<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
Form 10-Q
(X) Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the quarterly period ended September 30, 1999
---------------------------------
( ) Transition report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the Transition period from ____________________ to ____________________
State Auto Financial Corporation
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Ohio 31-1324304
---------------------------- -------------------
(State or other jurisdiction (I.R.S. Employer
of incorporation) Identification No.)
518 East Broad Street, Columbus, Ohio 43215-3976
- --------------------------------------------------------------------------------
(Address of principal executive offices) (zip code)
(614) 464-5000
- --------------------------------------------------------------------------------
Registrant's telephone number, including area code
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
(X) Yes ( ) No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
Common shares, without par value 39,630,005
- -------------------------------- -------------------------
(CLASS) (OUTSTANDING ON 11/12/99)
<PAGE> 2
INDEX
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed consolidated balance sheets - September 30, 1999 and
December 31, 1998
Condensed consolidated statements of income - Three months ended
September 30, 1999 and 1998
Condensed consolidated statements of income - Nine months ended
September 30, 1999 and 1998
Condensed consolidated statements of cash flows - Nine months
ended September 30, 1999 and 1998
Notes to condensed consolidated financial statements -
September 30, 1999
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Item 3. Quantitative and Qualitative Disclosure of Market Risk
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
<TABLE>
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share data)
(unaudited)
<CAPTION>
September 30 December 31
ASSETS 1999 1998
---- ----
<S> <C> <C>
Fixed maturities:
Held for investment, at amortized cost
(fair value $45,779 and $57,826, respectively) $ 45,181 $ 55,926
Available for sale, at fair value
(amortized cost $534,380 and $464,008, respectively) 526,360 481,844
Equity securities, at fair value (cost $34,910 and $29,233, respectively) 46,617 42,196
-------- --------
Total investments 618,158 579,966
Cash and cash equivalents 26,476 32,605
Surplus note receivable -- 9,000
Deferred policy acquisition costs 28,803 24,799
Accrued investment income and other assets 17,825 19,542
Net prepaid pension expense 18,257 16,378
Reinsurance receivable 13,764 12,416
Prepaid reinsurance premiums 15,783 13,007
Property and equipment, net 11,476 7,927
Due from affiliates 324 --
Current federal income taxes 2,630 --
Deferred federal income taxes 1,472 --
Goodwill 2,593 1,880
-------- --------
Total assets $757,561 $717,520
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Losses and loss expenses payable $243,096 $217,450
Unearned premiums 157,762 144,081
Note payable to affiliate 30,000 --
Current federal income taxes -- 2,608
Deferred federal income taxes -- 8,095
Due to affiliates -- 884
Other liabilities 3,949 3,578
-------- --------
Total liabilities 434,807 376,696
-------- --------
STOCKHOLDERS' EQUITY
Common stock, without par value. Authorized 100,000,000 shares;
42,232,487 and 42,039,892 shares issued, respectively, at stated
value of $2.50 per share 105,581 105,100
Less 2,438,714 and 13,212 treasury shares, respectively, at cost (30,163) (167)
Additional paid-in capital 41,788 41,539
Accumulated comprehensive income 2,584 20,276
Retained earnings 202,964 174,076
-------- --------
Stockholders' equity 322,754 340,824
-------- --------
Total liabilities and stockholders' equity $757,561 $717,520
======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
<PAGE> 4
<TABLE>
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Three Months Ended September 30, 1999 and 1998
(dollars in thousands, except per share amounts)
(unaudited)
<CAPTION>
1999 1998
---- ----
<S> <C> <C>
Earned premiums (net of ceded earned premiums of
$103,608 and $94,272, respectively) $ 98,229 $ 90,096
Net investment income 8,566 8,340
Management services income 2,182 1,986
Net realized gains on investments 734 1,115
Other income 749 675
-------- --------
Total revenues 110,460 102,212
-------- --------
Losses and loss expenses (net of ceded losses and loss
expenses of $76,394 and $65,182, respectively) 68,978 59,656
Acquisition and operating expenses 28,957 27,441
Interest expense 351 --
Other expense 1,508 1,646
-------- --------
Total expenses 99,794 88,743
-------- --------
Income before federal income taxes 10,666 13,469
Federal income tax expense:
Current 1,859 2,633
Deferred 275 284
-------- --------
