Management’s Discussion and Analysis of Financial Condition and Results of Operations
Qualitative and Quantitative Disclosures about Market Risk
Financial Statements and Supplementary Data
Reports of Independent Registered Public Accounting Firm
Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
Controls and Procedures
Other Information
Part III
Directors, Executive Officers and Corporate Governance
Executive Compensation
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Certain Relationships and Related Transactions, and Director Independence
Principal Accountant Fees and Services
Part IV
Exhibits and Financial Statement Schedules
Signatures
IMPORTANT INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
All statements, other than statements of historical facts, included in this Annual Report on Form 10-K of State Auto Financial Corporation (“State Auto Financial” or “STFC”) for the fiscal year ended December 31, 2020 (this “Form 10-K”), or incorporated herein by reference, including, without limitation, statements regarding State Auto Financial’s future financial position, business strategy, budgets, projected costs, goals and plans and objectives of management for future operations, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “believe” or “continue” or the negative thereof or variations thereon or similar terminology. Forward-looking statements speak only as the date the statements were made. Although State Auto Financial believes that the expectations reflected in forward-looking statements have a reasonable basis, it can give no assurance that these expectations will prove to be correct. Forward-looking statements are subject to risks and uncertainties that could cause actual events or results to differ materially from those expressed in or implied by the statements. For a discussion of the most significant risks and uncertainties that could cause State Auto Financial’s actual results to differ materially from those projected, see “Risk Factors” in Item 1A of this Form 10-K. Except to the limited extent required by applicable law, State Auto Financial undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
IMPORTANT DEFINED TERMS USED IN THIS FORM 10-K
Glossary of Terms for State Auto Financial Corporation and Its Subsidiaries and Affiliates
State Auto Financial or STFC
Refers to our holding company, State Auto Financial Corporation.
We, us, our or the Company
Refers to STFC and its consolidated subsidiaries, namely State Auto Property & Casualty Insurance Company (“State Auto P&C”), Milbank Insurance Company (“Milbank”), State Auto Insurance Company of Ohio (“SA Ohio”), and Stateco Financial Services, Inc. (“Stateco”).
State Auto Mutual
Refers to State Automobile Mutual Insurance Company, which owns approximately 59.1% of STFC’s outstanding common shares.
STFC Pooled Companies
Refers to State Auto P&C, Milbank, and SA Ohio.
Mutual Pooled Companies
Refers to State Auto Mutual, and certain subsidiaries and affiliates of State Auto Mutual, namely, State Auto Insurance Company of Wisconsin (“SA Wisconsin”), Meridian Security Insurance Company (“Meridian Security”), Patrons Mutual Insurance Company of Connecticut (“Patrons Mutual”), Rockhill Insurance Company (“RIC”), Plaza Insurance Company (“Plaza”), American Compensation Insurance Company (“American Compensation”) and Bloomington Compensation Insurance Company (“Bloomington Compensation”).
Pooled Companies or our Pooled Companies
Refers to the STFC Pooled Companies and the Mutual Pooled Companies.
Rockhill Insurers
Refers to RIC, Plaza, American Compensation and Bloomington Compensation.
State Auto Group
Refers to the Pooled Companies
Glossary of Selected Insurance and Accounting Terms
Accident year
The calendar year in which loss events occur, regardless of when the losses are actually reported, booked or paid.
Accounting standards codification or ASC
The Codification is the single source of authoritative nongovernmental GAAP developed by the Financial Accounting Standards Board (“FASB”).
Admitted insurer
An insurer licensed to transact insurance business within a state and subject to comprehensive policy rate, form and market conduct regulation by that state’s insurance regulatory authority.
American Institute of Certified Public Accountants or AICPA
The AICPA represents the certified public accounting profession nationally regarding rule-making and standard-setting, and serves as an advocate before legislative bodies, public interest groups and other professional organizations. The AICPA also monitors and enforces compliance with the profession’s technical and ethical standards.
Allocated loss adjustment expenses or ALAE
The costs that can be related to a specific claim, which may include attorney fees, external claims adjusters and investigation costs, among others.
Book value per share
Total common stockholders’ equity divided by the number of common shares outstanding.
Catastrophe loss
Loss and ALAE from catastrophes, where catastrophes are defined as a severe loss caused by various natural events, including hurricanes, hailstorms, tornadoes, windstorms, earthquakes, severe winter weather and fires. Our catastrophe losses are those designated by the Insurance Services Office (“ISO”) Property Claim Services (“PCS”). PCS defines a catastrophe as an event that causes $25.0 million or more in industry insured property losses and affects a significant number of property and casualty policyholders and insurers.
Combined ratio
The sum of the loss and LAE ratio and the expense ratio. A combined ratio under 100% generally indicates an underwriting profit. A combined ratio over 100% generally indicates an underwriting loss.
Debt to capital ratio
The ratio of notes payable to the sum of total stockholders’ equity and notes payable.
Deferred acquisition costs or DAC
Expenses that vary with, and are primarily related to, the production of new and renewal insurance business, and are deferred and amortized to achieve a matching of revenues and expenses when reported in financial statements prepared in accordance with GAAP.
Direct written premiums
The amounts charged by an insurer to insureds in exchange for coverages provided in accordance with the terms of an insurance contract. The amounts exclude the impact of all reinsurance premiums, either assumed or ceded.
Duration
A measure of the sensitivity of a financial asset’s price to interest rate movements.
Earned premiums or premiums earned
The portion of written premiums that applies to the expired portion of the policy term. Earned premiums are recognized as revenue under both SAP and GAAP.
Excess and surplus lines insurance
Specialized property and liability coverages written by non-admitted insurers. These coverages include exposures that do not fit within normal underwriting patterns, involve a degree of risk that is not commensurate with standard rates and/or policy forms, or are not written by admitted insurers because of general market conditions.
Expense ratio or underwriting expense ratio
For SAP, it is the ratio of (i) the sum of statutory underwriting and miscellaneous expenses incurred offset by miscellaneous income (collectively, “underwriting expenses”) to (ii) written premiums. For GAAP, it is the ratio of acquisition and operating expenses incurred to earned premiums.
Financial Accounting Standards Board or FASB
In the United States, a non-governmental body the SEC has charged with establishing and maintaining generally accepted standards for professional accountants.
Generally accepted accounting principles or GAAP
Accounting practices used in the United States of America determined by the FASB and American Institute of Certified Public Accountants (“AICPA”).
Incurred but not reported reserves or IBNR
Estimated losses and LAE that have been incurred but not yet reported to the insurer. This includes amounts for unreported claims, development on known cases, and re-opened claims.
Loss adjustment expenses or LAE
The expenses of settling claims, including legal and other fees, and the portion of general expenses allocated to claim settlement. LAE is comprised of ALAE and ULAE.
Loss and LAE ratio or loss ratio
For both SAP and GAAP, it is the ratio of incurred losses and LAE to earned premiums.
Loss reserves
Liabilities established by insurers and reinsurers to reflect the estimated cost of claims incurred that the insurer or reinsurer will ultimately be required to pay in respect of insurance or reinsurance it has written. Reserves are established for losses and for LAE, and consist of case reserves and IBNR reserves.
Managing general underwriter or MGU
An independent insurance professional firm that acts as an intermediary between the insurer and retail agents, much like a wholesaler. MGUs frequently have binding authority to issue insurance policies on behalf of an insurer that fit into the underwriting guidelines provided by that insurer. MGUs typically are compensated by an override commission on the insurance coverages sold by their sub-agents.
National Association of Insurance Commissioners or NAIC
An organization of the insurance commissioners or directors of all 50 states, the District of Columbia and the five U.S. territories organized to promote consistency of regulatory practices and statutory accounting standards throughout the United States.
Net premiums written to surplus ratio or leverage ratio
A SAP calculation which measures statutory surplus available to absorb losses. This ratio is calculated by dividing the net statutory premiums written for a rolling twelve month period by the ending statutory surplus for the period. For example, a ratio of 1.5 means that for every dollar of surplus, the insurer wrote $1.50 in premiums.
Net written premiums
Direct written premiums plus assumed reinsurance premiums less ceded reinsurance premiums.
Non-admitted insurer or surplus lines carrier
An insurer that is not required to be licensed in a state but is allowed to do business in that state subject to certain regulatory oversight by that state’s insurance regulatory authority. Non-admitted insurers are not subject to most of the rate and form regulations imposed on admitted insurers because they write specialized property and liability coverages, also known as excess and surplus lines insurance, which allows them the flexibility to change coverages offered and rates charged without time constraints and financial costs associated with the filing process. As such, these insurers offer an opportunity for coverage for specialized exposures that otherwise might not be insurable.
Retail agent or retail agency
An independent insurance professional who represents, and acts as an intermediary for, admitted insurers, generally recommending, marketing and selling insurance products and services to insurance consumers.
Return on average equity
The percent derived by dividing net income by average total stockholders’ equity.
Risk-based capital or RBC
A measure adopted by the NAIC and state regulatory authorities for determining the minimum statutory capital and surplus requirements of insurers. Insurers having total adjusted capital less than that required by the RBC calculation will be subject to varying degrees of regulatory action depending on the level of capital inadequacy.
Standard insurance
Insurance which is typically written by admitted insurers. Our personal and commercial insurance segments are comprised of standard insurance.
Statutory accounting practices or SAP
The practices and procedures prescribed or permitted by state insurance regulatory authorities in the United States for recording transactions and preparing financial statements.
Statutory surplus
Under SAP, the amount remaining after all liabilities, including loss reserves, are subtracted from all admitted assets. Admitted assets are assets of an insurer prescribed or permitted by a state to be recognized on the balance sheet prepared in accordance with SAP.
Unallocated loss adjustment expenses or ULAE
The costs incurred in settling claims, such as in-house processing costs, which cannot be associated with a specific claim.
Underwriting gain or loss
Under SAP, earned premiums less loss and LAE and underwriting expenses.
Unearned premiums
The portion of written premiums that applies to the unexpired portion of the policy term. Unearned premiums are not recognized as revenues under both SAP and GAAP.
Wholesale broker
An independent insurance professional who offers specialized insurance products and serves as an intermediary between a retail agent and an insurer, while typically having no contact with the insured. A wholesale broker may represent both admitted and non-admitted insurers, and may offer both standard and excess and surplus lines insurance.
PART I
Item 1. Business
State Auto Financial, through its subsidiaries, is engaged in writing personal and commercial insurance. State Auto Financial’s principal subsidiaries are State Auto P&C, Milbank and SA Ohio, each of which is a property and casualty insurance company, and Stateco, which provides investment management services to affiliated insurance companies.
State Auto Mutual owns approximately 59.1% of State Auto Financial’s outstanding common shares. State Auto Mutual’s other subsidiaries and affiliates include SA Wisconsin, Meridian Security, Patrons Mutual and the Rockhill Insurers, each of which is a property and casualty insurance company. State Auto Mutual and its insurance subsidiaries and affiliates, along with State Auto Financial’s insurance subsidiaries, pool their respective insurance business under the Pooling Arrangement, as further described below.
The State Auto Group markets its insurance products throughout the United States primarily through independent agencies, which include retail agencies and wholesale brokers. All of the property and casualty insurance companies in the State Auto Group are admitted insurers, except for RIC, which is a non-admitted insurer. The operations of the State Auto Group are headquartered in Columbus, Ohio.
The State Auto Group is rated A- (Excellent) by the A.M. Best Company (“A.M. Best”).
FINANCIAL INFORMATION ABOUT SEGMENTS
Our reportable insurance segments are personal insurance and commercial insurance (collectively the “insurance segments”). These insurance segments are business units managed separately from each other due to the differences in the types of customers they serve, products they provide or services they offer. Our investment operations is also a reportable segment. See a detailed discussion regarding our segments at Item 7 of this Form 10-K “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Overview” and Note 1 8 to our consolidated financial statements included in Item 8 of this Form 10-K.
The products within each reportable insurance segment are as follows:
• Personal Insurance Segment - personal auto, homeowners and other personal
• Commercial Insurance Segment - commercial auto, small commercial package, middle market commercial, workers’ compensation, farm and ranch and other commercial
PERSONAL AND COMMERCIAL INSURANCE
Products offered in our personal and commercial insurance segments are marketed exclusively through independent agents, but the segments are managed separately from each other due to the differences in the types of customers they serve, products they provide or services they offer.
Products
Personal Insurance
In our personal insurance segment, we write standard insurance covering personal exposures to individuals. The primary coverages offered are personal auto, homeowners, and other personal (examples of products included in other personal are dwelling fire, personal inland marine and personal umbrella).
Commercial Insurance
In our commercial insurance segment, we write standard insurance covering small to medium sized commercial exposures. We offer a broad range of coverages including commercial auto, small commercial package, middle market commercial, farm & ranch, workers’ compensation and other commercial (examples of products included in other commercial are commercial inland marine, small commercial package umbrella and middle market commercial umbrella).
Marketing
We market our personal and commercial insurance products through approximately 3,400 independent agencies, including traditional retail agents, network agents and platform agents. We view our agents as our primary customers, because they are in a position to either recommend our insurance products or those of a competitor to their customers. We strongly support the independent agency system and believe its maintenance is essential to our present and future success. We continually develop programs and procedures to enhance our agency relationships, including the following: interactions (virtual and in person when able) between senior management and agents; travel and virtual meetings by regional office staff to meet with agents in their home states; training opportunities; and incentives related to profit and growth.
We actively help our agencies develop the professional sales skills of their staff. Our training programs include both product and sales training conducted in our corporate headquarters, and, in response to the COVID-19 pandemic, we transitioned to conducting our training virtually with the intention of offering both in person and virtual training opportunities moving forward. Further, some of our training programs include disciplined follow-up and coaching for an extended time. In addition, from time to time we provide targeted training sessions in our agents’ offices.
We provide our independent agents with defined travel and cash incentives if they achieve certain sales and underwriting profit levels. Further, we recognize our very top agencies—measured by consistent profitability, achievement of written premium thresholds and growth—as Inner Circle Agencies. Inner Circle Agencies are rewarded with additional incentives.
INVESTMENT OPERATIONS
The primary objectives of our investment strategy are to maintain adequate liquidity and capital to meet our responsibilities to policyholders; grow surplus long term to support the growth of our company; provide a consistent level of income; and manage investment risk. Our investment portfolio is managed separately from that of State Auto Mutual and its subsidiaries and affiliates, and investment results are not shared through the Pooling Arrangement, as described below. Stateco performs investment management services for both us and State Auto Mutual and all subsidiaries and affiliates. Investment policies and guidelines are set for each company through the Investment Committee of each company's Board of Directors.
For additional discussion regarding our investments, including the market risks related to our investment portfolio, see Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Investment Operations Segment.”
CLAIMS
Our claims and risk engineering (“CARE”) division supports our insurance segments through emphasis on timely investigation of claims, settlement of meritorious claims for equitable amounts, maintenance of adequate case reserves for claims, sharing of relevant information, and control of external claims adjustment expenses. Achievement of these goals supports our marketing efforts by providing agents and policyholders with prompt and effective service.
We employ a specialized claims model that is skills-based and focused on yielding a quality customer experience regardless of the type and severity of the claim. We staff field adjusters in locations where we have size, scale and density of claims whenever possible to control file quality and enhance customer service. In areas where there is not a sufficient volume of claims to warrant staff adjusters, we supplement our field staff with outside adjusters and appraisers who work under our direction. We utilize the most current technology available to supplement and enhance the customer experience and the claim outcome. This will often times be a “virtual” experience and the customer may even assist with the administration of their claim by submitting photos of damage to their home, business or auto.
Claim settlement authority levels are established for each adjuster, supervisor and manager based on their level of expertise. Our claims division is responsible for reviewing the claim, obtaining necessary documentation and establishing loss and expense reserves of certain claims. Generally, property or casualty claims estimated to reach $100,000 or above are sent to specialists for direct handling.
We minimize claim adjusting costs by settling as many claims as possible through our claims staff and, when appropriate, by settling disputes regarding automobile physical damage, bodily injury and property insurance claims through arbitration or mediation.
In addition to our internal claims adjusters, we utilize third party claims administrators (“TPAs”) to investigate, process and settle certain specialty run-off claims on our behalf. As with our internal claims adjusters, claim settlement authority is established for adjusters, supervisors and managers within each TPA. Claims handling and reporting guidelines are established and provided to each TPA. Members of our internal claims staff perform periodic reviews of individual claim files produced by each TPA for compliance with such established claims handling and reporting guidelines.
We have in-house counsel offices to defend and resolve claims which are in litigation. These offices are strategically placed where we have size, scale and density of legal cases to warrant their existence. We also have a list of highly skilled panel counsel to defend our insureds, when appropriate.
POOLING ARRANGEMENT
Our Pooled Companies pool their respective insurance business in accordance with a quota share reinsurance agreement which we refer to as the “Pooling Arrangement.” In general, 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 a specified portion of premiums, losses and expenses based on each of the Pooled Companies’ respective pooling percentages. The balance of the pooled premiums, losses and expenses are retained by State Auto Mutual.
See the detailed discussion of our Pooling Arrangement at Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Pooling Arrangement.”
GEOGRAPHIC DISTRIBUTION
The following table sets forth the geographic distribution of our direct written premiums and premiums assumed under a quota share agreement with Home State County Mutual Insurance Company for the year ended December 31, 2020:
State
% of Total
Texas (1)
Michigan
Ohio
Kentucky
North Carolina
Illinois
South Carolina
Tennessee
West Virginia
Pennsylvania
Mississippi
Minnesota
All others (2)
Total
Includes premiums assumed under a quota share agreement with Home State County Mutual Insurance Company, whereby we assume 100% of the business issued under this agreement. See Note 7 of the Notes to Condensed Consolidated Financial Statements for additional information regarding this quota share agreement.
No other single state accounted for 3.0% or more of the total direct written premiums written in 2020.
MANAGEMENT AGREEMENT
Through various management and cost sharing agreements, State Auto P&C provides employees to perform all organizational, operational and management functions for the State Auto Group, while State Auto Mutual provides certain operating facilities, including our corporate headquarters.
Our primary management agreement, which we refer to as the 2005 Management Agreement, renewed for an additional ten-year period on January 1, 2015. If the 2005 Management Agreement was terminated for any reason, we would have to relocate our facilities to continue our operations. See “Properties” included in Item 2 of this Form 10-K.
REINSURANCE
Members of the State Auto Group follow the customary industry practice of reinsuring a portion of their exposures and paying to the reinsurers a portion of the premiums received. Insurance is ceded principally to reduce net liability on individual risks or for individual loss occurrences, including catastrophic losses. Although reinsurance does not legally discharge the individual members of the State Auto Group from primary liability for the full amount of limits applicable under their policies, it does make the assuming reinsurer liable to the extent of the reinsurance ceded. See the detailed discussion of our reinsurance arrangements at Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Reinsurance Arrangements.”
See “Regulation” in this Item 1 for a discussion of the Terrorism Acts.
LOSS RESERVES
Our loss reserves reflect all unpaid amounts for claims that have been reported, as well as for claims that have not yet been reported. Our loss reserves are not discounted to present value. Loss reserves are management’s best estimates at a given point in time of what we expect to pay to settle all claims incurred as of that date based on known facts, circumstances and historical trends. During the loss settlement period, additional facts regarding individual claims may become known, and consequently, it often becomes necessary to revise our estimate of the liability. The results of our operations and financial
condition could be impacted, perhaps significantly, in the future if our estimate of ultimate payments required to settle claims varies from the loss reserves currently recorded.
Loss reserves at the individual claim level are established on either a case reserve basis or formula reserve basis depending on the type and circumstances of the loss. The case reserve amounts are determined by claims adjusters based on our reserving practices, which take into account the type of risk, the circumstances surrounding each claim and applicable policy provisions. The formula reserves are based on historical data for similar claims with provision for changes caused by inflation. Case reserves and formula reserves are reviewed on a regular basis, and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis and not settled after six months are case reserved at that time. While a variety of factors are considered, there is no single method for determining the ultimate losses, and thus, our loss reserves. When unanticipated changes in the various factors do occur, those changes are incorporated in subsequent valuations of our reserves. For additional information regarding our reserves, see Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations— and LAE.”
The following table sets forth our one-year development information on changes in the loss reserve for the years ended December 31, 2020, 2019 and 2018:
($ millions)
Year Ended December 31
Beginning of Year:
Loss and loss expenses payable
Less: Reinsurance recoverable on losses and loss expenses payable
Net losses and loss expenses payable (1)
Provision for losses and loss expenses occurring:
Current year
Prior years (2)
Total
Loss and loss expense payments for claims occurring during:
Current year
Prior years
Total
End of Year:
Net losses and loss expenses payable
Add: Reinsurance recoverable on losses and loss expenses payable
Losses and loss expenses payable (3)
Includes net amounts assumed from affiliates of $500.8 million, $593.6 million, and $711.4 million at beginning of year 2020, 2019, and 2018, respectively.
This line item shows changes in the current calendar year in the provision for losses and loss expenses attributable to claims occurring in prior years. See discussion regarding the calendar year developments at Item 7 of this Form 10-K Management’s Discussion and Analysis section at “Results of Operations—Loss and LAE Development.”
Includes net amounts assumed from affiliates of $438.8 million, $500.8 million, and $593.6 million, at end of year 2020, 2019, and 2018, respectively.
COMPETITION
The property and casualty insurance industry is highly competitive. We compete with numerous insurance companies, with varying sizes and financial resources, in the personal and commercial insurance markets based on the following factors: price; product offerings and innovation; underwriting criteria; quality of service to insureds; relationships with our independent agents and wholesale brokers; prompt and fair claims handling and settlement; financial stability; and technology. In addition, because most of our retail agents and wholesale brokers represent more than one insurer, we face competition within each agency and broker.
