-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, LinHCmF49KUHTPewsMcfVFJd6RRQiJo+nM5N4zCpyufogu+5JzEl2J+GnqMcM6xg bdhHjqgYeb5Mn+jysMHwTw== 0000950152-99-002621.txt : 19990331 0000950152-99-002621.hdr.sgml : 19990331 ACCESSION NUMBER: 0000950152-99-002621 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990330 FILER: COMPANY DATA: COMPANY CONFORMED NAME: STATE AUTO FINANCIAL CORP CENTRAL INDEX KEY: 0000874977 STANDARD INDUSTRIAL CLASSIFICATION: FIRE, MARINE & CASUALTY INSURANCE [6331] IRS NUMBER: 311324304 STATE OF INCORPORATION: OH FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-19289 FILM NUMBER: 99576959 BUSINESS ADDRESS: STREET 1: 518 E BROAD ST CITY: COLUMBUS STATE: OH ZIP: 43215-3976 BUSINESS PHONE: 6144645000 MAIL ADDRESS: STREET 1: 518 EAST BROAD STREET CITY: COLUMBUS STATE: OH ZIP: 43215 10-K 1 STATE AUTO FINANCIAL CORPORATION 10-K 1 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 For the fiscal year ended December 31, 1998 or [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ___________ to _____________ Commission File Number 0-19289 STATE AUTO FINANCIAL CORPORATION -------------------------------- (exact name of Registrant as specified in its charter) Ohio 31-1324304 - ------------------------------- ------------------------------------ (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 518 East Broad Street, Columbus, Ohio 43215-3976 - ------------------------------------- ---------- (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (614) 464-5000 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Shares, without par value -------------------------------- (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. On March 22, 1999, 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 $142,774,951. On March 22, 1999, the Registrant had 42,057,917 Common Shares outstanding. 2 Page 2 DOCUMENTS INCORPORATED BY REFERENCE 1. Portions of the Registrant's Proxy Statement relating to the annual meeting of shareholders to be held May 27, 1999, which Proxy Statement will be filed within 120 days of December 31, 1998, are incorporated by reference in Part III, Items 10, 11, 12 and 13 of this report. 3 Page 3 PART I ITEM 1. BUSINESS - ------- -------- (a) GENERAL DEVELOPMENT OF BUSINESS State Auto Financial Corporation, an Ohio corporation formed April 18, 1990 ("State Auto Financial" or "STFC"), is an insurance holding company headquartered in Columbus, Ohio, which engages, through its subsidiaries, primarily in the property and casualty insurance business. State Auto Financial is approximately 70% owned by State Automobile Mutual Insurance Company, an Ohio property and casualty insurance company formed in 1921 ("Mutual"). State Auto Financial owns 100% of the outstanding shares of State Auto Property and Casualty Insurance Company, a South Carolina corporation ("State Auto P&C") and Milbank Insurance Company, a South Dakota corporation ("Milbank"). State Auto P&C and Milbank are regional standard insurers engaged primarily in writing personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation and fire insurance. While Mutual originally acquired Milbank, Mutual sold Milbank to STFC in July 1998. State Auto Financial issued approximately 5.1 million shares of STFC to Mutual in exchange for 100% of the outstanding shares of Milbank and as a result, Milbank became a wholly owned subsidiary of State Auto Financial. Since the transaction was a combination of entities under common control it has been accounted for similar to a pooling of interest. Any reference to prior years' financial information of State Auto Financial Corporation and Subsidiaries has been restated to include the financial position and operations of Milbank. State Auto National Insurance Company ("National"), an Ohio corporation formed by State Auto Financial in 1991 began writing personal automobile insurance for non-standard risks in early 1992. At year end National was operating in 15 states and in February 1999 it added South Carolina to its operating territory. As of January 1, 1999, Farmers Casualty Insurance Company ("Farmers Casualty") an Iowa domiciled standard property casualty insurer, writing in Iowa and Kansas, became a wholly owned subsidiary of STFC, following completion of its plan of conversion from a mutual insurer. In August 1998, STFC contributed $9.0 million in capital to Farmers Casualty in the form of a surplus note. On completion of Farmers Casualty's conversion, STFC exchanged the surplus note for all the issued and outstanding shares of Farmers Casualty. Farmers Casualty owns 100% of the outstanding shares of Mid-Plains Insurance Company ("Mid-Plains") which is an Iowa based insurer which principally writes nonstandard auto insurance in Iowa and Kansas. In addition to the above described insurers, effective as of January 1, 1997, Mutual acquired 100% of the outstanding shares of Midwest Security Insurance Company ("Midwest Security"), a Wisconsin domiciled standard personal lines property and casualty insurer. Midwest Security participates in the pooling arrangement discussed below. See "Pooling Arrangement" in the "Narrative Description of Business." In addition, in connection with this transaction, Mutual and State Auto Financial entered into an Option Agreement whereby, subject to the approval of the Office of the Insurance Commissioner of the State of Wisconsin, State Auto Financial may purchase Midwest Security at any time over the option term of five years at a price calculated pursuant to a formula set forth in the Option Agreement. State Auto P&C, Mutual, Milbank, Midwest Security and Farmers Casualty, all of which participate in the pooling arrangement are collectively referred to hereafter as the "Pooled Companies". The Pooled Companies, National, and Mid-Plains are collectively referred to as the "State Auto Group". See "Pooling Arrangement" in the "Narrative Description of Business." At this time, the insurers in the State Auto Group market their insurance products through approximately 12,500 independent insurance agents associated with approximately 2,200 agencies in 26 states. Iowa and Kansas have been added to STFC's states of operation as of January 1, 1999. STFC's 4 Page 4 insurance products are marketed primarily in the central and eastern part of the United States, excluding New York, New Jersey and the New England States. Another wholly owned subsidiary of State Auto Financial, Stateco Financial Services, Inc., an Ohio corporation ("Stateco"), provides investment management services to affiliated companies and insurance premium finance services to customers of State Auto P&C, Mutual and Milbank. See "Investment Management Services" and "Insurance Premium Finance Services" in the "Narrative Description of Business." Strategic Insurance Software, Inc. ("S.I.S."), an Ohio corporation formed by State Auto Financial in January 1995, began operations in July 1995. S.I.S. develops and sells software for the processing of insurance transactions, management of insurance policy data and electronic interfacing of insurance policy information between insurance companies and agencies. S.I.S. is a majority-owned subsidiary of State Auto Financial. See "Insurance Software Business" in the "Narrative Description of Business." In December 1997, 518 Property Management and Leasing, LLC ("518 PML") was organized. 518 PML is an Ohio limited liability company formed to engage in the business of owning and leasing real and personal property to affiliated companies. The members of 518 PML are State Auto P&C and Stateco. See "Property Leasing Business" in the "Narrative Description of Business." State Auto Financial and its subsidiaries, State Auto P&C, Stateco, National, Milbank, S.I.S., 518 PML, Farmers Casualty and Mid-Plains are collectively referred to as the "Company". IN ANY REFERENCE TO FINANCIAL INFORMATION FOR 1998 AND PRIOR PERIODS, IT IS UNDERSTOOD THAT, UNLESS OTHERWISE STATED, ALL REFERENCES TO THE COMPANY INCLUDE ONLY STATE AUTO P&C, STATECO, MILBANK, NATIONAL, S.I.S. AND 518 PML AND EXCLUDE FARMERS CASUALTY AND MID-PLAINS. Since January 1, 1987, State Auto P&C has participated in an underwriting pooling arrangement with Mutual. While it has been modified several times since 1987, as of January 1, 1999, the current pool participants and percentages of participation are State Auto Mutual (49%), State Auto P&C (37%), Milbank (10%), Midwest Security (1%), and Farmers Casualty (3%). See "Pooling Arrangement" in the "Narrative Description of Business." Pursuant to the Amended and Restated Management Agreement dated April 1, 1994 (the "Amended and Restated Management Agreement"), the Midwest Management Agreement (defined below), and the Farmers Casualty Management Agreement (defined below), State Auto P&C provides executive management services for all of its insurance affiliates and for Mutual and its insurer subsidiary, Midwest Security. Mutual provides non-executive employees and facilities for such entities. See "Management Agreement" in the "Narrative Description of Business." (b) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS. See Note 14 to the Company's Consolidated Financial Statements, included in Item 8, "Financial Statements and Supplementary Data" regarding the company's reportable segments. Additional information regarding the Company's segments is provided in the "Narrative Description of Business." 5 Page 5 (c) SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. Statements contained herein expressing the beliefs of management and the other statements which are not historical facts contained in this report are forward looking statements that involve risks and uncertainties. Such statements include, without limitation, those pertaining to the weather related catastrophes impacting the Company's losses, product offerings, National's premium receivable collections effort, the Year 2000 discussion, the statements relating to the new insurer to be created, State Auto Insurance Company, the legislative and regulatory environment and sales forecasts. These risks and uncertainties include, but are not limited to, legislative changes, judicial and regulatory decisions, the impact of competitive products and pricing, product development, geographic spread of risk, weather and weather-related events, other types of catastrophic events, fluctuations of securities markets, economic conditions, technological difficulties and advancements, availability of labor and materials in storm hit areas, late reported claims, previously undisclosed damage, utilities and financial institution disruptions, shortages of programmers, and regulatory or governmental systems breakdowns. (d) NARRATIVE DESCRIPTION OF BUSINESS. PROPERTY AND CASUALTY INSURANCE POOLING ARRANGEMENT Since January 1987, State Auto P&C and Mutual have participated in an intercompany pooling arrangement. Under the terms of the pooling arrangement, State Auto P&C ceded all of its insurance business to Mutual. All of Mutual's property and casualty insurance business was also included in the pooled business. Mutual then ceded a percentage of the pooled business to State Auto P&C and retained the balance. From January 1987 through December 31, 1991, State Auto P&C assumed 20% of the pooled business. Effective January 1, 1992, State Auto P&C increased its percentage of the pool to 30%. Effective January 1, 1995, the pooling arrangement was amended to include all of the property and casualty business of Milbank. Concurrently with the inclusion of Milbank, the participation percentages were amended as follows: Mutual 55%, State Auto P&C 35% and Milbank 10%. Effective January 1, 1998, Midwest Security was added to the pooling arrangement pursuant to an Amended and Restated Reinsurance Pooling Agreement dated January 1, 1998 (the "98 Pooling Agreement") which agreement also amended the participation percentages as follows: Mutual 52%, State Auto P&C 37%, Milbank 10%, and Midwest Security 1%. With the addition of Farmers Casualty to the State Auto Group, it was added to the pooling arrangement pursuant to a Reinsurance Pooling Agreement, Amended and Restated as of January 1, 1999 (the "99 Pooling Agreement"). Concurrently, with the inclusion of Farmers Casualty, the pooling percentages were also amended as follows: Mutual 49%, State Auto P&C 37%, Milbank 10%, Midwest 1% and Farmers Casualty 3%. The pooling percentages are reviewed by management at least annually, and more often if deemed appropriate by management or the Board of Directors of each company, to determine whether any adjustments should be made. Future adjustments in the pooling percentages are expected to be based on the performance of the insurance operations of Mutual, State Auto P&C, Milbank, Farmers Casualty and Midwest Security, the growth in direct premiums written of each company as it relates to the pooling percentages, the combined ratio of the pooled business and the net premiums written of the pooled business in relation to the statutory capital and surplus of Mutual, State Auto P&C, Milbank, Farmers Casualty and Midwest Security, respectively, among other factors. Management of each of the Pooled Companies makes recommendations to a four-member coordinating committee consisting of two members of Mutual's Board of Directors and two members of State Auto Financial's Board of Directors. The coordinating committee reviews and evaluates various factors relevant to the pooling percentages and recommends any appropriate pooling change to the Boards of both Mutual and State Auto Financial. See "Management Agreement" 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. Neither Mutual, State Auto P&C, Milbank, Farmers Casualty nor Midwest Security currently intends to terminate the pooling arrangement. 6 Page 6 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, by spreading the risk among each of the participants. Under the terms of the pooling arrangement, all premiums, incurred losses, loss expenses and other underwriting expenses are prorated among the companies on the basis of their participation in the pool. One effect of the pooling arrangement is to give State Auto P&C, Mutual, Milbank, Farmers Casualty and Midwest Security an identical mix of property and casualty insurance business on a net basis. The terms of the pooling arrangement were amended in December 1993 to clarify that certain liabilities created by FASB 106 (post-retirement health care benefits liability) and FASB 112 (post employment benefits liability) which did not exist when the pooling arrangement was initiated are to be carried by Mutual and not pooled except for those liabilities associated with the transfer of certain executives to State Auto P&C. See "Management Agreement" in the "Narrative Description of Business." The '99 Pooling Agreement contains a provision which excludes from the scope of the pooling arrangement catastrophic loss claims and loss adjustment expenses incurred by State Auto P&C, Mutual, Milbank, National, Midwest Security, Farmers Casualty and Mid-Plains in the amount of $100.0 million in excess of $120.0 million but less than $220.0 million and the premium for such exposures. State Auto P&C has become the reinsurer for each insurer in the State Auto Group for this layer of reinsurance under a Catastrophe Assumption Agreement. See "Reinsurance" in the "Narrative Description of Business." MANAGEMENT AGREEMENT The Company operates and manages its business in conjunction with Mutual under a management agreement which was restructured pursuant to an Amended and Restated Management Agreement effective April 1, 1994. Under this agreement, State Auto P&C provides executive management services for Mutual, Milbank, and National, overseeing the insurance operations of these companies. State Auto P&C does not provide investment management services because these services are provided by Stateco. See "Investment Management Services" in the "Narrative Description of Business." A management fee is paid by Mutual, Milbank, and National for the services provided by State Auto P&C equal to 2% of the five year average of annual statutory statement "surplus as regards policyholders", less valuations for managed subsidiaries, of each managed company. The Amended and Restated Management Agreement also imposes a performance standard which could result in State Auto P&C not being entitled to the fee for a particular quarter if a managed company's performance does not meet the standard incorporated in the agreement. Management believes that the amount of the management fee charged is fair and reasonable. In 1998, the managed companies paid a management fee of $6.0 million to State Auto P&C. In addition to the above-described Amended and Restated Management Agreement, State Auto P&C and Mutual entered into a Management Agreement with Midwest Security effective as of January 1, 1997 (the "Midwest Management Agreement") and with Farmers Casualty and Mid-Plains effective as of January 1, 1999, (the "Farmers Casualty Management Agreement"). Mutual is providing clerical and non-executive employees to Midwest Security, Farmers Casualty and Mid-Plains. Under the Midwest Management Agreement, the Company provides executive management services to Midwest Security in return for a management fee. Under this agreement, the Company's management fee is based on direct written premium of Midwest Security. The fee set for 1998 was 0.75% of direct written premium of Midwest Security and it includes a performance standard, as well. In 1998, Midwest Security paid a management fee of $158,000 to State Auto P&C. Under the Farmers Casualty Management Agreement, specific services are assigned to State Auto P&C by resolution of the Boards of Farmers Casualty and Mid-Plains. The fee due is dependent on the scope of the services assigned but it is capped at 0.75% of direct written premium. Under the Amended and Restated Management Agreement, Mutual provides the Company with the facilities, clerical personnel and other non-executive employees necessary to run its day-to-day operations. All costs incurred by Mutual with respect to underwriting expenses and loss expenses 7 Page 7 incurred on behalf of Mutual, State Auto P&C, Milbank, Midwest Security, and from January 1, 1999 forward, Farmers Casualty, continue to be shared pro rata among Mutual, State Auto P&C, Milbank, Midwest Security and Farmers Casualty through the 99 Pooling Agreement. "See Pooling Arrangement" in the "Narrative Description of Business." For companies not participating in the 99 Pooling Agreement, e.g., National and Mid-Plains, expenses directly attributable to a particular company continue to be charged to that company and expenses of personnel who are not dedicated entirely to work for a particular company are allocated among the companies based on an estimate of time devoted by such personnel to each company for which services are rendered. Mutual also charges rent to each company which has dedicated space within Mutual's facilities (currently National and Stateco). The Amended and Restated Management Agreement, the Midwest Management Agreement, and the Farmers Casualty Management Agreement set forth procedures for potential conflicts of interest. Generally, business opportunities presented to the common officers of the companies, other than business opportunities that meet certain criteria, must be presented to a four-member coordinating committee consisting of two directors of Mutual, who represent the interests of Mutual and its subsidiary, and two directors of the Company, who represent the interests of State Auto Financial and its subsidiaries. This committee reviews and evaluates the business opportunity using such factors as it considers relevant. Based upon such review and evaluation, this committee then makes recommendations to the respective boards of directors as to whether or not such business opportunity should be pursued and if so, by which company. The Boards of Directors of Mutual, State Auto Financial and, when appropriate, a subsidiary, must then act on the recommendation of the committee after considering all other factors they deem relevant. The Amended and Restated Management Agreement has a ten year term ending March 31, 2004, and automatically renews for an additional ten year term unless any of the managed companies terminates its participation, or the manager, State Auto P&C, terminates the agreement upon not less than two years advance written notice of non-renewal. The Midwest Management Agreement also has a ten year term ending December 31, 2006 and automatically renews for an additional ten year term unless sooner terminated in accordance with its provisions. The Farmers Casualty Management Agreement has a 10-year term expiring on December 31, 2008 with an automatic renewal provision unless sooner terminated in accordance with its terms. The Amended and Restated Management Agreement may also be terminated by any of the managed companies upon events constituting a change of control or potential change of control (as defined in the Amended and Restated Management Agreement) of the Company, upon agreement between a managed company and State Auto P&C and, the agreement is terminated automatically with respect to a party if it is subject to insolvency proceedings. Milbank may terminate its participation in the Amended and Restated Management Agreement upon 120 days notice. If the Amended and Restated Management Agreement is terminated for any reason, the Company would have to locate facilities, personnel and management to continue its operations. STANDARD INSURANCE SEGMENT The Company's share of the business written by the Pooled Companies (i.e., State Auto P&C and Milbank) constitutes the Company's standard insurance segment. This includes personal and commercial property and casualty insurance lines, including automobile, homeowners, commercial multi-peril, workers' compensation, liability, fire and other lines of business. Independent insurance agencies constitute the Company's sales force for both the standard insurance products and the non-standard insurance products. Footnote 14 in the Company's Consolidated Financial Statements included herewith sets forth the amount of the Company's net earned premiums by line of insurance for both standard lines and nonstandard lines. As mentioned above, the insurance business of Mutual, State Auto P&C, Milbank, Midwest Security and as of January 1, 1999, Farmers Casualty is combined through the pooling arrangement. This pooling arrangement effectively gives each of the Pooled Companies an identical mix of personal and commercial business as written by all five insurers. The Pooled Companies products' sales are predominantly personal lines. As part of their effort to increase the volume of commercial lines business, commercial lines were introduced in Wisconsin in the second quarter of 1998 and work has begun to 8 Page 8 make commercial lines available in Kansas during the second quarter of 1999 and in Iowa during the first quarter of 2000. The insurance business of National, with the exception of amounts reinsured with Mutual, is not included in the pooling arrangement and, therefore, remains 100% in the Company. As of January 1, 1999, the same is true for business written by Mid-Plains. See "Pooling Arrangement" in the "Narrative Description of Business." Both National's and Mid-Plains' products are personal lines auto insurance products written for non-standard risks, with less restrictive underwriting criteria and higher rates than those applicable to standard risks. The Company uses computer-based underwriting procedures for its personal lines business. Under such procedures, applications for such business may be accepted or rejected based upon established underwriting guidelines. Applications that do not meet guidelines for automated acceptance are referred to personal lines specialists who review the applications and assess exposure. During the underwriting process, risks are also reviewed to determine whether or not they are acceptable as submitted by the independent agents as preferred, standard or non-standard risks. Personal lines specialists continue to have significant responsibility for encouraging the Company's agency force to sell its personal lines products. The following table sets forth the statutory loss ratios by line of insurance and the combined ratios for the standard insurance segment of the Company's business, prepared in accordance with accounting practices prescribed or permitted by state insurance authorities, for the periods indicated. The loss ratio is the ratio of incurred losses and associated expenses to net earned premiums ("loss ratio"). The combined ratio is a traditional measure of underwriting profitability. The combined ratio is the sum of (a) the loss ratio; and (b) the ratio of expenses incurred for commissions, premium taxes, administrative and other underwriting expenses, to net written premium ("expense ratio"). When the combined ratio is under 100%, underwriting results are generally considered profitable. Conversely, when the combined ratio is over 100%, underwriting results are generally considered unprofitable. The combined ratio does not reflect investment income or federal income taxes. The Company's operating income depends on income from underwriting operations, investments and management fees.
Year Ended December 31(1) ------------------------------------------ 1998 1997 1996 ---- ---- ---- Loss ratios: Automobile................................. 65.7% 63.3% 68.6% Homeowners and Farmowners.................. 86.0% 71.6% 102.1% Commercial multi-peril..................... 57.1% 72.8% 70.5% Workers' compensation...................... 51.1% 64.2% 44.9% Fire and allied lines...................... 81.8% 59.3% 76.8% Other commercial liability................. 61.2% 64.9% 60.6% Other personal lines....................... 32.3% 34.6% 35.2% Other commercial lines..................... 20.0% 16.8% 11.1% ------ ------ ------ Total loss ratio................................ 67.9% 64.2% 72.4% Expense ratio................................... 29.8% 29.5% 27.8% ------ ------ ------ Combined ratio.................................. 97.7% 93.7% 100.2% ====== ====== ======
- ------------------ (1) This reflects a combination of the loss ratios of State Auto P&C and Milbank, after giving effect to reinsurance and the 98 Pooling Agreement. - ------------------ NON-STANDARD INSURANCE SEGMENT In October 1991, State Auto Financial formed National to write personal automobile insurance for nonstandard risks. National began writing insurance in Ohio in February 1992. It expanded into West Virginia in October 1993, Tennessee and Mississippi in August 1994 and Kentucky in March 1995. National entered Arkansas and Georgia in December 1996, Minnesota in February 1997 and Alabama, 9 Page 9 Illinois and Missouri in December 1997. It most recently expanded operations into Indiana, Pennsylvania, Utah and Wisconsin in December 1998. National is currently licensed in 21 states altogether, with plans to begin operations in Maryland and South Carolina within the first six months of 1999, with South Dakota to follow in the second half of 1999. National is seeking a certificate of authority in one additional state at this time. In addition to National, as of January 1, 1999, the Company writes nonstandard auto insurance through Mid-Plains. Mid-Plains operates in Kansas and Iowa. The Company currently does not contemplate combining the operations of Mid-Plains and National. Nonstandard automobile products provide insurance for private passenger automobile risks that are typically rejected or canceled by standard market companies because insureds have poor loss experience or a history of late payments of premium. Nonstandard products are priced to account for the additional risk and expenses normally associated with this market. The following Table sets forth the statutory loss ratios and combined ratios of National, which is engaged in the nonstandard segment of the business.
