. State Auto P&C, Mutual, Milbank, SA Wisconsin, Farmers, SA Ohio, SA Florida, Meridian Security (as of January 1,
2005) and Meridian Citizens Mutual (as of January 1, 2005) are hereafter referred to collectively as the “Pooled Companies.” State
Auto P&C, Milbank, Farmers and SA Ohio are hereafter referred to collectively as the “STFC Pooled Companies.” See “Pooling
Arrangement” in the “Narrative Description of Business.” The Pooled Companies and SA National are hereafter referred to as the
“State Auto Group.”
The insurers in the State Auto Group write a broad line of property and casualty insurance, such as standard personal and
commercial automobile, nonstandard personal automobile, homeowners, commercial multi-peril, workers’ compensation, general
liability and fire insurance, through approximately 22,500 independent insurance agents associated with approximately 3,250
agencies in 26 states. The State Auto Group’s insurance products are marketed primarily in the central and eastern parts of the
United States, excluding New York, New Jersey and the New England States.
1
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The Company considers one of its key strengths to be its core values, which are to (i) fairly price and ethically sell useful
insurance products, (ii) treat every transaction with absolute honesty and integrity, (iii) extend dignity and respect to everyone, (iv)
encourage innovation, and (v) fully utilize every person’s talents. These core values are reflected in, among other things, the long-
term strategic business plan adopted by the Boards of Directors of Mutual and STFC. This strategic business plan provides that the
long-term goal of the State Auto Group is to continue to be a premier, independent property and casualty insurer by consistently
performing in the top quartile of its peer group of companies. The Company believes its underwriting and pricing discipline, as well
as its commitment to delivering its products as effectively and efficiently as possible, have been key factors in the Company’s
underwriting results over the last several years.
(b) Financial Information about Segments
The Company currently operates in three segments: State Auto standard insurance, State Auto nonstandard insurance,
and investment management services. Prior to 2003, it operated in the following four insurance segments: the State Auto standard
insurance segment, consisting of the business operations of the STFC Pooled Companies; the State Auto nonstandard segment,
consisting of the business operations of SA National and Mid-Plains; the Meridian standard segment, consisting of the standard
insurance business of the former Meridian Mutual; and the Meridian nonstandard segment, consisting of the nonstandard business
of the former Meridian Mutual. As of January 1, 2004 and January 1, 2003, the Meridian standard and nonstandard segments,
respectively, were included in the State Auto standard and nonstandard segments because these Meridian segments no longer met
the quantitative thresholds for separate presentation as reportable segments. Financial information about all these segments is set
forth in Note 15 of the Notes to the Company’s Consolidated Financial Statements included in Item 8 of this Form 10-K Additional
information regarding the Company’s insurance and non-insurance segments is provided in “Narrative Description of Business.”
(c) Narrative Description of Business
Property and Casualty Insurance
Pooling Arrangement
The Pooled Companies are parties to an intercompany Pooling Arrangement. The Pooling Arrangement was governed by
the reinsurance pooling agreement known as the “2000 Pooling Agreement” prior to January 1, 2005, and by the reinsurance
pooling agreement known as the “2005 Pooling Agreement” on and after that date. The Pooling Arrangement covers all the
property and casualty insurance written by the parties, except voluntary assumed reinsurance written by Mutual, Mutual Middle
Market Insurance (as defined in the 2005 Pooling Agreement) and intercompany catastrophe reinsurance written by State Auto P&C.
Under the Pooling Arrangement each participant cedes premiums, losses and expenses on all of their business to Mutual, and
Mutual in turn cedes to each participant a specified portion of premiums, losses and expenses based on each participant’s pooling
percentage. Mutual then retains the balance of the pooled business. Mutual, SA Wisconsin, SA Florida, Meridian Security and
Meridian Citizens Mutual are hereafter referred to collectively as the “Mutual Pooled Companies.”
The following table sets forth a chronology of the participants and their participation percentage changes that have
occurred in the Pooling Arrangement since January 1, 2000:
Year *
2000 -9/30/2001
10/1/2001-2002
2003 – 2004
1/1/2005 -
State
Auto
P&C
39.0
59.0
59.0
59.0
Mutual
46.0
19.0
18.3
19.5
Milbank
SA
Wisconsin
Farmers
10.0
17.0
17.0
17.0
1.0
1.0
1.0
0.0
3.0
3.0
3.0
3.0
SA
Ohio
1.0
1.0
1.0
1.0
SA
Florida
Meridian
Security
Meridian
Citizens
Mutual
N/A
N/A
0.7
0.0
N/A
N/A
N/A
0.0
N/A
N/A
N/A
0.5
* Time period is for the year ended December 31, unless otherwise noted.
____________________
2
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following table sets forth a summary of the Pooling Arrangement participant percentages of STFC and Mutual,
aggregating their respective 100% owned subsidiaries:
Year*
STFC Pooled
Companies
Mutual Pooled
Companies
2000 – 9/30/2001
10/1/2001- current
53
80
47
20
* Time period is for the year ended December 31, unless otherwise noted.
___________________
Prior to 2001, the pooling percentages were reviewed by management at least annually, and more often if deemed
appropriate by management or the Board of Directors of each company, to determine whether any adjustments should be made.
As a result of the changes made to the pooling percentages in 2001, it is not management’s current intention to recommend an
adjustment to the STFC Pooled Companies aggregate participation percentage in the foreseeable future. Under revised procedures,
management of each of the Pooled Companies would make recommendations to a standing independent committee of the Board of
both Mutual and STFC. These independent committees would review and evaluate such factors as they deem relevant and
recommend any appropriate pooling change to the Boards of both Mutual and STFC. See “Management Agreement” in the
“Narrative Description of Business.” The Pooling Arrangement is terminable by any party on 90 days’ notice or by mutual agreement
of the parties. None of the Pooled Companies currently intends to terminate the Pooling Arrangement.
Under the terms of the Pooling Arrangement, all premiums, incurred losses, loss expenses and other underwriting
expenses are prorated among the companies party to the agreement on the basis of their participation in the pool. By spreading
the underwriting risk among each of the participants, the Pooling Arrangement is designed to produce more uniform and stable
underwriting results for each of the Pooled Companies than any one company would experience individually. One effect of the
Pooling Arrangement is to provide each participant with an identical mix of pooled property and casualty insurance business on a
net basis.
The 2005 Pooling Agreement and the 2000 Pooling Agreement both contain a provision excluding catastrophic losses and
loss adjustment expenses incurred by the parties in the amount of $100.0 million in excess of $120.0 million, as well as the
premium for such exposures. State Auto P&C reinsures each insurer in the State Auto Group for this layer of reinsurance under a
Catastrophe Assumption Agreement. No losses were paid by State Auto P&C under the Catastrophe Assumption Agreement in
2004, 2003 or 2002. See “Reinsurance” in the “Narrative Description of Business.”
Prior to January 1, 2005, the direct business of the MIGI Insurers was not included in the Pooling Arrangement and to
that extent was not included in the insurance operations of the Company for periods ending prior to January 1, 2005. If State Auto
P&C had been required to pay catastrophe losses of the MIGI Insurers under the above referenced Catastrophe Assumption
Agreement, those losses would have impacted the Company’s results.
Also, excluded from both the 2000 Pooling Agreement and the 2005 Pooling Agreement is Mutual Middle Market
Insurance. If State Auto P&C were required to pay catastrophe losses of the Mutual Middle Market Insurance under the above
referenced Catastrophe Assumption Agreement, these losses would impact the Company’s results.
Nonstandard Auto Insurance
The Company writes nonstandard auto insurance through SA National. See “Marketing” in “Narrative Description of
Business.” This business is not part of the Pooling Arrangement. See also “Reportable Segments” in “Narrative Description of
Business.”
Management Agreement
State Auto P&C’s employees provide all organizational, operational and management functions for all insurance affiliates
within the State Auto Group through management and cost sharing agreements. Through December 31, 2004, for the performance
of its services under two of the management agreements, State Auto P&C was paid a quarterly management and operations
services fee based on formulas outlined in the agreements. Under the “2000 Midwest Management Agreement” among State Auto
P&C, Mutual and SA Wisconsin, SA Wisconsin pays 0.75% of direct written premium for management and operation services
performed by employees of State Auto P&C. Under the “MIGI Management Agreement” among State Auto P&C, MIGI and the MIGI
Insurers, each of the MIGI Companies paid State Auto P&C a management fee of 10% of all State Auto P&C’s employee-related
costs in exchange for the services of those employees, in addition to reimbursing State Auto P&C for the actual costs of such
services. Mutual provides facilities for all the insurance affiliates under management or cost sharing agreements, including the
“2000 Management Agreement” to which State Auto P&C and Mutual are parties, among other affiliates. Subject to regulatory
approval, the 2000 Management Agreement has been amended and restated as of January 1, 2005, known as the “2005
Management Agreement,” and the MIGI Companies and Farmers will become parties. The Company anticipates terminating
separate management agreements that had been in place among State Auto P&C and the MIGI Companies and Farmers,
respectively, upon the 2005 Management Agreement taking effect.
3
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Each of the affiliated management and cost sharing agreements, except the MIGI Management Agreement, has a ten-
year term and automatically renews for an additional ten-year period unless sooner terminated in accordance with its terms. If the
2005 Management Agreement is terminated for any reason, the Company would have to locate facilities to continue its operations,
although the Company does not anticipate such termination.
Reportable Segments
See Note 15, Reportable Segments of the Notes to the Company’s Consolidated Financial Statements included in Item 8 of
this Form 10-K, and Item 7 of this Form 10-K.”
Marketing
The State Auto Group markets its products in 26 states through approximately 22,500 insurance agents associated with
approximately 3,250 independent insurance agencies. None of the companies in the State Auto Group has any contracts with
managing general agencies.
SA National markets nonstandard products in 21 states exclusively through the Company’s network of independent
agents. Mid-Plains wrote nonstandard auto insurance in Iowa and Kansas through the agency network of Farmers in those states.
In December 2004, Mid-Plains was dissolved and its insurance liabilities were assumed by SA National. See “Nonstandard Auto
Insurance” in the “Narrative Description of Business.”
Because independent insurance agents significantly influence which insurance company their customers select,
management views the Company’s independent insurance agents as its primary customers. Management strongly supports the
independent agency system and believes that maintenance of a strong agency system is essential for the Company’s present and
future success. As such, the Company continually develops programs and procedures to enhance agency relationships, including
the following: regular travel by senior management and branch office staff to meet with agents, in person, in their home states;
training opportunities; travel incentives related to profit and growth; and an agent stock purchase plan.
The Company actively helps its agencies develop professional sales skills within their staff. The training programs include
both products and sales training in concentrated programs conducted in the Company’s home office. Further, the training programs
include disciplined follow-up and coaching for an extended time. Other targeted training sessions are held in the Company’s branch
office locations from time to time.
The Company has made continuing efforts to use technology to make it easier for its agents to do business with the
Company. The Company offers internet-based rating, policy application submission and execution of endorsements for certain
products. In addition, the Company provides its agents with the opportunity to maintain policyholder records electronically, avoiding
the expense of preparing and storing paper records. Software developed by S.I.S. also enhances the ability of the Company and its
agents to take advantage of electronic data submission. The Company believes that, since agents and their customers realize better
service and efficiencies through automation, they value their relationship with the Company. Automation can make it easier for the
agent to do business with the Company, which attracts prospective agents and enhances the existing agencies’ relationships with
the Company.
The Company shares the cost of approved advertising with selected agencies. The Company provides agents with certain
travel and cash incentives if they achieve certain sales and underwriting profit levels. Further, the Company recognizes its very top
agencies – measured by consistent profitability, achievement of written premium thresholds and growth - as Inner Circle Agencies.
Inner Circle Agencies are rewarded with additional trip and financial incentives, including additional profit sharing bonus and
additional contributions to their Inner Circle Agent Stock Purchase Plan, a part of the Agent Stock Purchase Plan described below.
To strengthen agency commitment to producing profitable business and further develop its agency relationships, the
Company’s Agent Stock Purchase Plan offers its agents the opportunity to use commission income to purchase the Company’s stock.
The Company’s transfer agent administers the plan using commission dollars assigned by the agents to purchase shares on the
open market through a stockbroker. The Company also makes available to certain top performing agents the opportunity to vest
grants of options in the Company’s common shares provided the participants meet performance targets described in the Agent
Stock Option Plan.
The Company receives premiums on products marketed in Alabama, Arkansas, Florida, Georgia, Illinois, Indiana, Iowa,
Kansas, Kentucky, Maryland, Michigan, Minnesota, Mississippi, Missouri, North Carolina, North Dakota, Ohio, Oklahoma,
Pennsylvania, South Carolina, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wisconsin. During 2004, the seven states
that contributed the greatest percentage of the Company’s direct premiums written were as follows: Ohio (18.6%), Kentucky
(11.5%), Tennessee (6.9%), Minnesota (6.4%), Pennsylvania (5.2%), Maryland (4.7%) and Indiana (4.2%).
4
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Claims
Insurance claims on policies written by the Company are usually investigated and settled by staff claims adjusters. The
Company's claims division emphasizes timely investigation of claims, settlement of meritorious claims for equitable amounts,
maintenance of adequate reserves for claims, and control of external claims adjustment expenses. Achievement of these goals
supports the Company's marketing efforts by providing agents and policyholders with prompt and effective service.
Claim settlement authority levels are established for each adjuster, supervisor and manager based on his or her level of
expertise and experience. The claims division is responsible for reviewing the claim, obtaining necessary documentation and
establishing loss and expense reserves of certain claims. Generally, property or casualty claims estimated to reach $150,000 or
above are sent to the home office to be supervised by claims division specialists. Branches with small volumes of large claims report
claims to the home office at a lower dollar threshold. In territories in which there is not sufficient volume to justify having full-time
adjusters, the Company uses independent appraisers and adjusters to evaluate and settle claims under the supervision of claims
division personnel.
The Company attempts to minimize claims adjusting costs by settling as many claims as possible through its internal
claims staff and, if possible, by settling disputes regarding automobile physical damage and property insurance claims (first party
claims) through arbitration. In addition, selected agents have authority to settle small first party claims, which improves claims
service.
Claim representatives use third party, proprietary bodily injury evaluation software to help them value bodily injury claims,
except for the most severe injury cases. This software continues to be a valuable tool for the Company. The Claims Contact
Centers allow the Company to improve claims efficiency and economy by concentrating the handling of smaller, less complex claims
in a centralized environment. The Company provides 24 hour, seven days a week claim service, either through associates in the
Claims Contact Centers, which are located in Des Moines, Iowa and Columbus, Ohio, or, for a few overnight hours, through a third
party service provider.
Reserves
Loss reserves are management’s best estimates at a given point in time of what the Company expects to pay to
claimants, based on facts, circumstances and historical trends then known. During the loss settlement period, additional facts
regarding individual claims may become known, and consequently it often becomes necessary to refine and adjust the estimates of
liability. The Company’s results of operations and financial condition could be impacted, perhaps significantly, in the future if the
ultimate payments required to settle claims vary from the liability currently recorded.
The Company maintains reserves for the eventual payment of losses and loss expenses for both reported claims and
incurred claims that have not yet been reported. Loss expense reserves are intended to cover the ultimate costs of settling all
losses, including investigation, litigation and in-house claims processing costs from such losses.
Reserves for reported losses are initially established on either a case-by-case or formula basis depending on the type and
circumstances of the loss. The case-by-case reserve amounts are determined based on the Company's reserving practices, which
take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. The
formula reserves are based on historical paid loss data for similar claims with provisions for trend changes caused by inflation. Loss
and loss expense reserves for incurred claims that have not yet been reported are estimated based on many variables including
historical and statistical information, changes in exposure units, inflation, legal developments, storm loss estimates, and economic
conditions. Case and formula basis loss reserves are reviewed on a regular basis. As new data becomes available, estimates are
updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis which have not
settled after six months, are case reserved at that time. Although management uses many resources to calculate reserves, there is
no precise method for determining the ultimate liability. The Company does not discount loss reserves for financial statement
purposes. Additional information regarding the Company’s reserves is included in Item 7 of this Form 10-K in the Losses and Loss
Expenses Payable section included therein.
Mutual has guaranteed the adequacy of State Auto P&C's loss and loss expense reserves as of December 31, 1990.
Pursuant to the guarantee, Mutual has agreed to reimburse State Auto P&C for any losses and loss expenses in excess of State Auto
P&C's December 31, 1990 reserves ($65.5 million) that may develop from claims that have occurred on or prior to that date. This
guarantee ensures that any deficiency in the reserves of State Auto P&C as of December 31, 1990, under the Pooling Arrangement
percentages effective on December 31, 1990 will be reimbursed by Mutual. As of December 31, 2004, there has been no adverse
development of these reserves. In the event Mutual becomes financially impaired, and subject to regulatory restrictions, it may be
unable to make any such reimbursement.
5
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following table presents one-year development information on changes in the reserve for loss and loss expenses of
the Company for each of the three years in the period ended December 31, 2004:
($ millions)
Year Ended December 31
2003
2004
2002
Beginning of Year:
Loss and loss expenses payable ................................................................
Less: Reinsurance recoverable on losses and loss expenses payable(1) .......
Net losses and loss expenses payable(2) ....................................................
Provision for losses and loss expenses occurring:
Current year ..........................................................................................
Prior years(3) .........................................................................................
Total ...................................................................................................
Loss and loss expense payments
for claims occurring during:
Current year ........................................................................................
Prior years...........................................................................................
Total.................................................................................................
End of Year:
Net losses and loss expenses payable .....................................................
Add: Reinsurance recoverable on losses and loss expenses payable(4) ......
Losses and loss expenses payable(5)..........................................................
$ 643.0
14.2
628.8
641.4
(22.2)
619.2
361.5
230.6
592.1
655.9
25.9
$ 681.8
600.9
8.8
592.1
653.0
(1.8)
651.2
370.7
243.8
614.5
628.8
14.2
643.0
523.8
13.9
509.9
641.1
12.4
653.5
349.7
221.6
571.3
592.1
8.8
600.9
(1)
(2)
(3)
(4)
(5)
Includes amounts due from affiliates of $5.7 million, $4.3 million, and $8.9 million, respectively.
Includes net amounts assumed from affiliates of $303.9 million, $304.0 million and $280.0 million, respectively.
This line item shows increases (decreases) in the current calendar year in the provision for losses and loss
expenses attributable to claims occurring in prior years. The decrease of $22.2 million and $1.8 million in 2004
and 2003, respectively, and the increase of $12.4 million in 2002 for claims occurring in prior years is well
within normal expectations for reserve development and claim settlement uncertainty.
Includes amounts due from affiliates of $5.7 million for 2004 and 2003 and $4.3 million for 2002.
Includes net amounts assumed from affiliates of $296.9 million, $303.9 million, and $304.0 million, respectively.
_____________________
The following table sets forth the development of reserves for losses and loss expenses from 1994 through 2004 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, 2004, the Company had paid 68.8% of the currently
estimated losses and loss expenses that had been incurred, but not paid, as of December 31, 1995.
The amounts on the "cumulative redundancy (deficiency)" line represent the aggregate change in the estimates over all
prior years. For example, the 1995 calendar year reserve has developed a $33.0 million or 16.0% redundancy through December
31, 2004. That amount has been included in operations over the ten years and did not have a significant effect on income in any
one year. The effects on income caused by changes in estimates of the reserves for losses and loss expenses for the most recent
three years are shown in the foregoing three-year loss development table.
In evaluating the information in the table, it should be noted that each amount includes the effects of all changes in
amounts for prior periods. For example, the amount of the redundancy related to losses settled in 1997, but incurred in 1994, will
be included in the cumulative redundancy amount for years 1994, 1995 and 1996. The table does not present accident or policy
year development data, which readers may be more accustomed to analyzing. Conditions and trends that have affected the
development of the liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to
extrapolate future redundancies or deficiencies based on this table.
6
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
In 1995, 1998, 1999, 2000 and 2001, the Pooling Arrangement was amended to increase the Company’s share of
premiums, losses and expenses. An amount of assets equal to the increase in net liabilities was transferred to the Company from
Mutual in 1995, 1998, 1999, 2000 and 2001 in conjunction with each year's respective pooling change. The amount of the assets
transferred from Mutual in 1995, 1998, 1999, 2000 and 2001 has been netted against and has reduced the cumulative amounts
paid for years prior to 1995, 1998, 1999, 2000 and 2001, respectively.
[See table on following page.]
7
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
($ millions)
1994
1995
1996
1997
Years Ended December 31
2000
1999
1998
2001
2002
2003
2004
Net liability for losses
and loss expenses payable
Paid (cumulative)
as of:
One year later
Two years later
Three years later
Four years later
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
Two years later
Three years later
Four years later
Five years later
Six years later
Seven years later
Eight years later
Nine years later
Ten years later
Cumulative redundancy
(deficiency)
Cumulative redundancy
(deficiency)
$126.7
$206.3
$199.5
$194.2
$205.0
$221.7
$236.7
$509.9
$592.1
$628.8
$655.9
1.5%
29.1%
44.5%
51.0%
54.6%
58.8%
52.3%
54.4%
57.2%
59.1%
87.4%
77.1%
77.0%
72.9%
70.9%
70.0%
72.6%
72.8%
77.7%
79.2%
38.2%
55.4%
63.3%
67.7%
71.9%
67.1%
69.3%
67.2%
68.8%
87.0%
86.4%
83.2%
81.6%
81.3%
83.6%
83.7%
82.5%
84.0%
39.4%
54.1%
65.0%
73.2%
69.8%
74.6%
77.1%
79.8%
91.3%
87.3%
86.7%
87.0%
92.6%
92.9%
96.1%
98.0%
32.7%
54.6%
70.1%
69.2%
77.1%
81.8%
85.8%
35.4%
61.6%
62.1%
78.8%
86.3%
92.5%
41.8%
43.0%
71.9%
86.9%
96.1%
5.9%
52.7%
79.9%
95.5%
43.4%
65.3%
78.4%
41.2%
60.8%
36.7%
--
93.0%
92.0%
91.9%
102.0%
101.4%
106.1%
108.9%
96.6%
96.7%
111.9%
111.5%
115.6%
118.5%
97.5%
119.1%
120.3%
123.2%
126.7%
125.7%
129.1%
133.1%
136.1%
102.4%
105.1%
106.9%
99.7%
100.6%
96.5%
--
$26.4
$33.0
$3.9
($17.2)
($37.8)
($59.2)
($85.3)
($35.2)
($3.8)
$22.2
20.8%
16.0%
2.0%
(8.9%)
(18.5%)
(26.7%)
(36.1%)
(6.9%)
(0.6%)
3.5%
--
--
Gross* liability – end of year
Reinsurance recoverable
Net liability – end of year
$277.8
$151.0
$126.8
$412.6
$206.2
$206.4
$410.7
$211.2
$199.5
$402.7
$208.6
$194.1
$414.3
$209.2
$205.1
$438.7
$217.1
$221.6
$457.2
$220.5
$236.7
$743.7
$233.8
$509.9
$862.4
$270.3
$592.1
$934.0
$305.2
$628.8
$1,006.4
$ 350.5
$ 655.9
Gross liability
re-estimated - latest
Reinsurance recoverable
re-estimated -latest
Net liability
96.6%
85.4%
96.0%
102.7%
111.2%
113.9%
119.9%
105.2%
99.6%
96.5%
111.1%
86.8%
94.1%
97.0%
104.1%
100.7%
102.5%
101.6%
97.4%
96.7%
re-estimated - latest
79.2%
84.0%
98.0%
108.9%
118.5%
126.7%
136.1%
106.9%
100.6%
96.5%
*Gross liability includes: Direct & assumed losses and loss expenses payable.
As the Pooling Arrangement provides for the right of offset, the Company has reported losses and loss expenses payable ceded to
Mutual as assets only in situations when net amounts ceded to Mutual exceed that assumed. The following table provides a reconciliation
of the reinsurance recoverable to the amount reported in the Company’s consolidated financial statements at each balance sheet date:
--
--
--
Reinsurance recoverable
Amount netted against
assumed from Mutual
Net reinsurance recoverable
$151.0
$206.2
$211.2
$208.6
$209.2
$217.1
$220.5
$233.8
$270.3
$305.2
$350.5
$142.6
$8.4
$193.3
$12.9
$196.9
$14.3
$195.3
$13.3
$197.7
$11.5
$206.3
$10.8
$212.6
$7.9
$219.9
$13.9
$261.5
$8.8
$291.0
$14.2
$324.6
$25.9
8
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Reinsurance
Members of the State Auto Group follow the customary industry practice of reinsuring a portion of their exposures and
paying to the reinsurers a portion of the premiums received. Insurance is ceded principally to reduce net liability on individual risks
or for individual loss occurrences, including catastrophic losses. Although reinsurance does not legally discharge the individual
members of the State Auto Group from primary liability for the full amount of limits applicable under their policies, it does make the
assuming reinsurer liable to the extent of the reinsurance ceded.
Each member of the State Auto Group is party to working reinsurance treaties for property, casualty and workers
compensation lines with several reinsurers arranged through a reinsurance intermediary. Under the property per risk excess of loss
treaty, each member is responsible for the first $2.0 million of each covered loss, and the reinsurers are responsible for 100% of the
excess over $2.0 million up to $10.0 million of covered loss. The rates for this reinsurance are negotiated annually.
The terms of the casualty excess of loss program provide that each company in the State Auto Group is responsible for
the first $2.0 million of a covered loss. The reinsurers are responsible for 82.5% of the excess over $2.0 million up to $5.0 million of
covered loss. Also, certain unusual claim situations involving bodily injury liability, property damage, uninsured motorist and
personal injury protection are covered by an arrangement that provides for $10.0 million of coverage in excess of a $5.0 million
retention for each loss occurrence. This layer of reinsurance sits above the $3.0 million excess of $2.0 million arrangement. The
rates for this reinsurance are negotiated annually.
The terms of the workers compensation excess of loss program provide that each company in the State Auto Group is
responsible for the first $2.0 million of covered loss. The reinsurers are responsible for 100% of the excess over $2.0 million up to
$10.0 million of covered loss. Net retentions under this contract may be submitted to the casualty excess of loss program, subject to
a limit of $2.0 million per loss occurrence. The rates for this reinsurance are negotiated annually.
In addition to the workers compensation reinsurance program described above, as of July 1, 2004, each company in the
State Auto Group became party to an agreement which provides an additional layer of excess of loss reinsurance for workers
compensation losses involving multiple workers. Subject to $10.0 million of retention, reinsurers are responsible for 100% of the
excess over $10.0 million up to $20.0 million of covered loss. This coverage is subject to a “Maximum Any One Life” limit of $10.0
million. The rates for this reinsurance are negotiated annually.
In addition, the State Auto Group has secured other reinsurance to limit the net cost of large loss events for certain types
of coverage. Included are umbrella liability losses which are reinsured up to a limit of $10.0 million above a maximum $0.6 million
retention. The State Auto Group also makes use of facultative reinsurance for unique risk situations and participates in involuntary
pools and associations in certain states.
The State Auto Group participates in an intercompany catastrophe reinsurance program. Under this program, the
members of the State Auto Group, on a combined basis, retain the first $40.0 million of catastrophe losses that affect at least two
individual risks. For catastrophe losses incurred by the State Auto Group up to $80.0 million, in excess of $40.0 million, traditional
reinsurance coverage is provided with a co-participation of 5%. For catastrophe losses incurred by the State Auto Group up to
$100.0 million, in excess of $120.0 million, in exchange for a premium paid by each reinsured company, State Auto P&C acts as the
catastrophe reinsurer for the State Auto Group under the terms of an intercompany catastrophe reinsurance agreement. There
have been no losses assumed under this agreement.
To provide funding if the State Auto Group were to incur catastrophe losses in excess of $120.0 million, State Auto
Financial has a structured contingent financing arrangement in place with a financial institution and a syndicate of other lenders (the
“Lenders”) to provide up to $100.0 million for reinsurance purposes. In the event of such a loss, this arrangement provides that
State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (“SPC”), which
would borrow the money necessary for such purchase from the Lenders. State Auto Financial would then contribute to State Auto
P&C the funds received from the sale of its preferred shares, thereby preserving the statutory surplus of State Auto P&C. State Auto
P&C would use the contributed capital to pay its direct catastrophe losses and losses assumed under the intercompany catastrophe
reinsurance agreement. State Auto Financial is obligated to repay SPC (which would repay the Lenders) by redeeming the preferred
shares in ten semiannual installments. In the event of a default by State Auto Financial, the obligation to repay SPC has been
secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which Mutual would be obligated to either
purchase the preferred shares from SPC or repay SPC for the loan(s) outstanding. This funding arrangement, if exercised, would
have the impact of adding up to $100.0 million of additional debt to the Company while providing needed cash to pay claims, while
at the same time preserving the investment portfolio of the Company in the short term.
SA National has a reinsurance agreement with Mutual pursuant to which Mutual assumes up to $4.9 million of each
liability loss occurrence in excess of SA National’s $50,000 of retention; and up to $0.5 million of each catastrophe loss occurrence in
excess of SA National’s $50,000 of retention. Mutual further provides SA National with an 8.5% quota share within the $50,000
retention on liability coverages, and a 20% quota share on physical damage coverages. In connection with its dissolution in
December 2004, Mid-Plains entered into an assumption reinsurance agreement with SA National for all Mid-Plains’ property and
casualty insurance policy liabilities.
See the discussion regarding the federal Terrorism Risk Insurance Act of 2002 (the “Terrorism Act”) in the Regulation
section and in Item 7 of this Form 10-K in the Other External Factors section included therein.
9
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Regulation
Most states, including all the domiciliary states of the State Auto Group, have enacted legislation that regulates insurance
holding company systems. Each insurance company in the holding company system is required to register with the insurance
supervisory agency of its state of domicile and furnish information concerning the operations of companies within the holding
company system that may materially affect the operations, management or financial condition of the insurers within the system.
Pursuant to these laws, the respective insurance departments may examine any members of the State Auto Group, at any time,
require disclosure of material transactions involving insurer members of the holding company system, and require prior notice and
an opportunity to disapprove of certain "extraordinary" transactions, including, but not limited to, extraordinary dividends to
shareholders. Pursuant to these laws, all transactions within the holding company system affecting any members of the State Auto
Group must be fair and equitable. In addition, approval of the applicable Insurance Commissioner is required prior to the
consummation of transactions affecting the control of an insurer. The insurance laws of all the domiciliary states of the State Auto
Group provide that no person may acquire direct or indirect control of a domestic insurer without obtaining the prior written
approval of the state insurance commissioner for such acquisition.
In addition to being regulated by the insurance department of its state of domicile, each insurance company is subject to
supervision and regulation in the states in which it transacts business. Such supervision and regulation relate to numerous aspects
of an insurance company's business operations and financial condition. The primary purpose of such supervision and regulation is
to ensure financial stability of insurance companies for the protection of policyholders. The laws of the various states establish
insurance departments with broad regulatory powers relative to granting and revoking licenses to transact business, regulating trade
practices, licensing agents, approving policy forms, setting reserve requirements, determining the form and content of required
statutory financial statements, prescribing the types and amount of investments permitted and requiring minimum levels of statutory
capital and surplus. Although premium rate regulation varies among states and lines of insurance, such regulations generally
require approval of the regulatory authority prior to any changes in rates. In addition, all of the states in which the State Auto
Group transacts business have enacted laws which restrict these companies’ underwriting discretion. Examples of these laws
include restrictions on policy terminations, restrictions on agency terminations and laws requiring companies to accept any applicant
for automobile insurance. These laws may adversely affect the ability of the insurers in the State Auto Group to earn a profit on
their underwriting operations.
Insurance companies are required to file detailed annual reports with the supervisory agencies in each of the states in
which they do business, and their business and accounts are subject to examination by such agencies at any time.
There can be no assurance that such regulatory requirements will not become more stringent in the future and have an
adverse effect on the operations of the State Auto Group.
Dividends. STFC’s insurance subsidiaries generally are restricted by the insurance laws of their respective states of
domicile as to the amount of dividends they may pay to STFC without the prior approval of the respective state regulatory
authorities. Generally, the maximum dividend that may be paid by an insurance subsidiary during any year without prior regulatory
approval is limited to the greater of a stated percentage of that subsidiary’s statutory surplus as of a certain date, or adjusted net
income of the subsidiary, for the preceding year. Under current law, a total of $94.7 million is available for payment to State Auto
Financial as a dividend from State Auto P&C, Milbank, Farmers, SA Ohio and SA National during 2005 without prior approval from
their respective domiciliary state insurance departments.
Rate and Related Regulation. In general, the Company is not aware of the adoption of any adverse legislation or
regulation by any state where the Company did business during 2004 which would present material obstacles to the Company's
overall business. However, several states where the Company does business have passed or are considering more strict regulation
of the use of credit scoring in rating and/or risk selection in personal lines of business. Similarly, several states are considering
restricting insurers’ rights to use loss history information maintained in various databases by insurance support organizations.
These tools help the Company price its products more fairly and enhance its ability to compete for business that it believes will be
profitable. Such regulations would limit the ability of the Company, as well as the ability of all other insurance carriers operating in
any affected jurisdiction, to take advantage of these tools.
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 National Association of Insurance Commissioners (“NAIC”)
annually tests insurers’ risk-based capital requirements. As of December 31, 2004, each insurer affiliated with the Company
surpassed all standards tested by the formula applying risk-based capital requirements.
The property and casualty insurance industry is also affected by court decisions. Premium rates are actuarially
determined to enable an insurance company to generate an underwriting profit. These rates contemplate a certain level of risk.
The courts may modify, in a number of ways, the level of risk which insurers had expected to assume including eliminating
exclusions, expanding the terms of the contract, multiplying limits of coverage, creating rights for policyholders not intended to be
included in the contract and interpreting applicable statutes expansively to create obligations on insurers not originally considered
when the statute was passed. Courts have also undone legal reforms passed by legislatures, which reforms were intended to
reduce a litigant’s rights of action or amounts recoverable and so reduce the costs borne by the insurance mechanism. These court
decisions can adversely affect an insurer's profitability. They also create pressure on rates charged for coverages adversely
affected, and this can cause a legislative response resulting in rate suppression that can adversely affect an insurer.