REGULATION
Most states, including all the domiciliary states of the State Auto Group, have enacted legislation that regulates insurance holding company systems. Each insurance company in our holding company system is required to register with the insurance supervisory agency of its state of domicile and furnish information concerning the operations of companies within our holding company system that may materially affect the operations, management or financial condition of the insurers within the system. Pursuant to these laws, the respective insurance departments may examine any members of the State Auto Group, at any time, require disclosure of material transactions involving insurer members of our holding company system, and require prior notice and an opportunity to disapprove of certain “extraordinary” transactions, including, but not limited to, extraordinary dividends to shareholders. Additionally, these laws require that all transactions within our holding company system affecting any insurance subsidiary within the State Auto Group are fair and equitable. In addition, approval of the applicable state insurance commissioner is required prior to the consummation of transactions affecting the control of an insurer. The insurance laws of all the domiciliary states of the State Auto Group provide that no person may acquire direct or indirect control of a domestic insurer without obtaining the prior written approval of the state insurance commissioner for such acquisition.
In addition to being regulated by the insurance department of its state of domicile, each of our insurance companies is subject to supervision and regulation in the states in which we transact business. Such supervision and regulation relate to numerous aspects of an insurance company’s business operations and financial condition. The primary purpose of such supervision and regulation is to ensure financial stability of insurance companies for the protection of policyholders. The laws of the various states establish insurance departments with broad regulatory powers relative to granting and revoking licenses to transact business, regulating trade practices, licensing agents, approving policy forms, setting reserve requirements, determining the form and content of required statutory financial statements, prescribing the types and amount of investments permitted and requiring minimum levels of statutory capital and surplus. Although premium rate regulation varies among states and lines of insurance, such regulations generally require approval of the regulatory authority prior to any changes in rates. In addition, all of the states in which the State Auto Group transacts business have enacted laws which restrict these companies’ underwriting discretion. Examples of these laws include restrictions on policy terminations, restrictions on agency terminations and laws requiring companies to accept any applicant for automobile insurance. These laws may affect the ability of the insurers in the State Auto Group to earn a profit on their underwriting operations.
The Risk Management and Own Risk Solvency Assessment Model Act (“ORSA”), adopted by the NAIC in 2012, requires insurers to incorporate a comprehensive enterprise risk management framework within company operations. Overall, ORSA is an internal assessment of the risks associated with an insurer’s business and the sufficiency of capital resources to support those risks. Each insurer’s ORSA process will be unique, reflecting its business, strategy and approach to enterprise risk management. In 2020, the State Auto Group filed its ORSA Summary Report, supported by internal risk management materials, with the Ohio Department of Insurance, our lead state regulator.
We are required to file detailed annual reports with the supervisory agencies in each of the states in which we do business, and our business and accounts are subject to examination by such agencies at any time.
There can be no assurance that such regulatory requirements will not become more stringent in the future and have an adverse effect on the operations of the State Auto Group.
Dividends . Our insurance subsidiaries generally are restricted by the insurance laws of our respective states of domicile as to the amount of dividends we may pay without the prior approval of our respective state regulatory authorities. Generally, the maximum dividend that may be paid by an insurance subsidiary during any year without prior regulatory approval is limited to the greater of a stated percentage of that subsidiary’s statutory surplus as of a certain date, or adjusted net income of the subsidiary for the preceding year. Under current law, $91.0 million is available in 2021 for payment as a dividend from our insurance subsidiaries to STFC without prior approval from our respective domiciliary state insurance departments. STFC received dividends of $15.0 million, $10.0 million and $10.0 million in 2020, 2019 and 2018, respectively, from its insurance subsidiaries. Additional information regarding dividend restrictions can be found in this Item 7 and in Note 14 to our consolidated financial statements included in Item 8 of this Form 10-K.
Rates and Related Regulation . Except as discussed below, we are not aware of the adoption of any material adverse legislation or regulation in any state in which we conducted business during 2020 which would materially impact our business.
Many states in which we operate have passed or are considering legislation restricting or banning the use of credit scoring in the rating and risk selection process. There are a few states that have proposed making driving information the only variable to rate auto policies, leading to mandatory usage-based rating. Some states are also becoming active in questioning the use of catastrophe modeling in the pricing and underwriting areas. Regulation risk is realized when states do not approve or limit the amount of rate a company can charge which may result in writing underpriced business. See “Risk Factors - Regulations” in Item 1A of this Form 10-K.
In an attempt to make capital and surplus requirements more accurately reflect the underwriting risk of different lines of insurance, as well as investment risks that attend insurers’ operations, the NAIC annually tests insurers’ risk-based capital requirements. As of December 31, 2020, each of the Pooled Companies had adequate levels of capital as defined by the NAIC with its respective risk-based capital requirements.
The property and casualty insurance industry is also affected by court decisions. In general, premium rates are actuarially determined to enable an insurance company to generate an underwriting profit. These rates contemplate a certain level of risk. The courts may modify, in a number of ways, the level of risk which insurers had expected to assume, including eliminating exclusions, expanding the terms of the contract, multiplying limits of coverage, creating rights for policyholders not intended to be included in the contract and interpreting applicable statutes expansively to create obligations on insurers not originally considered when the statute was passed. Courts have also undone legal reforms passed by legislatures, which reforms were intended to reduce a litigant’s rights of action or amounts recoverable and so reduce the costs borne by the insurance mechanism. These court decisions can adversely affect an insurer’s profitability. They also create pressure on rates charged for coverages adversely affected, and this can cause a legislative response resulting in rate suppression that can unfavorably impact an insurer.
The Terrorism Risk Insurance Act of 2002 was extended in 2005, 2007 and again in 2019. The 2019 reauthorization of the Terrorism Risk Insurance Act provides an extension through 2027. Under these Terrorism Acts, commercial property and casualty insurers like State Auto Group, in exchange for making terrorism coverage available, may be entitled to be reimbursed by the Federal Government for a portion of their aggregate losses. As required by the Terrorism Acts, we offer policyholders in specific lines of commercial insurance the option to elect Terrorism coverage. In order for a loss to be covered under the Terrorism Act, the loss must meet the aggregate industry loss minimum and must be the result of an act of terrorism as certified by the Secretary of the Treasury. Policyholders may choose to reject terrorism coverage (terrorism coverage is mandatory for workers compensation). If the policyholder rejects coverage for certified acts of terrorism, we will only cover such acts of terrorism that are not certified acts under the Terrorism Acts and continue to apply policy exclusions that may limit any coverage from loss due to nuclear, biological or chemical agents. Our current commercial property reinsurance excludes certified acts of foreign terrorism and due to nuclear, biological or chemical agents. Insurers participating in the Terrorism Acts are required to provide information regarding insurance coverage for terrorism , including; (i) lines of business with exposure to such ; (ii) premiums earned on such coverage; (iii) geographical location of exposures; (iv) pricing of such coverage; (v) the take-up rate for such coverage; and (vi) the amount of private reinsurance for acts of terrorism purchased. See Risk Factors- Terrorism" in Item 1A of this From 10-K.
The Federal Insurance Office (“FIO”) was established in 2010 by the enactment of the Dodd-Frank Act. The FIO is a separate office within the United States Department of Treasury. The primary objective of the FIO is to monitor all aspects of the insurance industry, including identifying issues or gaps in the regulation of insurers that could contribute to a systemic crisis in the insurance industry or the United States financial system. The FIO also coordinates and develops federal policy on prudential aspects of international insurance matters, including representing the United States in the International Association of Insurance Supervisors, assists in negotiating certain international agreements, monitors access to affordable insurance by traditionally underserved communities and consumers, minorities, and low- and moderate-income persons, and assists in the administration of the terrorism risk insurance program; however, the FIO has no authority as a regulator or supervisor of insurance companies.
As the result of COVID-19, many states have either mandated that insurers provide grace periods for the payment of premiums or requested insurers to provide such grace periods in the event an insured requests payment deferral. We have complied with these payment extension periods in those states where we do business. Some states have issued regulatory guidance encouraging premium relief or return of premium to insureds. We have voluntarily, under certain circumstances and subject to regulatory approval, provided a one-time 5% premium discount to our personal auto insureds at the next renewal of their existing policies. There have been efforts at the state and federal levels to implement legislation that would expand the scope of business interruption insurance to include business closures related to COVID-19, although we are not aware of any such legislation being enacted at this time.
HUMAN CAPITAL MANAGEMENT
We believe our success depends on the strength of our employees. The Senior Vice President, Associate and External Relations (“SVP Associate and External Relations”) is responsible for developing and executing our human capital strategy, in close partnership with the Chief Executive Officer (“CEO”), who sets top priorities and determines central challenges. Our human capital strategy includes the acquisition, development, and retention of talent to execute our strategies as well as the design of employee compensation and benefits programs. The SVP Associate and External Relations and the CEO regularly update our Board of Directors on the operation and status of these human capital initiatives. We had approximately 2,025 employees as of March 5, 2021.
Associate Culture
A critical element of our business transformation of the past five years has been the corresponding transformation of our culture. At the foundation of our culture is mutual respect and trust for one another. Our culture of honesty, integrity and accountability is critical to our long-term success. Reflecting that culture, we offer our employees a "Time Away" program that allows them to balance their work and personal life so that they can take the time they need when they need it with no set number of days off. We understand that our employees do their best work when they are well rested and healthy.
We advocate a coaching culture instead of performance reviews; we believe in continuously coaching one another to improve every day. Because we value the feedback provided by our employees and use the information for organizational growth, we conduct annual engagement surveys so our employees can voice their opinions and provide open feedback on job satisfaction and leadership effectiveness.
In addition to competitive wages, we offer a variety of core benefits, such as health insurance, retirement savings, days off to volunteer in the community, and long-term disability and life insurance, flexible work hours, and work-from-home options, as well as many special programs that appeal to associates while aligning with our corporate values. All full-time employees are eligible for our One Team Incentive Plan, an annual cash bonus based on our ability as a company to work together to create value for shareholders and policyholders.
We have streamlined our recruiting processes with the introduction of artificial intelligence, which has enabled us to find previously untapped talent, and has positively impacted the diversity of our candidate pools. We offer internships, part-time opportunities, and a work-study program, that attract college students from all over the country and provide real-world work experience. We offer training and learning opportunities via classroom events, web conferences and online classes and a robust tuition assistance program to continue to develop our employees’ expertise and skills.
Diversity, Equity & Inclusion
An organization that consistently accepts and encourages diversity of thought, opinion and people is more effective. As a business imperative, we believe a diverse organization will best understand the needs of the communities in which we live and work and our diverse markets, enabling us to achieve better outcomes. By encouraging people from all backgrounds to express their thoughts and ideas freely, we make better decisions. We become more inclusive by not wasting a single voice. We believe a robust dialog, especially when we disagree, makes us stronger and diverse voices drive innovation.
In 2020, we made a conscious decision to identify a Culture and Inclusion Leader to assist in maintaining a consistent focus on the importance of diversity and inclusion as a key fiber in the fabric of our organization. We held a series of employee conversations hosted by President and CEO Mike LaRocco to share experiences and discuss ideas to combat systemic racism both from individual and corporate perspectives. We supplemented these conversations with unconscious bias training for all employees, supported by facilitated debrief sessions to further the conversation. President and CEO Mike LaRocco signed the CEO Action for Diversity & Inclusion™ Pledge to show his commitment to taking actions that support a more inclusive workplace. The CEO Action Pledge aims to rally the business community to advance diversity and inclusion within the workplace. State Auto is committed to a work environment in which all individuals are treated with respect and dignity.
Community Service
Each year, we take purposeful steps to strengthen our commitment to the community. With an employee base that spans the country and a diverse employee population that values a wide variety of initiatives, we empower our team to support the missions that are near to their hearts through both financial giving and volunteer support. Our State Auto Foundation administers a trust fund dedicated to helping other charitable organizations that support the community to address poverty, food insecurity, housing, health and wellness, and education.
Health & Safety
Providing a safe and secure work environment for our employees is a top priority. Our Safety & Security Policy and Emergency Preparedness Plan enforce those ideals by outlining regulations against illegal and illicit activities to help ensure that we have plans in place for emergencies, respectively.
COVID-19
Our top priority during the COVID-19 pandemic has been protecting the health and safety of our employees. We have offered our employees full autonomy to choose how and where they work during the pandemic. We have worked to ensure compliance with government requirements in our locations while continuing to operate the business and providing the services our customers need. We have increased safety procedures in all our locations with special consideration for our employees who continue to work onsite.
The investments that were part of our digital transformation enabled us to move to remote work quickly and seamlessly at the outset of the COVID-19 pandemic. Our independent agents quickly embraced working with us in this more digital and
virtual environment. We believe this shift will change the way we work as a company and with our independent agents moving forward. We expect a continued reduction in daily commutes and business travel, and more virtual engagement between employees and with our independent agents to best serve our customers.
In recognition of the additional pressures that our employees are experiencing during the pandemic, we introduced “State Auto For You,” a series of enhanced programs and benefits to help employees through the COVID-19 pandemic, and beyond. State Auto For You includes an expansion of the existing wellness reimbursement, plus newly eligible categories of child, elder and disabled care and educational assistance. This will help with the increased cost and reduced availability of care and support employees with children who may need tutoring or other help with schooling.
AVAILABLE INFORMATION
Our website address is www.StateAuto.com. Through this website (found by clicking the “Investors” link, then the “All SEC Filings” link), we make available, free of charge, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy and information statements and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), as soon as reasonably practicable after we electronically file such material with the Securities and Exchange Commission (the “SEC”). Also available on our website is information pertaining to our corporate governance, including the charters of each of our standing committees of our Board of Directors, our corporate governance guidelines, our employees’ code of business conduct and our directors’ ethical principles.
Any of the materials we file with the SEC may also be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. Information on the operation of the SEC’s Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.
Information about our Executive Officers
Name of Executive Officer and
Position(s) with Company
Age (1)
Principal Occupation(s)
During the Past Five Years
An Executive Officer
of the Company Since (2)
Michael E. LaRocco,
Chairman, President and Chief Executive Officer
President and Chief Executive Officer of STFC and State Auto Mutual, 5/15 to present; Chairman of the Board of STFC, 1/16 to present; chief executive officer of Business Insurance Direct LLC, 10/11 to 4/15; chief executive officer of AssureStart Insurance Agency LLC, 1/13 to 7/14; chief executive officer of Fireman’s Fund Insurance Company, 3/08 to 7/11.
Steven E. English,
Senior Vice President, Chief Financial Officer
Senior Vice President of STFC and State Auto Mutual, 8/13 to present; Vice President of STFC and State Auto Mutual, 5/06 to 7/13; Chief Financial Officer of STFC and State Auto Mutual, 12/06 to present.
Jason E. Berkey,
Senior Vice President, Data and Analytics
Senior Vice President of Data and Analytics of STFC and State Auto Mutual, 1/20 to present; Vice President of Personal Lines of STFC and State Auto Mutual, 9/17 to 1/20; Vice President of STFC and State Auto Mutual, 10/15 to 9/17; vice president of American Insurance Group (“AIG”), 1/04 to 7/15.
Melissa A. Centers,
Senior Vice President, Secretary and General Counsel
Senior Vice President, Secretary and General Counsel of STFC, 11/15 to present; General Counsel and Secretary of State Auto Mutual, 11/15 to present; Assistant Secretary of STFC and State Auto Mutual, 11/12 to 11/15; Associate General Counsel of STFC and State Auto Mutual, 3/12 to 11/15; Assistant General Counsel of STFC and State Auto Mutual, 6/10 to 3/12.
Kim B. Garland,
Senior Vice President, Personal & Commercial Lines and State Auto Labs
Senior Vice President of Personal & Commercial Lines of STFC and State Auto Mutual, and State Auto Labs, 1/20 to present, Senior Vice President of Commercial Lines of STFC and State Auto Mutual, 9/17 to 1/20; Senior Vice President of Standard Lines of STFC and State Auto Mutual, 8/15 to 9/17; chief product officer of AIG consumer division, 1/13 to 12/14; chief underwriting officer of AIG’s global consumer insurance division, 12/12 to 1/13; president and chief executive officer of United Guaranty Corporation (“UGC”), an affiliate of AIG, 2/12 to 12/12; chief operating officer of UGC, 6/09 to 12/12.
Elise D. Spriggs,
Senior Vice President, Associate and External Relations
Senior Vice President, Associate and External Relations of STFC and State Auto Mutual, 10/17 to present; Senior Vice President, External and Government Affairs of STFC and State Auto Mutual, 3/16 to present; vice president and director of government relations, 7/11 to 6/15. Attorney, Carpenter, Lipps & Leland LLP, 06/15 to 03/16.
Paul M. Stachura,
Senior Vice President, Chief CARE Officer
Senior Vice President and Chief CARE Officer of STFC and State Auto Mutual, 9/15 to present; chief claims officer, of QBE Holdings, Inc., 5/13 to 9/15; chief claims and risk services officer of Fireman’s Fund Insurance Company, 5/05 to 4/13.
Gregory A. Tacchetti,
Senior Vice President, Chief Information and Strategy Officer
Senior Vice President and Chief Information and Strategy Officer of STFC and State Auto Mutual, 8/15 to present; chief executive officer of AssureStart Insurance Agency LLC, 7/14 to 12/14; chief operating officer of AssureStart Insurance Agency LLC, 10/11 to 6/14; senior vice president and chief administrative officer of Fireman’s Fund Insurance Company, 2008 to 10/11.
Scott A. Jones,
Vice President, Chief Investment Officer
Vice President and Chief Investment Officer of STFC and State Auto Mutual, 3/12 to present; Assistant Vice President of STFC and State Auto Mutual, 8/09 to 3/12.
Matthew S. Mrozek,
Vice President, Chief Actuarial Officer
Vice President and Chief Actuarial Officer of STFC and State Auto Mutual, 3/09 to present.
Matthew R. Pollak,
Vice President, Chief Accounting Officer and Treasurer
Vice President, Chief Accounting Officer and Treasurer of STFC and State Auto Mutual, 4/13 to present; vice president, corporate finance and accounting of American Safety Insurance Holdings, Ltd. 2/10 to 4/13.
Age as of March 10, 2021.
Each of the foregoing officers has been designated by our Board of Directors as an executive officer for purposes of Section 16 of the Exchange Act.
Item 1A. Risk Factors
Statements contained in this Form 10-K may be “forward-looking” within the meaning of Section 21E of the Exchange Act. Such forward-looking statements are subject to certain risks and uncertainties that could cause our operating results to differ materially from those projected. The following factors, among others, in some cases have affected, and in the future could affect, our actual financial performance. If any risks or uncertainties discussed below develop into actual events, then such events could have a material adverse effect on our business, reputation, liquidity, capital resources, financial position or results of operations. In that case, the market price of our stock could decline materially.
The risk factors might affect, alter, or change actions we take in developing or executing our strategies, including, but not limited to, capital management. We employ a number of risk management approaches to reduce our exposure to risk, all of which have inherent limitations. The failure of our risk management actions could have material adverse effects on our business, reputation, liquidity, capital resources, financial position or results of operations.
The following list of risk factors is not exhaustive and others may exist or develop. This information should be carefully considered together with the other information included in this Form 10-K and in other reports and materials we file with the SEC, as well as news releases and other information we publicly disseminate from time to time.
RISKS RELATING TO STATE AUTO FINANCIAL CORPORATION
CREDIT AND FINANCIAL STRENGTH RATINGS
A downgrade in our financial strength ratings may negatively affect our business and reputation and a downgrade in our credit rating could negatively affect the cost and availability of debt financing.
Insurance companies are subject to financial strength ratings produced by external rating agencies. Higher ratings generally indicate financial stability and a strong ability to pay claims. Ratings are assigned by rating agencies to insurers based upon factors that they believe are relevant to policyholders and creditors. Ratings are important to maintaining public confidence in our Company and in our ability to market our products. A downgrade in our financial strength ratings could, among other things, negatively affect our ability to sell certain insurance products, our relationships with agents and our ability to compete.
Although other rating agencies cover the property and casualty industry, we believe our ability to write business is most influenced by our rating from A.M. Best. According to A.M. Best, its ratings are designed to assess an insurer’s financial strength and ability to meet ongoing obligations to policyholders. The State Auto Group’s current financial strength rating from A.M. Best is A- (Excellent) with a stable outlook.
Generally, credit ratings affect the cost, type and availability of debt financing. Higher rated securities receive more favorable pricing and terms relative to lower rated securities at the time of issue. The State Auto Group’s current credit rating from A.M. Best is bbb- with a stable outlook.
Depending on future results and developments, we may not be able to maintain our current ratings.
DIVIDENDS
There can be no assurance that we will continue to pay cash dividends consistent with current or past levels.
We have a history of consistently paying cash dividends to our shareholders; however, the future payment of cash dividends will depend upon a variety of factors, such as our results of operations, financial condition and cash requirements, as well as the ability of our insurance subsidiaries to make distributions to STFC. State insurance laws restrict the payment of dividends by insurance companies to their shareholders. In addition, competitive pressures generally require insurance companies to maintain insurance financial strength ratings. Such restrictions and other requirements and factors may affect the ability of our insurance subsidiaries to make dividend payments to STFC. Limits on the ability of our insurance subsidiaries to pay dividends could adversely affect STFC’s liquidity, including STFC’s ability to pay cash dividends to shareholders.
TECHNOLOGY AND TELECOMMUNICATION SYSTEMS
Our business success and profitability depend, in part, on effective information technology and telecommunication systems. If we are unable to keep pace with the rapidly developing technological advancements in the insurance industry, our ability to compete effectively could be impaired.
We depend in large part on our technology and telecommunication systems for conducting business and processing claims. Our business success is dependent on maintaining the effectiveness of existing technology and telecommunication systems and on their continued development and enhancement to support our business processes and strategic initiatives in a cost effective manner.
If we are unable to effectively execute our top initiatives and projects, we may not meet organizational objectives due to cost overruns, missed project milestones, defects and/or failing to deliver the desired business value.