Year Ended December 31 --------------------------------- 1998 1997 1996 ---- ---- ---- Loss Ratio Automobile................................. 75.0% 79.8% 78.2% Expense Ratio................................ 25.0% 20.6% 18.3% ----- ----- ----- Combined Ratio............................... 100.0% 100.4% 96.5% ===== ===== =====
MARKETING In its 26 states of operation, the State Auto Group markets its products through approximately 12,500 insurance agents associated with approximately 2,200 independent insurance agencies. State Auto Financial's acquisition of Farmers Casualty gave the Company the opportunity to enter its 25th and 26th states of operation effective January 1, 1999 adding approximately 200 agencies and 1,200 agents to market its products. Farmers Casualty markets personal lines only; the Company will introduce commercial lines to Farmers Casualty's product offerings in both states as soon as practicable. None of the company's in the State Auto Group has any contracts with managing general agencies. State Auto National markets non-standard products exclusively through the Company's network of independent agents. As noted above, State Auto National is licensed in 21 states and operated in 15 states in 1998. Four of those were added in 1998. Three more are expected to be added in 1999. Mid-Plains markets nonstandard auto insurance in Iowa and Kansas through the agency network of Farmers Casualty in those states. See "Non-Standard Automobile 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. Examples include regular travel by senior management and branch office staff to meet with agents, in person, in their home states and as discussed below, training opportunities, an agent stock purchase plan and an agent stock option 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 in the Company's home office. Further, the training programs include disciplined follow-up and coaching for an extended time. The Company takes a leadership role in the insurance industry with respect to agency automation, promoting single entry multi-company interface using industry standards, especially through software developed and marketed by S.I.S. (SEMCI Partner(R)). Since agents and their customers realize better 10 Page 10 service and efficiencies through automation, they value their relationship with the Company and it makes the Company attractive to new agency appointments. 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 as Inner Circle Agents; rewarding them with additional trip and financial incentives including additional profit sharing bonus and additions to the agent's contributions to their Inner Circle Agent Stock Purchase Plan, which is 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 broker. As of year-end 1998, 366 agencies participated in this agent stock purchase plan. In addition to the Agent Stock Purchase Plan, the Company has created an Agent Stock Option Plan incentive for a select group of agencies which represent the Company. If an agent/agency meets specific production requirements over a five year period, that agent/agency qualifies to earn State Auto Financial stock options granted at the market price on the day these performance based options are earned. The options vest only upon meeting additional sales and profitability targets. Options granted and vested under this program have a 10-year term. Under the Company's agency agreements with its independent insurance agencies, each agent the Company licenses is authorized to sell and bind coverage in accordance with established procedures. They are also authorized to collect and remit premiums. The authority of agents to bind an insurance company is common practice in the property and casualty insurance industry. The Company controls risk by its right to terminate coverage on a policy bound by the agent. In addition, the Company does not grant binding authority for risks it considers to present a greater than normal exposure to loss. Each agency receives a percentage of direct premiums written as a commission. As bonus compensation, the agency receives a share of the underwriting profits generated by their policies. This is subject to certain qualifying conditions as set forth in the agency agreement. The Company receives premiums on products marketed in Alabama, Arkansas, Florida, Georgia, Illinois, Indiana, 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 1998, the seven states that contributed the greatest percentage of direct premiums written to the State Auto Group were Ohio (22.3%), Kentucky (10.6%), Tennessee (7.6%), South Carolina (5.8%), North Carolina (5.5%), Maryland (5.1%) and Minnesota (4.8%). CLAIMS Insurance claims on policies written by the Company are usually investigated and settled by staff claims adjusters. The Company's claims policy emphasizes timely investigation of claims, settlement of meritorious claims for equitable amounts, maintenance of adequate reserves for claims, and control of external claims adjustment expenses. This claims policy is designed to support the Company's marketing efforts by providing agents and policyholders with prompt service. Claim settlement authority levels are established for each adjuster, supervisor and manager based on his or her level of expertise and experience. Upon receipt, each claim is reviewed and assigned to an adjuster based upon its type, severity and class of insurance. The claims department is responsible for reviewing the claim, obtaining necessary documentation and establishing loss and expense reserves of certain claims. Any property or casualty claims estimated to reach $100,000 or above are sent to the home office to be supervised by claims department specialists. In territories in which there is not sufficient volume to justify having full-time adjusters, the Company uses independent appraisers and adjusters to evaluate and settle claims under the supervision of claims department personnel. 11 Page 11 The Company attempts to minimize claims 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. The Company's in-house trial counsel operation created in Cleveland, Ohio in 1993 to represent insureds in third party claim litigation has achieved its objectives of reducing the cost of defending claims. A fourth attorney was added to the Cleveland Office in 1998. Presently, the Company also has a two lawyer in-house trial counsel's office in Baltimore, Maryland. It has no immediate plans to add in-house trial counsel in any other territories where it operates. The third party proprietary software installed in 1996 to assist claims adjusters in evaluating bodily injury claims, except for the most severe injury cases, continues to be a valuable tool in assisting adjusters in negotiating bodily injury settlements more effectively. In addition, in 1998, the Company put into place two measures that it expects will have a positive impact on claims expenses. It signed a contract with a vendor to create a glass network through which economies and efficiencies have been brought to bear in settling glass claims. It has also begun to centralize the handling of smaller, less complicated claims through a Central Claims Department ("CCD") created in the Company's home office. It expects that the CCD will be able to handle these smaller claims more efficiently, reducing loss expenses. RESERVES Loss reserves are estimates at a given point in time of what an insurer expects to pay to claimants, based on facts, circumstances and historical trends then known. It can be expected that the ultimate liability will exceed or be less than such estimates. During the loss settlement period, additional facts regarding individual claims may become known, and consequently it often becomes necessary to refine and adjust the estimates of liability. The Company maintains reserves for the eventual payment of losses and loss expenses for both reported claims and incurred claims that have not yet been reported. Loss expense reserves are intended to cover the ultimate costs of settling all losses, including investigation and litigation costs from such losses. Reserves for reported losses are established on either a case-by-case or formula basis depending on the type and circumstances of the loss. The case-by-case reserve amounts are determined based on the Company's reserving practices, which take into account the type of risk, the circumstances surrounding each claim and policy provisions relating to types of loss. The formula reserves are based on historical paid loss data for similar claims with provisions for trend changes caused by inflation. Loss and loss expense reserves for incurred claims that have not yet been reported are estimated based on many variables including historical and statistical information, inflation, legal developments, storm loss estimates, and economic conditions. Loss reserves are reviewed on a regular basis and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Although management uses many resources to calculate reserves, there is no precise method for determining the ultimate liability. The Company does not discount loss reserves for financial statement purposes. Mutual has guaranteed the adequacy of State Auto P&C's loss and loss expense reserves as of December 31, 1990. Pursuant to the guarantee, Mutual has agreed to reimburse State Auto P&C for any losses and loss expenses in excess of State Auto P&C's December 31, 1990 reserves ($65.5 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, 1998, 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. 12 Page 12 The following table presents one-year development information on changes in the reserve for loss and loss expenses of the Company for the three years ended December 31, 1998:
Year Ended December 31 -------------------------------------------- 1998 1997 1996 ------------ ------------ ------------ (in thousands) Reserve for losses and loss expenses at beginning of year(1)................................. $194,155 $199,480 $206,327 ------------ ------------ ------------ Provision for losses and loss expenses occurring: Current year....................................... 255,885 225,666 246,886 Prior years(2)..................................... (13,591) (17,432) (26,852) ------------ ------------ ------------ Total 242,294 208,234 220,034 ------------ ------------ ------------ Loss and loss expense payments for claims occurring during: Current year....................................... 157,988 134,890 148,095 Prior years........................................ 86,671 78,669 78,786 ------------ ------------ ------------ Total........................................... 244,659 213,559 226,881 ------------ ------------ ------------ Impact of pooling change 1/1/98.............................. 13,244 - - ============ ============ ============ Reserve for losses and loss expenses at end of year(1)....... $205,034 $194,155 $199,480 ============ ============ ============
- --------------- (1) This line item is net of reinsurance receivable on losses and loss expenses payable of approximately $13,667,000, $12,095,000 and $12,129,000 for the years 1998, 1997 and 1996, respectively. (2) This line item shows redundancies in the provision for losses and loss expenses attributable to prior years in the amounts of approximately $13,591,000, $17,432,000 and $26,852,000 for the years 1998, 1997 and 1996, respectively. These decreases have resulted primarily from moderating trends in the frequency and severity of losses and loss expenses due to lower inflation. This along with fundamental improvements primarily in the auto liability line of business resulted in incurred losses and loss expenses developing favorably. - --------------- The following table sets forth the development of reserves for losses and loss expenses from 1988 through 1998 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, 1998, the Company had paid 87.4% of the currently estimated losses and loss expenses that had been incurred, but not paid, as of December 31, 1989. The amounts on the "cumulative redundancy (deficiency)" line represent the aggregate change in the estimates over all prior years. For example, the 1988 reserve has developed a $3,233,000 redundancy over ten years. That amount has been included in operations over the ten years and did not have a significant effect on income of any one year. The effects on income caused by changes in estimates of the reserves for losses and loss expenses for the most recent three years are shown in the foregoing three-year loss development table. 13 Page 13 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 1991, but incurred in 1988, will be included in the cumulative redundancy amount for years 1988, 1989 and 1990. 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. Effective, January 1, 1992, the pooling percentage was changed whereby State Auto P&C increased its share in the pooled losses and loss expenses from 20% to 30%. This increase is reflected in the 1992 column. Effective January 1, 1995, the pooling percentage was again changed adding Milbank to the pool and increasing State Auto P&C's share in the pooled losses and loss expenses from 30% to 35%. This increase is reflected in the 1995 column. An amount of assets equal to the increase in net liabilities was transferred to State Auto P&C and Milbank from Mutual in 1992, 1995 and in 1998 from Mutual and Midwest Security in conjunction with each year's respective pooling change. The amount of the assets transferred from Mutual in 1992 and 1995 has been netted against and has reduced the cumulative amounts paid for years prior to 1992 for the January 1, 1992 pooling change and for years prior to 1995 for the January 1, 1995 pooling change and for years prior to 1998 for the January 1, 1998 pooling change. [See table on following page.] 14
State Auto Financial Corp. Years Ended December 31 ---------------------------------------------------------------------------- 1988 1989 1990 1991 1992 (Dollars in Thousands) Net liability for losses and loss expenses payable $ 51,142 $58,203 $65,464 $71,139 $119,044 Paid (cumulative) as of: One year later 47.7% 48.1% 43.3% 12.2% 41.3% Two years later 65.7% 68.8% 46.1% 43.0% 60.9% Three years later 76.0% 70.9% 62.9% 58.7% 60.6% Four years later 76.1% 79.9% 71.8% 58.4% 68.0% Five years later 80.8% 84.4% 72.1% 63.9% 71.9% Six years later 83.0% 83.3% 75.5% 67.5% 73.2% Seven years later 82.0% 86.0% 77.8% 68.6% Eight years later 84.1% 87.7% 77.9% Nine years later 85.6% 87.4% Ten years later 85.4% Net liability re-estimate as of: One year later 93.7% 98.0% 95.4% 91.2% 92.7% Two years later 91.6% 97.4% 92.1% 87.2% 90.5% Three years later 91.3% 95.9% 89.7% 85.4% 87.6% Four years later 90.4% 95.4% 88.1% 84.5% 85.6% Five years later 90.6% 95.0% 89.7% 82.3% 87.3% Six years later 89.9% 96.1% 88.4% 86.7% 84.5% Seven years later 92.0% 95.5% 93.2% 83.1% Eight years later 91.7% 100.1% 89.5% Nine years later 95.3% 97.2% Ten years later 93.7% Cumulative redundancy (deficiency) $ 3,233 $ 1,639 $ 6,843 $12,004 $ 18,443 Cumulative redundancy (deficiency) 6.3% 2.8% 10.5% 16.9% 15.5% Gross* liability - end of year Reinsurance receivable Net liability - end of year Gross liability re-estimated - latest Reinsurance receivable re-estimated - latest Net liability re-estimated - latest * Gross liability includes: Direct & assumed losses & loss expenses payable.
State Auto Financial Corp. Years Ended December 31 --------------------------------------------------------------------------------------- 1993 1994 1995 1996 1997 1998 Net liability for losses and loss expenses payable $123,337 $126,743 $206,327 $199,480 $194,155 $205,034 Paid (cumulative) as of: One year later 42.2% 1.5% 38.2% 39.4% 37.8% -- Two years later 41.3% 29.1% 55.4% 56.7% Three years later 55.6% 44.5% 64.6% Four years later 64.5% 52.4% Five years later 68.2% Six years later Seven years later Eight years later Nine years later Ten years later Net liability re-estimate as of: One year later 93.7% 87.4% 87.0% 91.3% 93.0% -- Two years later 90.0% 77.1% 86.4% 87.3% Three years later 85.0% 77.0% 83.2% Four years later 86.3% 72.9% Five years later 82.8% Six years later Seven years later Eight years later Nine years later Ten years later Cumulative redundancy (deficiency) $ 21,233 $34,403 $34,570 $25,343 $13,591 -- Cumulative redundancy (deficiency) 17.2% 27.1% 16.8% 12.7% 7.0% -- Gross* liability - end of year $206,250 $218,701 Reinsurance receivable $12,095 $13,667 Net liability - end of year $194,155 $205,034 Gross liability re-estimated - latest 93.5% Reinsurance receivable re-estimated - latest 101.9% Net liability re-estimated - latest 93.0% * Gross liability includes: Direct & assumed losses & loss expenses payable.
15 Page 15 The following table is a reconciliation as of each December 31 of losses and loss expenses payable, computed under generally accepted accounting principles ("GAAP"), to losses and loss expenses payable, computed under statutory accounting principles used by insurance companies for reporting to state insurance regulators ("STAT"):
1998 1997 1996 ------------- -------------- -------------- (in thousands) GAAP losses and loss expenses payable $218,701 $206,250 $211,611 Less: ceded reinsurance receivable on losses and loss expenses payable 13,667 12,095 12,129 Add: salvage and subrogation recoverable 12,817 10,870 10,612 ------------- -------------- -------------- STAT losses and loss expenses payable $217,851 $205,025 $210,094 ============= ============== ==============
REINSURANCE The Company, Mutual and Midwest Security follow the customary industry practice of reinsuring a portion of their exposures and paying to the reinsurers a portion of the premiums received on all policies. Insurance is ceded principally to reduce net liability on individual risks or for individual loss occurrences, including catastrophic losses. Effective January 1, 1999, reinsurance premiums and reimbursements are allocated among State Auto P&C, Milbank, Mutual, Midwest Security, and Farmers Casualty according to their relative pooling percentages. National and Mid-Plains do not directly participate in the pooling arrangement. Although reinsurance does not legally discharge State Auto P&C, Mutual, National, Milbank, Midwest Security, Farmers Casualty, or Mid-Plains 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 has separate working reinsurance treaties for property and casualty lines with several reinsurers arranged through a reinsurance broker. Under the property excess of loss treaty, each member of the State Auto Group is responsible for the first $2.0 million of each defined loss and the reinsurers are responsible for 100% of the excess over $2.0 million up to $10.0 million of such defined loss, depending upon the nature of the injury or damage. The rates for this reinsurance are negotiated annually. The terms of the casualty excess of loss program provide 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 100% of the loss excess of $2.0 million and up to $5.0 million. Also, certain unusual claim situations involving bodily injury liability, property damage liability, uninsured motorist, personal injury protection and workers' compensation insurance are covered by an arrangement which provides for $10.0 million of coverage above 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. In addition, the State Auto Group has secured other reinsurance to limit the net cost of large loss events for certain types of coverages. Included are umbrella liability losses which are reinsured up to a limit of $15.0 million above a maximum $600,000 retention. The State Auto Group also makes use of the facultative market for unique risk situations and participates in involuntary pools and associations in certain states. Catastrophe reinsurance has been arranged for property business, including automobile physical damage. Effective July 1, 1998, the Company and Mutual renewed, without change, both the traditional and structured financing pieces of their catastrophe reinsurance program, originally placed in July 1996. Each of State Auto P&C, Mutual, Milbank, Midwest Security, National, Farmers Casualty and Mid-Plains retain the first $40.0 million of each occurrence. 16 Page 16 $80.0 million of traditional reinsurance is available above the $40.0 million retention with a co-participation of 5%. In the event the State Auto Group incurs catastrophe losses in excess of $120.0 million, State Auto Financial has continued its structured contingent financing transaction with Chase Manhattan Bank ("Chase") to provide up to $100.0 million to be used to cover such catastrophe losses. Under this arrangement, in the event of such a loss, State Auto Financial would issue and sell redeemable preferred shares to SAF Funding Corporation, a special purpose company ("SPC"), which will borrow the money necessary for such purchase from Chase and a syndicate of other lenders (the "Lenders"). State Auto Financial will contribute to State Auto P&C the proceeds from the sale of its preferred shares. State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank, Midwest Security, National and Farmers Casualty and Mid-Plains pursuant to a Catastrophe Assumption Agreement in the amount of $100.0 million excess of $120.0 million. State Auto P&C will use the contributed capital to pay its direct catastrophe losses and losses assumed under the Catastrophe Assumption Agreement. State Auto Financial is obligated to repay SPC (which will repay the Lenders) by redeeming the preferred shares over a six-year period. This layer of $100.0 million in excess of $120.0 million has been excluded from the pooling arrangement as well by virtue of the `99 Pooling Agreement. See "Pooling Arrangement" in the "Narrative Description of Business." In addition, State Auto Financial's obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which, in the event of a default by State Auto Financial as described in the Credit Agreement or in the Put Agreement, Mutual would be obligated to put either the preferred shares or the loan(s) outstanding. This Chase contingent financing transaction originally could be extended only through July 1, 1999. The Company is currently studying catastrophe reinsurance alternatives which include non-traditional programs similar to the one currently in place. National has entered into a reinsurance agreement with Mutual. Pursuant to the agreement, on an excess of loss basis, Mutual assumes all liability losses in excess of National's $50,000 retention; on a quota share basis, Mutual assumes 20% of all liability losses - and premiums - within National's $50,000 retention. The excess of loss coverage is intended to insulate National from shock losses while the quota share arrangement is intended to slow the drain on statutory surplus which can normally be expected with a rapid increase in premium writings. Changes to this program that are being contemplated for 1999 include reducing the 20% quota share on liability coverages to 10% and extending a 2% quota share to the physical damage coverages. REGULATION The Company. Most states have enacted legislation that regulates insurance holding company systems. Ohio, the domiciliary state of Mutual and National, has adopted legislation regulating the activities of those companies. South Carolina has adopted legislation regulating the activities of State Auto P&C as the South Carolina domiciled member of the holding company system, as have South Dakota, and Wisconsin which are the domiciliary regulators of Milbank, Midwest Security, respectively, and Iowa which regulates Farmers Casualty and Mid-Plains. Each insurance company in the holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish information concerning the operations of companies within the holding company system that may materially affect the operations, management or financial condition of the insurers within the system. Pursuant to these laws, the respective insurance departments may examine Mutual, State Auto P&C, National, Milbank, Midwest Security, Farmers Casualty and Mid-Plains at any time, require disclosure of material transactions involving insurer members of the holding company system and require prior notice and an opportunity to disapprove of certain "extraordinary" transactions, including, but not limited to, extraordinary dividends from State Auto P&C, National, Milbank and Farmers Casualty to State Auto Financial. Pursuant to these laws, all transactions within the holding company system affecting Mutual, State Auto P&C, National, Milbank, Midwest Security, Farmers Casualty or Mid-Plains must be fair and equitable. In addition, approval of the applicable Insurance Commissioner is required prior to the consummation of transactions affecting the control of an insurer. South Carolina insurance law provides that no person may acquire direct or indirect control of State Auto P&C unless that person has obtained the prior written approval of the Chief Insurance Commissioner of South Carolina for such acquisition. Ohio has similar statutory provisions in place which would be applicable to National, as does South Dakota for Milbank, Wisconsin for Midwest Security and Iowa for Farmers Casualty and Mid-Plains. 17 Page 17 In addition to being regulated by the insurance department of its state of domicile, each insurance company is subject to supervision and regulation in the states in which it transacts business, and such supervision and regulation relate to numerous aspects of an insurance company's business and financial condition. The primary purpose of such supervision and regulation is to ensure financial stability of insurance companies for the protection of policyholders. The laws of the various states establish insurance departments with broad regulatory powers relative to granting and revoking licenses to transact business, regulating trade practices, licensing agents, approving policy forms, setting reserve requirements, determining the form and content of required statutory financial statements, prescribing the types and amount of investments permitted and requiring minimum levels of statutory capital and surplus. Although premium rate regulation varies among states and lines of insurance, such regulations generally require approval of the regulatory authority prior to any changes in rates. In addition, all of the states in which 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 State Auto companies to earn a profit on their underwriting operations. Insurance companies are required to file detailed annual reports with the supervisory agencies in each of the states in which they do business and their business and accounts are subject to examination by such agencies at any time. There can be no assurance that such regulatory requirements will not become more stringent in the future and have an adverse effect on the operations of the State Auto Group. Dividends. State Auto P&C, National, Milbank and Farmers Casualty are subject to regulations and restrictions under which payment of non-extraordinary dividends from statutory surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. State Auto Financial's insurer subsidiaries are permitted to pay dividends without prior approval from their respective domiciliary insurance departments unless the dividend is an "extraordinary dividend." While the statutes affecting each insurer subsidiary of State Auto Financial have different words, there is a common thread that runs through each state's statute regulating extraordinary dividends. That thread is the basic definition of an extraordinary dividend which is the greater of 10% of the insurer's surplus or net income. In three states, Ohio, South Dakota and Iowa, there is excluded from the net income of the insurer a distribution of the insurers own securities. In South Carolina, net realized capital gains and losses are excluded from the calculation of annual net income. In South Dakota, annual net income excludes net realized capital gains that exceed 20% of net unrealized capital gains. The laws of South Carolina, Iowa and Ohio also require advance notice of payment of an ordinary dividend. In addition, by acting within a statutory time frame, the insurance commissioner in each state has the authority to limit ordinary dividends if an insurer's surplus as regards policyholders is not reasonable in relation to the insurer's outstanding liabilities and adequate to its financial needs. Pursuant to these rules, a total of $21.9 million is available for payment to State Auto Financial as a dividend from State Auto P&C, National, Milbank and Farmers Casualty during 1999 without prior approval from the South Carolina, Ohio, South Dakota and Iowa Insurance Departments, respectively, under current law. Rate and Related Regulation. The Company is not aware of any adverse legislation or regulation that has been adopted by any state where the Company did business during 1998 which would present material obstacles to the Company's overall business. In an attempt to make capital and surplus requirements more accurately reflect the underwriting risk of different lines of insurance as well as investment risks that attend insurers' operations, the NAIC has tested insurer's risk-based capital requirements since 1994. Each insurer affiliated with the Company as of December 31, 1998 exceeded all standards tested by the formula applying risk-based capital requirements as of year-end 1998. 18 Page 18 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, 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. INVESTMENTS The Company's investment portfolio is managed to provide growth of statutory surplus in order to facilitate increased premium writings over the long term while maintaining the ability to service current insurance operations. The primary objectives are to generate income, preserve capital and maintain liquidity. The Company's investment portfolio is managed separately from that of Mutual and its affiliates and investment results are not shared by each of the Pooled Companies through the pooling arrangement. The investment management services on behalf of the Company and Mutual and its subsidiaries are performed by Stateco, although investment policies to be implemented by Stateco continue to be set for each company through the Investment Committee of its Board of Directors. See "Investment Management Services" in the "Narrative Description of Business." 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 2.0% 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 Part II - Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations"). Strategies as to specific investments can change depending on the Company's current federal tax position, market interest rates and general market conditions. Consequently, pursuant to the Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities," the Company segregates a portion of its fixed maturity investments for the purpose of providing greater flexibility in the investment portfolio. Fixed maturities that are purchased with the intention and ability of holding them until maturity are categorized as held-to-maturity and carried at amortized cost. Fixed maturities that may be sold, thereby providing the Company the flexibility noted above, are categorized as available-for-sale and are carried at fair value. Fixed maturities available-for-sale totaled $481.8 million, and $421.0 million at December 31, 1998 and 1997, respectively. During 1997, the Company began a program to build on the equity portfolio to enhance growth of surplus over the long term. At December 31, 1998 and 1997, respectively, the equity portfolio totaled $42.2 million and $26.1 million. 19 Page 19 The table below provides information about the quality of the Company's fixed maturity portfolio
Bond Portfolio Quality Investment Grade Corporates and Municipals 73.2% U.S. Governments 17.7% U.S. Government Agencies 9.1%
The following table sets forth the Company's investment results for the periods indicated:
Year Ended December 31 -------------------------------------------------- 1998 1997 1996 ---- ---- ---- (Dollars in thousands) Average invested assets (1) $571,152 $519,298 $488,528 Net investment income (2) $32,506 $31,107 $29,863 Average yield 5.7% 6.0% 6.1%
- -------------- (1) Average of the aggregate invested assets at the beginning and end of each period. Invested assets include fixed maturities at amortized cost, equity securities at cost and cash equivalents. (2) Net investment income is net of investment expenses and does not include realized or unrealized investment gains or losses or provision for income taxes. - -------------- INVESTMENT MANAGEMENT SERVICES Stateco has been providing investment management services since April 1993. These services are provided to all insurance companies affiliated with the Company or Mutual, including Mutual, Midwest Security, State Auto P&C, Milbank, National, Farmers Casualty and Mid-Plains. Stateco has entered into an Investment Management Agreement with each of these entities, pursuant to which Stateco manages the investment portfolios of these companies and receives an investment management fee based on performance and the size of the portfolio managed for each affiliate. INSURANCE PREMIUM FINANCE SERVICES Through Stateco, the Company provides insurance premium finance services to certain policyholders of Mutual, State Auto P&C and Milbank. Premiums for property and casualty insurance are typically payable at the time a policy is placed in force or renewed. On certain large commercial policies, the premium cost may be difficult for a policyholder to pay in one sum. Stateco makes loans to commercial insurance policyholders for the term of an insurance policy to enable them to pay the insurance premium in installments over the term of the policy, and retains a contractual right to cancel the insurance policy if the loan installment is not paid on a timely basis. 20 Page 20 INSURANCE SOFTWARE BUSINESS S.I.S. is developing and selling software used by insurance companies and agencies to allow more efficient and effective electronic management and communication of policyholder data from insurers to agents (download) and from agents to insurers (upload). S.I.S.' principal product, SEMCI Partner(R), is an alternative to significantly more costly agency management systems. SEMCI Partner(R), S.I.S. believes will be attractive to a substantial segment of independent insurance agencies. While S.I.S.' principal customer from a revenue standpoint is Mutual, it has sold and continues to sell SEMCI Partner(R) directly to agents, including agents who do not represent the State Auto Group. S.I.S.' revenue from SEMCI Partner(R) and other S.I.S. software sales is not material to the Company at this time. PROPERTY LEASING BUSINESS As noted above, the Company formed 518 PML, an Ohio limited liability company in December 1997. The initial members of 518 PML are Stateco and State Auto P&C. Stateco contributed $7.0 million in cash and a parcel of real property located in Goodlettsville, Tennessee, while State Auto P&C contributed real property located in Greer, South Carolina. 518 PML is constructing an office building on the real estate in Goodlettsville, which it expects to lease to Mutual commencing in the summer of 1999 for Mutual's Nashville Regional Office facility. 518 PML has leased the Greer property to Mutual to use as its Southern Regional Office facility. Revenue from 518 PML is not material to the Company at this time. YEAR 2000 See discussion included in Part II - Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations." COMPETITION The property and casualty insurance industry is highly competitive. Price competition has been very intense during recent years. This was particularly true in regards to commercial lines in 1998. In addition, over the course of the year there was evidence of rate reduction activity primarily by non-standard and "national" carriers and active marketing efforts with respect to personal lines auto insurance. 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, and quality service to the policyholder and the agent and through a fully developed agency relations program. EMPLOYEES As of March 5, 1999, the Company had 48 employees. See "Management Agreement." All of the other personnel providing services to State Auto Financial and its subsidiaries are employed by Mutual and made available under the terms of the Amended and Restated Management Agreement. See "Management Agreement" in the "Narrative Description of Business." At December 31, 1998, Mutual had approximately 1,230 full-time permanent employees. Employees of the Company and of Mutual are not covered by any collective bargaining agreement. Management of Mutual and of the Company consider their relationship with the employees to be excellent. 21
Page 21 EXECUTIVE OFFICERS OF THE REGISTRANT Name of Executive Officer and Principal Occupation(s) An Executive Officer Position(s) with Company (1) Age During the Past Five Years of the Company Since (2) - ------------------------------ ----- -------------------------- ------------------------ Robert L. Bailey, 65 Chairman of the Board of STFC, 3/93 to 1991 Chairman of the Board present; Chief Executive Officer of and Chief Executive Officer STFC, 5/91 to present; President of STFC, 5/91 to 5/96; Chairman of the Board of Mutual, 3/93 to present; Chief Executive Officer of Mutual, 5/89 to present; President of Mutual, 1983 to 5/96 Robert H. Moone, 55 President and Chief Operating Officer 1991 President and of STFC, 5/96 to present; Executive Chief Operating Officer Vice President, 11/93 to 5/96 and prior thereto Vice President of STFC; President and Chief Operating Officer of Mutual and National, 5/96 to present; Executive Vice President, 11/93 to 5/96 and prior thereto, Senior Vice President of Mutual Steven J. Johnston, 39 Vice President, Treasurer and Chief 1994 Vice President, Financial Officer of STFC and Mutual, Treasurer and Chief 4/97 to present; Vice President of Financial Officer STFC and Mutual, 5/95 to 4/97; Assistant Vice President of Mutual, 8/92 to 5/95 John R. Lowther, 48 Vice President, Secretary and General 1991 Vice President, Secretary Counsel of STFC, 5/91 to present; Vice and General Counsel President, Secretary and General Counsel of Mutual, 8/89 to present Michael F. Dodd, 61 Senior Vice President of STFC, 5/91 to 1991 Senior Vice President present; Senior Vice President of Mutual, 2/89 to present Terrence L. Bowshier, 46 Vice President and Comptroller of STFC 1991 Vice President and and Mutual, 5/91 to present Comptroller James E. Duemey, 52 Vice President and Investment Officer 1991 Vice President and of STFC and Mutual, 5/91 to present Investment Officer Terrence P. Higerd, 54 Vice President of STFC, 5/91 to 1991 Vice President present; Vice President of Mutual, 6/87 to present Gary L. Huber, 56 Vice President of STFC, 3/98 to 1997 Vice President present; Vice President of Mutual, 5/97 to present; Chief Operating Officer United Fire and Casualty Insurance Company, Des Moines, Iowa for more than five years prior to his joining Mutual Noreen W. Johnson, 50 Vice President of STFC and Mutual, 3/98 1998 Vice President to present; Assistant Vice President of Mutual, 3/97 to 3/98; employee of Mutual, 9/92 to 3/97 Robert A. Lett, 59 Vice President of STFC 3/98 to 1994 Vice President present; Vice President of Mutual, 2/88 to present
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Page 22 EXECUTIVE OFFICERS OF THE REGISTRANT Name of Executive Officer and Principal Occupation(s) An Executive Officer Position(s) with Company (1) Age During the Past Five Years of the Company Since (2) - ------------------------------ ----- -------------------------- ------------------------ John B. Melvin, 49 Vice President of STFC, 3/98 to 1994 Vice President present; Vice President of Mutual, 11/93 to present; and prior thereto an officer of Mutual Cathy B. Miley,(3) 49 Vice President of STFC, 3/98 to 1995 Vice President present; Vice President of Mutual, 3/95 to present; Assistant Vice President of Mutual, 8/92 to 3/95 Richard L. Miley,(3) 45 Vice President of STFC, 3/98 to 1995 Vice President present; Vice President of Mutual, 5/95 to present; Assistant Vice President of Mutual, 8/87 to 5/95
(1) Except for Mr. Bailey, each of the executive officers is elected by the respective company's Board of Directors for an indefinite term. Mr. Bailey has executed an employment agreement effective January 1, 1996, which is for a five-year term. (2) Each of the foregoing executive officers has been designated by the Company's Board of Directors as an officer for purposes of Section 16 of the Securities Exchange Act of 1934. (3) Richard L. Miley and Cathy B. Miley are husband and wife. ITEM 2. PROPERTIES - ------- ---------- Because the operations of the Company and Mutual are integrated with one another pursuant to the terms of the Amended and Restated Management Agreement, the Company and Mutual share their operating facilities. See Item 1, "Management Agreement" in the "Narrative Description of Business." The Company's and Mutual's corporate headquarters are located in Columbus, Ohio in buildings owned by Mutual that contain approximately 270,000 square feet of office space. The Company and Mutual also have regional underwriting and claims office facilities which they share through the Amended and Restated Management Agreement. These facilities include a 6,600 square foot branch office in Cleveland, Ohio owned by Mutual, and a 29,000 square foot branch office in Cincinnati, Ohio owned by Mutual. In addition, Mutual currently leases a 22,800 square foot regional office in Nashville, Tennessee pursuant to a 10-year lease. In June 1999, the Company expects an office building being constructed by 518 PML containing 38,000 square feet to be completed and occupied by Mutual as its Nashville Regional Office. Mutual also leases the regional office facility in Greer, South Carolina from 518 PML. Milbank owns an office facility in Milbank, South Dakota where Mutual employees provide services to Milbank agents and policyholders. Midwest Security leases an office facility in Onalaska, Wisconsin where Mutual employees service Midwest Security's agents and policyholders. Farmers Casualty leases an office in West Des Moines, Iowa where Mutual's employees service Farmers Casualty's and Mid-Plains' policyholders and agents. Mutual also leases a number of small offices throughout its operating area for the claims operations of Mutual and the Company. ITEM 3. LEGAL PROCEEDINGS - ------- ----------------- The Company is a party to a number of lawsuits arising in the ordinary course of its insurance business. Management of the Company believes that the ultimate resolution of these lawsuits will not, individually or in the aggregate, have a material, adverse effect on the financial condition of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS - ------- --------------------------------------------------- Not applicable. 23 Page 23 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON SHARES AND RELATED SHAREHOLDER MATTERS - ------- ----------------------------------------------------------------- STOCK TRADING Common shares are traded in the Nasdaq National Market System under the symbol STFC. As of March 12, 1999, there were 910 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:
1997 HIGH Low Dividend ---- ---- --- -------- First Quarter $ 9.50 $ 8.38 $.020 Second Quarter 11.50 8.38 .020 Third Quarter 11.94 10.13 .023 Fourth Quarter $ 16.13 $ 11.63 $.023 1998 ---- First Quarter $ 20.00 $ 14.25 $.023 Second Quarter 19.88 15.13 .023 Third Quarter 16.63 12.25 .025 Fourth Quarter $ 14.75 $ 11.44 $.025 (1)Adjusted for a March 1993 two-for-one, a July 1996 three-for-two common stock split effected in the form of a stock dividend and a July 1998 two-for-one common stock split, respectively.