Total federal income taxes 2,134 2,917
-------- --------
Net income $ 8,532 $ 10,552
======== ========
Earnings per share:
- basic $ 0.22 $ 0.25
======== ========
- diluted $ 0.21 $ 0.25
======== ========
Dividends paid per common share $ 0.028 $ 0.025
======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
<PAGE> 5
<TABLE>
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
For the Nine Months Ended September 30, 1999 and 1998
(dollars in thousands, except per share amounts)
(unaudited)
<CAPTION>
1999 1998
---- ----
(Restated -
See Note 1)
<S> <C> <C>
Earned premiums (net of ceded earned premiums of
$306,003 and $279,701, respectively) $295,558 $267,122
Net investment income 25,374 24,463
Management services income 6,558 5,945
Net realized gains on investments 2,660 2,165
Other income 2,427 1,700
-------- --------
Total revenues 332,577 301,395
-------- --------
Losses and loss expenses (net of ceded losses and loss
expenses of $214,660 and $197,973, respectively) 203,442 184,929
Acquisition and operating expenses 84,991 79,477
Interest expense 418 --
Other expense, net 4,632 4,351
-------- --------
Total expenses 293,483 268,757
-------- --------
Income before federal income taxes 39,094 32,638
Federal income tax expense (benefit):
Current 8,448 8,118
Deferred 865 (343)
-------- --------
Total federal income taxes 9,313 7,775
-------- --------
Net income $ 29,781 $ 24,863
======== ========
Net earnings per share:
- basic $ 0.72 $ 0.59
======== ========
- diluted $ 0.71 $ 0.58
======== ========
Dividends paid per common share $ 0.078 $ 0.070
======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
<PAGE> 6
<TABLE>
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended September 30, 1999 and 1998
(in thousands)
(unaudited)
<CAPTION>
1999 1998
---- ----
(Restated -
See Note 1)
<S> <C> <C>
Cash flows from operating activities:
Net income $ 29,781 $ 24,863
Adjustments to reconcile net earnings to net cash provided by
operating activities:
Depreciation and amortization, net 2,157 1,737
Net realized gains on investments (2,660) (2,165)
Changes in operating assets and liabilities:
Deferred policy acquisition costs (2,026) (951)
Accrued investment income and other assets 1,569 (1,332)
Net prepaid pension expense (1,442) (579)
Other liabilities and due to/from affiliate, net (2,131) 3,958
Reinsurance receivable and prepaid reinsurance premiums (7,678) (1,839)
Losses and loss expenses payable 3,507 1,565
Unearned premiums 8,223 6,014
Federal income taxes (3,613) (185)
--------- ---------
25,687 31,086
Cash provided from the change in the reinsurance pool
participation percentage 11,418 19,708
--------- ---------
Net cash provided by operating activities 37,105 50,794
--------- ---------
Cash flows from investing activities:
Purchase of fixed maturities - available for sale (180,906) (164,156)
Purchase of equity securities (16,161) (8,428)
Maturities, calls and principal reductions of fixed maturities -
held to maturity 10,595 18,130
Maturities, calls and principal reductions of fixed maturities -
available for sale 18,397 18,362
Sale of fixed maturities - available for sale 103,980 88,255
Sale of equity securities 12,435 3,945
Net cash acquired on acquisition of Farmers Casualty
Insurance Company and subsidiary 11,568 --
Purchase of surplus note receivable -- (9,000)
Net additions of property and equipment (3,443) (1,313)
--------- ---------
Net cash used in investing activities (43,535) (54,205)
--------- ---------
Cash flows from financing activities:
Proceeds from issuance of debt 30,000 --
Net proceeds from sale of common stock 1,281 930
Payments to acquire treasury stock (29,995) --
Payment of dividends (985) (896)
--------- ---------
Net cash provided by financing activities 301 34
--------- ---------
Net decrease in cash and cash equivalents (6,129) (3,377)
Cash and cash equivalents at beginning of period 32,605 30,931
--------- ---------
Cash and cash equivalents at end of period $ 26,476 $ 27,554
========= =========
Supplemental disclosures:
Federal income taxes paid $ 12,964 $ 7,768
========= =========
</TABLE>
See accompanying notes to condensed consolidated financial statements.
<PAGE> 7
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
September 30, 1999
(in thousands, except per share amounts)
(unaudited)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation have been included.
Operating results for the three and nine month periods ended September 30, 1999
are not necessarily indicative of the results that may be expected for the year
ended December 31, 1999. The balance sheet at December 31, 1998 has been derived
from the audited financial statements at that date but does not include all of
the information and footnotes required by generally accepted accounting
principles for complete financial statements.