An ongoing challenge during system development and enhancement is the effective and efficient utilization of our current technology in view of a constantly changing technological landscape. There can be no assurance that the development of current technology for future use will not result in our being competitively disadvantaged, especially with those carriers that have greater resources. If we are unable to keep pace with the advancements being made in technology, our ability to compete with other insurance companies who have advanced technological capabilities will be negatively affected. Further, if we are unable to effectively execute and update or replace our key legacy technology and telecommunication systems as they become obsolete or as emerging technology renders them competitively inefficient, our competitive position and/or cost structure could be affected.
System implementations are complex processes requiring extensive planning and coordination among multiple stakeholder groups. During 2020, we initiated the rollout of our “State Auto Connect” digital quote and issue platform for our Farm and Ranch, Workers’ Compensation, and Middle Market Commercial lines of business. We should complete the rollout for these three lines in all states by the end of 2021. All of our new business sales should be on the Connect platform by the end of 2021. These digital technology platforms are intended to provide us with quicker speed to market, improve ease of doing business for our policyholders and agents, lower our costs for maintenance and product introductions, and provide greater operational efficiency. However, even with our best planning and efforts and the involvement of third party expertise, there can be no assurance that the expected benefits will be realized upon implementation or that the transition will be completed within the planned time frame or budget. Such risks are also present in other key initiatives and projects planned for 2021 and beyond.
If we experience difficulties with outsourcing or other third party relationships, our ability to conduct business might be negatively impacted.
From time to time we may outsource certain business, information technology or administrative functions or otherwise rely on third parties for the performance of such functions for efficiency and cost saving purposes. If we fail to develop and implement our sourcing strategies or our third party providers fail to perform as expected, we may experience operational difficulties, increased costs, and a loss of business that may have a negative impact on our results of operations or financial condition.
DISTRIBUTION SYSTEM
Our independent agents, who are part of the independent agency distribution channel, are our sole distribution method for our personal and commercial insurance products. Our exclusive use of such distribution may constrain our ability to grow at a comparable pace to our competitors that utilize multiple distribution channels. In addition, consumers may prefer to purchase insurance products through other means, such as the internet, rather than through agents.
We market our insurance products exclusively through independent, non-exclusive insurance agents, whereas some of our competitors sell their insurance products through direct marketing techniques, the internet or “captive” insurance agents who sell products exclusively for one insurance company. Throughout its history, the State Auto Group has supported the independent agency system as our distribution channel. However, while we recognize that the number of distribution locations has expanded and the size of many agencies has grown, the number of individual independent agencies in the industry has dramatically shrunk over the past decade due to agency purchases, consolidations, bankruptcies and agent retirements. We also recognize that it may become more difficult to expand the number of independent agencies representing us. If we are unsuccessful in maintaining and increasing our agency representation, our sales and results of operations could be adversely affected.
The retail agents that market and sell our products also sell products of our competitors. These agents may recommend our competitors’ products over our products or may stop selling our products altogether. When price competition is intense, our premium production may be negatively impacted by the fact our independent agent distribution force has products to sell from other carriers that may be more willing to lower prices to grow top line sales. Consequently, we must remain focused on attracting and partnering with agents to market and sell our products. Our independent agents include network agents, which are traditional retail agents that have affiliated with a group, and corporate-owned agents, which are geographically diverse retail locations with common ownership. We compete for productive agents primarily on the basis of our financial position, support services, ease of doing business, compensation and product features. Although we make efforts to ensure we have strong relationships with our independent agents, we may not be successful and our sales and results of operations could be adversely affected.
In addition, consumers are increasingly using the internet and other alternative channels to purchase insurance products. While our website provides a significant amount of information about our insurance products, consumers cannot purchase insurance through our website. Instead, consumers must contact one of our independent agents to purchase our insurance products or make changes to their policies. We have expanded our distribution channel to include platform agents. These agents
are accessed by clients via the Internet and do not have retail locations. Nevertheless, our distribution system may place us at a disadvantage with consumers who prefer to purchase insurance products only online.
Additionally, in any given period we may drive a significant portion of our business from a limited number of agents and the loss of any of these relationships could have a significant impact on our ability to market our products and services. Likewise, in certain jurisdictions, when the insured remits payments to the agent in full, our premiums are considered to have been paid in full, notwithstanding that we may or may not have actually received the premiums from the agent. Consequently, we assume a degree of risk associated with certain agents with whom we transact business.
The insurance marketplace is evolving and independent insurance agency distribution systems are growing rapidly. Our success depends on our ability and our independent agents’ ability to react to these changes.
As the insurance industry changes and the growth of the independent insurance agency distribution system evolves, our ability to adapt to these changes with our agents is critical. An influx of agencies are joining larger independent network agencies. Our dependence on network agencies and the percentage of the book of business they write with us can be positively or negatively affected by the collective business decisions those network agencies make.
CONTROL BY OUR PARENT COMPANY
State Auto Mutual owns a significant interest in us and may exercise its control in a manner detrimental to the interests of other STFC shareholders.
As of December 31, 2020, State Auto Mutual owned approximately 59.1% of the voting power of our Company. Therefore, State Auto Mutual has the power to direct our affairs and is able to determine the outcome of substantially all matters required to be submitted to shareholders for approval, including the election of all our directors. State Auto Mutual could exercise its control over us in a manner detrimental to the interests of other STFC shareholders.
GENERAL RISK FACTORS
RESERVES
If our estimated liability for losses and loss expenses is incorrect, our loss reserves may be inadequate to cover our ultimate liability for losses and loss expenses and may have to be increased.
We establish loss reserves utilizing actuarial estimates of the amount to be paid in the future to settle all claims incurred as of the end of the accounting period. We maintain loss reserves to cover our estimated ultimate unpaid liability for losses and loss expenses with respect to reported and unreported claims incurred as of the end of each accounting period. Loss reserves do not represent an exact calculation of the liability, but instead represent estimates, generally using actuarial projection techniques at a given accounting date. Our loss reserve estimates are expectations of what the ultimate settlement and administration of claims will cost based on our assessment of facts and circumstances then known, historical settlement patterns, estimates of trends in claims severity and frequency, legal theories of liability and other factors. Variables in the reserve estimation process can be affected by both internal and external events, such as changes in handling procedures, trends in costs, economic inflation, legal developments, legislative changes, new medical procedures, and social inflation. Many of these items are not directly quantifiable, particularly on a prospective basis. Additionally, there may be a significant reporting , or changes in the report , between the occurrence of an insured event and the time a claim is actually reported to us. We refine reserve estimates as part of a regular, ongoing process as historical experience develops and additional are reported and settled. We record adjustments to reserves in the results of operations for the periods in which the estimates are changed. In establishing reserves, we take into account estimated recoveries for reinsurance, salvage and subrogation.
One of the impacts of COVID-19 has been the creation of reserve estimates for defense of business interruption related claims. Frequency and/or severity have also be impacted with respect to various coverages due to, among other things, disruptions in supply chains and changes in business practices and individual behaviors resulting from the stay-at-home and social distancing measures. In addition, the short-term and long-term impacts of COVID-19 on our various product lines could be different and cause additional uncertainty in the process of estimating loss reserves.
Because estimating loss reserves is an inherently uncertain process, currently established loss reserves may not be adequate. If we conclude our loss reserves are inadequate, we are obligated to increase them. An increase in loss reserves results in an increase in losses, reducing our net income for the period in which the deficiency is identified. Accordingly, an increase in loss reserves could have a material adverse effect on our results of operations, liquidity and financial condition.
CATASTROPHE LOSSES AND GEOGRAPHIC CONCENTRATIONS
The occurrence of catastrophic events could cause volatility in our results of operations and could materially reduce our level of profitability and adversely affect our liquidity and financial position.
Our insurance operations expose us to claims arising out of catastrophic events. We have experienced, and will in the future experience, catastrophe losses that may cause substantial volatility in our financial results for any fiscal quarter or year and could materially reduce our level of profitability or harm our financial condition, which in turn could adversely affect our ability to write new business. Catastrophes can be caused by various natural events, including hurricanes, hailstorms, tornadoes, windstorms, earthquakes, severe winter weather, wildfires, pandemics and man-made events, none of which are within our control. Catastrophe losses can vary widely and could significantly impact our results. The frequency and severity of are inherently . Additionally, incurred by residual markets or pooling mechanisms (such as wind pools) in certain states could trigger assessments to us. Such assessments could be material and may not be recoupable, depending on the applicable state mechanism.
The magnitude of loss from a catastrophe is a function of the severity of the event and the total amount of insured exposure in the affected area. Accordingly, we can sustain significant losses from less severe catastrophes, such as localized windstorms, when they affect areas where our insured exposure is concentrated. Although catastrophes can cause losses in a variety of our property and casualty lines, most of our catastrophe claims in the past have related to homeowners, allied lines, commercial property and commercial multi-peril coverages. The geographic distribution of our business subjects us to catastrophe exposure from severe thunderstorms, tornadoes and hail, as well as earthquakes and hurricanes affecting the United States.
Increases in the value and geographic concentration of insured properties and the effects of inflation could increase the severity of claims from catastrophic events in the future. In addition, states have from time to time passed legislation that limits the ability of insurers to manage catastrophe risk, such as legislation prohibiting insurers from withdrawing from catastrophe-prone areas or refusing to enforce policy provisions such as hurricane deductibles. Although we attempt to reduce the impact of catastrophes on our business by controlling concentrations of exposures in catastrophe prone areas and through the purchase of reinsurance, such reinsurance may prove inadequate if a major catastrophic loss exceeds the reinsurance limit, or we incur a number of smaller catastrophes that, individually, fall below the reinsurance retention level.
Along with others in the industry, we utilize catastrophe models developed by third party vendors to help assess and manage our exposure to catastrophe losses. Such models assume various conditions and probability scenarios and use historical information about catastrophic events, along with detailed information about our business. While we use modeling information in connection with our pricing and risk management activities, there are limitations with respect to the models’ usefulness in predicting losses in any reporting period. Such limitations are evidenced by the occurrence of significant variations in estimates between models and modelers; material increases or decreases in model results due to changes and refinements of the underlying data elements and assumptions; and differences observed between the results of actual event conditions and modeled expectations. Climate change, to the extent it affects changes in weather patterns, could impact the frequency or severity of weather events. Some industry commentators have expressed concerns that hydraulic fracturing or “fracking,” a process which involves drilling deep underground wells and injecting water, chemicals and sand into the rock formations in order to extract oil and gas, may cause seismic activity which, among other things, may affect the frequency of earthquakes. We view fracking as a potential emerging risk facing the industry.
Our ongoing catastrophe management efforts could negatively impact growth to the extent constraints on property exposures are deemed necessary in certain territories. In addition, due to the potential impact on cross-selling opportunities, new business growth in auto or other lines of business could be negatively affected.
A severe catastrophic event, pandemic or terrorist attack outside the United States may not result in material insurance losses to us. However, our investment portfolio, reinsurers or the general economy could be negatively affected, resulting in a material adverse effect on our business, liquidity, capital resources, financial position or results of operations.
UNDERWRITING AND PRICING
Our financial results depend primarily on our ability to underwrite risks effectively and to charge adequate rates to policyholders.
Our financial condition, cash flows and results of operations depend on our ability to underwrite and set rates adequately for a full spectrum of risks, across a number of lines of insurance. Rate adequacy is necessary to generate sufficient premium to pay losses, loss adjustment expenses and underwriting expenses and to earn a profit.
Our ability to underwrite and set rates effectively is subject to a number of risks and uncertainties, including, without limitation:
• the timely availability of sufficient, reliable data;
• our ability to conduct a complete and accurate analysis of available data;
• our ability to timely recognize changes in trends and to project both the severity and frequency of losses with reasonable accuracy;
• uncertainties which are generally inherent in estimates and assumptions;
• our ability to project changes in certain operating expense levels with reasonable accuracy;
• the development, selection and application of appropriate rating formula or other pricing methodologies;
• our ability to use credit scoring, education and occupation, and other data methodologies in pricing and underwriting;
• our use of predictive modeling or other underwriting tools to assist with correctly and consistently achieving the intended results in underwriting and pricing;
• our ability to establish and consistently follow company underwriting guidelines;
• our ability to innovate with new product and/or pricing strategies, and the success of those innovations on implementation;
• our ability to secure regulatory approval of premium rates on an adequate and timely basis and effectively implement such rate changes;
• our ability to accurately predict consumer behavior, such as policyholder retention;
• our ability to properly classify our new and renewal business;
• unanticipated court decisions, legislation or regulatory action;
• unanticipated changes or execution problems in our claim settlement practices, including our ability to recognize and respond to fraudulent or inflated claims;
• changing driving patterns for auto exposures including distracted driving; changing weather patterns (including those which may be related to climate change) for property exposures;
• technological innovations in automobiles, such as accident avoidance systems and advances leading to autonomous cars;
• changes in the medical sector of the economy; including healthcare reform cost shifting and other factors;
• unanticipated changes in auto repair costs, auto parts prices and used car prices;
• impact of inflation and other factors, such as demand surge on cost of construction materials, labor and other expenditures;
• our ability to monitor and manage property concentration in catastrophe prone areas, such as hurricane, earthquake, wildfires, and wind/hail regions; and
• the general state of the economy in the states in which we operate.
Such risks may result in our rates being based on inadequate or inaccurate data or inappropriate assumptions or methodologies, and may cause our estimates of future changes in the frequency or severity of claims to be incorrect. As a result, we could underprice risks, which would negatively affect our margins, or we could overprice risks, which could reduce our competitiveness. In either event, our operating results, financial condition and cash flows could be materially adversely affected.
VENDOR MANAGEMENT
Loss of key vendor relationships or failure of a vendor to perform as anticipated or to protect personal information of our customers, claimants or employees could negatively affect our operations.
We rely on services and products provided by various vendors. In the event that one or more of our vendors becomes unable to continue to provide products or services as anticipated, we may suffer operational impairment and financial loss. If one or more of our vendors fail to protect personal information of our customers, claimants or employees, we may incur operational impairments, or could be exposed to litigation, compliance costs or reputation damage. See the “Privacy” risk factor below for further information.
CYBERSECURITY THREATS
Our highly automated and networked organization is subject to cyberterrorism and a variety of other cybersecurity threats. These threats come in a variety of forms, such as viruses and malicious software. Such threats can be difficult to prevent or detect, and if experienced, could interrupt or damage our operations, harm our reputation or have a material adverse effect on our operations.
Our technology and telecommunications systems are highly integrated and connected with other networks. Cyber-attacks involving these systems could be carried out remotely from multiple sources and could interrupt, damage or otherwise adversely affect the operation of these critical systems. Threats to data security have risen in recent years due to new technologies, the use of the internet and telecommunications to conduct financial transactions and the increased sophistication and resources of hackers, activists and other external parties.
In addition, to access our online services, our customers may use devices or software that are beyond our control environment and which may provide additional avenues for attackers to gain access to confidential information. Although we have information security procedures and controls in place, our technologies, systems, networks, and customers' devices and software may become the target of cyber-attacks or information security breaches that could result in the unauthorized release, gathering, monitoring, misuse, loss, change, or destruction of our or our customers' confidential, proprietary and other information (including personal identifying information of individuals), or otherwise disrupt our or our customers' or other third parties' business operations.
We and others in our industry are regularly the subject of attempts by attackers to gain unauthorized access to our networks, systems, and data, or to obtain, change, or destroy confidential data (including personal identifying information of individuals) through a variety of means, including computer viruses, malware, and phishing. In the future, these attacks may result in unauthorized individuals obtaining access to our confidential information or that of our customers, or otherwise accessing, damaging, or disrupting our systems or infrastructure.
We are continuously developing and enhancing our controls, processes, and practices designed to protect our systems, computers, software, data, and networks from attack, damage, or unauthorized access. This continued development and enhancement will require us to expend additional resources, including the investigation and remediation of any information security vulnerabilities that may be detected. Despite our ongoing investments in security resources, talent, and business practices, we are unable to assure that these security measures will be effective. Additionally, as part of our technology strategy, we utilize U.S., off-shore and cloud vendors. Controls employed by these vendors may prove inadequate.
As the result of COVID-19, we have shifted to a mostly remote work force. While we have implemented enhanced procedures and protocols to further protect the security of our data systems, having a remote workforce increases our risk to successful cybersecurity attacks. Furthermore, there has been an increase in phishing and other social engineering attacks focused on COVID-19. These attacks typically come in the form of malicious links or emails, but they could involve phone calls or text messages as well. These cyberattacks, if successful, could interrupt, damage or otherwise adversely affect the operation of our critical systems.
If our systems and infrastructure were to be breached, damaged, or disrupted, or if we were to experience a loss of our confidential information or that of our customers, we could be subject to serious negative consequences, including disruption of our operations, damage to our reputation, a loss of trust in us on the part of our customers, vendors or other counterparties, client attrition, reimbursement or other costs, increased compliance costs, litigation exposure and legal liability and regulatory fines or penalties. Any of these could materially and adversely affect our results of operations, our financial condition, and/or our share price. We maintain cyber liability insurance coverage to offset certain potential , subject to policy limits, such as liability to others, costs of related management, data extortion, applicable forensics and certain regulatory defense costs, and .
PRIVACY
Privacy protection requirements for consumers are expanding from simply protecting personal information to a more consumer-driven model that allows individuals in some respects to control a company's ongoing storage and use of their personal information. Our failure to comply with such privacy laws could have an adverse effect on our business.
We continue to see increased regulation of data privacy and security, including the adoption of more stringent subject matter specific state laws, and federal laws regulating the collection and use of data, as well as security and data breach obligations. Privacy protection requirements for consumers are expanding from simply protecting personal information to a more consumer-driven model that allows individuals in some respects to control a company's ongoing storage and use of their personal information. This expansion places an increased burden on us to be able to respond to a consumer’s request to know or request to permanently anonymize their data, and failure to comply could result in fines, penalties, or litigation which could have an adverse effect on our business.
The regulatory framework for privacy issues is evolving in the U.S. and worldwide, and various government and consumer agencies and public advocacy groups have called for new regulation and changes in industry practices. It is possible that new laws and regulations will be adopted at the state or federal level, or both, or existing laws and regulations may be interpreted in new ways that would affect our business. Complying with any new regulatory requirements could force us to incur substantial costs or require us to change our business practices in a manner that could negatively impact the way we conduct business.
BUSINESS CONTINUITY
Our business depends on the uninterrupted operation of our facilities, systems and business functions, including our information technology, telecommunications and other business systems. Our business continuity and disaster recovery plans may not sufficiently address all contingencies.
Our business is highly dependent upon our ability to execute, in an efficient and uninterrupted fashion, necessary business functions, such as Internet support and 24-hour claims contact centers, processing new and renewal business, receiving and processing payment receipts and processing and paying claims. A shut-down of or inability to access one or more of our facilities, power outages, a major failure of the Internet, a pandemic, or a failure of one or more of our information technology, telecommunications or other systems could significantly impair our ability to perform such functions on a timely basis. In addition, because our information technology and telecommunications systems interface with and depend on third party systems, we could experience service denials if demand for such service exceeds capacity, or if our system or a third party system fails or experiences an interruption. If sustained or repeated, such a business , systems or service could result in a of our ability to write and process new and renewal business, provide customer service, receive premium payments, pay in a timely manner or perform other necessary corporate functions. This could result in a materially effect on our business results and liquidity and may cause reputational .
We have established a business continuity plan that is designed to continue our core business operations in the event that normal business operations cannot be performed due to a catastrophic event. Our rapid shift to a mostly remote work force following the onset of COVID-19 is an example of implementing our business continuity plan. However, because many businesses have also deployed a remote workforce as a result of COVID-19, internet usage has increased significantly. While we have been able to maintain, since the onset of COVID-19, normal business functions, such as our online support and 24-hour claims contact centers, process new and renewal business, receive and process payments, and process and pay claims, the increased usage and dependence on the internet may prevent us from continuing to perform such functions in an efficient and uninterrupted fashion. While we continue to test and assess our business continuity plan to meet the needs of our core business operations and address multiple business interruption events, there is no assurance that we will be able to perform our core business operations upon the occurrence of such an event, which may result in a material effect on our reputation, financial position and results of operations.
REINSURANCE
Reinsurance may not be available, collectible or adequate to protect us against losses, or may cause us to constrain the amount of business we underwrite in certain lines of business and locations.
We use reinsurance to help manage our exposure to insurance risks and to manage our capital. There can be no assurance that our use of reinsurance effectively meets our strategic business objectives. Reinsurance may not be adequate to protect us against losses and may not be available to us in the future at commercially reasonable rates. The availability, policy conditions and cost of reinsurance are subject to prevailing market conditions and loss experience, which can affect our business volume and profitability. Although the reinsurer is liable to us to the extent of the ceded reinsurance, we remain liable as the direct insurer on all risks reinsured. Ceded reinsurance arrangements do not eliminate our obligation to pay claims. As a result, we are subject to counterparty risk with respect to our ability to recover amounts due from reinsurers. In addition, the magnitude of losses in the reinsurance industry resulting from catastrophes may adversely affect the financial strength of certain reinsurers, which may result in our to collect or recover reinsurance. Reinsurers also may reserve their right to coverage with respect to specific .
CYCLICAL NATURE OF THE INDUSTRY
The property and casualty insurance industry is cyclical, which may cause fluctuations in our operating results.
The property and casualty insurance industry has been historically characterized by periods of intense price competition due to excess underwriting capacity, as well as periods of shortages of underwriting capacity that result in higher prices and more restrictive contract and/or coverage terms. The periods of intense price competition may adversely affect our operating results, and the cyclical nature of the industry may cause fluctuations in our operating results. While we may adjust prices during periods of intense competition, it remains our strategy to allow for acceptable profit levels and to decline coverage in situations where pricing or risk would not result in acceptable expected returns. Accordingly, our commercial lines of business tend to contract during periods of severe competition and price declines and expand when market pricing allows an acceptable return. This can cause volatility in our premium revenues. Policyholder reaction to price competition may result in the movement of business and volatility of premium revenues.