Additionally, see Liquidity and Capital Resources section of "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in Item 7 of this Form 10-K Annual Report. ITEM 6. SELECTED FINANCIAL DATA - ------- ----------------------- "Selected Consolidated Financial Data" is as follows: 24
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) SELECTED CONSOLIDATED FINANCIAL DATA YEAR ENDED DECEMBER 31 ---------------------- 1998* 1997(1) 1996(1) 1995*(1) 1994(1) ----- ------- ------- -------- ------- STATEMENTS OF INCOME DATA: (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) Earned premiums $ 356,210 320,050 304,472 296,364 225,297 Net investment income $ 32,506 31,107 29,863 28,461 22,189 Management services income $ 7,945 7,367 6,774 6,377 5,170 Net realized gains on investments $ 2,925 3,043 2,788 1,758 1,595 Other income $ 2,473 1,409 1,200 525 147 ---------------------------------------------------------------- Total revenues $ 402,059 362,976 345,097 333,485 254,398 ---------------------------------------------------------------- Income before federal income taxes $ 49,605 56,638 34,792 40,953 20,294 ---------------------------------------------------------------- Net income $ 37,497 40,998 26,407 29,894 15,835 ---------------------------------------------------------------- Earnings per common share(2)(3): Basic $ .89 .99 .64 .73 .39 ---------------------------------------------------------------- Diluted $ .87 .97 .63 .72 .39 ---------------------------------------------------------------- Cash dividends per common share(1) $ .10 .09 .08 .07 .06 ---------------------------------------------------------------- BALANCE SHEET DATA AT YEAR END: Total investments $ 579,966 526,363 499,277 479,908 350,639 Total assets $ 709,778 638,823 586,327 566,445 434,636 Total stockholders' equity $ 340,824 297,258 247,619 225,763 175,852 Book value per common share(2) $ 8.11 7.11 5.98 5.48 4.29 STATUTORY RATIOS: Loss ratio 68.4 65.2 72.7 68.6 75.4 Expense ratio 29.4 28.9 27.3 31.0 28.2 Combined ratio(4) 97.8 94.1 100.0 99.6 103.6 Industry combined ratio(5) 105.0 101.6 105.8 106.5 108.5 Ratio of net premiums written to statutory capital and surplus 1.63 1.71 1.91 2.12 1.77 (1) Financial information prior to 1998 has been restated to include the financial position and operations of Milbank Insurance Company. (2) Adjusted for a July 1998 2-for-1 common stock split as well as a July 1996 3-for-2 common stock split effected in the form of a stock dividend. (3) The earnings per share amounts prior to 1997 have been restated as required to comply with SFAS No. 128. (4) Derived from combined statutory financial statements on a pooled basis, including State Auto National. (5) Preliminary industry information for 1998 from A.M. Best Co. * Reflects change in pooling arrangement, effective January 1, 1998 and January 1, 1995.
25 Page 24 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - ------- ----------------------------------------------------------------------- "Management's Discussion and Analysis of Financial Condition and Results of Operations" is as follows: OVERVIEW State Auto Financial Corporation (State Auto Financial), through its principal insurance subsidiaries, State Auto Property and Casualty Insurance Company (State Auto P&C) and Milbank Insurance Company (Milbank), provides personal and commercial insurance for the standard insurance market primarily in the Midwest and eastern United States, excluding New York, New Jersey, and the New England states. Their principal lines of business include personal and commercial auto, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. Another insurance subsidiary of State Auto Financial, State Auto National Insurance Company (National), writes personal automobile insurance for risks in the nonstandard insurance market. State Auto P&C, Milbank and National's products are marketed through independent agents. State Auto P&C provides executive management services to oversee the insurance operations of all the State Auto Insurance Companies, which include: Milbank, National and State Automobile Mutual Insurance Company (Mutual) - a majority shareholder of State Auto Financial - and Mutual's wholly owned subsidiary, Midwest Security Insurance Company (Midwest Security) (Midwest Security was acquired by Mutual effective January 1, 1997) and until June 30, 1997, State Auto Life Insurance Company (State Auto Life was sold by Mutual effective July 1997). On July 7, 1998, State Auto Financial completed the exercise of its option, pursuant to the Option Agreement dated August 1993, with Mutual by acquiring the outstanding shares of Milbank. Milbank had been a wholly owned subsidiary of Mutual since July 1, 1993, but as a result of this transaction, Milbank is now a wholly owned subsidiary of State Auto Financial. The purchase price of Milbank was approximately $81.9 million. The transaction was effected through an exchange with Mutual of approximately 5.1 million State Auto Financial common shares for all the issued and outstanding capital stock of Milbank. This exchange of Milbank shares for State Auto Financial common shares increased Mutual's ownership of State Auto Financial to approximately 70% of its issued and outstanding shares. Since the transaction was a combination of entities under common control it has been accounted for similar to a pooling of interests. The prior years' financial information has been restated to include the financial position and operations of Milbank. Stateco Financial Services, Inc. (Stateco), a wholly owned subsidiary of State Auto Financial, provides investment management services to affiliated companies and also provides insurance premium finance services to customers of State Auto P&C, Milbank and Mutual. Strategic Insurance Software, Inc. (S.I.S.), a majority owned subsidiary, develops and sells software for the processing of insurance transactions, database management for insurance agents and electronic interfacing of information between insurance companies and agents. S.I.S. sells services and products to affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies. 518 Property Management and Leasing, LLC (518 PML), an Ohio limited liability company, was formed in December 1997 to engage in the business of owning and leasing real and personal property to affiliated companies. On January 1, 1998, State Auto P&C and Stateco became the initial members of 518 PML with State Auto P&C contributing real property and Stateco contributing $7.0 million in cash and real property. State Auto Financial, State Auto P&C, Milbank, National, Stateco, S.I.S. and 518 PML are referred to collectively herein as the Company. In August 1998, State Auto Financial purchased $9.0 million of surplus notes from Farmers Casualty Company Mutual (Farmers Casualty), an Iowa domiciled property casualty insurer for the 26 Page 25 standard insurance market. In 1998, a plan to convert Farmers Casualty into a stock insurance company was approved by the board of Farmers Casualty, its policyholders and the Iowa Division of Insurance. The plan of conversion contemplated that State Auto Financial, in exchange for the redemption of the surplus notes, would acquire the newly issued shares of Farmers Casualty. Effective January 1, 1999, Farmers Casualty, renamed Farmers Casualty Insurance Company, became a wholly owned subsidiary of State Auto Financial. In addition, Farmers Casualty owns 100% of the outstanding shares of Mid-Plains Insurance Company, an Iowa domiciled property casualty insurer, which principally writes nonstandard auto insurance. Since 1995, State Auto P&C and Milbank, the companies comprising the standard insurance segment, have participated in a reinsurance pooling arrangement (the Arrangement) with Mutual. The Arrangement provides that all premiums, losses, loss expenses and underwriting expenses of each company be pooled and then allocated back to each company based on percentages outlined in the Arrangement. Through December 31, 1997, the pooling percentages were allocated as follows: 35% to State Auto P&C, 10% to Milbank and 55% to Mutual. Effective January 1, 1998, the Arrangement was amended to include all of the property and casualty business of Midwest Security. Concurrently with the inclusion of Midwest Security, the pooling percentages were amended to allocate 37% to State Auto P&C, 52% to Mutual, 10% to Milbank and 1% to Midwest Security. In connection with the January 1, 1998 pooling change, State Auto P&C and Milbank received approximately $19.7 million to cover their increased share of the pooled liabilities. The pooling Arrangement was amended again effective January 1, 1999, to include all of the property and casualty business of Farmers Casualty. With the inclusion of Farmers Casualty in the pool, the pooling participation percentages were amended to allocate 37% to State Auto P&C, 49% to Mutual, 10% to Milbank, 1% to Midwest Security and 3% to Farmers Casualty. In discussing Results of Operations, State Auto P&C, National, Mutual, Milbank and Midwest Security are referred to collectively as the State Auto Insurance Companies, while State Auto P&C, Mutual, Milbank and Midwest Security are referred to as the Pooled Companies. RESULTS OF OPERATIONS Net income for the Company decreased 8.5% in 1998 (increased 55.3% in 1997). The Company's statutory combined ratios for 1998, 1997 and 1996, respectively, were 97.8%, 94.1% and 100.0%. Impacting the Company's results for 1998 and 1996 was an increase in the level of catastrophe losses for these periods; 1996 being the worst catastrophe year in the Company's history and 1998 being the second worst. Consolidated earned premiums increased 11.3% in 1998 (5.1% in 1997). This 11.3% increase was derived from three sources. The impact of the change in allocation percentages of the Company's pooling percentages as well as the addition of Midwest Security to the pool increased consolidated earned premiums 7.1%. The growth in the standard insurance segment, excluding the impact of the changes in the pooling arrangement, increased consolidated earned premiums 2.9% (2.6% in 1997). The Company's nonstandard insurance segment (i.e., National) increased consolidated earned premiums 1.3% from the previous period (2.5% in 1997). State Auto P&C and Milbank, which represents State Auto Financial's standard insurance segment, achieved a 10.7% increase in earned premiums in both personal and commercial lines in 1998 (2.7% in 1997). Of the 10.7% increase, 7.6% was due to the change in the pooling arrangement and 3.1% (2.7% in 1997) was due to external growth. With respect to personal lines, in both 1998 and 1997, the Pooled Companies' produced an increase of approximately 1.0% in its direct written premiums despite a significant increase in aggressive price competition in this book of business. Contributing favorably to the personal lines business over the last few years has been the Company's Prime of Life program (the Program), that targets insureds 50 and older, that was first introduced by the Company in late 1995. The Program, which has consistently generated 25% of the Company's new business, has also exhibited a significantly higher than average retention rate. The continued growth of the Program is gradually changing the profile of the Company's personal lines book of business as more and more baby boomers age into eligibility. 27 Page 26 The commercial lines direct written premium of the Pooled Companies increased in 1998 approximately 3.3% (8.3% in 1997). The rate of growth on the Company's commercial lines has slowed in recent years due primarily to a reduction in premiums in the Company's workers' compensation line of business which is due to rate reductions resulting from decreases in loss costs as promulgated by various rating bureaus. This phenomena, that began in late 1996, continued into 1998. The workers' compensation line of business represents approximately 10% of the Pooled Companies' commercial business at the end of 1998. The nonstandard segment (National) increased its earned premiums in 1998 19.0% (56.8% in 1997). This segment's growth has slowed compared to prior year levels due to aggressive underwriting action designed to improve profitability in Tennessee and Arkansas, National's two largest states, a more restrictive underwriting posture with several larger producers in its other states, and rate increases implemented during 1997 in several operating states. While these actions have resulted in a decrease in growth over prior year levels, National`s statutory loss experience has improved over comparative prior periods. See discussion below. National began operations in four new states during 1998: Indiana, Pennsylvania, Utah and Wisconsin. Contributing to National's 56.8% increase in premiums in 1997 was entry into Arkansas and Georgia in December 1996, Minnesota in February 1997 and in the later half of 1997, Alabama, Illinois and Missouri. In 1999, National has planned entry into at least three new states: South Carolina, South Dakota and Maryland. In 1998 premium growth was harder to achieve than it has been in some time. While commercial lines pricing continued to be very aggressive, the personal lines part of our business is also seeing intense price competition, with increased marketing activity among major players in personal lines auto insurance. This adversely affected the Pooled Companies ability to generate new business because management has continued to stress responsible pricing and diligent underwriting in contrast to much of its competition. At least annually, the State Auto Insurance Companies reviews each line of business to ensure that it is appropriately priced. As a result, much of the premium growth noted above within the standard insurance segment was attributable to the State Auto Insurance Companies' ability to put into place price increases on the existing book of business as opposed to the sale of new units. The Company has attempted to address the difficulties of securing growth by making selective acquisitions which afford opportunities for increased writings in new, desirable states of operation. Within the last eight years, entry into new states, other than Oklahoma, has been by acquisition. In 1993 Mutual acquired Milbank which took the State Auto Insurance Companies into South and North Dakota, Minnesota and Utah. In 1997 Mutual acquired Midwest Security, thus entering Wisconsin. In 1999, State Auto Financial acquired Farmers Casualty and Mid-Plains taking the State Auto Insurance Companies into Iowa and Kansas. Though all of these acquisitions have been primarily personal lines companies, they have taken the Company into additional targeted states with an established independent agency force with an existing book of business on which to build. Management believes this reduces start up costs and permits faster growth in new states than has been the case with starting in a new state from scratch. With an established agency force, the Company has a "ready made" distribution force for offering an expanded product portfolio, including commercial lines and additional personal lines products. Net investment income increased 4.5% in 1998 (4.2% in 1997). Contributing to the increase over previous years was an increase in cash flow from operations and a general increase in investable assets over the previous year's levels. Total cost of investable assets at December 31, 1998, 1997 and 1996, respectively, was $590.8 million, $535.2 million and $488.3 million. Additionally, in 1998 State Auto P&C and Milbank received approximately $19.7 million in conjunction with the change in the pooling arrangement. The investment yields, based on fixed and equity securities at cost, were 5.7%, 6.0% and 6.1% for the annual periods ending 1998, 1997 and 1996, respectively. Contributing to the decrease in the investment yields over these periods has been a decline in the overall market fixed maturity interest rate environment from the previous comparable periods as well as a gradual shift in the composition of the fixed maturity portfolio from taxable to tax-exempt fixed maturities. At December 31, 1998, 1997 and 1996, respectively, tax exempt securities comprised approximately 71%, 59%, and 52% of the fixed maturity portfolio. Somewhat lower yields are expected in 1999 on the fixed maturity portfolio given that a number of high yield fixed maturities are being called or maturing and are being reinvested at current 28 Page 27 lower yielding rates. Despite these lower yielding rates, the Company has no intention of compromising the quality of its portfolio for higher yielding, more risky investments. Additionally, the Company began a program in late 1997 to build on the equity portfolio to enhance growth of statutory surplus over the long term, which continued in 1998. See further discussion regarding investments at the Investments Market Risk section included herein. In February 1999, President Clinton proposed the 2000 fiscal year budget. One of the more significant revenue raising proposals contained in the budget directly affects property and casualty insurance companies. Property and casualty insurance companies are currently limited on the deductibility of the investment income earned on tax exempt fixed maturities and certain dividends received to 85%. This reduction was the result of the Tax Act of 1986. President Clinton, in his February proposal, has proposed a further limitation of 10% (i.e., deductibility of investment income earned from tax exempt fixed maturities and certain dividends received would be limited to 75%). The current proposal would be effective for taxable years beginning after the date of enactment, with respect to investments acquired on or after the date of first committee action. President Clinton had proposed a similar action for the 1999 fiscal year budget limiting the deductibility of investment income earned on tax exempt fixed maturities and certain dividends received to 70%. The municipalities lobbied very hard against such action as property and casualty insurance companies and other financial service industries are the largest investors in municipalities' fixed maturities. If this revenue raising proposal passes as it currently stands, certain tax exempt securities would become less appealing to the property and casualty insurance industry as the relative spread between after tax yields on tax-exempt and taxable fixed income maturities will narrow. This management will be monitoring the government's actions regarding this proposal. However, it is still too early in the budget process to anticipate the outcome. Management services income, which includes income generated from the investment management services segment and executive management services provided by Stateco and State Auto P&C, respectively, increased $0.6 million in both 1998 and 1997. Other income includes primarily revenue from S.I.S.' sales of its software products, and beginning in 1998 rental income on property leased by 518 PML. In 1998, other income increased 76% (17% in 1997). 518 PML's commencement of leasing operations in 1998 increased other income 19% while S.I.S.' increase in software sales over 1997 contributed a 47% increase. In 1997, other income was comprised mainly of S.I.S. software sales which increased 17% from same period in 1996. Losses and loss expenses, as a percentage of earned premiums, were 68.0%, 65.1% and 72.3% for years 1998, 1997 and 1996, respectively. As previously discussed, the Company experienced increased levels in storm-related catastrophe losses in 1998 and 1996, primarily in the standard insurance segment. The second quarter 1998 was impacted by storm-related catastrophe losses occurring in nearly all operating states and the third quarter was adversely affected by several Midwestern wind and hail storms. The impact of the 1998 catastrophe losses amounted to 8.1 GAAP loss ratio points whereas catastrophe losses totaled 2.4 GAAP loss ratio points. Despite the higher level of catastrophe losses as compared to 1997, the Company did not experience any significant loss activity from hurricanes Bonnie, Earl and Georges. In 1996 the Company was impacted by severe winter weather and storm losses in Raleigh, North Carolina resulting from Hurricane Fran moving inland. The impact of the 1996 catastrophe claims amounted to 9.3 GAAP loss ratio points. The relatively low level of hurricane losses within the last three years validates the Company's strategy of closely monitoring concentration of risks subject to coastal losses. Absent the increased level of catastrophes, the Company's underlying book remained strong and in fact, reflects improvement from prior years, validating the Company's philosophy of responsible underwriting versus emphasis on premium growth achieved with irresponsible pricing or risk selection. Losses and loss expenses, as a percentage of earned premiums, for the nonstandard insurance segment, were 74.4%, 79.4% and 76.6% for the years ended 1998, 1997 and 1996, respectively. Increase in the 1997 ratio was due to underwriting problems that occurred in two of the segment's larger states of operations as previously discussed. In early 1997, National implemented rate increases in these two states and took a more aggressive underwriting posture with several of its larger agencies in an effort to control the underwriting losses this segment was beginning to experience. 29 Page 28 In an effort to reduce its exposures to any one type of catastrophic loss, the Company, in recent years, has sought to geographically diversify into regions of the country not exposed to earthquakes and hurricanes. As previously discussed, this has been accomplished through the acquisitions of Milbank, Midwest Security, Farmers Casualty and Mid-Plains. While some states are not subject to the threats of hurricanes or earthquakes, virtually all have some windstorm and or hail exposure. Along with the increasing geographic dispersion of the Company's underwriting risk portfolio, the Company continues to refine its methods of monitoring its exposures to all types of catastrophe hazards. Acquisition and operating expenses, as a percentage of earned premiums (the "expense ratio"), were 29.3%, 29.5% and 28.2% for the years 1998, 1997 and 1996, respectively. The decrease in the expense ratio in 1998 can be attributed to a reduced amount of Quality Performance Bonus (the Bonus) paid to employees compared to that paid in 1997, but this was partially offset by an increase in guaranty fund assessments. The increase in the 1997 expense ratio from that in 1996 is due to the amortization of software expenses, the Bonus and the amount of bonus compensation earned by the Company's agents. Beginning with the first quarter of 1997, the State Auto Insurance Companies began amortizing costs associated with the development of its claims and billing processing system that began a little over two years ago. The amortization period of these costs will be approximately three years. The Bonus in 1997 exceeded that which was earned in 1996 due to an improvement in the underwriting operations of the Company in 1997. Also contributing to this increase was an increase over 1996 of the amount of bonus compensation earned by the Company's agents. Each agent who meets certain premium production thresholds shares in the underwriting profits generated by insurance placed by them. In an attempt to improve the efficiency of its operations and thereby reduce overall operating expenditures in the long-term, the Company has been making strides in the use of technology to streamline its personal and commercial operations, specifically in the area of electronic upload and download with its agencies using the APT industry standard. The advent of electronic transfers between the agent and the Company should have a long-term positive impact on the Company's expenses as the Company has been able to reduce its paper and postage costs as well as stabilize its employee count which should continue as this process expands to more agencies and lines of business. Additionally, it should improve the efficiency and effectiveness of the operations of both the agent and the Company through quicker response time and increased accuracy. In addition to the use of technology, the Company is realigning its claims procedures in order to improve service and reduce settlement expenses. The Company extensively trains its claims adjusters, whose professionalism is exhibited by the low number of complaints received by the various state insurance regulators. While the Company trains each adjuster to handle all types of claims, the Company recognizes that many claims are small and routine in nature. Rather than have a thoroughly trained adjuster spend time on these claims, the Company has established a Central Claims Department staffed by persons who focus exclusively on these losses. This allows for quicker response time to the insured, allows the fully trained claims adjuster to focus on the more serious claims, and reduces the use of independent adjusters. Other expense includes those operating expenses associated with general corporate expenses, S.I.S., 518 PML and Stateco's investment management services (the investment management services segment). In 1998 other expense increased 58.2% (12.1% decrease in 1997). S.I.S.' operating expenses increased over 1997 contributing an increase of 20% to other expense. Also contributing to this increase was an increase in write-offs of premium receivable during 1998, primarily in the nonstandard insurance segment. This segment has sought to improve its premium receivable collections by retaining the services of a third party whose business is receivables collection. Additionally, there was a general increase in corporate expenses over 1997. The decrease in other expenses in 1997 is primarily due to the State Auto Insurance Companies changing the catastrophe portion of its reinsurance program beginning July 1, 1996, that prior to this period was accounted for as deposit reinsurance (See Liquidity and Capital Resources). Expenses associated with the catastrophe portion of the program accounted for as deposit reinsurance were included in other expense. 30 Page 29 The effective Federal tax rate was 24%, 27% and 24% for the years ended 1998, 1997 and 1996, respectively. The lower rates in 1998 and 1996 were due to a decrease in the underwriting profit compared to the 1997 period as a result of the increased storm related catastrophes experienced by the Company during these periods as well as a shift in the composition of its investment portfolio from taxables to tax-exempts, as previously noted. The increased rate in 1997 was due to an increase in underwriting profit recorded for the year and higher realized capital gains. LIQUIDITY AND CAPITAL RESOURCES Liquidity refers to the ability of a company to generate adequate amounts of cash to meet its needs for both long and short-term cash obligations as they come due. The Company's significant sources of cash are premiums, investment income and investments as they mature. The Company continually monitors its investment and reinsurance programs to ensure they are appropriately structured to enable the insurance subsidiaries to meet anticipated and unanticipated short and long-term cash requirements without the need to sell investments to meet fluctuations in claim payments. In 1998, net cash provided by operating activities increased to $56.7 million ($28.9 million in 1997). This increase is due to the transfer of $19.7 million to State Auto P&C and Milbank in connection with the amended pooling arrangement, as discussed above, as well as a general increase in cash flows that resulted from a change in pool percentages from previous periods. In 1997, net cash provided by operating activities increased to $28.9 million ($24.2 million in 1996). This 1997 increase in cash flow was due to an overall improvement in the insurance operations of the Company, attributable to lower catastrophe losses from the previous year. Over the last three years, operating cash flows have been sufficient to meet the operating needs of the Company while providing opportunities for increased investment and financing needs. Management does not anticipate any significant changes in its operating cash flow. Net cash used in investing activities reflects cash flows used in purchases of fixed maturities and equity securities, respectively, of $193.9 million and $17.1 million in 1998, $137.6 million and $13.7 million in 1997 and $164.5 million and $11.8 million in 1996. The decline in the purchase of fixed maturities in 1997 was a matter of timing, as funds invested in cash equivalents at December 31, 1997 were allocated for investment in early 1998. As market interest rates on fixed maturities began to decline over the last three years, the Company began experiencing a steady increase in the amount of calls on fixed maturities. Cash flows provided by maturities, calls and principal reductions of fixed maturities were $47.8 million in 1998, $28.2 million in 1997 and $17.9 million in 1996. During 1998 518 PML began construction of a building in Goodlettsville, Tennessee that will be leased to Mutual and its affiliates in 1999. It is anticipated that the total construction costs of this building, excluding land will be approximately $4.5 million. Net cash provided by financing activities consists of proceeds from issuance of common stock that has exceeded the payment of dividends for the last three years. Mutual, whose ownership in State Auto Financial has increased from 65% to almost 70% in 1998, has waived its right to receipt of the dividends declared by State Auto Financial in an effort to enhance the statutory surplus of the insurance subsidiaries of State Auto Financial for use in support of underwriting operations. Additionally, waivers of dividends by Mutual enhance the Company's financial position which benefits Mutual, the Company's largest shareholder, and other shareholders as well. Each dividend waiver is reviewed by Mutual's Board of Directors. Effective July 1, 1996, the State Auto Insurance Companies negotiated a change in their catastrophe reinsurance program. The amount retained by the State Auto Insurance Companies is $40.0 million for each occurrence, an increase of $20.0 million over the prior program. For up to $80.0 million in losses, excess of $40.0 million, traditional reinsurance coverage is provided. To provide funding if the State Auto Insurance Companies were to incur catastrophe losses in excess of $120.0 million, State Auto Financial entered into a structured contingent financing transaction with Chase Manhattan Bank (Chase) to provide up to $100.0 million for reinsurance purposes. Under this arrangement, in the event of such a loss, State Auto Financial would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which will borrow the money necessary for such purchase from Chase and a syndicate of other lenders. State Auto Financial will contribute to State Auto P&C the proceeds from the sale of its preferred shares. State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank, 31 Page 30 National and beginning July 1, 1998, Midwest Security, pursuant to a catastrophe reinsurance agreement in the amount of $100.0 million excess of $120.0 million (Farmers Casualty and Mid-Plains will be added to the catastrophe reinsurance program in 1999). State Auto P&C will use the contributed capital to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. State Auto Financial is obligated to repay SPC (which will repay the lenders) by redeeming the preferred shares over a six-year period. This layer of $100.0 million in excess of $120.0 million has been excluded from the pooling agreement. In addition, State Auto Financial's obligation to repay SPC has been secured by a Put Agreement among State Auto Financial, Mutual and the Lenders, under which, in the event of a default by State Auto Financial as described in the Credit Agreement or in the Put Agreement, Mutual would be obligated to put either the preferred shares or the loan(s) outstanding. On March 11, 1997, Mutual acquired 100% of the outstanding shares of Midwest Security, effective as of January 1, 1997. In connection with this purchase, Mutual and State Auto Financial entered into an Option Agreement granting State Auto Financial the right to purchase Midwest Security from Mutual within five years at a price determined by a formula set out in the Option Agreement. As of March 19, 1999, State Auto Financial has not exercised its right to acquire Midwest Security. During the first quarter of 1999, State Auto Financial commenced the process of forming a new Ohio stock corporation and obtaining for it a certificate of authority from the Ohio Department of Insurance. It is expected to be a wholly owned subsidiary of State Auto Financial with initial capitalization of approximately $5.75 million. The capitalization is expected to be funded through dividends from subsidiaries. It is anticipated that this new subsidiary, to be called State Auto Insurance Company, will utilize leading edge technology to achieve maximum efficiencies for a carrier operating within the independent agency system. On March 5, 1999, the Board of Directors of State Auto Financial declared a quarterly cash dividend of $0.025 per common share, payable on March 31, 1999, to shareholders of record on March 17, 1999. This is the 31st consecutive cash dividend declared by the Company's Board since State Auto Financial had its initial public offering of common stock on June 28, 1991. Additionally, State Auto Financial has increased cash dividends to shareholders for seven consecutive years. During 1998, the Company's authorized common shares increased to 100 million and the Board declared a two-for-one stock split to be distributed July 8, 1998, to shareholders of record on June 18, 1998. The impact of this stock split has been appropriately reflected in the accompanying consolidated financial statements. The maximum amount of dividends that may be paid to State Auto Financial during 1999 by its insurance subsidiaries, including Farmers Casualty, as a non-extraordinary dividend is limited to $21.9 million, without prior approval under current law. The Company is required to notify the insurance subsidiaries' respective State Insurance Commissioner within five business days after declaration of all dividends and at least ten days prior to payment. Additionally, the domiciliary Commissioner of each insurer subsidiary has the authority to limit a non-extraordinary dividend when the Commissioner determines, based on factors set forth in the law, that an insurer's surplus is not reasonable in relation to the insurer's outstanding liabilities and adequate to its financial needs. Such restrictions are not expected to limit the capacity of State Auto Financial to meet its cash obligations. The National Association of Insurance Commissioners (NAIC) maintains risk-based capital requirements for property and casualty insurers. Risk-based capital is a formula that attempts to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, loss reserve adequacy and other business factors. Applying the risk-based capital requirements as of December 31, 1998, each of the State Auto Insurance Companies exceeded all standards tested by the formula. 32 Page 31 OTHER DISCLOSURES INVESTMENTS Stateco performs investment management services (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 maturities that are purchased with the intention and ability of holding them until maturity are categorized as held to maturity and carried at amortized cost. Fixed maturities that may be sold due to changing investment strategies are categorized as available for sale and are carried at fair value. At December 31, 1998, the Company had no fixed maturity investments rated below investment grade, nor any mortgage loans. As of December 31, 1998, the Company had fixed maturities with a fair value of $481.8 million designated as available for sale compared to $421.0 million at December 31, 1997. During 1998, the Company continued its program to increase its equity portfolio to enhance growth of statutory surplus over the long term. At December 31, 1998 and 1997, respectively, the equity portfolio totaled $42.2 million and $26.1 million. MARKET RISK Investable assets comprise approximately 86% of the Company's total assets. Of the total investments, 88% are invested in fixed maturities, 6.9% in equity securities and the remaining in cash and cash equivalents. 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 ladder-maturity style to ensure adequate cash flow to meet claims as they are presented. At December 31, 1998, the Company's fixed maturity portfolio had an average maturity of 11.1 years. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 2.0% of statutory assets, other than obligations of the U.S. government or government agencies, for which there is no limit. The fixed maturity portfolio is very high in quality with all holdings either in Government obligations, municipal, corporate obligations rated AA or better by the major bond rating agencies. 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, is included in note (2) of the Consolidated Financial Statements. The Company's primary market risk exposures are to changes in market price for equity securities and changes in interest rates and credit ratings for fixed maturity securities. The Company has no exposure to foreign currency exchange rate risk nor does it own any derivative financial instruments. To provide the Company greater flexibility in order to manage its market risk exposures, the Company has segregated a portion of its fixed maturity investments, in accordance with SFAS No. 115, as available for sale. Also, the Company does not maintain a trading portfolio. 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 paydowns from holdings in mortgage backed securities. The table also presents the average interest rate for each period presented. 33
Page 32 PRINCIPAL AMOUNT MATURING IN: (Dollars in thousands) 1999 2000 2001 2002 2003 Thereafter Total Fair Value ---- ---- ---- ---- ---- ---------- ----- ---------- Fixed interest rate securities $11,074 20,513 32,908 52,644 29,508 361,625 508,272 $539,670 Average Interest rate 6.4% 6.3% 6.6% 5.9% 5.1% 6.2% 6.0%