10
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The Terrorism Act requires the federal government and the insurance industry to share in insured losses up to $100 billion
per year resulting from future terrorist attacks within the United States. Under the Terrorism Act, commercial property and casualty
insurers must offer their commercial policyholders coverage against certified acts of terrorism, but the policyholders may choose to
reject this coverage. If the policyholder rejects coverage for certified acts of terrorism, the Company intends, subject to the
approval of the state regulators, to cover only such acts of terrorism that are not certified acts under the Terrorism Act and that do
not arise out of nuclear, biological or chemical agents. The requirement for insurers to make certain coverage available under the
Terrorism Act originally extended through December 2004, but Congress has extended it through the end of 2005. The Terrorism
Act will terminate on December 31, 2005, unless Congress acts to extend it again. The Company has advocated the extension of
this statute. If the statute is allowed to sunset, the foregoing description would become inapplicable. The Company’s current
property reinsurance treaties exclude certified acts of terrorism. If the Terrorism Act expires, those treaties will likely be revised to
exclude acts of terrorism as defined within the treaties. Likewise, if the Terrorism Act expires, the Company will pursue changes to
its direct commercial policies to exclude acts of terrorism as defined within its policies.
An area of regulatory focus that arose late in 2004, and which likely will continue to receive additional focus in 2005, is
“producer compensation arrangements.” The New York Attorney General has undertaken investigations and initiated lawsuits
involving allegations of improper compensation arrangements between brokers and insurance companies. These actions have led
several state insurance departments to undertake their own surveys or inquiries into the activities of their domestic insurers with
respect to producer compensation arrangements in their respective states. Two state insurance departments have delivered
inquiries to the Company, and the Company has responded to each of the inquiries. It is the Company’s understanding that these
inquiries are part of an overall fact-finding process initiated by these state insurance departments, and that similar inquiries were
made to a number of other domestic insurers in these states. The inquiries did not indicate or imply that the Company had done
anything improper with respect to its compensation arrangements with its agents. Because these inquiries are in their early stages
of fact finding, it cannot be predicted as to the next phase of inquiry or what, if any, legislation or rules may be proposed to address
producer compensation arrangements in those states where the Company has domestic insurers. The improper producer
compensation arrangements generally involve insurance brokers, which are persons retained and compensated by the insurance
customer. The Company markets its insurance products through independent insurance agents who have been appointed to act on
the Company’s behalf, and the Company, not the insurance customer, compensates these agents pursuant to contractual
arrangements. Under its agency agreements, the Company’s compensation arrangements with its agencies consist of commissions
paid for the sale of the Company’s insurance products, usually based upon a percentage of the premium paid by the insurance
customer, and a “contingent commission.” This “contingent commission” is based upon the underwriting profit generated by that
agency’s book of business placed with the State Auto Group. Like many other sales organizations, the Company also offers sales
incentives to its agencies. The Company believes that its agent compensation arrangements are in compliance with all laws and
consistent with good business practices.
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 subsidiaries, and investment results are not shared by the Pooled Companies through the Pooling
Arrangement. Stateco performs investment management services for the Company and Mutual and its subsidiaries, although
investment policies implemented by Stateco continue to be set for each company through the Investment Committee of its Board of
Directors.
The Company's decision to make a specific investment is influenced primarily by the following factors: (a) investment
risks; (b) general market conditions; (c) relative valuations of investment vehicles; (d) general market interest rates; (e) the
Company's liquidity requirements at any given time; and (f) the Company's current federal income tax position and relative spread
between after tax yields on tax-exempt and taxable fixed income investments. The Company has investment policy guidelines with
respect to purchasing fixed income investments which preclude investments in bonds that are rated below investment grade by a
recognized rating service. The maximum investment in any single note or bond is limited to 5.0% of assets, other than obligations
of the U.S. government or government agencies, for which there is no limit. Investments in equity securities are selected based on
their potential for appreciation as well as ability to continue paying dividends. See discussion regarding Market Risk included in Item
7 of this Form 10-K.
The Company’s fixed maturity investments are classified as available for sale and carried at fair market value, according
to the Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity
Securities.”
The Company’s Investment Policy and Guidelines permit investment in debt issues rated A or better by two major rating
services. The Company’s fixed maturities portfolio is composed of high quality, investment grade issues, comprised almost entirely
of debt issues rated AAA or AA. As of December 31, 2004 and 2003, the bond portfolio had a fair market value that totaled
$1,502.1 million and $1,427.9 million, respectively.
At December 31, 2004 and 2003, respectively, the Company’s equity portfolio is classified as available for sale and carried
at fair market value that totaled $193.6 million and $139.3 million, respectively.
11
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following table sets forth the Company's investment results for the periods indicated:
($ millions)
Year ended December 31
Average Invested Assets (1).....................
Net Investment Income (2)......................
Average Yield ........................................
2004
$1,607.3
71.8
4.5%
2003
1,391.9
64.6
4.6%
2002
1,210.6
59.7
4.9%
(1)
(2)
Average of the aggregate invested assets at the beginning and end of each period, including interim quarter
ends. Invested assets include fixed maturities at amortized cost, equity securities at cost, other invested assets
at cost and cash equivalents.
Net investment income is net of investment expenses and does not include realized or unrealized investment
gains or losses or provision for income taxes.
____________________
For additional discussion regarding the Company’s investments, see Item 7 “Management’s Discussion and Analysis of
Financial Condition and Results of Operations.”
Competition
The property and casualty insurance industry is highly competitive. The Company competes with numerous insurance
companies, many of which are substantially larger and have considerably greater financial resources. In addition, because the
Company's products are marketed exclusively through independent insurance agencies, most of which represent more than one
company, the Company faces competition within each agency. See "Marketing" in the “Narrative Description of Business.” The
Company competes through underwriting criteria, appropriate pricing, quality service to the policyholder and the agent, and a fully
developed agency relations program.
Employees
As of March 4, 2005, the Company had 2,029 employees. Employees of the Company are not covered by any collective
bargaining agreement. Management of the Company considers its relationship with its employees to be excellent.
Available Information
STFC’s internet website address is www.stfc.com. Through this internet website (found under the “SEC Filings” link),
STFC makes available, free of charge, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form
8-K, and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934 (the “Exchange Act”), as soon as reasonably practicable after STFC electronically files such material with the Securities and
Exchange Commission (the “SEC”). Also available on its website is information pertaining to the Company’s corporate governance,
including the charters of each the standing committees of the Company’s Board of Directors, the Company’s corporate governance
guidelines and the Company’s code of business conduct. For a free copy of the Form 10-K, write to Terrence L. Bowshier, Vice
President, State Auto Financial Corporation, 518 East Broad Street, Columbus, Ohio 43215.
Any of the materials the Company files with the SEC may also be read and copied at the SEC's Public Reference Room at
450 Fifth Street, NW, Washington, DC 20549. Information on the operation of the SEC's Public Reference Room may be obtained
by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and
other information regarding issuers that file electronically with the SEC at www.sec.gov.
12
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Executive Officers of the Registrant
Name of Executive Officer and
Position(s) with Company
Robert H. Moone,
Chairman, President and
Chief Executive Officer
Age(1)
61
Mark A. Blackburn,
Senior Vice President
Steven J. Johnston,
Senior Vice President,
Treasurer and Chief
Financial Officer
John R. Lowther,
Senior Vice President,
Secretary and
General Counsel
Steven R. Hazelbaker,
Vice President
Cathy B. Miley, (3)
Vice President
Richard L. Miley, (3)
Vice President
Cynthia A. Powell,
Vice President
53
45
54
49
55
50
44
Principal Occupation(s)
During the Past Five Years
An Executive Officer
of the Company Since (2)
Chairman of the Board of STFC and Mutual,
1/1/01 to present; Chief Executive Officer of
STFC and Mutual, 5/99 to present; President
of STFC and Mutual, 5/96 to present;
Executive Vice President, 11/93 to 5/96 and
prior thereto Vice President of STFC and
Mutual
Senior Vice President of STFC and Mutual,
3/01 to present; Vice President of STFC and
Mutual, 8/99 to 3/01
Senior Vice President of STFC and Mutual,
to present; Treasurer and Chief
8/99
Financial Officer of STFC and Mutual, 4/97 to
present; Vice President of STFC and Mutual,
5/95 to 8/99
Senior Vice President of STFC and Mutual,
3/01 to present; Secretary and General
Counsel of STFC, 5/91 to present and of
Mutual 8/89 to present; Vice President of
STFC, 5/91 to 3/01 and of Mutual 8/89 to
3/01
Vice President of Mutual, 6/01 to present;
Vice President of STFC, 6/01 to present;
COO of MIGI and Meridian Mutual, 8/00 to
6/01; Chief Financial Officer and Treasurer of
MIGI and Meridian Mutual, 1994 to 8/00;
Vice President of MIGI and Meridian Mutual,
1995 to 8/00
Vice President of STFC, 3/98 to present; Vice
to present;
President of Mutual, 3/95
Assistant Secretary of Mutual, 8/92 to 3/95
Vice President of STFC, 3/98 to present; Vice
President of Mutual, 5/95
to present;
Assistant Vice President of Mutual, 8/87 to
5/95
Vice President of Mutual, 3/00 to present;
Assistant Vice President, 8/96 to 3/00; Vice
President of STFC, 5/00 to present; Assistant
Vice President of STFC, 4/97 to 5/00
1991
1999
1994
1991
2001
1995
1995
2000
(1)
(2)
(3)
Age is as of March 4, 2005.
Each of the foregoing officers has been designated by the Company's Board of Directors as an executive officer for
purposes of Section 16 of the Exchange Act.
Richard L. Miley and Cathy B. Miley are husband and wife.
__________________________________________________________________________________________
13
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Item 2. Properties
The Company shares its operating facilities with Mutual pursuant to the terms of the 2000 Management Agreement, and
subject to regulatory approval, the 2005 Management Agreement. The Company’s corporate headquarters are located in Columbus,
Ohio, in buildings owned by Mutual that contain approximately 280,000 square feet of office space. The Company and Mutual also
own or lease other office facilities in numerous locations throughout the State Auto Group’s geographical areas of operation.
Item 3. Legal Proceedings
Insurance Business
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.
Minority Shareholder Litigation—Ohio
As previously reported, on October 16, 2003, State Auto Financial, Mutual, and their respective directors filed a
complaint against Gregory M. Shepard and his company in the Common Pleas Court of Franklin County, Ohio (the "Court"), seeking
(1) declaratory relief that neither State Auto Financial, Mutual, nor their respective directors and officers violated any fiduciary duties
to Mr. Shepard, his company, or State Auto Financial's minority shareholders in responding to a tender offer commenced by Mr.
Shepard and his company for State Auto Financial's common shares (the "Shepard tender offer"); (2) declaratory relief that neither
State Auto Financial nor its directors and officers have an obligation to call a meeting of shareholders under Ohio's Control Share
Acquisition statute with respect to the Shepard tender offer; and (3) compensatory damages in favor of State Auto Financial and
Mutual from Mr. Shepard and his company for knowingly making misrepresentations in connection with their control bid in violation
of Ohio law. Also as previously reported, on December 19, 2003, Mr. Shepard and his company filed a counterclaim against State
Auto Financial, Mutual, and their respective directors seeking (1) a declaratory judgment requiring State Auto Financial to call a
meeting of shareholders under Ohio's Control Share Acquisition statute with respect to the Shepard tender offer; (2) injunctive relief
to enjoin State Auto Financial, Mutual, and their respective directors and employees from taking actions that would have the effect
of impeding or interfering with the Shepard tender offer; and (3) compensatory damages from Mutual, Mutual's directors, and State
Auto Financial's directors for the alleged breach of their fiduciary duties. Mr. Shepard and his company announced the termination of
the Shepard tender offer on May 10, 2004.
On May 13, 2004, the Court entered an order (1) dismissing with prejudice all counterclaims of Mr. Shepard and his
company against State Auto Financial, Mutual, and their respective directors, and (2) dismissing without prejudice all claims for
declaratory relief against Mr. Shepard and his company. The only remaining claim before the Court was for compensatory damages
brought by State Auto Financial and Mutual against Mr. Shepard and his company for knowingly making misrepresentations in
connection with their control bid in violation of Ohio law. In January 2005, the Court granted a motion for summary judgment in
favor of Mr. Shepard and his company and entered an order dismissing State Auto Financial’s and Mutual’s claim for damages
against Mr. Shepard and his company. State Auto Financial and Mutual did not appeal the Court’s order. Therefore, this litigation
has been concluded.
Minority Shareholder Litigation—Indiana
On July 27, 2001, Mr. Shepard and American Union Insurance Company ("AUIC"), an Illinois insurance company owned
by Mr. Shepard and his brother, Tracy Shepard, filed a complaint against State Auto Financial, Mutual, MIGI, and MIGI's former
directors in the United States District Court for the Southern District of Indiana (the “Court”). The factual basis for this suit arises
from the circumstances surrounding the merger of MIGI with and into a wholly owned subsidiary of Mutual (the "Merger"), which
was effective June 1, 2001. In their complaint, Mr. Shepard and AUIC alleged claims of (1) breach of fiduciary duty against the
former MIGI directors for entering into the Merger; (2) breach of contract against State Auto Financial and Mutual with respect to a
confidentiality agreement, dated September 29, 2000, between State Auto Financial and AUIC; and (3) tortuous interference against
MIGI and one of its former directors with respect to such confidentiality agreement. On December 3, 2003, the Court granted the
request of Mr. Shepard and AUIC to voluntarily dismiss the claims of breach of fiduciary duty and tortuous interference against MIGI
and its former directors. Thus, the only remaining claim in this suit is for breach of the confidentiality agreement against State Auto
Financial and Mutual. Mr. Shepard and AUIC are seeking compensatory damages in this suit, which they allege exceed $25.0 million
based on an expert witness' report provided to State Auto Financial and Mutual by Mr. Shepard's counsel in April 2004. As of March
4, 2005, discovery is substantially concluded and the trial is currently scheduled to occur in October of 2005. State Auto Financial
and Mutual have filed a motion for summary judgment seeking the dismissal of all claims against them. As of March 4, 2005, the
Court has not ruled on this motion.
14
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Item 4.
Submission of Matters to a Vote of Security Holders
Not applicable.
PART II
Item 5. Market for the Registrant's Common Equity, Related Shareholder Matters, and Issuer Purchases of Equity
Securities
Market Information; Holders of Record
The Company’s common shares are traded in the NASDAQ National Market System under the symbol STFC. As of March
4, 2005, there were 898 shareholders of record of the Company’s common shares.
Market Price Ranges and Dividends Declared on Common Shares(1)
Initial Public Offering -- June 28, 1991, $2.25(1). The following table provides information with respect to the high and low
sale prices of the Company’s common shares for each quarterly period for the past two years as reported by NASDAQ, along with
the amount of cash dividends declared by the Company with respect to its common shares for each quarterly period for the past
two years:
2004
High
Low
Dividend
First Quarter............... $ 25.86
31.08
Second Quarter ..........
31.83
Third Quarter .............
29.26
Fourth Quarter ...........
$ 22.12
23.02
28.00
23.70
$ 0.040
0.040
0.045
0.045
2003
First Quarter...............
Second Quarter ..........
Third Quarter .............
Fourth Quarter ...........
High
17.75
24.24
26.60
26.90
Low
Dividend
14.96
16.59
21.45
22.50
0.035
0.035
0.040
0.040
(1) Adjusted for stock splits.
___________________
Additionally, see Liquidity and Capital Resources section of included in Item 7 of this Form 10-K for a discussion of
regulatory restrictions on the payment of dividends by the Company’s insurance subsidiaries.
Purchases of Common Shares by the Company
The following table provides information with respect to purchases made by the Company of its common shares during
the fourth quarter 2004:
Period
Total number
of shares
purchased*
Average
price paid per
share
Total number
of shares purchased
as part of publicly
announced plans
or programs
Maximum number
(or approximate dollar
value) of shares that
may yet be purchased
under the plans or programs
10/01/04-10/31/04.....
11/01/04-11/30/04.....
12/01/04-12/31/04.....
Total .........................
-
-
923
923
-
-
$ 26.80
$ 26.80
-
-
-
-
-
-
-
-
* All shares repurchased were acquired as a result of stock swap option exercises.
__________________
15
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Item 6. Selected Consolidated Financial Data
2004
2003
2002
2001*
2000*
1999*
1998*
1997
1996
1995*
(dollars and shares in millions, except per share data)
Year ended December 31
Statement of Income Data –
GAAP Basis:
Earned premiums
Net investment income
Total revenues
Net income
Earned premium growth
Return on average invested assets(1)
Balance Sheet Data –
GAAP Basis:
Total investments
Total assets
Total notes payable
Total stockholders’ equity
Common shares outstanding
Return on average equity (2)
Debt to stockholders’ equity
Per Common Share Data –
GAAP Basis:
Basic EPS(3)(4)
Diluted EPS (3)(4)
Cash dividends per share(3)
Book value per share(3)
Common Share Price
High
Low
Close at December 31
Close price to basic EPS
Close price to book
GAAP Ratios: (5)
Loss and LAE ratio
Expense ratio
Combined ratio
Statutory Ratios: (5)
Loss and LAE ratio
Expense ratio
Combined ratio
Industry combined ratio(6)
Net premiums written to surplus(7)
$1,006.8
$ 71.8
$1,092.4
$ 110.0
4.8%
4.5%
960.6
64.6
1,041.7
63.6
7.1
4.6
896.6
59.7
967.5
37.0
61.5
4.9
555.2
47.4
623.3
20.6
39.5
5.4
$1,699.1
$2,023.7
$ 164.5
$ 658.2
40.1
18.3%
25.0%
1,570.3
1,836.7
161.2
542.3
39.6
12.6
29.7
1,272.3
1,593.0
75.5
463.8
39.0
8.6
16.3
1,138.7
1,367.5
45.5
400.2
38.9
5.2
11.4
398.0
38.9
462.8
47.7
1.5
5.5
750.9
898.1
45.5
386.1
38.6
13.6
11.8
$ 2.76
$ 2.70
$ 0.17
1.62
1.58
0.15
0.95
0.93
0.14
0.53
0.52
0.13
1.24
1.21
0.12
$ 16.42
13.71
11.89
10.28
10.01
$ 31.83
$ 22.12
$ 25.85
9.37 x
1.57 x
61.5%
30.2%
91.7%
61.6%
30.6%
92.2%
97.6%
1.6
26.90
14.96
23.34
14.41
1.70
67.8
30.4
98.2
67.9
30.7
98.6
100.1
1.9
17.25
12.67
15.50
16.32
1.30
72.9
29.5
102.4
73.1
29.2
102.3
107.4
2.6
17.80
12.30
16.24
30.64
1.58
76.9
30.1
107.0
77.4
27.8
105.2
115.9
1.8
18.00
7.13
17.88
14.41
1.79
68.4
30.0
98.4
68.5
27.0
95.5
110.4
1.3
392.0
34.3
440.9
42.8
10.1
5.4
627.3
759.9
45.5
317.7
38.3
13.0
14.3
1.05
1.03
0.11
8.29
13.88
8.88
9.13
8.70
1.10
67.5
28.5
96.0
67.4
29.5
96.9
108.1
1.5
356.2
32.5
402.1
37.5
11.3
5.7
580.0
717.5
-
340.8
42.0
11.8
-
0.89
0.87
0.10
8.11
20.00
11.44
12.38
13.91
1.53
68.0
29.3
97.3
68.4
29.4
97.8
106.0
1.6
320.1
31.1
363.0
41.0
5.1
6.2
526.4
664.4
-
297.3
41.8
15.0
-
0.99
0.97
0.09
7.11
16.25
8.13
16.13
16.29
2.27
304.5
29.9
345.1
26.4
2.7
6.4
499.3
605.4
-
247.6
41.4
11.0
-
0.64
0.63
0.08
5.98
9.25
6.50
9.00
14.06
1.51
65.1
29.5
94.6
72.3
28.2
100.5
65.2
28.9
94.1
101.6
1.7
72.7
27.3
100.0
105.8
1.9
296.4
28.5
333.5
29.9
31.6
6.4
479.9
579.2
-
225.8
41.2
14.9
-
0.73
0.72
0.07
5.48
8.75
4.58
8.67
11.88
1.58
68.3
29.5
97.8
68.6
31.0
99.6
106.4
2.1
Invested assets include investments and cash equivalents.
(1)
(2) Net income less preferred share dividends, if any, divided by average common stockholders’ equity.
(3) Adjusted for 1998 2-for-1 and 1996 3-for-2 common stock split effected in the form of a stock dividend.
(4) The earnings per share amounts prior to 1998 have been restated as required to comply with SFAS No. 128.
(5) GAAP ratios are computed using earned premiums for both the loss and LAE ratio and the expense ratio, and include the effect of
eliminations in consolidation. The statutory expense ratio is computed using net written premiums. The Company uses the
statutory combined ratio to compare its results to the industry statutory combined ratio as there is no industry GAAP combined ratio
available.
(6) The industry combined ratios are from A.M. Best. The 2004 industry combined ratio is preliminary.
(7) The Company uses the statutory net premiums written to surplus ratio as there is no comparable GAAP measure. This ratio, also
called the leverage ratio, measures the Company’s statutory surplus available to absorb losses.
Reflects change in Pooling Arrangement, effective October 1, 2001, January 1, 2000, 1999, 1998 and 1995.
*
16
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
State Auto Financial Corporation (“State Auto Financial” or “STFC”) and its 100% owned subsidiaries are collectively referred to as the
“Company.” The Company is a member of the State Auto Group (defined below). The State Auto Group writes personal and commercial insurance
through approximately 22,500 independent insurance agents associated with approximately 3,250 agencies in 26 states. The State Auto Group operates
primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states. State Auto Financial is a majority-
owned subsidiary of State Automobile Mutual Insurance Company (“Mutual”), an Ohio domiciled property and casualty insurer and member of the State
Auto Group. Mutual is one of only 15 companies in the United States that have received A.M. Best’s A+ or higher rating every year since 1954.
State Auto Financial provides personal and commercial insurance to the standard insurance market through the following 100% owned
insurance subsidiaries, collectively referred to as the “STFC Pooled Companies”:
(cid:120)
(cid:120)
(cid:120)
(cid:120)
(cid:120)
(cid:120)
(cid:120)
State Auto Property and Casualty Insurance Company (“State Auto P&C”)
Milbank Insurance Company (“Milbank”)
Farmers Casualty Insurance Company (“Farmers”) and
State Auto Insurance Company of Ohio (“SA Ohio”).
The STFC Pooled Companies’ principal lines of business include:
Personal and commercial automobile
Homeowners
Commercial multi-peril
(cid:120)
(cid:120)
(cid:120)
Workers’ compensation
General liability
Fire
State Auto Financial also provides personal automobile insurance to the nonstandard insurance market through State Auto National Insurance
Company (“SA National”), a 100% owned insurance subsidiary. State Auto Financial also provided nonstandard automobile insurance through Mid-Plains
Insurance Company (“Mid-Plains”), a 100% owned subsidiary of Farmers. As of December 1, 2004, SA National and Mid-Plains entered into an
assumption reinsurance agreement whereby SA National assumed all outstanding insurance claim liabilities of Mid-Plains on this date. Mid-Plains was
dissolved on December 29, 2004.
The companies below are collectively referred to as the “Affiliates.” The Company and the Affiliates are collectively referred to as the “State
Auto Group.”
Mutual and its 100% owned subsidiaries:
(cid:131)
(cid:131)
(cid:131)
State Auto Insurance Company of Wisconsin (“SA Wisconsin”)
State Auto Florida Insurance Company (“SA Florida”)
Meridian Insurance Group, Inc. (“MIGI”) and its 100% owned subsidiary:
o
Meridian Security Insurance Company (“Meridian Security”)
o
Through an affiliation agreement with MIGI:
(cid:120)
Meridian Citizens Mutual Insurance Company (“Meridian Citizens Mutual”).
Meridian Security and Meridian Citizens Mutual are collectively referred to as the “Meridian Insurers.”
The STFC Pooled Companies participate in a quota share reinsurance pooling arrangement (the “Pooling Arrangement”) with Mutual, SA
Wisconsin and SA Florida (collectively the “Mutual Pooled Companies”). The Pooling Arrangement provides that the STFC Pooled Companies and the
Mutual Pooled Companies cede to Mutual all of their insurance business and assume from Mutual an amount equal to their respective participation
percentages as outlined in the Pooling Arrangement. The participation percentage for the STFC Pooled Companies has remained at 80% since October
1, 2001. The STFC Pooled Companies and Mutual Pooled Companies are collectively referred to as the “Pooled Companies.”
As of July 1, 2004, the Pooling Arrangement was amended to exclude certain middle market business written by Mutual.
As of January 1, 2005, the Pooling Arrangement was amended to add the Meridian Insurers as participants. In conjunction with this
amendment, the STFC Pooled Companies received $54.0 million in cash from the Meridian Insurers which related to the additional net insurance
liabilities assumed on January 1, 2005.
17
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
The following table sets forth a chronology of the participant and participant percentage changes that have occurred in the Pooling
Arrangement since January 1, 2002:
STFC Pooled Companies
Mutual Pooled Companies
Year(1)
State
Auto P&C
Milbank
Farmers
SA Ohio
2002
2003-2004
1/1/2005
59.0
59.0
59.0
17.0
17.0
17.0
3.0
3.0
3.0
1.0
1.0
1.0
Sub
Total
80.0
80.0
80.0
Mutual
19.0
18.3
19.5
SA
Wisconsin
SA
Florida
Meridian
Security
Meridian
Citizens
Mutual
1.0
1.0
0.0
N/A
0.7
0.0
N/A
N/A
0.0
N/A
N/A
0.5
Sub
Total
20.0
20.0
20.0
(1)
Time period is for the year ended December 31, unless otherwise noted.
___________________________
State Auto P&C provides employees to the Company and the Affiliates. This is contractually provided for under the following management
and/or cost sharing agreements: 1) the “2000 Management Agreement” to which State Auto P&C, Mutual, Milbank, SA Ohio and SA National are parties;
and 2) the “Midwest Management Agreement” to which State Auto P&C, Mutual and SA Wisconsin are parties. During 2004, there also existed the
following management and/or cost sharing agreements: (A) the “MIGI Management Agreement” to which State Auto P&C, MIGI, the Meridian Insurers
and an insurance company sold by Meridian Security in October 2004, were parties; and (B) the “Farmers Management Agreement” to which Mutual,
State Auto P&C, Farmers and Mid-Plains were parties. The Midwest Management Agreement provides for a management fee based on a percentage of
SA Wisconsin’s direct written premiums collected by the Company for the services State Auto P&C provides. The MIGI Management Agreement provided
for a management fee equal to a percentage of the allocable employee expenses attributable to the operations of these companies paid to the Company
for the services State Auto P&C provides. Each of the foregoing management or cost sharing agreements also apportions or apportioned among the
parties the actual costs of the services provided.
Subject to regulatory approval, the 2000 Management Agreement has been amended and restated as of January 1, 2005, as the “2005
Management Agreement,” and Meridian Security, Meridian Citizens Mutual and Farmers will become parties. As of this same date, the MIGI
Management Agreement and the Farmers Management Agreement will be terminated.
100% owned non-insurance subsidiaries (direct and indirect) of State Auto Financial include:
(cid:120)
(cid:120)
(cid:120)
Stateco Financial Services, Inc. (“Stateco”)
Strategic Insurance Software, Inc. (“S.I.S.”)
518 Property Management and Leasing, LLC (“518 PML”)
Stateco provides investment management services to the Company and Affiliates, which comprise the Company’s investment management
services segment. S.I.S. develops and sells software for the processing of insurance transactions, database management systems for insurance agents,
and electronic interfacing of information between insurance companies and agents. S.I.S. sells its services and products to insurance agencies and
nonaffiliated insurers. It also delivers its services and sells its products to the Affiliates. 518 PML is engaged in the business of owning and leasing real
and personal property to the Affiliates. The members of 518 PML are State Auto P&C and Stateco. The results of operations of S.I.S. and 518 PML are
not material to the total operations of the Company.
Significant Transactions Summary
The following is a summary of significant transactions that occurred during 2002 through 2004 that will assist in the discussion of the
Company’s current period financial results:
For the period October 1, 2001 through December 31, 2003, Mutual entered into a stop loss reinsurance arrangement (the “Stop Loss”) with
the STFC Pooled Companies. Under the Stop Loss, Mutual agreed to participate in the Pooling Arrangement’s quarterly underwriting losses and gains in
the manner described. If the Pooling Arrangement’s quarterly statutory loss and loss adjustment expense ratio (the “Pool loss and LAE ratio”) was
between 70.75% and 80.00% (after the application of all available reinsurance), Mutual reinsured the STFC Pooled Companies 27% of the Pooling
Arrangement’s losses in excess of a Pool loss and LAE ratio of 70.75% up to 80.00%. The STFC Pooled Companies were responsible for their share of
the Pooling Arrangement’s losses over the 80.00% threshold. Also, Mutual had the right to participate in the profits of the Pooling Arrangement.
Mutual assumed 27% of the Pooling Arrangement’s underwriting profits attributable to Pool loss and LAE ratios less than 69.25%, but more than
59.99%. The Stop Loss arrangement expired at December 31, 2003, and was not renewed.
On November 13, 2003 State Auto Financial issued $100.0 million unsecured 6.25% senior notes. State Auto Financial used the proceeds
from these debt instruments to contribute additional paid-in capital to its insurance subsidiaries as follows: $39.0 million to State Auto P&C, $30.0 million
to SA National and $15.0 million to Milbank. Milbank used the $15.0 million additional paid-in capital contribution to repay its $15.0 million surplus note
with Meridian Security. State Auto Financial also used these proceeds to repay $15.0 million of its bank debt and invested the remaining amount in fixed
maturity and equity securities.
18
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
Critical Accounting Policies
The Company’s significant accounting policies are more fully described in Note 15 of the Notes to the Company’s Consolidated Financial
Statements included in Item 8 of this Form 10-K. In preparing the consolidated financial statements, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the period then
ended and the financial entries in the accompanying notes to the financial statements. Such estimates and assumptions could change in the future, as
more information becomes known which could impact the amounts reported and disclosed therein.
Losses and loss expenses payable are management’s best estimates at a given point in time of what the Company expects to pay claimants,
based on known facts, circumstances and historical trends. Reserves for reported losses are established on either a case-by-case or formula basis
depending on the type and circumstances of the loss. The case-by-case reserve amounts are determined by claims adjusters based on the Company’s
reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss.
The formula reserves are based on historical data for similar claims with provision for trend changes caused by inflation. Loss and loss expense reserves
for incurred claims that have not yet been reported are estimated based on many variables including historical and statistical information, inflation, legal
developments, storm loss estimates, and economic conditions. Case and formula basis loss reserves are reviewed on a regular basis, and as new data
becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis and
not settled after six months, are case reserved at that time. Although management uses many internal and external resources, as well as multiple
established methodologies to calculate reserves, there is no method for determining the exact ultimate liability.
Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses relating to the production of property and
casualty business, are deferred and amortized ratably over the contract period. The method followed for computing the 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 expected to be incurred, and certain other costs expected to be incurred as premium is earned. These
amounts are based on estimates, and accordingly, the actual realizable value may vary from the estimated realizable value.
Pension and postretirement benefit obligations are long term in nature and require management judgment in estimating the factors used to
determine these amounts. Management, along with its defined benefit consulting actuary, reviews these factors, including the discount rate and
expected long term rate of return on plan assets among other factors. Because these obligations are based upon management estimates which could
change given available information, the ultimate benefit obligation could be different from the amount estimated.
Fixed maturity and equity security investments are classified as available for sale and carried at fair value. The unrealized holding gains or
losses, net of applicable deferred taxes, are shown as a separate component of stockholders’ equity as “accumulated other comprehensive income,” and
as such are not included in the determination of net income. Investment income is recognized when earned, and capital gains and losses are recognized
when investments are sold.
The Company regularly monitors its investment portfolio for declines in value that are other than temporary, an assessment that requires
significant management judgment. Among the factors management considers are the nature of the investment, severity and length of decline in fair
value, events impacting the issuer, and overall market conditions. When a security in the Company’s investment portfolio has been determined to have
a decline in fair value that is other than temporary, the Company adjusts the cost basis of the security to fair value. This results in a charge to earnings
as a realized loss, which is not changed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other than temporary,
are included in other comprehensive income.
See a discussion of other factors that may have an impact on management’s best estimates at “Impact of Significant External Factors”
included in this Item 7.
Note on Reportable Segments
In June 2001, Mutual merged with Meridian Mutual Insurance Company (“Meridian Mutual”), with Mutual continuing as the surviving
corporation. With the 2001 merger, all insurance business written by Meridian Mutual legally became the business of Mutual and was included in the
Pooling Arrangement as of July 1, 2001. Due to the integration efforts by management of the Meridian book of business, on January 1, 2004, the
Meridian Standard segment was included in the State Auto Standard segment; likewise, on January 1, 2003, the Meridian Nonstandard segment was
included in the State Auto Nonstandard segment as these Meridian segments no longer met the quantitative thresholds for separate presentation as
reportable segments. The 2003 and 2002 disclosures in this Item 7 have been revised to reflect this change. See Note 15 of the Notes to the
Company’s Consolidated Financial Statements included in Item 8 regarding the Company’s operating segments in the consolidated financial statements
of the Company.
19
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
Results of Operations
Summary
The following table summarizes certain key performance indicators used to manage the operations of the Company for the years ended
December 31, 2004, 2003, and 2002, respectively:
($ millions)
2004
2003
2002
GAAP Basis:
Total revenue................................................