For further information, refer to the consolidated financial statements and
footnotes thereto included in the Registrant Company and Subsidiaries' annual
report on Form 10-K for the year ended December 31, 1998.
In July 1998 the Company acquired the outstanding shares of Milbank Insurance
Company ("Milbank") from State Automobile Mutual Insurance Company ("Mutual"),
an affiliated company. The transaction was effected through an exchange with
Mutual of approximately 5.1 million Company common shares for all of the issued
and outstanding capital stock of Milbank. Since the transaction was a
combination of entities under common control it has been accounted for similar
to a pooling-of-interest. The September 30, 1998 financial information has been
restated to include the financial position and operations of Milbank.
Effective January 1, 1999, the Company purchased Farmers Casualty Insurance
Company ("Farmers Casualty"), an Iowa domiciled standard property casualty
insurer, for approximately $9.0 million. In addition, Farmers Casualty owns 100%
of the outstanding shares of Mid-Plains Insurance Company ("Mid-Plains"); an
Iowa domiciled property casualty insurer, which principally writes nonstandard
auto insurance. This transaction has been accounted for using the purchase
method of accounting. In conjunction with the acquisition, liabilities assumed
were as follows (in thousands):
Fair value of assets acquired $28,040
Cash paid for the common stock (9,000)
-------
Liabilities assumed $19,040
=======
Also on January 1, 1999, the pooling arrangement was amended to include all of
the property and casualty business of Farmers Casualty. With the inclusion of
Farmers Casualty in the pool, the pooling participation percentages were amended
to allocate 37% to State Auto Property & Casualty ("State Auto P&C"), a wholly
owned subsidiary of the Company, 49% to Mutual, 10% to Milbank, 1% to Midwest
Security Insurance Company, a wholly owned subsidiary of Mutual, and 3% to
Farmers Casualty. State Auto P&C, Milbank and Farmers Casualty received
approximately $11.4 million to cover their increased share of pool liabilities.
<PAGE> 8
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
September 30, 1999
(in thousands, except per share amounts)
(unaudited)
2. COMPREHENSIVE INCOME
The components of comprehensive income, net of related tax, are as follows:
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30 September 30
------------ ------------
1999 1998 1999 1998
---- ---- ---- ----
(Restated -
See Note 1)
<S> <C> <C> <C> <C>
Net income $ 8,532 $10,552 $ 29,781 $24,863
Unrealized holding gains (losses), net of tax (7,528) 2,039 (17,693) 3,806
------- ------- -------- -------
Comprehensive income $ 1,004 $12,591 $ 12,088 $28,669
======= ======= ======== =======
</TABLE>
The components of accumulated other comprehensive income, net of related tax,
included in stockholders' equity at September 30, 1999 and December 31, 1998
include only unrealized holding gains, net of tax.
3. EARNINGS PER COMMON SHARE
The following table sets forth the computation of basic and diluted earnings per
common share:
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30 September 30
------------ ------------
1999 1998 1999 1998
---- ---- ---- ----
(Restated -
See Note 1)
<S> <C> <C> <C> <C>
Numerator:
Net income for basic and diluted
Earnings per share $ 8,532 $10,552 $29,781 $24,863
------- ------- ------- -------
Denominator:
Weighted average shares for
Basic earnings per share 40,342 41,906 41,340 41,865
Effect of dilutive stock options 756 988 773 1,045
Adjusted weighted average shares
For diluted earnings per share 41,098 42,894 42,113 42,910
------- ------- ------- -------
Basic earnings per share $ 0.22 $ 0.25 $ 0.72 $ 0.59
------- ------- ------- -------
Diluted earnings per share $ 0.21 $ 0.25 $ 0.71 $ 0.58
------- ------- ------- -------
</TABLE>
<PAGE> 9
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements - continued
September 30, 1999
(in thousands, except per share amounts)
(unaudited)
4. SEGMENT INFORMATION
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30 September 30
------------ ------------
1999 1998 1999 1998
---- ---- ---- ----
(Restated -
See Note 1)
<S> <C> <C> <C> <C>
Revenues from external customers:
Standard insurance $ 99,696 $ 92,459 $299,301 $274,226
Nonstandard insurance 8,284 6,954 25,230 20,395
Investment management services 843 834 2,537 2,471
All other 814 786 2,646 2,032
-------- -------- -------- --------
Total revenues from external customers $109,637 $101,033 $329,714 $299,124
======== ======== ======== ========
Intersegment revenues:
Standard insurance $ 93 $ 65 $ 279 $ 196
Nonstandard insurance (30) (23) (90) (68)
Investment management services 640 598 1,930 1,757
All other 426 314 1,141 839
