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STATE AUTO FINANCIAL CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The term "State Auto Financial" as used below refers only to State Auto Financial Corporation and the terms "our Company," "we," "us," and "our" as used below refer to State Auto Financial Corporation and its consolidated subsidiaries. The term "second quarter" as used below refers to the three months ended June 30, for the time period then ended. For a glossary of terms for State Auto Financial Corporation and its subsidiaries and affiliates and a glossary of selected insurance and accounting terms, see the section entitled "Important Defined Terms Used in this Form 10-K" included in our Annual Report on Form 10-K for the year ended December 31, 2013 (the "2013 Form 10-K"). The discussion and analysis presented below relates to the material changes in financial condition and results of operations for our consolidated balance sheets as of June 30, 2014 and December 31, 2013, and for the consolidated statements of income for the three and six month periods ended June 30, 2014 and 2013. This discussion and analysis should be read together with "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the 2013 Form 10-K, and in particular the discussions in those sections thereof entitled "Overview," "Executive Summary" and "Critical Accounting Policies." Readers are encouraged to review the entire 2013 Form 10-K, as it includes information regarding our Company not discussed in this Form 10-Q. This information will assist in your understanding of the discussion of our current period financial results. The discussion and analysis presented below includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements generally can be identified by the use of forward-looking terminology such as "may," "will," "expect," "intend," "estimate," "anticipate," "project," "believe" or "continue" or the negative thereof or variations thereon or similar terminology. Forward-looking statements speak only as of the date the statements were made available. Although we believe that the expectations reflected in forward-looking statements have a reasonable basis, we can give no assurance that these expectations will prove to be correct. Forward-looking statements are subject to risks and uncertainties that could cause actual events or results to differ materially from those expressed in or implied by the statements. For a discussion of the most significant risks and uncertainties that could cause our actual results to differ materially from those projected, see "Risk Factors" in Item 1A of the 2013 Form 10-K, updated by Part II, Item 1A of this Form 10-Q. Except to the limited extent required by applicable law, we undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. The Company has four reportable segments: personal insurance, business insurance, specialty insurance and investment operations. The reportable insurance segments are business units managed separately because of the differences in the type of customers they serve or products they provide or services they offer. The insurance segments market a broad line of property and casualty insurance products throughout the United States through independent insurance agencies, which include retail agents and wholesale brokers. The personal insurance segment provides primarily personal automobile and homeowners to the personal insurance market. The business insurance segment provides primarily commercial automobile, commercial multi-peril, fire & allied and general liability insurance covering small-to-medium sized commercial exposures in the business insurance market. The specialty insurance segment provides commercial coverages that require specialized product underwriting, claims handling or risk management services through a distribution channel of retail agents and wholesale brokers, which may include program administrators and other specialty sources. The investment operations segment, managed by Stateco, provides investment services. See "Personal and Business Insurance" and "Specialty Insurance" in Item 1 of the 2013 Form 10-K for more information about our insurance segments. Financial information about our reportable segments for 2014 is set forth in Note 10 of our condensed consolidated financial statements included in Item 1 of this Form 10-Q. 