Net income ...................................................
Stockholders’ equity.......................................
Loss and LAE ratio(1) ......................................
Expense ratio(1) .............................................
Combined ratio..............................................
Catastrophe loss and LAE points(1) .................
Premium written growth ................................
Premium earned growth ................................
Investment yield............................................
$ 1,092.4
$ 110.0
$ 658.2
61.5
30.2
91.7
7.0
3.1%
4.8%
4.5%
1,041.7
63.6
542.3
67.8
30.4
98.2
6.8
4.7
7.1
4.6
967.5
37.0
463.8
72.9
29.5
102.4
5.6
64.3
61.5
4.9
Statutory Basis:
Net premiums written to surplus(2)..................
1.6
1.9
2.6
(1) Definition follows
(2) The Company uses the statutory net premiums written to surplus ratio because there is no
comparable GAAP measure. This ratio, also called the leverage ratio, measures the Company’s
statutory surplus available to absorb losses.
___________________________
The Company’s reportable segments are State Auto standard insurance, State Auto nonstandard insurance, and investment management
services. The profits of these segments are monitored by management on an unconsolidated basis and therefore do not reflect adjustments for
transactions with other segments or realized gains or losses on sales of investments.
The following table reflects segment profits for the years ended December 31, 2004, 2003, and 2002, respectively:
($ millions)
2004
2003
2002
State Auto standard insurance .................................................... $135.3
9.8
State Auto nonstandard insurance ..............................................
8.6
Investment management services...............................................
All other ....................................................................................
1.0
Total segment profit............................................................... $154.7
60.8
6.7
7.4
2.2
77.1
22.2
4.1
6.4
1.9
34.6
The reader is referred to the complete disclosure on reportable segments in Note 15, Reportable Segments, of the Notes to the Company’s
Consolidated Financial Statements included in Item 8 of this Form 10-K.
___________________________
The investment management services segment reflects management of the investment portfolios of affiliate companies. Its significant source
of segment profit is the fee generated from providing this service. The relative stable improvement in profit over the years is attributable to the
combined growth of the investment portfolios managed along with fair value improvement. This segment’s revenue is based on the average fair value
of the portfolios managed.
A necessary discipline of a successful property and casualty insurance company is to produce an underwriting profit. When underwriting is not
profitable, premiums are inadequate to pay for insurance losses and related acquisition and operating expenses. When an insurance company operates
at an underwriting loss, net investment income may enable an insurance company to produce income. However, if an underwriting loss persists over an
extended period of time, the insurance company puts itself at risk as a going concern. The Company has consistently focused on this underwriting
objective and therefore views its underwriting results as a critical component of its overall performance.
The Company monitors the profitability of its insurance segments by utilizing certain components of segment profit that are characteristic
within the property and casualty insurance industry, namely underwriting profit and combined ratio. Underwriting profit under Statutory Accounting
Principles (“SAP”) is determined by subtracting from earned premiums, losses and loss expenses and net underwriting expenses incurred. SAP requires
all underwriting expenses to be expensed immediately and not deferred over the same period that the premium is earned. Generally Accepted
20
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
Accounting Principles (“GAAP”), however, permits the recognition of acquisition costs as the premiums are earned. In converting SAP underwriting
results to GAAP underwriting results, acquisition costs are deferred through the capitalization of deferred policy acquisition costs and amortized over the
periods the related premiums written are earned. See the discussion of deferred policy acquisition costs under “Critical Accounting Policies” included in
this Item 7. The “GAAP Combined Ratio” is defined as the sum of the “GAAP loss and LAE ratio” (loss and loss expenses, as a percentage of earned
premiums) plus “GAAP expense ratio” (acquisition and operating expenses, as a percentage of earned premiums). When the combined ratio is greater
than 100%, the insurer is operating at an underwriting loss. When the combined ratio is less than 100%, the insurer is operating at an underwriting
profit.
The following tables provide a reconciliation to the insurance segments’ GAAP net underwriting profit (loss), GAAP Combined Ratio along with
related segment net investment income, for the years 2004, 2003 and 2002, respectively. The tabular information provided does not reflect
adjustments for transactions with other segments.
($ millions)
2004
Standard
%
Ratio
Nonstandard
%
Ratio
Total
%
Ratio
Written premiums
$ 952.2
$ 65.9
$1,018.1
Earned premiums
Losses and loss expenses
Acquisition and operating expenses
Net underwriting profit/combined ratio
935.3
568.8 60.8
290.7 31.1
75.8 91.9
Net investment income
59.8
71.5
50.4
13.6
7.5
4.0
70.5
19.0
89.5
1,006.8
619.2
304.3
83.3
63.8
($ millions)
Standard
%
Ratio
Nonstandard
%
Ratio
2003
Written premiums
$ 906.9
$ 80.4
Earned premiums
Losses and loss expenses
Acquisition and operating expenses
Net underwriting profit/combined ratio
Net investment income
878.3
589.0
278.1
11.2
55.3
67.1
31.6
98.7
82.3
62.2
13.7
6.4
3.1
75.6
16.6
92.2
($ millions)
Standard
%
Ratio
Nonstandard
%
Ratio
2002
Written premiums
$ 860.5
$ 82.3
Earned premiums
Losses and loss expenses
Acquisition and operating expenses
Net underwriting profit (loss)/combined
Net investment income
823.0
596.2
252.0
(25.2)
51.5
72.4
30.6
103.0
73.6
57.3
12.4
3.9
2.8
77.8
16.9
94.7
Total
$ 987.3
960.6
651.2
291.8
17.6
58.4
Total
$ 942.8
896.6
653.5
264.4
(21.3)
54.3
61.5
30.2
91.7
%
Ratio
67.8
30.4
98.2
%
Ratio
72.9
29.5
102.4
Written premiums are initially deferred and earned based upon the contract terms of the underlying policies. The unearned premium
represents the deferred revenues of the unexpired terms of coverage which are earned ratably over the policy period. Thus, unearned
premium is not fully recognized as premiums earned until the end of the policy period.
___________________________
During each of 2004 and 2003, the Company’s insurance segments attained then record level net underwriting profit while also incurring then
record level catastrophe losses. The GAAP Combined Ratio improvements are the direct result of the Company obtaining adequate cost based rates, re-
underwriting the former Meridian Mutual business applying State Auto underwriting guidelines along with terminating unprofitable Meridian programs.
Management of the Company continues to focus on growing premiums without compromising profitability. The Company’s investment yield has declined
consistent with the decrease in long term interest rates. The Company invests for yield while maintaining a conservative approach for principal
preservation.
21
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
During 2003, the Company debt issuance, net of debt repayments, was $85.5 million. The net proceeds of debt were used by State Auto
Financial to contribute additional paid-in capital to certain of its insurance subsidiaries to strengthen the statutory surplus position for support of
continued premium growth and for general corporate purposes. See below for additional discussion of the Company’s operations.
2004 Compared to 2003
Net income before federal income taxes for the Company increased $68.3 million (82.0%) to $151.6 million in 2004 from 2003. The most
significant factors contributing to this increase were an improvement in the Company’s loss experience from 2003 along with growth in earned premium.
The Company’s GAAP loss and LAE ratio reflected a 6.3 point improvement in 2004 from 2003, despite 2004 being the largest catastrophe (in dollars)
loss year in the Company’s history. As discussed in more detail below, the Company’s challenge is to grow premiums without compromising profitability
as industry-wide price competition appears to be increasing.
The following table summarizes the consolidated earned premiums by segment, by line of business, for the years ended December 31, 2004
and 2003:
($ millions)
2004
2003
State
Auto
%
of Total
State
Auto
%
of Total
Standard segment:
Auto – personal ........................... $ 384.9
Auto – commercial .......................
99.8
165.9
Homeowners and farmowners ......
78.9
Commercial multi-peril .................
30.9
Workers’ compensation ................
76.8
Fire and allied lines ......................
Other & products liability ..............
67.2
Miscellaneous personal
& commercial ............................
Total Standard...........................
30.9
935.3
38.2
9.9
16.5
7.8
3.1
7.6
6.7
3.1
92.9
365.9
99.7
148.6
79.2
32.6
66.7
56.2
29.4
878.3
38.1
10.4
15.5
8.2
3.4
6.9
5.8
3.1
91.4
Nonstandard segment:
Auto – personal ...........................
71.5
7.1
82.3
8.6
Grand Total............................... $1,006.8
100.0
960.6
100.0
Consolidated earned premiums increased $46.2 million (4.8%) to $1,006.8 million in 2004 from 2003. The Company’s standard segment
contributed a 4.6% increase to consolidated earned premiums in 2004 from 2003, while the nonstandard segment generated a 1.1% decrease in the
same period. The 2003 consolidated earned premiums were affected by the Stop Loss. The STFC Pooled Companies ceded $12.8 million in earned
premiums to Mutual in 2003, which reduced the Company’s earned premiums in 2003 by 1.3%. The Stop Loss reinsurance agreement expired
December 31, 2003 and was not renewed.
As reflected in the table above, earned premiums increased from year to year across almost all lines of business, with the exception of
nonstandard auto, commercial multi-peril and workers’ compensation. Overall the composition of the Company’s book of business did not change
significantly from year to year, with the standard auto – personal line continuing to be the Company’s most significant line of business.
Earned premiums within the standard segment increased $57.0 million (6.5%) in 2004 from 2003. During 2003 and 2002, the Company took
necessary and in some cases significant base rate increases, particularly within the Meridian book, in almost all lines of business. The impact of these
base rate changes affects earned premium growth in the years following the implementation of these changes. After a number of years of having
attained a healthy degree of rate adequacy, during 2004 the Company implemented more moderate base rate changes, which is expected to slow
earned premium growth. In an effort to address personal lines growth, the Company introduced programs in 2004 focusing on increasing personal lines
applications from its agency partners. Additionally, the Company introduced a specialized training program to its agency partners service representatives
that focuses specifically on sales techniques. The addition of the Meridian Insurers to the Pooling Arrangement in 2005 is expected to contribute
approximately $50.0 million in earned premium to both the Company’s consolidated and standard segment’s earned premiums in 2005.
Earned premiums within the nonstandard segment decreased $10.8 million (13.1%) in 2004 from 2003. The nonstandard automobile industry
is highly price sensitive, which can have an adverse impact on renewal business as well as new premium growth. In an effort to provide insurance to a
broader segment of the nonstandard market, the Company has modified the nonstandard program offering higher limits than has historically been the
case. The Company continues to take cost based targeted rate increases; however, some nonstandard insurers have taken rate decreases within the
last year. This intense price competition, along with the Company’s termination or suspension during 2003 and 2002 of certain fast growing, but
unprofitable agencies, has resulted in a decrease in new and renewal business, which in turn has negatively impacted the Company’s earned premiums.
The Company continues to emphasize that it will not compromise underwriting profitability for top line growth. The Company believes that it
can implement periodic rate changes in most states and remain an attractive market to its independent agency partners by stressing the strengths it
22
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
brings to the market place. These strengths include stability, financial soundness, prompt and fair claims service, and technology which makes it easier
for the agent to do business with State Auto and provide substantial value to their customers. The Company’s new internet-based upload system for
personal lines business, netXpress, and an automated intelligent underwriting system, Apollo, are examples of new, standards based, user friendly
technology, making it easier for agents to submit personal lines accounts to the Company. Recent statistics indicate that approximately 72% of the
Company’s new personal auto and homeowners business applications and 66% of change requests in those lines are delivered and processed
electronically. Apollo is now applying underwriting business decision logic to all nonstandard new business and change transactions. In 2004, Apollo
evaluated in excess of 85,000 transactions in these two categories.
Net investment income increased $7.2 million (11.1%) to $71.8 million in 2004 from 2003. This growth was the result of an increase in
invested assets generated by cash flow provided by operations and financing activities, partly offset by a decline in the investment yield. Between April
1, 2003 and December 31, 2003, the Company issued debt, net of repayments, of $85.5 million. Total cost of invested assets at December 31, 2004
and 2003 was $1,682.8 million and $1,530.1 million, respectively. Invested assets are comprised of total investments and cash equivalents. Reflecting
a decline in the interest rate environment, the annualized investment yields based on average invested assets at cost decreased to 4.5% in 2004 from
4.6% in 2003. The Company manages its investment portfolio to maximize after tax profits. With the Company’s improving loss experience throughout
2003, management began allocating a higher proportion of new monies and reinvestments to municipal bonds in the fourth quarter of 2003 which
continued throughout 2004. This reallocation is expected to result in lower pre-tax investment yields but higher after tax investment income than if the
Company continued with the portfolio allocation of 2003. See further discussion regarding investments at the “Liquidity and Capital Resources,”
“Investments” and “Market Risk” sections, included in this Item 7.
Consolidated losses and loss expenses, as a percentage of earned premiums (the “GAAP loss and LAE ratio”), were 61.5% and 67.8% for the
years 2004 and 2003, respectively. Losses and loss expenses for a calendar year represents the combined estimated ultimate liability for claims
occurring in the current calendar year along with development of claims occurring in prior years. The following table presents the provision for losses
and loss expenses for those claims occurring in the current calendar year and prior years, along with the respective impact on the current calendar year
GAAP loss and LAE ratio for the years 2004 and 2003, respectively:
($ millions)
%
GAAP loss
and LAE
%
GAAP loss
and LAE
2003
2004
Provision for losses and loss expenses occurring:
$ 641.4
Current year
Prior years
(22.2)
Total losses and loss expenses $ 619.2
63.7
(2.2)
61.5
653.0
(1.8)
651.2
68.0
(0.2)
67.8
The development in the respective calendar year for claims occurring in prior years is well within normal expectations for reserve development
and claim settlement uncertainty. See additional discussion in “Other Disclosures”, “Losses and Loss Expenses Payable”, included in this Item 7.
For the years 2004 and 2003, catastrophe claims contributed 7.0 and 6.8 points, respectively, to the consolidated GAAP loss and LAE ratio.
During 2004, hurricanes Charley, Frances, Jeanne and Ivan contributed a total of $39.6 million in catastrophe losses, or 3.9 GAAP loss and LAE ratio
points. In 2003, high winds, tornadoes, hail, lightning and resulting fires from one numbered catastrophe loss caused damage in 17 of the Company’s
26 operating states (“CAT 88”). Claims resulting from CAT 88 totaled $39.6 million or 4.1 GAAP loss and LAE points for the year 2003. In terms of
dollars, CAT 88 remains the largest single catastrophe loss event in State Auto history. As discussed below, each of the Company’s insurance operating
segments was impacted by these catastrophe losses. Catastrophe losses discussed herein are as designated by Insurance Services Office’s Property
Claim Services (“PCS”) unit, a nationally recognized industry service. PCS defines catastrophes as events resulting in $25.0 million or more in insured
losses industry wide and affecting significant numbers of insureds and insurers.
For the year 2003, the STFC Pooled Companies ceded a total of $12.8 million in earned premium and $5.6 million in losses and loss
adjustment expenses to Mutual under the Stop Loss. The net impact of this cession increased the 2003 GAAP loss and LAE ratio by 0.3 points.
23
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
The following table summarizes the consolidated GAAP loss and LAE ratio by segment, by line of business for the years ended December 31,
2004 and 2003, respectively:
2004
2003
(Improve)
Deteriorate
Standard segment:
Auto – personal ...........................
Auto – commercial .......................
Homeowners ...............................
Commercial multi-peril .................
Workers’ compensation ................
Fire and allied lines ......................
Other & products liability ..............
Miscellaneous personal
& commercial ............................
25.5
Total Standard........................... 60.9
58.2
62.4
68.2
64.6
69.8
55.2
70.0
66.6
53.3
75.0
80.6
93.0
60.8
67.6
28.3
67.1
(8.4)
9.1
(6.8)
(16.0)
(23.2)
(5.6)
2.4
(2.8)
(6.2)
Nonstandard segment:
Auto – personal ...........................
70.5
75.6
(5.1)
Consolidated.............................. 61.5
67.8
(6.3)
As noted in the above table, all lines of business contributed to the 6.3 point GAAP loss and LAE improvement in 2004 from 2003, except for
auto - commercial and other and products liability, which combined represent 17.5% of total earned premiums in 2004. The Company monitors all lines
of business paying particular attention to auto - personal, homeowners and workers’ compensation due to the significance these lines have on the
profitability of the Company. The auto - personal line continues to be the most significant line of business and therefore has the greatest influence on
net income. The homeowners line of business is the Company’s second largest (see earned premium table above) and has been most significantly
impacted by weather-related losses in the last two years by the apparent increased severity of storms. Improvement in the loss results in both auto -
personal and homeowners is the result of the Company’s efforts to obtain adequate rate increases, maintain effective underwriting guidelines along with
the discipline of adhering to these guidelines. Workers’ compensation continues to be the Company’s most volatile line of business due to the risks
insured. Workers’ compensation results have been volatile both for the Company and the industry and can have a significant adverse impact on
earnings. The Company manages this exposure with conservative underwriting and rate levels that are based on National Council of Compensation
Insurance loss costs. As a result of the Company’s conservative approach, workers’ compensation represents 3% of total earned premium.
The State Auto standard segment’s GAAP loss and LAE ratio improved 6.3 points in 2004 from 2003, despite being impacted by the record
level catastrophe losses described above. For the years 2004 and 2003, catastrophe losses represent 7.5 and 7.3 points of this segment’s GAAP loss and
LAE ratios, respectively. Hurricanes Charley, Frances, Jeanne and Ivan accounted for 4.2 points of the 2004 total segment catastrophe loss points and
CAT 88 accounted for 4.4 points of the 2003 total catastrophe points. Absent the impact of catastrophe losses in each year, this segment’s GAAP loss
and LAE ratio improved 6.4 points in 2004 from 2003.
The State Auto nonstandard segment’s GAAP loss and LAE ratio improved 5.1 points in 2004 to 70.5 from 75.6 in 2003. The 2004 and 2003
catastrophe losses represent 0.5 points and 1.4 points, respectively, of this segment’s GAAP loss and LAE ratio. Absent the impact of catastrophe losses,
this segment’s GAAP loss and LAE ratio improved 4.2 points in 2004 from 2003. The nonstandard automobile segment typically is a more volatile line of
business in terms of higher loss frequency than the standard segment. The Company continually monitors this segment’s underwriting performance
paying particular attention to rate adequacy and risk selection in states and agencies with unusually high written premium growth.
Acquisition and operating expenses, as a percentage of earned premiums (the “GAAP expense ratio”), were 30.2% and 30.4% for the years
2004 and 2003, respectively. As noted above, the Company ceded to Mutual in 2003 $12.8 million in earned premiums under the Stop Loss which
increased the GAAP expense ratio for 2003 by 0.4 points.
Incentive compensation to employees and agents represents potentially significant variable expenses tied directly to the State Auto Group’s
insurance operation’s profitability and contributed to the GAAP expense ratio. The incentive profit based compensation plans include a Quality
Performance Bonus (“QPB”) Plan that covers substantially all employees and a Quality Performance Agreement (“QPA”) available to all the Company’s
independent agencies. QPB is earned quarterly and is based on the quarterly direct underwriting profit of the State Auto Group. For the years ended
December 31, 2004 and 2003, QPB accounted for 1.2 and 0.8 GAAP expense ratio points, respectively. As of April 1, 2005, the QPB will be amended to
adjust the targeted profitability requirement from a 100.0% statutory direct combined ratio to 98.0% and to implement an annual cap in the amount of
QPB earned in any one year to 35.0% of an associate’s annual salary.
The QPA obligates the Company to share a portion of the underwriting profit generated by the independent agency’s State Auto book of
business. The QPA is paid annually in the year after it is earned. While there is a provision in the QPA that causes the percentage of the profit sharing
to vary based on overall written premium, there is no bonus earned in the absence of underwriting profit. Based on improvement in the Company’s
underwriting results in 2004 as compared to 2003, the Company increased its expected 2004 QPA accrual as compared to 2003. For the years ended
December 31, 2004 and 2003, QPA accounted for 1.9 and 1.6 GAAP expense ratio points, respectively.
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, Continued
Interest expense increased $3.6 million (97.3%) to $7.3 million in 2004 from 2003. This increase was the result of an additional $85.5 million
of debt, net of repayments, obtained during the last nine months of 2003. See “Liquidity and Capital Resources” for further discussion of the Company’s
debt activity in 2004 and 2003.
The consolidated effective tax rate for 2004 was 27.4% and for 2003 was 23.6%. The increase in the effective tax rate is largely due to the
increase in underwriting profit in 2004 versus 2003. Underwriting profit is taxed at approximately 35%. The effective tax rate on net investment
income in 2004 was 19.4% versus approximately 20.0% in 2003. Late in 2003, the Company began shifting the investment portfolio to more tax
exempt investments.
2003 Compared to 2002
Net income before federal income taxes for the Company increased $45.5 million (120.0%) to $83.3 million in 2003 from 2002. The most
significant factors contributing to this increase were an improvement in the Company’s loss experience from 2002 along with growth in earned premium.
The Company’s GAAP loss and LAE ratio reflected a 5.1 point improvement in 2003 from 2002, despite the largest catastrophe loss event in Company
history occurring in May 2003.
Consolidated earned premiums increased $64.0 million (7.1%) to $960.6 million in 2003 from 2002. This increase was primarily the result of
premium rate increases across all lines of business (see earned premium table below). The State Auto standard segment contributed a 6.7% increase to
consolidated earned premiums in 2003 from 2002, while the State Auto nonstandard segment contributed a 1.2% increase to consolidated earned
premiums in the same period. These increases in earned premiums were partly offset by two factors: re-underwriting the Meridian policies migrating on
renewal to the State Auto systems platform, as well as the non-renewal of policies due to significant rate increases, execution of underwriting action that
the Company believed was necessary to improve the underwriting performance of the Meridian book of business and an increase in premiums ceded to
Mutual under the Stop Loss. The Meridian integration also included the migration of Indiana business to affiliate companies outside the Pooled
Companies. During the years 2003 and 2002, the STFC Pooled Companies ceded a total of $12.8 million and $1.4 million, respectively, in earned
premiums to Mutual in accordance with the Stop Loss arrangement. The effect of the increased premiums ceded reduced consolidated earned premium
by 1.2% in 2003 from 2002 (premiums ceded were 1.4% and 0.2% of consolidated earned premium for the years 2003 and 2002, respectively). The
Stop Loss ended on December 31, 2003 and was not renewed. See the Stop Loss discussion below regarding loss and loss adjustment expense cession.
The following table summarizes the consolidated earned premiums by segment and by line of business for the years ended December 31,
2003 and 2002:
($ millions)
2003
2002
State
Auto
%
of Total
State
Auto
%
of Total
Standard segment:
Auto – personal.........................
Auto – commercial ....................
Homeowners ............................
Commercial multi-peril...............
Workers’ compensation .............
Fire and allied lines ...................
Other & products liability ...........
Miscellaneous personal
& commercial..........................
Total Standard........................
Nonstandard segment:
Auto – personal .......................
$ 365.9
99.7
148.6
79.2
32.6
66.7
56.2
38.1
10.4
15.5
8.2
3.4
6.9
5.8
338.3
97.1
133.5
76.2
39.3
58.4
51.1
37.7
10.8
14.9
8.5
4.3
6.5
5.7
29.4
878.3
3.1
91.4
29.1
823.0
3.3
91.8
8822..33
8.6
73.6
8.2
Grand Total............................ $ 960.6
100.0
896.6
100.0
As reflected in the table above, earned premiums increased from year to year across almost all lines of business, with the exception of
workers’ compensation. Overall, the composition of the Company’s book of business did not change significantly from year to year, with the standard
auto – personal line continuing to be the Company’s most significant line of business.
Net investment income increased $4.9 million (8.2%) to $64.6 million in 2003 from 2002. This increase was the result of an increase in
invested assets generated by cash flow provided from operations and financing, partly offset by a decline in the investment yield. Total cost of invested
assets at December 31, 2003 and 2002 was $1,530.1 million and $1,303.1 million, respectively. Invested assets are comprised of total investments and
cash equivalents. Reflecting a decline in the interest rate environment, the annualized investment yields based on average invested assets at cost
decreased to 4.6% in 2003 from 4.9% in 2002. The Company manages its investment portfolio to maximize after tax profits. With the Company’s
improving loss experience throughout 2003, management began allocating a higher proportion of new monies to tax exempt securities in the fourth
quarter of 2003. This reallocation of new monies is expected to result in lower pre-tax investment yields but higher after tax investment income than if
the Company continued with the portfolio allocation of 2003. See further discussion regarding investments at the “Liquidity and Capital Resources,”
“Investments” and “Market Risk” sections, included in this Item 7.
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
The GAAP loss and LAE ratio was 67.8% and 72.9% for the years 2003 and 2002, respectively. See the Stop Loss discussion above regarding
earned premiums cessions. For the years 2003 and 2002, the STFC Pooled Companies ceded a total of $5.6 million and $8.8 million, respectively, in
losses and loss adjustment expenses to Mutual in accordance with the Stop Loss arrangement. The net effect of the earned premium and losses and
loss adjustment expenses cessions under the Stop Loss increased the GAAP loss and LAE ratio by 0.3 point in 2003 and decreased the GAAP loss and
LAE ratio by 0.9 point in 2002.
For the years 2003 and 2002, catastrophe claims contributed 6.8 and 5.6 points, respectively, to the consolidated GAAP loss and LAE ratio. As
previously discussed, CAT 88 caused damage in 17 of the Company’s 26 operating states between May 2 and May 11, 2003, and resulted in claims
totaling $39.6 million or 4.1 GAAP loss and LAE points for the year 2003. In terms of dollars, CAT 88 remains the largest catastrophe loss event in State
Auto history. The second most costly catastrophe loss event occurred in the second quarter of 2002, from a widespread series of storms that included a
tornado in the community of La Plata, Maryland (“CAT 61”). Claims resulting from CAT 61 totaled $27.5 million or 3.1 GAAP loss and LAE points for the
year 2002. As discussed below, each of the Company’s insurance operating segments was impacted by these catastrophe losses.
The following table summarizes the consolidated GAAP loss and LAE ratio by segment, by line of business for the years ended December 31,
2003 and 2002, respectively:
2003
2002
(Improve)
Deteriorate
Standard segment:
Auto – personal ...........................
Auto – commercial.......................
Homeowners ...............................
Commercial multi-peril .................
Workers’ compensation ................
Fire and allied lines ......................
Other & products liability..............
Miscellaneous personal
& commercial ............................
28.3
Total Standard.......................... 67.1
66.6
53.3
75.0
80.6
93.0
60.8
67.6
68.8
66.5
85.1
89.9
83.7
58.9
77.7
35.5
72.5
(2.2)
(13.2)
(10.1)
(9.3)
9.3
1.9
(10.1)
(7.2)
(5.4)
Nonstandard segment:
Auto - personal............................
75.6
77.8
(2.2)
Consolidated............................. 67.8
72.9
(5.1)
As noted in the above table, all lines of business contributed to the 5.1 point GAAP loss and LAE improvement in 2003 from 2002, except for
workers’ compensation and fire and allied lines which combined represent 10% of total earned premiums in 2003. The Company monitors all lines of
business paying particular attention to auto - personal, homeowners and workers’ compensation due to the significance these lines have on the
profitability of the Company. The auto - personal line continues to be the most significant line of business and therefore has the greatest influence on
net income. The homeowners line of business is the Company’s second largest (see earned premium table above). The loss experience in this line was
adversely affected in the last two years by the apparent increased severity of storms; however, due to management’s efforts, its GAAP loss and LAE ratio
improved by 10.1 points in 2003 from 2002. Workers’ compensation continues to be the Company’s most volatile line of business due to the risks
insured.
The State Auto standard segment’s GAAP loss and LAE ratio improved 5.4 points in 2003 from 2002, despite being impacted by the record
level catastrophe losses described above. For the years 2003 and 2002, catastrophe losses represent 7.3 and 5.9 points, respectively, of which CAT 88
accounted for 4.4 points of the 2003 total catastrophe points and CAT 61 accounted for 3.3 points of the 2002 total catastrophe points. Absent the
impact of catastrophe losses, this segment’s GAAP loss and LAE ratio improved 6.8 points in 2003 from 2002. This improvement reflects the Company’s
continual emphasis on strict underwriting, which includes taking necessary and appropriate rate increases across most lines of business.
The State Auto nonstandard segment’s GAAP loss and LAE ratio improved 2.2 points in 2003 to 75.6 from 77.8 in 2002 (see the consolidated
GAAP loss and LAE ratio table above, nonstandard auto line). The 2003 and 2002 catastrophe losses represent 1.4 points and 0.8 points, respectively,
of the foregoing GAAP loss and LAE ratio. Absent the impact of catastrophe losses, this segment’s GAAP loss and LAE ratio improved 2.8 points in 2003
from 2002. This improvement was primarily driven by significant underwriting action and rate level improvement on the former Meridian nonstandard
segment private passenger auto book of business. The Company implemented corrective rate increases on the business that continued to renew on the
Meridian systems platform. In addition, all new nonstandard private passenger auto business produced by the former Meridian Mutual agents is now
written through the SA National system platform utilizing a more appropriate rating structure as well as credit scoring (as permitted by local law) and
“point-of-sale” underwriting tools. The Company continually monitors this segment’s underwriting performance, as it is typically a more volatile line of
business than the standard segment, paying particular attention to rate adequacy and risk selection in states and agencies with unusually high premium
written growth. Kentucky, this segment’s largest state of operation, had experienced significant written premium growth over the last year, but with
unacceptable underwriting results. The Company terminated or suspended eleven fast growing, but extremely unprofitable, nonstandard auto oriented
agencies in Kentucky. While this action adversely affected this segment’s premium growth, it is expected to improve long term underwriting results.
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
The GAAP expense ratio was 30.4% and 29.5% for the years 2003 and 2002, respectively. One factor contributing to the 0.9 point increase is
the Company cession of earned premium under the Stop Loss, which was $12.8 million and $1.4 million in 2003 and 2002, respectively. These earned
premium cessions under the Stop Loss increased the Company’s GAAP expense ratio by 0.4 point and less than 0.1 point for the years 2003 and 2002,
respectively. The Stop Loss agreement terminated December 31, 2003 and was not renewed. Certain significant variable expenses that are tied directly
to the Company’s insurance operation’s profitability also contributed to the increased GAAP expense ratio. These are the Company’s profit sharing plans,
the Quality Performance Bonus (“QPB”) that covers substantially all employees and the Quality Performance Agreement or contingent commission
agreement (“QPA”) which is available to substantially all the Company’s agents. QPA was 1.6 points and 1.2 points within the GAAP expense ratio in
2003 and 2002, respectively. QPB was 0.8 point and 0.2 point within the GAAP expense ratio in 2003 and 2002, respectively. Excluding the Stop Loss,
QPA and QPB effects, the GAAP expense ratio would have been 27.6% and 28.0% for the years 2003 and 2002, respectively. Management reviews the
QPB plan and the QPA annually to determine the appropriateness of each bonus’ formula. Any increase in the expense ratio is difficult to accept, but the
fact is, that the increase seen this year is largely the result of the Company’s profitable underwriting operations, as discussed above. Notwithstanding
these directly profit driven expense increases, expense control has been and remains one of the critical elements of the Company’s success, and the
importance of this is regularly communicated to all employees.
Interest expense increased $1.3 million (55.9%) to $3.6 million in 2003 from 2002. This increase was the result of the additional net $85.5
million of debt obtained as of December 31, 2003 from December 31, 2002 (see discussion included in Liquidity and Capital Resources), partly offset by
a decline in the interest rate on the $45.5 million line of credit with Mutual.
Other expense, as a percentage of earned premiums, was 1.2% and 1.1% for the years 2003 and 2002, respectively. The increase in 2003
other expense is primarily attributable to the legal and other related costs incurred by the Company related to the tender offer initiated by Gregory M.
Shepard and his wholly owned company, and other proposals from Mr. Shepard that preceded the tender offer. See Item 3 of this Form 10-K.
The effective tax expense rates for the years 2003 and 2002 were 23.6% and 2.1%, respectively. Improvement in the Company’s 2003
underwriting results along with an increase in net realized gains on investments and the gradual shift in increasing the fixed maturity portfolio from tax-
exempt to taxable securities from 2002 contributed to the tax expense rate increase.
Liquidity and Capital Resources
Liquidity refers to the ability of the 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, sales of investments and the maturity of
fixed maturity investments. The Company continually monitors its investment and reinsurance programs to ensure they are appropriately structured to
enable the insurance subsidiaries to meet anticipated short and long-term cash requirements without the need to sell investments to meet fluctuations in
claim payments.
At December 31, 2004 and 2003, the Company had $64.3 million and $40.0 million, respectively, of cash and cash equivalents and $1,699.1
million and $1,570.3 million, respectively, of total investments at fair value. The majority of the Company’s investment portfolio is traded on public
markets.
Net cash provided by operating activities was $147.6 million, $138.0 million and $126.6 million for the 2004, 2003 and 2002 years,
respectively. The significant sources of operating cash flows are derived from underwriting operations and investment income. The increase in the cash
flows over the three year period is attributable to improved underwriting and investment income cash flows, offset by increases in cash paid on
estimated federal income taxes, interest expense and cash contributions to the Companies defined benefit pension plan (the “Pension Plan”). Over the
last three years, operating cash flows have been sufficient to meet the operating needs of the Company while providing increased opportunities for
investment. The Company utilizes reinsurance agreements to limit its loss exposure and contribute to its liquidity and capital resources. See the
discussion of Reinsurance Arrangements included in Item 1 of this Form 10-K.
