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State Auto Financial 10-Q 2011 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended March 31, 2011 or
For the transition period from _________ to _________ Commission File Number 000-19289 STATE AUTO FINANCIAL CORPORATION (Exact name of Registrant as specified in its charter)
Registrant’s telephone number, including area code: (614) 464-5000 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 whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated file ¨ Accelerated filer x Non-accelerated filer ¨ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x On April 29, 2011, the Registrant had 40,209,284 Common Shares outstanding.
Table of ContentsIndex to Form 10-Q Quarterly Report for the three month period ended March 31, 2011
Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
PART I – FINANCIAL STATEMENTS Item 1. Condensed Consolidated Balance Sheets
See accompanying notes to condensed consolidated financial statements.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Condensed Consolidated Statements of Income
See accompanying notes to condensed consolidated financial statements.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Condensed Consolidated Statements of Cash Flows
See accompanying notes to condensed consolidated financial statements.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements (Unaudited)
1. Basis of Presentation The accompanying unaudited condensed consolidated financial statements of State Auto Financial Corporation and Subsidiaries (“State Auto Financial” or the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles (“GAAP”) for complete financial statements. In the opinion of the Company, all adjustments (consisting of normal, recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. The balance sheet at December 31, 2010 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete financial statements. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2010 (the “2010 Form 10-K”). Capitalized terms used herein and not otherwise defined shall have the meaning ascribed to them in the 2010 Form 10-K. Adoption of Accounting Pronouncements Improving Disclosures about Fair Value Measurements In January 2010, the Financial Accounting Standards Board (“FASB”) issued guidance to improve the disclosures related to fair value measurements. The guidance requires the information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements to be presented separately on a gross basis, rather than as one net number. The Company adopted this guidance effective January 1, 2011. The disclosures required by this guidance are provided in the accompanying Note 3. Pending Adoption of Accounting Pronouncements Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts In October 2010, the FASB issued updated guidance to address diversity in practice for the accounting of costs associated with acquiring or renewing insurance contracts. This guidance modifies the definition of acquisition costs to specify that a cost be directly related to the successful acquisition of a new or renewal insurance contract in order to be deferred. The new guidance is effective on a prospective basis for fiscal years beginning after December 15, 2011, with early adoption permitted. Retrospective application is also permitted, but not required. The Company is still assessing the impact the provisions of the new guidance will have on its consolidated financial statements.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
2. Investments The following tables set forth the cost or amortized cost and fair value of available-for-sale securities by lot at March 31, 2011 and December 31, 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
The following tables set forth the Company’s gross unrealized losses and fair value on its investments by lot, aggregated by investment category and length of time for individual securities that have been in a continuous unrealized loss position at March 31, 2011 and December 31, 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
The following table sets forth the realized losses related to other-than-temporary impairments on the Company’s investment portfolio recognized for the three months ended March 31, 2011 and 2010:
The Company did not recognize other-than-temporary impairments on its fixed maturity securities for the three months ended March 31, 2011 and 2010. The Company reviewed its investments at March 31, 2011, and determined no additional other-than-temporary impairment existed in the gross unrealized holding losses. The Company regularly monitors its investments that have fair values less than cost or amortized cost for signs of other-than-temporary impairment, an assessment that requires significant management judgment regarding the evidence known. Such judgments could change in the future as more information becomes known, which could negatively impact the amounts reported. Among the factors that management considers for fixed maturity securities are the financial condition of the issuer including receipt of scheduled principal and interest cash flows, and intent to sell including if it is more likely than not that the Company will be required to sell the investments before recovery. When a fixed maturity has been determined to have an other-than-temporary impairment, the impairment charge is separated into an amount representing the credit loss, which is recognized in earnings as a realized loss, and the amount related to non-credit factors, which is recognized in accumulated other comprehensive loss. Future increases or decreases in fair value, if not other-than-temporary, are included in accumulated other comprehensive loss. Among the factors that management considers for equity securities and other invested assets are the length of time and/or the significance of decline below cost, the Company’s ability and intent to hold these securities through their recovery periods, the current financial condition of the issuer and its future business prospects, and the ability of the market value to recover to cost in the near term. When an equity security or other invested asset has been determined to have a decline in fair value that is other-than-temporary, the cost basis of the security is adjusted to fair value. This results in a charge to earnings as a realized loss, which is not reversed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other-than-temporary, are included in accumulated other comprehensive loss. The following table sets forth the amortized cost and fair value of available-for-sale fixed maturities by contractual maturity at March 31, 2011:
Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay the obligations with or without call or prepayment penalties. Fixed maturities with fair values of $67.9 million and $72.2 million were on deposit with insurance regulators as required by law at March 31, 2011 and December 31, 2010, respectively.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