The personal lines products are influenced by a collection of loss cost trends. Driving patterns including behavioral changes like distracted driving, along with inflation in the cost of auto repairs and medical care and increasing litigation of liability claims are some of the more important factors that affect loss cost trends. Inflation in the cost of building materials and labor costs and demand caused by weather-related catastrophic events affect personal lines homeowners loss cost trends. We
may be unable to increase premiums at the same pace as coverage costs increase. Accordingly, profit margins initially decline prior to periods of increasing loss costs.
ECONOMIC CONDITIONS
Economic conditions may adversely affect our business.
The ongoing impact of COVID-19 on general economic activity is uncertain and could continue to negatively impact our business and results of operations. The degree of the impact will depend on the duration of the pandemic and the related impact on the economy. While the volatility of the economic climate makes it difficult for us to predict the overall impact of economic conditions on our business and results of operations, our business may be impacted in a variety of ways.
Economic conditions affect consumer behavior. For example, negative economic conditions may cause consumers and businesses to decrease their spending, which may impact the demand for insurance products. More specifically, declining automotive sales and weaknesses in the housing market generally impact the purchase of our personal auto and homeowners insurance products by consumers and business insurance products by businesses involved in these industries. High levels of unemployment have a tendency to cause the number of workers’ compensation claims to increase, as laid-off and unemployed workers may seek workers’ compensation benefits to replace their lost healthcare benefits. Similarly, uninsured and under insured motorist claims may rise. Vacated homes and business properties pose increased insurance industry risk.
Volatility and weakness in the financial and capital markets may negatively impact the value of our investment portfolio. Economic strains on states and municipalities could result in downgrades or defaults of certain municipal obligations.
We may be adversely affected by business difficulties, bankruptcies and impairments of other parties with whom we do business, such as independent agents, key vendors and suppliers, reinsurers or banks, which increases our credit risk and other counterparty risks. Bankruptcies among our current business insurance customers can negatively affect our retention. Reductions in new business start-ups may negatively affect the number of future potential business insurance customers.
In response to economic conditions, the United States federal government and other governmental and regulatory bodies have taken action and may take additional actions to address such conditions. There can be no assurance as to what impact such actions or future actions will have on the financial markets, economic conditions or our Company.
In addition, government spending and monetary policies or other factors may cause the rate of inflation to increase in the future. Inflation can have a significant negative impact on property and casualty insurers because premium rates are established before the amount of losses and loss expenses are known. When establishing rates, we attempt to anticipate increases from inflation subject to the limitations of modeling economic variables. Premium rates may prove to be inadequate due to low trend assumptions arising from the use of historical data. Even when general inflation is relatively modest, price inflation on the goods and services purchased by insurance companies in settling claims can steadily increase. Reserves may develop adversely and become inadequate. Retentions and deductibles may be exhausted more quickly. Interest rate increases in an inflationary environment could cause the values of our fixed income investments to decline.
Adverse capital and credit market conditions may negatively affect our ability to meet unexpected liquidity needs or to obtain credit on acceptable terms.
In the event that we need access to additional capital to pay our operating expenses, make payments on our indebtedness, pay for capital expenditures or fund acquisitions, our ability to obtain such capital may be constrained and the cost of any such capital may be significant. Our ability to obtain additional financing will depend on numerous factors, such as market conditions, the general availability of credit, the overall availability of credit to our industry, our credit ratings and credit capacity, as well as lenders’ perception of our long- or short-term financial prospects. Our access to funds may also be constrained if regulatory authorities or rating agencies take negative actions. If certain factors were to occur, our internal sources of liquidity may prove to be insufficient and we may not be able to successfully obtain additional financing on satisfactory terms.
REGULATION
Our business is heavily regulated, and changes in regulation may reduce our profitability and limit our growth.
We are subject to extensive regulation in the states in which we conduct business. This regulation is generally designed to protect the interests of policyholders, as opposed to shareholders and other investors, and relates to authorization for lines of business, capital and surplus requirements, investment limitations, underwriting limitations, transactions with affiliates, dividend limitations (see “Regulation-Dividends” in Item 1), changes in control, premium rates and a variety of other financial and non-financial components of an insurance company’s business. The NAIC and state insurance regulators are constantly examining laws and regulations, generally focusing on modifications to holding company regulations, interpreting existing laws and developing new laws.
Nearly all states require licensed insurers to participate in guaranty funds through assessments covering a portion of insurance claims against impaired or insolvent insurers. An increase in the magnitude of impaired companies could result in an increase in our share of such assessments. Residual market or pooling arrangements exist in many states to provide certain types of insurance coverage to those that are otherwise unable to find private insurers willing to insure them. Licensed insurers voluntarily writing such coverage are required to participate in these residual markets or pooling mechanisms. Such participation exposes us to possible assessments, some of which could be material to our results of operations. The potential availability of recoupments or premium rate increases, if applicable, may not offset such assessments in the financial statements nor do so in the same fiscal periods.
From time to time, some of the states in which we operate consider legislation restricting or banning the use of credit scoring in rating and/or risk selection in personal lines of business. Similarly, several states have considered restricting insurers’ rights to use loss history information maintained in various databases by insurance support organizations. There are a few states that have proposed making driving information the only variable to rate auto policies, leading to mandatory usage-based rating. The current pricing tools we utilize help us price our products more fairly and enhance our ability to compete for business that we believe will be profitable. Such regulations would limit our ability, as well as the ability of all other insurance carriers operating in any affected jurisdiction, to take advantage of these tools.
Currently the federal government does not directly regulate the insurance business. However, in recent years the state insurance regulatory framework has come under increased federal scrutiny. Congress and some federal agencies from time to time investigate the current condition of insurance regulation in the United States to determine whether to impose federal regulation or to allow an optional federal charter, similar to banks. In addition, changes in federal legislation and administrative policies in several areas, including changes in the Gramm-Leach-Bliley Act, financial services regulation and federal taxation, or repeal of McCarran-Ferguson Act (which largely exempts the insurance industry from the federal antitrust laws), could significantly impact the insurance industry and us.
We cannot predict with certainty the effect any enacted, proposed or future state or federal regulation or NAIC initiatives may have on the conduct of our business. Furthermore, there can be no assurance that the regulatory requirements applicable to our business will not become more stringent in the future or result in materially higher costs than current requirements. For example, concerns over climate change may prompt federal, state or local laws intended to protect the environment. Changes in the regulation of our business may reduce our profitability, limit our growth or otherwise adversely affect our operations.
We could be adversely affected if our controls designed to assure compliance with guidelines, policies, and legal and regulatory standards, including financial and regulatory reporting, are ineffective. Our business is dependent on our ability to regularly engage in a large number of insurance underwriting, claim processing, personnel and human resources, and investment activities, many of which are complex. These activities often are subject to internal guidelines and policies, as well as legal and regulatory requirements. No matter how well designed and executed, control systems provide only reasonable assurance that the system objectives will be met. If our controls are not effective, it could lead to financial loss, unexpected risk exposures or damage to our reputation.
Regulatory matters, as well as claims and claim coverages, have been impacted by COVID-19.
As the result of COVID-19, many states have either mandated that insurers provide grace periods for the payment of premiums or requested insurers to provide such grace periods in the event an insured requests payment deferral. We have complied with these payment extension periods in those states where we do business.
Some states have issued regulatory guidance encouraging premium relief or return of premium to insureds. While we are voluntarily, under certain circumstances and subject to regulatory approval, providing a one-time 5% premium discount to our personal auto insureds at the next renewal of their existing policies, if states where we do business were to mandate premium relief or refunds beyond what we have implemented, such actions could have a material adverse effect on our results of operations and cash flows.
There have been efforts at the state and federal levels to implement legislation that would expand the scope of business interruption insurance to include business closures related to COVID-19, although we are not aware of any such legislation being enacted at this time. If legislation were enacted in states where we do business that would expand the scope of business interruption insurance beyond what is intended and include COVID-19 related business closures, or judicial decisions of courts in such states determine that business interruption coverage includes COVID-19 related business closures, such legislation or judicial decisions would have a material adverse effect on our results of operations, liquidity, financial condition, and cash flows, and potentially, our solvency.
We have incurred, and expect to continue to incur in future periods, claim and claim adjustment expenses in certain lines of business as a result of COVID-19, such as workers’ compensation, if the injury or illness arose both out of and in the course of employment.
We have recognized some impact, and there is the potential for additional impact on our auto and property coverages due to changes in both business practices and individual behaviors. We have recognized an increase, and may continue to recognize an increase in commercial property claims due to unoccupied businesses being at greater risk of vandalism. Since the onset of the pandemic, there has been a decrease in the frequency of personal auto claims, attributed to a reduction in miles driven by insureds as a result of people working remotely and staying at home more due to COVID-19 concerns. The duration of this decrease and its impact to claim severity is unknown at this time.
Further, the anticipated and unknown risks related to COVID-19 cause additional uncertainty in the process of estimating loss reserves. We have experienced, and may continue to experience, an increase in fraudulent claims. COVID-19 has had an impact on the timing of claims settlements. COVID-19 has also had an impact on the litigation process, as courts have been forced to close or operate on a limited basis, which has resulted in trials and other court proceedings being extended for significant time periods.
Tax legislation initiatives or challenges to our tax positions could adversely affect our results of operations and financial condition.
We are subject to the tax laws and regulations of the United States federal, state and local governments. Tax legislative initiatives by these governmental bodies, including actions by departments of insurance, taxing authorities and other state and local agencies, to change the current tax structure or to increase taxes, assessments and other revenue-generating fees may increase the cost of doing business in those jurisdictions.
From time to time, various legislative initiatives are enacted or proposed that could materially impact our financial statements or tax positions. There can be no assurance that our effective tax rate or tax positions will not be adversely affected by enacted or proposed tax initiatives. In addition, United States federal, state and local tax laws and regulations are extremely complex and subject to varying interpretations. There can be no assurance that our tax positions will not be challenged by relevant tax authorities or that we would be successful in any such challenge.
CLAIM AND COVERAGE DEVELOPMENTS
Developing claim and coverage issues in our industry are uncertain and may adversely affect our insurance operations.
As industry practices and legislative, judicial and regulatory conditions change, unexpected and unintended issues related to claims and coverage may develop. These issues could have an adverse effect on our business by either extending coverage beyond our underwriting intent or by increasing the frequency or severity of claims. The premiums we charge for our insurance products are based upon certain risk expectations. When legislative, judicial or regulatory authorities expand the burden of risk beyond our expectations, the premiums we previously charged or collected may no longer be sufficient to cover the risk, and we do not have the ability to retroactively modify premium amounts. Furthermore, our reserve estimates do not take into consideration a major retroactive expansion of coverage through legislative or regulatory actions or judicial interpretations.
An emerging risk faced by the property and casualty industry is commonly referred to as the opioid crisis. Numerous lawsuits have been filed on behalf of states, counties and municipalities alleging a variety of claims and generally seek compensatory damages caused by the opioid crisis. In general, defendants named in these lawsuits have been major pharmaceutical companies, wholesale distributors, retail pharmacies and doctors. Since these lawsuits are at early stages, we are unable to predict the outcome of these lawsuits or their impact to our financial results.
Court decisions have had, and are expected to continue to have, significant impact on the property and casualty insurance industry. These decisions may increase the level of risk which insurers are expected to assume in a number of ways, such as by eliminating exclusions, increasing limits of coverage, creating rights in claimants not intended by the insurer and interpreting applicable statutes expansively to create obligations on insurers not originally considered when the statute was passed. In some cases, court decisions have been applied retroactively. Court decisions have also negated legal reforms passed by state legislatures.
We have seen instances of political pressure exerted to force or persuade insurers to provide extra-contractual coverage, such as foregoing the use of deductibles.
There is also a growing trend of plaintiffs targeting property and casualty insurers, including us, in putative class action litigation relating to claim-handling and other practices, particularly with respect to the handling of personal lines auto and homeowners claims.
There are concerns that the focus on climate change and global warming could affect court decisions or result in litigation, including potential matters arising from federal, state or local laws intended to protect the environment. Other environmental concerns could also create or affect potential liability exposures.
Many of these issues are beyond our control. The effects of these and other unforeseen claims and coverage issues are extremely hard to predict and could materially harm our business and results of operations.
LITIGATION
We may suffer losses from litigation, which could materially and adversely affect our operating results or cash flows and financial condition.
As is typical in our industry, we face risks associated with litigation of various types, including disputes relating to insurance claims under our policies, as well as other general commercial and corporate litigation. Litigation is subject to inherent uncertainties and in the event of an unfavorable outcome in one or more litigation matters, the ultimate liability may be in excess of amounts currently reserved and may be material to our operating results or cash flows for a particular quarter or annual period and to our financial condition.
Lawsuits, including putative class actions, have been initiated against us and most other insurers regarding the denial of business interruption coverage claims for business closures related to COVID-19. Our commercial property policies that include business interruption coverage are not intended to apply for pure economic losses caused by shutdown orders due to a widespread epidemic or pandemic. We intend to vigorously challenge any claims that our business interruption coverage applies to economic losses caused by such business closures.
TERRORISM
Terrorist attacks, and the threat of terrorist attacks, and ensuing events could have an adverse effect on us.
Terrorism, both within the United States and abroad, and military and other actions and heightened security measures in response to these types of threats, may cause loss of life, property damage, reduced economic activity, and additional disruptions to commerce. Terrorist attacks could cause losses from insurance claims related to the property and casualty insurance operations of the State Auto Group, as well as a decrease in our stockholders’ equity, net income and/or revenue.
The Terrorism Acts require the federal government and the insurance industry to share the risk of insured losses on future acts of terrorism that are certified by the U.S. Secretary of the Treasury. We are required to participate in the Terrorism Acts as a result of our commercial insurance business. In addition, under the Terrorism Acts, terrorism coverage is mandatory for all primary workers’ compensation policies. Insureds with non-workers’ compensation commercial policies, however, have the option to accept or decline our terrorism coverage. In 2020, over —% of our commercial lines non-workers’ compensation policyholders purchased terrorism coverage. Although the Terrorism Acts mitigate our exposure to a large-scale terrorist attack, our deductible is substantial and losses could have a material adverse effect on our results of operations, financial condition and liquidity.
In addition, some of the assets in our investment portfolio may be adversely affected by declines in the equity markets and economic activity caused by the continued threat of terrorism, ongoing military and other actions and heightened security measures. We cannot predict at this time the extent to which industry sectors in which we maintain investments may suffer losses as a result of potentially decreased commercial and economic activity, or how any such decrease might impact the ability of companies within the affected industry sectors to pay interest or principal on their securities, or how the value of any underlying collateral might be affected.
Furthermore, our reinsurers could experience significant losses as a result of terrorist attacks, potentially jeopardizing their ability to pay losses ceded to them and reducing the availability of reinsurance. Our current commercial property reinsurance excludes certified acts of foreign terrorism and loss due to nuclear, biological or chemical agents.
INVESTMENTS
The performance of our investment portfolios is subject to various investment risks, such as market, credit, concentration, liquidity, and interest rate risks. Such risks could result in material adverse effects to our results of operations, cash flows and financial position.
Like other property and casualty insurance companies, we depend on income from our investment portfolio for a portion of our revenues and earnings and are therefore subject to market risk, credit risk, concentration risk, liquidity risk and the risk that we will incur losses due to adverse changes in equity, interest, commodity or foreign currency exchange rates and prices. Our primary market risk exposures are to changes in interest rates and equity prices. Low interest rate environments put downward pressure on investment income. Increases in interest rates could cause the values of our fixed income portfolios to decline, with the magnitude of the decline depending on the duration of our portfolio. Individual securities in our fixed income portfolio are subject to credit risk and default. Downgrades in the credit ratings of fixed maturities can have a significant negative effect on the market valuation of such securities. For example, budget strains on certain states and local governments could negatively affect the credit quality and ratings of their issued securities.
Our fixed income portfolio includes certain securities with call features permitting them to be redeemed by the issuers prior to stated maturity. Reinvestment risk exists with such securities as it may not be possible to reinvest the proceeds from the called securities at equivalent yields.
If the fixed income or equity portfolios, or both, were to be impaired by market, sector or issuer-specific conditions to a substantial degree, our liquidity, financial position and financial results could be materially adversely affected. Under these circumstances, our income from these investments could be materially reduced, and declines in the value of certain securities could further reduce our reported earnings and capital levels. A decrease in value of our investment portfolio could also put our insurance subsidiaries at risk of failing to satisfy regulatory minimum capital requirements. If we were not at that time able to supplement our subsidiaries’ capital from STFC or by issuing debt or equity securities on acceptable terms, our business could be materially adversely affected. Also, a decline in market rates of fixed income securities or a decline in the fair value of equity securities could cause the investments in our pension plans to decrease, resulting in additional expense and increasing required contributions to the pension plan.
Our investment portfolio is invested mostly in fixed income securities, the majority of which consist of securities issued by the U.S. Treasury, federal agencies, and state and local governments. Our portfolio also contains a number of securities issued by corporations. A prolonged economic recession caused by COVID-19 could negatively impact the financial condition of corporate issuers in our portfolio, resulting in rating downgrades or an inability to make timely principal and/or interest payments. It is possible we could suffer a partial or complete loss of principal from an issuer who fails to meet its obligations. Our portfolio could suffer large decreases in market value if the economic crisis deepens and the financial solvency of issuers is called into question. Likewise, our exposure to state and local governments carries risk of in an economic . A reduction in tax collections for local governments can cause them to on interest or principal payments resulting in a of capital from our portfolio.
The value of our equity portfolio, which consists of mutual funds, exchange traded funds, and individual company holdings, is impacted by economic activity in the United States and around the world. Mutual funds and exchange traded funds can be expected to exhibit less volatility than an individual company security, but these funds are exposed to economic risk as well. Depending on the length and depth of the pandemic, it is possible that companies in which we have invested could become bankrupt or cease doing business. As a result, our portfolio could suffer permanent loss of capital. It is also possible that equity prices could remain depressed for an extended period of time. Portfolio dividend income can also decline as companies reduce or eliminate dividends as they look for ways to survive in a difficult economy.
Changes in tax laws impacting marginal tax rates and/or the preferred tax treatment of municipal obligations under current law, could adversely affect the market value of municipal obligations. Since a portion of our investment portfolio is invested in tax-exempt municipal obligations, any such changes in tax law could adversely affect the value of the investment portfolio.
EMPLOYEES
Our ability to attract, develop and retain talented employees, managers and executives, and to maintain appropriate staffing levels, is critical to our success, as is our ability to effectively plan for the succession and transition of key executives and subject matter experts.
Our success depends on our ability to attract, train, develop and retain talented, ethical, diverse employees, including executives and other key managers in a specialized industry. The loss of certain key officers and employees or the failure to attract and develop talented new executives and managers could have a materially adverse effect on our business. Effective succession planning is important to assure the timely, competent replacement of retiring or transitioning senior executives and other departing management talent and subject matter experts.
Our success also depends on our ability to maintain and improve the effectiveness of our staff. Our ability to do so may be impaired as a result of a variety of internal and external factors which affect employees and the employment marketplace, as well as our ability to recognize and respond to changing trends and other circumstances that affect our employees. In addition, we must forecast the changing business environments (for multiple business units and in many geographic markets) with reasonable accuracy and adjust hiring programs and/or employment levels accordingly. Our failure to recognize the need for such adjustments, or the failure or inability to react appropriately on a timely basis, could lead either to over-staffing (which would adversely affect our cost structure) or under-staffing (impairing our ability to execute and effectively service our business) in one or more business units or locations. In either event, our financial results could be materially adversely affected.
As a result of COVID-19, we have had up to approximately 90% of our associates working remotely. While this transition was implemented quickly and without significant disruption, there are new challenges with a work from home workforce. Communication levels between associates and management increased at a similar pace as the transition. We will need to continue to balance communication with engagement and productivity as we move into future phases of the pandemic, while planning for a new post COVID-19 work model.
Changes in U.S. immigration policies and laws could impact our ability to hire and retain foreign national employees working under visas, which could adversely affect our operations.
We have many foreign national employees who work for us under visas issued by the U.S. government. These foreign national employees are highly skilled with expertise in technology and other areas needed for the operation of our business. Changes to U.S. immigration policies and laws by the prior administration placed more restrictions on the issuance and extension of work visas. With the recent administration change, if those restrictions are lifted or relaxed, it may reduce our risk in hiring and retaining these highly skilled employees.
COMPETITION
Our industry is highly competitive, which could adversely affect our sales and profitability.
The property and casualty insurance business is highly competitive, and we compete with a large number of other insurers. Some of our competitors have well-established national reputations and brands supported by extensive media advertising. Some of our competitors have substantially greater financial, technical and operating resources and market share than us. We may not be able to effectively compete, which could adversely affect our sales and profitability. We believe that competition in our lines of business is based primarily on price, service, commission structure, product features, technology, use of telematics, financial strength ratings, producer relationships, reputation and name or brand recognition. Market developments such as usage-based auto insurance or new entrants into the insurance marketplace could potentially result in reduced market share or adverse selection. Several automobile manufacturers have announced plans to begin marketing autonomous vehicles in the coming years. Some manufacturers have indicated that liability coverage may be included as part of the purchase price of the vehicle. Over time, as the sale of autonomous vehicles becomes more common, sales of our commercial and private passenger auto liability products may be impacted. The growth in mobile communications and the prominence of social media as a source of information for consumers are recent examples of significant developments in the marketplace which may affect our competitive position. Social media, for example, could be potentially utilized in a manner which affects our reputation with current or prospective policyholders and agents.