During 2004 and 2003, as permitted by regulations of the Internal Revenue Service, the Company contributed $5.0 million and $4.6 million,
respectively, to the Company’s Pension Plan on behalf of its employees. There were no contributions to the Pension Plan in 2002. The contribution to
the Pension Plan in 2003 was the first year since 1997 that the Company was permitted to make a tax deductible contribution to the Pension Plan under
applicable rules. The actuarially determined funding amount to the pension plan ranges from the minimum amount the Company would be required to
contribute to the maximum amount that would be deductible for tax purposes. Contributed amounts in excess of the minimum amounts are deemed
voluntary. Amounts in excess of the maximum amount would be subject to an excise tax and may not be deductible for tax purposes. The actuarially
determined funding amount to the Pension Plan is generally not determined until the second quarter with respect to the contribution year. The
Company expects to contribute approximately $7.5 million during 2005 to the Pension Plan, depending on the actuarially determined funding
requirements of the Pension Plan.
Net cash used in investing activities was $130.4 million, $280.2 million and $85.6 million for the 2004, 2003 and 2002 years, respectively. The
decreased net investing activities during 2004 was the result of the Company having a smaller amount of cash and cash equivalents available to invest
at the beginning of 2004 versus 2003 ($40.0 million in 2004 compared to $96.0 million in 2003), along with a decrease in cash provided by financing
activities, as compared to 2003. The 2003 cash used in investing activities reflects the increase in cash flow provided by financing activities discussed
below.
Net cash provided by financing activities was $7.1 million in 2004, $86.2 million in 2003, and $25.0 million in 2002. The decreased net
financing activity during 2004 was due to the absence of $85.5 million in net proceeds the Company received in 2003 and $30.0 million in 2002 from the
issuance of debt, partly offset by payment of dividends and repurchase of Company common shares. Positively impacting cash flows during 2004 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
the Company’s termination of two separate fair value hedge transactions, described below, for a cash settlement of $3.8 million on future net swap
payments.
Impacting cash provided by financing activities during 2003 and 2002 was State Auto Financial’s Board of Directors approving a plan to
repurchase shares of its common stock from the public. In March 2002, the Board of Directors of State Auto Financial approved a plan to repurchase up
to 1.0 million shares of its common stock from the public over a period extending to December 31, 2003. During 2003 and 2002, the Company
repurchased 45,000 and 393,000 shares from the public for a total of $0.7 million and $6.3 million, respectively.
In conjunction with a plan approved by State Auto Financial’s Board of Directors in 1999 to repurchase shares of its common stock, State Auto
Financial entered into a line of credit agreement with Mutual for $45.5 million. The interest rate is adjustable annually on each January 1 to reflect
adjustments in the then current prime lending rate less 1.75 points, as well as State Auto Financial’s current financial position. The interest rate was
2.25%, 2.50% and 3.00% for 2004, 2003, and 2002, respectively. Beginning January 1, 2005, the interest rate on this credit agreement is 3.50%.
Principal is due upon demand, with final payment to be received on or prior to December 31, 2005. At December 31, 2004, State Auto Financial had
approximately $38.5 million in cash and invested assets to meet its current operating and debt related obligations that include interest expense and
principal repayments. While the Company is considering its options with regard to its outstanding debt to Mutual, if it chooses repayment, the funding is
anticipated to be derived from State Auto Financial’s current cash and invested assets as well as cash dividend payments in 2005 from its insurance
subsidiaries.
In May 2003, State Auto Financial’s Delaware business trust subsidiary (the “Capital Trust”) issued 30-year, unsecured $15.0 million liquidation
amount of its capital securities to a third party. In connection with the Capital Trust’s issuance of the capital securities and the related purchase by State
Auto Financial of all of the Capital Trust’s common securities (liquidation amount of $0.5 million), State Auto Financial issued to the Capital Trust 30-
year, unsecured $15.5 million aggregate principal amount of Floating Rate Junior Subordinated Debt Securities due 2033 (the “Subordinated
Debentures”). The sole assets of the Capital Trust are the Subordinated Debentures and any interest accrued thereon. Proceeds from the Subordinated
Debentures were used by State Auto Financial to fund $15.0 million cash capital contribution to SA National. Interest on the Capital Trust’s capital and
common securities is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly. The applicable interest rates for
the periods from May 22, 2003 thru December 31, 2004 ranged from 5.32% to 6.60%. In January 2003, the FASB issued FIN 46, Consolidation of
Variable Interest Entities, effective for reporting periods beginning after June 15, 2003. As a result of the Company’s adopting FIN 46 effective July 1,
2003, the financial statements of the Capital Trust are no longer consolidated within the accompanying financial statements of the Company.
In November 2003, State Auto Financial issued $100.0 million unsecured senior notes bearing interest fixed at 6.25% due November 15, 2013
(the “Senior Notes”). Proceeds from the Senior Notes were used by State Auto Financial to fund cash capital contributions to certain of State Auto
Financial’s insurance subsidiaries (State Auto P&C $39.0 million and SA National $15.0 million), to repay $15.0 million of bank debt and for general
corporate purposes (State Auto Financial has since invested these funds in fixed maturities and common stocks). Interest on the Senior Notes is payable
May 15 and November 15 of each year beginning May 15, 2004. The Senior Notes are general unsecured obligations ranking senior to all existing and
future subordinated indebtedness and equal with all existing and future senior indebtedness. The Senior Notes are not guaranteed by any of the State
Auto Financial subsidiaries and thereby are effectively subordinated to all State Auto Financial subsidiaries’ existing and future indebtedness. State Auto
Financial may redeem the Senior Notes in whole at anytime or in part from time to time at State Auto Financial’s option, on at least 30 but not more
than 60 days’ prior written notice. The redemption price must be equal to the greater of the principal amount of such Senior Notes being redeemed on
the redemption date or the make whole amount, based on U.S. Treasury rates as defined by the note, plus in each case, accrued and unpaid interest, if
any, on the Senior Notes to the redemption date. The Senior Notes issued contain certain covenants as defined in the Senior Notes, which among other
things, limit State Auto Financial and its subsidiaries’ ability to issue indebtedness secured by the capital stock of certain State Auto Financial subsidiaries
and sell the capital stock of certain State Auto Financial subsidiaries. The Senior Notes also contain a covenant that requires State Auto Financial to take
certain actions in the event it engages in mergers, consolidations or sales of all or substantially all of the assets and prohibits it from engaging in such
transaction if State Auto Financial is in default under the Senior Notes. State Auto Financial incurred approximately $1.5 million in issuance cost related
to the Senior Notes. The effective interest rate on the Senior Notes, net of issuance costs and interest rate swap transactions discussed below, is
5.83%.
On October 1, 2003 State Auto Financial entered into an interest rate swap contract for a notional amount of $25.0 million as a hedge on the
ten year treasury rate in connection with the forecasted issuance of the Senior Notes. The swap contract was designated as a cash flow hedge and
settled on November 6, 2003, the pricing date of the Senior Notes, with the Company receiving $0.8 million in cash. The gain has been recorded in
accumulated other comprehensive income and is being amortized into interest expense as the underlying interest expense is recognized for the Senior
Notes.
On November 6, 2003 State Auto Financial entered into an interest rate swap contract for a notional amount of $50.0 million, receiving
semiannual payments at a fixed rate of 6.25% and making semiannual payments at a variable rate equal to the six month LIBOR plus 1.25% with
LIBOR to be determined the last day of each interest reset period (total 2.47% at December 31, 2003). The swap contract was designated as a fair
value hedge to protect against changes in fair value of the Senior Notes. At December 31, 2003 the fair market value of the fixed to floating interest
rate swap was $0.5 million, of which $0.3 million related to net accrued interest to be received and reduced reported interest expense in the period.
On March 11, 2004, State Auto Financial terminated its interest rate swap contract entered into on November 6, 2003 and received proceeds
of $2.9 million. Of the $2.9 million received, $2.3 million settled future net swap payments and was deferred in notes payable and will be amortized as
an offset to interest expense over the life of the Senior Notes. The remaining $0.6 million related to net swap payments from inception to termination
and was recorded as an offset to interest expense.
On May 6, 2004, State Auto Financial entered into an interest rate swap contract for a notional amount of $50.0 million, receiving semiannual
payments at a fixed rate of 6.25% and making semiannual payments at a variable rate equal to the six month LIBOR plus 0.94% with LIBOR to be
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
determined the last day of each interest reset period. The swap contract was designated as a fair value hedge to protect against changes in fair value
of the Senior Notes. During August 2004, State Auto Financial terminated the interest rate swap contract entered into on May 6, 2004 and received
proceeds of $1.8 million. Of the $1.8 million received, $1.5 million settled future net swap payments and was deferred in notes payable and will be
amortized as an offset to interest expense over the life of the Senior Notes. The remaining $0.3 million related to net swap payments from inception to
termination was recorded as an offset to interest expense.
During 2003, 2002 and 2001, the Company generated substantial earned premium growth which required capital resources. Earned
premiums through the State Auto Pool increased significantly beginning in July 2001 with the addition of the former Meridian Mutual business. Also
increasing earned premiums significantly was a pooling participation percentage change from 53% to 80%, effective October 1, 2001. During the years
2003, 2002, and 2001 earned premiums increased 7.1%, 61.5%, and 39.5%, respectively, from the preceding year. At December 31, 2004 and 2003,
all of the Company’s insurance subsidiaries were in compliance with statutory requirements relating to capital adequacy.
The National Association of Insurance Commissioners (“NAIC”) utilizes a collection of analytical tools designed to assist state insurance
departments with an integrated approach to screening and analyzing the financial condition of insurance companies operating in their respective states.
One such set of analytical tools is 12 key financial ratios that have come to be known in the insurance industry as the “IRIS” ratios. IRIS ratios are
derived from financial statements prepared on a statutory accounting basis, which are accounting practices prescribed or permitted by the insurance
department with regulatory authority over the Company’s insurance subsidiaries. A “defined range” of results for each ratio has been established by the
NAIC for solvency monitoring. While management utilizes each of these IRIS ratios in monitoring its operating performance on a statutory accounting
basis, the net written premium to statutory surplus ratio (the “leverage ratio”) is monitored to ensure that each of the Company’s insurance subsidiaries
continues to operate within the “defined range” of 3.0 to 1.0. The higher the leverage ratio, the more risk a company bears in relation to statutory
surplus available to absorb losses. In considering this range, management also considers the distribution of net premiums between property and liability
lines of business. A company with a larger portion of net premiums from liability lines should generally maintain a lower leverage ratio.
The statutory leverage ratios for the Company at December 31, 2004, 2003 and 2002 are as follows:
Statutory Leverage Ratios(1)
2004
2003
2002
State Auto P&C ................................
Milbank............................................
Farmers ..........................................
SA Ohio ...........................................
SA National ......................................
Weighted Average ............................
1.7
1.7
1.5
1.4
1.1
1.6
(to 1)
1.9
2.0
1.8
1.7
1.5
1.9
2.6
2.4
2.3
1.8
4.4
2.6
____________________
(1) The Company uses the statutory leverage ratio as there is no comparable GAAP measure.
This ratio measures the company’s statutory surplus available to absorb losses.
These improvements over the three year periods are due to a combination of the capital contributions made by State Auto Financial (State
Auto P&C $39.0 million and SA National $30.0 million) from proceeds of the debt securities issued in 2003, improvement in the results of underwriting
operations in 2004 and 2003 as well as effective January 1, 2003, the reserving process for statutory reporting began anticipating salvage and
subrogation recoverable for each company. Under GAAP, the reserving process has historically anticipated salvage and subrogation recoverable. The
Company believes these leverage ratios at December 31, 2004 indicate the financial strength of the Company and its position to support future premium
growth.
On March 4, 2005, the Board of Directors of State Auto Financial declared a quarterly cash dividend of $0.045 per common share, payable on
March 31, 2005, to shareholders of record on March 19, 2005. This is the 55th consecutive cash dividend declared by State Auto Financial’s Board since
State Auto Financial had its initial public offering of common stock on June 28, 1991. State Auto Financial has increased cash dividends to shareholders
for twelve consecutive years.
Mutual, whose ownership in State Auto Financial is approximately 65%, has waived its right to receipt of the dividends declared by State Auto
Financial since 1994. This is expected to increase the statutory surplus of Mutual. The Standing Independent Committee of the Board of Directors of
Mutual (the “Standing Independent Committee”) met in August 2004 and voted to waive Mutual’s dividends that might be declared by the Board of
Directors of State Auto Financial, for the period from August 1, 2004 to July 31, 2005, in order to take better advantage of the investment opportunity
State Auto Financial represents for Mutual. The Standing Independent Committee will continue to monitor relevant conditions, including but not limited
to financial conditions. If in the good faith exercise of the Standing Independent Committee’s business judgment such conditions change in a materially
adverse way from those in place currently, it retains the right to revoke its recommendation to waive such dividends as to a particular dividend otherwise
payable by State Auto Financial on its common shares, provided that any such revocation shall be effected prior to the declaration of a quarterly
dividend by State Auto Financial.
The maximum amount of dividends that may be paid to State Auto Financial during 2005 by its insurance subsidiaries without prior approval
under current law is limited to $94.6 million. The Company is required to notify the insurance subsidiaries’ respective State Insurance Commissioner
within five business days after declaration of all such dividends and at least ten days prior to payment. Additionally, the domiciliary Commissioner of
each insurer subsidiary has the authority to limit a dividend when the Commissioner determines, based on factors set forth in the law, that an insurer’s
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
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.
State Auto Financial’s insurance subsidiaries are subject to regulation and supervision by the states in which they do business. The NAIC has
developed Risk-Based Capital (“RBC”) requirements. RBC relates an individual insurance company’s statutory surplus to the risk inherent in its overall
operations. At December 31, 2004, the risk-based adjusted surplus of each of State Auto Financial’s insurance subsidiaries exceeded each of their RBC
standards.
As discussed above, as of January 1, 2005, the Pooling Arrangement was amended to make the Meridian Insurers participants. The pooling
participation percentage of the STFC Pooled Companies remained at 80%. In conjunction with this amendment, the STFC Pooled Companies received
$54.0 million in cash from the Meridian Insurers which related to the additional net insurance liabilities assumed on January 1, 2005. The following table
presents the impact on the Company’s balance sheet on January 1, 2005 relating to the additional net insurance liabilities assumed on this date:
($ millions)
Losses and loss expense payable.................................
Unearned premiums ...................................................
Deferred policy acquisition costs ..................................
Net cash received.....................................................
$35.3
24.0
(5.3)
$54.0
Other Disclosures
Investments
Stateco performs investment management services, which comprises the investment management services segment, on behalf of the
Company and Mutual and its subsidiaries. The Investment Committee of each insurer’s Board of Directors sets investment policies to be followed by
Stateco.
The primary investment objectives of the Company are to generate income, preserve capital and maintain adequate liquidity for the payment
of claims. Fixed maturity securities are categorized as available for sale and are carried at fair value. The Company’s Investment Policy and Guidelines
permit investment in debt issues rated A or better by two major rating services. The Company’s fixed maturities portfolio is composed of high quality,
investment grade issues, comprised almost entirely of debt issues rated AAA or AA. At December 31, 2004, the Company had no fixed maturity
investments rated below investment grade, nor any mortgage loans.
Despite the volatility in the equity market during 2004 and 2003, the Company continued its direction of moderately increasing its equity
portfolio investments to enhance growth of statutory surplus over the long term. Gains and losses on the sale of equity securities are computed using
the first-in, first-out method. The Company’s current investment strategy does not rely on the use of derivative financial instruments.
At December 31, 2004 and 2003, all investments in fixed maturity and equity securities were held as available for sale and therefore are
carried at fair value. Other invested assets is comprised of a limited liability partnership and is carried at fair value. The unrealized holding gains or
losses, net of applicable deferred taxes, are shown as a separate component of stockholders’ equity as “accumulated other comprehensive income” and
as such are not included in the determination of net income.
The following table provides the composition of the Company’s investment portfolio at December 31, 2004 and 2003, respectively:
($ millions)
2004
2003
Fair value:
Fixed maturities ................................
Equity securities ................................
Other invested assets ........................
Total investments............................
$1,502.1
193.6
_ 3.4
$1,699.1
1,427.9
88.4%
139.3
11.4
0.2
3.1
100.0% 1,570.3
90.9
8.9
0.2
100.0
The Company regularly monitors its investment portfolio for declines in value that are other than temporary, an assessment which requires
significant management judgment regarding the evidence known. Such judgments could change in the future as more information becomes known
which could negatively impact the amounts reported herein. Among the factors that management considers are the nature of the investment, severity
and length of decline in fair value, events impacting the issuer, and overall market conditions. When a security in the Company’s investment portfolio
has been determined to have a decline in fair value that is other than temporary, the Company adjusts the cost basis of the security to fair value. This
results in a charge to earnings as a realized loss, which is not changed for subsequent recoveries in fair value. Future increases or decreases in fair
value, if not other than temporary, are included in other comprehensive income.
The Company reviewed its investments at December 31, 2004, and determined no additional other than temporary impairment exists in the
gross unrealized holding losses, as provided in the table below, due to the evidence that exists indicating temporary impairment. At December 31, 2004,
30
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
there were no investments reflected in the table below with an unrealized holding loss that had a fair value significantly below cost continually for more
than one year. There are no individually material securities with an unrealized holding loss at December 31, 2004.
The following table provides detailed information on the Company’s investment portfolio for its gross unrealized gains and losses, adjusted for
investments with other than temporary impairment at December 31, 2004:
($ millions)
Investment Category
Cost or
amortized
cost
Gross
unrealized
holding
gains
Gain
number of
positions
Gross
unrealized
holding losses
Loss
number of
positions
Fair
value
Fixed Maturities:
U.S. Treasury securities &
Obligations...........................................
States & political subdivisions ..................
Corporate securities ................................
Mortgage-backed securities of
U.S. Gov. Agencies ...............................
Other debt securities...............................
Total fixed maturities..........................
Equity Securities:
Consumer ..............................................
Technologies ..........................................
Pharmaceuticals .....................................
Financial services....................................
Manufacturing & other ............................
Total equity securities.........................
$ 328.2
865.4
33.1
219.0
6.2
1,451.9
33.9
16.3
12.3
45.0
55.9
163.4
Other invested assets................................
3.2
Total.................................................
$1,618.5
4.6
42.8
2.6
5.0
-
55.0
6.1
2.3
1.2
8.2
14.3
32.1
0.2
87.3
71
366
21
41
-
499
16
8
4
21
32
81
1
581
(1.9)
(1.8)
-
(1.1)
-
(4.8)
(0.3)
(0.2)
(0.6)
(0.7)
(0.1)
(1.9)
-
(6.7)
46
72
1
23
-
142
3
1
2
2
4
12
-
154
330.9
906.4
35.7
222.9
6.2
1,502.1
39.7
18.4
12.9
52.5
70.1
193.6
3.4
1,699.1
The amortized cost and fair value of fixed maturities at December 31, 2004, by contractual maturity, are summarized as follows:
($ millions)
Amortized
Cost
Fair
Value
$ 5.2
Due in 1 year or less ...........................................
66.4
Due after 1 year through 5 years .........................
279.6
Due after 5 years through 10 years......................
881.7
Due after 10 years ..............................................
1,232.9
Subtotal...........................................................
Mortgage-backed securities .................................
219.0
Total................................................................ $1,451.9
5.2
68.1
292.7
913.2
1,279.2
222.9
1,502.1
Expected maturities may differ from contractual maturities as the issuers may have the right to call or prepay the obligations with or without
call or prepayment penalties.
Included in the 2004 realized losses of fixed maturities below, was $0.2 million recognized related to other than temporary impairment on two
fixed maturity securities, which continue to be held by the Company at December 31, 2004. The individual circumstances impacting the other than
temporary impairments recognized in 2004 did not impact other investments.
The securities sold during 2004, were sold to either recognize the gain available, to dispose of the security because of the Company’s
opportunity to invest in securities with greater potential return considering capital preservation, or to reposition the taxable/tax-exempt fixed maturity
position of the Company.
31
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Management’s Discussion and Analysis of Financial Condition and Results of Operations, Continued
Realized gains and losses for the year ended December 31, 2004, are summarized as follows:
($ millions)
Realized
Gains/Losses
Fair Value
at Sale
Realized gains:
Fixed maturities .......................................
Equity securities ......................................
Total realized gains................................
Realized losses:
Fixed maturities .......................................
Equity securities ......................................
Total realized losses...............................
Net realized gains on investments...........
$ 7.6
4.0
11.6
2.1
1.9
4.0
$ 7.6
227.2
15.1
242.3
73.0
7.1
80.1
162.2
The Company participates in a securities lending program whereby certain fixed maturity and equity securities from the Company’s investment
portfolio are loaned to other institutions for short periods of time. The Company requires collateral, equal to 102% of the market value of the loaned
securities. The collateral is invested by the lending agent, in accordance with Company guidelines, generating net investment income, net of applicable
fees. Based on terms of the agreement, the Company does not have the right to sell or re-pledge the collateral, unless there is an event of default by
the borrower. At December 31, 2004 and 2003, the amount of collateral held was approximately $144.7 million and $193.2 million, respectively.
Market Risk
Investments
At December 31, 2004, total investments at fair value comprise approximately 84.0% of the Company’s total assets. Of the total investments,
88.4% are invested in fixed maturities, 11.4% in equity securities, and 0.2% in other invested assets. Cash and cash equivalents represent
approximately 3.2% of the Company’s total assets at December 31, 2004.
The Company’s decision to make a specific investment is influenced primarily by the following factors: (a) investment risks; (b) general market
conditions; (c) relative valuations of investment vehicles; (d) general market interest rates; (e) the Company’s liquidity requirements at any given time;
and (f) the Company’s current federal income tax position and relative spread between after tax yields on tax-exempt and taxable fixed income
investments.
The fixed maturity portfolio is managed in a laddered-maturity style and considers business mix and liability payout patterns to ensure
adequate cash flow to meet claims as they are presented. At December 31, 2004, the Company’s fixed maturity portfolio had an average maturity of
9.9 years. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 5.0% of statutory assets, other than
obligations of the U.S. government or government agencies, for which there is no limit. As indicated in the table above, the fixed maturity portfolio is of
high quality with all holdings in either Government obligations, municipal, or corporate obligations. The Company does not intend to change its
investment policy on the quality of its fixed maturity investments. Investments in equity securities are selected based on their potential for appreciation
as well as ability to continue paying dividends. Additional information regarding the composition of investments, along with maturity schedules
regarding investments in fixed maturities at December 31, 2004, is presented in tabular form above.
The Company’s primary market risk exposures are to changes in market prices for equity securities and changes in interest rates and credit
ratings for fixed maturity securities. Related to the Company’s investment portfolio, the Company has no exposure to foreign currency exchange rate
risk nor does it rely on the use of derivative financial instruments. To provide the Company greater flexibility in order to manage its market risk
exposures, the Company categorizes its fixed maturities as available for sale. The Company does not maintain a trading portfolio.
The Company’s total investments at fair value grew approximately 8.2% during 2004 to $1,699.1 million at December 31, 2004, from
$1,570.3 million at December 31, 2003. This growth was generated primarily from cash flow provided by operations. The increase in unrealized gains
on equity securities at December 31, 2004 was offset by a decline in the unrealized gain on fixed maturity securities.
The equity markets increased during 2004. The net unrealized gain on the Company’s equity portfolio increased $11.9 million to $30.2 million
at December 31, 2004. With the increase in the equity markets in 2004, the fixed maturity fair values increased as the interest rate environment
continued to fluctuate. The net unrealized gain on the Company’s fix maturity portfolio declined $11.6 million to $50.2 million at December 31, 2004.
32
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Management’s Discussion and Analysis of Financial Condition and Results of Operations, Continued
The following table provides information about the Company’s fixed maturity investments used for purposes other than trading that are
sensitive to changes in interest rates. The table presents principal cash flows from maturities, anticipated calls and estimated prepayments, or pay
downs from holdings in asset backed securities. The table also presents the average interest rate for each period presented.
($ millions)
Principal Amount Maturing In:
2005
2006
2007
2008
2009
Thereafter
Total
Fair Value
Fixed interest rate
securities ......................... $ 8.3
Average interest
Rate ................................
6.55%
20.9
4.53
15.1
4.82
28.8
4.85
40.2
5.42
1,275.0
1,388.3
$1,502.1
5.58%
Notes Payable and Hedge
At December 31, 2004, the Company’s notes payable are summarized as follows:
($ millions)
Carrying
Value
Fair
Value
Interest
Rate
Senior notes due 2013: issued $100.0 million,
November 2003 with fixed interest ...........................................
Subordinated debentures due 2033: issued $15.5
million, May 2003 with variable interest adjusting
quarterly .................................................................................
Affiliate note payable due on demand prior to
December 31, 2005: issued $45.5 million, June
1999 with variable interest adjusting annually ...........................
45.5
Total Notes Payable................................................................. $ 164.5
$ 103.5
15.5
108.0
6.25%
15.5
6.60%
45.5
169.0
2.25%
Related to the Company’s notes payable, the Company’s primary market risk exposure is to the change in interest rates and its credit rating.
Based upon the notes payable carrying value at December 31, 2004, the Company has $61.0 million notes payable with variable interest and $103.5
million notes payable with interest fixed at 6.25%, which equates to approximately 37.1% variable interest debt and 62.9% fixed interest debt. The
Company’s decision to obtain fixed versus variable interest rate debt is influenced primarily by the following factors: (a) current market interest rates, (b)
anticipated future market interest rates, (c) availability of fixed versus variable interest instruments, and (d) its currently existing notes payable fixed and
variable interest rate position. As noted above, the Company’s notes payable mature staggered over the next 30 years with $45.5 million due in 2005,
$103.5 million in 2013 and $15.5 million in 2033.
See discussion above included in the “Liquidity and Capital Resources” section regarding the Company’s interest rate swap transactions related
to its Senior Notes.
Losses and Loss Expenses Payable
The following table presents the loss and loss expenses payable by major line of business at December 31, 2004 and 2003, respectively:
($ millions)
2004
2003
Automobile – personal standard ............................................
Automobile – personal nonstandard.......................................
Automobile – commercial......................................................
Homeowners .......................................................................
Commercial multi-peril ..........................................................
Workers compensation .........................................................
Fire and allied lines...............................................................
Other liability and products liability ........................................
Miscellaneous personal & commercial lines.............................
Total losses and loss expenses payable net of
reinsurance recoverable on losses and loss expenses
payable of $25.9 and $14.2, respectively........................... $655.9
$184.9
35.6
86.2
40.4
89.2
81.6
18.2
115.7
4.1
%
Change
(0.3)%
(5.8)
6.8
2.3
-
(0.1)
27.3
20.9
(6.8)
185.5
37.8
80.7
39.5
89.2
81.7
14.3
95.7
4.4
628.8
4.3%
Total net losses and loss expenses payable increased 4.3% at December 31, 2004 from 2003, due in part to the total earned premium
increase of 4.8% during 2004 from 2003. More of the growth was contributed by commercial lines, where the reserve needs are typically higher due to
the extended time necessary to identify and settle claims. Another contributing factor was seasonal catastrophes, mostly coming from hurricanes in
33
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
Florida and a late December freeze in the Midwest. Finally, one exceptionally large liability claim added over 8% to the other liability reserves in 2004.
The current year development of the prior years’ ultimate liability does not reflect any changes in the Company's fundamental claims reserving practices.
The Company's internal actuarial staff conducts quarterly reviews of projected loss development information to assist management in making
estimates of reserves for ultimate losses and loss expenses payable. Several factors are considered in estimating ultimate liabilities including consistency
in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, accounting
projections, exposure growth, current business conditions, catastrophe developments, and late reported claims. In addition, reasonableness tests are
performed on measures of claim severity, loss ratio, and trend factors, all of which are implicit to the liability estimates.
Losses and loss expenses payable is management’s best estimate (“MBE”) at a given point in time of what the Company expects to pay
claimants, based on known facts, circumstances and historical trends. Reserves for reported losses are established by the Company’s claim division 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 objective of the claims division is to establish ultimate case reserves that are sufficient, but not excessive. The formula reserves
are based on historical data for similar claims with provision for trend changes caused by inflation. Loss and loss expense reserves for incurred claims
that have not yet been reported (“IBNR”) are estimated based on many variables including historical and statistical information, inflation, legal
developments, storm loss estimates, and economic conditions. Case and formula basis loss reserves are reviewed on a regular basis, and as new data
becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis and
not settled after six months are case reserved at that time. Although management uses many resources to calculate reserves, there is no method for
determining the exact ultimate liability.
Management establishes a reserve for loss adjustment expenses contemplating functions and costs that are not attributable to a specific claim,
which are called Unallocated Loss Adjustment Expenses (ULAE). Historical ratios of paid ULAE to paid losses are developed, and then imposed on the
current outstanding reserves. The method uses a traditional assumption that 50% of the expenses are realized when the claim is open, and the other
50% are incurred as the loss payments are made. The method also assumes that the underlying claims process and mix of business do not change
drastically over time.
MBE for SA National and the STFC Pooled Companies’ share of the Pooled Companies’ losses and allocated loss expense reserve (“Loss and
ALAE Reserve”) at December 31, 2004 is $682.1 million, compared with an actuarial point estimate of $655.0 million that is within a projected range of
$618.0 million to $703.0 million. These values presented are on a direct basis, gross of salvage and subrogation recoverable, and before reinsurance,
except for the STFC Pooled Companies’ participation in the intercompany Pooling Arrangement. Therefore the Company cautions the reader that these
values cannot be compared to other loss and loss expenses payable tables included elsewhere within this Form 10-K. Reserve ranges provide a
quantification of the variability in the reserve projections, which is often referred to as the standard deviation or error term, while the point estimates
establish a mean, or expected value for the ultimate reserve. MBE of loss reserves considers the actuarial point estimate and expected variation to
establish an appropriate position within the range.
The potential impact of loss reserve variability on net income is quantifiable using the range end points and carried reserve amounts listed
above. For example, if ultimate losses reach the high point of $703.0 million, the reserve increase of $20.9 million is an after-tax decrease of $13.6
million on net income. Likewise, should losses decline to the low end of $618.0 million, the $64.1 million reserve decrease would add $41.7 million of
after-tax net income.
An important assumption underlying the reserve estimation methods for the major casualty lines is that the loss cost trends implicitly built into
the loss and ALAE patterns will continue into the future. To estimate the sensitivity of reserves to an unexpected change in inflation, projected calendar
year payment patterns were applied to the December 31, 2004, other liability loss and ALAE payable to generate estimated annual incremental loss and
ALAE payments for each subsequent calendar year. Then, for purposes of sensitivity testing, an additional annual loss cost trend of two percent was
added to the trend implicitly embedded in the estimated payment pattern, and revised incremental loss and ALAE payments were calculated. This type
of inflationary jump could arise from a variety of sources including tort law changes, development of new medical procedures, social inflation, and other
inflationary changes in costs beyond assumed levels.
The estimated cumulative impact that this additional, unexpected two percent increase in the loss cost trend would have on our results of
operations over the lifetime of the underlying claims in other liability is an increase of $8.2 million on reserves, or a $5.3 million after-tax reduction
(assuming a tax rate of 35%) to net income. Inflation changes have much more impact on the longer tail commercial lines like other liability and
workers compensation, and much less impact on the shorter tail personal lines’ reserves.
34
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Management’s Discussion and Analysis of Financial Condition and Results of Operations, Continued
The following table provides a reconciliation of MBE of the Company’s direct Loss and ALAE Reserve to the Company’s net loss and loss
expenses payable at December 31, 2004. The STFC Pooled Companies net additional share of transactions assumed from Mutual through the Pooling
Arrangement for the year 2004 has been reflected in the table below as Assumed by STFC Pooled Companies:
($ millions)
Direct Loss and ALAE Reserve (1):
STFC Pooled Companies, National and Mid-Plains ..................................................
Assumed by STFC Pooled Companies ...................................................................
Total direct loss and ALAE reserve......................................................................
Direct unallocated loss adjustment expense (“ULAE”)(1):
STFC Pooled Companies, National and Mid-Plains ..................................................
Assumed by STFC Pooled Companies ...................................................................
Total direct ULAE..............................................................................................
MBE
$ 376.7
305.4
682.1
23.0
19.3
42.3
Direct salvage and subrogation recoverable:
STFC Pooled Companies, National and Mid-Plains ..................................................
Assumed by STFC Pooled Companies ...................................................................
Total direct salvage and subrogation recoverable................................................
(18.9)
(8.3)
(27.2)
Reinsurance recoverable......................................................................................
Assumed reinsurance ..........................................................................................
Reinsurance assumed by STFC Pooled Companies.................................................
Total losses and loss expenses payable, net of reinsurance
recoverable on losses and loss expenses payable of $25.9................................
(25.9)
4.1
(19.5)
$ 655.9
(1)
ALAE are those costs that can be related to a specific claim, which may include attorney fees, external claims adjusters, and
investigation costs, among others. ULAE are those costs incurred in settling claims, such as in-house processing costs, for which no
identification can be made to specific claims. ALAE and ULAE comprise the loss expense portion of the total loss and loss expenses
payable.
___________________
The risks and uncertainties inherent in the estimates include, but are not limited to, actual settlement experience being different from historical
data and trends, changes in business and economic conditions, court decisions creating unanticipated liabilities, ongoing interpretation of policy
provisions by the courts, inconsistent decisions in lawsuits regarding coverage and additional information discovered before settlement of claims. The
Company's results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required to settle
claims vary from the liability currently recorded.