-------- -------- -------- --------
Total intersegment revenues $ 1,129 $ 954 $ 3,260 $ 2,724
======== ======== ======== ========
Segment profit (loss):
Standard insurance $ 7,854 $ 10,286 $ 31,515 $ 26,170
Nonstandard insurance 999 691 811 751
Investment management services 1,291 1,251 3,926 3,659
All other 180 406 1,139 966
-------- -------- -------- --------
Total segment profit 10,324 12,634 37,391 31,546
Reconciling items:
Corporate expenses (432) (261) (947) (1,038)
Net realized gains 734 1,115 2,660 2,165
Miscellaneous adjustments 40 (19) (10) (35)
-------- -------- -------- --------
Total consolidated income before taxes $ 10,666 $ 13,469 $ 39,094 $ 32,638
======== ======== ======== ========
Segment assets:
Standard insurance $702,049 $633,142
Nonstandard insurance 45,568 39,720
Investment management services 6,028 7,458
All other 14,636 14,569
-------- --------
Total segment assets $768,281 $694,889
======== ========
</TABLE>
The standard insurance segment's assets increased about $68.9 million at
September 30, 1999 from the amount reported at December 31, 1998 because the
acquisition of Farmers Casualty and the concurrent change in the pooling
arrangement, as discussed above in Note 1. The nonstandard insurance segment's
assets increased about $5.8 million from the amount reported at December 31,
1998, because Mid-Plains, which is a wholly owned subsidiary of Farmers
Casualty, is a part of the nonstandard insurance segment.
<PAGE> 10
5. DEBT
During the second quarter of 1999, State Auto Financial's Board of Directors
approved a plan to repurchase up to 4.0 million shares of its common stock until
December 31, 2000. Since the repurchase began in the second quarter of 1999,
State Auto Financial has repurchased 2,420,000 shares, 1,657,900 from Mutual and
762,100 from the public. Repurchases are transacted to maintain the same
ownership ratios, with 70% of the repurchased stock from Mutual and 30% from the
public.
In conjunction with the stock repurchase plan State Auto Financial entered into
a line of credit agreement with Mutual whereby State Auto Financial may draw up
to $30.0 million, at an interest rate of 6.0%, to be used specifically to
repurchase shares of the Company's stock. To date, State Auto Financial has
drawn on the entire $30.0 million line of credit. Repayment of principal shall
begin no later than 2001.
6. RECLASSIFICATIONS
Certain items in the 1998 condensed consolidated financial statements have been
reclassified to conform with the 1999 presentation.
<PAGE> 11
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Results of Operations
- ---------------------
Income before federal income taxes decreased $2.8 million to $10.7 million and
increased $6.5 million to $39.1 million for the three months and nine months
ended September 30, 1999, respectively, from the same 1998 periods. For the
third quarter 1999 as compared with the same 1998 period this decrease was
largely attributable to an increase in the amount of large commercial claims.
The increase in income before federal income taxes for the nine months ended
September 30, 1999, compared to the same period in 1998 was principally due to a
decrease in the level of catastrophes of approximately $10.3 million from the
same 1998 period.
1999 has been impacted by the acquisition of Farmers Casualty Insurance Company
("Farmers Casualty") and its subsidiary Mid Plains Insurance Company, both Iowa
domiciled insurers as well as an amendment to the Company's pooling arrangement,
both of which occurred as of January 1, 1999. Farmers Casualty is a standard
property and casualty insurer while Mid-Plains writes principally nonstandard
auto insurance. This transaction was accounted for under the purchase method of
accounting. During 1998, the Company's standard insurance subsidiaries, State
Auto Property & Casualty Insurance Company ("State Auto P&C") and Milbank
Insurance Company ("Milbank") participated in a pooling arrangement with State
Automobile Mutual Insurance Company ("Mutual"), a majority shareholder of the
Company and Midwest Security Insurance Company ("Midwest Security"), a wholly
owned subsidiary of Mutual. State Auto P&C assumed 37% of the pooled business,
Milbank 10%, Mutual 52% and Midwest Security 1%. Effective January 1, 1999, the
Company amended its pooling arrangement to include all of the property and
casualty insurance business of Farmers Casualty and adjusted the pooling
percentages as follows: 37% to State Auto P&C, 49% to Mutual, 10% to Milbank, 1%
to Midwest Security and 3% to Farmers Casualty (collectively, these companies
are referred to as the "Pooled Companies"). In connection with the January 1,
1999 pooling changes, the Company received approximately $11.4 million to cover
its increased share of the pooled liabilities.