YEAR 2000 Description of the Year 2000 Issues Affecting the Company - ---------------------------------------------------------- The Company commenced work on its Year 2000 ("Y2K") issues in the fall of 1996. At that time, one of its first tasks was to perform an inventory of all software systems. As a result of this inventory, it identified approximately 5 million lines of in house maintained program code in its various software systems. Following this inventory the Company set priorities as to system remediation based on the role each system played in the Company's being able to carry on its insurance operations or meet its general business needs. The Company's applications software must support certain essential functions: issuing insurance policies, collecting policy premiums and paying claims and premium refunds. In addition, there is other applications software used by the Company in the general operation and management of its business. Following months of intensive remediation effort, in April 1998, the Company conducted its first major test of one of its major insurance policy processing systems. The results of that test were positive. The Company conducted a second comprehensive Millennium test at an off-site computer facility in August 1998. All major insurance policy processing systems were tested as if it were the Year 2000. Testing also included Leap Day, February 29, 2000. This test was also successful. In 1999, two additional tests are planned for March and September. Additionally, all internal test systems run with advanced dates giving the Company the opportunity to identify Y2K issues early enough to react to them. At this time, one hundred percent (100%) of the Company's in-force insurance policies are being processed on a Y2K compliant system, based on the test results mentioned above. However, in an effort to ensure that no material problems arise from the policy processing systems used by the Company and its affiliates or subsidiaries (all of which are sometimes collectively referred to hereafter as "State Auto") the Company plans to continue simulated Year 2000 testing throughout 1999. State Auto's Y2K project team has, through February 1999, completed its efforts on approximately 95% of State Auto's applications software. That means that approximately 95% of the software systems State Auto uses in its insurance operations or in meeting its general business needs has been through Y2K remediation, testing, and has been introduced back into the Company's production environment. Included within this 95% are the systems that address policy issuance, premium billing and collection and claims processing at State Auto. The remaining 5% of applications software code that is not presently Y2K compliant involves applications that are not "mission critical", such as certain management reports and other similar tools. Some of this remaining code may well be determined to be obsolete. State Auto plans to have 100% of its non-obsolete applications software Y2K compliant by mid-year 1999. In addition to addressing its own applications software Y2K problems, State Auto may be affected by the Y2K issues of third parties with which it has a material relationship. This includes the independent insurance agents who sell the Company's products, many of whom have automated agency management systems in place. In addition, a number of State Auto Agencies and the Company are able to communicate policy data electronically. There are several agency management systems that permit this so-called upload and download of information but not all are Y2K compliant. If upload and download are disrupted by Y2K issues, it will likely affect the efficiency with which the Company operates its business. 34 Page 33 The Company has surveyed all State Auto Agencies that currently upload data electronically to State Auto and verified that every one of these agencies has a Y2K compliant agency vendor system. For those agencies that only receive a download of policy information from State Auto, current information on the Y2K compliance status of their systems available to State Auto indicates that the majority of them are Y2K compliant. In the event that any of these agencies encounters any difficulty with download, State Auto is prepared to suspend the electronic transfer and turn back on the generation of policy documents of which an agency would need to maintain records manually. The consequences of the disruption would depend on the extent to which State Auto's various lines of business may be uploaded and downloaded at the time the disruption would occur and the duration of the disruption. Thus, it is not possible to reasonably estimate the financial impact of such reduced efficiency. There are certain other vendors which have a material relationship with the company by virtue of the fact that they provide a product or service that State Auto uses in the ordinary course of its business, such as underwriting information providers, task specific software or hardware product vendors, and financial institutions. Y2K compliance by third party vendors will continue to be one of State Auto's focal points throughout the remainder of 1999. State Auto expects to have third party vendor products then in use Y2K compliant by the end of the 3rd quarter of 1999. Stateco Financial Services, Inc. ("Stateco"), a wholly owned subsidiary of State Auto Financial which provides investment management services to each of the State Auto insurers, has had in place a third party vendor investment management system which is represented by the vendor to be Y2K compliant. Based on its present use of this system, Stateco does not expect its services to be disrupted by Y2K issues affecting it, although Stateco will be included in the contingency planning discussed below should some unanticipated system failure arise. State Auto Financial's Costs to Address Year 2000 Issues - -------------------------------------------------------- State Auto Financial's Y2K compliance expense to date for resources has been $1.7 million dollars of a projected $2.4 million dollars. This estimate is subject to change depending on future, presently unforeseen developments which could affect the cost of Y2K compliance for State Auto. The money spent to date is virtually all payroll costs attributable to the State Auto employees on the Y2K project team. The foregoing expense does not include approximately $0.2 million spent by State Auto Financial on accelerated technology purchases for systems or equipment to ensure Y2K compliance for such system or equipment. Also, an outsourcing agreement with State Auto's primary third party software vendor to provide additional resources for other systems projects has generated an additional expense to State Auto Financial of approximately $1.3 million over the last two years. State Auto's Risks Due to Year 2000 Issues - ------------------------------------------ As a property casualty insurer, State Auto faces the additional risk of insured or allegedly insured losses to its policyholders from the Y2K exposure. State Auto has clarified certain commercial liability insurance policies with respect to this exposure. It is too early to know the nature and extent of insured losses that might arise from the Y2K problem, be they from information systems failures or embedded chip processing failures. State Auto does not expect a material adverse impact from Y2K issues arising from embedded chip processing failures occurring on site. Those embedded chip issues which the Company has some opportunity to control or address that have been identified to date have been generally facilities related or involving small business equipment (i.e. fax machines). Upgrades and equipment replacement are being coordinated by a variety of business managers responsible for such equipment. State Auto's Year 2000 Contingency Plans - ---------------------------------------- State Auto has not yet created a formal Y2K contingency plan. Discussions and communications have begun in regards to this. Each internal department has responded to a survey relating to its use of external systems which might be subject to disruption. State Auto has also had one meeting with a 35 Page 34 consultant regarding contingency planning. The Company expects to have a contingency plan in place by the 4th quarter 1999. Some of the issues that the plan would likely contemplate would be manual processing alternatives, non-electronic forms of information distribution, assurance of adequate supplies, and mitigation of the impact of utilities and financial institution disruptions. State Auto continues to work with its business recovery service provider. State Auto is following a program developed by that provider that requires a comprehensive Y2K preparation approach. Conforming to this allows State Auto to take advantage of its provider's facilities for business recovery in the event that an external Y2K issue that was addressed does happen to fail. NEW ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133), which is required to be adopted in years beginning after June 15, 1999. SFAS No. 133 will require companies to recognize all derivatives on the balance sheet at fair value. The Company does not anticipate that the adoption of SFAS No. 133 will have a significant effect on its results of operations or financial position. IMPACT OF SIGNIFICANT EXTERNAL CONDITIONS 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 limitations imposed for competitive pricing. Inflation has been modest over the last several years thereby allowing pricing of premiums to keep pace with inflation on certain 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 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. SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Statements contained herein expressing the beliefs of management and the other statements which are not historical facts contained in this report are forward looking statements that involve risks and uncertainties. Such statements include, without limitation, those pertaining to the weather related catastrophes impacting the Company's losses, product offerings, National's premium receivable collections effort, the Year 2000 discussion, the statements relating to the new insurer to be created, State Auto Insurance Company, the legislative and regulatory environment and sales forecasts. These risks and uncertainties include, but are not limited to, legislative changes, judicial and regulatory decisions, the impact of competitive products and pricing, product development, geographic spread of risk, weather and weather-related events, other types of catastrophic events, fluctuations of securities markets, economic conditions, technological difficulties and advancements, availability of labor and materials in storm hit areas, late reported claims, previously undisclosed damage, utilities and financial institution disruptions, shortages of programmers, and regulatory or governmental systems breakdowns. ITEM 7(a). QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK - ---------- ---------------------------------------------------------- "Qualitative and Quantitative Disclosures About Market Risk" is included in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" under Market Risk. 36 Page 35 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA - ------- ------------------------------------------- The Consolidated Financial Statements, including the Notes to Consolidated Financial Statements and the Report of Independent Auditors are as follows: 37 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders State Auto Financial Corporation We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of State Auto Financial Corporation and subsidiaries as of December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. As discussed in Note 1, the Company acquired the outstanding shares of Milbank Insurance Company from State Automobile Mutual Insurance Company on July 7, 1998 in a transaction accounted for similar to a pooling of interest. Accordingly, the Company's consolidated financial statements for each of the two years ended December 31, 1997 have been restated to include the financial position and operations of Milbank Insurance Company. /S/ERNST & YOUNG LLP Columbus, Ohio February 12, 1999 38
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) CONSOLIDATED BALANCE SHEETS - ----------------------------------------------------------------------------------------------------------------------------- DECEMBER 31 ----------- 1998 1997 ---- ---- ASSETS (dollars in thousands, except share data) (Restated-see Note 1) Fixed maturities: Held to maturity, at amortized cost (fair value $57,826 and $81,571, respectively)......................................................................... $ 55,926 79,300 Available for sale, at fair value (amortized cost $464,008 and $405,815, respectively)......................................................................... 481,844 420,994 Equity securities, available for sale, at fair value (cost $29,233 and $19,120, respectively) 42,196 26,069 ---------------------------- Total investments.......................................................................... 579,966 526,363 Cash and cash equivalents.................................................................. 32,605 30,931 Surplus note receivable.................................................................... 9,000 -- Deferred policy acquisition costs.......................................................... 24,799 22,440 Accrued investment income and other assets................................................. 19,542 17,983 Net prepaid pension expense................................................................ 16,378 14,608 Reinsurance recoverable on losses and loss expenses payable................................ 13,667 12,095 Prepaid reinsurance premiums............................................................... 4,014 4,199 Property and equipment, at cost, net of accumulated depreciation of $1,980 and $1,710, respectively................................................................ 7,927 5,315 Goodwill................................................................................... 1,880 2,078 Due from affiliates........................................................................ -- 2,811 ---------------------------- Total assets............................................................................... $ 709,778 638,823 ---------------------------- - --------------------------------------------------------------------------------------------------------------------------- Liabilities and Stockholders' Equity Losses and loss expenses payable........................................................... $ 218,701 206,250 Unearned premiums.......................................................................... 135,088 125,033 Federal income taxes: Current................................................................................. 2,608 2,278 Deferred................................................................................ 8,095 5,287 Other liabilities.......................................................................... 3,578 2,717 Due to affiliates.......................................................................... 884 -- ---------------------------- Total liabilities.......................................................................... 368,954 341,565 ---------------------------- Commitments and contingencies.............................................................. -- -- Stockholders' equity: Class A Preferred stock (nonvoting), without par value. Authorized 2,500,000 shares; none issued................................................................... -- -- Class B Preferred stock, without par value. Authorized 2,500,000 shares; none issued........................................................................... -- -- Common stock, without par value. Authorized 100,000,000; 42,039,892 and 41,828,845 shares issued and outstanding respectively, at stated value of $2.50 per share....................................................................... 105,100 104,572 Less 13,212 and 8,118 treasury shares, respectively, at cost............................ (167) (90) Additional paid-in capital.............................................................. 41,539 40,210 Accumulated other comprehensive income.................................................. 20,276 14,761 Retained earnings....................................................................... 174,076 137,805 ---------------------------- Total stockholders' equity................................................................. 340,824 297,258 ---------------------------- Total liabilities and stockholders' equity................................................. $ 709,778 638,823 ----------------------------
See accompanying notes to consolidated financial statements. 39
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) CONSOLIDATED STATEMENTS OF INCOME - ----------------------------------------------------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (dollars in thousands, except per share amount) (Restated - (Restated - see Note 1) see Note 1) Earned premiums (net of ceded earned premiums of $14,382, $14,063 and $13,473, respectively) ....................................... $ 356,210 320,050 304,472 Net investment income........................................................ 32,506 31,107 29,863 Management services income .................................................. 7,945 7,367 6,774 Net realized gains on investments............................................ 2,925 3,043 2,788 Other income................................................................. 2,473 1,409 1,200 -------------------------------------------- Total revenues............................................................... 402,059 362,976 345,097 -------------------------------------------- Losses and loss expenses (net of ceded losses and loss expenses of $6,893, $7,359 and $6,561, respectively).................................. 242,294 208,234 220,034 Acquisition and operating expenses........................................... 104,224 94,351 86,003 Other expense................................................................ 5,936 3,753 4,268 -------------------------------------------- Total expenses............................................................... 352,454 306,338 310,305 -------------------------------------------- Income before federal income taxes........................................... 49,605 56,638 34,792 -------------------------------------------- Federal income tax expense (benefit): Current................................................................... 12,271 14,130 8,300 Deferred.................................................................. (163) 1,510 85 -------------------------------------------- Total federal income taxes................................................... 12,108 15,640 8,385 -------------------------------------------- Net income................................................................... $ 37,497 40,998 26,407 -------------------------------------------- Earnings per common share: Basic..................................................................... $ .89 .99 .64 -------------------------------------------- Diluted................................................................... $ .87 .97 .63 -------------------------------------------- Dividends paid per common share.............................................. $ .10 .09 .08 --------------------------------------------
See accompanying notes to consolidated financial statements. 40
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (in thousands) - -------------------------------------------------------------------------------------------------------------------------- ACCUMULATED ADDITIONAL OTHER COMMON COMMON TREASURY TREASURY PAID-IN COMPREHENSIVE RETAINED SHARES STOCK SHARES STOCK CAPITAL INCOME EARNINGS TOTAL ------ ----- ------ ----- ------- ------ -------- ----- BALANCE - DECEMBER 31, 1995 41,188 $102,969 -- $ -- $37,927 $12,473 $72,394 $225,763 (Restated-see Note 1) ------ -------- ------ ------- ------- ------- ------- -------- Net income 26,407 26,407 Unrealized losses, net of tax and reclassification adjustment (4,944) (4,944) ------ Comprehensive income 21,463 ------ Issuance of common stock 220 551 775 1,326 Cash dividends paid (933) (933) BALANCE - DECEMBER 31, 1996 41,408 103,520 -- -- 38,702 7,529 97,868 247,619 (Restated-see Note 1) ------ -------- ------ ------- ------- ------- ------- -------- Net income 40,998 40,998 Unrealized gains, net of tax and reclassification adjustment 7,232 7,232 ----- Comprehensive income 48,230 ------ Issuance of common stock 421 1,052 1,508 2,560 Treasury shares acquired on stock option exercises 8 (90) (90) Change in minority interest of subsidiaries (2) (2) Cash dividends paid (1,059) (1,059) ------ -------- ------ ------- ------- ------- ------- -------- BALANCE - DECEMBER 31, 1997 41,829 104,572 8 (90) 40,210 14,761 137,805 297,258 (Restated-see Note 1) ------ -------- ------ ------- ------- ------- ------- -------- Net income 37,497 37,497 Unrealized gains, net of tax and reclassification adjustment 5,515 5,515 -------- Comprehensive income 43,012 -------- Issuance of common stock 211 528 1,329 1,857 Treasury shares acquired on stock option exercises 5 (77) (77) Change in minority interest of subsidiaries (7) (7) Cash dividends paid (1,219) (1,219) ------ -------- ------ ------- ------- ------- ------- -------- BALANCE - DECEMBER 31, 1998 42,040 $105,100 13 ($167) $41,539 $20,276 $174,076 $340,824 ============================================================================================
41
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) CONSOLIDATED STATEMENTS OF CASH FLOWS - ------------------------------------------------------------------------------------------------------------------------------- YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (in thousands) (Restated - (Restated - see Note 1) see Note 1) Cash flows from operating activities: Net income................................................................ $ 37,497 40,998 26,407 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization, net...................................... 2,666 2,324 2,069 Net realized gains on investments....................................... (2,925) (3,043) (2,788) Changes in operating assets and liabilities: Deferred policy acquisition costs..................................... (1,151) (2,407) 144 Accrued investment income and other assets............................ (2,232) (3,133) (64) Net prepaid pension expense........................................... (1,029) (1,890) (1,556) Reinsurance recoverable on losses and loss expenses payable and prepaid reinsurance premiums................... 4,546 (179) (597) Other liabilities and due to/from affiliates, net..................... 1,130 (5,728) 2,546 Losses and loss expenses payable...................................... (3,400) (5,361) (6,425) Unearned premiums..................................................... 1,733 6,484 4,245 Federal income taxes.................................................. 167 871 208 ------------------------------------------- Cash provided from the change in the reinsurance pool participation percentage.............................................. 19,708 -- -- ------------------------------------------- Net cash provided by operating activities.................................... 56,710 28,936 24,189 ------------------------------------------- Cash flows from investing activities: Purchase of fixed maturities - held to maturity........................... -- -- (9,073) Purchase of fixed maturities - available for sale......................... (193,881) (137,599) (155,392) Purchase of equity securities............................................. (17,051) (13,718) (11,811) Maturities, calls and principal reductions of fixed maturities - held to maturity............................................................. 23,106 10,680 10,110 Maturities, calls and principal reductions of fixed maturities - available for sale................................................................ 24,654 17,545 7,762 Sale of fixed maturities - available for sale............................. 111,085 98,745 121,992 Sale of equity securities................................................. 8,306 9,997 10,943 Purchase of surplus notes receivable...................................... (9,000) -- -- Net additions of property and equipment................................... (2,816) (911) (167) ------------------------------------------- Net cash used in investing activities........................................ (55,597) (15,261) (25,636) ------------------------------------------- Cash flows from financing activities: Net proceeds from issuance of common stock................................ 1,780 2,470 1,325 Payment of dividends...................................................... (1,219) (1,059) (933) ------------------------------------------- Net cash provided by financing activities.................................... 561 1,411 392 ------------------------------------------- Net increase (decrease) in cash and cash equivalents......................... 1,674 15,086 (1,055) ------------------------------------------- Cash and cash equivalents at beginning of year............................... 30,931 15,845 16,900 ------------------------------------------- Cash and cash equivalents at end of year..................................... $ 32,605 30,931 15,845 ============================================ See accompanying notes to consolidated financial statements.
42 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of State Auto Financial Corporation (the Company) and its wholly owned subsidiaries State Auto Property and Casualty Insurance Company (State Auto P&C), Milbank Insurance Company, (Milbank), State Auto National Insurance Company (National), Stateco Financial Services, Inc. (Stateco), and majority-owned subsidiary Strategic Insurance Software, Inc. (S.I.S.). The financial statements also include the operations and financial position of 518 Property Management and Leasing, LLC (518 PML), whose members are State Auto P&C and Stateco. On July 7, 1998, the Company exercised its option with State Automobile Mutual Insurance Company (Mutual), pursuant to the Option Agreement dated August 20, 1993, by acquiring the outstanding shares of Milbank. Milbank had been a wholly owned subsidiary of Mutual since July 1, 1993, but as a result of this transaction, is now a wholly owned subsidiary of the Company. The purchase price of Milbank was approximately $81.9 million. The transaction was effected through an exchange with Mutual of approximately 5.1 million Company common shares for all the issued and oustanding capital stock of Milbank. Since the transaction was a combination of entities under common control it has been accounted for similar to a pooling-of-interests. The prior years' financial information has been restated to include the financial position and operations of Milbank. The following provides financial information for Milbank included in the accompanying financial statements for the years ended December 31, 1997 and 1996:
1997 1996 ---- ---- Revenues....................... $73,416 71,037 Net income..................... $ 7,039 3,805
State Auto Financial Corporation and subsidiaries are referred to herein as "the Companies." The Company, an Ohio corporation, is a majority-owned subsidiary of Mutual. All significant intercompany balances and transactions have been eliminated in consolidation. (b) DESCRIPTION OF BUSINESS The Company, through State Auto P&C, a South Carolina corporation and Milbank, a South Dakota Corporation, provide standard personal and commercial insurance to its policyholders. Their principal lines of business include personal and commercial automobile, homeowners, commercial multi-peril, workers' compensation, general liability and fire insurance. National, an Ohio corporation, provides nonstandard automobile insurance. State Auto P&C, Milbank and National operate primarily in the midwest and eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. State Auto P&C, Milbank and National are chartered and licensed as property and casualty insurers in the states of South Carolina, South Dakota and Ohio, respectively, and are licensed in various other states. As such, they are subject to the regulations of the applicable Departments of Insurance of the states of South Carolina, South Dakota and Ohio (collectively, the Departments) and the regulations of each state in which they operate. State Auto P&C, Milbank and National undergo periodic financial examination by the Departments and insurance regulatory agencies of the states that choose to participate. Through State Auto P&C, the Company also provides executive management services to its affiliated insurance companies. Through Stateco, the Company provides investment management services to affiliated companies and also provides insurance premium finance services to customers of State Auto P&C, Mutual and Milbank. 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 affiliated companies and their agents and markets similar services and products to nonaffiliated insurers and their agencies. 518 PML, an Ohio limited liability company, was formed in December 1997 to engage in the business of owning and leasing real and personal property to affiliated companies. On January 1, 1998, State Auto P&C and Stateco became initial members of 518 PML. State Auto P&C contributed real property, while Stateco contributed $7.0 million in cash and real property. 43 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (c) BASIS OF PRESENTATION The consolidated financial statements have been prepared in conformity with generally accepted accounting principles, which vary in certain respects from statutory accounting practices followed by State Auto P&C, Milbank and 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 and the recoverability of deferred policy acquisition costs. In connection with the determination of these items, management uses historical data and current business conditions to formulate estimates including assumptions related to the ultimate cost to settle claims. These estimates by their nature are subject to uncertainties for various reasons. The Company's results of operations and financial condition could be impacted in the future should the ultimate payments required to settle claims vary from the liability currently provided. (d) DEFERRED POLICY ACQUISITION COSTS Acquisition costs, consisting of commissions, premium taxes, and certain underwriting expenses related to the production of property and casualty business, are deferred and amortized ratably over the contract period. The method followed in computing deferred policy acquisition costs limits the amount of such deferred costs to their estimated realizable value. In determining estimated realizable value, the computation gives effect to the premium to be earned, losses and loss expenses to be incurred, and certain other costs expected to be incurred as premium is earned, without credit for anticipated investment income. These amounts are based on estimates and accordingly, the actual realizable value may vary from the estimated realizable value. Net deferred policy acquisition costs were:
YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (dollars in thousands) Balance, beginning of year................... $22,440 20,033 20,176 Acquisition costs deferred............... 87,573 79,249 73,545 Amortized to expense during the year ....... 85,214 76,842 73,688 --------------------------------- Balance, end of year................ $24,799 22,440 20,033 =================================
(e) INVESTMENTS Investments in fixed maturities, where the Companies have the ability and intent to hold to maturity, are carried at amortized cost. Accordingly, unrealized holding gains or losses are not reflected in the accompanying consolidated financial statements. Investments in fixed maturity and equity securities held as available for sale are carried at fair value. The net unrealized holding gains or losses, net of applicable deferred taxes, are shown as a separate component of stockholders' equity as accumulated other comprehensive income and as such are not included in the determination of net income. Gains and losses on the sale of equity securities are computed using the first-in, first-out method. (f) SURPLUS NOTE RECEIVABLE In August 1998, the Company purchased $9.0 million of surplus notes from Farmers Casualty Company Mutual (Farmers Casualty), an Iowa domiciled standard property casualty insurer. In 1998, a plan to convert Farmers Casualty into a stock insurance company was approved by the board of Farmers Casualty, its policyholders and the Iowa Division of Insurance. The plan of conversion contemplated that the Company, in exchange for the redemption of the surplus notes, would acquire the newly issued shares of Farmers Casualty. Effective January 1, 1999, Farmers Casualty, renamed Farmers Casualty Insurance Company, became a wholly owned subsidiary of the Company. In addition, Farmers Casualty owns 100% of the outstanding shares of Mid-Plains Insurance Company, an Iowa domiciled property casualty insurer, which principally writes nonstandard auto insurance. 44 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (g) GOODWILL Goodwill represents the excess of cost of acquisition over the fair value of the net assets acquired and is being amortized using the straight-line method over 15 years. Accumulated amortization is $1,089,000 and $891,000 at December 31, 1998 and 1997, respectively. (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, for unreported claims and loss expenses. The liability for unpaid losses and loss expenses, net of estimated salvage and subrogation recoverable of $12,817,000 and $10,870,000 at December 31, 1998 and 1997, 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. (i) PREMIUM REVENUES Premiums are recognized as earned using the monthly pro rata method over the contract period. (j) MANAGEMENT SERVICES INCOME Management services income includes income for executive management services provided by State Auto P&C and income for investment management services provided by Stateco. Executive management income is recognized quarterly based on a percentage of the five year average adjusted annual statutory surplus of each company managed except for Midwest Security Insurance Company (Midwest Security), a wholly owned subsidiary of Mutual, which is based on a percentage of quarterly direct premiums written. Investment management income is recognized quarterly based on a percentage of the average fair value of investable assets and the performance of the equity portfolio of each company managed. (k) SOFTWARE REVENUE RECOGNITION S.I.S. recognizes revenue from license fees when the product is delivered and service revenue when services are performed. Costs of developing and testing new or enhanced software products are capitalized and are amortized on a product-by-product basis utilizing the straight-line method over a period not to exceed three years. Unamortized software development costs of $1,567,000 and $1,285,000 are included in accrued investment income and other assets at December 31, 1998 and 1997, respectively. Software amortization, included in other expenses, was $673,000, $489,000 and $394,000 in 1998, 1997 and 1996, respectively. (l) FEDERAL INCOME TAXES The Companies file a consolidated federal income tax return and pursuant to an agreement, each entity within the consolidated group pays its share of federal income taxes based on separate return calculations. Milbank will file a consolidated federal income tax return with the Company for periods subsequent to July 1, 1998. Prior to this time, Milbank was included in the consolidated federal income tax return of Mutual and its subsidiaries. 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 basis 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. (m) CASH EQUIVALENTS For purposes of the statements of cash flows, the Company considers all highly liquid debt instruments with a maturity of three months or less to be cash equivalents. (n) EARNINGS PER COMMON SHARE In 1997, the Financial Accounting Standards Board issued SFAS No. 128, "Earnings per Share." SFAS No. 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where appropriate, restated to conform to SFAS No. 128 presentation. For additional disclosure, see note 12. 45 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (o) OTHER COMPREHENSIVE INCOME As of January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income" (SFAS No. 130), which establishes new rules for the reporting and display of comprehensive income and its components. 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, and excludes any impact of changes in minority interest of subsidiaries. Other comprehensive income includes all other non-owner related changes to equity and includes net unrealized gains and losses on available-for-sale fixed maturities and equity securities. SFAS No. 130 also requires separate presentation of the accumulated balance of other comprehensive income within the equity section of the statement of financial position. The Company has presented the required displays of total comprehensive income and its components, within the "Consolidated Statements of Stockholders' Equity." The adoption of SFAS No. 130 had no impact on the Company's net income or shareholders' equity. Prior year financial statements have been reclassified to conform to the requirements of SFAS No. 130. See additional disclosures at note 13. (p) NEW ACCOUNTING STANDARD In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS No. 133), which is required to be adopted in years beginning after June 15, 1999. SFAS No. 133 will require companies to recognize all derivatives on the balance sheet at fair value. The Company does not anticipate that the adoption of SFAS No. 133 will have a significant effect on its results of operations or financial position. (q) RECLASSIFICATIONS Certain items in the 1997 and 1996 consolidated financial statements have been reclassified to conform with the 1998 presentation. 46 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (2) Investments Realized and unrealized gains and losses are summarized as follows:
YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (dollars in thousands) Realized gains: Fixed maturities available for sale............................................ $ 1,588 914 2,007 Equity securities.............................................................. 1,449 2,464 1,469 --------------------------------------- Total realized gains.............................................................. 3,037 3,378 3,476 --------------------------------------- Realized losses: Fixed maturities available for sale............................................ 32 236 480 Equity securities.............................................................. 80 99 208 --------------------------------------- Total realized losses............................................................. 112 335 688 --------------------------------------- Net realized gains on investments................................................. $ 2,925 3,043 2,788 --------------------------------------- Increase (decrease) in unrealized holding gains -- Fixed maturities held to maturity.................................................... $ (371) 1,464 (1,604) --------------------------------------- Increase in unrealized holding gains -- Equity securities..................................................................... $ 6,014 3,426 1,628 Increase (decrease) in unrealized holding gains -- Fixed maturities available for sale at fair value.................................... 2,657 7,819 (9,102) Change in deferred unrealized gain................................................ (184) (119) (132) Deferred federal income taxes thereon............................................. (2,970) (3,894) 2,662 Minority interest................................................................. (2) -- -- --------------------------------------- Increase (decrease) in net unrealized holding gains or losses..................... $ 5,515 7,232 (4,944) ---------------------------------------
47 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED The Company's investments in held to maturity securities and available for sale securities are summarized as follows:
GROSS GROSS HELD TO MATURITY AT DECEMBER 31, 1998: AMORTIZED UNREALIZED UNREALIZED FAIR COST HOLDING GAINS HOLDING LOSSES VALUE ---- ------------- -------------- ----- (dollars in thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies................... $ 6,291 145 -- 6,436 Obligations of states and political subdivisions.......... 7,055 508 -- 7,563 Mortgage-backed securities................................ 42,580 1,247 -- 43,827 --------------------------------------------------------------- Total..................................................... $ 55,926 1,900 -- 57,826 --------------------------------------------------------------- AVAILABLE FOR SALE AT DECEMBER 31, 1998: U.S. Treasury securities and obligations of U.S. government corporations and agencies................... $ 79,089 2,812 24 81,877 Obligations of states and political subdivisions.......... 363,532 14,346 261 377,617 Corporate securities...................................... 8,996 798 -- 9,794 Mortgage-backed securities................................ 12,391 185 20 12,556 --------------------------------------------------------------- Total fixed maturities................................. 464,008 18,141 305 481,844 Equity securities......................................... 29,233 14,081 1,118 42,196 --------------------------------------------------------------- Total..................................................... $ 493,241 32,222 1,423 524,040 --------------------------------------------------------------- HELD TO MATURITY AT DECEMBER 31, 1997: U.S. Treasury securities and obligations of U.S. government corporations and agencies................... $ 6,689 73 2 6,760 Obligations of states and political subdivisions.......... 7,068 430 -- 7,498 Mortgage-backed securities................................ 65,543 1,806 36 67,313 --------------------------------------------------------------- Total..................................................... $ 79,300 2,309 38 81,571 --------------------------------------------------------------- AVAILABLE FOR SALE AT DECEMBER 31, 1997: U.S. Treasury securities and obligations of U.S. government corporations and agencies................... $ 101,020 2,135 252 102,903 Obligations of states and political subdivisions.......... 280,423 12,597 8 293,012 Corporate securities...................................... 12,148 636 104 12,680 Mortgage-backed securities................................ 12,224 214 39 12,399 --------------------------------------------------------------- Total fixed maturities................................. 405,815 15,582 403 420,994 Equity securities......................................... 19,120 7,207 258 26,069 --------------------------------------------------------------- Total..................................................... $ 424,935 22,789 661 447,063 --------------------------------------------------------------- Deferred federal income taxes on the net unrealized holding gain was $10,919,000 and $7,949,000 at December 31, 1998 and 1997, respectively.