In the preceding paragraphs, the Company has offered a description of certain factors management considers in estimating the ultimate
liability for losses and loss expenses. With respect to the auto line of business, which represents almost half of the Company’s total reserves, perhaps
the most significant external variable is legal developments. As discussed in “Impact of Significant External Factors” below, court decisions have a
significant impact on the property and casualty insurance industry. Some of these decisions have a more prospective effect as, for example, when
contract provisions relating to third party coverages are construed in ways not anticipated by the Company. Other court decisions may have more of a
retroactive effect which may be seen more clearly in the auto insurance line. Auto insurance tends to be a line of business more regulated by statutes;
consequently, the courts tend to have more of an opportunity to construe and apply those statutes to existing contracts. Uninsured motorists and
underinsured motorists (collectively “UM”) are statutory coverages in almost every state where the Company does business. When courts of appeal
construe UM statutes adversely to the Company and the industry, the effect of that decision is typically retroactive, because, legally speaking, when the
court interprets a statute it is as though the statute was always construed in the manner that the court determined. This retroactive effect is
exacerbated in UM cases (and other first party coverage cases) because the statute of limitations applicable to UM claims and other first party coverages
can be as long as 15 years. Claims that had been closed or not even presented, going back as long as fifteen years, can be re-born by an adverse court
decision. The Company considers the impact of adverse court decisions of which it has become aware when it sets ultimate loss and LAE reserves for
auto insurance as well as other lines to the extent those lines may be retroactively affected by such matters.
The effect of court decisions is also apparent in the commercial lines of coverages such as commercial multi-peril and other liability and
products liability. Courts can expand coverage or void exclusions which can increase the Company’s exposure to claims. Some of these third party
claims may still be brought within the statute of limitations applicable to such third party claims and expose the Company to some retroactive liabilities.
These liabilities are sought to be addressed by the ultimate loss and LAE reserve that is the Company’s estimate of loss and loss expenses payable.
It is not feasible to quantify the impact of judicial decisions that may have retroactive effect because the Company cannot foresee, among the
range of issues that are litigated every day in courts in each state in which the Company does business, which cases will be decided adversely and how
such decisions will actually apply to the Company.
35
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
The property and casualty industry has had significant loss experience from claims related to asbestos, environmental remediation, product
liability, mold and other mass torts. Asbestos reserves are $4.5 million, and environmental reserves are $5.1 million, for a total of $9.6 million, or 1.5%
of net reserves. Because the Company has insured primarily product retailers and distributors, not manufacturers, incurred losses have not been
significant from asbestos and environmental claims activity.
The reserve estimates do not contemplate substantial loss from any mass torts, including those already listed above, or others not known at
this time. In addition, there is no provision in the reserves for a major retroactive expansion of coverage through judicial interpretation. If these
assumptions prove to be incorrect, ultimate liabilities could increase substantially. The Company’s Claims, Underwriting, and Actuarial staff track
separately all claims within the family of mass torts, and respond accordingly as information becomes known.
A tabular presentation of the current year $22.2 million favorable development broken down by accident year is shown below derived from the
Company's 2004 and 2003, 10 year loss development table, as presented in the Reserves section of the Company's Form 10-K, “Narrative Description of
Business” section. The development is measured in dollars and as a percentage of the total December 31, 2004, net loss and loss expense payable:
($ millions)
Accident
year
1994 and prior
1995
1996
1997
1998
1999
2000
2001
2002
2003
Total
Current year
development
of ultimate
liability
redundancy
(deficiency)
% of
12/31/2004
total net loss and
loss expenses
payable
$ (1.9)
(1.2)
(0.7)
(1.6)
(0.4)
(2.1)
0.9
(2.3)
3.7
27.8
$ 22.2
(0.29)
(0.18)
(0.11)
(0.24)
(0.06)
(0.32)
0.14
(0.35)
0.56
4.24
3.39
In management’s opinion, the 3.39% current year development, given the breakdown by accident year, is well within normal expectations
for reserve development and claim settlement uncertainty.
Contractual Obligations
Included in the table are the estimated payments to be made with respect to the Company’s notes payable and in the settlement of direct loss
and ALAE reserves:
($ millions)
Due
1 year
or less
Due after
1-3
years
Due after
3-5
years
Due
after 5
years
Total
Direct loss and ALAE reserves(1)
$682.1
277.2
229.1
86.5
89.3
Notes Payable:
Senior Notes due 2013: issued $100.0, November
2003 with fixed interest.......................................
$103.5
Subordinated debentures due 2033: issued $15.5,
May 2003 with variable interest
adjusting quarterly..............................................
15.5
Affiliate note payable due on demand prior to
December 31, 2005: issued $45.5, June 1999
with variable interest adjusting annually ...............
45.5
Total Notes Payable................................................ $164.5
-
-
45.5
45.5
-
-
-
-
103.5
15.5
-
-
-
-
-
119.0
36
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
(1)
The Company’s actuarial department derived expected payment patterns separately for the direct loss and ALAE reserves. These
patterns were applied to the December 31, 2004, loss and ALAE payable to generate estimated annual incremental loss and ALAE payments
for each subsequent calendar year. These amounts are based on historical payment patterns and do no represent actual contractual
obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates.
___________________________
Lease and other purchase obligations are allocated to the Company through the Pooling Arrangement.
New Accounting Standards
On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB
Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) requires all share-based
payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro-forma
disclosure only will no longer be an alternative. The Statement provides two alternative methods of adoption: the modified prospective transition or the
modified retrospective transition. Under the modified prospective method, unvested stock based awards, that were granted prior to adoption, will
continue to be accounted for in accordance with Statement 123 except the compensation cost attributable to the unvested portion of the awards must
be recognized in the income statement. Awards that are vested will not be recognized in the income statement. Under the modified retrospective
method, prior periods are restated by recognizing compensation cost in the amounts previously reported in the pro-forma footnote disclosures under
Statement 123. The Company has not elected a transition method. Statement 123(R) must be adopted no later than July 1, 2005.
Impact of Significant External Factors
Inflation can have a significant impact on property and casualty insurers because premium rates are established before the amount of losses
and loss expenses are known. When establishing rates, the Company attempts to anticipate increases from inflation subject to the limitations of
modeling economic variables. General inflation, as measured by the CPI, has been relatively modest over the last several years; however, price inflation
on the goods and services purchased by insurance companies in settling claims has been steadily increasing. In particular, repair costs for homes,
autos, and commercial buildings, and medical care costs, have risen disproportionately over the last few years. Costs for building materials typically rise
dramatically following substantial natural catastrophes such as the industry experienced in Florida and adjacent states in 2004. The Company continues
to adjust its pricing projections as loss cost trends change in order to ensure premiums keep pace with inflation in all lines of business.
The Company considers inflation when estimating liabilities for losses and loss expenses, particularly for claims having a long period between
occurrence and settlement. The liabilities for losses and loss expenses are management’s best estimates of the ultimate net cost of underlying claims
and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on investment income may
partially offset potentially higher claims and expenses.
The Company is also affected by court decisions. Premium rates are actuarially determined to enable an insurance company to generate an
underwriting profit. These rates contemplate a certain level of risk. The courts may modify, in a number of ways, the level of risk which insurers had
expected to assume including eliminating exclusions, multiplying limits of coverage, creating rights for policyholders not intended to be included in the
contract and interpreting applicable statutes expansively to create obligations on insurers not originally considered when the statute was passed. Courts
have also undone legal reforms passed by legislatures, which reforms were intended to reduce a litigant’s rights of action or amounts recoverable and so
reduce the costs borne by the insurance mechanism. These court decisions can adversely affect an insurer’s profitability. They also create pressure on
rates charged for coverages adversely affected, and this can cause a legislative response resulting in rate suppression that can adversely affect an
insurer. The Company may also be adversely affected by regulatory actions on matters within the jurisdiction of the various insurance departments
where the Company does business or has entities domiciled.
After credit scoring, the industry’s use of which has been limited to varying extents by certain states’ laws, the next most predictive
underwriting report available to insurers is previous loss information. Third party vendors obtain loss information from insurers based on the insured,
the vehicle and/or the property location. As insurers write new business the database is accessed to analyze any loss experience of the insured, vehicle
and/or property location. Many times insurer’s premium rates will be adjusted to reflect the loss experience accessed from these databases. In some
cases the overall acceptability of the insured’s application in the standard market may be determined by these reports. During the last few years, use of
this loss information database product by the insurance industry as a predictive underwriting tool has been challenged by several west coast states and
most recently in a few of the Company’s states of operation. While it is too soon to determine states’ reaction to the utilization of these database
systems, any restrictive regulation of the full use of these underwriting reports could have an adverse impact on the Company as it has utilized these
database systems for several years as an underwriting tool. Since such regulation is applicable to all companies writing business which utilize these
reports, the Company does not expect to suffer a competitive disadvantage.
The Terrorism Risk Insurance Act of 2002 (the "Terrorism Act") established a temporary federal program that provides for a system of shared
public and private compensation for insured losses resulting from acts of terrorism committed by or on behalf of a foreign interest. In order for a loss to
be covered under the Terrorism Act, it must be the result of an event that is certified as an act of terrorism by the U.S. Secretary of Treasury (“subject
losses”). In the case of a war declared by Congress, only workers' compensation losses are covered by the Terrorism Act. The Terrorism Insurance
Program (the "Program") generally requires that all commercial property casualty insurers licensed in the U.S. participate in the Program. The amount
of compensation paid to participating insurers under the Program is 90% of subject losses, after an insurer deductible, subject to an annual cap that
limits the amount of subject losses to $100 billion aggregate per program year. The Company's deductible under this federal Program is approximately
$63.9 million for 2005, subject to final rules to be established by the U.S. Treasury. Under the Terrorism Act, commercial property and casualty insurers
must offer their commercial policyholders coverage against certified acts of terrorism, but the policyholders may choose to reject this coverage. If the
37
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
policyholder rejects coverage for certified acts of terrorism, the Company intends, subject to the approval of the state regulators, to cover only such acts
of terrorism that are not certified acts under the Terrorism Act and that do not arise out of nuclear, biological or chemical agents. This is currently
scheduled to sunset at year end 2005. If it does not continue in place, none of the foregoing would be applicable and each carrier would have to make
its own decisions with respect to terrorism insurance. The Company’s current property reinsurance treaties exclude certified acts of terrorism. If the
Terrorism Act expires, those treaties will likely be revised to exclude acts of terrorism as defined within the treaties. Likewise, if the Terrorism Act
expires, the Company will pursue changes to its direct commercial policies to exclude acts of terrorism as defined within its policies.
Trends and Uncertainties
The Company has identified certain trends and uncertainties that have the potential to significantly affect the Company’s business and the
property and casualty insurance industry. The Company considers these risks in the management of the Company operations:
Increased price competition
Increased price competition can have the effect of decreasing the rate of growth of earned premiums, as well as decreasing earned
premiums, as the Company’s underwriting philosophy is not consistent with risk selection at a price below which management believes is
adequate.
Declining investment rate of return and volatile investment market
The declining investment rate of return can decrease the rate of growth of investment income, as well as decrease investment income and
net income. The Company invests for an adequate return with a focus on principal preservation risk. The volatile investment market and
related investment valuation can affect the insurers’ statutory surplus and stockholders’ equity as the fair value of investments fluctuates.
Increased frequency and severity of storm losses, including catastrophes and increasing health care costs
The increased frequency and severity of storm losses and rising health care costs can have the effect of increasing losses and decreasing
operating profits. While the Company does not write health care insurance, rules affecting health care services can affect other insurance
that is written by the Company, including workers’ compensation and commercial and personal automobile and liability insurance.
Management considers these trends and uncertainties in the writing and pricing of policies. Because of the Company’s growth and planned
greater geographic dispersion of risk, the loss ratio point impact of recent catastrophes has not been as severe as catastrophe losses
several years ago that had fewer loss dollars associated with them.
Increased consolidation of the property and casualty insurance industry
Consolidation continues within the property and casualty insurance industry which can increase competition by creating insurance
companies with more resources and capital. As demonstrated over the years, the Company has acquired and successfully integrated
insurance companies in the past and considers acquisition opportunities as they arise. The Company believes acquisitions will be an
important part of its growth strategies.
Changing product distribution channels
Company management monitors the changing product distribution channels, along with its changing relationships with agencies and
consolidation occurring within the agency distribution system itself. The Company remains committed to cultivating strong relationships
with its agencies and to selling insurance products through the independent agency system.
New and changing insurance risks such as asbestos, mold, silica and acts of terrorism
The Company considers the expanding scope of insurance risks, such as asbestos, mold, silica and acts of terrorism, in its pricing, writing of
policies and drafting policy forms.
Bad faith claims
In at least two of the states where the Company does business, the law permits a plaintiff/claimant to bring an action directly against the
Company, as opposed to its insured, for “third party bad faith.” This right creates a certain amount of negotiating leverage for plaintiffs in
those states that might not otherwise exist and presents an exposure to loss to the Company.
Business continuity planning
The Company has established a business continuity plan in an effort to ensure the continuation of core business operations in the event
that normal business operations could not be performed due to a catastrophic event. While the Company continues to test and assess its
business continuity plan to ensure it meets the needs of the Company’s core business operations and addresses multiple business
interruption events, there is no assurance that core business operations could be performed in the occurrence of such an event.
38
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
Forward-Looking Statements; Certain Factors Affecting Future Results
Statements contained in this Form 10-K or any other reports or documents prepared by the Company or made by management may be
“forward-looking” within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are subject to certain
risks and uncertainties that could cause the Company’s actual results to differ materially from those projected. Forward-looking statements may be
identified, preceded by, followed by, or otherwise include, without limitation, words such as “plans,” “believes,” “expects,” “anticipates,” “intends,”
“estimates,” or similar expressions. The following factors, among others, in some cases have affected and in the future could affect the Company’s
actual financial performance.
(cid:120) The Company maintains loss reserves to cover its estimated ultimate unpaid liability for losses and loss expenses with respect to reported
and unreported claims incurred as of the end of each accounting period. Reserves do not represent an exact calculation of liability, but
instead represent estimates, generally using actuarial projection techniques at a given accounting date. The Company refines reserve
estimates in a regular ongoing process as historical loss experience develops and additional claims are reported and settled. The
Company records adjustments to reserves in the results of operations for the periods in which the estimates are changed. Because
establishing reserves is an inherently uncertain process involving estimates, currently established reserves may not be adequate. If the
Company concludes that estimates are incorrect and reserves are inadequate, the Company is obligated to increase its reserves. An
increase in reserves results in an increase in losses and a reduction in the Company’s net income for the period in which the deficiency in
reserves is identified. Accordingly, an increase in reserves could have a material adverse effect on the Company’s results of operations,
liquidity, and financial condition.
(cid:120) The Company’s insurance operations expose it to claims arising out of catastrophic events. The Company has experienced, and will in
the future experience, catastrophe losses that may cause substantial volatility in the Company’s financial results for any fiscal quarter or
year and could materially reduce the Company’s profitability or harm the Company’s financial condition. Catastrophes can be caused by
various natural events, including hurricanes, hailstorms, windstorms, earthquakes, explosions, severe winter weather, and fires, none of
which are within the Company’s control. The extent of losses from a catastrophe is a function of both the total amount of insured
exposure in the area affected by the event and the severity of the event. The geographic distribution of the Company’s business subjects
it to catastrophe exposure from hailstorms and earthquakes in the Midwest as well as catastrophe exposure from hurricanes in Florida
and the Gulf Coast, southern coastal states, and Mid-Atlantic regions. The Company does have in place very specific underwriting
guidelines designed to provide spread of risk and control aggregate exposures in those areas most exposed to natural catastrophes.
Catastrophe losses can vary widely and could significantly exceed the Company’s recent historic results. The frequency and severity of
catastrophes are inherently unpredictable.
(cid:120) The Company uses reinsurance to help manage its exposure to insurance risks. The availability and cost of reinsurance are subject to
prevailing market conditions, both in terms of price and available capacity, which can affect the Company’s business volume and
profitability. Although the reinsurer is liable to the Company to the extent of the ceded reinsurance, the Company remains liable as the
direct insurer on all risks reinsured. As a result, ceded reinsurance arrangements do not eliminate the Company’s obligation to pay
claims. The Company is subject to credit risk with respect to the Company’s ability to recover amounts due from reinsurers. Reinsurance
may not be adequate to protect the Company against losses and may not be available to the Company in the future at commercially
reasonable rates. In addition, the magnitude of losses in the reinsurance industry resulting from catastrophes may adversely affect the
financial strength of certain reinsurers, which may result in the Company’s inability to collect or recover reinsurance.
(cid:120) Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate
financial stability and a strong ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors that they
believe are relevant to policyholders. Ratings are important to maintaining public confidence in the Company and in its ability to market
its products. A downgrade in the Company’s financial strength ratings could, among other things, negatively affect the Company’s ability
to sell certain insurance products, the Company’s relationships with agents, new sales, and the Company’s ability to compete.
(cid:120) The Company markets its insurance products through independent, non-exclusive insurance agents, whereas some of the Company’s
competitors sell their insurance products through insurance agents who sell products exclusively for one insurance company. If the
Company is unsuccessful in attracting and retaining productive agents to sell the Company’s insurance products, the Company’s sales and
results of operations could be adversely affected. The agents that market and sell the Company’s products also sell the Company’s
competitors' products. These agents may recommend the Company’s competitors' products over the Company’s products or may stop
selling the Company’s products altogether. Additionally, the Company competes with the Company’s competitors for productive agents,
primarily on the basis of the Company’s financial position, support services and compensation and product features.
(cid:120) Mutual and the Company have acquired other insurance companies, and it is anticipated that Mutual and the Company will continue to
pursue acquisitions of other insurance companies in the future. Acquisitions involve numerous risks and uncertainties, including the
following: obtaining necessary regulatory approvals of the acquisition may prove to be more difficult than anticipated; integrating the
acquired business may prove to be more costly or difficult than anticipated; integrating the acquired business without material disruption
to existing operations may prove to be more difficult than anticipated; anticipated cost savings may not be fully realized (or not realized
within the anticipated time frame) or additional or unexpected costs may be incurred; loss results of the Company acquired may be
worse than expected; and retaining key employees of the acquired business may prove to be more difficult than anticipated. In addition,
other companies in the insurance industry have similar acquisition strategies. There can be no assurance that any future acquisitions will
be successfully integrated into the Company’s operations, that competition for acquisitions will not intensify or that the Company will be
able to complete such acquisitions on acceptable terms and conditions. In addition, the costs of unsuccessful acquisition efforts may
adversely affect the Company’s financial performance.
39
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
(cid:120) The Company’s operations are subject to changes occurring in the legislative, regulatory and judicial environment. Risks and
uncertainties related to the legislative, regulatory, and judicial environment include, but are not limited to, legislative changes at both the
state and federal level; state and federal regulatory rulemaking promulgations and adjudications that may affect the Company
specifically, its affiliates or the industry generally; class action and other litigation involving the Company, its affiliates, or the insurance
industry generally; and judicial decisions affecting claims, policy coverages and the general costs of doing business. Many of these
changes are beyond the Company’s control.
(cid:120) The laws of the various states establish insurance departments with broad regulatory powers relative to approving intercompany
arrangements, such as management, pooling, and investment management agreements, granting and revoking licenses to transact
business, regulating trade practices, licensing agents, approving policy forms, setting reserve requirements, determining the form and
content of required statutory financial statements, prescribing the types and amount of investments permitted and requiring minimum
levels of statutory capital and surplus. In addition, although premium rate regulation varies among states and lines of insurance, such
regulations generally require approval of the regulatory authority prior to any changes in rates. Furthermore, all of the states in which
the State Auto Group transacts business have enacted laws which restrict these companies’ underwriting discretion. Examples of these
laws include restrictions on agency terminations and laws requiring companies to accept any applicant for automobile insurance and laws
regulating underwriting “tools.” These laws may adversely affect the ability of the insurers in the State Auto Group to earn a profit on
their underwriting operations.
(cid:120) The property and casualty insurance industry is highly competitive. The Company competes with numerous insurance companies, many
of which are substantially larger and have considerably greater financial resources. The Company competes through underwriting
criteria, appropriate pricing, and quality service to the policyholder and the agent and through a fully developed agency relations
program. See “Marketing” in the “Narrative Description of Business” in Item 1 of this Form 10-K.
(cid:120) The Company is subject to numerous other factors which affect its operations, including, without limitation, the development of new
insurance products, geographic spread of risk, fluctuations of securities markets, economic conditions, technological difficulties and
advancements, availability of labor and materials in storm hit areas, late reported claims, previously undisclosed damage, utilities and
financial institution disruptions, and shortages of technical and professional employees and unexpected challenges to the control of the
Company by Mutual.
Item 7A. Qualitative and Quantitative Disclosures about Market Risk
“Qualitative and Quantitative Disclosures About Market Risk” is included in Item 7 of this Form 10-K under Market Risk.
Item 8. Financial Statements and Supplementary Data
The Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Reports of Independent Registered
Public Accounting Firm are as follows:
40
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
State Auto Financial Corporation
We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 2004 and
2003, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended
December 31, 2004. Our audits also included the financial statement schedules listed in the Index at Item 15(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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of State Auto
Financial Corporation and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 2004, in conformity with U.S. 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.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of State
Auto Financial Corporation’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—
Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 9, 2005
expressed an unqualified opinion thereon.
Columbus, Ohio
March 9, 2005
/s/ Ernst & Young LLP
41
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
State Auto Financial Corporation
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting,
that State Auto Financial Corporation maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established
in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria).
State Auto Financial Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on
the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all
material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment,
testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in
the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal
control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a
material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that State Auto Financial Corporation maintained effective internal control over financial reporting as of
December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, State Auto Financial Corporation
maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance
sheets of State Auto Financial Corporation as of December 31, 2004 and 2003, and the related consolidated statements of income, changes in
stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2004, and our report dated March 9, 2005 expressed
an unqualified opinion thereon.
Columbus, Ohio
March 9, 2005
/s/ Ernst & Young LLP
42
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Consolidated Balance Sheets
(in millions, except per share amount)
December 31
2004
2003
Assets
Fixed maturities, available for sale, at fair value (amortized cost $1,451.9 and $1,366.1, respectively) .
Equity securities, available for sale, at fair value (cost $163.4 and $121.0, respectively) .....................
Other invested assets, at fair value (amortized cost $3.2 and $3.0, respectively) ................................
Total investments...........................................................................................................................
Cash and cash equivalents ..............................................................................................................
Deferred policy acquisition costs ......................................................................................................
Accrued investment income and other assets....................................................................................
Due from affiliate............................................................................................................................
Net prepaid pension expense...........................................................................................................
Reinsurance recoverable on losses and loss expenses payable (affiliates $5.7)....................................
Prepaid reinsurance premiums (affiliates $3.0 and $3.9, respectively) ................................................
Current federal income taxes ...........................................................................................................
Property and equipment, at cost, net of accumulated depreciation of $4.8 and $4.4, respectively ........
Total assets...............................................................................................................................
Liabilities and Stockholders’ Equity
Losses and loss expenses payable (affiliates $296.9 and $303.9, respectively)....................................
Unearned premiums (affiliates $112.9 and $121.3, respectively)........................................................
Notes payable (affiliates $61.0) .......................................................................................................
Postretirement benefit liabilities .......................................................................................................
Other liabilities................................................................................................................................
Current federal income taxes ...........................................................................................................
Deferred federal income taxes .........................................................................................................
Due to affiliates ..............................................................................................................................
Total liabilities...........................................................................................................................
Stockholders’ equity:
Class A Preferred stock (nonvoting), without par value. Authorized 2.5 shares; none issued ...............
Class B Preferred stock, without par value. Authorized 2.5 shares; none issued .................................
Common stock, without par value. Authorized 100.0 shares; 44.7 and 44.2 shares
issued, respectively, at stated value of $2.50 per share.................................................................
Less 4.6 treasury shares, at cost......................................................................................................
Additional paid-in capital .................................................................................................................
Accumulated other comprehensive income .......................................................................................
Retained earnings...........................................................................................................................
Total stockholders’ equity.........................................................................................................
Total liabilities and stockholders’ equity...................................................................................
$ 1,502.1
193.6
3.4
1,699.1
64.3
97.5
49.9
10.5
54.9
25.9
8.3
-
13.3
$ 2,023.7
$ 681.8
415.0
164.5
80.1
20.2
0.7
3.2
-
1,365.5
-
-
111.8
(56.5)
64.1
53.1
485.7
658.2
$ 2,023.7
1,427.9
139.3
3.1
1,570.3
40.0
87.1
52.5
-
51.4
14.2
8.4
0.2
12.5
1,836.6
643.0
404.3
161.2
74.3
8.6
-
2.0
0.9
1,294.3
-
-
110.4
(55.8)
56.7
53.0
378.0
542.3
1,836.6
See accompanying notes to consolidated financial statements.
43
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Consolidated Statements of Income
($ millions, except per share amounts)
2004
Year ended December 31
2003
2002
Earned premiums (ceded to affiliate $657.8, $603.8 and $506.8, respectively) ..............
Net investment income ..............................................................................................
Net realized gains on investments...............................................................................
Other income (affiliates $3.9, $3.7 and $3.2, respectively) ...........................................
Total revenues.................................................................................................
Losses and loss expenses (ceded to affiliate $395.5, $387.6 and $368.8, respectively)...
Acquisition and operating expenses ............................................................................
Interest expense (affiliates $1.9, $2.8 and $2.3, respectively) ......................................
Other expenses .........................................................................................................
Total expenses................................................................................................
$ 1,006.8
71.8
7.6
6.2
1,092.4
619.2
304.3
7.3
10.0
940.8
Income before federal income taxes.................................................................
151.6
Federal income tax expense (benefit):
Current .................................................................................................................
Deferred ...............................................................................................................
Total federal income taxes.........................................................................................
40.5
1.1
41.6
Net income ........................................................................................................
$ 110.0
Earnings per common share:
Basic ....................................................................................................................
Diluted..................................................................................................................
$ 2.76
$ 2.70
Dividends paid per common share ..............................................................................
$ 0.17
960.6
64.6
10.6
5.9
1,041.7
651.2
291.8
3.7
11.7
958.4
83.3
17.1
2.6
19.7
63.6
1.62
1.58
0.15
896.6
59.7
5.9
5.3
967.5
653.5
264.4
2.3
9.5
929.7
37.8
8.2
(7.4)
0.8
37.0
0.95
0.93
0.14
See accompanying notes to consolidated financial statements.
44
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Consolidated Statements of Stockholders' Equity
(in millions)
Common shares:
Year ended December 31
2004
2003
2002
Balance at beginning of year.....................................................................................................
Issuance of shares ...................................................................................................................
Balance at end of year.............................................................................................................
44.2
0.5
44.7
Common stock:
Balance at beginning of year.....................................................................................................
Issuance of shares ...................................................................................................................
Balance at end of year.............................................................................................................
$ 110.4
1.4
111.8
Treasury shares:
Balance at beginning of year.....................................................................................................
Shares acquired on stock option exercises .................................................................................
Shares acquired under repurchase program...............................................................................
Balance at end of year.............................................................................................................
4.6
-
-
4.6
Treasury stock:
Balance at beginning of year.....................................................................................................
Shares acquired on stock option exercises .................................................................................
Shares acquired under repurchase program...............................................................................
Balance at end of year.............................................................................................................
Additional paid-in capital:
Balance at beginning of year.....................................................................................................
Issuance of common stock .......................................................................................................
Tax benefit from stock options exercises ...................................................................................
Stock options granted ..............................................................................................................
Balance at end of year.............................................................................................................
Accumulated other comprehensive income:
Balance at beginning of year.....................................................................................................
Unrealized gains on investments, net of tax and reclassification adjustment.................................
Gain on derivative used in cash flow hedge ...............................................................................
Amortization of gain on derivative used in cash flow hedge ........................................................
Balance at end of year.............................................................................................................
Retained earnings:
Balance at beginning of year.....................................................................................................
Net income..............................................................................................................................
Cash dividends paid .................................................................................................................
Balance at end of year.............................................................................................................
$ (55.8)
(0.7)
-
(56.5)
$ 56.7
4.9
2.3
0.2
64.1
$ 53.0
0.2
-
(0.1)
53.1
$ 378.0
110.0
(2.3)
485.7
43.5
0.7
44.2
108.8
1.6
110.4
4.5
-
0.1
4.6
(54.3)
(0.8)
(0.7)
(55.8)
50.4
3.9
2.1
0.3
56.7
42.5
9.7
0.8
-
53.0
43.0
0.5
43.5
107.6
1.2
108.8
4.1
-
0.4
4.5
(47.6)
(0.4)
(6.3)
(54.3)
47.1
2.2
0.9
0.2
50.4
12.0
30.5
-
-
42.5
316.4
63.6
(2.0)
378.0
281.1
37.0
(1.7)
316.4
Total stockholders’ equity at end of year.............................................................................
$ 658.2
542.3
463.8
See accompanying notes to consolidated financial statements.
45
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Consolidated Statements of Cash Flows
($ millions)
Year ended December 31
2004
2003
2002
Cash flows from operating activities:
Net income ......................................................................................................................
$ 110.0
63.6
37.0
Adjustments to reconcile net income to net cash provided by
Operating activities:
Depreciation and amortization, net .....................................................................
Net realized gains on investments ......................................................................
Changes in operating assets and liabilities:
Deferred policy acquisition costs .................................................................
Accrued investment income and other assets...............................................
Net prepaid pension expense......................................................................
Postretirement benefit liabilities ..................................................................
Reinsurance recoverable on losses and loss expenses
payable and prepaid reinsurance premiums...............................................
Other liabilities and due to/from affiliates, net..............................................
Losses and loss expenses payable...............................................................
Unearned premiums...................................................................................
Federal income taxes .................................................................................
8.7
(7.6)
(10.4)
2.1
(3.5)
5.8
(11.6)
0.2
38.8
10.7
4.4
8.8
(10.6)
(9.2)
0.1
(4.7)
7.5
(6.2)
16.5
42.1
26.4
3.7
5.6
(5.9)
(10.8)
(10.1)
(3.4)
9.5
2.4
(18.1)
77.1
48.5
(5.2)
Net cash provided by operating activities................................................................
147.6
138.0
126.6
Cash flows from investing activities:
Purchase of fixed maturities – available for sale .........................................................
Purchase of equity securities – available for sale ........................................................
Purchase of other invested assets ..............................................................................
Maturities, calls and pay downs of fixed maturities – held to maturity .........................
Maturities, calls and pay downs of fixed maturities – available for sale ........................
Sale of fixed maturities – available for sale ................................................................
Sale of equity securities – available for sale ...............................................................
Net additions of property and equipment ...................................................................
(487.5)
(62.5)
(0.2)
-
98.5
300.3
22.3
(1.3)
Net cash used in investing activities........................................................................
(130.4)
Cash flows from financing activities:
Proceeds from issuance of common stock ...................................................................
Payments to acquire treasury shares ..........................................................................
Payment of dividends ................................................................................................
Proceeds from terminating hedge derivatives ..............................................................
Proceeds from issuance of debt..................................................................................
Debt issuance costs ...................................................................................................
Payment of debt ......................................................................................................
Net cash provided by financing activities................................................................
Net increase (decrease) in cash and cash equivalents .........................................................
Cash and cash equivalents at beginning of year .................................................................
5.6
-
(2.3)
3.8
-
-
-
7.1
24.3
40.0
Cash and cash equivalents at end of year................................................................
$ 64.3
Supplemental disclosures:
Interest paid (affiliate $1.9, $2.8, and $2.2, respectively) ............................................
Federal income taxes paid .........................................................................................
$ 8.2
$ 37.2
(566.1)
(72.6)
(7.6)
-
84.9
275.4
6.1
(0.3)
(280.2)
4.7
(0.7)
(2.0)
0.8
115.5
(2.1)
(30.0)
86.2
(56.0)
96.0
40.0
3.2
15.9
(507.6)
(22.1)
(1.9)
8.2
61.5
363.6
12.7
-
(85.6)
3.0
(6.3)
(1.7)
-
30.0
-
-
25.0
66.0
30.0
96.0
2.3
6.0
See accompanying notes to consolidated financial statements.
46
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 State Auto Financial Corporation (State Auto Financial) and its wholly-owned subsidiaries:
(cid:120)
(cid:120)
(cid:120)
(cid:120)
(cid:120)
(cid:120)
(cid:120)
State Auto Property and Casualty Insurance Company (State Auto P&C), a South Carolina corporation
Milbank Insurance Company (Milbank), a South Dakota corporation
Farmers Casualty Insurance Company (Farmers), an Iowa corporation
State Auto Insurance Company of Ohio (SA Ohio), an Ohio corporation
State Auto National Insurance Company (SA National), an Ohio corporation
Stateco Financial Services, Inc. (Stateco), an Ohio corporation
Strategic Insurance Software, Inc. (S.I.S.), an Ohio corporation.
Mid-Plains Insurance Company (Mid-Plains), an Iowa corporation, a wholly-owned subsidiary of Farmers, was dissolved effective December 29,
2004. Its results of operations are included in these consolidated financial statements up through the date of dissolution and through December 31,
2004, by virtue of an assumption reinsurance agreement with SA National.
The financial statements include the operations and financial position of 518 Property Management and Leasing, LLC (518 PML), whose
members are State Auto P&C and Stateco.
State Auto Financial, an Ohio corporation, is a majority-owned subsidiary of State Automobile Mutual Insurance Company (Mutual), an Ohio
corporation. State Auto Financial and subsidiaries are referred to herein as the “Companies” or the “Company.” All significant intercompany balances and
transactions have been eliminated in consolidation.
b. Description of Business
The Company, through State Auto P&C, Milbank, Farmers and SA Ohio, provides standard personal and commercial insurance to its
policyholders. The Company’s principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers’
compensation, general liability and fire insurance. SA National provides nonstandard automobile insurance. State Auto P&C, Milbank, Farmers, SA Ohio,
and SA National operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, through an
independent insurance agency system. State Auto P&C, Milbank, Farmers, SA Ohio, and SA National are chartered and licensed as property and casualty
insurers in the states of South Carolina, South Dakota, Iowa, and Ohio (SA Ohio and SA National), respectively, and are licensed in various other states.
As such, they are subject to the regulations of the applicable Departments of Insurance of their respective states of domicile (the Departments) and the
regulations of each state in which they operate. These property and casualty insurance companies undergo periodic financial examination by the
Departments and insurance regulatory agencies of the states that choose to participate. A large portion of the Company’s revenues are derived from a
reinsurance pooling agreement with Mutual. The nature of the underlying policies and geographical distribution of underwriting activity is similar to the
Company.