The following table sets forth the components of net investment income for the three months ended March 31, 2011 and 2010:
The Company’s current investment strategy does not rely on the use of derivative financial instruments. The unrealized holding gains and losses, net of applicable deferred federal income taxes, are shown as a separate component of stockholders’ equity as a part of accumulated other comprehensive loss and, as such, are not included in the determination of net income. Realized gains and losses on the sales of investments are computed using the first-in, first-out method. The following table sets forth the realized and unrealized holding gains (losses) on the Company’s investment portfolio for the three months ended March 31, 2011 and 2010:
There was a deferred federal income tax liability on the net unrealized holding gains at March 31, 2011 and December 31, 2010, of $40.7 million and $38.4 million, respectively.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
3. Fair Value of Financial Instruments Below is the fair value hierarchy that categorizes into three levels the inputs to valuation techniques that are used to measure fair value:
The Company utilizes one nationally recognized pricing service to estimate the majority of its available for sale investment portfolio’s fair value. The Company obtains one price per security and the processes and control procedures employed by the Company are designed to ensure the value is accurately recorded on an unadjusted basis. Through discussions with the pricing service, the Company gains an understanding of the methodologies used to price the different types of securities, that the data and the valuation methods utilized are appropriate and consistently applied, and that the assumptions are reasonable and representative of fair value. To validate the reasonableness of the valuations obtained from the pricing service, the Company compares to other fair value pricing information gathered from other independent pricing sources. At March 31, 2011 and December 31, 2010, the Company did not adjust any of the prices received from the pricing service. Transfers between level categorizations may occur due to changes in the availability of market observable inputs. Transfers in and out of level categorizations are reported as having occurred at the beginning of the quarter in which the transfer occurred. There were no transfers between level categorizations during the three months ended March 31, 2011 and 2010. The following sections describe the valuation methods used by the Company for each type of financial instrument it holds that are carried at fair value: Fixed Maturities The Company utilizes a pricing service to estimate fair value measurements for the majority of its fixed maturities. The fair value estimate of the Company’s fixed maturity investments are determined by evaluations that are based on observable market information rather than market quotes. Inputs to the evaluations include, but are not limited to, market prices from recently completed transactions and transactions of comparable securities, interest rate yield curves, credit spreads, and other market-observable information. Investments valued using these inputs include U.S. treasury securities and obligations of U.S. government agencies, obligations of states and political subdivisions, corporate securities (except for one security discussed below), and U.S. government agencies residential mortgage-backed securities. All unadjusted estimates of fair value for fixed maturities priced by the pricing service are included in the amounts disclosed in Level 2 of the hierarchy. If market inputs are unavailable, then no fair value is provided by the pricing service. For these securities, fair value is determined either by requesting brokers who are knowledgeable about these securities to provide a quote; or the Company internally determines the fair values by employing widely accepted pricing valuation models, and depending on the level of observable market inputs, renders the fair value estimate as Level 2 or Level 3. The Company holds one fixed maturity corporate security for which the Company estimates the fair value of this security using the present value of the future cash flows. Due to the limited amount of observable market information, the Company includes the fair value estimates for this security in Level 3. Equities The fair value of each equity security is based on an observable market price for an identical asset in an active market and is priced by the same pricing service discussed above. All equity securities are recorded using unadjusted market prices and have been disclosed in Level 1.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
Other Invested Assets Included in other invested assets are two international private equity funds (“the funds”) that invest in equity securities of foreign issuers and are managed by third party investment managers. The funds had a fair value of $77.9 million and $75.3 million at March 31, 2011 and December 31, 2010, respectively, which was determined using each fund’s net asset value. The Company employs procedures to assess the reasonableness of the fair value of the funds including obtaining and reviewing each fund’s audited financial statements. There are no unfunded commitments related to the funds. The Company may not sell its investment in the funds; however, the Company may redeem all or a portion of its investment in the funds at net asset value per share with the appropriate prior written notice. Due to the Company’s ability to redeem its investment in the funds at net asset value per share at the measurement date, the funds have been disclosed in Level 2. The remainder of the Company’s other invested assets consist primarily of holdings in publicly-traded mutual funds. The Company believes that its prices for these publicly-traded mutual funds based on an observable market price for an identical asset in an active market reflect their fair values and consequently these securities have been disclosed in Level 1. The following tables set forth the Company’s available-for-sale investments within the fair value hierarchy at March 31, 2011 and December 31, 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
For assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3), the following tables set forth a reconciliation of the beginning and ending balances for the three months ended March 31, 2011 and the year ended December 31, 2010, separately for each major category of assets:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
The following table sets forth the carrying value and fair value of financial instruments at March 31, 2011:
4. Reinsurance The insurance subsidiaries of State Auto Financial, including State Auto Property & Casualty Insurance Company (“State Auto P&C”), Milbank Insurance Company, Farmers Casualty Insurance Company and State Auto Insurance Company of Ohio (collectively referred to as the “STFC Pooled Companies”) participate in a quota share reinsurance pooling arrangement (“the Pooling Arrangement”) with State Automobile Mutual Insurance Company (“State Auto Mutual”) and its subsidiaries and affiliates, State Auto Insurance Company of Wisconsin, State Auto Florida Insurance Company, Meridian Citizens Mutual Insurance Company, Meridian Security Insurance Company, Beacon National Insurance Company, Patrons Mutual Insurance Company of Connecticut, Litchfield Mutual Fire Insurance Company, Rockhill Insurance Company (“RIC”), Plaza Insurance Company (“Plaza”), American Compensation Insurance Company (“American Compensation”) and Bloomington Compensation Insurance Company (“Bloomington Compensation”), (collectively referred to as the “Mutual Pooled Companies”). RIC, Plaza, American Compensation and Bloomington Compensation are referred to as the “Rockhill Insurers.” In conjunction with the January 1, 2010 Pooling Arrangement amendment, which added to the pool State Auto National Insurance Company (“SA National”) and voluntary assumed reinsurance from third parties unaffiliated with the pool participants that was assumed on or after January 1, 2009, the STFC Pooled Companies received $3.7 million in cash from the Mutual Pooled Companies for net insurance assets transferred on January 1, 2010. State Auto Financial sold SA National to a third party on December 31, 2010. SA National’s participation in the Pooling Arrangement was terminated on its sale. In conjunction with the January 1, 2011 Pooling Arrangement amendment, which added the Rockhill Insurers to the pool, the STFC Pooled Companies received $149.8 million ($69.1 million in cash and $80.7 million in investment securities) from the Rockhill Insurers for net insurance liabilities transferred on January 1, 2011. The following table sets forth the impact on the Company’s balance sheet at January 1, 2011, relating to this Pooling Arrangement amendment:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
The following table sets forth a summary of the Company’s external reinsurance transactions, as well as reinsurance transactions with State Auto Mutual under the Pooling Arrangement, for the three months ended March 31, 2011 and 2010:
5. Transactions with Affiliates In May 2009, the Company entered into two separate credit agreements with State Auto Mutual pursuant to which it loaned State Auto Mutual a total of $70.0 million. Under these agreements, State Auto Financial earned interest of $1.2 million for the three months ended March 31, 2011 and 2010. Interest income is included in net investment income on the condensed consolidated statements of income. The Company estimates the fair value of the notes receivable from affiliate using market quotations for U.S. treasury securities with similar maturity dates and applies an appropriate credit spread. The following table sets forth the notes receivable at March 31, 2011 and December 31, 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
6. Notes Payable The fair value of the Senior Notes is based on the quoted market price at March 31, 2011 and December 31, 2010, respectively. The carrying amount of the Subordinated Debentures approximates its fair value as the interest rate adjusts quarterly. The following table sets forth the notes payable at March 31, 2011 and December 31, 2010:
7. Income Taxes For the three months ended March 31, 2011 and 2010, the effective tax rate was 17.6% and 37.3%, respectively. The effective tax rate differs from the statutory rate of 35% principally because of tax exempt investment income. Included in the 2010 effective tax rate is consideration of a one-time tax charge of $4.5 million related to the enactment of the Patient Protection and Affordable Care Act. This legislation eliminated the tax benefit associated with Medicare Part D subsidies the Company receives for providing qualifying prescription drug coverage to retirees. 8. Pension and Postretirement Benefit Plans The following table sets forth the components of net periodic cost for the State Auto Group’s pension and postretirement benefit plans for the three months ended March 31, 2011 and 2010:
The Company expects to contribute up to $15.0 million to the pension plan during 2011.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
9. Earnings per Common Share The following table sets forth the compilation of basic and diluted net earnings per common share for the three months ended March 31, 2011 and 2010:
The following table sets forth the options to purchase shares of common stock that were not included in the computation of diluted earnings per common share because the exercise price of the options was greater than the average market price or their inclusion would have been antidilutive for the three months ended March 31, 2011 and 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
10. Comprehensive Income The following table sets forth the components of comprehensive income, net of related tax, for the three months ended March 31, 2011 and 2010:
11. Segment Information Effective January 1, 2011, the Company had four reportable segments: personal insurance, business insurance, specialty insurance and investment operations. The reportable insurance segments are business units managed separately because of the differences in the type of customers they serve or products they provide or services they offer. The insurance segments market a broad line of property and casualty insurance products in all 50 states and the District of Columbia exclusively through independent insurance agencies, which include retail agents and wholesale brokers. The personal insurance segment provides primarily personal automobile and homeowners to the personal insurance market. The business insurance segment provides primarily commercial automobile, commercial multi-peril, fire & allied and general liability insurance covering small-to-medium sized commercial exposures in the business insurance market. The specialty insurance segment provides commercial coverages that require specialized product underwriting, claims handling or risk management services through a distribution channel of retail agents and wholesale brokers, which may include program administrators and other specialty sources. The investment operations segment, managed by Stateco, provides investment services. Due to internal changes which occurred in 2010, that included realigning the internal organization to be more strategic in the personal, business and specialty insurance markets, along with changes to the Pooling Arrangement as of January, 1, 2011 (see Note 4), the Company changed its reportable insurance segments from personal and business insurance to the new segments described above. No changes were made to the investment operations segment. Prior reporting periods have been restated to conform to the new insurance segment presentation. The Company evaluates the performance of its insurance segments using industry financial measurements based on Statutory Accounting Practices (“SAP”), which include loss and loss adjustment expense ratios, underwriting expense ratios, combined ratios, statutory underwriting gain (loss), net premiums earned and net written premiums. One of the most significant differences between SAP and GAAP is that SAP requires all underwriting expenses to be expensed immediately and not deferred and amortized over the same period the premium is earned. The investment operations segment is evaluated based on investment returns of assets managed by Stateco. Asset information by segment is not reported for the insurance segments because the Company does not produce such information internally.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