48 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED The amortized cost and fair value of fixed maturities segregated by held to maturity and available for sale, at December 31, 1998, by contractual maturity, are summarized as follows:
HELD TO MATURITY AVAILABLE FOR SALE ---------------- ------------------ AMORTIZED FAIR AMORTIZED FAIR COST VALUE COST VALUE ---- ----- ---- ----- (dollars in thousands) Due after 1 year or less........................... $ 1,404 1,408 3,207 3,247 Due after 1 year through 5 years................... 2,364 2,457 49,263 51,111 Due after 5 years through 10 years................. 4,541 4,756 155,414 164,481 Due after 10 years................................. 5,037 5,378 243,733 250,449 ------------------------------------------------------------ ................................................... 13,346 13,999 451,617 469,288 Mortgage-backed securities......................... 42,580 43,827 12,391 12,556 ------------------------------------------------------------ $55,926 57,826 464,008 481,844 ============================================================
Expected maturities may differ from contractual maturities because the issuers may have the right to call or prepay the obligations with or without call or prepayment penalties. Fixed maturities with carrying values of approximately $17,666,000 and $16,360,000 were on deposit as required by law or specific escrow agreement at December 31, 1998 and 1997, respectively. Components of net investment income are summarized as follows:
YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (dollars in thousands) Fixed maturities............................................................. $ 30,182 29,784 29,141 Equity securities............................................................ 477 372 342 Surplus note receivable...................................................... 235 -- -- Cash and cash equivalents.................................................... 1,908 1,210 995 ------------------------------------------- Investment income............................................................ 32,802 31,366 30,478 ------------------------------------------- Investment expenses.......................................................... 296 259 615 ------------------------------------------- Net investment income........................................................ $ 32,506 31,107 29,863 ============================================
(3) DISCLOSURES ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: 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. Cash and cash equivalents and surplus note receivable: The carrying amounts reported in the balance sheet for these instruments approximate their fair value. See note 2 for additional fair value disclosures. 49 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (4) Losses and Loss Expenses Payable Activity in the liability for losses and loss expenses is summarized as follows:
YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (dollars in thousands) Losses and loss expenses payable, net of reinsurance receivables, at beginning of year......................................................... $ 194,155 199,480 206,327 Incurred related to: Current year................................................................. 255,885 225,666 246,886 Prior years.................................................................. (13,591) (17,432) (26,852) ----------------------------------------- Total incurred.................................................................. 242,294 208,234 220,034 ----------------------------------------- Paid related to: Current year................................................................. 157,988 134,890 148,095 Prior years.................................................................. 86,671 78,669 78,786 ----------------------------------------- Total paid...................................................................... 244,659 213,559 226,881 ----------------------------------------- Impact of pooling change, January 1, 1998 (note 5).............................. 13,244 -- -- ----------------------------------------- Losses and loss expenses payable, net of reinsurance recoverables, at end of year............................................................... $ 205,034 194,155 199,480 ==========================================
The liability for losses and loss expenses decreased by $13,591,000 in 1998, $17,432,000 in 1997 and $26,852,000 in 1996, for claims that had occurred in prior years. These decreases have resulted primarily from moderating trends in the frequency and severity of losses and loss expenses due to lower inflation. This along with fundamental improvements primarily in the auto liability and workers' compensation lines of business resulted in incurred losses and loss expenses developing favorably. Because of the nature of the business written over the years, the Company's management believes that the Company has limited exposure to environmental claim liabilities. (5) REINSURANCE In the ordinary course of business, State Auto P&C and Milbank assume and cede reinsurance with other insurers and reinsurers and are members in various pools and associations. The voluntary arrangements provide greater diversification of business and limit the maximum net loss potential arising from large risks and catastrophes. Most of the ceded reinsurance is effected under reinsurance contracts known as treaties; some is by negotiation on individual risks. Although the ceding of reinsurance does not discharge the original insurer from its primary liability to its policyholder, the insurance company that assumes the coverage assumes the related liability. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business. The recoverability of these assets depends on the reinsurers' ability to perform under the reinsurance agreements. The Company evaluates and monitors the financial condition and concentrations of credit risk associated with its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. Since 1995, State Auto P&C and Milbank have participated in a reinsurance pooling arrangement with Mutual. During 1996 and 1997 the pooling participation percentages allocated 35% to State Auto P&C, 55% to Mutual and 10% to Milbank. Effective January 1, 1998, the pooling arrangement was amended to include all of the property and casualty business of Midwest Security Insurance Company (Midwest), a wholly owned subsidiary of Mutual. Concurrent, with the inclusion of Midwest, the pooling participation percentages were amended to allocate 37% to State Auto P&C, 52% to Mutual, 10% to Milbank and 1% to Midwest Security. In connection with the January 1, 1998 change in pooling percentages, State Auto P&C and Milbank received approximately $19.7 million to cover their increased share of pool liabilities. The pooling arrangement was amended pursuant 50 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED to a Reinsurance Pooling Agreement, amended and restated, referred to hereafter to include each of its predecessor agreements as the "Pooling Agreement", as of January 1, 1999, to include all of the property and casualty business of Farmers Casualty. Concurrent, with the inclusion of Farmers Casualty, the pooling participation percentages were amended to allocate 37% to State Auto P&C, 49% to Mutual, 10% to Milbank, 1% to Midwest and 3% to Farmers Casualty. In connection with the January 1, 1999 change in pooling percentages, State Auto P&C, Milbank and Farmers Casualty received approximately $ 11.4 million to cover their increased share of pool liabilities. Pursuant to the pooling arrangement, Mutual is responsible for the collection of premiums and payment of losses, loss expenses and underwriting expenses of the pooled companies. Unpaid balances are reflected in due to or due from affiliates in the accompanying consolidated balance sheets. Settlements of the intercompany account are made quarterly. No interest is paid on this account. All premium balances receivable and reinsurance recoverable on paid losses from unaffiliated reinsurers are carried by Mutual. Effective July 1, 1996, the State Auto Insurance Companies (State Auto P&C, Mutual, Milbank and National) negotiated a change in their catastrophe reinsurance program. In 1998, Midwest Security became party to the catastrophe reinsurance program. State Auto P&C has assumed catastrophe reinsurance from Mutual, Milbank, Midwest Security and National pursuant to a catastrophe reinsurance agreement in the amount of $100.0 million excess of $120.0 million. To protect against a catastrophe loss event in which the State Auto Insurance Companies would incur catastrophe losses in excess of $120.0 million, the Company entered into a structured contingent financing transaction with Chase Manhattan Bank (Chase) to provide up to $100.0 million of additional reinsurance protection. Under this arrangement, in the event of such a loss, the Company would sell redeemable preferred shares to SAF Funding Corporation, a special purpose company (SPC), which will borrow the money necessary for such purchase from Chase and a syndicate of other lenders. The Company will contribute to State Auto P&C the proceeds from the sale of its preferred shares. State Auto P&C will use the contributed capital to pay its direct catastrophe losses and losses assumed under the catastrophe reinsurance agreement. The Company is obligated to repay SPC by redeeming the preferred shares over a six year period. This layer of $100.0 million in excess of $120.0 million has been excluded from the pooling arrangement pursuant to the terms of the Pooling Agreement. In addition, the Company's obligation to repay SPC has been secured by a Put Agreement among the Company, Mutual and the Lenders, under which, in the event of a default by the Company, as described in the Credit Agreement or in the Put Agreement, Mutual would be obligated to put either the preferred shares or the loan(s) outstanding. The Company has reported ceded losses and loss expenses payable and prepaid reinsurance premiums as assets. The amounts reported represent State Auto P&C's and Milbank's pooling percentage of the total amounts ceded to unaffiliated reinsurers and National's ceded amounts. All contracts providing indemnification against loss or liability relating to insurance risk have been accounted for as reinsurance. Contracts for which it is not clear that the treaty results in the reasonable possibility that the reinsurance may realize a significant loss from the insurance risk assumed have been accounted for as deposits. 51 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED The following table summarizes State Auto P&C's and Milbank's direct business, amounts contributed to the pool and their participation in the pool:
DECEMBER 31 ----------- 1998 1997 ---- ---- (dollars in thousands) Losses and loss expenses payable: Direct................................................................................... $ 196,473 195,802 Assumed (excluding intercompany pooling)................................................. 10,437 11,675 Ceded (excluding intercompany pooling)................................................... (9,180) (11,224) ------------------------------ Net amount contributed to the pool.................................................... 197,730 196,253 ------------------------------ Direct and assumed (intercompany pooling)................................................ 208,161 197,515 Ceded (intercompany pooling)............................................................. (11,343) (10,009) ------------------------------ Net participation in the pool......................................................... $ 196,818 187,506 ============================== Unearned premiums: Direct................................................................................... $ 130,160 127,057 Assumed (excluding intercompany pooling)................................................. 4,243 4,688 Ceded (excluding intercompany pooling)................................................... (2,943) (3,236) ------------------------------ Net amount contributed to the pool.................................................... 131,460 128,509 ------------------------------ Direct and assumed (intercompany pooling)................................................ 125,411 115,146 Ceded (intercompany pooling)............................................................. (2,389) (2,573) ------------------------------ Net participation in the pool......................................................... $ 123,022 112,573 ============================== YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (dollars in thousands) Earned premiums: Direct.................................................................... $ 354,291 340,808 326,779 Assumed (excluding intercompany pooling).................................. 14,386 14,917 17,842 Ceded (excluding intercompany pooling).................................... (12,039) (13,416) (15,512) ---------------------------------------------- Net amount contributed to the pool..................................... 356,638 342,309 329,109 ---------------------------------------------- Direct and assumed (intercompany pooling)................................. 337,538 305,965 300,291 Ceded (intercompany pooling).............................................. (9,395) (9,919) (10,773) ---------------------------------------------- Net participation in the pool.......................................... 328,143 296,046 289,518 Assumed from affiliates (excluding intercompany pooling).................. 2,475 2,505 1,260 ---------------------------------------------- Total.................................................................. $ 330,618 298,551 290,778 ============================================== Losses and loss expenses incurred: Direct.................................................................... $ 244,302 227,599 247,790 Assumed (excluding intercompany pooling).................................. 13,644 14,875 19,698 Ceded (excluding intercompany pooling).................................... (5,151) (6,016) (9,571) ---------------------------------------------- Net amount contributed to the pool..................................... 252,795 236,458 257,917 ---------------------------------------------- Direct and assumed (intercompany pooling)................................. 227,000 195,636 214,662 Ceded (intercompany pooling).............................................. (3,689) (4,409) (5,094) ---------------------------------------------- Net participation in the pool.......................................... $ 223,311 191,227 209,568 ==============================================
52 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED National has a reinsurance agreement with Mutual to cede 20% of its premiums written and losses and loss expenses incurred to Mutual for liability lines. The agreement also has a provision for excess of loss coverage, whereby Mutual will reinsure National for all losses over a prescribed limit for each individual occurrence. Through Mutual's participation, the effects of the reinsurance agreement are indirectly subject to the pooling agreement between Mutual, State Auto P&C and Milbank. Amounts related to National's reinsurance agreement that are reported as assets in the accompanying consolidated balance sheets are summarized as follows:
DECEMBER 31 ----------- 1998 1997 ---- ---- (dollars in thousands) Losses and loss expenses payable.............................................................. $ 2,324 2,086 Unearned premiums............................................................................. 1,625 1,626 ----------------------------
The effects of the agreement on the indicated income and expense accounts are summarized as follows:
YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (dollars in thousands) Earned premiums...................................................................... $ 4,987 4,144 2,700 Losses and loss expenses incurred.................................................... 3,204 2,950 1,467 ------------------------------------
(6) TRANSACTIONS WITH MUTUAL State Auto P&C provides Mutual and its insurance affiliates executive management services to oversee the insurance operations of these companies. Fees relating to these services amounted to $4,908,000 in 1998, $4,563,000 in 1997 and $4,144,000 in 1996. Stateco provides Mutual and its affiliates investment management services. Fees related to these services amounted to $3,037,000 in 1998, $2,804,000 in 1997 and $2,588,000 in 1996. S.I.S. provides insurance software products and services to Mutual and its affiliates. Fees relating to these services amounted to $1,048,000 in 1998, $889,000 in 1997 and $859,000 in 1996 and is included in other income. Effective January 1, 1998, 518 PML began leasing assets to Mutual and its affiliates. Fees relating to these services amounted to $268,000 in 1998 and is included in other income. State Auto P&C's December 31, 1990 liability for losses and loss expenses of $65,464,000 has been guaranteed by Mutual. Pursuant to the guaranty agreement, all ultimate adverse development of the December 31, 1990 liability, if any, is to be reimbursed by Mutual to State Auto P&C. As of December 31, 1998, there has been no adverse development of the liability. 53 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (7) FEDERAL INCOME TAXES A reconciliation between actual federal income taxes and the amount computed at the indicated statutory rate is as follows:
YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 AMOUNT % AMOUNT % AMOUNT % ------ ---- ------ ---- ------ ---- (dollars in thousands, except percentages) Amount at statutory rate......................................... $ 17,361 35 19,823 35 12,177 35 Tax-free interest and dividends received deduction............... (5,423) (11) (4,368) (8) (3,913) (11) Other, net....................................................... 170 -- 185 -- 121 -- ---------------------------------------------------------- Effective tax rate............................................... $ 12,108 24 15,640 27 8,385 24 ==========================================================
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities at December 31, 1998 and 1997 are presented below:
1998 1997 ---- ---- (dollars in thousands) Deferred tax assets: Unearned premiums not deductible......................................................... $ 8,885 8,458 Losses and loss expenses payable discounting............................................. 8,257 7,347 Other.................................................................................... 1,604 1,133 -------------------------- Total deferred tax assets............................................................ 18,746 16,938 ========================== Deferred tax liabilities: Deferral of policy acquisition costs..................................................... 8,680 7,854 Net pension expense...................................................................... 5,732 5,112 Unrealized holding gain on investments................................................... 10,919 7,948 Other.................................................................................... 1,510 1,311 --------------------------- Total deferred tax liabilities....................................................... 26,841 22,225 --------------------------- Net deferred tax liabilities......................................................... $ (8,095) (5,287) ============================
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 1998, 1997 and 1996 were $11,768,000, $14,254,000 and $13,602,000, respectively. 54 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (8) PENSION BENEFIT PLANS State Auto P&C, Stateco and S.I.S., pursuant to an intercompany agreement, are participants, together with Mutual, in a defined benefit pension plan that covers substantially all employees of Mutual, State Auto P&C, Milbank, Stateco and S.I.S. The assets of the plan are represented primarily by U.S. government and agency obligations, bonds, and common stocks. Mutual, State Auto P&C, Stateco and S.I.S.'s policy is to fund pension costs in accordance with the requirements of the Employee Retirement Income Security Act of 1974. Benefits are determined by applying factors specified in the plan to a participant's defined average annual compensation. Information regarding the funded status and net periodic pension cost for State Auto P&C, Milbank, Stateco and S.I.S.'s participation in the plan is as follows:
DECEMBER 31 ----------- 1998 1997 ---- ---- (in thousands) CHANGE IN BENEFIT OBLIGATION Benefit obligation at beginning of year........................................................ $ 39,727 38,838 Service cost................................................................................... 1,686 1,548 Interest cost.................................................................................. 2,977 2,760 Actuarial loss................................................................................. 4,024 348 Benefits paid.................................................................................. (3,656) (3,767) ----------------------------- Benefit obligation at end of year.............................................................. $ 44,758 39,727 ----------------------------- CHANGE IN PLAN ASSETS Fair value of plan assets at beginning of year................................................. $ 64,565 54,991 Actual return on plan assets................................................................... 11,984 11,655 Company contributions.......................................................................... -- 1,446 Asset gain..................................................................................... 2,560 240 Benefits paid.................................................................................. (3,656) (3,767) ----------------------------- Fair value of plan assets at end of year....................................................... $ 75,453 64,565 ----------------------------- Funded status.................................................................................. $ 30,695 24,838 Unrecognized net actuarial gain................................................................ (14,816) (10,721) Unrecognized prior service cost................................................................ 1,587 1,700 Unrecognized transition asset.................................................................. (1,088) (1,209) ----------------------------- Prepaid pension expense........................................................................ $ 16,378 14,608 ============================= YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (in thousands) COMPONENTS OF NET PERIODIC BENEFIT COST Service cost..................................................................... $ 1,686 1,548 1,481 Interest cost.................................................................... 2,977 2,760 2,648 Expected return on plan assets................................................... (5,430) (4,742) (4,172) Amortization of prior service cost............................................... 114 114 114 Amortization of transition asset................................................. (121) (121) (121) Amortization of net gain......................................................... (8) (3) -- ------------------------------------------- Net periodic benefit cost........................................................ $ (782) (444) (50) ===========================================
55 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- WEIGHTED-AVERAGE ASSUMPTIONS AS OF DECEMBER 31 Discount rate.................................................................... 7.00% 7.25 7.25 Rates of increase in compensation levels......................................... 9.00% 9.00 9.00 Expected long-term rate of return on assets...................................... 4.50% 4.50 4.50
State Auto P&C, Stateco and S.I.S. are also participants with Mutual in a defined contribution plan that covers substantially all employees of Mutual, State Auto P&C, Milbank, Stateco and S.I.S. Contributions to the plan are based on employee contributions and the level of Company match. State Auto P&C, Milbank, Stateco and S.I.S.'s share of the expense under the plan totaled $782,000, $726,000 and $667,000 for the years 1998, 1997 and 1996, respectively. (9) STOCKHOLDERS' EQUITY (a) STOCK SPLIT On May 28, 1998, the Company's authorized capital was increased to 100,000,000 shares of common stock and the Company's Board of Directors declared a two-for-one common stock split. Also, on May 30, 1996, the Company's Board declared a three-for-two common stock split effected in the form of a stock dividend. The financial statements, notes and other references to share information and per share data have been given retroactive effect to reflect the stock splits for all periods presented. Fractional shares were paid in cash. (b) DIVIDEND RESTRICTIONS AND STATUTORY FINANCIAL INFORMATION State Auto P&C, Milbank, National and Farmers Casualty are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to the Company during the year without prior approval of regulatory authorities. Pursuant to these rules, approximately $21.9 million is available for payment to the Company in 1999 without prior approval. 56 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED Reconciliations of statutory capital and surplus and net income, as determined using statutory accounting practices, to the amounts included in the accompanying consolidated financial statements are as follows:
DECEMBER 31 ----------- 1998 1997 ---- ---- (dollars in thousands) Statutory capital and surplus of insurance subsidiaries....................................... $ 232,407 208,050 Net assets of noninsurance parent and affiliates.............................................. 28,677 15,869 ----------------------------- 261,084 223,919 Add (subtract) cumulative effect of adjustments: Deferred policy acquisition costs.......................................................... 24,799 22,440 Losses and loss expenses payable........................................................... 12,817 10,870 Net prepaid pension expense................................................................ 16,368 14,577 Deferred federal income taxes.............................................................. (7,899) (5,211) Excess of statutory loss liabilities over case basis amounts............................... 11,482 9,940 Fixed maturities at fair value............................................................. 18,809 16,625 Goodwill................................................................................... 1,880 2,078 Other, net................................................................................. 1,484 2,020 ----------------------------- Stockholders' equity per accompanying consolidated financial statements................................................................... $ 340,824 297,258 ============================= YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (dollars in thousands) Statutory net income of insurance subsidiaries............................... $ 28,696 35,660 22,268 Net income of noninsurance parent and affiliates............................. 3,227 2,581 2,301 -------------------------------------------- 31,923 38,241 24,569 Increases (decreases): Deferred policy acquisition costs......................................... 2,359 2,407 (144) Losses and loss expenses payable.......................................... 1,947 258 1,078 Net prepaid pension expense............................................... 1,791 1,898 1,571 Deferred federal income taxes............................................. 279 (1,344) (51) Goodwill amortization..................................................... (198) (198) (198) Other, net................................................................ (604) (264) (418) -------------------------------------------- Net income per accompanying consolidated financial statements................................................... $ 37,497 40,998 26,407 ============================================
(10) PREFERRED STOCK The Company has authorized two classes of preferred stock. For both classes, upon issuance, the Board of Directors has authority to fix and determine the significant features of the shares issued, including, among other things, the dividend rate, redemption price, redemption rights, conversion features and liquidation price payable in the event of any liquidation, dissolution, or winding up of the affairs of the Company. See note (5) regarding the Company's obligation to issue redeemable preferred shares to SPC in connection with its catastrophic reinsurance arrangements with Chase Manhattan Bank. 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. 57 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (11) STOCK INCENTIVE PLANS The Company follows Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB 25), and related Interpretations in accounting for its stock incentive plans. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Had compensation cost for the Company's plans been determined based on the fair values at the grant dates consistent with the method of SFAS No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123), the Company's pro forma net earnings and net earnings per share information would have been as follows:
1998 1997 1996 ---- ---- ---- (in thousands, except per share figures) Pro forma net earnings....................................................................$ 35,700 40,045 25,565 Pro forma net earnings per common share Basic................................................................................$ .85 .96 .62 Diluted..............................................................................$ .83 .94 .61
The Company has stock option plans for certain directors and key employees of Mutual, State Auto P&C, Stateco and S.I.S. The nonemployee directors' plan provides each nonemployee director an option to purchase 1,000 shares of common stock following each annual meeting of the shareholders at an option price equal to the fair market value at the last business day prior to the annual meeting. The Company has reserved 300,000 shares of common stock under this plan. These options are exercisable at issuance to 10 years from date of grant. The key employee's plan provides that qualified stock options may be granted at an option price not less than fair market value at date of grant and that nonqualified stock options may be granted at any price determined by the options committee of the Board of Directors. The Company has reserved 3,600,000 shares of common stock under this plan. For certain employees these options are exercisable from 1 to 10 years from date of grant, and 3 to 10 years for remaining employees. The fair value of these options utilized in the pro forma information above were estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions for 1998, 1997 and 1996, respectively: dividend yield of .75%, 1.0% and 1.0%; expected volatility factors of .26, .24 and .23; risk-free interest rates of 5.5%, 6.7% and 6.6%; and expected life of the option of 8.5, 8.0 and 8.0 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's option, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. 58 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 the Company's stock option activity and related information for these plans for the years ended December 31, 1998, 1997 and 1996, follows:
1998 1997 1996 ---------------------------- ---------------------------- ---------------------------- WEIGHTED - AVERAGE WEIGHTED - AVERAGE WEIGHTED - AVERAGE OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE OPTIONS EXERCISE PRICE ------- -------------- ------- -------------- ------- -------------- (numbers in thousands, except per share figures) Outstanding, beginning of year 2,019 $5.04 2,261 $4.79 1,900 $4.17 Granted 339 16.31 37 9.31 433 7.36 Exercised (86) 4.02 (276) 3.49 (72) 3.88 Cancelled -- -- (3) 7.32 -- -- ----- ----- ----- Outstanding, end of year 2,272 $6.76 2,019 $5.04 2,261 $4.79 ===== ===== ===== Weighted - average fair value of options granted during the year: $6.78 $4.37 $2.91