Through State Auto P&C, the Company provides management and operation services under management agreements for all insurance and
non-insurance affiliates.
Through Stateco, the Company provides investment management services to affiliated companies.
The Company, through S.I.S., develops and sells software for the processing of insurance transactions, database management for insurance
agents and electronic interfacing of information between insurance companies and agencies. S.I.S. sells services and products to insurance agencies and
nonaffiliated insurers and their agencies. S.I.S. also delivers services and sells products to affiliated entities.
518 PML, an Ohio limited liability company, was formed to engage in the business of owning and leasing real and personal property to the
Company’s affiliates.
c.
Basis of Presentation
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States,
which vary in certain respects from statutory accounting practices followed by State Auto P&C, Milbank, Farmers, SA Ohio, and SA National that are
prescribed or permitted by the Departments.
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported
amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the period then ended, and the accompanying notes to
the financial statements. Such estimates and assumptions could change in the future as more information becomes known which could impact the
amounts reported and disclosed herein.
Material estimates that are particularly susceptible to significant change in the near term relate to the determination of losses and loss
expenses payable. In connection with the determination of this estimate, management uses historical data and current business conditions and
assumptions about future conditions to formulate estimates of the ultimate cost to settle claims. These estimates by their nature are subject to
uncertainties for various reasons. The Company's results of operations and financial condition could be impacted in the future should the ultimate
payments required to settle claims vary from the amount of the liability currently provided.
47
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
Certain items in the prior period consolidated financial statements have been reclassified to conform to the 2004 presentation.
d.
Investments
At December 31, 2004 and 2003, all investments in fixed maturity and equity securities were classified as available for sale and therefore are
carried at fair value. Other invested assets are comprised of limited liability partnership and other investments that are carried at fair value. The
unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders’ equity as “accumulated other
comprehensive income” and as such are not included in the determination of net income. Gains and losses on the sale of investments are computed
using the first-in, first-out method.
The Company regularly monitors its investments that have fair value less than the carrying amount for signs of other than temporary
impairment. Among the factors that management considers are market conditions, the amount, timing and length of decline in fair value, and events
impacting the issuer. When other than temporary impairment is recognized, the investment cost is written down to fair value of the date the
determination is made and a realized loss is recorded. The cost is not adjusted for any subsequent recovery in fair value.
e.
Cash Equivalents
The Company considers all highly liquid debt instruments with a maturity of three months or less to be cash equivalents.
f.
Deferred Policy Acquisition Costs
Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses that relate to and vary with 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 for the year ended December 31, are:
($ millions)
2004
2003
2002
Balance, beginning of year..........................
$ 87.1
Acquisition costs deferred ...........................
Amortized to expense.................................
246.6
(236.2)
Balance, end of year................................
$ 97.5
77.9
253.5
(244.3)
87.1
67.1
235.1
(224.3)
77.9
g.
Federal Income Taxes
The Company files a consolidated federal income tax return, and pursuant to a written tax sharing 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.
h.
Losses and Loss Expenses Payable
Losses and loss expenses payable are based on formula and case-basis estimates for reported claims, and on estimates, based on experience
and perceived trends, for unreported claims and loss expenses. The liability for unpaid losses and loss expenses, net of estimated salvage and
subrogation recoverable of $27.2 million and $26.8 million at December 31, 2004 and 2003, respectively, has been established to cover the estimated
ultimate cost of insured losses. The amounts are necessarily based on estimates of future rates of inflation and other factors, and accordingly there can
be no assurance that the ultimate liability will not vary from such estimates. The estimates are continually reviewed and adjusted as necessary; such
adjustments are included in current operations (see Note 4). Salvage and subrogation recoverables are estimated using historical experience. As such,
losses and loss expenses payable represent management’s best estimate of the ultimate liability related to reported and unreported claims.
i.
Premium
Premiums are recognized as earned using the monthly pro rata method over the contract period. Unearned premiums represent the portion
of premiums written relative to the unexpired terms of coverage.
48
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
j.
Derivatives
As part of the Company’s management of its exposure to fluctuations in interest rates, the Company utilizes interest rate swap agreements in
connection with its $100.0 million 6.25% senior notes. At December 31, 2004, there are no agreements outstanding (see Note 7). The interest rate
swap agreements are accounted for in accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and
Hedging Activities, as amended. This Statement requires all derivatives to be recorded at fair value on the consolidated balance sheet.
At the time a derivative contract is entered into, the Company formally documents and designates the derivative as either a hedge of the fair
value of a recognized asset or liability (fair value hedge) or a hedge of a forecasted transaction or the variability of cash flows to be received or paid
related to a recognized asset or liability (cash flow hedge). The Company does not have any derivative contracts hedging foreign currencies or
derivative contracts held for speculative purposes. The Company formally assesses, both at the hedge’s inception and on an ongoing basis, whether the
derivatives used for hedging transactions are highly effective in offsetting changes in fair values or cash flows of hedged items. When it is determined
that a derivative is not highly effective as a hedge or that it has ceased to be a highly effective hedge, the Company discontinues hedge accounting
prospectively.
Changes in fair value of derivatives designated as cash flow hedges, to the extent effective, are recorded in net unrealized gains/losses on
derivatives, a separate component of accumulated other comprehensive income. Amounts are reclassified to earnings from accumulated other
comprehensive income when the underlying hedged item impacts earnings. Changes in fair value of derivatives designated as fair value hedges are
recorded currently in earnings to the extent the derivative was effective in offsetting changes in fair value of the hedged item. The Company classifies in
the statement of cash flows amounts received from derivative contracts that are accounted for as hedges of identifiable transactions in the same
category as the cash flows from the items being hedged.
k. Other Comprehensive Income
Comprehensive income is defined as all changes in an enterprise’s equity during a period other than those resulting from investments by
owners and distributions to owners. Comprehensive income includes net income and other comprehensive income. Other comprehensive income
includes all other non-owner related changes to equity and represents net unrealized gains and losses on available for sale fixed maturities, equity
securities, other invested assets, and derivative instruments.
Separate presentation of the accumulated balance of other comprehensive income within the equity section of the statement of financial
position is also required. The Company has presented the required displays of total comprehensive income and its components, within the “Consolidated
Statements of Stockholders’ Equity.” See additional disclosures at Note 14.
l.
Stock Compensation
The Company follows Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related
Interpretations in accounting for its employee stock incentive plans using the intrinsic value method to account for stock-based compensation. 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:
Pro-forma Fair Value Method:
($ millions, except per share amounts)
2004
2003
2002
Net income as reported ............................................................................................
Less pro-forma stock compensation expense, net of tax .............................................
Pro-forma net income...............................................................................................
$ 110.0
(2.8)
$107.2
Pro-forma net earnings per common share
Basic...............................................................................................................
Diluted ............................................................................................................
$2.69
$2.57
63.6
(1.7)
61.9
1.58
1.51
37.0
(1.4)
35.6
0.91
0.89
The fair value of options granted to employees and directors in 2004, 2003 and 2002 were estimated at the date of grant using the Black-
Scholes option-pricing model.
49
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
The weighted average fair values and related assumptions for options granted were as follows:
Fair value ........................................................................................................
Expected dividend yield ....................................................................................
Risk free interest rate .......................................................................................
Expected volatility factor ...................................................................................
Expected life in years........................................................................................
$13.08
0.74%
4.21%
0.36
6.8
7.09
0.79%
2.73%
0.37
7.2
6.09
0.94%
4.20%
0.33
6.8
2004
2003
2002
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.
m. New Accounting Standards
On December 16, 2004, the FASB issued FASB Statement No. 123 (revised 2004), Share-Based Payment, which is a revision of FASB
Statement No. 123, Accounting for Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to
Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach in Statement 123(R) requires all share-based
payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro-forma
disclosure only will no longer be an alternative. The Statement provides two alternative methods of adoption: the modified prospective transition or the
modified retrospective transition. Under the modified prospective method, unvested stock based awards, that were granted prior to adoption, will
continue to be accounted for in accordance with Statement 123 except the compensation cost attributable to the unvested portion of the awards must
be recognized in the income statement. Awards that are vested will not be recognized in the income statement. Under the modified retrospective
method, prior periods are restated by recognizing compensation cost in the amounts previously reported in the pro-forma footnote disclosures under
Statement 123. The Company has not elected a transition method. Statement 123(R) must be adopted no later than July 1, 2005.
2.
Investments
During 2004, the Company recognized realized losses of $0.2 million on its fixed maturity portfolio, and in 2003 and 2002, $0.3 million and
$2.2 million, respectively, on its equity security portfolio. The Company reviewed its investments at December 31, 2004, and determined no additional
other than temporary impairment exists in the gross unrealized holding losses, as provided in the table below, due to the evidence that exists indicating
temporary impairment.
Realized and unrealized gains and losses for the year ended December 31, are summarized as follows:
($ millions)
2004
2003
2002
Realized gains:
Fixed maturities, available for sale ..........................................................................
Equity securities.....................................................................................................
Total realized gains..............................................................................................
Realized losses:
Fixed maturities, available for sale ..........................................................................
Equity securities.....................................................................................................
Total realized losses.............................................................................................
Net realized gains on investments.........................................................................
Change in unrealized gains (losses):
Increase (decrease) in unrealized holding gains – fixed maturity securities ................
Increase (decrease) in unrealized holding gains – equity securities ...........................
Increase in unrealized holding gains – other invested assets.....................................
Change in deferred unrealized gain .........................................................................
Deferred federal income taxes thereon....................................................................
Increase in net unrealized holding gains................................................................
$ 7.6
4.0
11.6
2.1
1.9
4.0
$ 7.6
$ (11.6)
11.9
0.1
-
(0.2)
$ 0.2
12.2
0.7
12.9
0.3
2.0
2.3
10.6
(5.5)
20.4
0.1
(0.1)
(5.2)
9.7
12.7
2.0
14.7
2.8
6.0
8.8
5.9
58.5
(11.6)
-
-
(16.4)
30.5
50
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
The cost or amortized cost and fair value of the Company’s investments are summarized as follows:
($ millions)
Available for sale at December 31, 2004:
U.S. Treasury securities and obligations of U.S.
government agencies ............................................................
Obligations of states and political subdivisions ...........................
Corporate securities.................................................................
U.S. government agencies mortgage-backed securities ..............
Other debt securities ...............................................................
Total fixed maturities...........................................................
Equity securities ......................................................................
Other invested assets ..............................................................
Total..................................................................................
($ millions)
Available for sale at December 31, 2003:
U.S Treasury securities and obligations of U.S.
government agencies .............................................................
Obligations of states and political subdivisions ...........................
Corporate securities .................................................................
U.S. government agencies mortgage-backed securities...............
Other debt securities ................................................................
Total fixed maturities...........................................................
Equity securities.......................................................................
Other invested assets ...............................................................
Total...................................................................................
Cost or
amortized
cost
$ 328.2
865.4
33.1
219.0
6.2
1,451.9
163.4
3.2
$ 1,618.5
Cost or
amortized
cost
$ 366.5
676.4
98.7
218.0
6.5
1,366.1
121.0
3.0
$ 1,490.1
Gross
unrealized
holding
gains
Gross
unrealized
holding
losses
4.6
42.8
2.6
5.0
-
55.0
32.1
0.2
87.3
(1.9)
(1.8)
-
(1.1)
-
(4.8)
(1.9)
-
(6.7)
Gross
unrealized
holding
gains
Gross
unrealized
holding
losses
8.0
46.5
6.8
4.7
-
66.0
19.8
0.1
85.9
(1.8)
(0.6)
(0.1)
(1.7)
-
(4.2)
(1.5)
-
(5.7)
Fair
value
330.9
906.4
35.7
222.9
6.2
1,502.1
193.6
3.4
1,699.1
Fair
value
372.7
722.3
105.4
221.0
6.5
1,427.9
139.3
3.1
1,570.3
Deferred federal income taxes on the net unrealized holding gain for available for sale investments was $28.3 million and $28.1 million at
December 31, 2004 and 2003, respectively.
At December 31, 2004 and 2003, there were no investments reflected in the tables below with an unrealized holding loss that had a fair value
significantly below cost continually for more than one year. There are no individually material securities with an unrealized holding loss at December 31,
2004 and 2003. The following tables show the Company’s investments gross unrealized losses and fair value, aggregated by investment category and
length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004 and 2003:
At December 31, 2004
Less than 12 months
12 months or more
Total
Description of
Securities
Fair
Value
Unrealized
Losses
($ millions, except number of positions)
Number
of
Positions
Fair
Value
Unrealized
Losses
Number
of
Positions
Fair
Value
Unrealized
Losses
Number
of
Positions
U.S. Treasury securities
and obligations of U.S.
government agencies......... $ 132.8
Obligations of states and
political subdivisions ..........
Corporate securities ..............
U.S. government agencies
mortgage backed
securities ..........................
Total fixed maturities ............
Equity securities ...................
Total temporarily
impaired securities............ $ 360.2
67.4
340.0
20.2
137.6
2.2
(1.9)
(1.7)
-
(0.5)
(4.1)
(1.9)
48
71
1
13
133
11
-
2.5
-
21.1
23.6
1.1
-
(0.1)
-
(0.6)
(0.7)
-
-
1
-
8
9
1
132.8
140.1
2.2
88.5
363.6
21.3
(1.9)
(1.8)
-
(1.1)
(4.8)
(1.9)
48
72
1
21
142
12
(6.0)
144
24.7
(0.7)
10
384.9
(6.7)
154
51
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
At December 31, 2003
Less than 12 months
12 months or more
Total
Description of
Securities
Fair
Value
Unrealized
Losses
Number
of
Positions
Fair
Value
Unrealized
Losses
Number
of
Positions
Fair
Value
Unrealized
Losses
Number
of
Positions
($ millions, except number of positions)
$ 83.4
U.S. Treasury securities
and obligations of U.S.
government agencies.........
Obligations of states and
political subdivisions ..........
Corporate securities ..............
U.S. government agencies
mortgage backed
securities ..........................
Total fixed maturities ............
Equity securities ...................
Total temporarily
impaired securities............ $ 248.0
111.7
235.4
12.6
33.9
6.4
(1.8)
(0.6)
(0.1)
(1.7)
(4.2)
(0.2)
(4.4)
24
17
2
24
67
8
75
-
-
-
-
-
10.4
10.4
-
-
-
-
-
(1.3)
(1.3)
-
-
-
-
-
8
8
83.4
33.9
6.4
111.7
235.4
23.0
258.4
(1.8)
(0.6)
(0.1)
(1.7)
(4.2)
(1.5)
(5.7)
24
17
2
24
67
16
83
See Note 1d for assessment of other than temporary impairments. The Company believes the above fixed maturity and equity securities
unrealized losses are not other than temporary as the Company has the ability and intent to hold the investments for a period of time sufficient for a
forecasted market price recovery up to or beyond the cost of the investment. Also, evidence indicating the cost of the investment is recoverable within a
reasonable period of time outweighs evidence to the contrary in considering the severity and duration of the impairment in relation to the forecasted
market price recovery.
The amortized cost and fair value of available for sale fixed maturities at December 31, 2004, by contractual maturity, are summarized as
follows:
($ millions)
Amortized
cost
Fair
value
Due in 1 year or less..............................................................................................
Due after 1 year through 5 years............................................................................
Due after 5 years through 10 years ........................................................................
Due after 10 years.................................................................................................
Mortgage-backed securities ....................................................................................
Total.................................................................................................................
$ 5.2
66.4
279.6
881.7
219.0
$1,451.9
5.2
68.1
292.7
913.2
222.9
1,502.1
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 fair values of approximately $52.3 million and $49.4 million were on deposit with regulators as required by law or specific
escrow agreement at December 31, 2004 and 2003, respectively.
Components of net investment income for the year ended December 31, are summarized as follows:
($ millions)
2004
2003
2002
Fixed maturities ..........................................................................................
Equity securities..........................................................................................
Cash and cash equivalents, and other ..........................................................
Investment income.................................................................................
$ 67.7
3.5
2.1
73.3
Investment expenses ..................................................................................
Net investment income...........................................................................
1.5
$ 71.8
63.3
1.7
1.5
66.5
1.9
64.6
58.2
1.2
1.2
60.6
0.9
59.7
The Company participates in a securities lending program whereby certain fixed maturity and equity securities from the Company’s investment
portfolio are loaned to other institutions for short periods of time. The Company requires collateral, equal to 102% of the market value of the loaned
securities. The collateral is invested by the lending agent, in accordance with Company’s guidelines, generating net investment income, net of applicable
fees. Based on terms of the agreement, the Company does not have the right to sell or re-pledge the collateral, unless there is an event of default by
the borrower. At December 31, 2004 and 2003, the amount of collateral held was approximately, $144.7 million and $193.2 million, respectively.
52
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 current investment strategy does not rely on the use of derivative financial instruments. See Note 3 for additional fair value
disclosures.
3.
Fair Value of Financial Instruments
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
Investment securities: Fair values for investments in fixed maturities are based on quoted market prices, where available. For fixed
maturities not actively traded, fair values are estimated using values obtained from independent pricing services. The fair values for
equity securities are based on quoted market prices. The fair value of other invested assets is based on equity or cash flow, as
applicable. The investment securities fair value adjustments are recorded in the consolidated financial statements.
Cash and cash equivalents: The carrying amounts reported in the balance sheets for these instruments approximate their fair value,
because of their short-term nature.
Notes payable and interest swap: The Mutual note and Trust Preferred note (each as defined below) carrying amounts reported in
the consolidated balance sheets for these instruments approximate their fair value as the interest rates adjust annually and quarterly,
respectively. The $100.0 million, 6.25% senior notes have a fair value of $108.0 million and $100.5 million at December 31, 2004 and
2003, respectively. The fair value of the senior notes is based on the quoted market price at December 31, 2004. At December 31,
2003, the financial statements reflect the fair value adjustments related to the interest rate swap.
($ millions)
December 31, 2004
December 31, 2003
Fixed Maturities ......................................................
Equity Securities .....................................................
Other Invested Assets .............................................
Cash and Cash Equivalents ......................................
Carrying
Value
$ 1,502.1
193.6
3.4
64.3
Notes Payable.........................................................
Fair Value Hedge ....................................................
164.5
-
Fair Value
Carrying
Value
Fair Value
1,502.1
193.6
3.4
64.3
169.0
-
1,427.9
139.3
3.1
40.0
161.2
0.5
1,427.9
139.3
3.1
40.0
161.5
0.5
4.
Losses and Loss Expenses Payable
Activity in the liability for losses and loss expenses for the year ended December 31, are summarized as follows:
($ millions)
2004
2003
2002
Losses and loss expenses payable, at beginning of year ...................................................
Less: reinsurance recoverable on losses and loss expenses payable...................................
Net balance at beginning of year.....................................................................................
Incurred related to:
Current year .......................................................................................................
Prior years..........................................................................................................
Total incurred................................................................................................................
Paid related to:
Current year .......................................................................................................
Prior years..........................................................................................................
Total paid......................................................................................................................
Net balance at end of year..............................................................................................
Plus: reinsurance recoverable on losses and loss expenses payable ..................................
Losses and loss expenses payable, at end of year (affiliate $296.9,
$303.9, and $304.0, respectively)..........................................................................
$ 643.0
14.2
628.8
641.4
(22.2)
619.2
361.5
230.6
592.1
655.9
25.9
$ 681.8
600.9
8.8
592.1
653.0
(1.8)
651.2
370.7
243.8
614.5
628.8
14.2
643.0
523.8
13.9
509.9
641.1
12.4
653.5
349.7
221.6
571.3
592.1
8.8
600.9
The decrease of $22.2 million and $1.8 million in 2004 and 2003, respectively, and the increase of $12.4 million in 2002, for claims occurring
in prior years are well within normal expectations for reserve development and claim settlement uncertainty.
53
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
5. Reinsurance
In the ordinary course of business, the Company assumes and cedes reinsurance with other insurers and reinsurers and is a member in
various pools and associations. See Note 6a for discussion of reinsurance with affiliates. The voluntary arrangements provide greater diversification of
business and limit the maximum net loss potential arising from large risks and catastrophes. Most of the ceded reinsurance is effected under reinsurance
contracts known as treaties; some is by negotiation on individual risks. Although the ceding of reinsurance does not discharge the original insurer from
its primary liability to its policyholder, the insurance company that assumes the coverage assumes the related liability.
Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. The
recoverability of these assets depends on the reinsurers’ ability to perform under the reinsurance agreements. The Company evaluates and monitors the
financial condition and concentrations of credit risk associated with its reinsurers under voluntary reinsurance arrangements to minimize its exposure to
significant losses from reinsurer insolvencies. The Company has reported ceded losses and loss expenses payable and prepaid reinsurance premiums
with other insurers and reinsurers as assets. All reinsurance contracts provide indemnification against loss or liability relating to insurance risk and have
been accounted for as reinsurance.
Prior to the reinsurance transaction with Mutual under the Pooling Arrangement, as discussed in Note 6a, the effect of the Company’s external
reinsurance on its balance sheets and income statements, are summarized as follows:
($ millions)
Losses and loss expenses payable:
Direct .........................................................................................................................
Assumed .....................................................................................................................
Ceded ........................................................................................................................
Net losses and loss expenses payable.........................................................................
Unearned premiums:
Direct .........................................................................................................................
Assumed .....................................................................................................................
Ceded .........................................................................................................................
Net unearned premiums............................................................................................
December 31
2004
2003
$ 380.8
4.1
(20.2)
$ 364.7
$ 300.7
1.4
(5.3)
$ 296.8
335.7
3.4
(8.5)
330.6
281.7
1.3
(4.5)
278.5
($ millions)
2004
Year ended December 31
2003
2002
Written premiums:
Direct ...........................................................................................
Assumed .......................................................................................
Ceded ...........................................................................................
Net written premiums..................................................................
Earned premiums:
Direct...........................................................................................
Assumed ......................................................................................
Ceded ..........................................................................................
Net earned premiums..................................................................
Losses and loss expenses incurred:
Direct...........................................................................................
Assumed ......................................................................................
Ceded ..........................................................................................
Net losses and loss expenses incurred..........................................
$ 757.7
6.2
(16.1)
$ 747.8
$ 738.7
6.1
(15.4)
$ 729.4
$ 459.1
5.1
(17.1)
$ 447.1
717.9
5.1
(13.4)
709.6
679.9
4.9
(12.8)
672.0
447.3
3.3
(6.5)
444.1
631.3
3.9
(12.2)
623.0
577.8
3.9
(11.2)
570.5
413.3
2.4
(1.9)
413.8
54
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
6. Transactions with Affiliates
a. Reinsurance
State Auto P&C, Milbank, Farmers, SA Ohio (the “STFC Pooled Companies”), State Auto Insurance Company of Wisconsin (SA Wisconsin), and
State Auto Florida Insurance Company (SA Florida), participate in a quota share reinsurance pooling arrangement (the Pooling Arrangement) with
Mutual whereby the STFC Pooled Companies, SA Wisconsin and SA Florida cede to Mutual all of their insurance business and assume from Mutual an
amount equal to their respective participation percentages in the Pooling Arrangement. All premiums, losses and loss expenses and underwriting
expenses are allocated among the participants on the basis of each Company’s participation percentage in the Pooling Arrangement. The Pooling
Arrangement provides indemnification against loss or liability relating to insurance risk and has been accounted for as reinsurance. SA Wisconsin and SA
Florida are wholly owned subsidiaries of Mutual.
The Pooling Arrangement does not relieve each individual pooled subsidiary of its primary liability as the originating insurer; consequently,
there is a concentration of credit risk arising from business ceded to Mutual. As the Pooling Arrangement provides for the right of offset, the Company
has reported losses and loss expenses payable and prepaid reinsurance premiums to Mutual as assets only in situations when net amounts ceded to
Mutual exceed that assumed. The STFC Pooled Companies’ participation percentage was 80% for the years 2004, 2003, and 2002. All parties that
participate in the Pooling Arrangement have an A.M. Best rating of A+ (Superior).
The following provides a summary of the reinsurance transactions on the Company’s balance sheets and income statements for the Pooling
Arrangement between the STFC Pooled Companies and Mutual:
($ millions)
Losses and loss expenses payable:
Ceded......................................................................................................................
Assumed..................................................................................................................
Net assumed..........................................................................................................
Unearned premiums:
Ceded......................................................................................................................
Assumed..................................................................................................................
Net assumed..........................................................................................................
December 31
2004
2003
$ (324.6)
621.5
$ 296.9
$ (275.1)
388.0
$ 112.9
(291.0)
594.9
303.9
(250.3)
371.6
121.3
($ millions)
Year ended December 31
2003
2004
2002
Written premiums:
Ceded..............................................................................................
Assumed..........................................................................................
$ (671.1)
949.4
Earned premiums:
Ceded..............................................................................................
Assumed..........................................................................................
$ (646.3)
932.5
Losses and loss expenses incurred:
Ceded..............................................................................................
Assumed..........................................................................................
$ (388.2)
567.6
(616.6)
917.1
(578.2)
889.6
(372.9)
594.8
(534.4)
864.8
(495.1)
830.0
(353.5)
609.9
Effective January 1, 2005, the Pooling Arrangement was amended to add as participants Meridian Security Insurance Company (Meridian
Security) and Meridian Citizens Mutual Insurance Company (Meridian Citizens), Indiana domiciled property and casualty insurers together, referred to as
the “Meridian Insurers”. Meridian Security is a wholly-owned subsidiary of Meridian Insurance Group, Inc. (“MIGI”), which is wholly-owned by Mutual.
MIGI is party to an affiliation agreement with Meridian Citizens. The STFC Pooled Companies pooling participation percentage remains at 80%. In
conjunction with the Pooling Arrangement Amendment, the STFC Pooled Companies received $54.0 million in cash in 2005 from the Meridian Insurers
which related to the additional net insurance liabilities assumed on January 1, 2005.
The STFC Pooled Companies, SA National, Mutual, SA Wisconsin, SA Florida and the Meridian Insurers are collectively referred to as the “State
Auto Group.”
55
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
State Auto P&C assumes catastrophe reinsurance from the State Auto Group in the amount of $100.0 million excess of $120.0 million in
exchange for a premium paid by each reinsured company. Under this agreement, the Company has assumed from Mutual and its affiliates premiums
written and earned of $2.7 million, $2.8 million, and $2.9 million for 2004, 2003, and 2002, respectively. There have been no losses assumed under this
agreement. The catastrophe reinsurance program with State Auto P&C has been excluded from the Pooling Arrangement.
To protect against a catastrophe loss event in which the State Auto Group would incur catastrophe losses in excess of $120.0 million, State
Auto Financial has a structured contingent financing transaction with a financial institution and a syndicate of other lenders (the “Lender”) to provide up
to $100.0 million for reinsurance purposes. In the event of such a loss, this arrangement provides that State Auto Financial would sell redeemable
preferred shares to SAF Funding Corporation, a special purpose company (“SPC”), which would borrow the money necessary for such purchase from the
Lenders. This arrangement with the Lenders, SPC and State Auto Financial is a financing arrangement, whereby State Auto Financial would receive cash
funding in the event of a catastrophe loss as described above. State Auto Financial would then contribute to State Auto P&C the funds received from the
sale of its preferred shares. State Auto P&C would use the contributed capital proceeds to pay its direct catastrophe losses and losses assumed under
the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC by redeeming the preferred shares in ten semiannual
installments. In the event of a default by State Auto Financial, the obligation to repay SPC has been secured by a Put Agreement among State Auto
Financial, Mutual and the Lenders, under which Mutual would be obligated to either purchase the preferred shares from the SPC or repay the SPC for the
loan(s) outstanding.
For the period October 1, 2001 through December 31, 2003, Mutual entered into a stop loss reinsurance arrangement (Stop Loss) with the
STFC Pooled Companies. Under the Stop Loss, Mutual agreed to participate in the Pooling Arrangement’s quarterly underwriting losses and gains in the
manner described. If the Pooling Arrangement’s statutory loss and loss adjustment expense ratio (loss ratio) was between 70.75% and 80% (after the
application of all available reinsurance), Mutual reinsured the STFC Pooled Companies 27% of the Pooling Arrangement’s losses in excess of a loss ratio
of 70.75% up to 80.00%. The STFC Pooled Companies were responsible for their share of the Pooling Arrangement’s losses over the 80% threshold.
Also, Mutual had the right to participate in the profits of the Pooling Arrangement. Mutual assumed 27% of the Pooling Arrangement’s underwriting
profits attributable to loss ratios less than 69.25%, but more than 59.99%. During 2003 and 2002, the STFC Pooled Companies ceded to Mutual, $5.6
million and $8.8 million in losses, respectively, and $12.8 million and $1.4 million, respectively, in premiums under the Stop Loss. The Stop Loss ceased
at December 31, 2003.
SA National has a ceding reinsurance agreement with Mutual that include excess of loss and quota share coverages. Through Mutual’s
participation in the Pooling Arrangement, the effects of this agreement with SA National is indirectly subject to the Pooling Arrangement between Mutual
and the STFC Pooled Companies.
Effective December 1, 2004, SA National entered into an assumption reinsurance agreement with Mid-Plains, assuming Mid-Plains outstanding
insurance liabilities. This agreement was completed to facilitate the dissolution of Mid-Plains as of December 29, 2004.
The following provides a summary of the ceding reinsurance transactions on the Company’s balance sheet and income statement for the
reinsurance agreement between SA National and Mutual and Mid-Plains and Mutual:
($ millions)
2004
2003
Balance sheet:
Losses and loss expenses payable ......................................................
Unearned premiums ..........................................................................
$ 5.7
$ 3.0
5.7
3.9
($ millions)
2004
2003
2002
Income statement:
Written premiums...................................................
Earned premiums ...................................................
Losses and loss expenses incurred...........................
$ 10.7
$ 11.5
$ 7.3
12.8
12.8
9.2
12.1
10.3
7.9
b.
Intercompany Balances
Pursuant to the Pooling Arrangement, Mutual is responsible for the collection of premiums and payment of losses, loss expenses and
underwriting expenses of the STFC 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 balance receivables and
reinsurance recoverable on paid losses from unaffiliated reinsurers are carried by Mutual. The Company had off-balance-sheet credit risk of
approximately $214.2 million and $201.0 million related to premium balances due to Mutual from agents and insureds at December 31, 2004 and 2003,
respectively, which is collateralized by the unearned premium from the respective policies.
56
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
c. Notes Payable
In 1999, State Auto Financial entered into a line of credit agreement with Mutual for $45.5 million in conjunction with its stock repurchase
program. Principal payment is due on demand, but not later than December 31, 2005. The interest rate is adjustable annually at January 1 to reflect
adjustments in the then current prime lending rate less 1.75% as well as State Auto Financial’s current financial position. Interest rate for the years
2004, 2003, and 2002 was 2.25%, 2.50%, and 3.00%, respectively. Interest rate for the year 2005 is 3.50 %.
Upon receipt of the written approval of the South Dakota Director of Insurance, in the fourth quarter of 2003, Milbank repaid the $15.0 million
surplus contribution note to Meridian Security that was entered into on September 30, 2002. The interest rate was equal to the U.S. Treasury ten-year
note yield at September 30, 2002 plus 100 basis points (total 4.59%).
On May 22, 2003, STFC Capital Trust I, State Auto Financial’s Delaware business trust subsidiary (the “Capital Trust”), issued $15.0 million
liquidation amount of its capital securities to a third party. In connection with the Capital Trust’s issuance of the capital securities and the related
purchase by State Auto Financial of all of the Capital Trust’s common securities (liquidation amount of $0.5 million included in other invested assets),
State Auto Financial issued to the Capital Trust $15.5 million aggregate principal amount of Floating Rate Junior Subordinated Debt Securities due 2033
(the “Subordinated Debentures”). The sole assets of the Capital Trust are the Subordinated Debentures and any interest accrued thereon. Interest on
the Capital Trust’s capital and common securities (the “Trust Securities”) is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20%,
adjusted quarterly (total 6.60% at December 31, 2004). Prior to May 2008, the interest rate may not exceed 12.5% per annum. The interest rate and
interest payment dates on the Subordinated Debentures are the same as the interest rate and interest payment dates on the Trust Securities. In
January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities, effective for reporting periods beginning after June 15, 2003. As a
result of the Company’s adopting FIN 46 effective July 1, 2003, the financial statements of the Capital Trust are no longer consolidated within the
accompanying financial statements of the Company.
The Trust Securities are mandatorily redeemable on May 23, 2033, and may be redeemed at any time on and after May 23, 2008, at 100% of
the principal amount thereof plus unpaid interest. The Trust Securities may be redeemed in whole, but not in part, at any time within 90 days following
the occurrence of a “Tax Event” or “Investment Company Event” (as defined in the declaration of trust) (a) if such Tax Event or Investment Company
Event occurs on or after May 23, 2008, at a redemption price equal to 100% of the principal amount thereof plus unpaid interest, and (b) if such Tax
Event or Investment Company Event occurs prior to May 23, 2008, at a redemption price equal to the greater of 100% of the principal amount thereof
plus accrued interest and a “make-whole” amount. The Subordinated Debentures are subject to these same redemption terms. The obligations under
the Subordinated Debentures and related agreements, taken together, constitute a full and unconditional guarantee of payments due on the Trust
Securities.
State Auto Financial has the right, at any time, to defer payments of interest on the Subordinated Debentures for up to 20 consecutive
quarterly payment periods. Consequently, distributions on the Trust Securities would be deferred (though such distributions would continue to accrue
with interest since interest would accrue on the Subordinated Debentures during any such extended interest payment period). In no case may the
deferral of payments and distributions extend beyond the stated maturity dates of the respective securities. During such deferments, State Auto
Financial may not declare or pay any dividends on, or purchase any of, its capital stock, make any principal or interest payments on debt securities that
rank in all respects equally with or subordinated to the Subordinated Debentures, or make any payment under guarantees that rank in all respects
equally with or subordinated to State Auto Financial’s guaranty of the Trust Securities.