The following table sets forth financial information regarding the Company’s reportable segments for the three months ended March 31, 2011 and 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
The following table sets forth revenues from external sources for reportable segments for the three months ended March 31, 2011 and 2010:
Investable assets attributable to our investment operations segment totaled $2,584.4 million and $2,395.4 million at March 31, 2011 and December 31, 2010, respectively.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Notes to Condensed Consolidated Financial Statements, Continued (Unaudited)
12. Contingencies and Litigation The following describes significant pending legal proceedings, other than ordinary routine litigation incidental to our business, to which State Auto Financial or any of its subsidiaries is a party or to which any of our property is subject: In December 2010, a putative class action lawsuit (Kelly vs. State Automobile Mutual Insurance Company, et al.) was filed against State Auto Financial, State Auto P&C and State Auto Mutual in state court in Ohio. In this lawsuit, plaintiffs allege that the defendants have engaged, and continue to engage, in deceptive practices by failing to disclose to plaintiffs the availability, through one or more related companies, of insurance policies providing for identical coverage and service as those policies purchased by plaintiffs but at a lower premium amount. Plaintiffs are seeking class certification and compensatory and punitive damages to be determined by the court and restitution and/or disgorgement of profits derived from plaintiffs and the alleged class. The Company filed a motion to dismiss on March 1, 2011, and it remains pending. Plaintiffs filed an amended complaint on April 13, 2011, adding an additional plaintiff but not materially revising the claims raised in the original action. The Company believes its practices with respect to pricing, quoting and selling its insurance policies are in compliance with all applicable laws, and denies any and all liability to plaintiffs or the alleged class, and intends to vigorously defend this lawsuit. Based on the Company’s current understanding and assessment of this case, it does not expect this matter to have a material adverse effect on its results of operations. Other – The Company is involved in a number of lawsuits, and may become involved in other potential litigation, arising in the ordinary course of its business. Generally, the Company’s involvement in a lawsuit involves defending third-party claims brought against its insureds in its role as liability insurer or against the Company as a principal of surety bonds, as well as defending policy coverage claims brought against the Company or the Company’s business practice. The Company considers all lawsuits relating to insurance claims in establishing the Company’s loss and loss adjustment expense reserves. In accordance with the Contingencies Topic of the FASB ASC, the Company accrues for a litigation-related liability when it is probable that such a liability has been incurred and the amount can be reasonably estimated. Based on currently available information known to the Company, the Company believes that its reserves for litigation-related liabilities are reasonable. Given the inherent uncertainty surrounding the ultimate resolution of these legal proceedings, an adverse outcome could have a material impact to the Company’s results of operations in a future period, though in the opinion of the Company’s management, none would likely have a material adverse effect on its consolidated financial or cash flow position. Additionally, the Company may be impacted by adverse regulatory actions and adverse court decisions where insurance coverages are expanded beyond the scope originally contemplated in its insurance policies. The Company believes that the effects, if any, of such regulatory actions and published court decisions are not likely to have a material adverse effect on its financial or its cash flow position. 13. Subsequent events On May 2, 2011, the Company issued a press release announcing second quarter 2011 storm activity from five separate catastrophes that triggered widespread damage from tornadoes and wind and hail in 20 of its operating states. Claims from these storms are expected to exceed the Company’s recent historic five –year catastrophe experience average which for the second quarter is 18 percentage points or $50 million of losses.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operation The term “State Auto Financial” as used below refers only to State Auto Financial Corporation and the terms “our Company,” “we,” “us,” and “our” as used below refer to State Auto Financial Corporation and its consolidated subsidiaries. The term “first quarter” as used below refers to the three months ended March 31 for the time period then ended. For a glossary of terms for State Auto Financial Corporation and its subsidiaries and affiliates and a glossary of selected terms including insurance terms, see the section entitled “Important Defined Terms Used in this Form 10-K” included in our Annual Report on Form 10-K for the year ended December 31, 2010 (the “2010 Form 10-K”). The discussion and analysis presented below relates to the material changes in financial condition and results of operations for our consolidated balance sheets as of March 31, 2011 and December 31, 2010, and for the consolidated statements of income for the three-month periods ended March 31, 2011 and 2010. This discussion and analysis should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in the 2010 Form 10-K, and in particular the discussions in those sections thereof entitled “Executive Summary” and “Critical Accounting Policies.” Readers are encouraged to review the entire 2010 Form 10-K, as it includes information regarding our Company not discussed in this Form 10-Q. This information will assist in your understanding of the discussion of our current period financial results. The discussion and analysis presented below includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “believe” or “continue” or the negative thereof or variations thereon or similar terminology. Forward-looking statements speak only as of the date the statements were made. Although we believe that the expectations reflected in forward-looking statements have a reasonable basis, we can give no assurance that these expectations will prove to be correct. Forward-looking statements are subject to risks and uncertainties that could cause actual events or results to differ materially from those expressed in or implied by the statements. For a discussion of the most significant risks and uncertainties that could cause our actual results to differ materially from those projected, see “Risk Factors” in Item 1A of the 2010 Form 10-K, updated by Part II, Item 1A of this Form 10-Q. Except to the limited extent required by applicable law, we undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Prior to January 1, 2011, we operated in three reportable segments – personal insurance, business insurance and investment operations. In 2010, management focused on assessing and positioning a realignment of our internal organization, including people, processes and compensation reward programs, to be more strategic in the personal, business and specialty insurance markets. Considering these internal changes and the 2011 pooling change (defined below), beginning with the first quarter 2011, our reportable segments became personal insurance, business insurance and specialty insurance (collectively the “insurance segments”), along with investment operations, which aligned how these insurance segments report to our principal operating decision makers. See “Personal and Business Insurance” and “Specialty Insurance” in Item 1 of the 2010 Form 10-K for more information about our insurance segments. Financial information about our reportable segments for 2011 is set forth in Note 11 of our condensed consolidated financial statements included in Item 1 of this Form 10-Q. Prior period segment information has been restated to conform to current period presentation.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
POOLING ARRANGEMENT The STFC Pooled Companies and the Mutual Pooled Companies participate in a quota share reinsurance pooling arrangement referred to as the “Pooling Arrangement.” Under the Pooling Arrangement, State Auto Mutual assumes premiums, losses and expenses from each of the remaining Pooled Companies and in turn cedes to each of the Pooled Companies a specified portion of premiums, losses and expenses based on each of the Pooled Companies’ respective pooling percentages. State Auto Mutual then retains the balance of the pooled business. The participation percentage for the STFC Pooled Companies has remained at 80% since 2001. As of January 1, 2010, the Pooling Arrangement was amended (the “2010 pooling changes”) to add SA National with a participation percentage of 0.0% and to include voluntary assumed reinsurance from third parties unaffiliated with the Pooled Companies that was assumed on or after January 1, 2009. In conjunction with the 2010 pooling changes, the STFC Pooled Companies received $3.7 million in cash from the Mutual Pooled Companies, for net insurance assets transferred on January 1, 2010. As of January 1, 2011, the Pooling Arrangement was amended (the “2011 pooling change”) to add the Rockhill Insurers to the pool each with a participation percentage of 0.0%. In conjunction with the 2011 pooling change, the STFC Pooled Companies received $149.8 million ($69.1 million in cash and $80.7 million in investment securities) from the Rockhill Insurers, for net insurance liabilities transferred on January 1, 2011. The following table sets forth the impact on our balance sheet at January 1, 2011, relating to the 2011 pooling change:
State Auto Financial sold its nonstandard automobile insurance subsidiary, SA National, to a third party on December 31, 2010. Concurrently with this sale, SA National’s participation in the Pooling Arrangement was terminated, and we entered into a loss portfolio transfer and a 100% quota share reinsurance agreements on December 31, 2010 to assume liability for the pre- and post-closing book of business of SA National, including providing policy and claims service to SA National policyholders, until policies are renewed with the third party purchaser on such purchaser’s systems during a transition period of up to six months following effective date of sale. This business assumed by us is subject to the Pooling Arrangement.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following table sets forth the participants and their participation percentages in the Pooling Arrangement:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
RESULTS OF OPERATIONS Our net income was $12.7 million and $12.9 million for the three months ended March 31, 2011 and 2010, respectively. Pretax income was $15.4 million and $20.6 million for the first quarter 2011 and 2010, respectively. First quarter 2011 results were impacted by an increase in the level of our weather-related catastrophe losses and an increase in the level of our non-catastrophe losses due to an increase in the number of large losses in our business insurance segment. Our investment results included an increase in net realized gains on investments in the first quarter 2011 when compared to the same 2010 period. The following table sets forth certain key performance indicators we use to monitor our operations for the three months ended March 31, 2011 and 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Insurance Segments The insurance segments market a broad line of property and casualty insurance products in all 50 states and the District of Columbia exclusively through independent insurance agencies, which include retail agents and wholesale brokers. The personal insurance segment provides primarily personal automobile and homeowners to the personal insurance market. The business insurance segment provides primarily commercial automobile, commercial multi-peril, fire & allied and general liability insurance covering small-to-medium sized commercial exposures in the business insurance market. The specialty insurance segment provides commercial coverages requiring specialized product underwriting, claims handling or risk management services through a distribution channel of retail agents and wholesale brokers, which may include program administrators and other specialty sources. Insurance industry regulators require our insurance subsidiaries to report their financial condition and results of operations using SAP. We use SAP financial results, along with industry standard financial measures determined on a SAP basis and certain measures determined on a GAAP basis, to internally monitor the performance of our insurance segments and reward our employees. One of the more significant differences between GAAP and