A summary of information pertaining to options outstanding and exercisable as of December 31, 1998 follows:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------------------------- ------------------------------- WEIGHTED - AVERAGE REMAINING WEIGHTED - AVERAGE WEIGHTED - AVERAGE RANGE OF EXERCISE PRICES NUMBER CONTRACTUAL LIFE EXERCISE PRICE NUMBER EXERCISE PRICE ------------------------ ------ ---------------- -------------- ------ -------------- (numbers in thousands, except per share figures) Less than $5.00 964 3.8 $ 3.75 964 $ 3.75 $5.01 - $10.00 969 6.8 6.41 902 6.33 Greater than $10.01 339 9.2 16.31 58 12.94 ----- ----- 2,272 5.9 $ 6.76 1,924 $ 5.24 ===== =====
The Company has an employee stock purchase plan with a dividend reinvestment feature, under which employees of Mutual, State Auto P&C, Stateco and S.I.S. 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 2,400,000 shares of common stock under this plan. At December 31, 1998, 1,407,000 shares have been purchased under this plan. Compensation expense is recognized for the fair value of the employee's purchase rights, which was estimated using the Black-Scholes model with the following weighted-average assumptions for 1998, 1997 and 1996, respectively: dividend yield of .75%, 1.0% and 1.0%; expected volatility factors of .44, .32 and .24; risk-free interest rates of 4.7%, 5.6% and 6.5%; and expected lives of 6 months for both years. The weighted-average fair value of those purchase rights granted in 1998, 1997 and 1996 were $3.92, $2.61 and $1.76, respectively. 59
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (12) NET EARNINGS PER COMMON SHARE The following table sets forth the compilation of basic and diluted net earnings per common share: YEAR ENDED DECEMBER 31 ---------------------- 1998 1997 1996 ---- ---- ---- (in thousands, except per share data) Numerator: Net earnings for basic and diluted earnings per common share.............. $37,497 40,998 26,407 =========================================== Denominator: Weighted average shares for basic net earnings........................... per common share ..................................................... 41,887 41,544 41,277 Effect of dilutive stock options.......................................... 1,014 906 668 Adjusted weighted average shares for..................................... diluted net earnings per common share................................. 42,901 42,450 41,945 =========================================== Basic net earnings per common share.......................................... $ .89 .99 .64 =========================================== Diluted net earnings per common share........................................ $ .87 .97 .63 ===========================================
(13) OTHER COMPREHENSIVE INCOME The related federal income tax effects of each component of other comprehensive income are as follows:
YEAR ENDED DECEMBER 31, 1998 ---------------------------- BEFORE-TAX TAX (EXPENSE) NET-OF-TAX AMOUNT OR BENEFIT AMOUNT ------ ---------- ------ (in thousands) Net unrealized holding gains on securities: Unrealized holding gains arising during 1998.............................. $11,412 (3,994) 7,418 Reclassification adjustments for gains realized in net income............. (2,925) 1,023 (1,902) Minority interest......................................................... (2) 1 (1) ------------------------------------------- Net unrealized holding gains.............................................. 8,485 (2,970) 5,515 ------------------------------------------ Other comprehensive income................................................... $ 8,485 (2,970) 5,515 ============================================ YEAR ENDED DECEMBER 31, 1997 ---------------------------- BEFORE-TAX TAX (EXPENSE) NET-OF-TAX AMOUNT OR BENEFIT AMOUNT ------ ---------- ------ ( in thousands) Net unrealized holding gains on securities: Net unrealized holding gains.............................................. $11,125 (3,894) 7,232 ------------------------------------------ Other comprehensive income................................................... $11,125 (3,894) 7,232 ========================================== YEAR ENDED DECEMBER 31, 1996 ---------------------------- BEFORE-TAX TAX (EXPENSE) NET-OF-TAX AMOUNT OR BENEFIT AMOUNT ------ ---------- ------ ( in thousands) Net unrealized holding losses on securities: Net unrealized holding losses............................................. $(7,606) 2,662 (4,944) ------------------------------------------ Other comprehensive income................................................... $(7,606) 2,662 (4,944) ==========================================
60 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED (14) REPORTABLE SEGMENTS The Company has three reportable segments: standard insurance, nonstandard insurance and investment management services. The 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 nonstandard insurance segment provides personal automobile insurance to policyholders that are typically rejected or canceled by standard insurance carriers because of poor loss experience or a history of late payment of premiums. Both the standard and nonstandard insurance segments operate primarily in the Midwest and Eastern United States, excluding New York, New Jersey, and the New England states, through the independent insurance agency system. The investment management services segment manages the investment portfolios of affiliated insurance companies. The Company evaluates performance and allocates resources 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. Intersegment sales and transfers are priced at estimated market value. The reportable segments are business units that are each managed separately because of the differences in products or service they offer and type of customer they serve. Revenue from segments in the other category is attributable to three other operating segments of the Company; an insurance software development and resale segment, a premium finance segment and a property management and leasing segment. These segments have never met the quantitative thresholds for determing reportable segments. 61 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED The following provides financial information regarding the Company's reportable segments:
1998 1997 1996 ---- ---- ---- (in thousands) REVENUES FROM EXTERNAL CUSTOMERS: Standard insurance........................................................... $365,510 332,126 323,259 Nonstandard insurance........................................................ 27,064 22,893 14,725 Investment management services............................................... 3,328 3,422 3,048 All other.................................................................... 2,906 1,424 1,247 ------------------------------------------ Total revenues from external customers......................................... 398,808 359,865 342,279 Intersegment revenues: Standard insurance........................................................... 261 261 156 Nonstandard insurance........................................................ (90) (75) (30) Total intersegment revenues.................................................... 171 186 126 ------------------------------------------ Total revenue.................................................................. $398,979 360,051 342,405 ========================================== Reconciling items: Intersegment revenues........................................................ $ (171) (186) (126) Corporate revenues........................................................... 326 68 30 Net realized gains on investment............................................. 2,925 3,043 2,788 ------------------------------------------ Total consolidated revenues..................................................... $402,059 362,976 345,097 ========================================== Segment profit: Standard insurance........................................................... $ 40,310 48,376 27,280 Nonstandard insurance........................................................ 1,313 1,192 1,242 Investment management services............................................... 4,908 4,901 4,459 All other.................................................................... 1,323 269 71 ------------------------------------------ Total segment profit......................................................... 47,854 54,738 33,052 Reconciling items: Corporate expenses........................................................... (1,104) (1,120) (1,044) Net realized gains on investment............................................. 2,925 3,043 2,788 Miscellaneous adjustment in consolidation.................................... (70) (23) (4) ------------------------------------------ Total consolidated income before federal income taxes........................... $ 49,605 56,638 34,792 ==========================================
62 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
1998 1997 1996 ---- ---- ---- (in thousands) NET INVESTMENT INCOME: Standard insurance........................................................... $ 27,710 26,984 26,374 Nonstandard insurance........................................................ 1,383 1,315 971 Investment management services............................................... 292 598 460 All other.................................................................... 432 62 60 ------------------------------------------- Total net investment income.................................................... 29,817 28,959 27,865 Reconciling items: Corporate net investment income.............................................. 326 41 16 Reclassification adjustments in consolidation................................ 2,363 2,107 1,982 ------------------------------------------- Total consolidated net investment income..................................... $ 32,506 31,107 29,863 ============================================ DEPRECIATION AND AMORTIZATION EXPENSE: Standard insurance........................................................... $ 1,865 1,796 1,620 Nonstandard insurance........................................................ 13 8 8 Investment management services............................................... 25 10 28 All other.................................................................... 763 509 413 ------------------------------------------- Total depreciation and amortization expense..................................... $ 2,666 2,323 2,069 =========================================== SEGMENT ASSETS: Standard insurance........................................................... $641,195 586,042 547,136 Nonstandard insurance........................................................ 37,997 35,037 28,207 Investment management services............................................... 7,449 13,115 9,578 All other.................................................................... 15,741 3,385 3,260 ------------------------------------------- Total segment assets......................................................... 702,382 637,579 588,181 Reconciling items: Corporate expenses........................................................... 10,979 2,212 1,486 Reclassificaiton adjustments in consolidation................................ (3,583) (968) (3,340) ------------------------------------------- Total consolidated assets....................................................... $709,778 638,823 586,327 =========================================== EXPENDITURE FOR ADDITIONS TO LONG-LIVED ASSETS: Standard insurance........................................................... $ 51 109 124 Investment management services............................................... 209 771 -- All other.................................................................... 2,556 31 43 ------------------------------------------- Total expenditure for additions to long-lived assets......................... $ 2,816 911 167 ===========================================
63 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:
1998 1997 1996 ---- ---- ---- (in thousands) Earned premiums Standard insurance: Automobile................................................................... $186,283 167,241 164,099 Homeowners and farmowners.................................................... 57,983 51,865 51,435 Commercial multi-peril....................................................... 21,791 19,812 18,228 Workers' compensation........................................................ 12,006 12,605 14,878 Fire and allied.............................................................. 23,698 21,310 19,610 Other and products liability................................................. 17,313 15,364 13,478 Other lines.................................................................. 11,545 10,354 9,049 ------------------------------------------- Total standard insurance earned premiums....................................... 330,619 298,551 290,777 Nonstandard insurance: Automobile................................................................... 25,591 21,499 13,695 ------------------------------------------- Total nonstandard insurance earned premiums.................................... 25,591 21,499 13,695 ------------------------------------------- Total earned permiums.......................................................... 356,210 320,050 304,472 Investment management services................................................. 3,036 2,804 2,588 Net investment income.......................................................... 32,180 31,066 29,868 Other income................................................................... 7,382 5,945 5,351 ------------------------------------------- Total revenues from external customers......................................... $398,808 359,865 342,279 ===========================================
The standard insurance segment (State Auto P&C and Milbank) participates in a reinsurance pooling agreement with other standard insurance affiliates. For discussion regarding this arrangement and the segment's contribution to the pool and participation in the pool, see note 5. Revenues from external customers are derived entirely within the United States. Also, all long-lived assets are located within the United States. (15) QUARTERLY FINANCIAL DATA (UNAUDITED)
FOR THREE MONTHS ENDED ---------------------- MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, --------- -------- ------------- ------------ 1998 ---- (dollars in thousands, except per share amounts) Total revenues.......................................... $ 99,361 99,823 102,212 100,663 Earnings before federal income taxes.................... 15,874 3,296 13,469 16,966 Net earnings ........................................... 11,531 2,780 10,552 12,634 Net earnings per common share (note 9a): Basic................................................ .27 .07 .25 .30 Diluted.............................................. .27 .06 .25 .29 ================================================================
64 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED
FOR THREE MONTHS ENDED ---------------------- MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, --------- -------- ------------- ------------ 1997 ---- (dollars in thousands, except per share amounts) Total revenues.......................................... $ 88,998 90,443 91,052 92,483 Earnings before federal income taxes.................... 12,082 13,345 13,629 17,582 Net earnings ........................................... 8,871 9,680 9,746 12,701 Net earnings per common share (note 9a): Basic................................................ .21 .24 .23 .31 Diluted.............................................. .21 .23 .23 .30 ===============================================================
(16) CONTINGENCIES State Auto P&C, Milbank and National are involved in litigation and may become involved in potential litigation arising in the ordinary course of business. In the opinion of management, the effects, if any, of such litigation are not expected to be material to the consolidated financial statements. 65 Page 36 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE - ------- --------------------------------------------------------------- Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT - -------- -------------------------------------------------- Information required under this Item with respect to directors will be contained in the Company's proxy statement to be filed within 120 days of December 31, 1998, and is hereby incorporated herein by reference. Information required under this Item with respect to executive officers is contained under the heading "Executive Officers of the Registrant" in Item 1 of this Form 10-K report. ITEM 11. EXECUTIVE COMPENSATION - -------- ---------------------- Information required under this Item will be contained in the Company's proxy statement to be filed within 120 days of December 31, 1998, and is hereby incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT - -------- -------------------------------------------------------------- Information required under this Item will be contained in the Company's proxy statement to be filed within 120 days of December 31, 1998, and is hereby incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS - -------- ---------------------------------------------- Information required under this Item will be contained in the Company's proxy statement to be filed within 120 days of December 31, 1998, and is hereby incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K - -------- --------------------------------------------------------------- (a)(1) LISTING OF FINANCIAL STATEMENTS ------------------------------- The following consolidated financial statements of the Company, are filed as part of this Form 10-K Report and are included in Item 8: Report of Independent Auditors Consolidated Balance Sheets as of December 31, 1998 and 1997 Consolidated Statements of Income for each of the three years in the period ended December 31, 1998 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December 31, 1998 Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1998 Notes to Consolidated Financial Statements 66 Page 37 (a)(2) LISTING OF FINANCIAL STATEMENT SCHEDULES ---------------------------------------- The following financial statement schedules of the Company for the years 1998, 1997 and 1996 are included in Item 14(d), following the signatures, and should be read in conjunction with the consolidated financial statements contained in this Form 10-K Annual Report.
Schedule Number Schedule -------- -------- I. Summary of Investments-Other Than Investments in Related Parties II. Condensed Financial Information of Registrant III. Supplementary Insurance Information IV. Reinsurance
Independent Auditors' Consent (filed as Exhibit 23). All other schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements or notes thereto. 67
Page 38 (a)(3) LISTING OF EXHIBITS ------------------- If incorporated by reference document with which Exhibit was previously Exhibit No. Description of Exhibit filed with SEC ----------- ---------------------- ------------------------------------- 3(A)(1) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No. Articles of Incorporation 33-40643 on Form S-1 (see Exhibit 3(a) therein) 3(A)(2) State Auto Financial Corporation's Amendment to the 1933 Act Registration Statement No. Amended and Restated Articles of Incorporation 33-89400 on Form S-8 (see Exhibit 4(b) therein) 3(A)(3) State Auto Financial Corporation Certificate of Included herein Amendment to the Amended and Restated Articles of Incorporation as of June 2, 1998 3(B) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement No. Code of Regulations 33-40643 on Form S-1 (see Exhibit 3(b) therein) 4 State Auto Financial Corporation's Amended and Restated See Exhibit 3(A) and 3(B) Articles of Incorporation, and Articles 1, 3, 5 and 9 of the Company's Amended and Restated Code of Regulations 10(A) Reinsurance Agreement between State Automobile Mutual 1933 Act Registration Statement No. Insurance Company and Southern Home Insurance Company, 33-40643 on Form S-1 (see Exhibit now known as State Auto Property and Casualty Insurance 10(a) therein) Company, dated January 1, 1987 10(B) Amendment Number 1 effective January 1, 1992 to Form 10-K Annual Report for the year Reinsurance Agreement between State Automobile Mutual ended December 31, 1991 (see Exhibit Insurance Company and State Auto Property and Casualty 10(B) therein) insurance Company formerly known as Southern Home Insurance Company, effective as of January 1, 1987 10(C) Amendment Number 2 dated as of December 1, 1993 to the Form 10-K Annual Report for the year Reinsurance Agreement between State Automobile Mutual ended December 31, 1993 (see Exhibit Insurance Company and State Auto Property and Casualty 10(C) therein) Insurance Company formerly known as Southern Home Insurance Company, effective as of January 1, 1987 10(D) Amendment Number 3 dated as of December 1, 1994 Form 10-K Annual Report for the year effective as of January 1, 1995 to the Reinsurance ended December 31, 1994 (see Exhibit Agreement between State Automobile Mutual Insurance 10(D) therein) Company and State Auto Property and Casualty Insurance Company 10(E)* Amended and Restated Management Agreement among State Form 10-K Annual Report for the year Automobile Mutual Insurance Company, State Auto Property ended December 31, 1994 (see Exhibit and Casualty Insurance Company, State Auto National 10(E) therein) Insurance Company, State Auto Financial Corporation, State Auto Life Insurance Company, and Milbank Insurance Company effective April 1, 1994 as approved by insurance regulatory officials in Ohio, South Carolina and South Dakota 10(F)* Amendment Number 1-A to the Amended and Restated Form 10-K Annual Report for the year Management Agreement among State Automobile Mutual ended December 31, 1994 (see Exhibit Insurance Company, State Auto Property and Casualty 10(F) therein) Insurance Company, State Auto National Insurance Company, State Auto Financial Corporation, State Auto Life Insurance Company and Milbank Insurance Company effective as of January 1, 1995
- --------------------------------- *Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit 68 Page 39
10(G) Guaranty Agreement between State Automobile Mutual 1933 Act Registration Statement Insurance Company and State Auto Property and Casualty No. 33-40643 on Form S-1 (see Insurance Company dated as of May 16, 1991 Exhibit 10(d) therein) 10(H) Form of Indemnification Agreement between State Auto 1933 Act Registration Statement No. Financial Corporation and each of its directors 33-40643 on Form S-1 (see Exhibit 10 (e) therein) 10(I)* State Auto 1991 Quality Performance Bonus Plan 1933 Act Registration Statement No. 33-40643 on Form S-1 (see Exhibit 10 (f) therein) 10(J)* Non-Qualified Deferred Compensation Plan 1933 Act Registration Statement No. 33-40643 on Form S-1 (see Exhibit 10 (g) therein) 10(K)* 1991 Stock Option Plan 1933 Act Registration Statement No. 33-40643 on Form S-1 (see Exhibit 10 (h) therein) 10(L)* Amendment Number 1 to the 1991 Stock Option Plan 1933 Act Registration Statement No. 33-89400 on Form S-8 (see Exhibit 4 (a) therein) 10(M)* 1991 Directors' Stock Option Plan 1933 Act Registration Statement No. 33-40643 on Form S-1 (see Exhibit 10 (i) therein) 10(N) Lease Agreement between Longhollow Associates Limited 1933 Act Registration Statement Partnership and State Automobile Mutual Insurance No. 33-40643 on Form S-1 (see Exhibit 10 Company dated July 8, 1988, as amended (j) therein) 10(O) License Agreement between State Automobile Mutual 1933 Act Registration Statement Insurance Company and Policy Management Systems No. 33-40643 on Form S-1 (see Exhibit 10 Corporation dated December 28, 1984 (k) therein) 10(P) Investment Management Agreement between Stateco Form 10-K Annual Report for the year Financial Services, Inc. and State Automobile Mutual ended December 31, 1992 (see Exhibit Insurance Company, effective April 1, 1993 10(N) therein) 10(Q) Option Agreement between State Automobile Mutual Form 10-K Annual Report for year ended Insurance Company and State Auto Financial Corporation December 31, 1993 (see Exhibit 10(R) dated as of August 20, 1993 therein) 10(R)* Supplemental Executive Retirement Income Plan effective Form 10-K Annual Report for the year December 1, 1992 ended December 31, 1992 (see Exhibit 10(O) therein) 10(S)* State Auto Insurance Companies Directors' Deferred Form 10-K Annual Report for year ended Compensation Plan December 31, 1995 (see Exhibit 10(S) therein) 10(T)* State Auto Insurance Companies Non-Qualified Incentive Form 10-K Annual Report for year ended Deferred Compensation Plan December 31, 1995 (see Exhibit 10(T) therein) 10(U)* Strategic Insurance Software, Inc. 1995 Stock Option Plan Form 10-K Annual Report for year ended December 31, 1995 (see Exhibit 10(U) therein) 10(V)* Strategic Insurance Software, Inc. Warrant to purchase Form 10-K Annual Report for year ended common stock December 31, 1995 (see Exhibit 10(V) therein) 10(W)* Strategic Insurance Software, Inc. Shareholder's Form 10-K Annual Report for year ended Agreement December 31, 1995 (see Exhibit 10(W) therein)
- --------------------------------- *Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit 69
Page 40 10(X)* Robert L. Bailey Employment Contract Form 10-K Annual Report for year ended December 31, 1995 (see Exhibit 10(X) therein) 10(Y) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended between State Automobile Mutual Insurance Company, State September 30, 1996 (see Exhibit 10(Y) Auto Property and Casualty Insurance Company and Milbank therein) Insurance Company effective July 1, 1996 10(Z) Property Catastrophe Overlying Excess of Loss Form 10-Q for the period ended Reinsurance Contract between State Automobile Mutual September 30, 1996 (see Exhibit 10(Z) Insurance Company, Milbank Insurance Company, State Auto therein) National Insurance Company and State Auto Property and Casualty Insurance Company dated July 1,1996 10(AA) Credit Agreement between SAF Funding Corporation and The Form 10-Q for the period ended Chase Manhattan Bank dated August 16, 1996 September 30, 1996 (see Exhibit 10(AA) therein) 10(BB) Put Agreement between State Automobile Mutual Insurance Form 10-Q for the period ended Company, State Auto Financial Corporation and The Chase September 30, 1996 (see Exhibit 10(BB) Manhattan Bank dated August 16, 1996 therein) 10(CC) Standby Purchase Agreement between State Auto Financial Form 10-Q for the period ended Corporation and SAF Funding Corporation dated August 16, September 30, 1996 (see Exhibit 1996 10(CC) therein) 10(DD)* Amendment Number 2 to the 1991 Stock Option Plan Form 10-K Annual Report for the year ended December 31, 1996 (see Exhibit 10(DD) therein) 10(EE)* Amendment Number 1 to the 1991 Directors' Stock Option Form 10-K Annual Report for the year Plan ended December 31, 1996 (see Exhibit 10(EE) therein) 10(FF) Option Agreement between State Auto Mutual and State Form 10-K Annual Report for the year Auto Financial dated March 11, 1997 ended December 31, 1996 (see Exhibit 10(FF) therein) 10(GG) Amended and Restated Credit Agreement dated August 16, Form 10-Q for the period ended 1996 amended and restated July 18, 1997 between SAF September 30, 1997 (see Exhibit 10(GG) Funding Corporation and the Chase Manhattan Bank therein) 10(HH) Amended and Restated SERP of State Auto Mutual effective Form 10-K Annual Report for the year as of January 1, 1994 ended December 31, 1997 (see Exhibit 10(HH) therein) 10(II) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended March between State Automobile Mutual Insurance Company, State 31, 1998 (see Exhibit 10(II) therein) Auto Property and Casualty Insurance Company, Milbank Insurance Company and Midwest Security Insurance Company effective January 1, 1998 10(JJ) Agreement and Plan of Reorganization dated July 7, 1998, Form 8-K filed on July 7, 1998 (see by and among State Auto Financial Corporation, SAF Exhibit 10(JJ) therein) Acquisition Corp., State Automobile Mutual Insurance Company and Milbank Insurance Company and the Closing Agreement dated July 7, 1998 10(KK) Reinsurance Pooling Agreement Amended and Restated as of Included herein January 1, 1999 by and among State Automobile Mutual Insurance Company, State Auto Property and Casualty Insurance Company, Milbank Insurance Company, Midwest Security Insurance Company and Farmers Casualty Insurance Company 11 Statement regarding computation of earnings per share Included herein
- --------------------------------- *Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit 70
Page 41 21 List of Subsidiaries of State Auto Financial Corporation Included herein 23 Consent of Independent Auditors Included herein 24 Powers of Attorney - John R. Lowther, David L. Form 10-K Annual Report for the year Bickelhaupt, Paul W. Huesman, George R. ended December 31, 1991 (see Manser and Robert J. Murchake Exhibit 25 therein) 24(A) Power of Attorney - William J. Lhota Form 10-K Annual Report for the year ended December 31, 1994 (see Exhibit 25(A) therein) 24(B) Power of Attorney - David J. D'Antoni Form 10-K Annual Report for the year ended December 31, 1995 (see Exhibit 25(B) therein) 24(C) Powers of Attorney - William J. Lhota, Urlin G. Harris, Form 10-Q for the period ended June Jr., Robert J. Murchake, Paul W. Huesman, George R. 30, 1997 (see Exhibit 24(C) therein) Manser, David L. Bickelhaupt, and David J. D'Antoni 24(D) Power of Attorney - John R. Lowther Form 10-Q for the period ended March 31, 1998 (see Exhibit 24(D) therein) 24(E) Power of Attorney - Robert H. Moone Included herein 27 Financial Data Schedule Included herein
(b) REPORTS ON FORM 8-K ------------------- The Company did not file any Form 8-K current reports during the fourth quarter of the Company's fiscal year ended December 31, 1998. (c) EXHIBITS -------- The exhibits have been submitted as a separate section of this report following the financial statement schedules. (d) FINANCIAL STATEMENT SCHEDULES ----------------------------- The financial statement schedules have been submitted as a separate section of this report following the signatures. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. STATE AUTO FINANCIAL CORPORATION Dated: March 29, 1999 /s/ Robert L. Bailey -------------------------------- Robert L. Bailey, Chairman and Chief Executive Officer 71
Page 42 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Name Title Date ---- ----- ---- /s/ Robert L. Bailey Chairman of the Board, March 29, 1999 - ----------------------- Chief Executive Officer Robert L. Bailey and Director (principal executive officer) /s/ Steven J. Johnston Chief Financial Officer, March 29, 1999 - ----------------------- Vice President, Treasurer Steven J. Johnston (principal financial officer and principal accounting officer) John R. Lowther* Secretary and Director March 29, 1999 - ----------------------- John R. Lowther Urlin G. Harris, Jr.* Director March 29, 1999 - ----------------------- Urlin G. Harris, Jr. David L. Bickelhaupt* Director March 29, 1999 - ----------------------- David L. Bickelhaupt David J. D'Antoni* Director March 29, 1999 - ----------------------- David J. D'Antoni Paul W. Huesman* Director March 29, 1999 - ----------------------- Paul W. Huesman William J. Lhota* Director March 29, 1999 - ----------------------- William J. Lhota George R. Manser* Director March 29, 1999 - ----------------------- George R. Manser /s/ Robert H. Moone Director March 29, 1999 - ----------------------- Robert H. Moone
72 Page 43 *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 March 29, 1999 - ----------------------- Steven J. Johnston Attorney in Fact 73 Item 14(d) Financial Statement Schedules 74 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE I(a) - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1998