The Subordinated Debentures are unsecured and subordinated to all of the Company’s existing and future senior indebtedness. As sponsor of
the Capital Trust, State Auto Financial incurred security issuance costs related to the Trust Preferred Capital Securities and Subordinated Debentures of
$0.5 million, which is recorded in other assets and is being amortized into interest expense ($18,000 and $13,000 for 2004 and 2003, respectively) as
the underlying interest expense is recognized on the Trust Securities.
See discussion of Notes Payable (non-affiliate) and Derivatives at Note 7.
d. Management Services
Stateco provides Mutual and its affiliates investment management services. Investment management income is recognized quarterly based on
a percentage of the average fair value of investable assets and the equity portfolio performance of each company managed. Revenue related to these
services amounted to $2.5 million, $2.2 million and $2.1 million in 2004, 2003 and 2002, respectively, and is included in other income (affiliates).
State Auto P&C provides management and operation services to certain of Mutual’s insurance affiliates for a fee. Revenue relating to these
services amounted to $1.0 million, $1.1 million, and $0.6 million in 2004, 2003, and 2002, respectively, and is included in other income (affiliates).
e. Other Transactions
State Auto P&C’s December 31, 1990 liability for losses and loss expenses of $65.5 million has been guaranteed by Mutual. Pursuant to the
guaranty agreement, all ultimate adverse development of the December 31, 1990 liability, if any, is to be reimbursed by Mutual to State Auto P&C in
conformance with pooling percentages in place at that time. As of December 31, 2004, there has been no adverse development of the liability.
57
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
7. Notes Payable and Derivatives
On November 13, 2003, State Auto Financial issued $100.0 million unsecured senior notes (“Senior Notes”) bearing interest fixed at 6.25%
due November 15, 2013. Interest on the Senior Notes is payable May 15 and November 15 of each year beginning May 15, 2004. The Senior Notes are
general unsecured obligations ranking senior to all existing and future subordinated indebtedness and equal with all existing and future senior
indebtedness. The Senior Notes are not guaranteed by any of the Company subsidiaries and thereby are effectively subordinated to all Company
subsidiaries’ existing and future indebtedness. State Auto Financial may redeem the Senior Notes in whole at anytime or in part from time to time at
State Auto Financial’s option, on at least 30 but not more than 60 days’ prior written notice, at a redemption price equal to the greater of the principal
amount of such notes being redeemed on the redemption date or the make whole amount, based on U.S. Treasury rates as defined by the Senior Notes,
plus in each case, accrued and unpaid interest, if any, on the Senior Notes to the redemption date. The Senior Notes issued contain certain covenants
as defined in the notes, which among other things, limit State Auto Financial and its subsidiaries ability to issue indebtedness secured by the capital
stock of certain State Auto Financial subsidiaries and sell the capital stock of certain State Auto Financial subsidiaries. The Senior Notes also contain a
covenant that requires State Auto Financial to take certain actions in the event it engages in mergers, consolidations or sales of all or substantially all of
the assets and prohibits State Auto Financial from engaging in such transaction if the Company is in default under the Senior Notes. State Auto
Financial incurred $1.5 million in issuance costs related to the Senior Notes, which is recorded in other assets and is being amortized into interest
expense ($118,000 and $13,000 for 2004 and 2003, respectively) as the underlying interest expense is recognized on the Trust Securities.
On October 1, 2003, State Auto Financial entered into an interest rate swap contract for a notional amount of $25.0 million as a hedge on the
ten year treasury rate in connection with the forecasted issuance of the Senior Notes. The swap contract was designated as a cash flow hedge and
settled on November 6, 2003, the pricing date of the Senior Notes, with the Company receiving $0.8 million. The gain has been recorded in
accumulated other comprehensive income and is being amortized as an offset to interest expense ($62,000 and $7,000 in 2004 and 2003, respectively)
as the underlying interest expense is recognized for the Senior Notes.
On November 6, 2003, State Auto Financial entered into an interest rate swap contract for a notional amount of $50.0 million receiving
semiannual payments at a fixed rate of 6.25% and making semiannual payments at a variable rate equal to six month LIBOR plus 1.25 percent with
LIBOR to be determined the last day of each interest reset period (total 2.47% at December 31, 2003). The swap contract was designated as a fair
value hedge to protect against changes in fair value of the Senior Notes. Recorded in other assets at December 31, 2003, the fair market value of the
fixed to floating interest rate swap was $0.5 million of which $0.2 million related to net accrued interest to be received and reduce reported interest
expense in the period.
On March 11, 2004, State Auto Financial terminated its interest rate swap contract entered into on November 6, 2003 and received proceeds
of $2.9 million. Of the $2.9 million received, $2.3 million settled future net swap payments and was deferred in notes payable and will be amortized as
an offset to interest expense over the life of the Senior Notes. The remaining $0.6 million related to net swap payments from inception to termination
and was recorded as an offset to interest expense.
On May 6, 2004, State Auto Financial entered into an interest rate swap contract for a notional amount of $50.0 million, receiving semiannual
payments at a fixed rate of 6.25% and making semiannual payments at a variable rate equal to the six month LIBOR plus 0.94% with LIBOR to be
determined the last day of each interest reset period. The swap contract was designated as a fair value hedge to protect against changes in fair value
of the Senior Notes. During August 2004, State Auto Financial terminated the interest rate swap contract entered into on May 6, 2004 and received
proceeds of $1.8 million. Of the $1.8 million received, $1.5 million settled future net swap payments and was deferred in notes payable and will be
amortized as an offset to interest expense over the life of the Senior Notes. The remaining $0.3 million related to net swap payments from inception to
termination and was recorded as an offset to interest expense. The amount of hedge ineffectiveness, in all periods presented, was not material.
On December 21, 2003, State Auto Financial repaid the $15.0 million term loan note to the bank that it entered into on December 21, 2002.
Interest adjusted quarterly and accrued at LIBOR plus 0.75 points (2.15% at December 31, 2002) and was payable quarterly. This note agreement had
various covenants including financial ratio covenants.
See discussion of affiliate notes payable at Note 6c. Notes payable at December 31, consisted of the following:
($ millions, except interest rates)
Carrying
Value
2004
Fair
Value
Interest
Rate
Carrying
Value
2003
Fair
Value
Interest
Rate
Senior notes due 2013: issued $100.0, November
2003 with fixed interest.........................................
Affiliate subordinated debentures due 2033:
issued $15.5, May 2003 with variable interest
(see Note 6c) .......................................................
Affiliate note payable due on demand prior to
December 31, 2005: issued $45.5, June 1999
with variable interest (see Note 6c)........................
Total Notes Payable............................................
$ 103.5
108.0
6.25%
100.2
100.5
6.25
15.5
15.5
6.60%
15.5
15.5
5.37
45.5
$ 164.5
45.5
169.0
2.25%
45.5
161.2
45.5
161.5
2.50
58
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
8. Federal Income Taxes
A reconciliation between actual federal income tax expense (benefit) and the amount computed at the indicated statutory rate for the year
ended December 31, is summarized as follows:
($ millions)
2004
%
2003
%
2002
%
Amount at statutory rate...............................
$ 53.1
35
29.1
35
13.2
35
Tax-free interest and dividends
received deduction ....................................
Other, net ....................................................
Effective tax and rate.................................
(11.2)
(0.3)
$ 41.6
(7)
(1)
27
(9.7)
0.3
19.7
(12)
1
24
(11.9)
(0.5)
0.8
(32)
(1)
2
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities as of December 31,
are presented below:
($ millions)
Deferred tax assets:
2004
2003
Unearned premiums not deductible..............................................................................
Losses and loss expenses payable discounting ..............................................................
Postretirement benefit liabilities ...................................................................................
Other
Alternative minimum tax credit ....................................................................................
Total deferred tax assets.....................................................................................
$ 28.5
23.1
20.2
5.8
-
77.6
Deferred tax liabilities:
Deferral of policy acquisition costs ...............................................................................
Net prepaid pension expense.......................................................................................
Unrealized holding gain on investments........................................................................
Other
Total deferred tax liabilities..................................................................................
Net deferred tax liability......................................................................................
34.1
17.8
28.2
0.7
80.8
$ (3.2)
27.8
22.0
18.3
5.9
0.2
74.2
30.5
16.9
28.1
0.7
76.2
(2.0)
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 2004, 2003, and 2002 were $37.2 million, $15.9 million, and $6.0 million, respectively.
9. Pension and Postretirement Benefit Plans
The Company provides a defined pension benefit plan for its eligible employees. Substantially all Company employees become eligible to
participate the year after becoming 20 years of age and vest with 5 years of credited service or attained age 65. The Company’s policy is to fund
pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Benefits are determined by applying
factors specified in the plan to a participant's defined average annual compensation.
In addition to the pension benefit plan, the Company provides a postretirement benefit plan including certain health care and life insurance
benefits for its eligible retired employees. Substantially all of the Company's employees may become eligible for these postretirement benefits if they
retire between age 55 and 65 with 15 years or more of service or if they retire at age 65 or later with 5 years or more of service.
On December 8, 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was signed into law. The Act
expanded Medicare to include, for the first time, coverage for prescription drugs. In May of 2004, the FASB issued FASB Staff Position 106-2 (“FSP 106-
2”), Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003. FSP 106-2
provides guidance on accounting for the effects of the Act for employers that sponsor postretirement health care plans that provide drug benefits. The
accrued postretirement benefit obligation or net periodic postretirement costs do not reflect any amount associated with the subsidy at December 31,
2004, as the Company has not concluded whether the benefits provided by its plan are “actuarially equivalent” to Medicare Part D under the Act.
The Company used September 30, 2004, 2003 and 2002, respectively, to determine the pension and postretirement benefit measurements.
The accumulated benefit obligation with respect to the pension benefit plan was $148.3 million and $139.0 million as of December 31, 2004 and 2003,
respectively.
59
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
Information regarding the Company’s pension and postretirement benefit plans’ change in benefit obligation, plan assets and funded status as
of December 31, are as follows:
($ millions)
Pension
Postretirement
2004
2003
2004
2003
Change in benefit obligation:
Benefit obligation at beginning of year .................................
Change in plan provisions....................................................
Service cost ........................................................................
Interest cost .......................................................................
Actuarial loss ......................................................................
Contributions ......................................................................
Benefits paid ......................................................................
$ 164.0
1.9
7.8
10.4
1.3
-
(10.0)
Benefit obligation at end of year........................................
$ 175.4
Change in plan assets:
Fair value of plan assets at beginning of year .......................
Employer contribution .........................................................
Actual gain return on plan assets .........................................
Benefits paid ......................................................................
Expected return on plan assets ............................................
Loss on assets ....................................................................
$ 161.0
9.5
16.3
(10.0)
-
-
Fair value of plan assets at end of year..............................
$ 176.8
Funded status.....................................................................
Unrecognized transition asset ..............................................
Unrecognized prior service cost............................................
Unrecognized net loss .........................................................
Contribution .......................................................................
Net prepaid benefit (accrued obligation) at end of year.......
$ 1.3
(4.2)
4.3
53.5
-
54.9
150.1
-
7.0
9.9
6.5
-
(9.5)
164.0
150.6
-
19.9
(9.5)
-
-
161.0
(3.0)
(4.9)
2.7
52.0
4.6
51.4
79.1
-
3.6
5.0
16.8
(3.0)
-
101.5
2.0
-
-
-
0.2
(0.1)
2.1
(99.5)
-
4.1
19.4
-
(76.0)
71.2
-
3.2
4.7
2.2
(2.2)
-
79.1
1.9
-
-
-
0.2
(0.1)
2.0
(77.2)
-
4.6
2.4
-
(70.2)
Amounts recognized in the statement of
financial position consist of the following:
SERP (definition follows) liability ..........................................
Net prepaid benefit (accrued obligation) recognized............
-
$ 54.9
-
51.4
(4.1)
(80.1)
(4.1)
(74.3)
Information regarding the Company’s pension and postretirement benefit plans’ components of net periodic (benefit) cost for the year ended
December 31, are as follows:
($ millions)
Components of net periodic (benefit) cost:
Service cost ..........................................................
Interest cost .........................................................
Expected return on plan assets ..............................
Amortization of prior service cost ...........................
Amortization of transition asset ..............................
Amortization of net gain ........................................
Net periodic (benefit) cost...................................
2004
$ 7.8
10.4
(16.8)
0.3
(0.6)
0.4
$ 1.5
Pension
2003
2002
2004
Postretirement
2003
2002
7.0
9.9
(16.7)
0.3
(0.7)
-
(0.2)
5.5
9.4
(16.7)
0.3
(0.6)
-
(2.1)
3.6
5.0
(0.2)
0.5
-
-
8.9
3.2
4.7
(0.2)
0.5
-
-
8.2
2.4
4.2
(0.2)
-
0.5
(0.3)
6.6
The Company had no additional minimum liability included in other comprehensive income for the pension and postretirement plans for 2004,
2003 and 2002.
60
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
Summarized in the following table are the weighted average assumptions used to determine the Company’s benefit obligations for the year
ended December 31:
Pension
Postretirement
2004
2003
2004
2003
Benefit obligations weighted-average assumptions:
Discount rate..............................................................
Rates of increase in compensation levels......................
6.50%
5.00
6.50%
5.00
6.50%
-
6.50%
-
Summarized in the following table are the weighted average assumptions used to determine the Company’s net periodic benefit cost for the
years ended December 31, 2004, 2003 and 2002:
2004
Pension
2003
2002
2004
Postretirement
2003
2002
Periodic (benefit) cost
Weighted-average assumptions:
Discount rate ..............................................................
Expected long-term rate of return on assets..................
Rates of increase in compensation levels ......................
6.50%
9.00
5.00
6.75%
9.00
5.00
7.50%
9.00
5.00
6.50%
9.00
-
6.75%
9.00
-
7.50%
8.50
-
The Company’s defined benefit plan obligations are long-term in nature and consequently the investment strategies have a long-term time
horizon. In establishing the long term rate of return assumption on plan assets, management, along with its pension consulting actuary, reviews the
historical performance of the plan assets and the stability in mix of investment portfolio. The expected inflation rate and expected real rates of return of
applicable asset classes are then determined to assist in setting appropriate assumptions. The relatively stable investment strategy between fixed
maturities and equity securities has produced a 10 year average rate of return on plan assets through September 30, 2004 of 12.02%.
The assumed health care cost trend rates used for the year ended December 31, are as follows:
Assumed health care cost trend rates:
Health care cost trend rate assumed for the next year .....................
Rate to which the cost trend rate is assumed to
decline (the ultimate trend rate) ...................................................
Year that the rate reaches the ultimate trend rate............................
10.00%
9.00%
10.00%
5.00%
2010
5.00%
2008
5.00%
2008
2004
Postretirement
2003
2002
The assumed health care cost trend rates have a significant effect on the amounts reported for the postretirement plan. A one percentage
point change in assumed health care cost trend rates would have the following effects for the year ended December 31, 2004:
($ millions)
Postretirement
Increase
(Decrease)
One percentage point change:
Effect on total service and interest cost.....................................
Effect on accumulated postretirement
benefit obligation ..................................................................
$ 2.0
18.9
$ (1.6)
(15.2)
61
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 pension and postretirement benefit plans’ weighted average asset allocations by asset category at the Plans’ measurement
date of September 30, 2004 and 2003, respectively, are as follows:
Pension
Postretirement
2004
2003
2004
2003
Asset Category:
Equity securities...............................................
Fixed maturity securities...................................
Preferred securities ..........................................
Cash and cash equivalents................................
Total.............................................................
59.5%
33.4
1.0
6.1
100.0
60.6%
37.8
0.9
0.7
100.0
-
100.0%
-
100.0%
-
100.0
-
100.0
The Plan’s investment policy objective is to preserve the investment principal while generating income and appreciation in fair value to meet
the Plans’ obligations. The Plans’ investment strategy and risk tolerance is balanced between meeting cash obligation requirements and a long term
relatively high risk tolerance. Since the nature and timing of the Plans’ liabilities and cash requirements are predictable, the liquidity requirements are
somewhat moderate. Therefore at least 75% of the Plans’ assets should be in public marketable securities. Bond investments will normally range from
10 to 20 years in maturity. Debt instruments, convertible debt and preferred stock are rated “A” or better by two major rating services. The equity
portfolio is comprised primarily of large capitalization, high quality stocks with a strong earnings growth and dividends payment history. Total holding of
a specific stock cannot exceed 2% of the outstanding stock. No one equity holding can be greater than 5% of the total equity portfolio. Total holdings
of bonds and stocks of any one corporation cannot exceed 5% of admitted assets.
The following table summarizes the Plans’ permitted asset allocation exposure range as a percent of total assets’ fair market value:
Investment Instrument:
Cash and cash equivalents .................................................................................
U.S. governments debt ......................................................................................
U.S. government agencies debt ..........................................................................
Corporate debt..................................................................................................
Preferred securities............................................................................................
Equity securities ................................................................................................
Convertible securities.........................................................................................
Private placement and other ..............................................................................
Exposure
Range
(0 to 100%)
10
100
50
20
10
70
25
6
The actuarially prepared funding amount to the pension plan ranges from the minimum amount the Company would be required to contribute
to the maximum amount that would be deductible for tax purposes. Contributed amounts in excess of the minimum amounts are deemed voluntary.
Amounts in excess of the maximum amount would be subject to an excise tax and may not be deductible for tax purposes. This range is generally not
determined until the second quarter with respect to the contribution year. The Company expects to contribute approximately $7.5 million during 2005
to its pension plan, depending on the actuarially calculated funding requirements of such plan. Postretirement and SERP plan payments are deductible
for tax purposes when paid.
The following benefit payments, which reflect expected future service, as appropriate, are expected to be paid:
($ millions)
Pension
Postretirement
2005..........................
2006..........................
2007..........................
2008..........................
2009..........................
2010-2014 .................
$ 7.5
7.3
7.4
7.6
7.9
50.9
3.5
3.8
4.1
4.3
4.7
30.9
All Company and affiliate personnel are employees of State Auto P&C. The Company, through State Auto P&C, provides management and
operation services under management agreements for all insurance and non-insurance affiliates. The net prepaid pension expense is carried on the
financial statements of the Company, and the annual periodic pension benefit or cost is allocated to affiliated companies based on allocations pursuant to
intercompany management agreements. The Company’s share of the 2004 net periodic cost was $1.5 million, and for 2003 and 2002 net periodic
benefits were $0.2 million and $2.1 million, respectively.
62
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
The postretirement net accrued obligation is also carried on the financial statements of the Company and the annual periodic postretirement
benefit or cost is allocated to affiliated companies based on allocations pursuant to intercompany management agreements. The Company’s share of the
2004, 2003, and 2002 net periodic cost was $8.9 million, $8.2 million, and $6.6 million, respectively.
Also, the Company has a supplemental executive retirement plan (“SERP”) for which the accrued obligation at December 31, 2004 and 2003
was $4.1 million, for both years, that is included in the balance sheet postretirement benefit liabilities amount.
The Company maintains a defined contribution plan that covers substantially all employees of the Company. The Company matches the first
2% of contributions of participants’ salary at the rate of 75 cents for each dollar contributed. Participant contributions of 3% to 6% are matched at a
rate of 50 cents for each dollar contributed. The Company’s share of the expense under the plan totaled $2.2 million, $2.1 million, and $2.0 million for
the years 2004, 2003, and 2002, respectively.
10. Stockholders' Equity
a.
Treasury Shares
On March 1, 2002, the State Auto Financial’s Board of Directors approved a plan to repurchase up to 1.0 million shares of common stock from
the public over a period extending to and through December 31, 2003. Through December 31, 2003, State Auto Financial repurchased 0.5 million
shares from the public under this plan of which 0.1 million and 0.4 million shares were purchased during 2003 and 2002, respectively. Repurchases
during 2003 and 2002 were funded through dividends from subsidiaries. There were no repurchases in 2004.
b. Dividend Restrictions and Statutory Financial Information
State Auto P&C, Milbank, Farmers, SA Ohio and SA National are subject to regulations and restrictions under which payment of dividends from
statutory earned surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Pursuant to these rules,
approximately $94.6 million is available for payment to State Auto Financial in 2005 without prior approval.
Reconciliations of statutory capital and surplus and net income (loss), as determined using statutory accounting practices, to the amounts
included in the accompanying consolidated financial statements as of December 31, are as follows:
($ millions)
2004
2003
Statutory capital and surplus of insurance subsidiaries .................................................................
Net assets of non-insurance parent and affiliates .........................................................................
Increases (decreases):
Deferred policy acquisition costs .....................................................................................
Net prepaid pension expense..........................................................................................
Postretirement benefit liability.........................................................................................
Deferred federal income taxes ........................................................................................
Fixed maturities at fair value...........................................................................................
Other, net .....................................................................................................................
$ 628.5
(103.6)
524.9
97.5
54.9
(27.8)
(45.1)
50.2
3.6
Stockholders’ equity per accompanying consolidated financial statements.....................................
$ 658.2
527.1
(120.9)
406.2
87.1
51.4
(24.6)
(44.9)
61.8
5.3
542.3
($ millions)
2004
Year ended December 31
2003
2002
Statutory net income of insurance subsidiaries ........................................................
Net income (loss) of non-insurance parent and affiliates ..........................................
Increases (decreases):
Deferred policy acquisition costs .....................................................................
Anticipated salvage and subrogation ...............................................................
Net prepaid pension benefit............................................................................
Postretirement benefit expense.......................................................................
Deferred federal income taxes ........................................................................
Other, net .....................................................................................................
$ 109.8
(0.6)
109.2
10.4
-
(1.5)
(3.2)
(1.4)
(3.5)
Net income per accompanying consolidated financial statements..............................
$ 110.0
54.5
1.6
56.1
9.2
-
0.2
(2.6)
(1.2)
1.9
63.6
17.0
2.5
19.5
10.8
0.9
0.5
(2.3)
7.7
(0.1)
37.0
63
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
11. Preferred Stock
State Auto Financial has authorized two classes of preferred stock. For both classes, upon issuance, the Board of Directors has authority to fix
and determine the significant features of the shares issued, including, among other things, the dividend rate, redemption price, redemption rights,
conversion features and liquidation price payable in the event of any liquidation, dissolution, or winding up of the affairs of State Auto Financial. See
Note 6a regarding State Auto Financial’s obligation to issue redeemable preferred shares to SPC in connection with its catastrophic reinsurance
arrangements with a financial institution.
The Class A preferred stock is not entitled to voting rights until, for any period, dividends are in arrears in the amount of six or more quarterly
dividends.
12. Stock Incentive Plans
The Company has stock option plans for certain directors and key employees. For each year, 2004 and 2003, the Non-employee Directors'
Stock Option Plan provided each non-employee director an option to purchase 4,200 shares of common stock. The Plan provides that such grants are
effective immediately following each annual meeting of the shareholders at an option price equal to the fair market value at the close of business on the
last trading day prior to the day of the annual meeting. The Company has reserved 0.3 million shares of common stock under this plan. These options
are exercisable at issuance to 10 years from date of grant. The Key Employees Stock Option 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
Compensation Committee of the Board of Directors. The Company has reserved 5.0 million shares of common stock under this plan. These options are
exercisable at such time or times as may be determined by a committee of the Company’s Board of Directors. Normally, these options are exercisable
from 1 to 10 years from date of grant.
The Company has an employee stock purchase plan with a dividend reinvestment feature, under which employees of the Company may
choose at two different specified time intervals each year to have up to 6% of their annual base earnings withheld to purchase the Company's common
stock. The purchase price of the stock is 85% of the lower of its beginning-of-interval or end-of-interval market price. The Company has reserved 2.4
million shares of common stock under this plan. At December 31, 2004 and 2003, 2.1 million and 2.0 million shares, respectively, have been purchased
under this plan.
The Company has a stock option incentive plan for certain designated independent insurance agencies that represent the Company and its
affiliates. The Company has reserved 0.4 million shares of common stock under this plan. The plan provides that the options become exercisable on the
first day of the calendar year following the agency’s achievement of specific production and profitability requirements over a period not greater than two
calendar years from date of grant or a portion thereof in the first calendar year in which an agency commences participation under the plan. Options
granted and vested under this plan have a 10-year term. The Company has accounted for this plan in its accompanying financial statements at fair
value. Expense of $0.2 million, $0.3 million and $0.2 million associated with this plan was recognized in 2004, 2003, and 2002, respectively. The fair
value of options granted to agencies was estimated at the reporting date or vesting date using the Black-Scholes option-pricing model.
Fair value .................................................................................................................
Expected dividend yield .............................................................................................
Risk free interest rate ................................................................................................
Expected volatility factor............................................................................................
Expected life in years ................................................................................................
$13.97
13.37
0.75%
4.11%
0.37
8.6
0.78%
4.07%
0.36
8.9
7.55
0.87%
4.50%
0.36
8.1
2004
2003
2002
A summary of the Company's total stock option activity and related information for these plans for the years ended December 31, 2004, 2003
and 2002, follows:
($ millions, except per share amounts)
2004
Weighted-
Average
Exercise Price
Options
2003
Weighted-
Average
Exercise Price
2002
Weighted-
Average
Exercise Price
Options
Options
Outstanding, beginning of year...........................
Granted .....................................................
Exercised ...................................................
Canceled....................................................
Outstanding, end of year....................................
2.6
0.4
(0.4)
-
2.6
$ 12.84
30.33
9.33
24.25
$ 16.46
2.8
0.4
(0.6)
-
2.6
10.98
18.51
7.22
16.24
12.84
2.8
0.4
(0.4)
-
2.8
9.58
16.00
5.11
-
10.98
64
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
A summary of information pertaining to the total options outstanding and exercisable as of December 31, 2004 follows:
($ millions, except per share amounts)
Options Outstanding
Options Exercisable
Weighted-Average
Remaining
Contractual Life
Number
Weighted-Average
Exercise Price
Number
Weighted-Average
Exercise Price
Range of Exercise Prices:
Less than $10.00 .........................................
$10.01 - $20.00...........................................
Greater than $20.01 ....................................
0.4
1.8
0.4
2.6
1.4
6.0
9.4
5.9
$ 7.05
14.98
30.32
$ 16.46
0.4
1.4
-
1.8
$ 7.05
14.30
29.40
$ 13.14
13. Net Earnings Per Common Share
The following table sets forth the compilation of basic and diluted net earnings per common share for the year ended December 31:
($ millions, except per share amounts)
2004
2003
2002
Numerator:
Net earnings for basic and
diluted earnings per common share...................................................
Denominator:
Weighted average shares for basic net earnings
per common share ...........................................................................
Effect of dilutive stock options.............................................................
Adjusted weighted average shares for diluted
net earnings per common share......................................................
39.9
0.9
$ 40.8
Basic net earnings per common share....................................................
Diluted net earnings per common share.................................................
$ 2.76
$ 2.70
$ 110.0
63.6
37.0
39.0
0.7
39.7
0.95
0.93
39.3
0.9
40.2
1.62
1.58
The following options to purchase shares of common stock were not included in the computation of diluted earnings per share because the
exercise price of the options was greater than the average market price for the year ended December 31:
(in millions)
2004
2003
2002
Number of options................................................................
0.4
None
0.9
14. Other Comprehensive Income
The related federal income tax effects of each component of other comprehensive income (loss) for the year ended December 31, are as
follows:
($ millions)
2004:
Before-Tax
Amount
Tax (Expense)
or Benefit
Net-of-Tax
Amount
Net unrealized holding gains on securities:
Unrealized holding gains arising during the year ...............................................
Reclassification adjustments for gains realized in net income .............................
Net unrealized holding gains.........................................................................
Amortization of gain on derivative used in cash flow hedge ...............................
Other comprehensive income........................................................................
$ 8.0
7.6
0.4
(0.1)
$ 0.3
(2.9)
(2.7)
(0.2)
-
(0.2)
5.1
4.9
0.2
(0.1)
0.1
65
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
($ millions)
2003:
Before-Tax
Amount
Tax (Expense)
or Benefit
Net-of-Tax
Amount
Net unrealized holding gains on securities:
Unrealized holding gains arising during the year ...............................................
Reclassification adjustments for gains realized in net income.............................
Net unrealized holding gains.........................................................................
Gain on derivative used in cash flow hedge ......................................................
Other comprehensive income........................................................................
$ 25.5
10.6
14.9
0.8
$ 15.7
2002:
Net unrealized holding gains on securities:
Unrealized holding gains arising during the year ...............................................
Reclassification adjustments for gains realized in net income .............................
Net unrealized holding gains.........................................................................
Other comprehensive income........................................................................
$ 52.8
5.9
46.9
$ 46.9
(8.9)
(3.7)
(5.2)
-
(5.2)
(18.5)
(2.1)
(16.4)
(16.4)
16.6
6.9
9.7
0.8
10.5
34.3
3.8
30.5
30.5
15. Reportable Segments
At December 31, 2004, the Company has three reportable segments: State Auto standard insurance, State Auto nonstandard insurance, and
investment management services. The reportable segments are business units managed separately because of the differences in products or service
they offer, type of customer they serve or because of management considerations. The State Auto standard and State Auto nonstandard segments
operate primarily in the central and eastern United States, excluding New York, New Jersey, and the New England states, distributing products through
the independent insurance agency system.
The State Auto standard insurance segment provides personal and commercial insurance to its policyholders. Its principal lines of business
include personal and commercial automobile, homeowners, commercial multi-peril, workers’ compensation, general liability and fire insurance. The State
Auto nonstandard insurance segment provides personal automobile insurance to policyholders that are typically rejected or canceled by standard
insurance carriers because of various reasons deemed relevant to such carriers.
The investment management services segment manages the investment portfolios of affiliated insurance companies.
The Company evaluates performance of its reportable segments and allocates resources thereon based on profit or loss from operations,
excluding net realized gains on investments on the Company’s investment portfolio, before federal income taxes. The accounting policies of the
reportable segments are the same as those described in the summary of significant accounting policies.
Revenue from segments in the other category is attributable to three other operating segments of the Company, which individually are not
material: management and operations services segment, an insurance software development and resale segment, and a property management and
leasing segment.
The following provides financial information regarding the Company’s reportable segments for the year ended December 31:
($ millions)
2004
2003
2002
Revenues from external customers:
State Auto standard insurance .....................................................................................
State Auto nonstandard insurance ................................................................................
Investment management services ................................................................................
All other ....................................................................................................................
Total revenues from external customers.....................................................................
$ 1,001.4
76.1
2.9
3.6
1,084.0
Intersegment revenues:
State Auto standard insurance .....................................................................................
Investment management services ................................................................................
All other ....................................................................................................................
Total intersegment revenues......................................................................................
Total revenue...........................................................................................................
0.2
6.6
1.7
8.5
1,092.5
939.0
85.8
2.5
3.6
1,030.9
0.1
5.9
1.9
7.9
1,038.8
879.3
76.6
2.5
3.2
961.6
0.1
5.0
2.2
7.3
968.9
66
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
($ millions)
2004
2003
2002
Reconciling items:
Intersegment revenues................................................................................................
Corporate revenues .....................................................................................................
Net realized gains on investment..................................................................................
Total consolidated revenues.......................................................................................
(8.5)
0.8
7.6
$ 1,092.4
(7.9)
0.2
10.6
1,041.7
(7.3)
-
5.9
967.5
Segment profit (loss):
State Auto standard insurance .....................................................................................
State Auto nonstandard insurance ................................................................................
Investment management services ................................................................................
All other ....................................................................................................................
Total segment profit..................................................................................................
$ 135.3
9.8
8.6
1.0
154.7
Reconciling items:
Corporate expenses.....................................................................................................
Net realized gains on investments ................................................................................
Total consolidated income before federal income taxes................................................
(10.7)
7.6
$ 151.6
Net investment income:
State Auto standard insurance .....................................................................................
State Auto nonstandard insurance ................................................................................
Investment management services ................................................................................
All other ....................................................................................................................
Total net investment income......................................................................................
Reconciling items:
Corporate net investment income .................................................................................
Reclassification adjustments in consolidation .................................................................
Total consolidated net investment income...................................................................
$ 59.8
4.0
0.2
0.2
64.2
0.8
6.8
$ 71.8
60.8
6.7
7.4
2.2
77.1
(4.4)
10.6
83.3
55.3
3.1
0.1
0.1
58.6
0.1
5.9
64.6
22.2
4.1
6.4
1.9
34.6
(2.7)
5.9
37.8
51.5
2.8
0.1
0.2
54.6
-
5.1
59.7
($ millions)
Segment assets:
December 31
2004
2003
Standard insurance ..................................................................................................
Nonstandard insurance .............................................................................................
Investment management services .............................................................................
All other ..................................................................................................................
Total segment assets................................................................................................
Reconciling items:
$ 1,970.0
130.5
8.3
14.0
2,122.8
Corporate assets ......................................................................................................
Reclassification adjustments in consolidation..............................................................
Total consolidated assets.................................................................................................
40.4
(139.5)
$ 2,023.7
1,962.5
140.8
4.7
16.3
2,124.3
22.0
(309.7)
1,836.6
67
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
Revenues from external customers include the following products and services for the year ended December 31:
($ millions)
Earned premiums:
State Auto standard insurance:
2004
2003
2002
Automobile - Personal .......................................................................
Automobile - Commercial...................................................................
Homeowners and farmowners............................................................
Commercial multi-peril.......................................................................
Workers’ compensation .....................................................................
Fire and allied ...................................................................................
Other liability and products liability.....................................................
Other lines........................................................................................
Total State Auto standard insurance earned premiums................................
Total State Auto nonstandard insurance earned premiums ..........................
Total earned premiums.............................................................................
Investment management services..............................................................
Net investment income..............................................................................
Other income ..........................................................................................
$ 384.9
99.8
165.9
78.9
30.9
76.8
67.2
30.9
935.3
71.5
1,006.8
2.5
71.0
3.7
365.9
99.7
148.6
79.2
32.6
66.7
56.2
29.4
878.3
82.3
960.6
2.2
64.5
3.6
Total revenues from external customers.....................................................