Consolidated earned premiums during the quarter ended September 30, 1999,
increased $8.1 million (9.0%) to $98.2 million from the same 1998 period. The
9.0% increase was principally the product of the following factors. The change
in allocation percentages of the Company's pooling arrangement, as well as the
addition of Farmers Casualty to the pool increased consolidated earned premiums
8.1%. The standard insurance segment, as written by the Pooled Companies,
excluding the impact of the changes in the pooling arrangement, decreased
consolidated earned premiums about 0.5%. The addition of Mid-Plains to the
nonstandard insurance segment increased consolidated earned premiums 2.2%.
However, the nonstandard insurance segment continued to experience a decline in
earned premium into the third quarter of 1999, which was a decrease of 0.8% as
compared to the same 1998 period.
Consolidated earned premiums for the nine months ended September 30, 1999,
increased $28.4 million (10.6%) to $295.6 million from the same 1998 period. The
10.6% increase was principally the product of the following factors. The change
in allocation percentages of the Company's pooling arrangement, as well as the
addition of Farmers Casualty to the pool increased consolidated earned premiums
7.1%. The growth in the standard insurance segment, as written by the Pooled
Companies, excluding the impact of the changes in the pooling arrangement,
increased consolidated earned premiums 0.5%. The addition of Mid-Plains to the
nonstandard insurance segment increased consolidated earned premiums 3.4%.
Nevertheless, the nonstandard insurance segment experienced a 0.4% decrease in
its earned premiums for the nine months ended September 30, 1999 as compared
with the same 1998 period.
Like many other property casualty insurers 1999 has been a difficult year for so
called internal growth for the Company. In its standard insurance segment,
management continues to stress responsible pricing and sound underwriting even
in the face of extraordinary competition in both personal and commercial lines.
Indeed, the Company's underwriting experience in commercial lines of late has
prompted management to commence a careful review of its underwriting guidelines
in these lines of business which could be expected to have an impact on earned
premium going forward. Management's emphasis on the
<PAGE> 12
importance of profit in its underwriting operations has had and may continue to
have an affect on earned premium of the Company.
This same approach to underwriting has also had an impact on the Company's
nonstandard insurance segment, as it experienced a decrease in its earned
premiums. This was the continuing result of significant auto physical damage
rate increases, the continuation of a more restrictive underwriting posture the
Company implemented in this segment throughout most of its operating states
during 1998 and increased competition in this market segment during 1999. While
these management actions have resulted in a decrease in the volume of business
over the last several reporting periods, this segment's statutory loss
experience continues to improve over comparative prior periods. The statutory
loss ratio for the nine months ended September 30, 1999 decreased to 72.7% from
76.1% for the same period in 1998.
Net investment income increased $0.2 million (2.7%) to $8.6 million and $0.9
million (3.7%) to $25.4 million for the three months and nine months ended
September 30, 1999, respectively, from the same 1998 periods. Contributing to
these increases was the transfer to the Company of approximately $11.4 million
in conjunction with the change in the pooling arrangement, the addition of
Farmers Casualty and Mid-Plains to the Company's operations and a general
increase in investable assets over the previous 1998 period. Total cost of
investable assets at September 30, 1999 was $640.9 million compared to $576.7
million at September 30, 1998. The investment yield, based on fixed and equity
securities at cost, decreased to 5.4% for the three months and nine months ended
September 30, 1999, respectively, from 5.8% for the same 1998 comparable
periods.
Losses and loss expenses, as a percentage of earned premiums, increased to 70.2%
for the three months ended September 30, 1999 from 66.2% for the same 1998
period and for the nine months ended September 30, 1999, decreased to 68.8% from
69.2% for the same 1998 period. During 1999, the Company experienced a decrease
in the level of catastrophe losses compared to the same 1998 periods. The
improvement in the level of catastrophe claims in 1999 compared to 1998
contributed to a one percentage point decrease in the GAAP loss ratio in the
current quarter and approximately 4.5 percentage points for the nine months
ended September 30, 1999. Catastrophe losses for the current quarter were
impacted by losses resulting from Hurricane Floyd, which amounted to 3.7 GAAP
loss ratio points. Offsetting the improvement in the 1999 catastrophe levels (as
well as the GAAP loss ratio) was an increase in the amount of commercial claims
impacting the current quarterly and year to date results.