Our competitors sell through various distribution channels, including independent agents, captive agents and directly to the consumer. We compete not only for personal and business insurance customers, but also for independent agents to market and sell our products. Some of our competitors offer a broader array of products, have more competitive pricing or have higher claims paying ability ratings. In addition, other financial institutions are now able to offer services similar to our own as a result of the Gramm-Leach-Bliley Act.
New digital carriers have entered the insurance marketplace over the past few years. These carriers typically market personal lines automobile or homeowners products direct to the consumer and do not utilize the independent agency system. As these carriers grow, their new customers will either be first time buyers of insurance products or customers leaving other carriers. Insuretech companies, a term used to describe companies that focus on the use of technology innovation to reduce costs and improve efficiencies, have also benefited from the evolving marketplace. Insurance companies, including State Auto, have been investing in these insuretech companies. Insuretech companies seek a business partner that will allow them to take advantage of new technology that can help a carrier either attract quality business or improve underwriting results, with an ultimate goal of improved financial performance. The growth of both the digital carriers and insuretech companies could impact the potential growth of other carriers.
The increased transparency that arises from information available from the use of tools, such as comparative rater software, could work to our disadvantage. The competitive environment for certain lines of business, such as personal auto insurance, puts pressure on achieving sustainable profit margins. We may have difficulty differentiating our products or becoming among the lowest cost providers. Expense efficiencies are important to maintaining and increasing our growth and profitability. If we are unable to efficiently execute and realize future expense efficiencies, it could affect our ability to establish competitive pricing and could have a negative effect on new business growth and retention of existing policyholders.
CHANGES IN ACCOUNTING STANDARDS
Changes in accounting standards issued by the FASB or other standard-setting bodies may adversely affect our results of operations and financial condition.
Our financial statements are prepared in accordance with GAAP; FASB, AICPA and other accounting standard-setting bodies may periodically issue changes to, interpretations of or guidance with respect to GAAP. The adoption of such guidance may have an adverse effect on our results of operations and financial position. See Note 1 to our consolidated financial statements included in Item 8 of this Form 10-K regarding adoption of recent accounting pronouncements.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
We share our operating facilities with State Auto Mutual pursuant to the terms of the 2005 Management Agreement. Our corporate headquarters are located in Columbus, Ohio, in buildings owned by State Auto Mutual that contain approximately 280,000 square feet of office space. State Auto Mutual also leases other office facilities in numerous locations throughout the State Auto Group’s geographical areas of operation.
Item 3. Legal Proceedings
We are involved in lawsuits in the ordinary course of our business arising out of or otherwise related to our insurance policies. Additionally, from time to time we may be involved in lawsuits, including class actions, in the ordinary course of business but not arising out of or otherwise related to our insurance policies. These lawsuits are in various stages of development. We generally will contest these matters vigorously but may pursue settlement if appropriate. Based on currently available information, we do not believe it is reasonably possible that any such lawsuit or related lawsuits will be material to our results of operations or have a material adverse effect on our consolidated financial position or cash flows.
Item 4. Mine Safety Disclosures
Not applicable.
PART II
Item 5. Market for the Registrant’s Common Equity, Related Shareholder Matters, and Issuer Purchases of Equity Securities
Market Information; Holders of Record
Our common shares are traded on the Nasdaq Global Select Market under the symbol STFC. As of March 5, 2021, there were 983 shareholders of record of our common shares.
Market Price Ranges and Dividends Declared on Common Shares
Initial Public Offering—June 28, 1991 – $2.25. The following table sets forth information with respect to the high and low sale prices of our common shares for each quarterly period for the past two years as reported by Nasdaq, along with the amount of cash dividends declared by us with respect to our common shares for each quarterly period for the past two years:
High
Low
Dividend
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
High
Low
Dividend
First Quarter
Second Quarter
Third Quarter
Fourth Quarter
See Item 7 of this Form 10-K, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources—Regulatory Considerations,” for information regarding regulatory restrictions on the payment of dividends to State Auto Financial by its insurance subsidiaries.
Performance Graph
The line graph below compares the total return on $100.00 invested on December 31, 2015, in STFC’s shares, the CRSP Total Return Index for the Nasdaq Stock Market (“Nasdaq Index”), and the CRSP Total Return Index for Nasdaq insurance stocks (“Nasdaq Ins. Index”), with dividends reinvested.
STFC
Nasdaq Index
Nasdaq Ins. Index
Item 6. Selected Consolidated Financial Data
Not applicable.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Capitalized terms used in this Item 7 and not otherwise defined have the meanings ascribed to such terms under the caption “Important Defined Terms Used in this Form 10-K” which immediately precedes Part I of this Form 10-K. This discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Form 10-K and the narrative description of our business contained in Item 1 of this Form 10-K. For information regarding our financial results for the fiscal year ended December 31, 2018, please see the discussion included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2019.
OVERVIEW
State Auto Financial is a property and casualty insurance holding company. Our insurance subsidiaries are part of the State Auto Group and Pooling Arrangement described below. The State Auto Group markets its insurance products throughout the United States primarily through independent agencies, which include retail agencies and brokers. The State Auto Group is rated A- (Excellent) by A.M. Best.
State Auto Financial’s principal subsidiaries are State Auto P&C, Milbank and SA Ohio, each of which is a property and casualty insurance company, and Stateco, which provides investment management services to affiliated insurance companies.
Our reportable insurance segments are personal insurance and commercial insurance. These insurance segments are managed separately from each other due to the differences in the types of customers they serve, products they provide or services they offer. Investment operations is also a reportable segment. As previously reported, we have exited our specialty business, which has resulted in the elimination of our specialty insurance segment. As a result, effective January 1, 2019, the specialty insurance business is no longer a reportable segment as it no longer is material to our results and is disclosed as
"specialty run-off." See “Personal and Commercial Insurance” in Item 1 of this Form 10-K for more information about our insurance segments.
We evaluate the performance of our insurance segments using industry financial measurements determined under SAP and certain measures determined under GAAP. We evaluate our investment operations segment based on investment returns of assets managed. Financial information about our segments for 2020 is set forth in this Item 7 and in Note 18 to our consolidated financial statements included in Item 8 of this Form 10-K.
COVID-19
The impact of COVID-19 on our future results of operations and financial condition are highly uncertain at this time and outside of our control. The scope, duration and magnitude of the effects of the on-going COVID-19 pandemic continue to evolve rapidly and in ways that are difficult or impossible to anticipate. For discussions on how COVID-19 affected our operations, see the "Results of Operations" included in this Item 7. For a discussion of the most significant risks and uncertainties that could impact our results of operations, financial position, liquidity or cash flows as a result of the COVID-19 pandemic, see “Part I - Item 1A. Risk Factors” included in this Form 10-K.
EXECUTIVE SUMMARY
2020 was a year in which our results were negatively impacted by catastrophe losses with improved non-cat loss and LAE and expense ratios. Our 2020 personal and commercial insurance segments statutory combined ratio of 103.6% included 14.0 points of catastrophe losses, which was 6.4 points higher than our five-year average. Our net premium growth of 10.7% was above the industry average.
Insurance Operations
Our focus in 2020 was on personal auto profitability and, although our results fell far short of our expectations, we are pleased with the progress we made. We introduced a new private passenger auto pricing model in 2020, addressed additional underwriting issues with the product and fixed the stability of our digital-only platform, State Auto Connect. We believe that these efforts will return personal auto to profitable growth in 2021. Our homeowners business, now our largest line of business, saw improvements in both the non-catastrophe ratio and expense ratio while producing strong premium growth of 23.6%. Commercial lines achieved both profit and growth while completing the rollout of products on State Auto Connect, with the launch of farm and ranch, middle market commercial and workers’ compensation.
The impact of COVID-19 on our results included a decline in auto accidents due to fewer miles driven by insureds. We experienced an increase in workers’ compensation claims, primarily from nursing homes and other medical facilities. And we, along with the rest of the insurance industry, are facing legal challenges with respect to business interruption claims related to COVID-19.
Our Claims and Risk Engineering (CARE) organization works to deliver exceptional service not only to customers affected by catastrophes throughout the year, but to those who, every day, reach out to us for help. In 2020, the CARE team began to introduce customer service enhancements via our digital platform that will continue throughout 2021. Continuing to improve the customer experience is central to CARE’s strategy going forward.
Improvements in customer and agent experience are being delivered through State Auto Connect. Since its launch in 2016, we have rebuilt all nine of our product lines, concluding with the launch of workers’ compensation in the fourth quarter of 2020. In 2019, we focused on providing a more stable technology experience for agents and policyholders, which we delivered in 2020. In addition, our investments in improving the technology experience for our associates enabled us to quickly move to a remote work environment at the beginning of the COVID-19 pandemic.
Moving forward
Our success in navigating the challenges of 2020 was a result of the decisions made in recent years in transforming our company. We have built a technology platform that will grow efficiently as our company grows, and our products can adapt more quickly to the expectations of our customers and the marketplace. Our service organizations are striving to meet and exceed customer expectations and our sales teams are working to build even stronger relationships with independent agents, leading to continued exceptional sales growth.
While our 2020 profit goal was not met, we enter 2021 as a much stronger organization.
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 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 following table sets forth the participants and their participation percentages in the Pooling Arrangement. There were no changes to the participants or to their participation percentages during 2020.
STFC Pooled Companies:
State Auto P&C
Milbank
SA Ohio
Total STFC Pooled Companies
State Auto Mutual Pooled Companies:
State Auto Mutual
SA Wisconsin
Meridian Security
Patrons Mutual
RIC
Plaza
American Compensation
Bloomington Compensation
Total State Auto Mutual Pooled Companies
We anticipate that the STFC Pooled Companies will maintain a 65% participation percentage in the Pooling Arrangement for the foreseeable future. However, under applicable governance procedures, if the Pooling Arrangement were to be amended, management would make recommendations to the Independent Committees of the Board of Directors of both State Auto Mutual and STFC. The Independent Committees review and evaluate such factors as they deem relevant and recommend any appropriate pooling change to the Board of Directors of both State Auto Mutual and STFC subject to regulatory approval by each participant’s respective domiciliary insurance department. The Pooling Arrangement is terminable by any of our Pooled Companies at any time by any party by giving twelve months’ notice to the other parties and their respective domiciliary insurance departments. None of our Pooled Companies currently intends to terminate the Pooling Arrangement.
Under the terms of the Pooling Arrangement, all subject premiums, incurred losses, loss expenses and other underwriting expenses are prorated among our Pooled Companies on the basis of their participation in the pool. By spreading the underwriting risk, the Pooling Arrangement is designed to produce more uniform and stable underwriting results for each of our Pooled Companies than any one company would experience individually. This has the effect of providing each of our Pooled Companies with a similar mix of pooled property and casualty insurance business on a net basis.
RESULTS OF OPERATIONS
Summary
The following table sets forth certain key performance indicators we use to monitor our operations for the years ended December 31, 2020 and 2019:
($ millions, except per share data)
GAAP Basis:
Total revenues
Income before federal income taxes
Net income
Stockholders’ equity
Book value per share
Return on average equity
Debt to capital ratio
Cat loss and ALAE ratio
Non-cat loss and LAE ratio
Loss and LAE ratio
Expense ratio
Combined ratio
Premiums written growth
Investment yield
SAP Basis:
Cat loss and ALAE ratio
Non-cat loss and ALAE ratio
ULAE ratio
Loss and LAE ratio
Expense ratio
Combined ratio
Net premiums written to surplus
2020 Overview :
COVID-19
Beginning in March 2020, the global COVID-19 pandemic has impacted our results of operations. For the year ended December 31, 2020, the impact on the non-cat loss and ALAE current accident year included:
• A decline in claim frequency in personal auto and commercial auto due to a reduction in miles driven as a result of people working remotely and staying at home more because of COVID-19 concerns,
• A decline in claim frequency in commercial auto, small commercial package, middle market commercial and workers' compensation due to reduced business and employment activity,
• Increased workers' compensation claims for businesses in the medical field, such as nursing homes and hospitals, due to employees being exposed to COVID-19 in the course of their employment, and
• Increased legal defense costs in small commercial package and middle market commercial due to litigation involving business interruption insurance claims.
Other Factors
• Net investment gain was $27.3 million which included $31.8 million of recognized net losses on equity securities sold during the year. During the third quarter, we completed the exit of our investments in the Master Limited Partnership Exchange Traded Funds ("MLP ETF's") equity security asset class and recognized net investment losses of $35.1 million. The decline in the fair value of the investments in the MLP ETFs during 2020 was in part
due to the market volatility caused by the COVID-19 pandemic. Net investment gain for 2020 included $59.3 million of unrealized gains from equity securities and other invested assets still held at the end of 2020.
• Earned premiums were $1,380.9 million and reflected new business growth and rate increases in our personal and commercial segments. State Auto Connect, our fully digital quote and issue platform that incorporates advanced data analytics and updated pricing models, is now live for all of our products and is driving our new business growth.
• The SAP catastrophe loss and ALAE ratio was 14.9%, or $206.2 million. The year ended December 31, 2020 was impacted by (i) a first quarter wind and hail storm, including tornadoes, in Tennessee that primarily impacted the middle market line of business, (ii) widespread second quarter wind and hail events in the South and Midwest that primarily impacted the homeowners line of business, (iii) a Midwest derecho in August, with approximately 75% of the losses occurring in Iowa, as well as widespread wind and hail events in the third quarter, and (iv) adverse development of prior accident year losses of $12.4 million in E&S property related to hurricane Irma in the third quarter. Approximately 50% of the catastrophe losses for the year were in our homeowners line of business.
• The SAP non-cat loss and ALAE ratio was 49.9%, or $688.6 million.
◦ The current accident year non-cat loss and ALAE ratio was impacted by (i) the COVID-19 pandemic discussed above, (ii) non-cat weather losses, primarily wind and hail, and (iii) an elevated level of large commercial losses, including fires.
◦ Non-catastrophe losses and ALAE included 3.7 points of favorable development relating to prior years, or $51.5 million. The commercial insurance segment contributed $78.4 million of favorable development which was partially offset by $21.7 million of adverse development from the personal insurance segment and $5.2 million of adverse development from specialty run-off primarily due to an adverse court decision relating to an E&S casualty claim from 2016.
2019 Overview :
• Net investment gain was $74.2 million, which included $73.8 million of unrealized gains from equity securities and other invested assets. Net investment income was $80.4 million, which included $62.3 million of income from the fixed maturities portfolio.
• Earned premiums were $1,250.2 million and reflected new business growth in the personal insurance segment and the exit of the specialty business.
• The SAP catastrophe loss and ALAE ratio was 8.0%, or $100.5 million. 2019 was impacted by (i) severe wind and hail storms, approximately half of which occurred in Texas, and (ii) adverse development of prior accident year catastrophe losses in the specialty run-off business relating to Hurricanes Irma and Harvey.
• The SAP non-cat loss and ALAE ratio was 53.7%, or $669.7 million. Non-catastrophe losses and ALAE included 5.8 points of favorable development relating to prior years, or $72.4 million, primarily from the commercial insurance segment which contributed $58.8 million. The 2019 current accident year non-cat loss and ALAE was primarily impacted by non-cat weather losses and large losses, including fires.
Insurance Segments
We measure our top-line growth for our insurance segments based on net written premiums, which 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.
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 Note 1f of the "Notes to Consolidated Financial Statements" in Item 8.
The accounting for pension benefits also contributes to the difference between our GAAP loss and expense ratios and our SAP loss and expense ratios. For a discussion of our pension and postretirement benefit obligations, see the “Critical Accounting Policies – Pension and Postretirement Benefit Obligations” section included in this Item 7.
All references to financial measures or components thereof in this discussion are calculated on a GAAP basis, unless otherwise noted.
Summary of Key Indicators of Insurance Segment Results
The following table sets forth certain key performance indicators for our insurance segments for the years ended December 31, 2020 and 2019:
($ in millions)
Personal & Commercial
Specialty run-off
Total
Net written premiums
Net earned premiums
Losses and LAE incurred:
Cat loss and ALAE
Non-cat loss and ALAE:
Prior accident years non-cat loss and ALAE
Current accident year non-cat loss and ALAE
Total non-cat loss and ALAE
Total Loss and ALAE
ULAE
Total Loss and LAE
Underwriting expenses
Net underwriting loss
Cat loss and ALAE ratio
Non-cat loss and ALAE ratio:
Prior accident years non-cat loss and ALAE ratio
Current accident year non-cat loss and ALAE ratio
Total non-cat loss and ALAE ratio
Total Loss and ALAE ratio
ULAE ratio
Total Loss and LAE ratio
Expense ratio
Combined ratio
(1) N/M = Not Meaningful
($ in millions)
Personal & Commercial
Specialty run-off
Total
Net written premiums
Net earned premiums
Losses and LAE incurred:
Cat loss and ALAE
Non-cat loss and ALAE:
Prior accident years non-cat loss and ALAE
Current accident year non-cat loss and ALAE
Total non-cat loss and ALAE
Total Loss and ALAE
ULAE
Total Loss and LAE
Underwriting expenses
Net underwriting loss
Cat loss and ALAE ratio
Non-cat loss and ALAE ratio:
Prior accident years non-cat loss and ALAE ratio
Current accident year non-cat loss and ALAE ratio
Total non-cat loss and ALAE ratio
Total Loss and ALAE ratio
ULAE ratio
Total Loss and LAE ratio
Expense ratio
Combined ratio
(1) N/M = Not Meaningful
Personal Insurance Segment
The following tables set forth certain key performance indicators by major product line of business for our personal insurance segment for the years ended December 31, 2020 and 2019:
Table 1
($ in millions)
Personal Auto
Homeowners
Other Personal
Total
Net written premiums
Net earned premiums
Losses and LAE incurred:
Cat loss and ALAE
Non-cat loss and ALAE:
Prior accident years non-cat loss and ALAE
Current accident year non-cat loss and ALAE
Total non-cat loss and ALAE
Total Loss and ALAE
ULAE
Total Loss and LAE
Underwriting expenses
Net underwriting (loss) gain
Cat loss and ALAE ratio
Non-cat loss and ALAE ratio:
Prior accident years non-cat loss and ALAE ratio
Current accident year non-cat loss and ALAE ratio
Total non-cat loss and ALAE ratio
Total Loss and ALAE ratio
ULAE ratio
Total Loss and LAE ratio
Expense ratio
Combined ratio
Table 2
($ in millions)
Personal Auto
Homeowners
Other Personal
Total
Net written premiums
Net earned premiums
Losses and LAE incurred:
Cat loss and ALAE
Non-cat loss and ALAE:
Prior accident years non-cat loss and ALAE
Current accident year non-cat loss and ALAE
Total non-cat loss and ALAE
Total Loss and ALAE
ULAE
Total Loss and LAE
Underwriting expenses
Net underwriting (loss) gain
Cat loss and ALAE ratio
Non-cat loss and ALAE ratio:
Prior accident years non-cat loss and ALAE ratio
Current accident year non-cat loss and ALAE ratio
Total non-cat loss and ALAE ratio
Total Loss and ALAE ratio
ULAE ratio
Total Loss and LAE ratio
Expense ratio
Combined ratio
The personal insurance segment's net written premiums for the year ended December 31, 2020 increased 9.4% compared to 2019 (Tables 1 - 2), primarily driven by new business growth and increased rates in homeowners and other personal. The new business growth resulted in higher levels of policies in force for homeowners for the year ended December 31, 2020 compared to the same 2019 period. Partially offsetting the 2020 net written premium growth was a decrease in personal auto net written premiums, which was driven by a decline in new business primarily attributable to cumulative rate and underwriting actions taken during the fourth quarter of 2019 and throughout 2020 to address personal auto profitability.
In response to the COVID-19 pandemic and its impact on our personal auto policyholders, in April 2020, we announced our "In This Together" plan that provides a one-time 5% discount at renewal on a personal auto policyholder's entire policy term premium, which will be applied at an upcoming renewal for active personal auto policies in force as of the renewal date. The plan was approved by 26 of our 28 personal lines states with renewal effective dates beginning mid-July. As of December 31, 2020, this reduced the personal auto net written premiums by approximately $4.2 million.
The personal insurance segment's SAP catastrophe loss ratio for the year ended December 31, 2020 increased 5.1 points compared to 2019 (Tables 1 - 2), driven by an increase in the frequency and severity of wind and hail events, which primarily impacted the homeowners line of business. Approximately 40% of our 2020 reported catastrophe losses occurred in Texas. During 2019, catastrophe losses were primarily related to wind and hail storms, with over half of the reported losses occurring in Texas.
The personal insurance segment's SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 3.0 points compared to 2019 (Tables 1 - 2).
The personal auto SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 1.1 points when compared to the same 2019 period (Tables 1 - 2). The 2020 non-catastrophe loss and ALAE ratio was impacted by (i) a lower level of current accident year losses attributable to fewer miles driven as a result of people working remotely and staying at home more because of COVID-19 concerns, and (ii) adverse development from prior accident years compared to favorable
development in the same 2019 periods. The 2020 prior accident year adverse development was primarily driven by higher than expected severity for bodily injury claims from multiple accident years. The 2019 prior accident year favorable development was across multiple coverages including bodily injury and uninsured and under-insured motorist coverages, primarily from the 2018 and 2017 accident years.
The homeowners SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 1.9 points when compared to the same 2019 period (Tables 1 - 2). The 2020 improvement was primarily driven by lower claim frequency in the current accident year. Partially offsetting this improvement was adverse development of prior accident year losses, primarily driven by higher than expected severity for 2019 property and third-party liability claims.