$ 1,084.0
1,030.9
338.3
97.1
133.5
76.2
39.3
58.4
51.1
29.1
823.0
73.6
896.6
2.5
59.6
2.9
961.6
The standard insurance segment participates in a reinsurance pooling agreement with other standard insurance affiliates. For discussion
regarding this arrangement and this segment contribution to the pool and participation in the pool, see Note 6. Revenues from external customers are
derived entirely within the United States. Also, all long-lived assets are located within the United States.
16. Quarterly Financial Data (Unaudited)
($ millions, except per share amounts)
March 31
June 30
September 30
December 31
2004
For three months ended
Total revenues ..............................................................
Income before federal income taxes...............................
Net income ...................................................................
Net earnings per common share:
Basic ....................................................................
Diluted .................................................................
$ 273.1
46.0
32.4
0.82
0.80
273.1
49.2
34.6
0.87
0.85
273.2
2.6
5.0
0.12
0.12
273.0
53.8
38.0
0.95
0.93
($ millions, except per share amounts)
March 31
June 30
September 30
December 31
2003
For three months ended
Total revenues ..............................................................
Income before federal income taxes ...............................
Net income ...................................................................
Net earnings per common share:
Basic ....................................................................
Diluted..................................................................
$ 253.3
28.6
21.1
0.54
0.53
263.2
8.9
8.3
0.21
0.21
265.1
20.8
15.6
0.40
0.38
260.1
25.0
18.7
0.47
0.46
17. Contingencies
The Company’s insurance subsidiaries are involved in litigation and may become involved in potential litigation arising in the ordinary course of
business. Additionally, the insurance subsidiaries may be impacted by adverse regulatory actions and adverse court decisions where insurance coverages
are expanded beyond the scope originally contemplated in the policies at December 31, 2004. In the opinion of management, the effects, if any, of such
litigation and published court decisions are not expected to be material to the consolidated financial statements.
68
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Notes to Consolidated Financial Statements, Continued
18.
Subsequent Event (Unaudited)
Effective January 1, 2005, the pooling arrangement was amended to make the Meridian Insurers participants. The STFC Pooled Companies’
pooling participation percentages remain at 80%. In conjunction with this amendment, the STFC Pooled Companies received $54.0 million in cash from
the Meridian Insurers, which related to the additional net insurance liabilities assumed on January 1, 2005. The following table presents the impact on
the Company’s balance sheet relating to the additional net insurance liabilities assumed on this date.
($ millions)
Losses and loss expense payable...............................
Unearned premiums .................................................
Deferred policy acquisition costs................................
Net cash received...................................................
$ 35.3
24.0
(5.3)
$ 54.0
69
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A. Controls and Procedures
Management’s Annual Report on Internal Control Over Financial Reporting
Management’s annual report on internal control over financial reporting required by Item 308(a) of Regulation S-K follows. The attestation
report of the independent registered public accounting firm required by Item 308(b) of Regulation S-K is found under the caption “Report of the
Independent Registered Public Accounting Firm” in Item 8 of this Form 10-K.
The following report is provided by the Company’s management on the Company’s internal control over financial reporting (as defined in Rules
13a-15(f) and 15d-15(f) of the Exchange Act):
1.
2.
The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting for the
Company.
The Company’s management has used the Committee Of Sponsoring Organizations of the Treadway Commission (COSO) framework to
evaluate the effectiveness of the Company’s internal control over financial reporting. Management believes that the COSO framework is a
suitable framework for its evaluation of the Company’s internal control over financial reporting because it is free from bias, permits reasonably
qualitative and quantitative measurements of the Company’s internal controls, is sufficiently complete so that those relevant factors that would
alter a conclusion about the effectiveness of the Company’s internal controls are not omitted and is relevant to an evaluation of internal control
over financial reporting.
3. Management has assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, and has
concluded that such internal control over financial reporting is effective. There are no material weaknesses in the Company’s internal control
over financial reporting that have been identified by management.
Our management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, has
been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included herein.
Disclosure Controls and Procedures
The Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the
Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and
procedures (as defined in Exchange Act Rule 13a-15(e)). Based upon that evaluation, the Company's Chief Executive Officer and Chief Financial Officer
concluded that, as of the end of the period covered by this report, the Company's disclosure controls and procedures were effective in timely alerting
them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings
with the Securities and Exchange Commission.
Changes in Internal Control over Financial Reporting
There has been no change in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal
quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting.
Item 9B. Other information
Not applicable.
Item 10. Directors and Executive Officers of the Registrant
PART III
Information regarding directors of the Company required by Items 401(a) and (d)-(f) of Regulation S-K will be found under the caption
“Proposal One: Election of Directors” in the 2005 Proxy Statement, which information is incorporated herein by reference. Information regarding
executive officers of the Company required by Items 401(b) and (d)-(f) of Regulation S-K is found under the caption “Executive Officers of the
Registrant” at the end of Item 1 of this Form 10-K, which information is also incorporated by reference into this Item 10.
The Company has a separately-designated standing Audit Committee established in accordance with Section 3(a)(58)(A) of the Exchange Act.
As of March 4, 2005, the members of the Audit Committee were Richard K. Smith, David J. D’Antoni, William J. Lhota, and Paul S. Williams. Mr. Smith is
Chairman of the Audit Committee. The Company’s Board of Directors has determined that Mr. Smith is an “audit committee financial expert,” as that
term is defined in Item 401(h)(2) of Regulation S-K, and “independent,” as that term is defined in Rule 10A-3 of the Exchange Act.
Information regarding compliance with Section 16(a) of the Exchange Act required by Item 405 of Regulation S-K will be found under the
caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2005 Proxy Statement, which information is incorporated herein by reference.
70
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The Company’s Board of Directors has adopted a code of ethics that applies to the Company’s principal executive officer, principal financial
officer, principal accounting officer, controller, and persons performing similar functions. This code of ethics has been posted on the Company’s website
at http://www.stfc.com under “Corporate Governance.” Any amendment (other than any technical, administrative or other non-substantive amendment)
to, or waiver from, a provision of this code will be posted on the Company’s website described above within five business days following its occurrence.
Item 11. Executive Compensation
Information regarding executive compensation required by Item 402 of Regulation S-K will be found under the captions “Compensation of
Directors,” “Compensation of Executive Officers,” “Compensation Committee Interlocks and Insider Participation,” “Compensation Committee Report,”
and “Performance Graph” in the 2005 Proxy Statement, which information is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information regarding security ownership of certain beneficial owners and management required by Item 403 of Regulation S-K will be found
under the caption “Proposal One: Election of Directors” and “Principal Holders of Voting Securities” in the 2005 Proxy Statement, which information is
incorporated herein by reference.
Information regarding equity compensation plan information required by Item 201(d) of Regulation S-K will be found under the caption
“Equity Compensation Plan Information” in the 2005 Proxy Statement, which information is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions
Information regarding certain relationships and related transactions required by Item 404 of Regulation S-K will be found under the caption
“Certain Transactions” in the 2005 Proxy Statement, which information is incorporated herein by reference.
Item 14. Principal Accountant Fees and Services
Information regarding principal accountant fees and services required by Item 9(e) of Schedule 14A will be found under the caption
“Independent Public Accountants” in the 2005 Proxy Statement, which information is incorporated herein by reference.
Item 15. Exhibits and Financial Statement Schedules
(a)(1)
LISTING OF FINANCIAL STATEMENTS
PART IV
The following consolidated financial statements of the Company are filed as part of this Form 10-K and are included in Item 8:
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of
December 31, 2004 and 2003
Consolidated Statements of Income for
each of the three years in the
period ended December 31, 2004
Consolidated Statements of Stockholders’
Equity for each of the three years in the
period ended December 31, 2004
Consolidated Statements of Cash Flows for
each of the three years in the
period ended December 31, 2004
Notes to Consolidated Financial Statements
71
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
(a)(2)
LISTING OF FINANCIAL STATEMENT SCHEDULES
The following financial statement schedules of the Company for the years 2004, 2003, and 2002 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.
Schedule
Number
I.
II.
III.
IV.
Schedule
Summary of Investments - Other Than Investments in
Related Parties
Condensed Financial Information of Registrant
Supplementary Insurance Information
Reinsurance
All other schedules and footnotes are omitted because they are not applicable or the required information is included in the
consolidated financial statements or notes thereto.
72
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
(a)(3) LISTING OF EXHIBITS
Exhibit
No.
Description of Exhibit
If incorporated by reference document with which
Exhibit was previously filed with SEC
3.01
3.02
3.03
3.04
4.01
10.01
10.02
State Auto Financial Corporation's Amended and Restated
Articles of Incorporation
1933 Act Registration Statement No. 33-40643 on
Form S-1 (see Exhibit 3(a) therein)
State Auto Financial Corporation's Amendment to the Amended
and Restated Articles of Incorporation
1933 Act Registration Statement No. 33-89400 on
Form S-8 (see Exhibit 4(b) therein)
State Auto Financial Corporation Certificate of Amendment to
the Amended and Restated Articles of Incorporation as of June
2, 1998
Form 10-K Annual Report for the year ended
December 31, 1998 (see Exhibit 3(A)(3) therein)
State Auto Financial Corporation's Amended and Restated Code
of Regulations
1933 Act Registration Statement No. 33-40643 on
Form S-1 (see Exhibit 3(b) therein)
State Auto Financial Corporation's Amended and Restated
Articles of Incorporation, and Articles 1, 3, 5 and 9 of the
Company's Amended and Restated Code of Regulations
Form 10-K Annual Report for the year ended
December 31, 1992 (see Exhibit 3(A) and 3(B)
therein)
Guaranty Agreement between State Automobile Mutual
Insurance Company and State Auto Property and Casualty
Insurance Company dated as of May 16, 1991
1933 Act Registration Statement No. 33-40643 on
Form S-1 (see Exhibit 10 (d) therein)
Form of Indemnification Agreement between State Auto
Financial Corporation and each of its directors
1933 Act Registration Statement No. 33-40643 on
Form S-1 (see Exhibit 10 (e) therein)
10.03*
State Auto 1991 Quality Performance Bonus Plan
10.04*
1991 Stock Option Plan
10.05*
Amendment Number 1 to the 1991 Stock Option Plan
10.06 *
1991 Directors' Stock Option Plan
1933 Act Registration Statement No. 33-40643 on
Form S-1 (see Exhibit 10 (f) therein)
1933 Act Registration Statement No. 33-40643 on
Form S-1 (see Exhibit 10 (h) therein)
1933 Act Registration Statement No. 33-89400 on
Form S-8 (see Exhibit 4 (a) therein)
1933 Act Registration Statement No. 33-40643 on
Form S-1 (see Exhibit 10 (i) therein)
10.07
10.08
10.09*
10.10*
License Agreement between State Automobile Mutual
Insurance Company and Policy Management Systems
Corporation dated December 28, 1984
1933 Act Registration Statement No. 33-40643 on
Form S-1 (see Exhibit 10 (k) therein)
Investment Management Agreement between Stateco Financial
Services,
Insurance
Inc. and State Automobile Mutual
Company, effective April 1, 1993
Form 10-K Annual Report for the year ended
December 31, 1992 (see Exhibit 10 (N) therein)
State Auto
Compensation Plan
Insurance Companies Directors’ Deferred
Form 10-K Annual Report
December 31, 1995 (see Exhibit 10(S) therein)
for year ended
State Auto Insurance Companies Amended and Restated Non-
Qualified Incentive Deferred Compensation Plan
Registration Statement on Form S-8, File No. 333-
56338 (see Exhibit 4(e) therein)
10.11*
Amendment Number 2 to the 1991 Stock Option Plan
10.12*
Amendment Number 1 to the 1991 Directors’ Stock Option Plan
Form 10-K Annual Report for the year ended
December 31, 1996 (see Exhibit 10(DD) therein)
Form 10-K Annual Report for the year ended
December 31, 1996 (see Exhibit 10(EE) therein)
73
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Exhibit
No.
10.13
10.14
10.15
10.16
10.17
10.18
10.19
10.20*
10.21
Description of Exhibit
Amended and Restated SERP of State Auto Mutual effective as
of January 1, 1994
Credit Agreement dated as of June 1, 1999 between State Auto
Financial Corporation and State Automobile Mutual Insurance
Company
Reinsurance Pooling Agreement amended and restated as of
January 1, 2000 by and among State Automobile Mutual
Insurance Company, State Auto Property and Casualty
Insurance Company, Milbank Insurance Company, Midwest
Security Insurance Company (n/k/a State Auto Insurance
Company of Wisconsin), Farmers Casualty Insurance Company
and State Auto Insurance Company (n/k/a State Auto
Insurance Company of Ohio)
Management and Operations Agreement as of January 1, 2000
among State Automobile Mutual Insurance Company, State
Auto Financial Corporation, State Auto Property and Casualty
Insurance Company, State Auto National Insurance Company,
Milbank Insurance Company, State Auto Insurance Company
(n/k/a State Auto Insurance Company of Ohio), Stateco
Financial Services, Inc., Strategic Insurance Software, Inc., 518
Property Management and Leasing, LLC
to
First Amendment
the Management and Operations
Agreement effective January 1, 2000 among State Automobile
Mutual Insurance Company, State Auto Financial Corporation,
State Auto Property and Casualty Insurance Company, State
Auto National
Insurance
Company, State Auto Insurance Company (n/k/a State Auto
Insurance Company of Ohio), Stateco Financial Services, Inc.,
Strategic
Inc. and 518 Property
Management and Leasing, LLC
Insurance Company, Milbank
Insurance Software,
If incorporated by reference document with which
Exhibit was previously filed with SEC
Form 10-K Annual Report for the year ended
December 31, 1997 (see Exhibit 10(HH) therein)
Form 10-Q for the period ended June 30, 1999
(see Exhibit 10(LL) therein)
Form 10-K Annual Report for the year ended
December 31, 1999 (see Exhibit 10(W) therein)
Form 10-K Annual Report for the year ended
December 31, 1999 (see Exhibit 10(X) therein)
Form 10-K Annual Report for the year ended
December 31, 1999 (see Exhibit 10(Z) therein)
First Amendment to the June 1, 1999 Credit Agreement dated
November 1, 1999 between State Auto Financial Corporation
and State Automobile Mutual Insurance Company
Form 10-K Annual Report for the year ended
December 31, 1999 (see Exhibit 10(AA) therein)
Second Amendment to the June 1, 1999 Credit Agreement
dated December 1, 1999 between State Auto Financial
Corporation and State Automobile Mutual Insurance Company
Form 10-Q for the period ended March 31, 2000
(see Exhibit 10(BB) therein)
Form of Executive Agreement between State Auto Financial
Corporation and certain executive officers
Form 10-K Annual Report for the year ended
December 31, 2000 (see Exhibit 10(CC) therein)
First Amendment to the Reinsurance Pooling Agreement
Amended and Restated as of January 1, 2000 by and among
State Auto Property and Casualty Insurance Company, State
Automobile Mutual Insurance Company, Milbank Insurance
Company, Midwest Security Insurance Company (n/k/a State
Auto Insurance Company of Wisconsin), Farmers Casualty
Insurance Company and State Auto Insurance Company (n/k/a
State Auto Insurance Company of Ohio)
Form 10-K Annual Report for the year ended
December 31, 2000 (see Exhibit 10(DD) therein)
10.22*
2000 Stock Option Plan
74
000-19289,
Definitive Proxy Statement on Form DEF 14A, File
No.
of
Shareholders held on May 26, 2000 (see
Appendix A therein)
for Annual Meeting
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Exhibit
No.
Description of Exhibit
If incorporated by reference document with which
Exhibit was previously filed with SEC
10.23*
2000 Directors Stock Option Plan
10.24*
First Amendment to 2000 Directors Stock Option Plan
10.25*
Second Amendment to the Reinsurance Pooling Agreement
Amended and Restated as of January 1, 2000, by the State
Automobile Mutual Insurance Company, State Auto Property
Insurance
and Casualty
Company, Midwest Security Insurance Company (n/k/a State
Auto Insurance Company of Wisconsin), Farmers Casualty
Insurance Company and State Auto Insurance Company (n/k/a
State Auto Insurance Company of Ohio)
Insurance Company, Milbank
10.26*
Second Amendment to 1991 Directors Stock Option Plan
10.27*
Second Amendment to 2000 Directors Stock Option Plan
10.28*
Third Amendment to 2000 Directors Stock Option Plan
000-19289,
Definitive Proxy Statement on Form DEF 14A, File
No.
of
Shareholders held on May 26, 2000 (see
Appendix B therein)
for Annual Meeting
Form 10-Q for the period ended March 31, 2001
(see Exhibit 10(HH) therein)
Form 10-Q for the period ended June 30, 2001
(see Exhibit 10(II) therein)
Form 10-Q for the period ended September 30,
2001 (see Exhibit 10(JJ) therein)
Form 10-Q for the period ended September 30,
2001 (see Exhibit 10(KK) therein)
Form 10-K Annual Report for the year ended
December 31, 2001 (see Exhibit 10(EE) therein)
10.29
10.30
10.31
10.32
10.33
10.34
Third Amendment
Agreement, Amended and Restated as of January 1, 2000
to State Auto Reinsurance Pooling
Form 10-K Annual Report for the year ended
December 31, 2001 (see Exhibit 10(FF) therein)
Stop Loss Reinsurance Agreement dated October 1, 2001
among inter alia Mutual and State Auto P&C
Form 10-K Annual Report for the year ended
December 31, 2001 (see Exhibit 10(GG) therein)
Amendment No. 2 to the Management and Operations
Agreement dated January 1, 2000 among, inter alia, Mutual
and State Auto P&C
Form 10-K Annual Report for the year ended
December 31, 2001 (see Exhibit 10(HH) therein)
Amendment No. 3 to Management and Operations Agreement
effective January 1, 2002, among State Automobile Mutual
Insurance Company, State Auto Financial Corporation, State
Auto Property and Casualty Insurance Company, State Auto
National Insurance Company, Milbank Insurance Company,
State Auto Insurance Company, Stateco Financial Services,
Inc., Strategic Insurance Software, Inc., and 518 Property
Management and Leasing, LLC
Management Services Agreement as of July 1, 2002 by and
among State Auto Property and Casualty Insurance Company,
Meridian Insurance Group, Inc., Meridian Security Insurance
Company, Meridian Citizens Mutual Insurance Company and
Great Northwest Insurance Company
Cost Sharing Agreement among State Auto Property and
Casualty
Insurance Company, State Automobile Mutual
Insurance Company, and State Auto Florida Insurance
Company effective January 1, 2003
Form 10-Q for the period ended June 30, 2002
(see Exhibit 10(LL) therein)
Form 10-Q for the period ended September 30,
2002 (see Exhibit 10(NN) therein)
Form 10-K Annual Report for year ended 12-31-
02 (see Exhibit 10(OO) therein)
10.35
Fourth Amendment
Agreement, Amended and Restated as of January 1, 2000
to State Auto Reinsurance Pooling
Form 10-K Annual Report for year ended 12-31-
02 (see Exhibit 10(TT) therein)
10.36*
Fourth Amendment to 2000 Directors Stock Option Plan
Form 10-K Annual Report for year ended 12-31-
02 (see Exhibit 10(UU) therein)
75
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Exhibit
No.
Description of Exhibit
If incorporated by reference document with which
Exhibit was previously filed with SEC
10.37
10.38
10.39
10.40
10.41
10.42
10.43
10.44
10.45
10.46
10.47
10.48
10.49
10.50
Employment Agreement dated as of May 22, 2003, between
State Auto Financial Corporation and Robert H. Moone
Form 10-Q for the period ending June 30, 2003
(see 10(WW) therein)
Amended and Restated Declaration of Trust of STFC Capital
Trust I, dated as of May 22, 2003
Form 10-Q for the period ending June 30, 2003
(see 10(XX) therein)
Indenture dated as of May 22, 2003, for Floating Rate Junior
Subordinated Debt Securities Due 2033
Form 10-Q for the period ending June 30, 2003
(see 10(YY) therein)
Amendment No. 3 to 1991 Stock Option Plan Effective January
1, 2001
Form 10-Q for the period ending September 30,
2003 (see 10.01) therein)
Amendment No. 1 to 2000 Stock Option Plan Effective January
1, 2001
Form 10-Q for the period ending September 30,
2003 (see 10.02) therein
Property Catastrophe Overlying Excess of Loss Reinsurance
Contract effective as of July 1, 2003
Form 10-K Annual Report for the year ended
December 31, 2003 (see Exhibit 10.46 therein)
Property Catastrophe Overlying Excess of Loss Reinsurance
Contract effective as of July 1, 2004
Included herein
Credit Agreement Among SAF Funding Corporation, The
Lenders and KeyBank National Association dated November
12, 2003
Form 8-K Current Report filed on December 16,
2003 (see Exhibit 10.01 therein)
Put Agreement among State Automobile Mutual Insurance
Company, State Auto Financial Corporation and KeyBank
National Association dated November 12, 2003
Form 8-K Current Report filed on December 16,
2003 (see Exhibit 10.02 therein)
Standby Purchase Agreement between State Auto Financial
Corporation and SAF Funding Corporation dated November 12,
2003
Form 8-K Current Report filed on December 16,
2003 (see Exhibit 10.03 therein)
Standby Confirmation, effective November 10, 2004, to the
Standby Purchase Agreement between State Auto Financial
Corporation and SAF Funding Corporation dated November 12,
2003
Included herein
Acknowledgment of Extension and First Amendment to Put
Agreement effective November 10, 2004
Included herein
Confirmation of Extension and First Amendment to Credit
Agreement effective November 10, 2004
Included herein
Indenture dated as of November 13, 2003, among State Auto
Financial Corporation, as Issuer, and Fifth Third Bank as
Trustee
Securities Act Registration Statement on Form S-4
(File No. 333-111507)(see Exhibit 4.01 therein)
10.51
Form of 6 1/4% Senior Note due 2013 (Exchange Note)
Securities Act Registration Statement on Form S-4
(File No. 333-111507)(see Exhibit 4.02 therein)
10.52
10.53
State Auto Insurance Companies Quality Performance Bonus
Plan Amended and Restated as of April 1, 2004
Form 10-Q for the period ending June 30, 2004
(see Exhibit 10.53 therein)
State Auto Insurance Companies Quality Performance Bonus
Plan 2004 Addendum
Form 10-Q for the period ending June 30, 2004
(see Exhibit 10.54 therein)
76
Exhibit
No.
10.54
10.55
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Description of Exhibit
If incorporated by reference document with which
Exhibit was previously filed with SEC
Fifth Amendment to the Reinsurance Pooling Agreement
Amended and Restated as of January 1, 2000 by and among
State Automobile Mutual Insurance Company, State Auto
Property and Casualty Insurance Company, Milbank Insurance
Company, State Auto Insurance Company of Wisconsin,
Farmers Casualty Insurance Company, State Auto Insurance
Company of Ohio and State Auto Florida Insurance Company
Reinsurance Pooling Agreement Amended and Restated as of
January 1, 2005 by and among State Automobile Mutual
Insurance Company, State Auto Property and Casualty
Insurance Company, Milbank Insurance Company, State Auto
Insurance Company of Wisconsin, Farmers Casualty Insurance
Company, State Auto Insurance Company of Ohio, State Auto
Florida Insurance Company, Meridian Security Insurance
Company, and Meridian Citizens Mutual Insurance Company
Form 10-Q for the period ending June 30, 2004
(see Exhibit 10.55 therein)
Included herein
21.01
List of Subsidiaries of State Auto Financial Corporation
Included herein
23.01
Consent of Independent Registered Public Accounting Firm
Included herein
24.01
Powers of Attorney – William J. Lhota, Urlin G. Harris, Jr., Paul
W. Huesman, and David J. D’Antoni
Form 10-Q for the period ended June 30, 1997
(see Exhibit 24(C) therein)
24.02
Power of Attorney – John R. Lowther
24.03
Power of Attorney – Robert H. Moone
24.04
Power of Attorney – Richard K. Smith
24.05
Power of Attorney – S. Elaine Roberts
24.06
Power of Attorney – Paul S. Williams
24.07
Power of Attorney – James E. Kunk
Form 10-Q for the period ended March 31, 1998
(see Exhibit 24(D) therein)
Form 10-K Annual Report for the year ended
December 31, 1998 (see Exhibit 24(E) therein)
Form 10-K Annual Report for the year ended
December 31, 2000 (See Exhibit 24(D) therein)
Form 10-K Annual Report for the year ended
December 31, 2002 (See Exhibit 24(F) therein)
Form 10-K Annual Report for the year ended
December 31, 2003 (See Exhibit 24.06 therein)
Included herein
Included herein
31.01
31.02
32.01
32.02
CEO certification required by Section 302 of Sarbanes-Oxley
Act of 2002
CFO certification required by Section 302 of Sarbanes-Oxley
Act of 2002
Included herein
CEO certification required by Section 906 of Sarbanes-Oxley
Act of 2002
Included herein
CFO certification required by Section 906 of Sarbanes-Oxley
Act of 2002
Included herein
*Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit.
_________________________________
(b) EXHIBITS
The exhibits have been submitted as a separate section of this report following the financial statement schedules.
(c) FINANCIAL STATEMENT SCHEDULES
The financial statement schedules have been submitted as a separate section of this report following the signatures and certifications.
77
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
(a majority-owned subsidiary of State Automobile Mutual Insurance Company)
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.
SIGNATURES
Dated: March 11, 2005
STATE AUTO FINANCIAL CORPORATION
/s/Robert H. Moone
Robert H. Moone
Chairman, President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Name
Title
Date
/s/Robert H. Moone
Robert H. Moone
/s/Steven J. Johnston
Steven J. Johnston
Chairman, President and
March 11, 2005
Chief Executive Officer
(principal executive officer)
Chief Financial Officer,
Senior Vice President, and Treasurer
(principal financial officer)
/s/ Cynthia A. Powell
Cynthia A. Powell
Vice President and Controller
(principal accounting officer)
David J. D’Antoni*
David J. D’Antoni
James E. Kunk*
James E. Kunk
Paul W. Huesman*
Paul W. Huesman
William J. Lhota*
William J. Lhota
John R. Lowther*
John R. Lowther
S. Elaine Roberts*
S. Elaine Roberts
Richard K. Smith*
Richard K. Smith
Paul S. Williams*
Paul S. Williams
Director
Director
Director
Director
Director
Director
Director
Director
March 11, 2005
March 11, 2005
March 11, 2005
March 11, 2005
March 11, 2005
March 11, 2005
March 11, 2005
March 11, 2005
March 11, 2005
March 11, 2005
*Steven J. Johnston by signing his name hereto, does sign this document on behalf of the person indicated above pursuant to a Power of
Attorney duly executed by such person.
/s/Steven J. Johnston
Steven J. Johnston
Attorney in Fact
March 11, 2005
78
Exhibit 23.01
Consent of Independent Registered Public Accounting Firm
We consent to the incorporation by reference in the following Registration Statements and related prospectuses of State Auto
Financial Corporation of our reports dated March 9, 2005, with respect to the consolidated financial statements and schedules
of State Auto Financial Corporation, State Auto Financial Corporation management’s assessment of the effectiveness of internal
control over financial reporting, and the effectiveness of internal control over financial reporting of State Auto Financial
Corporation, included in this Annual Report (Form 10-K) for the year ended December 31, 2004.
Form
S-8
S-8
S-8
S-8
S-8
S-8
S-3
S-3
S-4
Registration
Number
33-44667
33-89400
33-44666
33-41423
333-05755
333-56336
333-43882
333-43880
333-41849
333-90529
Description
1991 Stock Option Plan
1991 Directors’ Stock Option Plan
1991 Employee Stock Purchase and Dividend Reinvestment Plan
State Auto Insurance Companies Capital Accumulation Plan
2000 Directors’ Stock Option Plan
2000 Stock Option Plan
Monthly Stock Purchase Plan for Independent Agents
1998 State Auto Agents’ Stock Option Plan
333-111507
6 ¼% Senior Notes due 2013
Columbus, Ohio
March 9, 2005
/s/ Ernst & Young LLP
79
I, Robert H. Moone, certify that:
CERTIFICATION
EXHIBIT 31.01
1.
2.
3.
4.
I have reviewed this Form 10-K of State Auto Financial Corporation;
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this report;
Based on my knowledge, the financial statements, and other financial information included in this report, fairly
present in all material respects the financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls
and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial
reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a)
(b)
(c)
(d)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures
to be designed under our supervision, to ensure that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us by others within those entities,
particularly during the period in which this report is being prepared;
Designed such internal control over financial reporting, or caused such internal control over financial
reporting to be designed under our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles;
Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in
this report our conclusions about the effectiveness of the disclosure controls and procedures, as of
the end of the period covered by this report based on such evaluation; and
Disclosed in this report any change in the registrant's internal control over financial reporting that
occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the
case of an annual report) that has materially affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5.
The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal
control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of
directors:
(a)
(b)
All significant deficiencies and material weaknesses in the design or operation of internal control over
financial reporting which are reasonably likely to adversely affect the registrant's ability to record,
process, summarize and report financial information; and
Any fraud, whether or not material, that involves management or other employees who have a
significant role in the registrant's internal control over financial reporting.
Date:
March 11, 2005
/s/Robert H. Moone
Robert H. Moone, Chief Executive Officer
(Principal executive officer)
80
I, Steven J. Johnston, certify that:
CERTIFICATION
EXHIBIT 31.02
1.
2.
3.
4.
I have reviewed this Form 10-K of State Auto Financial Corporation;
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a
material fact necessary to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this report;
Based on my knowledge, the financial statements, and other financial information included in this report, fairly
present in all material respects the financial condition, results of operations and cash flows of the registrant as
of, and for, the periods presented in this report;
The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls
and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial
reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a)
(b)
(c)
(d)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures
to be designed under our supervision, to ensure that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us by others within those entities,
particularly during the period in which this report is being prepared;
Designed such internal control over financial reporting, or caused such internal control over financial
reporting to be designed under our supervision, to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles;
Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in
this report our conclusions about the effectiveness of the disclosure controls and procedures, as of
the end of the period covered by this report based on such evaluation; and
Disclosed in this report any change in the registrant's internal control over financial reporting that
occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the
case of an annual report) that has materially affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5.
The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal
control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of
directors:
(a)
(b)
All significant deficiencies and material weaknesses in the design or operation of internal control over
financial reporting which are reasonably likely to adversely affect the registrant's ability to record,
process, summarize and report financial information; and
Any fraud, whether or not material, that involves management or other employees who have a
significant role in the registrant's internal control over financial reporting.
Date:
March 11, 2005
/s/Steven J. Johnston
Steven J. Johnston, Chief Financial Officer
(Principal financial officer)
81
EXHIBIT 32.01
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Annual Report of State Auto Financial Corporation (the "Company") on Form 10-K for the period
ending December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Robert H.
Moone, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of
the Company.
/s/ Robert H. Moone
---------------------------------
Robert H. Moone
Chief Executive Officer
March 11, 2005
A signed original of this written statement required by Section 906 has been provided to State Auto Financial Corporation and will be
retained by State Auto Financial Corporation and furnished to the Securities and Exchange Commission or its staff upon request.
82
EXHIBIT 32.02
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Annual Report of State Auto Financial Corporation (the "Company") on Form 10-K for the period
ending December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Steven J.
Johnston, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002, that:
(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of
the Company.
/s/ Steven J. Johnston
--------------------------------------
Steven J. Johnston
Chief Financial Officer
March 11, 2005
A signed original of this written statement required by Section 906 has been provided to State Auto Financial Corporation and will be
retained by State Auto Financial Corporation and furnished to the Securities and Exchange Commission or its staff upon request.
83
Corporate
Information
CORPORATE HEADQUARTERS
State Auto Financial Corporation
518 E. Broad Street
Columbus, OH 43215
(614) 464-5000
www.STFC.com
ANNUAL MEETING
10 a.m. Wednesday, May 11, 2005,
at Corporate Headquarters
SHAREHOLDER INQUIRIES
Terrence Bowshier
Director of Investor Relations
State Auto Financial Corporation
518 E. Broad Street
Columbus, OH 43215
Phone (614) 464-5078
FAX (614) 464-5325
E-mail Terry.Bowshier@stateauto.com
INDEPENDENT AUDITORS
Ernst & Young LLP
One Columbus
10 W. Broad Street
Columbus, OH 43215
LEGAL COUNSEL
Baker & Hostetler LLP
65 E. State Street
Columbus, OH 43215
10-K REPORT
The Company’s 10-K report filed annualIy with
the Securities and Exchange Commission is
available at no cost by contacting Mr. Bowshier.
This report and other filings with the Securities and
Exchange Commission are also available free of
charge on the company’s Web site maintained at
www.STFC.com.
TRANSFER AGENT/REGISTRAR
National City Bank
Corporate Trust Operations
P.O Box 92301
Cleveland Ohio 44193-0900
Phone (800) 622-6757
STOCK TRADING
Common shares are traded in the Nasdaq
National Market System under the symbol
STFC. As of March 4, 2005, there were
898 shareholders of record of the Company’s
common shares.
MARKET PRICE RANGE, COMMON STOCK(1)
Initial Public Offering – June 28, 1991, $2.25
The high and low sale prices for each quarterly
period for the past two years as reported by
Nasdaq are:
2004
First Qtr.
Second Qtr.
Third Qtr.
Fourth Qtr.
2003
First Qtr.
Second Qtr.
Third Qtr.
Fourth Qtr.
$25.86
$22.12 $.040
31.08 23.02 .040
28.00 .045
31.83
23.70 .045
29.26
$17.75
$14.96 $.035
24.24 16.59 .035
21.45 .040
26.60
22.50 .040
26.90
(1) Adjusted for stock splits.
2004
Annual Report
State Auto
Financial Corporation
STATE AUTO®
Insurance Companies
®