SAP is that SAP requires all underwriting expenses to be expensed immediately and not deferred over the same period that the premium is earned. In converting SAP underwriting results to GAAP underwriting results, acquisition costs are deferred and amortized over the periods the related written premiums are earned. For a discussion of deferred acquisition costs, see “Critical Accounting Policies – Deferred Acquisition Costs” section included in Item 7 of our 2010 Form 10-K. The accounting for retroactive reinsurance contributes to the difference between our GAAP loss and expense ratios and our SAP loss and expense ratios. Retroactive reinsurance balances result from reinsurance placed to cover losses on insured events occurring prior to the inception of a reinsurance contract. For GAAP reporting, retroactive reinsurance balances are included in losses and loss expenses in the condensed consolidated statements of income and the GAAP loss ratio. Statutory accounting practices require retroactive reinsurance balances to be recorded in other expenses rather than in losses and loss expenses, and included in the SAP expense ratio. All references to financial measures or components thereof in this discussion are calculated on a GAAP basis, unless otherwise noted.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following tables set forth a summary of our insurance segments’ SAP underwriting gain (loss) and SAP combined ratio for the three months ended March 31, 2011 and 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Revenue We measure our top-line growth for our insurance segments based on net written premiums, which represent the premiums on the policies we have issued for a period, net of reinsurance. Net written premiums provide us with an indication of how well we are doing in terms of revenue growth before it is actually earned. Our policies provide a fixed amount of coverage for a stated period of time, often referred to as “the policy term.” As such, our written premiums are recognized as earned ratably over the policy term. The unearned portion of written premiums, called unearned premiums, is reflected on our balance sheet as a liability and represents our obligation to provide coverage for the unexpired term of the policies. The following table sets forth the reconciliation of the one-time impact on net written premiums for the three months ended March 31, 2011, of the unearned premiums transferred by the Rockhill Insurers on January 1, 2011, in conjunction with the 2011 pooling change:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following table sets forth the reconciliation of the one-time impact on net written premiums for the three months ended March 31, 2010, of the unearned premiums transferred to the Mutual Pooled Companies on January 1, 2010, in conjunction with the 2010 pooling changes:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Personal Insurance Segment Revenue Our personal insurance segment represented 55.2% and 63.2% of our total consolidated net written premiums for the three months ended March 31, 2011 and 2010, respectively. This decline was primarily due to the addition of the Rockhill Insurers to the Pooling Arrangement in 2011 and growth in our business written through our RED unit. We believe introducing new products, leveraging predictive modeling capabilities and making it easier for our agents and policyholders to do business with us through enhanced systems and easier to use technologies will enable us to strategically grow our personal lines business in desired geographic locations. CustomFit SM, our standard auto product, provides additional quoting opportunities by allowing our agents to tailor policies to fit the insured’s needs. Further expanding our product portfolio, our CustomFit Homeowners product employs predictive modeling and by-peril rating, allowing us to target business with expected long-term profit potential. Compared to the traditional method of using fire as the main basis for rating, by-peril rating uses multiple perils (such as wind, hail and water) in the rating process designed to provide a more accurate and adequate rate. As of first quarter 2011, our CustomFit Homeowners product has been deployed in 11 states, with plans of deployment in five additional states during 2011 and future deployment for all of our states. We have placed a priority of deploying CustomFit Homeowners into our largest states which have historically experienced adverse catastrophe experience. States in which CustomFit Homeowners will be offered in 2011 represent 75% of our Homeowners premium and account for 82% of our five year wind/hail losses. Our emphasis in personal insurance continues to be homeowners profitability. In addition to rate increases and the introduction of our CustomFit homeowners product, we are aggressively evaluating and monitoring unprofitable agencies, which may include the review of an agency’s existing policies, implementation of tighter new business and renewal guidelines for that agency, and the application of other loss mitigation tools for use by that agency, all with the purpose of improving operating results at the agency level. We are continuing with a proactive insurance to value program, which is designed to have our insureds maintain an amount of coverage sufficient to replace their home and contents in the case of a total loss consistent with our loss settlement practices. In addition, we have implemented mandatory wind and hail deductibles in 14 states, with plans to add the deductibles to another four states during 2011. We continue to deploy strategies to provide greater spread of risk for our homeowners line, and we have begun to experience improvement in our non-catastrophe loss results. See “Loss and LAE” section for SAP loss and LAE ratios by major lines of business. Over the years, we have focused on improved technology interfaces with our agents and policyholders. We have enhanced our agents’ personal lines sale portal netXpress SM by increasing the number of integration points to our rating engine, thus eliminating duplicate entry for agents. We have also made changes to streamline the quoting and policy issuance steps in this portal. These actions have resulted in more efficiency for our agents and increased levels of quote activity by our agents. For our policyholders, we have increased the number of electronic bill pay options, including 24 x 7 online capabilities, along with web based claim reporting technology.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following table sets forth a summary of written premium, net of reinsurance, by major product line of business for our personal insurance segment for the three months ended March 31, 2011 and 2010. The one-time impacts of the 2011 and 2010 pooling changes have been excluded from 2011 and 2010 to present net written premiums on a comparative basis (see Net Written Premium Reconciliation Table above).