Commercial Insurance Segment
The following tables set forth certain key performance indicators by major product line of business for our commercial insurance segment for the years ended December 31, 2020 and 2019:
Table 3
($ in millions)
Commercial Auto
Small Commercial Package
Middle Market Commercial
Workers' Comp
Farm & Ranch
Other Commercial
Total
Net written premiums
Net earned premiums
Losses and LAE incurred:
Cat loss and ALAE
Non-cat loss and ALAE
Prior accident years non-cat loss and ALAE
Current accident year non-cat loss and ALAE
Total non-cat loss and ALAE
Total Loss and ALAE
ULAE
Total Loss and LAE
Underwriting expenses
Net underwriting (loss) gain
Cat loss and ALAE ratio
Non-cat loss and ALAE ratio
Prior accident years non-cat loss and ALAE ratio
Current accident year non-cat loss and ALAE ratio
Total non-cat loss and ALAE ratio
Total Loss and ALAE ratio
ULAE ratio
Total Loss and LAE ratio
Expense ratio
Combined ratio
Table 4
($ in millions)
Commercial Auto
Small Commercial Package
Middle Market Commercial
Workers' Comp
Farm & Ranch
Other Commercial
Total
Net written premiums
Net earned premiums
Losses and LAE incurred:
Cat loss and ALAE
Non-cat loss and ALAE
Prior accident years non-cat loss and ALAE
Current accident year non-cat loss and ALAE
Total non-cat loss and ALAE
Total Loss and ALAE
ULAE
Total Loss and LAE
Underwriting expenses
Net underwriting (loss) gain
Cat loss and ALAE ratio
Non-cat loss and ALAE ratio
Prior accident years non-cat loss and ALAE ratio
Current accident year non-cat loss and ALAE ratio
Total non-cat loss and ALAE ratio
Total Loss and ALAE ratio
ULAE ratio
Total Loss and LAE ratio
Expense ratio
Combined ratio
Commercial auto has been written on State Auto Connect since 2018, and in January 2019, we finished the rollout of State Auto Connect for small commercial package. Our farm and ranch product launched on State Auto Connect during the first quarter of 2020 and is now live in 27 states. Eight of the 27 states are states that we previously were not writing policies for farm & ranch products. The rollout of the State Auto Connect platform in farm & ranch's remaining states will continue throughout 2021. Our middle market commercial product launched on State Auto Connect in March 2020 and is currently live in 16 states, with subsequent state rollouts scheduled throughout 2021. Finally, our workers' compensation product launched on State Auto Connect in the fourth quarter of 2020 and is currently live in eight states with subsequent state rollouts scheduled throughout 2021.
The commercial insurance segment's net written premiums for the year ended December 31, 2020 increased 12.7% compared to 2019 (Tables 3 - 4), primarily driven by (i) new business growth and rate increases in commercial auto, (ii) new business growth in farm & ranch, and (iii) rate increases in middle market commercial. The 2020 increase was partially offset by a decrease in net written premiums in workers’ compensation due to (i) a decline in new business as a result of COVID-19, (ii) a strategic decision to not renew and no longer write nursing home policies, and (iii) continued intense competition in this market.
The commercial insurance segment's SAP catastrophe loss and ALAE ratio for the year ended December 31, 2020 increased 9.5 points compared to 2019 (Tables 3 - 4), with most of the catastrophe losses impacting middle market commercial, small commercial package, and farm & ranch. The 2020 cat loss and ALAE ratio was impacted (i) an increase in the severity of weather events when compared to 2019, (ii) a severe wind and hail storm, including tornadoes, in Tennessee, which contributed 4.4 points to the cat loss and ALAE ratio, of which 2.7 points were from three large losses in Nashville, (iii) the Midwest
derecho in August which contributed 1.4 points to the cat loss and ALAE ratio, and (iv) property losses resulting from the civil unrest which added 1.1 points to the cat loss and LAE ratio.
The commercial insurance segment's SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 5.3 points compared to 2019. (Tables 3 - 4).
The commercial auto SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 2.9 points when compared to 2019 (Tables 3 - 4), driven by improvement in the current accident year. The 2020 current accident year was impacted by lower claims frequency, attributable to (i) fewer miles driven due to people working remotely and staying at home more because of COVID-19 concerns, and (ii) reduced business activity due to the impact of COVID-19 concerns. Partially offsetting the 2020 improvement was less favorable development of prior accident year losses when compared to 2019. The 2019 prior accident year favorable development was primarily attributable to lower than anticipated from the 2017 year.
The small commercial package SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 7.0 points compared to 2019 (Tables 3 - 4), primarily due to greater favorable development of prior accident year losses, driven by lower than expected bodily injury severity from multiple accident years when compared to 2019. The 2020 current accident year ratio was impacted by (i) a decline in claim frequency as a result of reduced business activity caused by COVID-19, and (ii) increased severity of property losses, primarily related to fire. The 2020 current accident year was also impacted by increased legal defense costs from claims related to COVID-19, which added 2.0 points to the non-cat ratio. 2019 development of prior year was attributable to lower than expected bodily from multiple years.
The middle market commercial SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 7.3 points when compared to 2019 (Tables 3 - 4), primarily due to improvement in the current accident year, driven by a decline in claim frequency as a result of reduced business activity caused by the impact of COVID-19, partially offset by increased legal defense costs from claims related to COVID-19, which added 0.6 points to the non-cat loss and ALAE ratio. Greater favorable development of prior accident year losses, driven by lower than expected bodily injury severity from multiple accident years, also contributed to the when compared to 2019. The 2019 non-cat and ALAE ratio was impacted by development of prior year due to lower than expected bodily claim from multiple years. Also impacting 2019 were large fire in the 2019 current year, including a single large that added 2.0 points to the ratio.
The workers' compensation SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 increased 0.5 points when compared to 2019. The 2020 current accident year was impacted by increased claims for businesses in the medical field (e.g. nursing homes, hospitals) due to the COVID-19 pandemic, which added 10.0 points to the non-cat loss ratio, which were partially offset by a decline in claim frequency due to reduced business and employment activity in response to the COVID-19 pandemic. The 2020 current accident year ratio was also impacted by a large loss in the third quarter that added 2.5 points to the non-cat loss ratio. Partially offsetting the increase in the non-cat loss ratio was greater favorable development of prior accident year losses primarily due to lower than anticipated across multiple years. The 2019 non-cat and ALAE ratio was impacted by development of prior year primarily due to lower than anticipated from multiple years. The 2019 current year reflected (i) elevated claim frequency and , and (ii) a single large that added 3.5 points to the ratio.
The farm & ranch SAP non-catastrophe loss and ALAE ratio for the year ended December 31, 2020 improved 0.6 points when compared to 2019. The improvement in the 2020 non-cat loss ratio was primarily due to lower claim frequency in the current accident year.
Loss and LAE Development
Losses and loss expenses for a calendar year represent the combined estimated ultimate liability for claims occurring in the current calendar year along with any change in the estimated ultimate liability for claims occurring in prior years. The following table sets forth the provision for losses and loss expenses for those claims occurring in the current and prior years, along with the GAAP loss and LAE ratio for the years ended December 31, 2020 and 2019:
($ millions)
GAAP Loss
and LAE Ratio
GAAP Loss
and LAE Ratio
Provision for losses and loss expenses occurring:
Current year
Prior years
Total losses and loss expenses
The following table sets forth a tabular presentation of the development of the ultimate liability of prior accident years by line of business for the years ended December 31, 2020 and 2019:
($ millions)
(Favorable)/Adverse
Non-cat loss and ALAE:
Personal Insurance Segment:
Personal Auto
Homeowners
Other Personal
Total Personal Insurance Segment
Commercial Insurance Segment:
Commercial Auto
Small Commercial Package
Middle Market Commercial
Workers' Compensation
Farm & Ranch
Other Commercial
Total Commercial Insurance Segment
Specialty run-off
Total non-cat loss and ALAE
Cat loss and ALAE:
Personal Insurance Segment
Commercial Insurance Segment
Specialty run-off
Total cat loss and ALAE
ULAE
Total
For further information, see the discussion below and the "Personal Insurance Segment" and "Commercial Insurance Segment" sections of “Results of Operations – Insurance Segments” included in this Item 7.
The following table sets forth a tabular presentation of the development of the ultimate liability by accident year for the year ended December 31, 2020:
($ millions)
Accident Year
(Favorable)/Adverse
2010 and prior
Total
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the more notable items contributing to 2020 development were as follows:
• The commercial insurance segment non-catastrophe loss and ALAE reserves contributed $78.4 million of favorable development, driven by workers’ compensation, small commercial package, and middle market commercial which contributed $24.9 million, $23.0 million, and $16.7 million, respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years.
• The personal insurance segment non-catastrophe loss and ALAE reserves contributed $21.7 million of adverse development, primarily from accident year 2019. Personal auto contributed $20.3 million of adverse development primarily driven by higher than expected severity for bodily injury claims from multiple accident years.
• Catastrophe reserves in specialty run-off contributed $12.6 million of adverse development primarily from Hurricane Irma.
• ULAE was $2.5 million higher than anticipated in the reserves at December 31, 2019.
The following table sets forth a tabular presentation of the development of the ultimate liability by accident year for the year ended December 31, 2019:
($ millions)
Accident Year
(Favorable)/Adverse
2009 and prior
Total
While emergence by accident year includes normal fluctuations due to the uncertainty associated with loss reserve development and claim settlement, the more notable items contributing to 2019 development were as follows:
• The commercial insurance segment non-catastrophe loss and ALAE reserves contributed $58.8 million of favorable development, driven by workers’ compensation, small commercial package, and middle market commercial which contributed $20.9 million, $15.2 million, and $11.8 million, respectively. Favorable development in these lines was driven by lower than anticipated severity emerging from multiple accident years.
• The personal insurance segment non-catastrophe loss and ALAE reserves contributed $12.5 million of the favorable development, driven by personal auto which contributed $10.7 million of favorable development, primarily due to lower than anticipated bodily injury severity.
• Catastrophe reserves in specialty run-off contributed $10.7 million of adverse development primarily from Hurricanes Irma and Harvey. Partially offsetting the adverse development in specialty run-off was $5.0 million of favorable development in the personal and commercial insurance segments.
• ULAE was $2.0 million lower than anticipated in the reserves at December 31, 2018.
The following table sets forth loss and loss expenses payable by major line of business at 2020 and 2019:
($ millions)
Change
Personal Insurance Segment:
Personal auto
Homeowners
Other Personal
Total Personal Insurance Segment
Commercial Insurance Segment:
Commercial Auto
Small Commercial Package
Middle Market Commercial
Workers’ Compensation
Farm & Ranch
Other Commercial
Total Commercial Insurance Segment
Specialty run-off:
E&S Property
E&S Casualty
Programs
Total Specialty run-off
Total losses and loss expenses payable net of reinsurance recoverable on losses and loss expenses payable
The loss and loss expenses payable at December 31, 2020 decreased $26.8 million from the loss and loss expenses payable at December 31, 2019, due to the run-off of specialty business partially offset by (i) a higher level of catastrophe losses in the commercial and personal insurance segments discussed above, (ii) growth in the homeowners and commercial auto lines, and (iii) adverse development of prior accident years for personal auto driven by higher than expected severity for bodily injury claims.
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, 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 would 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, see “Critical Accounting Policies – Losses and Loss Expenses Payable” included in this Item 7.
Acquisition and Operating Expenses
Our GAAP acquisition and operating expenses were $481.4 million in 2020 compared to $440.7 million in 2019. The increase in acquisition and operating expenses was driven by (i) amortization of deferred acquisition costs due to growth, (ii) IT expenses, including electronic data processing equipment and software cost amortization and IT consulting, and (iii) variable agent compensation. The shift to State Auto Connect and our digital journey over the last five years continue to drive the increases in IT expenses. Partially offsetting this increase in acquisition and operating expenses was a decrease in estimated variable associate compensation when compared to 2019.
Investment Operations Segment
Our investment portfolio and the investment portfolios of other members of the State Auto Group are managed by our subsidiary, Stateco. Stateco utilizes its own personnel to invest in fixed maturities, U.S. large-cap equities, U.S. small-cap equity funds, international equity funds, and exchange traded funds ("ETF"). In addition, Stateco uses an outside investment manager who invests in international funds and one outside manager who invests in fixed maturities. The Investment and Finance Committee (the “Committee”) of our Board of Directors establishes the investment policies to be followed by Stateco. Our primary investment objectives are to maintain adequate liquidity and capital to meet our responsibilities to policyholders, grow long term economic surplus to increase our capital position, maintain a consistent level of income to support operations and manage investment risk. Our current investment strategy does not rely on the use of derivative financial instruments.
Our decision to make a specific investment is influenced primarily by the following factors: (a) investment risks; (b) general market conditions; (c) relative valuations of investment vehicles; (d) general market interest rates; (e) our liquidity requirements at any given time; and (f) our current federal income tax position and relative spread between after tax yields on tax exempt and taxable fixed maturity investments.
We have investment policy guidelines with respect to purchasing fixed maturity investments for our insurance subsidiaries which preclude purchases of bonds that are rated below investment grade by a recognized rating service. Our fixed maturity portfolio is composed of high quality, investment grade issues, comprised mostly of debt issues rated A, or higher. We obtain investment ratings from nationally recognized ratings agencies. If there is a split rating, we assign the lowest rating obtained.
Our internally managed equity portfolio invests in U.S. large-cap companies across many different industries, selected based upon their potential for appreciation. This diversification across companies and industries reduces volatility in the value of the large-cap equity portfolio. Our investment policy guidelines limit the purchase of a specific stock to no more than 5.0% of the market value of the stock at the time of purchase, and no individual company’s equity holding should exceed 5.0% of the total equity portfolio. In addition, we also invest in dividend-paying exchange traded funds and mutual funds which add to the diversification of the portfolio by allowing us to invest in a large number of companies via one security.
Our externally managed equity portfolio invests in international funds. External managers are permitted to manage the portfolios according to their own respective portfolio objectives. In selecting our outside investment managers we confirm that their portfolio objectives, including risk tolerance, are acceptable to us; however, there may be slight differences in their objectives when compared to how we manage our large-cap equity holdings.
At December 31, 2020, our investments in fixed maturities, equity securities and certain other invested assets were carried at fair value. The unrealized holding gains or losses of our available-for-sale fixed maturities, net of applicable deferred taxes, are included as a separate component of stockholders’ equity as accumulated other comprehensive income and as such are not included in the determination of net income. Changes in the fair value of equity securities and other invested assets are reported in "net investment gain (loss)" in the condensed consolidated statements of income.
Composition of Investment Portfolio
The following table sets forth the composition of our investment portfolio at carrying value at December 31, 2020 and 2019:
($ millions)
% of Total
% of Total
Cash and cash equivalents
Fixed maturities, at fair value:
Fixed maturities
Treasury inflation-protected securities
Total fixed maturities
Notes receivable from affiliate (1)
Equity securities:
Large-cap securities
Mutual and exchange traded funds
Total equity securities
Other invested assets:
International instruments
Other invested assets
Total other invested assets
Other invested assets, at cost
Total portfolio
(1) In May 2019, we refinanced our two credit agreements with State Auto Mutual. Under these credit agreements, State Auto Mutual borrowed $70.0 million from us on an unsecured basis at an interest rate of 4.05%, with principal payable in May 2029.
The following table sets forth the amortized cost and fair value of available-for-sale fixed maturities by contractual maturity at December 31, 2020:
($ millions)
Amortized
Cost
Fair
Value
Due in 1 year or less
Due after 1 year through 5 years
Due after 5 years through 10 years
Due after 10 years
U.S. government agencies residential mortgage-backed securities
Total
Expected maturities may differ from contractual maturities as issuers may have the right to call or prepay the obligations with or without call or prepayment penalties.
At December 31, 2020, our equity portfolio consisted of approximately 37 different large-cap stocks and 14 mutual and exchange traded funds. The largest single fund holding was 17.7% of the equity portfolio based on fair value and the top ten positions accounted for 65.8% of the equity portfolio. At December 31, 2019, our equity portfolio consisted of approximately 38 different large-cap stocks and 17 mutual and exchange traded funds. The largest single fund holding was 18.7% of the equity portfolio based on fair value and the top ten positions accounted for 68.6% of the equity portfolio.
Market Risk
Our primary market risk exposures are to changes in market prices for equity securities and changes in interest rates and credit ratings for fixed maturity securities. Our fixed maturity securities are subject to interest rate risk whereby the value of the securities varies as market interest rates change. We manage this risk by closely monitoring the duration of the fixed maturity portfolio. The duration of the fixed maturity portfolio was approximately 4.72 and 4.17 as of December 31, 2020 and 2019, respectively. The following table sets forth our interest rate risk and the effects of a parallel change in interest rates on the fair value of the available-for-sale fixed maturity portfolio at December 31, 2020:
($ millions)
Fair Value
-200 bps
Change
-100 bps
Change
Actual
+100 bps
Change
+200 bps
Change
Fixed maturities:
U.S. treasury securities and obligations of U.S. government agencies
Obligations of states and political subdivisions
Corporate securities
U.S. government agencies mortgage-backed securities
Balance as of December 31, 2020
This table summarizes only the effects that a parallel change in interest rates could have on the fixed maturity portfolio. Changes in rates would also change the value of our liabilities and possibly other financial assets. We caution the reader that this analysis does not take into account nonparallel changes in interest rates. It is likely that some rates would increase or decrease more than others depending upon market conditions at the time of the change. This nonparallel change would alter the value of the fixed maturity portfolio. The analysis is also limited in that it does not take into account any actions that might be taken by us in response to these changes. As a result, the actual impact of a change in interest rates and the resulting fixed maturity values may differ significantly from what is shown in the table.
We believe that the fixed maturity portfolio’s exposure to credit risk is minimal as approximately 86.7% of the bonds we own are rated A or better. We do not intend to change our investment policy or the quality of our fixed maturity investments. The fixed maturity portfolio is managed in a laddered-maturity style and considers business mix and liability payout patterns to ensure adequate cash flow to meet claims as they are presented. We also manage liquidity risk by maintaining sufficient cash balances, owning some agency and U.S. Treasury securities at all times, purchasing bonds of major issuers, and purchasing bonds that are part of a medium or large issue. The fixed maturity portfolio does not have any direct exposure to either exchange rate risk or commodity risk. We do not rely on the use of derivative financial instruments. We categorize our fixed maturities as available-for-sale in order to provide us greater flexibility in managing our portfolio. We do not maintain a trading portfolio.
There are no mortgage backed securities in our fixed maturity portfolio which may be labeled sub-prime mortgage backed securities. We invest only in mortgage backed securities issued by a federal agency or that are U.S. Government guaranteed. Specifically, at December 31, 2020, approximately $660.7 million, or 29.5%, of our fixed maturity available-for-sale investment portfolio was in either GNMA pools, which are guaranteed by the full faith and credit of the U.S. Government, or FNMA or Freddie Mac pools.
The following table sets forth the credit ratings of our municipal securities based on ratings by nationally recognized rating agencies at December 31, 2020:
($ millions)
Rating
Total fair
value
AAA
BBB
Total
Our AA rating category includes securities that have been either pre-funded or escrowed to maturity.
We believe our Muni Portfolio is well diversified by issuer and state. We have 22.3% invested in securities which have been either pre-refunded or escrowed to maturity bonds. No single issuer comprises more than 8.0% of our Muni Portfolio. For the bonds that are not in the pre-refunded category, no more than 15% is concentrated in any one state. We believe our Muni Portfolio is invested within the strongest sectors of the municipal bond market. Revenue bonds represent 69.9% of our Muni Portfolio and state and local government general obligation bonds make up 24.0% of our Muni Portfolio. Our credit research is an important part of our investment management process, and we continually monitor all holdings for any signs of deterioration. We believe that our municipal holdings will maintain their high credit quality and that the issuers will be able to make all principal and interest payments as they come due.
At December 31, 2020, our large-cap equity portfolio had a weighted beta of 1.02 using the S&P 500 Index as the benchmark. At December 31, 2020, our mutual and exchange traded funds portfolio had a weighted beta of 1.00 using the S&P 500 Index and the CRSP US Small Cap Index as benchmarks. Beta estimates the degree the portfolio’s price will fluctuate based on a given movement in the market index. The following tables set forth what changes might occur in the value of the large-cap equity portfolio and the mutual fund and ETF portfolio given a change in the respective index at December 31, 2020:
Large-cap equity portfolio:
Fair value ($ millions)
Change in S&P 500 Index
Value as % of original value
Mutual fund and ETF portfolio:
Fair value ($ millions)
Change in Index
Value as % of original value
The above analysis is limited in that it does not take into account any actions that might be taken by us in response to these changes. As a result, the actual impact of a change in equity market prices and the resulting equity values may differ significantly from what is shown in the table. By investing in mostly large-cap issues we hope to limit liquidity risk in the equity portfolio. The U.S. large-cap equity portfolio does not have any direct exposure to exchange rate risk since we do not directly hold any foreign stocks. We constantly monitor the equity portfolio holdings for any credit risk issues that may arise. We do not invest in any commodity futures or commodity oriented mutual funds.
At December 31, 2020, we had one international fund, which was included in other invested assets. The international fund had a beta of 0.74 using the MSCI EAFE Index as a benchmark. The following table sets forth what changes might occur in the value of Funds 1 given a change in the MSCI EAFE Index at December 31, 2020:
International fund:
Fair value ($ millions)
Change in MSCI EAFE Index
Value as % of original value
The above analysis does not take into account any actions that might be taken by the portfolio managers in response to these changes. As a result, the actual impact of a change in international equity market prices and the resulting international equity value may differ significantly from what is shown in the table above.
Investment Operations Revenue
The following table sets forth the components of net investment income for the years ended December 31, 2020 and 2019:
($ millions)
Year Ended December 31
Gross investment income:
Fixed maturities
Equity securities
Other
Total gross investment income
Less: Investment expenses
Net investment income
Average invested assets (at cost)
Annualized investment yield
Annualized investment yield, after tax
Net investment income, after tax
Effective tax rate
Our investment operations revenue for the year ended December 31, 2020 decreased when compared to the same 2019 period due to (i) less income from the MLP ETF's, (ii) the lower interest rate on notes payable from State Auto Mutual, and (iii) a lower interest rate environment when compared to the same 2019 periods.