This is being addressed in the manner described above.
Acquisition and operating expenses, as a percentage of earned premiums (the
"expense ratio"), decreased to 29.5% for the quarter ended September 30, 1999
from 30.5% for the same 1998 period and for the nine months ended September 30,
1999, decreased to 28.8% from 29.8% for the 1998 period. These decreases are
attributable to an improvement in a number of expense items of the Company and
not any one specific item.
Interest expense relates to the line of credit agreement State Auto Financial
commenced with Mutual during the second quarter of 1999 to assist in the funding
of its repurchase program as discussed in the Liquidity and Capital Resources
section below.
The effective Federal tax rate was 20.0% and 23.8% for the three months and nine
months ended September 30, 1999, respectively, compared to 21.7% and 23.8% for
the same 1998 periods, respectively. During 1998 and continuing into 1999, the
Company continued to shift its fixed maturity portfolio from taxable to tax
exempt securities. Consequently, tax exempt income comprised a larger proportion
of income before federal income taxes in 1999 versus 1998.
Liquidity and Capital Resources
- -------------------------------
As of the end of the third quarter 1999, net cash provided by operating
activities was $37.1 million ($50.8 million in 1998). In conjunction with the
January 1, 1999 pooling change the Company received $11.4 million from Mutual.
Absent this cash transfer, net cash provided by operating activities was $25.7
million at September 30, 1999 ($31.1 million in 1998). Contributing to this
decrease in net cash provided by operating activities was an increase of $5.0
million in Federal income taxes paid in 1999 over the amount that was paid
through the nine months ended September 30, 1998.
<PAGE> 13
Overall, net cash used in investing activities was $43.5 million ($54.2 million
in 1998). This sum included $11.6 million in net cash acquired by the Company on
the acquisition of Farmers Casualty and its subsidiary Mid-Plains.
Net cash provided by financing activities for the nine months ended September
30, 1999 remained comparable to the same period in 1998. During the second
quarter of 1999, State Auto Financial's Board of Directors approved a plan to
repurchase up to 4.0 million shares of its common stock over a period ending
December 31, 2000. Since the repurchase began in the second quarter of 1999,
State Auto Financial has repurchased 2,420,000 shares, 1,657,900 from Mutual and
762,100 from the public. Repurchases are transacted to maintain the same
ownership ratios between Mutual and the public as currently exist, with 70% of
the repurchased stock from Mutual and 30% from the public.
In conjunction with the stock repurchase plan State Auto Financial entered into
a line of credit agreement with Mutual whereby State Auto Financial may draw up
to $30.0 million, at an interest rate of 6.0%, to be used specifically to
repurchase shares of the Company's stock. To date, State Auto Financial has
drawn on the entire $30.0 million line of credit. Mutual intends to seek the
approval of the Ohio Insurance Department and the boards of directors of both
State Auto Financial and Mutual to increase the line of credit by an additional
$20,000,000. If these approvals are obtained, the additional line of credit
would be available to State Auto Financial in mid November 1999. Repayment of
principal shall begin no later than 2001.
As of September 30, 1999, funds consisting of cash and cash equivalents were
$26.5 million versus $27.6 million at September 30, 1998. At September 30, 1999
approximately $5.8 million had been allocated to an escrow account for the
capitalization of State Auto Insurance Company ("SAIC"), with the balance
allocated to fund general operations. Effective, November 1, 1999, State Auto
Financial completed the capitalization of SAIC by transferring the $5.8 million
from the escrow account to SAIC. Insurance operations in SAIC are not expected
to commence until the first quarter of 2000.
Market Risk
- -----------
With respect to Market Risk, see the discussion regarding this subject in the
Company's December 31, 1998 Management's Discussion and Analysis of Financial
Condition and Results of Operations, included in the December 31, 1998 Form
10-K. There have been no material changes from the information reported
regarding Market Risk in the 1998 Form 10-K.