Personal auto net written premiums for the three months ended March 31, 2011 declined 4.5% compared to the same 2010 period. The loss of premium associated with the sale of our nonstandard automobile insurance subsidiary, SA National, in 2010 accounted for a significant portion of this decline. While we are experiencing a slowdown in growth in our standard auto business, we continue to see strong premium growth in our newer states of Texas, Colorado and Connecticut. While standard auto quote activity continues to be strong, we are experiencing a slowdown in new business and a lower issue-to-quote ratio which we attribute to the impact of our rate increases. We also have a high percentage of auto policies in which we write the companion home policy. Consequently, the aggressive actions we have been implementing to address profit levels in homeowners can impact the entire account and cause some loss of automobile policies and produce a slowdown of new business. Homeowners net written premiums for the three months ended March 31, 2011 increased 4.7% compared to the same 2010 period. The majority of the growth was attributable to rate increases. We continue to aggressively address our rate needs and seek higher rates in this line of business. We are aggressively targeting certain states for growth we believe have lower catastrophe exposure.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Business Insurance Segment Revenue Our business insurance accounts are primarily small-to-medium sized exposures where we offer a broad range of both property and liability coverages. The following table sets forth a summary of written premiums, net of reinsurance, by major product line of business for our business insurance segment for the three months ended March 31, 2011 and 2010. The one-time impacts of the 2011 and 2010 pooling changes have been excluded from 2011 and 2010 to present net written premiums on a comparative basis (see Net Written Premiums Reconciliation Tables above).
Net written premiums for the business insurance segment for the three months ended March 31, 2011 decreased 0.5% compared to the same 2010 period. Business insurance continues to be impacted by rate competition, general economic conditions, and depressed premium bases, such as payrolls, sales and number of vehicles, as well as ease of doing business issues. After strengthening our premium per exposure on our renewal policies in the second half of 2009, our premium per exposure decreased slightly in 2010 and that trend continued in the first quarter 2011. New business declined in 2010; however, in the first quarter 2011, we experienced an increase in premiums related to new business. Despite new business growth, we believe it will be difficult to generate measurable premium growth in our current book of business given the continued impact of the economy on premium bases. However, we are seeking to balance our traditional underwriting discipline with new products and pricing tools that support the production of profitable new business. We continue to invest in products, processes and systems that we believe will increase our business insurance writings. We have implemented a pricing process that we believe will help us price property, liability and auto risks at appropriate levels. In addition, we have broadened our property, liability and auto pricing ranges to improve our ability to recognize the spectrum of risks within our markets. We continue to enhance our insurance policy administration system to make it easier for our agents to quote and submit business insurance policies to us. In 2010, we expanded our electronic funds transfer billing capability making it available to business insurance policyholders. BizXpressSM, our web-based quote system, currently gives agents the ability to quote most commercial risks online. We plan to continue to provide additional functionality on that platform. In 2011, we plan to introduce policy download capabilities for most business insurance lines allowing agents to import policy information directly into their agency management systems to better serve their clients. Commercial auto is currently available for our agents to download.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
We have also expanded the eligibility of our businessowners product to facilitate businesses with greater liability exposures, such as artisan contractors, auto service garages, manufacturers and restaurants. While we regularly insure these types of businesses through other insurance products, offering them in our businessowners program leverages our bizXpress technology, simplifies agents’ rating and submission processes, and offers broader base coverages for these types of risks. In 2010, we completed the implementation of our enhanced businessowners product, BOP Choice, which has been introduced into 28 states. The majority of our new business premium has come from this new product, which is included in our commercial multi-peril line. Specialty Insurance Segment Revenue In our specialty insurance segment, we offer commercial coverages requiring specialized product design, underwriting, claims handling or risk management services through a distribution channel of retail agents and wholesale brokers, which may include program administrators and other specialty sources. See “Specialty Insurance” in Item 1 of the 2010 Form 10-K. The following table sets forth a summary of written premiums, net of reinsurance, by unit for our specialty insurance segment for the three months ended March 31, 2011 and 2010. The one-time impacts of the 2011 and 2010 pooling changes have been excluded from 2011 and 2010 to present net written premiums on a comparative basis (see Net Written Premiums Reconciliation Tables above).