When a fixed maturity has been determined to have an impairment, the impairment charge representing the credit loss is recognized in earnings as a realized loss and on the balance sheet as an allowance for credit losses netted with the amortized cost of fixed maturities. Future increases in fair value, if related to credit factors, are recognized through earnings limited to the amount previously recognized as an allowance for credit losses. The amount related to non-credit factors is recognized in accumulated other comprehensive income and future increases or decreases in fair value, if not credit losses, are included in accumulated other comprehensive (loss) income. We reviewed our available-for-sale fixed maturities at December 31, 2020 and determined that no credit impairment existed in the gross unrealized holding losses. See Note 3, “Investments” to our consolidated financial statements included in Item 8 of this Form 10-K for additional information.
Gross Unrealized Investment Gains and Losses
Based upon our review of our investment portfolio at December 31, 2020, we determined that there were no individual investments with an unrealized holding loss that had a fair value significantly below cost continually for more than one year. The following table sets forth detailed information on our available-for-sale investment portfolio by lot at fair value for our gross unrealized holding gains (losses) at December 31, 2020:
($ millions, except number of positions)
Cost or
amortized
cost
Gross
unrealized
holding
gains
Gross
unrealized
holding
losses
Fair
value
Available-for-sale fixed maturities:
U.S. treasury securities and obligations of U.S. government agencies
Obligations of states and political subdivisions
Corporate securities
U.S. government agencies mortgage-backed securities
Total available-for-sale fixed maturities
The following table sets forth our unrealized holding gains by investment type, net of deferred tax that was included as a component of accumulated comprehensive income at December 31, 2020 and 2019, and the change in unrealized holding gains, net of deferred tax, for the year ended December 31, 2020:
($ millions)
$ Change
Available-for-sale investments
Unrealized holding gains (losses):
Fixed maturities
Net deferred federal income tax
Unrealized gains (losses), net of tax
Fair Value Measurements
We primarily use one independent nationally recognized pricing service in developing fair value estimates. We obtain one price per security, and our processes and control procedures are designed to ensure the value is accurately recorded on an unadjusted basis. Through discussions with the pricing service, we gain 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, we compare to other fair value pricing information gathered from other independent pricing sources. See Note 4, “Fair Value of Financial Instruments” to our consolidated financial statements included in Item 8 of this Form 10-K for a presentation of our available-for-sale investments within the fair value hierarchy at December 31, 2020.
Other Items
Income Taxes
For the year ended December 31, 2020, the federal income tax expense was $1.3 million compared to $19.7 million for 2019. Our effective tax rate for 2020 was 8.8% compared with 18.7% in 2019. The change in our effective tax rate in 2020 when compared to 2019 was primarily due to the relationship of taxable to non-taxable income. Taxable income was lower in 2020 due to (i) less recognized gains on equity securities in 2020 compared 2019, and (ii) an increase in the underwriting loss in 2020 when compared to 2019. Non-taxable income, which is primarily tax exempt interest and a portion of our dividend income, remained comparable.
We have foreign tax credit carryforwards of $0.3 million which will expire in 2021. We believe it is more likely than not that the benefit from these foreign tax credit carryforwards will not be realized. In recognition of this risk, we have provided a valuation allowance of $0.3 million on the deferred tax assets related to these foreign tax credit carryforwards.
See Note 11, “Federal Income Taxes” to our consolidated financial statements included in Item 8 of this Form 10-K for a reconciliation between our actual federal income tax expense (benefit) and the amount computed at the indicated statutory rate for the years ended December 31, 2020 and 2019.
LIQUIDITY AND CAPITAL RESOURCES
General
Liquidity refers to our ability to generate adequate amounts of cash to meet our short and long-term needs. Our primary sources of cash are premiums, investment income, investment sales and the maturity of fixed income security investments. The significant outflows of cash are payments of claims, commissions, premium taxes, operating expenses, income taxes, dividends, interest and principal payments on debt and investment purchases. The cash outflows may vary due to uncertainties regarding settlement of large losses or catastrophe events. As a result, we continually monitor our investment and reinsurance programs to ensure they are appropriately structured to enable the insurance subsidiaries to meet anticipated short and long-term cash requirements without the need to sell investments to meet fluctuations in claim payments.
Liquidity
Our insurance subsidiaries must have adequate liquidity to ensure that their cash obligations are met. However, as discussed below, the STFC Pooled Companies do not have the day-to-day liquidity concerns normally associated with an insurance company due to their participation in, and the terms of, the Pooling Arrangement. In addition, State Auto P&C’s $100.0 million open line of credit with the Federal Home Loan Bank of Cincinnati (the “FHLB”) is available for general corporate purposes, which includes funding for any of our liquidity needs. See “Liquidity and Capital Resources – Borrowing Arrangements" included in this Item 7.
Under the terms of the Pooling Arrangement, each period State Auto Mutual collects all premiums from policyholders and pays all losses and expenses associated with the insurance business produced by the STFC Pooled Companies and the other pool participants, and then it settles the intercompany balances generated by these transactions with the pool participants within 60 days following each quarter end. We believe this provides State Auto Mutual with sufficient liquidity to pay losses and expenses of our insurance operations on a timely basis.
We are exposed to third-party credit risk both directly through its cessions to reinsurers and indirectly through its participation in the Pooling Arrangement. In addition to exposure to credit risk on reinsurance recoverables, we are also exposed to credit risk on amounts due from insureds and agents. When settling the intercompany balances, State Auto Mutual provides the STFC Pooled Companies with full credit for the net premiums written and net losses paid during the quarter.
While the total amount due to State Auto Mutual from policyholders and agents is significant, the individual amounts due are relatively small at the policyholder and agency level. The State Auto Group mitigates its exposure to this credit risk through its in-house collections unit for both personal and commercial accounts which is supplemented by third party collection service providers. In addition to reliance upon recent and historical collection trends, determination of the allowance for uncollectible premiums receivable at December 31, 2020 included consideration of other factors, including macro-economic conditions and trends, in particular the estimated impact of COVID-19. Credit risk is partially mitigated by the State Auto Group's ability to cancel the policy if the policyholder does not pay the premium. Pursuant to the Pooling Arrangement, bad debt expense for uncollectible premiums for the pool is allocated to pool members on the basis of pool participation and is included in the quarterly settlement of intercompany balances. This is included in "other expenses" on the consolidated statements of income and reflected in “due to/from affiliates” on our consolidated balance sheets.
We generally manage our cash flows through current operational activity and maturing investments, without a need to liquidate any of our other investments. However, should our written premiums decline or paid losses increase significantly, or a combination thereof, our cash flows from operations could be impacted requiring us to liquidate investments. This action was not necessary in 2020 or 2019.
We maintain a portion of our investment portfolio in relatively short-term and highly liquid investments to ensure the immediate availability of funds to pay claims and expenses. At December 31, 2020 and 2019, we had $90.7 million and $78.0 million, respectively, in cash and cash equivalents, and $2,698.0 million and $2,593.3 million, respectively, of total investments. Our available-for-sale fixed maturities included $9.7 million and $9.3 million, respectively, of securities on deposit with insurance regulators, as required by law, at December 31, 2020 and 2019. In addition, substantially all of our fixed maturity and equity securities are traded on public markets. For a further discussion regarding investments, see “Results of Operations – Investments Operations Segment” included in this Item 7.
Cash provided by operating activities was $49.0 million and cash used in operating activities was $43.9 million in 2020 and 2019, respectively. Net cash from operations will vary from period to period if there are significant changes in underwriting results, primarily the level of premiums written or loss and loss expenses paid, and in cash flows from investment income.
Cash used in investing activities was $21.8 million and cash provided by investing activities was $74.1 million in 2020 and 2019, respectively. The change from 2020 compared to 2019 was primarily driven by increases in the purchases of fixed maturities.
Cash used in financing activities was $14.5 million and $12.0 million in 2020 and 2019, respectively. The change was primarily driven by a decrease in stock option exercises in 2020 when compared to 2019.
Borrowing Arrangements
FHLB Line of Credit
State Auto P&C has an Open Line of Credit Commitment (the "OLC") with the FHLB that provides State Auto P&C with a $100.0 million one-year open line of credit available for general corporate purposes. The OLC matures in April 2021. Draws under the OLC are to be funded with a daily variable rate advance with a term of no more than 180 days with interest payable monthly. All advances under the OLC are fully secured by a pledge of specific investment securities of State Auto P&C. As of December 31, 2020, no advances had been made under the OLC.
FHLB Loans
On September 2, 2020, State Auto P&C retired its five-year term loan with the FHLB in the amount of $21.5 million and maturing on September 2, 2021 and replaced it with a new ten-year term loan with the FHLB in the amount of $21.5 million (the “2020 FHLB Loan”). The 2020 FHLB Loan is at a fixed rate of interest of 1.37%, provides for interest-only payments during its term, with principal due in full at maturity, and may be prepaid without penalty after five years and each of the
succeeding six months thereafter. The 2020 FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C.
State Auto P&C also has an outstanding term loan with the FHLB in the principal amount of $85.0 million (the "2018 FHLB Loan"). The 2018 FHLB Loan matures in May 2033 and provides for interest-only payments during its term, with principal due in full at maturity. The interest rate is fixed over the term of the loan at 3.96%. Prepayment of the 2018 FHLB Loan would require a prepayment fee. The 2018 FHLB Loan is fully secured by a pledge of specific investment securities of State Auto P&C.
Subordinated Debentures
State Auto Financial’s Delaware business trust subsidiary (the “Capital Trust”) has outstanding $15.0 million liquidation amount of capital securities, due 2033. In connection with the Capital Trust’s issuance of the capital securities and the related purchase by State Auto Financial of all of the Capital Trust’s common securities (liquidation amount of $0.5 million), State Auto Financial has issued to the Capital Trust $15.5 million aggregate principal amount of unsecured Floating Rate Junior Subordinated Debt Securities due 2033 (the “Subordinated Debentures”). The sole assets of the Capital Trust are the Subordinated Debentures and any interest accrued thereon. Interest on the Capital Trust’s capital and common securities is payable quarterly at a rate equal to the three-month LIBOR rate plus 4.20%, adjusted quarterly. The applicable interest rates for December 31, 2020 and 2019 were 4.43% and 6.11%, respectively.
Notes Payable Summary
The following table sets forth our notes payable at December 31, 2020:
($ millions)
Carrying
Value
Fair
Value
Interest
Rate
FHLB loan due 2030: issued $21.5 million , September 2020 with fixed interest
FHLB loan due 2033: issued $85.0 million, May 2018 with fixed interest
Subordinated Debentures due 2033: issued $15.5 million, May 2003 with variable interest adjusting quarterly
Total notes payable
Related to our notes payable, our primary market risk exposure is to the change in interest rates and our credit rating. For a discussion regarding our credit ratings see “Liquidity and Capital Resources – Credit and Financial Strength Ratings” included in this Item 7. Based upon the notes payable carrying value at December 31, 2020, we had $15.3 million notes payable with variable interest and $85.3 million and $21.5 million of notes payable with interest fixed at 3.96% and 1.37%, respectively, which equated to approximately 12.5% variable interest debt and 87.5% fixed interest debt. Our decision to obtain fixed versus variable interest rate debt is influenced primarily by the following factors: (a) current market interest rates; (b) anticipated future market interest rates; (c) availability of fixed versus variable interest instruments; and (d) our currently existing notes payable fixed and variable interest rate position. See our contractual obligations table included in “Liquidity and Capital Resources –Contractual Obligations” included in this Item 7.
Reinsurance Arrangements
Members of the State Auto Group follow the customary industry practice of reinsuring a portion of their exposures and paying to the reinsurers a portion of the premiums received. Insurance is ceded principally to reduce net liability on individual risks or for individual loss occurrences, including catastrophic losses. Although reinsurance does not legally discharge the individual members of the State Auto Group from primary liability for the full amount of limits applicable under their policies, it does make the assuming reinsurer liable to the extent of the reinsurance ceded.
To minimize the risk of reinsurer default, the State Auto Group cedes only to third-party reinsurers who are rated A- or better by A.M. Best or Standard & Poor’s and also utilizes both domestic and international markets to diversify its credit risk. We utilize reinsurance to limit our loss exposure and contribute to our liquidity and capital resources.
Other Reinsurance Arrangements
Each member of the State Auto Group is party to working reinsurance treaties for casualty, workers’ compensation and property lines with several reinsurers arranged through reinsurance intermediaries. These agreements are described in more detail below. We have also secured other reinsurance to limit the net cost of large loss events for certain types of coverage. The State Auto Group also makes use of facultative reinsurance for unique risk situations. The State Auto Group also participates in state insurance pools and associations. In general, these pools and associations are state sponsored and/or operated, impose mandatory participation by insurers doing business in that state, and offer coverage for hard-to-place risks at rates established by the state sponsor or operator, thereby transferring risk of loss to the participating insurers in exchange for premiums which may not be commensurate with the risk assumed.
Adverse Development Cover
The State Auto Group has an adverse development reinsurance agreement implemented at the end of 2014, providing $40.0 million of coverage for adverse claims development in excess of carried reserves as of November 30, 2014 for the terminated restaurant program business previously underwritten by a MGU-subsidiary of State Auto Mutual.
Property Catastrophe Treaty
Members of the State Auto Group maintain a property catastrophe excess of loss reinsurance agreement, covering property catastrophe related events affecting at least two risks. This property catastrophe reinsurance agreement renewed as of July 1, 2020. Under this reinsurance agreement, we retain the first $90.0 million of catastrophe loss, each occurrence, with a 5.0% co-participation on the next $180.0 million of covered loss, each occurrence which is broken down into two layers of $70.0 million and $110.0 million. The reinsurers are responsible for 95.0% of the catastrophe losses excess of $90.0 million up to $270.0 million, each occurrence. The State Auto Group is responsible for catastrophe losses above $270.0 million. There is also an automatic reinstatement of the limit, for 100% of the deposit premium.
Property Per Risk Treaty
As of April 1, 2020, the State Auto Group renewed the property per risk excess of loss reinsurance agreement for a 15-month term. Under this reinsurance agreement, the State Auto Group retains the first $4.0 million of covered loss, with a 19.5% co-participation on the next $6.0 million of covered loss and a 14.0% co-participation on covered loss between $10.0 million and $20.0 million. The reinsurers are responsible for 80.5% of the loss excess of the $4.0 million retention up to $10.0 million and 86.0% of the loss excess of $10 million up to $20.0 million.
Casualty and Workers' Compensation Treaties
As of July 1, 2020, the State Auto Group renewed the casualty excess of loss reinsurance agreement. Under this reinsurance agreement, the State Auto Group is responsible for the first $3.0 million of losses that involve workers' compensation, auto liability, other liability and umbrella liability policies. This reinsurance agreement provides coverage up to $10.0 million, except for commercial umbrella policies which are covered for limits up to $15.0 million.
Also, certain unusual claim situations involving extra contractual obligations, excess of policy limits, LAE coverage and multiple policy or coverage loss occurrences arising from bodily injury liability, property damage, uninsured motorist and personal injury protection are covered by a Clash reinsurance agreement that provides for $20.0 million of coverage in excess of $10.0 million retention for each loss occurrence. This Clash reinsurance coverage sits above the $7.0 million excess of $3.0 million arrangement.
In addition, each company in the State Auto Group is party to a workers’ compensation catastrophe insurance agreement that provides additional reinsurance coverage for workers’ compensation losses involving multiple workers. Subject to $10.0 million of retention, reinsurers are responsible for 100.0% of the excess over $10.0 million up to $30.0 million of covered loss. For loss amounts over $30.0 million, the casualty excess of loss reinsurance agreement provides $20.0 million coverage in excess of $30.0 million. Workers’ compensation catastrophe coverage is subject to a “Maximum Any One Life” limitation of $10.0 million. This limitation means that losses associated with each worker may contribute no more than $10.0 million to covered loss under these agreements.
Contractual Obligations
The following table sets forth our significant contractual obligations at December 31, 2020:
($ millions)
Total
Due
1 year
or less
Due
years
Due
years
Due
after 5
years
Direct loss and ALAE reserves (1)
Notes payable (2) :
FHLB loan due 2033; issued $85.0 million, May 2018 with fixed interest
FHLB loan due 2030: issued $21.5 million, September 2020 with fixed interest
Subordinated Debentures due 2033: issued $15.5, May 2003 with variable interest (3) adjusting quarterly
Total notes payable
Interest payable (2) :
FHLB loan due 2033; issued $85.0 million, May 2018 with fixed interest
FHLB loan due 2030: issued $21.5 million, September 2020 with fixed interest
Subordinated Debentures due 2033: issued $15.5, May 2003 with variable interest (3) adjusting quarterly
Total interest payable
Postretirement benefits
Pension funding (4)
Total
Gross of the allowance for credit losses on reinsurance recoverables of $0.9 million. We derived expected payment patterns separately for the direct loss and ALAE reserves. Amounts included the STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement. Under the current Pooling Arrangement, STFC will recover 35% of these payments. For a reconciliation of management’s best estimate, see “Critical Accounting Policies – Losses and Loss Expenses Payable” included in this Item 7. These patterns were applied to the December 31, 2020, loss and ALAE payable to generate estimated annual incremental loss and ALAE payments for each subsequent calendar year. These amounts are based on historical payment patterns and do not represent actual contractual obligations. The actual payment amounts and the related timing of those payments could differ significantly from these estimates.
For a discussion of these debt instruments, see “Liquidity and Capital Resources—Borrowing Arrangements” included in this Item 7.
Interest on the subordinated debentures was calculated using an interest rate equal to the three-month LIBOR rate at December 31, 2020 of 0.2254% plus 4.20%, or 4.4254%.
These amounts are estimates of ERISA minimum funding levels based on adjustments to prior year assumptions for our defined benefit pension plan and do not represent an estimate of our expected contributions. Funding levels generally are not determined until later in the year with respect to the contribution year. See Note 12, “Pension and Postretirement Benefits Plans” to our consolidated financial statements included in Item 8 of this Form 10-K for a tabular presentation of expected benefit payments from the State Auto Group’s defined benefit pension plan.
The cost of leases and other purchase obligations of State Auto Mutual are allocated to us through the Pooling Arrangement.
Regulatory Considerations
At December 31, 2020 and 2019, each of our insurance subsidiaries was in compliance with statutory requirements relating to capital adequacy.
The NAIC utilizes a collection of analytical tools designed to assist state insurance departments with an integrated approach to screening and analyzing the financial condition of insurance companies operating in their respective states. One such set of analytical tools is 12 key financial ratios that are known in the insurance industry as the “IRIS” ratios. A “defined range” of results for each ratio has been established by the NAIC for solvency monitoring. While management utilizes each of these IRIS ratios in monitoring our insurance companies’ operating performance on a statutory accounting basis (each of our insurance subsidiaries operates within the defined range for the other measures), the net premiums written to surplus or leverage ratio is monitored to ensure that each of our insurance subsidiaries continue to operate within the “defined range” of 3.0 to 1.0. The higher the leverage ratio, the more risk a company bears in relation to statutory surplus available to absorb losses. In considering this range, management also considers the distribution of net premiums between property and liability lines of business. A company with a larger portion of net premiums from liability lines should generally maintain a lower leverage ratio.
The following table sets forth the statutory leverage ratios for our insurance subsidiaries at December 31, 2020 and 2019:
Statutory Leverage Ratios
State Auto P&C
Milbank
Weighted Average
State Auto P&C, Milbank and SA Ohio are subject to regulations and restrictions under which payment of dividends from statutory surplus can be made to State Auto Financial during the year without prior approval of regulatory authorities. Under the insurance regulations of Iowa and Ohio (the states of domicile), the maximum amount of dividends that we may pay out of earned surplus to shareholders within a twelve month period without prior approval of the Department is limited to the greater of 10% of the most recent year-end policyholders’ surplus or net income for the twelve month period ending the 31st day of December of the previous year-end. Pursuant to these rules, $91.0 million is available for payment to State Auto Financial from its insurance subsidiaries in 2021 without prior approval. State Auto Financial received dividends from its insurance subsidiaries in the amount of $15.0 million and $10.0 million in 2020 and 2019.
Our insurance subsidiaries are subject to risk-based capital (“RBC”) requirements that have been adopted by individual states. These requirements subject insurers having statutory capital less than that required by the RBC calculation to varying degrees of regulatory action, depending on the level of capital inadequacy. The RBC formulas specify various weighting factors to be applied to financial balances or various levels of activity based on the perceived degree of risk. Regulatory compliance is determined by a ratio of total adjusted capital to authorized control level RBC. Generally, no remedial action is required by an insurance company if its adjusted statutory surplus exceeds 200% of the authorized level RBC. At December 31, 2020, the ratio of total adjusted statutory capital to authorized control level of State Auto Financial’s insurance subsidiaries ranged from 489% to 19,110%.
Credit and Financial Strength Ratings
As of July 16, 2020, the State Auto Group’s financial strength rating from A.M. Best was A- (Excellent) with a stable outlook and its credit rating from A.M. Best was bbb- with a stable outlook.
The financial strength rating is for the State Auto Group and expresses the opinion of the rating agency as to the ability of the State Auto Group to meet its ongoing obligations to policyholders. The A.M. Best financial strength rating influences our ability to write insurance business as agents and policyholders generally prefer higher rated companies. Lower rated companies may be required to compete for agents and policyholders by offering higher commissions or lower premiums and expanded coverage, or a combination thereof.
We believe that these ratings provide a meaningful way for policyholders, agents, creditors, shareholders and others to compare us to our competitors. Our ratings are influenced by many factors, including operating and financial performance, asset quality, liquidity, financial leverage, exposure to catastrophe risks and operating leverage.