Column A Column B Column C Column D -------- -------- -------- -------- HELD TO MATURITY Amount at which shown in the Type of Investment Cost Value balance sheet ------------------ ---- ----- ------------- (in thousands) Fixed maturities: Bonds: United States Government and government agencies and authorities $ 48,871 $ 50,263 $ 48,871 States, municipalities and political subdivisions 7,055 7,563 7,055 -------- -------- -------- Total fixed maturities - Held to maturity $ 55,926 $ 57,826 $ 55,926 ======== ======== ========
SCHEDULE I(b) - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES DECEMBER 31, 1998
Column A Column B Column C Column D -------- -------- -------- -------- AVAILABLE FOR SALE Amount at which shown in the Type of Investment Cost Value balance sheet ------------------ ---- ----- ------------- (in thousands) Fixed maturities: Bonds: United States Government and government agencies and authorities $ 91,480 $ 94,433 $ 94,433 States, municipalities and political subdivisions 363,532 377,617 377,617 Public utilities 4,987 5,213 5,213 All other corporate bonds 4,009 4,581 4,581 -------- -------- -------- Total fixed maturities $464,008 $481,844 $481,844 -------- -------- -------- Equity securities: Public utilities 1,364 2,106 2,106 Banks, trust and insurance companies 3,048 4,760 4,760 Industrial, miscellaneous and all other 24,821 35,330 35,330 -------- -------- -------- Total equity securities 29,233 42,196 42,196 -------- -------- -------- Total investments - Available for sale $493,241 $524,040 $524,040 ======== ======== ========
75 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEETS
December 31 ------------------------- ASSETS 1998 1997 ---- ---- (dollars in thousands) (Restated - see Note A) Investments in common stock of subsidiaries (equity method) $329,104 $294,403 Surplus note receivable 9,000 -- Cash 1,220 1,501 Real estate 461 458 Other assets 759 253 Federal income tax benefit 647 952 -------- -------- Total assets $341,191 $297,567 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Due to affiliates $ 122 $ 142 Accrued expenses 245 167 -------- -------- Total liabilities 367 309 STOCKHOLDERS' EQUITY Class A Preferred stock (nonvoting), without par value. Authorized 2,500,000 shares; none issued -- -- Class B Preferred stock, without par value Authorized 2,500,000 shares; none issued -- -- Common stock, without par value. Authorized 100,000,000 shares; issued and outstanding 42,039,892 and 41,828,845 shares issued and outstanding, respectively, at stated value of $2.50 per share 105,100 104,572 Less 13,212 and 8,118 treasury shares, respectively, at cost (167) (90) Additional paid-in capital 41,539 40,210 Accumulated other comprehensive income 20,276 14,761 Retained earnings 174,076 137,805 -------- -------- Total stockholders' equity 340,824 297,258 -------- -------- Total liabilities and stockholders' equity $341,191 $297,567 ======== ========
76 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONTINUED CONDENSED STATEMENTS OF INCOME
Year ended December 31 --------------------------------------- 1998 1997 1996 ---- ---- ---- (in thousands) (Restated - (Restated - see Note A) see Note A) Investment income $ 326 $ 68 $ 30 Net realized gains on investments 2 -- -- ------- ------- ------- Total revenue 328 68 30 ------- ------- ------- Total operating expenses 1,423 1,188 1,074 ------- ------- ------- Loss before federal income taxes (1,095) (1,120) (1,044) Federal income tax benefit (394) (378) (405) ------- ------- ------- Net loss before equity in undistributed net earnings of subsidiaries (701) (742) (639) Equity in undistributed net earnings of subsidiaries 38,198 41,740 27,046 ------- ------- ------- Net Income $37,497 $40,998 $26,407 ======= ======= =======
77 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONTINUED CONDENSED STATEMENTS OF CASH FLOWS
Year Ended December 31 ------------------------------------------ 1998 1997 1996 ---- ---- ---- (in thousands) (Restated - (Restated - see Note A) see Note A) Cash flows from operating activities: Net income $ 37,497 $ 40,998 $ 26,407 -------- -------- -------- Adjustments to reconcile net earnings to net cash used in operating activities: Depreciation 17 16 16 Equity in undistributed earnings of subsidiaries (38,198) (41,740) (27,046) Changes in operating assets and liabilities: Change in accrued expenses and due to affiliates 58 36 (188) Change in other assets (505) 60 (216) Change in federal income taxes 305 (492) (303) -------- -------- -------- Net cash used in operating activities (826) (1,122) (1,330) -------- -------- -------- Cash flows from investing activities: Capitalization of subsidiary -- -- (5,000) Dividends received from subsidiaries 9,004 1,250 6,402 Purchase of surplus notes receivable (9,000) -- -- Additions to real estate (20) (769) (94) -------- -------- -------- Net cash (used in) provided by investing activities (16) 481 1,308 -------- -------- -------- Cash flows from financing activities: Net proceeds from sale of common stock 1,780 2,470 1,325 Payment of dividends (1,219) (1,059) (933) -------- -------- -------- Net cash provided by financing activities 561 1,411 392 -------- -------- -------- Net increase (decrease) in cash and invested cash (281) 770 370 -------- -------- -------- Cash and cash equivalents at beginning of year 1,501 731 361 -------- -------- -------- Cash and cash equivalents at end of year $ 1,220 $ 1,501 $ 731 ======== ======== ======== Supplemental Disclosures: Federal income taxes received $ (902) $ (401) $ (165) ======== ======== ======== Noncash investing activity: Capitalization of subsidiary -- $ 738 -- ======== ======== ========
78 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONTINUED NOTE 1 - BASIS OF PRESENTATION In the parent company-only financial statements, State Auto Financial's investment in subsidiaries is stated at cost plus equity in undistributed earnings of subsidiares and net unrealized gains and losses on investments. The parent company-only financial statements should be read in conjunction with the Company's consolidated financial statements. On July 7, 1998, State Auto Financial exercised its option with Mutual, pursuant to the Option Agreement dated August 20, 1993, by acquiring the outstanding shares of Milbank. Milbank had been a wholly-owned subsidiary of Mutual since July 1, 1993, but as a result of this transaction, is now a wholly-owned subsidiary of State Auto Financial. The purchase price of Milbank was approximately $81.9 million. The transaction was effected through an exchange with Mutual of approximately 5.1 million State Auto Financial common shares for all the issued and outstanding capital stock of Milbank. Since the transaction was a combination of entities under common control it has been accounted for similar to a pooling-of-interests. The prior year's financial information has been restated to include the financial position and operations of Milbank. 79 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (in thousands)
Column A Column B Column C Column D Column E Column F -------- -------- -------- -------- -------- -------- Future policy Other policy benefits, losses, claims and Deferred policy claims and Unearned benefits Premium Segment acquisition cost loss expenses premiums payable revenue ------- ---------------- ------------- -------- ------- ------- Year ended December 31, 1998 Standard insurance segment $23,619 $208,161 $125,410 -- $330,709 Nonstandard insurance segment 1,180 10,540 9,678 -- 25,501 ------- -------- -------- ------- -------- Total 24,799 218,701 135,088 -- 356,210 ======= ======== ======== ======= ======== Year ended December 31, 1997 Standard insurance segment 21,344 197,516 115,146 -- 298,626 Nonstandard insurance segment 1,096 8,734 9,887 -- 21,424 ------- -------- -------- ------- -------- Total $22,440 $206,250 $125,033 -- 320,050 ======= ======== ======== ======= ======== Year ended December 31, 1996 Standard insurance segment 290,807 Nonstandard insurance segment 13,665 -------- Total $304,472 ======== Column G Column H Column I Column J Column K -------- -------- -------- -------- -------- Amortization Benefits, claims, of deferred losses and policy Net investment settlement acquisition Other operating Premiums income expenses costs expenses written ------ -------- ----- -------- ------- Year ended December 31, 1998 Standard insurance segment $27,710 $223,311 $ 80,766 $17,802 $332,975 Nonstandard insurance segment 1,383 18,983 4,448 1,208 25,292 ------- -------- -------- ------- -------- Total 29,093 242,294 85,214 19,010 358,267 ======= ======== ======== ======= ======== Year ended December 31, 1997 Standard insurance segment 26,984 191,228 72,029 18,175 302,931 Nonstandard insurance segment 1,315 17,006 4,813 (666) 23,389 ------- -------- -------- ------- -------- Total 28,299 208,234 76,842 17,509 326,320 ======= ======== ======== ======= ======== Year ended December 31, 1996 Standard insurance segment 26,374 209,568 70,355 12,985 293,078 Nonstandard insurance segment 971 10,466 3,333 (670) 15,466 ------- -------- -------- ------- -------- Total $27,345 $220,034 $ 73,688 $12,315 $308,544 ======= ======== ======== ======= ========
80 STATE AUTO FINANCIAL CORPORATION SCHEDULE IV - REINSURANCE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (in thousands, except percentages)
Column A Column B Column C Column D Column E Column F -------- -------- -------- -------- -------- -------- Percentage Ceded to Assumed from of amount Outside Affiliated Outside Affiliated assumed Gross Amount Companies Companies(1) Companies Companies(1) Net Amount to net(2) ------------ --------- ------------ --------- ------------ ---------- --------- Year ended 12-31-98 property-casualty earned premiums $384,870 $17,026 $356,638 $14,386 $330,618 $356,210 4.0% Year ended 12-31-97 property-casualty earned premiums $366,451 $17,560 $342,309 $14,917 $298,551 $320,050 4.7% Year ended 12-31-96 property-casualty earned premiums $343,173 $18,212 $329,109 $17,842 $290,778 $304,472 5.9%
- -------------- (1) These columns include the effect of intercompany pooling. (2) Calculated as earned premiums assumed from outside companies to net amount. 81
Item 14(c) Exhibit Index (a)(3) LISTING OF EXHIBITS ------------------- If incorporated by reference document with which Exhibit was Exhibit No. Description of Exhibit previously filed with SEC ----------- ---------------------- -------------------------------- 3(A)(1) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement Articles of Incorporation No. 33-40643 on Form S-1 (see Exhibit 3(a) therein) 3(A)(2) State Auto Financial Corporation's Amendment to the 1933 Act Registration Statement Amended and Restated Articles of Incorporation No. 33-89400 on Form S-8 (see Exhibit 4(b) therein) 3(A)(3) State Auto Financial Corporation Certificate of Amendment Included herein to the Amended and Restated Articles of Incorporation as of June 2, 1998 3(B) State Auto Financial Corporation's Amended and Restated 1933 Act Registration Statement Code of Regulations No. 33-40643 on Form S-1 (see Exhibit 3(b) therein) 4 State Auto Financial Corporation's Amended and Restated See Exhibit 3(A) and 3(B) Articles of Incorporation, and Articles 1, 3, 5 and 9 of the Company's Amended and Restated Code of Regulations 10(A) Reinsurance Agreement between State Automobile Mutual 1933 Act Registration Statement Insurance Company and Southern Home Insurance Company, No. 33-40643 on Form S-1 (see now known as State Auto Property and Casualty Insurance Exhibit 10(a) therein) Company, dated January 1, 1987 10(B) Amendment Number 1 effective January 1, 1992 to Form 10-K Annual Report for the Reinsurance Agreement between State Automobile Mutual year ended December 31, 1991 Insurance Company and State Auto Property and Casualty (see Exhibit 10 (B) therein) insurance Company formerly known as Southern Home Insurance Company, effective as of January 1, 1987 10(C) Amendment Number 2 dated as of December 1, 1993 to the Form 10-K Annual Report for the Reinsurance Agreement between State Automobile Mutual year ended December 31, 1993 Insurance Company and State Auto Property and Casualty (see Exhibit 10 (C) therein) Insurance Company formerly known as Southern Home Insurance Company, effective as of January 1, 1987 10(D) Amendment Number 3 dated as of December 1, 1994 Form 10-K Annual Report for the effective as of January 1, 1995 to the Reinsurance year ended December 31, 1994 Agreement between State Automobile Mutual Insurance (see Exhibit 10(D) therein) Company and State Auto Property and Casualty Insurance Company 10(E)* Amended and Restated Management Agreement among State Form 10-K Annual Report for the Automobile Mutual Insurance Company, State Auto year ended December 31, 1994 Property and Casualty Insurance Company, State Auto (see Exhibit 10(E) therein) National Insurance Company, State Auto Financial Corporation, State Auto Life Insurance Company, and Milbank Insurance Company effective April 1, 1994 as approved by insurance regulatory officials in Ohio, South Carolina and South Dakota
- --------------------------------- *Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit 82
10(F)* Amendment Number 1-A to the Amended and Restated Form 10-K Annual Report for the Management Agreement among State Automobile Mutual year ended December 31, 1994 Insurance Company, State Auto Property and Casualty (see Exhibit 10(F) therein) Insurance Company, State Auto National Insurance Company, State Auto Financial Corporation, State Auto Life Insurance Company and Milbank Insurance Company effective as of January 1, 1995 10(G) Guaranty Agreement between State Automobile Mutual 1933 Act Registration Statement Insurance Company and State Auto Property and Casualty No. 33-40643 on Form S-1 (see Insurance Company dated as of May 16, 1991 Exhibit 10 (d) therein) 10(H) Form of Indemnification Agreement between State Auto 1933 Act Registration Statement Financial Corporation and each of its directors No. 33-40643 on Form S-1 (see Exhibit 10 (e) therein) 10(I)* State Auto 1991 Quality Performance Bonus Plan 1933 Act Registration Statement No. 33-40643 on Form S-1 (see Exhibit 10 (f) therein) 10(J)* Non-Qualified Deferred Compensation Plan 1933 Act Registration Statement No. 33-40643 on Form S-1 (see Exhibit 10 (g) therein) 10(K)* 1991 Stock Option Plan 1933 Act Registration Statement No. 33-40643 on Form S-1 (see Exhibit 10 (h) therein) 10(L)* Amendment Number 1 to the 1991 Stock Option Plan 1933 Act Registration Statement No. 33-89400 on Form S-8 (see Exhibit 4 (a) therein) 10(M)* 1991 Directors' Stock Option Plan 1933 Act Registration Statement No. 33-40643 on Form S-1 (see Exhibit 10 (i) therein) 10(N) Lease Agreement between Longhollow Associates Limited 1933 Act Registration Statement Partnership and State Automobile Mutual Insurance No. 33-40643 on Form S-1 (see Company dated July 8, 1988, as amended Exhibit 10 (j) therein) 10(O) License Agreement between State Automobile Mutual 1933 Act Registration Statement Insurance Company and Policy Management Systems No. 33-40643 on Form S-1 (see Corporation dated December 28, 1984 Exhibit 10 (k) therein) 10(P) Investment Management Agreement between Stateco Form 10-K Annual Report for the Financial Services, Inc. and State Automobile Mutual year ended December 31, 1992 Insurance Company, effective April 1, 1993 (see Exhibit 10 (N) therein 10(Q) Option Agreement between State Automobile Mutual Form 10-K Annual Report for year Insurance Company and State Auto Financial Corporation ended December 31, 1993 (see dated as of August 20, 1993 Exhibit 10 (R) therein) 10(R)* Supplemental Executive Retirement Income Plan effective Form 10-K Annual Report for the December 1, 1992 year ended December 31, 1992 (see Exhibit 10(O) therein) 10(S)* State Auto Insurance Companies Directors' Deferred Form 10-K Annual Report for year Compensation Plan ended December 31, 1995 (see Exhibit 10(S) therein) 10(T)* State Auto Insurance Companies Non-Qualified Incentive Form 10-K Annual Report for year Deferred Compensation Plan ended December 31, 1995 (see Exhibit 10(T) therein)
- --------------------------------- *Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit 83
10(U)* Strategic Insurance Software, Inc. 1995 Stock Option Form 10-K Annual Report for year Plan ended December 31, 1995 (see Exhibit 10(U) therein) 10(V)* Strategic Insurance Software, Inc. Warrant to purchase Form 10-K Annual Report for year common stock ended December 31, 1995 (see Exhibit 10(V) therein) 10(W)* Strategic Insurance Software, Inc. Shareholder's Form 10-K Annual Report for year Agreement ended December 31, 1995 (see Exhibit 10(W) therein) 10(X)* Robert L. Bailey Employment Contract Form 10-K Annual Report for year ended December 31, 1995 (see Exhibit 10(X) therein) 10(Y) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended between State Automobile Mutual Insurance Company, September 30, 1996 (see Exhibit State Auto Property and Casualty Insurance Company and 10(Y) therein) Milbank Insurance Company effective July 1, 1996 10(Z) Property Catastrophe Overlying Excess of Loss Form 10-Q for the period ended Reinsurance Contract between State Automobile Mutual September 30, 1996 (see Exhibit Insurance Company, Milbank Insurance Company, State 10(Z) therein) Auto National Insurance Company and State Auto Property and Casualty Insurance Company dated July 1,1996 10(AA) Credit Agreement between SAF Funding Corporation and Form 10-Q for the period ended The Chase Manhattan Bank dated August 16, 1996 September 30, 1996 (see Exhibit 10(AA) therein) 10(BB) Put Agreement between State Automobile Mutual Insurance Form 10-Q for the period ended Company, State Auto Financial Corporation and The Chase September 30, 1996 (see Exhibit Manhattan Bank dated August 16, 1996 10(BB) therein) 10(CC) Standby Purchase Agreement between State Auto Financial Form 10-Q for the period ended Corporation and SAF Funding Corporation dated August September 30, 1996 (see Exhibit 16, 1996 10(CC) therein) 10(DD)* Amendment Number 2 to the 1991 Stock Option Plan Form 10-K Annual Report for the year ended December 31, 1996 (see Exhibit 10(DD) therein) 10(EE)* Amendment Number 1 to the 1991 Directors' Stock Option Form 10-K Annual Report for the Plan year ended December 31, 1996 (see Exhibit 10(EE) therein) 10(FF) Option Agreement between State Auto Mutual and State Form 10-K Annual Report for the Auto Financial dated March 11, 1997 year ended December 31, 1996 (see Exhibit 10(FF) therein) 10(GG) Amended and Restated Credit Agreement dated August 16, Form 10-Q for the period ended 1996 amended and restated July 18, 1997 September 30, 1997 (see Exhibit between SAF Funding Corporation 10(GG) therein) and the Chase Manhattan Bank 10(HH) Amended and Restated SERP of State Auto Mutual Form 10-K Annual Report for the year effective as of January 1, 1994 ended December 31, 1997 (see Exhibit 10(HH) therein) 10(II) Amended and Restated Reinsurance Pooling Agreement Form 10-Q for the period ended March 31, between State Automobile Mutual Insurance Company, State 1998 (see Exhibit 10(II) therein) Auto Property and Casualty Insurance Company, Milbank Insurance Company and Midwest Security Insurance Company effective January 1, 1998
- --------------------------------- *Constitutes either a management contract or a compensatory plan or arrangement required to be filed as an Exhibit 84
10(JJ) Agreement and Plan of Reorganization dated July 7, 1998, Form 8-K filed on July 7, 1998 by and among State Auto Financial Corporation, SAF (see Exhibit 10(JJ) therein) Acquisition Corp., State Automobile Mutual Insurance Company and Milbank Insurance Company and the Closing Agreement dated July 7, 1998 10(KK) Reinsurance Pooling Agreement Amended and Restated as of Included herein January 1, 1999 by and among State Automobile Mutual Insurance Company, State Auto Property and Casualty Insurance Company, Milbank Insurance Company, Midwest Security Insurance Company and Farmers Casualty Insurance Company 11 Statement regarding computation of earnings per share Included herein 21 List of Subsidiaries of State Auto Financial Corporation Included herein 23 Consent of Independent Auditors Included Herein 24 Powers of Attorney - John R. Lowther, David L. Form 10-K Annual Report for the Bickelhaupt, Paul W. Huesman, George R. Manser and year ended December 31, 1991 Robert J. Murchake (see Exhibit 25 therein) 24(A) Power of Attorney - William J. Lhota Form 10-K Annual Report for the year ended December 31, 1994 (see Exhibit 25(A) therein) 24(B) Power of Attorney - David J. D'Antoni Form 10-K Annual Report for the year ended December 31, 1995 (see Exhibit 25(B) therein) 24(C) Powers of Attorney - William J. Lhota, Urlin G. Harris, Form 10-Q for the period ended Jr., Robert J. Murchake, Paul W. Huesman, George R. June 30, 1997 (see Exhibit 24(C) Manser, David L. Bickelhaupt, and David J. D'Antoni therein) 24(D) Power of Attorney - John R. Lowther Form 10-Q for the period ended March 31, 1998 (see Exhibit 24(D) therein) 24(E) Power of Attorney - Robert H. Moone Included herein 27 Financial Data Schedule Included herein
EX-3.A.3 2 EXHIBIT 3(A)(3) 1 3(A) (3) State Auto Financial Corporation Certificate of Amendment to the Amended and Restated Articles of Incorporation as of June 2, 1998 2 CERTIFICATE OF AMENDMENT TO ARTICLES OF INCORPORATION OF STATE AUTO FINANCIAL CORPORATION The undersigned officers of State Auto Financial Corporation with its principal office at 518 East Broad Street, Columbus, Ohio 43215 do hereby certify that at the Annual Meeting of Shareholders of State Auto Financial Corporation held on May 28, 1998, the following resolution was approved by the shareholders as 98.4% of the shares voted and 89.6% of the shares outstanding were cast in favor of the resolution. RESOLVED, that the Amended and Restated Articles of Incorporation of State Auto Financial Corporation are further amended by deleting the first sentence of the Article Fourth and replacing it with the following: FOURTH: The maximum number of shares which the Corporation shall be authorized to have outstanding is One Hundred and Five Million (105,000,000) which shall be divided into three classes consisting of One Hundred Million (100,000,000) common shares, without par value (the "Common Shares"), Two Million, Five Hundred Thousand (2,500,000) Class A preferred shares, without par value (the "Class A Preferred Shares"), and Two Million, Five Hundred Thousand (2,500,000) Class B preferred shares, without par value (the "Class B Preferred Shares"). IN WITNESS WHEREOF, the undersigned officers of State Auto Financial Corporation acting for and on behalf of the corporation have hereunto subscribed their names this third day of June 1998. /s/ John R. Lowther /s/ Robert H. Moone - ------------------------------ ------------------------------ John R. Lowther Robert H. Moone Secretary President EX-10.KK 3 EXHIBIT 10(KK) 1 10(KK) Reinsurance Pooling Agreement Amended and Restated as of January 1, 1999 by and among State Automobile Mutual Insurance Company State Auto Property and Casualty Insurance Company Milbank Insurance Company and Farmers Casualty Insurance Company 2 Page 1 REINSURANCE POOLING AGREEMENT ----------------------------- AMENDED AND RESTATED -------------------- AS OF JANUARY 1, 1999 --------------------- This Reinsurance Pooling Agreement Amended and Restated effective as of 12:01 a.m., Eastern Standard Time, January 1, 1999 is by and among State Automobile Mutual Insurance Company, 518 East Broad Street, Columbus, Ohio (hereinafter referred to as "State Auto Mutual"), State Auto Property and Casualty Insurance Company, 112 Main Street, Greer, South Carolina (hereinafter referred to as "State Auto P&C"), Milbank Insurance Company, East Highway 12, Milbank, South Dakota (hereinafter referred to as "Milbank"), Midwest Security Insurance Company, 2700 Midwest Drive, Onalaska, Wisconsin (hereinafter referred to as "Midwest Security") and Farmers Casualty Insurance Company, 1300 Woodland Drive West Des Moines, Iowa (hereinafter referred to as "Farmers Casualty"). (State Auto Mutual, State Auto P&C, Milbank, Midwest Security, and Farmers Casualty are herein collectively referred to as the "State Auto Insurance Companies" or "Group"). BACKGROUND INFORMATION ---------------------- The members of the Group have determined that the underwriting operations of the Group should be conducted by State Auto Mutual on behalf of the Group which has been effected through the Amended and Restated Management Agreement dated April 1, 1994 (the "4/1/94 Management Agreement"), as to Midwest Security through the Management Agreement dated March 11, 1997 (the "Midwest Management Agreement"), as to Farmers Casualty through the Management Agreement dated effective January 1, 1999 (the "Farmers Casualty Management Agreement") and by means of mutual reinsurance on a percentage basis as herein provided. State Auto Mutual and State Auto P&C originally entered into an intercompany Reinsurance Agreement effective as of 12:01 a.m., January 1, 1987 (the "Reinsurance Agreement"). The Reinsurance Agreement has since been amended by an Addendum effective January 1, 1987, adding insolvency and arbitration provisions; by Amendment Number 1 effective as of January 1, 1992 amending the pooling percentages from 20% State Auto P&C - 80% State Auto Mutual to 30% and 70% respectively; by Amendment Number 2 effective as of January 1, 1991 excluding post retirement health care benefits as a pooled expense and as of January 1, 1994 excluding post employment benefits liability as a pooled expense; and by Amendment Number 3 effective as of January 1, 1995 adding Milbank as a party and adjusting the pooling percentages as follows: State Auto P&C 35%, State Auto Mutual 55% and Milbank 10% and by an Amended and Restated Reinsurance Pooling Agreement dated July 1, 1996 (the "7/1/96 Reinsurance Agreement"), which excluded from the Reinsurance Agreement catastrophic loss claims and loss adjustment expenses incurred by State Auto Mutual, State Auto P&C and Milbank in the amount of $100,000,000 in excess of $120,000,000 of such losses and loss adjustment expense and the premiums for such exposure; and by an Amended and Restated Reinsurance Pooling Agreement effective January 1, 1998 (the "'98 Pooling Agreement") which added Midwest Security as a party and adjusted the Respective Percentages (as defined below) to State Auto P&C 37%, State Auto Mutual 52%, 3 Page 2 Milbank 10%, and Midwest Security 1%. The parties now desire to execute a Reinsurance Pooling Agreement Amended and Restated as of January 1, 1999 (hereafter referred to as the "'99 Pooling Agreement") to add Farmers Casualty as a party and to adjust the Respective Percentages as set forth herein. The parties desire to amend and restate the '98 Pooling Agreement as set forth herein to provide for the continuation of the pooling arrangement it effects, including the above-described previous amendments and the additional amendment. STATEMENT OF AGREEMENT ---------------------- In consideration of the mutual covenants set forth herein and INTENDING TO BE LEGALLY BOUND HEREBY, the parties hereto hereby agree as follows: 1. DEFINITIONS: As used in this Agreement: a. "Net Liabilities" shall mean all direct liabilities plus reinsurance assumed minus reinsurance ceded, except as otherwise expressly excluded below. b. "Net Premiums" shall mean all direct premiums plus reinsurance assumed minus reinsurance ceded, except as otherwise expressly excluded below. c. "Respective Percentage" shall be: As to Farmers Casualty 3% As to Midwest Security 1% As to Milbank 10% As to State Auto P&C 37% As to State Auto Mutual 49% 2. CESSION: (a) State Auto P&C Cession: State Auto Mutual hereby reinsures and assumes and State Auto P&C hereby cedes and transfers to State Auto Mutual all Net Liabilities incurred under or in connection with all contracts and policies of insurance issued by State Auto P&C outstanding and in force as of and subsequent to 12:01 a.m. Eastern Standard Time, January 1, 1999. Such liabilities shall include State Auto P&C's reserves for unearned premiums, outstanding losses and loss expenses (including unreported losses) and all other outstanding underwriting and administrative expenses as evidenced by State Auto P&C's books and records at the close of business on December 31, 1998, but shall not include intercompany balances, liabilities incurred in connection with the investment transactions of State Auto P&C, liabilities for dividends to stockholders 4 Page 3 declared and unpaid, other liabilities not incurred in connection with underwriting operations, post retirement health care benefits liability, and post employment benefits liability. It is further agreed State Auto Mutual shall receive the Net Premiums for said contracts and policies. (b) Milbank Cession: State Auto Mutual hereby reinsures and assumes and Milbank hereby cedes and transfers to State Auto Mutual all Net Liabilities incurred under or in connection with all contracts and policies of insurance issued by Milbank outstanding and in force as of and subsequent to 12:01 a.m. EST, January 1, 1999. Such liabilities shall include Milbank's reserves for unearned premiums, outstanding losses and loss expenses (including unreported losses) and all other outstanding underwriting and administrative expenses as evidenced by Milbank's books and records at the close of business on December 31, 1998, but shall not include intercompany balances, liabilities incurred in connection with the investment transactions of Milbank, liabilities for dividends to stockholders declared and unpaid, other liabilities not incurred in connection with underwriting operations, post retirement health care benefits liability, and post employment benefits liability. It is further agreed that State Auto Mutual shall receive the Net Premiums for said contracts and policies. (c) Midwest Security Cession: State Auto Mutual hereby reinsures and assumes and Midwest Security hereby cedes and transfers to State Auto Mutual all Net Liabilities incurred under or in connection with all contracts and policies of insurance issued by Midwest Security outstanding and in force as of and subsequent to 12:01 a.m. EST, January 1, 1999. Such liabilities shall include Midwest Security's reserves for unearned premiums, outstanding losses and loss expenses (including unreported losses) and all other outstanding underwriting and administrative expenses as evidenced by Midwest Security's books and records at the close of business on December 31, 1998, but shall not include intercompany balances, liabilities incurred in connection with the investment transactions of Midwest Security, liabilities for dividends to stockholders declared and unpaid, other liabilities not incurred in connection with underwriting operations, post retirement health care benefits liability, and post employment benefits liability. It is further agreed that State Auto Mutual shall receive the Net Premiums for said contracts and policies. (d) Farmers Casualty Cession: State Auto Mutual hereby reinsures and assumes and Farmers Casualty hereby cedes and transfers to State Auto Mutual all Net Liabilities incurred 5 Page 4 under or in connection with all contracts and policies of insurance issued by Farmers Casualty outstanding and in force as of and subsequent to 12:01 a.m. EST, January 1, 1999. Such liabilities shall include Farmers Casualty's reserves for unearned premiums, outstanding losses and loss expenses (including unreported losses) and all other outstanding underwriting and administrative expenses as evidenced by Farmers Casualty's books and records at the close of business on December 31, 1998, but shall not include intercompany balances, liabilities incurred in connection with the investment transactions of Farmers Casualty, liabilities for dividends to stockholders declared and unpaid, other liabilities not incurred in connection with underwriting operations, post retirement health care benefits liability, and post employment benefits liability. It is further agreed that State Auto Mutual shall receive the Net Premiums for said contracts and policies. 