Net written premiums for the specialty insurance segment for the three months ended March 31, 2011 increased $42.2 million compared to the same 2010 period. The increase in net written premiums for the specialty insurance segment was principally driven by the addition of the Rockhill Insurers’ business to the pooling arrangement and increased business written through our RED unit. Net written premiums for our RED unit for the three months ended March 31, 2011 increased by $17.9 million compared to the same 2010 period. This business was new to us in 2010, as the underwriting management agreement with RED went into effect during the fourth quarter 2009. Throughout 2010, the net written premium written through our RED unit increased and, totaled $83.2 million. Net written premiums for our Rockhill and Workers’ Compensation units for the three months ended March 31, 2011 increased $14.1 million and $10.2 million, respectively, compared to the same 2010 period. The growth in these units is primarily due to the addition of the Rockhill Insurers into the Pooling Arrangement in 2011.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following table sets forth, on a pro forma basis, Specialty Insurance segment net written premiums for the three months ended March 31, 2011 and 2010, as if the Rockhill Insurers business had been included in our net written premium results for the three months ended March 31, 2010.
On a pro forma basis, net written premiums for the specialty insurance segment for the three months ended March 31, 2011 increased $19.1 million compared to the same 2010 period. On a pro forma basis, net written premiums for our Rockhill unit for the three months ended March 31, 2011 declined $1.0 million compared to the same 2010 period. The Rockhill unit was impacted by soft market conditions, specifically on its property lines. Liability lines remained flat in the first quarter 2011 when compared to the same 2010 period. On a pro forma basis, net written premiums for our Workers’ Compensation unit for the three months ended March 31, 2011 increased by $2.2 million when compared to the same 2010 period. The growth was driven by increased renewal retention and rate increases, which we believe is an indication that pricing levels within this line of business are improving.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Loss and LAE The following tables set forth our insurance segments’ SAP loss and LAE ratios by major lines of business with the catastrophe and non-catastrophe impact shown separately for the three months ended March 31, 2011 and 2010:
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
Over the past year, we have implemented a number of changes to our liability claim handling process accelerating the reserving and resolution of outstanding liability claims. We believe these actions will better control indemnity payouts and legal expenses; however, in the short term, we believe they are increasing the number, not the severity, of large casualty losses. We define a large loss as any claim either newly or previously reported, which produces an incurred amount greater than $100,000 in the period. We expect the impact of this more active claim file management to level out in the coming quarters. In the personal insurance segment, the overall non-cat loss ratio for the three months ended March 31, 2011 improved 2.3 points from the same 2010 period, due to a 14.8 point improvement in our homeowners non-cat loss ratio, offset by a 4.5 point increase in our personal auto non-cat loss ratio. The impact of rate increases contributed significantly to the improvement in homeowners, where we continue to file increases in the high single to low double digit range. Our personal auto non-cat loss ratio increased due primarily to the number of large losses, which contributed an additional 3.0 points to our loss ratio for the three months ended March 31, 2011 when compared to the same 2010 period. In the business insurance segment, the overall non-cat loss ratio for the three months ended March 31, 2011 increased 12.9 points from the same 2010 period. Our commercial auto and other & product liability non-cat loss ratios increase is driven by an increase in the number of large losses, which contributed approximately 22.0 points and 33.0 points, respectively more to these loss ratios than for the same 2010 period. Intense competition in the business insurance segment continues to impact our ability to implement price increases where needed. In the specialty insurance segment, the overall non-cat loss ratio for the three months ended March 31, 2011 improved 4.2 points from the same 2010 period, which was primarily due to a change in business mix caused by the addition of the Rockhill Insurers into the Pooling Arrangement in 2011. While we have not seen any impact to date, the earthquake and tsunami in Japan in March 2011 may cause a disruption in the availability of replacement parts for certain makes and models of automobiles, which may result in a temporary increase in loss costs for automobile coverages.
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Table of ContentsSTATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company)
The following table sets forth loss and loss expenses payable by major line of business at March 31, 2011 and December 31, 2010:
________ We conduct quarterly reviews of loss development reports and make judgments in determining the reserves for ultimate losses and loss expenses payable. Several factors are considered by us when estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, accounting projections, exposure changes, anticipated inflation, current business conditions, catastrophe developments, late reported claims, and other reasonableness tests. The risks and uncertainties inherent in our estimates include, but are not limited to, actual settlement experience different from historical data, trends, changes in business and economic conditions, court decisions creating unanticipated liabilities, ongoing interpretation of policy provisions by the courts, inconsistent decisions in lawsuits regarding coverage and additional information discovered before settlement of claims. Our results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required to settle claims vary from the liability currently recorded. For a discussion of our reserving methodologies as well as a measure of sensitivity discussion see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies – Loss and Loss Expenses Payable” in Item 7 of the 2010 Form 10-K.
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