Generally, credit ratings affect the cost, type and availability of debt financing. Higher rated securities receive more favorable pricing and terms relative to lower rated securities at the time of issue.
Our management considers how its overall strategy and decisions may influence the rating agencies’ evaluation of our credit strength and capital position, which may in turn directly impact the credit and financial strength ratings assigned by those agencies. In its decision-making process with respect to significant transactions, such as reinsurance, financing and investing activities, and acquisitions, management takes into consideration the potential impact these decisions will have on our earnings volatility and capital position.
OTHER
Impact of Inflation
Inflation can have a significant impact on property and casualty insurers because premium rates are established before the amount of losses and loss expenses are known. When establishing rates, we attempt to anticipate increases from inflation subject to the limitations of modeling economic variables. Even when general inflation, as measured by the Consumer Price Index, has been relatively modest, as has been the case over the last several years, price inflation on the goods and services purchased by insurance companies in settling claims can steadily increase. For example, historically medical care costs have risen at a higher rate than general inflation over the last few years. Costs for building materials typically rise significantly following widespread natural catastrophes, such as what the industry experienced in areas affected by Superstorm Sandy in 2012. We continue to adjust our pricing projections to reflect current and anticipated changes in costs in all lines of business.
We consider inflation when estimating liabilities for losses and loss expenses, particularly for claims having a long period between occurrence and final settlement. The liabilities for losses and loss expenses are management’s best estimates of the
ultimate net cost of underlying claims and expenses and are not discounted for the time value of money. In times of high inflation, the normally higher yields on investment income may partially offset potentially higher claims and expenses.
CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are more fully described in Note 1 of the notes to our consolidated financial statements included in Item 8 of this Form 10-K. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet, revenues and expenses for the period then ended and the financial entries in the accompanying notes to the financial statements. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed in this Item 7. We have identified the policies and estimates described below as critical to our business operations and the understanding of the results of our operations.
Losses and Loss Expenses Payable
Our loss reserves reflect all unpaid amounts for claims that have been reported, as well as for claims that have not yet been reported. Our loss reserves are not discounted to present value.
Loss reserves are management’s best estimates (“MBE”) at a given point in time of what we expect to pay to settle all claims incurred as of that date based on known facts, circumstances and historical trends. Loss reserves at the individual claim level are established on either a case reserve basis or formula reserve basis depending on the type and circumstances of the loss. The case reserve amounts are determined by claims adjusters based on our reserving practices, which take into account the type of risk, the circumstances surrounding each claim and applicable policy provisions. The formula reserves are based on historical data for similar claims with provision for changes caused by inflation. Case reserves and formula reserves are reviewed on a regular basis, and as new data becomes available, estimates are updated resulting in adjustments to loss reserves. Generally, reported losses initially reserved on a formula basis and not settled after six months are case reserved at that time. The process for calculating the IBNR component of the reserve is to develop an estimate of the ultimate and allocated adjustment expenses incurred, and subtract all amounts already paid or held as case or formula reserves. Note that reference to below includes allocated adjustment expenses.
Management’s determination of ultimate losses incorporates information and analysis provided by several disciplines within our Company, including accounting, claims, product and actuarial. While all of the information is considered, the actuarial analysis is the primary piece of information used in determining ultimate losses. Our actuarial personnel conduct quarterly reviews of loss development information to assist management in making estimates of ultimate losses. The actuarial analysis provides two key pieces of information, the actuarial central estimate (“ACE”) and a range of reasonable estimates of ultimate losses. Management’s selections have resulted in reported loss reserves exceeding the ACE while being within the range of reasonable estimates as provided by the actuarial analysis. In addition to the actuarial analysis and information provided by other disciplines, management’s assessment in making their determination of ultimate losses considers a number of factors including inflation, legal developments, recent changes in the volume or type of business written, changes in claim handling practices, general economic conditions, and the accuracy of past estimates. While a variety of factors are considered, there is no single method for determining the ultimate , and thus, our reserves. When changes in the various factors do occur, those changes are incorporated in subsequent valuations of our reserves.
Our actuarial personnel conduct quarterly reviews to determine the ACE of ultimate losses. The reviews include performing calculations using a number of actuarial methods. The methods most commonly relied upon are discussed below. Determining the ACE of ultimate losses also requires considerable judgment in interpreting historical and statistical information. Metrics such as average claim severity and loss ratio are evaluated to assess the reasonableness of the ultimate losses. In addition, metrics such as outstanding amounts (case plus formula reserves) per claim and the level of claim closure are evaluated to assess the assumptions underlying various reserving methods.
For catastrophe losses, within the first month following an event, there is typically insufficient data available to rely on an actuarial analysis using paid loss and case reserve amounts. In those situations management relies on estimates provided by our claims personnel in determining the ultimate losses. When providing such estimates, claims personnel consider a number of factors specific to a given event, including the type of catastrophe event, the severity of the event, the policies in-force that may be affected by the event, the contract provisions of those policies and their knowledge of prior catastrophes. After the first month following an event, there is more data available on which to base an actuarial projection of unreported loss amounts. This projection is based on an estimate of the number of yet to be reported and the average amount of each such claim. The actuarial projections and the estimates are considered by management when determining the ultimate for an event.
For non-catastrophe losses, actuarial personnel use a number of methods to estimate ultimate losses. Our loss reserves include amounts related to short-tail and long-tail lines of business. “Tail” refers to the time period between the occurrence of a loss and the settlement of the claim. In general, the longer the time span between the incidence of a loss and the settlement of
the claim, the more the ultimate settlement amount can vary. The most commonly relied upon reserving methods, and their strengths and weaknesses, are described below.
Short-Tail Business: For short-tail business, claims are typically settled within five years, and the most common actuarial estimates are based on methods using link ratio projections of incurred losses (paid plus outstanding amounts) and paid losses, and methods projecting claim counts and claim severities. These methods are described below.
Incurred Loss Development Method: The Incurred Loss Development Method is probably the most common actuarial method used in projecting ultimate losses. This method uses incurred losses for claims that have been reported. A pattern of incurred losses is estimated to project ultimate losses for each accident year. An important assumption underlying the Incurred Loss Development Method is that case reserve adequacy remains consistent over time. This method’s primary advantage is its responsiveness to changes in incurred losses, which is particularly valuable for more recent accident years. A disadvantage of the Incurred Loss Development Method is that changes in case reserve adequacy can the projections.
Paid Loss Development Method: The Paid Loss Development Method uses calculations that are similar to the Incurred Loss Development Method. The key difference is that the data used in the Paid Loss Development Method exclude outstanding amounts, so only paid losses are used. With this method, a payment pattern is estimated to project ultimate losses for each accident year. An important underlying assumption is that claims are settled at a consistent rate over time. Case reserves and the rate at which claims are reported, except to the extent that the reporting pattern influences the settlement pattern, are not relevant to the results of this method. This method’s advantage is that the estimates of ultimate loss are independent of case reserve adequacy and are unaffected by changes in case reserving practice. The disadvantages are that (i) not all of the available information is used because outstanding amounts are not considered, (ii) in some cases the payment patterns require the application of very large development factors to relatively small payment amounts for less mature years, and (iii) changes in the settlement rate will the projections.
Claim Counts and Severities Method: The Counts and Severities Methods are best suited for lines of business with a large number of claims and a low average claim amount. They are primarily relied upon for certain auto coverages. With these methods, a pattern of claims to be closed in the future is estimated, and the corresponding average dollar amount of those claims, adjusted for inflation, is estimated. Future payments for each accident year are calculated as the total future claims to be closed times the corresponding average dollar amounts. Advantages of these methods include the advantages noted above for the Paid Loss Development Method. In addition, these methods also have the advantage of being responsive to changes in the settlement rate. are that not all available information is used because outstanding amounts are not considered, and that estimates derived using these methods can be sensitive to the implied level of inflation.
Long-Tail Business: : For long-tail business, a significant portion of claims may not be settled within five years. Reserve estimates for long-tail business use the same methods listed above along with several other methods. Premium-based methods may be used in developing ultimate loss estimates, including the Expected Loss Ratio and Bornhuetter-Ferguson methods described below. While these methods are more commonly relied upon for long-tail business, they may be relied upon for short-tail business as well.
Expected Loss Ratio Method: The Expected Loss Ratio Method generates ultimate losses by multiplying an expected loss ratio by earned premiums. For slower reporting lines of business, new products or data that is immature, the reported to date claim data is often too limited or too volatile to rely upon other projection methods. In such cases, an advantage of this method is that the ultimate losses are independent of losses paid or outstanding to date. With this method the premiums are used as a measure of loss exposure, and the loss ratios can be derived from pricing expectations, recent claim history or other sources. When there are underlying changes in the frequency or severity of claims, a of this method is that the ultimate will not respond to those changes.
Incurred Bornhuetter-Ferguson Method: The Incurred Bornhuetter-Ferguson Method is a weighted average of the Expected Loss Ratio Method and the Incurred Loss Development Method, using the percentage of losses reported to date as the weight applied to the Incurred Loss Development Method. This method is particularly useful where there is a low volume of data in the more recent accident years or where the experience is volatile. In more mature accident years, this method generally produces estimates that are similar to the Incurred Loss Development Method.
Paid Bornhuetter-Ferguson Method: The Paid Bornhuetter-Ferguson Method is a weighted average of the Expected Loss Ratio Method and the Paid Loss Development Method, using the percentage of losses paid to date as the weight applied to the Paid Loss Development Method. In less mature accident years, in which payment activity is relatively low, this method generally produces estimates that are similar to the Expected Loss Ratio Method.
Selection Process: In determining which reserving methods to rely on for a particular line of business or accident year, diagnostic tests of loss ratios and severity trends are considered, as well as the historical case reserve adequacy and claim settlement rate. Various reserving methods are considered, along with supplemental information such as open claim counts, open claim severity and prior period development, and the final selection may be a weighted average of multiple methods. For
short-tail business the Incurred Loss Development Method may be most heavily relied upon if the projections are stable, the data is credible, historical case reserve adequacy is consistent and the resulting loss ratios and loss severities are reasonable. For long-tail business the Expected Loss Ratio Method may be most heavily relied upon for less mature accident years where the data is not credible. For more mature accident years, where the data is more credible, greater reliance may be placed on the Incurred Loss Development Method. There is considerable judgment applied in the analysis of the historical patterns and in integrating knowledge about the business, such as change in underwriting, pricing and claims functions.
The actuarial range of reasonable estimates of ultimate losses is derived based on the variability of the loss reserve projections. The primary determinants in estimating the loss reserve range boundaries are the variances measured within the historical reserving data for the various lines of business. Therefore, the actuarial range reflects likely outcomes, and does not reflect all possible outcomes.
In addition to establishing loss reserves described above, actuarial estimates are established for ULAE reserves. Historical patterns of paid ULAE relative to paid losses (excluding allocated loss adjustment expenses) are analyzed along with historical claim counts including claims opened, claims closed and claims remaining open. The product of this analysis is an estimate of the relationship, or ratio, between ULAE and losses underlying the current loss reserves. This ratio is applied to the current outstanding loss reserves to estimate the required ULAE reserve. Consequently, this component of the loss expense reserve has a proportional relationship to the overall claim inventory and held loss reserves. The method assumes that the underlying claims process and mix of business do not change materially from period to period.
When management establishes ultimate losses within the actuarial range of reasonable estimates of ultimate losses, the resulting MBE loss reserves fall within the actuarial range of reasonable reserves. Management considers the expected variability of loss reserves described above when establishing an appropriate reserve within the actuarial range. At December 31, 2020, loss and loss expenses payable were $1,026.1 million, within an estimated range of $919.3 million to $1,063.7 million.
The potential impact of the loss reserve variability on net income can be illustrated using the range end points and carried reserve amounts listed above. For example, if ultimate losses reach a level corresponding to the high point of the range, $1,063.7 million, the reserve increase of $37.6 million corresponds to an after-tax decrease of $29.7 million in net income, assuming a tax rate of 21%. Likewise, should ultimate losses decline to a level corresponding to the low point of the range, $919.3 million, the $106.8 million reserve decrease would add $84.4 million of after-tax net income. The loss reserve range noted above represents a range of reasonably likely reserves, not a range of all possible reserves. Therefore, the ultimate losses could reach levels corresponding to reserve amounts outside the range provided.
An important assumption underlying certain loss reserve methods is that the loss cost trends underlying historical data will continue into the future. To estimate the sensitivity of reserves to an unexpected change in inflation, projected calendar year payment patterns were applied to the December 31, 2020, workers’ compensation loss and ALAE reserve balance to generate estimated annual incremental loss and ALAE payments for each subsequent calendar year. Then, for purposes of sensitivity testing, an additional annual loss cost trend of 5% was added to the trend implicitly embedded in the estimated payment pattern, and revised incremental loss and ALAE payments were calculated. This type of inflationary increase could arise from a variety of sources including tort law changes, development of new medical procedures and social inflation. The estimated cumulative impact that this additional, unexpected 5% increase in the loss cost trend would have on our results of operations over the lifetime of the underlying claims in workers’ compensation is an increase of $86.4 million on reserves, or a $68.3 million reduction to net income, assuming a tax rate of 21%. Inflation changes have much more impact on the longer tail commercial lines like workers’ compensation, and much less impact on the shorter tail personal lines.
The following table sets forth a reconciliation of MBE of our direct loss and LAE reserve to our net losses and loss expenses payable at December 31, 2020 and 2019. The STFC Pooled Companies net additional share of transactions assumed from State Auto Mutual through the Pooling Arrangement for the years ended December 31, 2020 and 2019, respectively, has been reflected in the table below as assumed by STFC Pooled Companies.
($ millions)
Direct loss and ALAE reserve :
STFC Pooled Companies
Assumed by STFC Pooled Companies
Total direct loss and ALAE reserve
Direct ULAE reserve:
STFC Pooled Companies
Assumed by STFC Pooled Companies
Total direct ULAE reserve
Direct salvage and subrogation recoverable :
STFC Pooled Companies
Assumed by STFC Pooled Companies
Total direct salvage and subrogation recoverable
Reinsurance recoverable
Assumed reinsurance
Reinsurance assumed by STFC Pooled Companies
Total losses and loss expenses payable, net of reinsurance recoverable on losses and loss expenses payable of $24.3 million and $13.6 million in 2020 and 2019, respectively
The following tables set forth the net losses and loss expenses payable by major line of business at December 31, 2020 and 2019:
($ millions)
December 31, 2020
Ending Loss & ALAE Case & Formula
Ending Loss & ALAE IBNR
Ending ULAE Bulk
Total
Reserves
Personal Insurance Segment:
Personal Auto
Homeowners
Other personal
Total Personal Insurance Segment
Commercial Insurance Segment:
Commercial Auto
Small Commercial Package
Middle Market Commercial
Workers’ Compensation
Farm & Ranch
Other Commercial
Total Commercial Insurance Segment
Specialty run-off:
E&S Property
E&S Casualty
Programs
Total Specialty run-off
Total losses and loss expenses payable, net of reinsurance recoverable on losses and loss expenses payable
($ millions)
December 31, 2019
Ending Loss & ALAE Case & Formula
Ending Loss & ALAE IBNR
Ending ULAE Bulk
Total Reserves
Personal Insurance Segment:
Personal Auto
Homeowners
Other personal
Total Personal Insurance Segment
Commercial Insurance Segment:
Commercial Auto
Small Commercial Package
Middle Market Commercial
Workers’ Compensation
Farm & Ranch
Other Commercial
Total Commercial Insurance Segment
Specialty run-off:
E&S Property
E&S Casualty
Programs
Total Specialty run-off
Total losses and loss expenses payable net of reinsurance recoverable on losses and loss expenses payable
See discussion in “Results of Operations—Loss and LAE Development” section included in this Item 7.
The property and casualty industry has experienced significant loss from claims related to asbestos, environmental remediation, product liability, mold and other mass torts. Because we have insured primarily product retailers and distributors, we do not expect to incur the same level of liability, particularly related to asbestos, as companies that have insured manufacturing risks.
At December 31, 2020, asbestos reserves were $1.9 million and environmental reserves were $20.3 million, for a total reserve of $22.2 million, or 2.2% of net losses and loss expenses payable. Relative to December 31, 2019, asbestos and environmental reserves decreased $0.3 million and $0.5 million, respectively.
Pension and Postretirement Benefit Obligations
Pension and postretirement benefit obligations are long-term in nature and require management’s judgment in estimating the factors used to determine these amounts. We review these factors annually, including the discount rate and expected long-term rate of return on plan assets. Because these obligations are based on estimates which could change, the ultimate benefit obligation could be different from the amount estimated.
The State Auto Group has a defined benefit pension plan covering substantially all employees hired prior to January 1, 2010 and a postretirement healthcare plan covering certain associates and retirees (collectively “the benefit plans”). We record the funded status of these plans on our balance sheet while the annual net periodic costs are allocated to affiliated companies based on allocations pursuant to intercompany management agreements including the Pooling Arrangement for insurance subsidiaries and affiliates party to this agreement. We receive reimbursement of 35% of the annual net periodic costs from the Mutual Pooled Companies in accordance with the terms of the Pooling Arrangement.
Several factors, which attempt to anticipate future events, are used in calculating the expense and liability related to the benefit plans. Key factors include assumptions about the expected rates of return on plan assets, discount rates, and health care cost trend rates. We consider market conditions, including changes in investment returns and interest rates, in making these assumptions. The actuarial assumptions used by us in determining benefit obligations may differ materially from actual results due to changing market and economic conditions, higher or lower turnover and retirement rates, or longer or shorter life spans
of participants. While we believe that the assumptions used are appropriate, differences in actual experience or changes in assumptions may materially affect our financial position or results of operations.
For the December 31, 2020 and 2019 valuations, the Adjusted RP-2014 mortality table was used as a baseline for the mortality assumption and to project future mortality rates. Incorporated into the table are rates projected generationally using Scale MP-2017 to reflect mortality improvement (Scale MP-2016 was used at the beginning of the year). The January 1, 2020 and 2019 actuarial reports of the benefit plans included these revised mortality assumptions.
To calculate the State Auto Group’s December 31, 2020 benefit obligation for each of the benefit plans, we used a discount rate of 2.32% based on an evaluation of the expected future benefit cash flows of our benefit plans used in conjunction with the FTSE Pension Discount Curve at the measurement date. A lower discount rate, all else being equal, results in a higher present value benefit obligation. To calculate our benefit obligation at December 31, 2020 and net periodic benefit cost for the year ended December 31, 2021, a discount rate of 1.95% and an expected long-term rate of return on plan assets of 6.25% were used. We selected an expected long-term rate of return on our plan assets by considering the mix of investments and stability of investment portfolio along with actual investment experience during the lifetime of the plans. Our assumptions regarding the discount rate and expected return on plan assets could have a significant effect on the amounts related to our benefit obligations and net periodic benefit cost depending on the degree of change between reporting periods.
As a result of revised mortality assumptions and the change in the discount rate, the benefit plan’s liability increased $27.2 million for the year ended December 31, 2020 and decreased $3.1 million for the year ended December 31, 2019.
Effective January 1, 2020, we changed the funding of our postretirement benefit plan from self-insured to a fully-insured group Medicare advantage program. The group Medicare advantage program is less than half the cost of the self-insured plan. As a result, the postretirement benefit plan's liability decreased $13.9 million for the year ended December 31, 2019.
The following table sets forth an illustration of variability with respect to the discount rate on the December 31, 2020 benefit obligation and expected net periodic benefit cost for the year ending December 31, 2021, along with the variability of the expected return on plan assets to the expected net periodic benefit cost for the year ending December 31, 2021. Holding all other assumptions constant, sensitivity to changes in any one of our key assumptions are as follows:
($ millions)
Pension
Postretirement
Discount rate
Discount rate
Benefit obligation
Net periodic benefit cost (benefit)
Expected return on plan assets
Net periodic benefit cost
The accumulated benefit obligation (“ABO”) of a defined benefit pension plan represents the actuarial present value of benefits attributed by the pension benefit formula to employee service rendered prior to the measurement date and based on current and past compensation levels, while the projected benefit obligation (“PBO”) is the ABO plus a factor for future compensation levels. The ABO, which considers current compensation levels only, provides information about the obligation an employer would have if the plan were discontinued at the measurement date. At December 31, 2020, our ABO and PBO were $522.8 million and $549.6 million, respectively. At December 31, 2020, our defined benefit pension plan’s fair value of the assets was $506.7 million, which resulted in an underfunded status within our balance sheet of $42.9 million. On a cash flow basis, we target an annual contribution level that meets at least the targeted normal cost plus any shortfall amortizations of the plan, as defined by ERISA. Currently, we expect to make a cash contribution to the pension plan up to $15.0 million in 2021.
The unfunded status on the pension plan and supplemental executive retirement plan decreased from $48.1 million at December 31, 2019, to $56.0 million at December 31, 2020. Primarily influencing the change from year to year are actuarial gains and losses arising from factors that include (i) changes in the discount rate, (ii) expected to actual demographic changes, such as retirement age, mortality, turnover, rate of compensation changes, and (iii) changes in returns on our plan assets.
See Note 12, “Pension and Postretirement Benefit Plans,” to our consolidated financial statements included in Item 8 of this Form 10-K for further disclosures regarding our benefit plans.
Other
Other items that could have a significant impact on the financial statements include the risks and uncertainties listed in Item 1A of this Form 10-K under “Risk Factors.” Actual results could differ materially using different estimates and assumptions, or if conditions are significantly different in the future.
Item 7A. Qualitative and Quantitative Disclosures about Market Risk
Qualitative and Quantitative Disclosures about Market Risk are included in Item 7 of this Form 10-K under “Results of Operations—Investment Operations Segment—Market Risk.”