Year 2000
- ---------
Description of the Year 2000 Issues Affecting the Company
- ---------------------------------------------------------
The Company and its affiliates (all of which are sometimes collectively referred
to hereafter as "State Auto") commenced work on its Year 2000 ("Y2K") issues in
the fall of 1996. At that time, one of its first tasks was to perform an
inventory of all software systems. As a result of this inventory, it identified
approximately 5 million lines of in house maintained program code in its various
software systems. Following this inventory the Company set priorities as to
system remediation based on the role each system played in the Company being
able to carry on its insurance operations or meet its general business needs.
The Company's applications software must support certain essential functions:
issuing insurance policies, collecting policy premiums and paying claims and
premium refunds. In addition, there is other applications software used by the
Company in the general operation and management of its business.
Following months of intensive remediation effort, in April 1998, the Company
conducted its first major test of one of its major insurance policy processing
systems. The results of that test were positive. The Company conducted a second
comprehensive Millennium test at an off-site computer facility in August 1998.
All major insurance policy processing systems were tested as if it were the Year
2000. Testing also included Leap Day, February 29, 2000. This test was also
successful. In March and September 1999, the Company conducted successful Y2K
tests at an offsite computer facility, which was geared specifically to Leap
Day, February 29, 2000 and March 1, 2000. An additional test is planned for
December. Additionally, all internal test systems run with advanced dates giving
the Company the
<PAGE> 14
opportunity to identify Y2K issues early enough to react to them. Testing has
already begun with policies that renew with effective dates beyond January 1,
2000.
At this time, one hundred percent (100%) of the Company's in-force insurance
policies are being processed on a Y2K compliant system, based on the test
results mentioned above. However, in an effort to ensure that no material
problems arise from the policy processing systems used by the Company the
Company plans to continue simulated Year 2000 testing throughout 1999.
State Auto's Y2K project team has, through September 1999, completed its efforts
on approximately 99.8% of State Auto's applications software. That means that
approximately 99.8% of the software systems State Auto uses in its insurance
operations or in meeting its general business needs has been through Y2K
remediation, testing, and has been introduced back into the Company's production
environment. Included within this 99.8% are the systems that address policy
issuance, premium billing and collection and claims processing at State Auto.
The remaining 0.2% 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 non-obsolete
applications software Y2K compliant during the fourth quarter 1999.
In addition to addressing its own applications software Y2K problems, State Auto
may be affected by the Y2K issues of third parties with which it has a material
relationship. This includes the independent insurance agents who sell the
Company's products, many of whom have automated agency management systems in
place.
In addition, a number of State Auto Agencies and the Company are able to
communicate policy data electronically. There are several agency management
systems that permit this so-called upload and download of information but not
all are Y2K compliant. If upload and download are disrupted by Y2K issues, it
will likely affect the efficiency with which the Company operates its business.
The Company has surveyed all State Auto Agencies that currently upload data
electronically to State Auto and verified that every one of these agencies has a
Y2K compliant agency vendor system. For those agencies that only receive a
download of policy information from State Auto, current information on the Y2K
compliance status of their systems available to State Auto indicates that the
majority of them are Y2K compliant. In the event that any of these agencies
encounters any difficulty with download, State Auto is prepared to suspend the
electronic transfer and turn back on the generation of policy documents of which
an agency would need to maintain records manually. This should have a minor
impact on the efficiency with which the company operates its business.
Should there be a Y2K related problem with upload and download, 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 that 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 was one of State
Auto's focal points throughout 1999. State Auto is reasonably satisfied with its
verification of the Y2K compliance of State Auto third party vendor products
which was completed during the third 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.
<PAGE> 15
State Auto's Costs to Address Year 2000 Issues
- ----------------------------------------------
State Auto's Y2K compliance expense to date for resources has been $4.6 million
dollars of a projected $5.0 million dollars. This estimate is subject to change
depending on future, presently unforeseen developments, which could affect the
cost of Y2K compliance for State Auto. The money spent to date is virtually all
payroll costs attributable to the State Auto employees on the Y2K project team.
The foregoing expense does not include approximately $0.5 million spent by State
Auto on accelerated technology purchases for systems or equipment to ensure Y2K
compliance for such system or equipment. Also, an outsourcing agreement with
State Auto's primary third party software vendor to provide additional resources
for other systems projects has generated an additional expense to State Auto of
approximately $3.2 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, but they may range from
information systems failures to embedded chip processing failures.