3. ASSETS TRANSFER TO STATE AUTO MUTUAL: (a) State Auto P&C: In consideration of the agreements herein contained, State Auto P&C hereby agrees that there has been or will be assigned and transferred to State Auto Mutual an amount, in cash or other assets, equal to the aggregate of all liabilities of State Auto P&C assumed by State Auto Mutual under paragraph 2(a) hereof, less a ceding commission equal to the sum of the acquisition expenses associated with the unearned premium reserves which are transferred as provided herein. There have been included among the assets assigned and transferred to State Auto Mutual by State Auto P&C all of the right, title and interest of State Auto P&C in and to all assets relative to the underwriting operations of State Auto P&C, due or that became due, as evidenced by its books and records at the close of business on December 31, 1998, not including investments, accrued investment income, intercompany balances and bank deposits. (b) Milbank: In consideration of the agreements herein contained, Milbank hereby agrees that there has been or will be assigned and transferred to State Auto Mutual an amount, in cash or other assets, equal to the aggregate of all liabilities of Milbank assumed by State Auto Mutual under paragraph 2(b) hereof, less a ceding commission equal to the sum of the acquisition expenses associated with the unearned premium reserves which are transferred as provided herein. There shall be included among the assets assigned and transferred to State Auto Mutual by Milbank all of the right, title and interest of Milbank in and to all assets relative to the underwriting operations of Milbank due or that 6 Page 5 may become due as evidenced by its books and records at the close of business on December 31, 1998 not including investments, accrued investment income, intercompany balances and bank deposits. (c) Midwest Security: In consideration of the agreements herein contained, Midwest Security hereby agrees that there has been or will be assigned and transferred to State Auto Mutual an amount, in cash or other assets, equal to the aggregate of all liabilities of Midwest Security assumed by State Auto Mutual under paragraph 2(c) hereof, less a ceding commission equal to the sum of the acquisition expenses associated with the unearned premium reserves which are transferred as provided herein. There shall be included among the assets assigned and transferred to State Auto Mutual by Midwest Security all of the right, title and interest of Midwest Security in and to all assets relative to the underwriting operations of Midwest Security due or that may become due as evidenced by its books and records at the close of business on December 31, 1998, not including investments, accrued investment income, intercompany balances and bank deposits. (d) Farmers Casualty: In consideration of the agreements herein contained, Farmers Casualty hereby agrees that there has been or will be assigned and transferred to State Auto Mutual an amount, in cash or other assets, equal to the aggregate of all liabilities of Farmers Casualty assumed by State Auto Mutual under paragraph 2(d) hereof, less a ceding commission equal to the sum of the acquisition expenses associated with the unearned premium reserves which are transferred as provided herein. There shall be included among the assets assigned and transferred to State Auto Mutual by Farmers Casualty all of the right, title and interest of Farmers Casualty in and to all assets relative to the underwriting operations of Farmers Casualty due or that may become due as evidenced by its books and records at the close of business on December 31, 1998, not including investments, accrued investment income, intercompany balances and bank deposits. 4. ASSUMPTION OF REINSURANCE: (a) State Auto P&C: State Auto P&C hereby reinsures and assumes and State Auto Mutual hereby cedes and transfers to State Auto P&C its Respective Percentage of all Net Liabilities under all contracts and policies of insurance, (including those ceded by State Auto P&C and reinsured by State Auto Mutual as provided in paragraph 2(a)), on which 7 Page 6 State Auto Mutual is subject to liability and which are outstanding and in force on or after the effective date hereof. Such liabilities shall include reserves for unearned premiums, outstanding losses (including unreported losses) and loss expenses and all other underwriting and administrative expenses, but shall not include intercompany balances, liabilities for federal income taxes, liabilities incurred in connection with investment transactions, liabilities for dividends to stockholders declared and unpaid, other liabilities not incurred in connection with underwriting operations, post retirement health care benefits liability and post employment benefits liability. (b) Milbank: Milbank hereby reinsures and assumes and State Auto Mutual hereby cedes and transfers to Milbank its Respective Percentage of all Net Liabilities under all contracts and policies of insurance, (including those ceded by Milbank and reinsured by State Auto Mutual as provided in paragraph 2(b)), on which State Auto Mutual is subject to liability and which are outstanding and in force on or after the effective date hereof. Such liabilities shall include reserves for unearned premiums, outstanding losses (including unreported losses) and loss expenses and all other underwriting and administrative expenses, but shall not include intercompany balances, liabilities for federal income taxes, liabilities incurred in connection with investment transactions, liabilities for dividends to stockholders declared and unpaid, other liabilities not incurred in connection with underwriting operations, post retirement health care benefits liability and post employment benefits liability. (c) Midwest Security: Midwest Security hereby reinsures and assumes and State Auto Mutual hereby cedes and transfers to Midwest Security its Respective Percentage of all Net Liabilities under all contracts and policies of insurance, (including those ceded by Midwest Security and reinsured by State Auto Mutual as provided in paragraph 2(c), on which State Auto Mutual is subject to liability and which are outstanding and in force on or after the effective date hereof. Such liabilities shall include reserves for unearned premiums, outstanding losses (including unreported losses) and loss expenses and all other underwriting and administrative expenses, but shall not include intercompany balances, liabilities for federal income taxes, liabilities incurred in connection with investment transactions, liabilities for dividends to stockholders declared and unpaid, other liabilities not incurred in connection with underwriting operations, post retirement health care benefits liability and post employment benefits liability. (d) Farmers Casualty: Farmers Casualty hereby reinsures and assumes and State Auto Mutual hereby cedes and 8 Page 7 transfers to Farmers Casualty its Respective Percentage of all Net Liabilities under all contracts and policies of insurance, (including those ceded by Farmers Casualty and reinsured by State Auto Mutual as provided in paragraph 2(d), on which State Auto Mutual is subject to liability and which are outstanding and in force on or after the effective date hereof. Such liabilities shall include reserves for unearned premiums, outstanding losses (including unreported losses) and loss expenses and all other underwriting and administrative expenses, but shall not include intercompany balances, liabilities for federal income taxes, liabilities incurred in connection with investment transactions, liabilities for dividends to stockholders declared and unpaid, other liabilities not incurred in connection with underwriting operations, post retirement health care benefits liability and post employment benefits liability. 5. ASSET TRANSFER BY STATE AUTO MUTUAL: (a) State Auto P&C: In consideration of the agreements herein contained, State Auto Mutual hereby agrees that there has been or will be assigned and transferred to State Auto P&C an amount, in cash or other assets, equal to the aggregate of all liabilities of State Auto Mutual assumed by State Auto P&C under paragraph 4(a) hereof, less a ceding commission equal to the sum of the acquisition expenses associated with the unearned premium reserves which are transferred as provided herein. There shall be included among the assets assigned and transferred to State Auto P&C by State Auto Mutual all of the right, title and interest of State Auto Mutual in and to all assets relative to the underwriting operations of State Auto Mutual, due or that may become due, as evidenced by its books and records at the close of business on December 31, 1998, not including investments, accrued investment income, intercompany balances and bank deposits. (b) Milbank: In consideration of the agreements herein contained, State Auto Mutual hereby agrees that there has been or will be assigned and transferred to Milbank an amount, in cash or other assets, equal to the aggregate of all liabilities of State Auto Mutual assumed by Milbank under paragraph 4(b) hereof, less a ceding commission equal to the sum of the acquisition expenses associated with the unearned premium reserves which are transferred as provided herein. There shall be included among the assets assigned and transferred to Milbank by State Auto Mutual all of the right, title and interest of State Auto Mutual in and to all assets relative to the underwriting operations of State Auto Mutual, due or that may become due, as evidenced by its books and records at the close of business on December 9 Page 8 31, 1998, not including investments, accrued investment income, intercompany balances and bank deposits. (c) Midwest Security: In consideration of the agreements herein contained, State Auto Mutual hereby agrees that there has been or will be assigned and transferred to Midwest Security an amount, in cash or other assets, equal to the aggregate of all liabilities of State Auto Mutual assumed by Midwest Security under paragraph 4(c) hereof, less a ceding commission equal to the sum of the acquisition expenses associated with the unearned premium reserves which are transferred as provided herein. There shall be included among the assets assigned and transferred to Midwest Security by State Auto Mutual all of the right, title and interest of State Auto Mutual in and to all assets relative to the underwriting operations of State Auto Mutual, due or that may become due, as evidenced by its books and records at the close of business on December 31, 1998, not including investments, accrued investment income, intercompany balances and bank deposits. (d) Farmers Casualty: In consideration of the agreements herein contained, State Auto Mutual hereby agrees that there has been or will be assigned and transferred to Farmers Casualty an amount, in cash or other assets, equal to the aggregate of all liabilities of State Auto Mutual assumed by Farmers Casualty under paragraph 4(d) hereof, less a ceding commission equal to the sum of the acquisition expenses associated with the unearned premium reserves which are transferred as provided herein. There shall be included among the assets assigned and transferred to Farmers Casualty by State Auto Mutual all of the right, title and interest of State Auto Mutual in and to all assets relative to the underwriting operations of State Auto Mutual, due or that may become due, as evidenced by its books and records at the close of business on December 31, 1998, not including investments, accrued investment income, intercompany balances and bank deposits. 6. PREMIUM COLLECTION AND PAYMENT OF LOSSES: As of the effective date of this Agreement and pursuant to the terms of the 4/1/94 Management Agreement as amended from time to time, the Midwest Management Agreement, as amended from time to time, and the Farmers Casualty Management Agreement, as amended from time to time, State Auto P&C, Milbank, Midwest Security and Farmers Casualty hereby authorize and empower State Auto Mutual to collect and receive all premiums and to take charge of, adjust and administer the payment of all losses with respect to any and all contracts and policies of insurance previously or thereafter issued by State Auto P&C, Milbank, Midwest 10 Page 9 Security and Farmers Casualty and to reinsure or terminate all such contracts and policies, and in all respects to act as though said contracts and policies were issued by State Auto Mutual. State Auto Mutual agrees to administer the payment of all losses and loss adjustment expenses in connection with such contracts and policies. None of the foregoing is intended to affect or impair the direct obligation of State Auto P&C, Milbank, Midwest Security and Farmers Casualty to their insureds under policies issued by State Auto P&C, Milbank, Midwest Security and Farmers Casualty, respectively. 7. PREMIUM PAYABLE BY STATE AUTO MUTUAL: (a) State Auto P&C: Commencing with the effective date of this Agreement, State Auto Mutual hereby agrees to pay to State Auto P&C its Respective Percentage of the Net Premiums written by the parties hereto. Similarly, commencing with the effective date of this Agreement, all losses, loss expenses, underwriting expenses, and administrative expenses chargeable to underwriting of the parties hereto, including the policyholder dividends, less all losses and expenses recovered and recoverable under reinsurance ceded to reinsurers other than the parties hereto, (except for catastrophe reinsurance ceded by State Auto Mutual and Milbank to State Auto P&C pursuant to a Property Catastrophe Overlying Excess of Loss Reinsurance Contract dated as of July 1, 1996 in which State Auto P&C provides catastrophe coverage for State Auto Mutual and Milbank for $100,000,000 of catastrophe losses and loss expenses in excess of $120,000,000 of such losses and loss expenses incurred by the Group) (the "State Auto P&C Catastrophe Assumption Agreement") shall be prorated between the parties on the basis of the Respective Percentage of each. Accounts shall be rendered at quarterly intervals and shall be settled within 60 days thereafter. (b) Milbank: Commencing with the effective date of this Agreement, State Auto hereby agrees to pay Milbank its Respective Percentage of the Net Premiums written by the parties hereto. Similarly, commencing with the effective date of this Agreement, all losses, loss expenses, underwriting expenses, and administrative expenses chargeable to underwriting of the parties hereto, including policyholder dividends, less all losses and expenses recovered and recoverable under reinsurance ceded to reinsurers other than the parties hereto, (except for the State Auto P&C Catastrophe Assumption Agreement) shall be prorated between the parties on the basis of the Respective Percentage of each. Accounts shall be rendered at quarterly intervals and shall be settled within sixty (60) days thereafter. 11 Page 10 (c) Midwest Security: Commencing with the effective date of this Agreement, State Auto hereby agrees to pay Midwest Security its Respective Percentage of the Net Premiums written by the parties hereto. Similarly, commencing with the effective date of this Agreement, all losses, loss expenses, underwriting expenses, and administrative expenses chargeable to underwriting of the parties hereto, including policyholder dividends, less all losses and expenses recovered and recoverable under reinsurance ceded to reinsurers other than the parties hereto, (except for the State Auto P&C Catastrophe Assumption Agreement) shall be prorated between the parties on the basis of the Respective Percentage of each. Accounts shall be rendered at quarterly intervals and shall be settled within sixty (60) days thereafter. (d) Farmers Casualty: Commencing with the effective date of this Agreement, State Auto hereby agrees to pay Farmers Casualty its Respective Percentage of the Net Premiums written by the parties hereto. Similarly, commencing with the effective date of this Agreement, all losses, loss expenses, underwriting expenses, and administrative expenses chargeable to underwriting of the parties hereto, including policyholder dividends, less all losses and expenses recovered and recoverable under reinsurance ceded to reinsurers other than the parties hereto, (except for the State Auto P&C Catastrophe Assumption Agreement) shall be prorated between the parties on the basis of the Respective Percentage of each. Accounts shall be rendered at quarterly intervals and shall be settled within sixty (60) days thereafter. 8. OFFSET: It is understood and agreed that, insofar as is practicable and consistent with the purposes and intentions of this Agreement, the obligations of each company under this Agreement to transfer assets to the other company may, in whole or in part, be offset against the reciprocal reinsurance obligations of each company to the other company so that each company shall deliver hereunder only a net amount of assets required under such offset. 9. GENERAL STATEMENT OF INTENT: It is the purpose and intent of this Agreement that: (a) State Auto Mutual shall be liable as a reinsurer to State Auto P&C, Milbank, Midwest Security and Farmers Casualty on the policies and contracts of insurance of State Auto P&C, Milbank, Midwest Security and Farmers Casualty respectively, issued and in force at 12:01 a.m., EST, January 1, 1999, or on which there were, at that time, unsettled 12 Page 11 claims or losses, and on policies and contracts thereafter issued by State Auto P&C, Milbank, Midwest Security and Farmers Casualty to the extent of State Auto Mutual's Respective Percentage. (b) State Auto P&C shall be liable as a reinsurer to State Auto Mutual, Milbank, Midwest Security and Farmers Casualty on the policies and contracts of insurance of State Auto Mutual, Milbank, Midwest Security and Farmers Casualty, respectively, issued and in force at 12:01 a.m., EST, January 1, 1999, or on which there were, at that time, unsettled claims or losses, and on policies and contracts thereafter issued by State Auto Mutual, Milbank, Midwest Security and Farmers Casualty to the extent of State Auto P&C's Respective Percentage. (c) Milbank shall be liable as a reinsurer to State Auto Mutual, State Auto P&C, Midwest Security and Farmers Casualty on the policies and contracts of State Auto Mutual, State Auto P&C, Midwest Security and Farmers Casualty, respectively, issued and in force at 12:01 a.m., EST, on January 1, 1999 or on which there were, at that time, unsettled claims or losses and on policies thereafter issued by State Auto Mutual, State Auto P&C, Midwest Security and Farmers Casualty to the extent of Milbank's Respective Percentage. (d) Midwest Security shall be liable as a reinsurer to State Auto Mutual, State Auto P&C, Milbank and Farmers Casualty on the policies and contracts of State Auto Mutual, State Auto P&C, Milbank and Farmers Casualty, respectively, issued and in force at 12:01 a.m., EST, on January 1, 1999 or on which there were, at that time, unsettled claims or losses and on policies thereafter issued by State Auto Mutual, State Auto P&C, Milbank and Farmers Casualty to the extent of Midwest Security's Respective Percentage. (e) Farmers Casualty shall be liable as a reinsurer to State Auto Mutual, State Auto P&C, Milbank and Midwest Security on the policies and contracts of State Auto Mutual, State Auto P&C, Milbank and Midwest Security, respectively, issued and in force at 12:01am., EST, January 1, 1999 or on which there were, at that time, unsettled claims or losses, and on policies and contracts thereafter issued by State Auto Mutual, State Auto P&C, Milbank and Midwest Security to the extent of Farmers Casualty's Respective Percentage. (f) The parties hereto shall, on and after 12:01 a.m., EST, January 1, 1999, participate on the basis of 49% for State Auto, 37% for State Auto P&C, 10% for Milbank, 1% 13 Page 12 for Midwest Security and 3% for Farmers Casualty in all of the underwriting operations of each of the five parties hereto. 10. LOSSES EXCLUDED: Notwithstanding any of the foregoing, the parties hereto understand and agree that this Amended and Restated Reinsurance Pooling Agreement shall not apply to catastrophe losses and loss expenses for residential and commercial property to the extent such losses and loss expenses are covered by the State Auto P&C Catastrophe Assumption Agreement. Once the aforesaid $100,000,000 of coverage is exhausted by loss expenses and loss payments on behalf of any party hereto, under either the State Auto P&C Catastrophe Assumption Agreement or directly, all parties understand and agree that catastrophe losses and loss expenses in excess of $220,000,000 shall once again be ceded and assumed under the terms of the `99 Pooling Agreement. All premiums attributable to the State Auto P&C Catastrophe Assumption Agreement are to be paid to State Auto P&C outside of the `99 Pooling Agreement. 11. LIABILITIES EXCLUDED: In addition to the liabilities set forth in paragraphs 2(a), 2(b), 2(c), 2(d) and 10 above, this Agreement shall not apply to the investment operation or liabilities for federal income tax or other liabilities excluded by this Agreement. 12. "FOLLOW THE FORTUNES": The reinsurance provided by the terms of this Agreement shall be subject to the same terms and conditions under which the original insurance was concluded, or which may be or may have been agreed to during the term of the original insurance contract. 13. METHODS AND PROCEDURES: The president of State Auto Mutual, State Auto P&C, Milbank, Midwest Security and Farmers Casualty, or any officer of any of these companies designated by said president, shall determine the methods and procedures, including accounting transactions, by which the terms of this Agreement shall be performed by and on behalf of the parties hereto. 14. AMENDMENTS: This Agreement may be modified from time to time, so as to adapt its provisions to the varying conditions of the business of the Group, by a mutual agreement in writing of the parties hereto, subject to ratification by the Board of Directors of each party and with the approval of the insurance officials from the State of Ohio, the State of South Carolina, the State of South Dakota, the State of Wisconsin, and the State of Iowa as required by law. 15. TERM: This Agreement shall remain in full force and effect until canceled by agreement of the parties or by the giving of ninety (90) days notice by one of the parties to the other parties and to the respective domiciliary insurance department of each of the parties. 16. INTERPRETATION: Wherever required to give the correct meaning throughout this Agreement, the singular shall be interpreted in the plural. Clerical errors or errors of involuntary or inadvertent omission or 14 Page 13 commission shall not be interpreted as a discharge of liability on behalf of any of the parties to this contract. Such errors shall be rectified at the time of discovery or as soon as practicable thereafter. Caption headings are for convenience only and are not intended to affect the construction of the terms hereof. 17. INSOLVENCY: The reinsurance made under this Agreement shall be payable by the assuming reinsurer on the basis of the liability of the ceding insurer under the contract or contracts reinsured without diminution because of the insolvency of the ceding insurer. In the event of insolvency of the ceding insurer, the liquidator or receiver or statutory successor of such insurer shall give written notice to the assuming reinsurer of the pendency of a claim against the insolvent ceding insurer on the policy or bond reinsured within a reasonable time after such claim is filed in the insolvency proceeding; that during the pendency of such claim the assuming reinsurer may investigate such claim and interpose, at its own expense, in the proceeding where such claim is to be adjudicated any defense or defenses which it may deem available to the ceding insurer or its liquidator or receiver or statutory successors; that the expense thus incurred by the assuming reinsurer shall be chargeable, subject to court approval, against the insolvent ceding insurer as part of the expense of liquidation to the extent of a proportionate share of the benefit which may accrue to the ceding insurer solely as a result of the defense undertaken by the assuming reinsurer. The reinsurance made effective under this Agreement shall be payable by the assuming reinsurer to the ceding insurer or to the liquidator, receiver or statutory successor of the ceding insurer. 18. ARBITRATION: In the event of any dispute hereafter arising with respect to this Agreement, State Auto Mutual, State Auto P&C, Milbank, Midwest Security and Farmers Casualty hereby agree that such dispute shall, upon the request of the one of the parties, be submitted to arbitration. One arbitrator shall be chosen by each party and those arbitrators shall then select an umpire who shall hear and decide the issues to be arbitrated. If one party fails to name an arbitrator within thirty (30) days after receipt of a written request to do so, the party initiating the arbitration may choose the arbitrators. The decision of the umpire shall be final and binding on the parties. Each party shall bear the expense of its arbitrator and the cost of the umpire shall be shared equally. The arbitration shall take place at Columbus, Ohio or such other location upon which the parties may mutually agree. 19. COUNTERPARTS: The `99 Pooling Agreement may be executed in two or more counterparts, each of which shall be deemed an original and all of which shall constitute one and the same instrument. 15 Page 14 IN WITNESS WHEREOF, the parties have caused this Agreement to be duly executed as of the date and the year first above written. Attest State Automobile Mutual Insurance Company /s/John R. Lowther By /s/Robert H. Moone - ------------------------------- ------------------------------- Secretary President State Auto Property and Casualty Insurance Company /s/John R. Lowther By /s/Robert H. Moone - ------------------------------- ------------------------------- Secretary President Milbank Insurance Company /s/John R. Lowther By /s/Robert H. Moone - ------------------------------- ------------------------------- Secretary President Midwest Security Insurance Company /s/John R. Lowther By /s/Robert H. Moone - ------------------------------- ------------------------------- Secretary President Farmers Casualty Insurance Company /s/John R. Lowther By /s/Marion D. Houk - ------------------------------- ------------------------------- Assistant Secretary President EX-11 4 EXHIBIT 11 1 Exhibit 11 Statement Regarding Computation of Earnings Per Share The computation of net earnings per common share on a basic and diluted basis is included in footnote (12) of the consolidated financial statements of State Auto Financial Corporation and Subsidiaries for the years ended December 31, 1998, 1997 and 1996, included herein at Part II, Item 8. EX-21 5 EXHIBIT 21 1 Exhibit 21 List of subsidiaries of State Auto Financial Corporation State Auto Property and Casualty Insurance Company, a South Carolina corporation State Auto National Insurance Company, an Ohio corporation Stateco Financial Services, Inc., an Ohio corporation Strategic Insurance Software, Inc., an Ohio corporation Milbank Insurance Company, a South Dakota corporation Farmers Casualty Insurance Company, an Iowa corporation Mid-Plains Insurance Company, an Iowa corporation 518 Property Management and Leasing, LLC, an Ohio limited liability company EX-23 6 EXHIBIT 23 1 Exhibit 23 Consent of Independent Auditors We consent to the incorporation by reference in the Registration Statement on Forms S-8 pertaining to the 1991 Stock Option Plan, the 1991 Directors' Stock Option Plan and the 1991 Employee Stock Purchase and Dividend Reinvestment Plan, and on Form S-3 pertaining to the Monthly Stock Purchase Plan for Independent Agents of our report dated February 12, 1999, with respect to the consolidated financial statements and schedules of State Auto Financial Corporation and subsidiaries included in this Annual Report (Form 10-K) for the year ended December 31, 1998. /s/Ernst & Young LLP Columbus, Ohio March 26, 1999 2 STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Report of Independent Auditors The Board of Directors and Stockholders State Auto Financial Corporation We have audited the accompanying consolidated balance sheets of State Auto Financial Corporation and subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of earnings, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1998. Our audits also included the financial statement schedules listed in the Index at Item 14(a) (2). These consolidated financial statements and schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of State Auto Financial Corporation and subsidiaries as of December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1, the Company acquired the outstanding shares of Milbank Insurance Company from State Automobile Mutual Insurance Company on July 7, 1998 in a transaction accounted for similar to a pooling of interest. Accordingly, the Company's consolidated financial statements for each of the two years ended December 31, 1997 have been restated to include the financial position and operations of Milbank Insurance Company. /s/Ernst & Young LLP Columbus, Ohio February 12, 1999 EX-24.E 7 EXHIBIT 24(E) 1 24(E) Power of Attorney Robert H. Moone 2 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that the undersigned director or officer of State Auto Financial Corporation, an Ohio corporation (the "Company"), hereby constitutes and appoints Robert L. Bailey, Robert H. Moone, John R. Lowther, and Steven J. Johnston and each of them, my true and lawful attorney-in-fact and agents, with full power to act without the other, with full power of substitution and resubstitution, for me and in my name, place and stead, in my capacity as director or officer of the Company, to execute the Company's Form 10-K Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Company's fiscal year ended December 31, 1998, for each fiscal year thereafter and any amendments thereto, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full powers and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as I might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them or their or his substitute or substitutes may lawfully do or cause to be done by virtue hereof. IN WITNESS WHEREOF, the undersigned has hereunto set his hand as of the 3rd day of March 1999. Signature Position(s) with the Company --------- ---------------------------- /s/Robert H. Moone Director - ----------------------------- ---------------------------- EX-27.1 8 EXHIBIT 27.1
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM STATE AUTO FINANCIAL CORPORATION'S AUDITED FINANCIAL STATEMENTS ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. YEAR DEC-31-1998 JAN-01-1998 DEC-31-1998 481,844,000 55,926,000 0 42,196,000 0 0 579,966,000 32,605,000 0 24,799,000 709,778,000 218,701,000 135,088,000 0 0 0 0 0 105,100,000 235,724,000 709,778,000 356,210,000 32,506,000 2,925,000 10,418,000 242,294,000 85,214,000 19,010,000 49,605,000 12,108,000 37,497,000 0 0 0 37,497,000 0.89 0.87 194,155,000 255,885,000 (13,591,000) 144,744,000 86,671,000 205,034,000 (13,591,000)
EX-27.2 9 EXHIBIT 27.2
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM STATE AUTO FINANCIAL CORPORATION'S AUDITED FINANCIAL STATEMENTS ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 420,994,000 79,300,000 0 26,069,000 0 0 526,363,000 30,931,000 0 22,440,000 638,823,000 206,250,000 125,033,000 0 0 0 0 0 104,572,000 192,686,000 638,823,000 320,050,000 31,107,000 3,043,000 8,776,000 208,234,000 76,842,000 17,509,000 56,658,000 15,640,000 40,998,000 0 0 0 40,998,000 0.99 0.97 199,480,000 225,666,000 (17,432,000) 134,890,000 78,669,000 194,155,000 (17,432,000)
EX-27.3 10 EXHIBIT 27.3
7 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM STATE AUTO FINANCIAL CORPORATION'S AUDITED FINANCIAL STATEMENTS ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 392,469,000 90,251,000 0 16,556,000 0 0 499,277,000 15,845,000 0 20,033,000 586,327,000 211,611,000 118,548,000 0 0 0 0 0 103,520,000 144,099,000 586,327,000 304,472,000 29,863,000 2,788,000 7,974,000 220,034,000 73,688,000 12,315,000 34,792,000 8,385,000 26,407,000 0 0 0 26,407,000 0.64 0.63 206,327,000 246,886,000 (26,852,000) 148,095,000 78,786,000 226,881,000 (26,852,000)
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