State Auto does not expect a material adverse impact from Y2K issues arising
from embedded chip processing failures occurring on site. Those embedded chip
issues which the Company has some opportunity to control or address that have
been identified to date have been generally facilities related or involving
small business equipment (i.e. fax machines). Upgrades and equipment replacement
are being coordinated by a variety of business managers responsible for such
equipment.
State Auto's Year 2000 Contingency Plans
- ----------------------------------------
State Auto is making progress in the development of a formal Y2K contingency
plan. Each internal department has responded to a survey relating to its use of
external systems, which might be subject to disruption. The company is also
utilizing some previously developed Business Recovery documents as part of this
contingency plan. The Company expects to have a contingency plan in place during
the 4th quarter 1999. Some of the issues that the plan would likely contemplate
would be manual processing alternatives, non-electronic forms of information
distribution, assurance of adequate supplies, and mitigation of the impact of
utilities and financial institution disruptions.
State Auto continues to work with its business recovery service provider. State
Auto is following a program developed by that provider that requires a
comprehensive Y2K preparation approach. Conforming to this allows State Auto to
take advantage of its provider's facilities for business recovery in the event
that an external Y2K issue that was addressed does happen to fail.
Safe Harbor Statement Under the Private Securities Litigation Reform Act of 1995
- --------------------------------------------------------------------------------
Statements contained herein expressing the beliefs of management and the other
statements, which are not historical facts contained in this report, are forward
looking statements that involve risks and uncertainties. Such statements
include, without limitation, those pertaining to the weather related
catastrophes impacting the Company's losses, product offerings, the Year 2000
discussion, the statements relating to the new insurer, State Auto Insurance
Company, the legislative and regulatory environment and sales forecasts. These
risks and uncertainties include, but are not limited to, legislative changes at
both the state and federal level, state and federal regulatory rule making
promulgations, class action litigation involving the insurance industry and
judicial decisions affecting claims, policy coverages and the general costs of
doing business, 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.
<PAGE> 16
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
- ---------------------------------------------------------------
The information called for by this item is provided under the caption "Market
Risk" under Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations.
<PAGE> 17
STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES
PART II. OTHER INFORMATION
Item 1. Legal Proceedings - None
Item 2. Changes in Securities and Use of Proceeds - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders - None
Item 5. Other Information - None
INDEX TO EXHIBITS
Item 6. a. Exhibits
Exhibit No. Description of Exhibits
----------- -----------------------
27 Financial data schedules
b. Reports on Form 8-K - None
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
STATE AUTO FINANCIAL CORPORATION
Date: NOVEMBER 12, 1999 /s/ Steven J. Johnston
-------------------------------------
Steven J. Johnston
Treasurer and Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
<TABLE> <S> <C>
<ARTICLE> 7
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM STATE AUTO
FINANCIAL CORPORATION'S QUARTERLY REPORT ON FORM 10-Q FOR THE INTERIM PERIOD
ENDED SEPTEMBER 30, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<DEBT-HELD-FOR-SALE> 526,360,000
<DEBT-CARRYING-VALUE> 45,181,000
<DEBT-MARKET-VALUE> 0
<EQUITIES> 46,617,000
<MORTGAGE> 0
<REAL-ESTATE> 0
<TOTAL-INVEST> 618,158,000
<CASH> 26,476,000
<RECOVER-REINSURE> 0
<DEFERRED-ACQUISITION> 28,803,000
<TOTAL-ASSETS> 757,561,000
<POLICY-LOSSES> 243,096,000
<UNEARNED-PREMIUMS> 157,762,000
<POLICY-OTHER> 0
<POLICY-HOLDER-FUNDS> 0
<NOTES-PAYABLE> 30,000,000
0
0
<COMMON> 105,581,000
<OTHER-SE> 217,173,000
<TOTAL-LIABILITY-AND-EQUITY> 757,561,000
295,558,000
<INVESTMENT-INCOME> 25,374,000
<INVESTMENT-GAINS> 2,660,000
<OTHER-INCOME> 8,985,000
<BENEFITS> 203,442,000
<UNDERWRITING-AMORTIZATION> 0
<UNDERWRITING-OTHER> 84,991,000
<INCOME-PRETAX> 39,094,000
<INCOME-TAX> 9,313,000
<INCOME-CONTINUING> 29,781,000
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 29,781,000
<EPS-BASIC> 0.72
<EPS-DILUTED> 0.71
<RESERVE-OPEN> 0
<PROVISION-CURRENT> 0
<PROVISION-PRIOR> 0
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</TABLE>