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. 26-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) The following table sets forth the participants and their participation percentages in the Pooling Arrangement since January 1, 2012: STFC Pooled Companies: State Auto P&C 51.0 % Milbank 14.0 SA Ohio - Total STFC Pooled Companies 65.0 % State Auto Mutual Pooled Companies: State Auto Mutual (1) 34.5 % SA Wisconsin - Meridian Security - Patrons Mutual 0.5 RIC - Plaza - American Compensation - Bloomington Compensation -Total State Auto Mutual Pooled Companies 35.0 % (1) Includes the pooling participation percentage of Meridian Citizens Mutual which was merged into State Auto Mutual as of the close of business on July 2, 2014. Meridian Citizen Mutual's pooling participation percentage was 0.5% from January 1, 2011 to July 2, 2014. 27 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) RESULTS OF OPERATIONS Our net income for the three and six months ended June 30, 2014 was $3.0 million and $30.1 million, respectively, compared to net income of $6.2 million and $25.9 million, respectively, for the same 2013 periods. The decrease in net income for the three months ended June 30, 2014, when compared to the same 2013 period, was primarily due to an increase in non-catastrophe losses in our specialty insurance segment as a result of reserve strengthening of $11.4 million for terminated RED programs and an increase in our acquisition and operating expenses related to the reorganization of our information technology department. The decrease was partially offset by improved underwriting results in lines of business other than Programs, an increased level of net investment income, realized gains on investments and less interest expense, when compared to the same 2013 period. The increase in net income for the six months ended June 30, 2014, when compared to the same 2013 period, was primarily due to improved underwriting results in lines of business other than Programs, increased levels of net investment income, realized gains on investments and less interest expense, offset by RED reserve strengthening within the Programs line and severance expenses reflected in the current quarter results. In May 2014, we initiated a plan to reorganize our information technology ("IT") department in support of our long-term IT strategy. This strategic initiative is designed to advance our application maintenance and support capabilities while delivering an improved customer experience. This reorganization is expected to be completed during the second half of 2014. We recognized severance expenses expected to be incurred in connection with this reorganization of $4.4 million for the three and six months ended June 30, 2014. These expenses are included within acquisition and operating expenses on the consolidated statements of income. 28-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) The following table sets forth certain key performance indicators we use to monitor our operations for the three and six months ended June 30, 2014 and 2013: ($ millions, except per share amounts) Three months ended June 30 Six months ended June 30 GAAP Basis: 2014 2013 2014 2013 Total revenues $ 294.4 $ 285.3 $ 585.7 $ 570.6 Net income $ 3.0 $ 6.2 $ 30.1 $ 25.9 Basic earnings per share $ 0.07 $ 0.15 $ 0.74 $ 0.64 Diluted earnings per share $ 0.07 $ 0.15 $ 0.73 $ 0.64 Stockholders' equity $ 843.7 $ 711.3 Return on average equity (LTM) 8.4 % 5.8 % Book value per share $ 20.65 $ 17.53 Debt to capital ratio 10.7 % 14.0 % Cat loss and ALAE ratio 7.9 % 8.1 % 5.2 % 4.9 % Non-cat loss and LAE ratio 63.1 % 62.5 % 63.0 % 63.5 % Loss and LAE ratio 71.0 % 70.6 % 68.2 % 68.4 % Expense ratio 36.3 % 33.0 % 35.0 % 33.5 % Combined ratio 107.3 % 103.6 % 103.2 % 101.9 % Premium written growth 3.5 % 5.8 % 2.1 % 3.0 % Investment yield 3.8 % 3.7 % 3.6 % 3.4 % SAP Basis : Cat loss and ALAE points 7.9 % 8.1 % 5.2 % 4.9 % Non-cat loss and ALAE 56.9 % 56.0 % 57.0 % 57.2 % ULAE 6.5 % 6.8 % 6.3 % 6.6 % Loss and LAE ratio 71.3 % 70.9 % 68.5 % 68.7 % Expense ratio 35.8 % 33.0 % 35.6 % 34.1 % Combined ratio 107.1 % 103.9 % 104.1 % 102.8 % Twelve months ended June 30 2014 2013 Net premiums written to surplus 1.4 1.6 29 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Homeowners Quota Share Arrangement To reduce risk and volatility in our homeowners line of business, while at the same time providing us with additional catastrophe reinsurance protection, the State Auto Group entered into a quota share reinsurance agreement on December 31, 2011 with a syndicate of unaffiliated reinsurers covering its homeowners line of business (the "HO QS Arrangement"). Under the HO QS Arrangement, the State Auto Group ceded to the reinsurers 75% of its homeowners business under policies in force at December 31, 2011 and new and renewal policies thereafter issued during the term of the agreement. The HO QS Arrangement is in effect until December 31, 2014. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Reinsurance Arrangements" in Item 7 of the 2013 Form 10-K for a discussion of the HO QS Arrangement. 30-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) The following tables set forth, on a GAAP and pro forma basis, certain of our key performance indicators before and after the impact of our HO QS Arrangement cession for the three and six months ended June 30, 2014 and 2013: Reconciliation Tables 1 - 2 ($ millions) GAAP HO QS Arrangement Cession - Overall Results Pro-Forma without HO QS Three months ended June 30, 2014 As Reported HO QS Cession Cession Net written premiums $ 295.1 $ 48.6 $ 343.7 Earned premiums 268.3 44.1 312.4 Losses and LAE incurred: Cat loss and ALAE 21.2 15.6 36.8 Non-cat loss and LAE 169.2 18.3 187.5 Total Loss and LAE incurred 190.4 33.9 224.3 Acquisition and operating expenses 97.3 12.8 110.1 Net underwriting loss $ (19.4 ) $ (2.6 ) $ (22.0 ) Cat loss and ALAE ratio 7.9 % 35.3 % 11.8 % Non-cat loss and LAE ratio 63.1 % 41.7 % 60.0 % Total Loss and LAE ratio 71.0 % 77.0 % 71.8 % Expense ratio 36.3 % 29.0 % 35.2 % Combined ratio 107.3 % 106.0 % 107.0 % ($ millions) GAAP HO QS Arrangement Cession - Overall Results Pro-Forma without HO QS Three months ended June 30, 2013 As Reported HO QS Cession Cession Net written premiums $ 285.1 $ 49.4 $ 334.5 Earned premiums 263.5 43.5 307.0 Losses and LAE incurred: Cat loss and ALAE 21.2 12.2 33.4 Non-cat loss and LAE 164.9 22.0 186.9 Total Loss and LAE incurred 186.1 34.2 220.3 Acquisition and operating expenses 87.0 12.6 99.6 Net underwriting loss $ (9.6 ) $ (3.3 ) $ (12.9 ) Cat loss and ALAE ratio 8.1 % 28.0 % 10.9 % Non-cat loss and LAE ratio 62.5 % 50.6 % 60.9 % Total Loss and LAE ratio 70.6 % 78.6 % 71.8 % Expense ratio 33.0 % 29.0 % 32.4 % Combined ratio 103.6 % 107.6 % 104.2 % 31 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Reconciliation Tables 3 - 4 ($ millions) GAAP HO QS Arrangement Cession - Overall Results Pro-Forma without HO QS Six months ended June 30, 2014 As Reported HO QS Cession Cession Net written premiums $ 560.5 $ 86.5 $ 647.0 Earned premiums 530.8 88.3 619.1 Losses and LAE incurred: Cat loss and ALAE 27.5 18.0 45.5 Non-cat loss and LAE 334.7 38.8 373.5 Total Loss and LAE incurred 362.2 56.8 419.0 Acquisition and operating expenses 185.8 25.6 211.4 Net underwriting (loss) gain $ (17.2 ) $ 5.9 $ (11.3 ) Cat loss and ALAE ratio 5.2 % 20.4 % 7.3 % Non-cat loss and LAE ratio 63.0 % 43.9 % 60.4 % Total Loss and LAE ratio 68.2 % 64.3 % 67.7 % Expense ratio 35.0 % 29.0 % 34.1 % Combined ratio 103.2 % 93.3 % 101.8 % ($ millions) GAAP HO QS Arrangement Cession - Overall Results Pro-Forma without HO QS Six months ended June 30, 2013 As Reported HO QS Cession Cession Net written premiums $ 548.8 $ 87.3 $ 636.1 Earned premiums 524.8 88.9 613.7 Losses and LAE incurred: Cat loss and ALAE 25.8 14.2 40.0 Non-cat loss and LAE 333.3 39.3 372.6 Total Loss and LAE incurred 359.1 53.5 412.6 Acquisition and operating expenses 175.8 25.8 201.6 Net underwriting (loss) gain $ (10.1 ) $ 9.6 $ (0.5 ) Cat loss and ALAE ratio 4.9 % 16.0 % 6.5 % Non-cat loss and LAE ratio 63.5 % 44.2 % 60.7 % Total Loss and LAE ratio 68.4 % 60.2 % 67.2 % Expense ratio 33.5 % 29.0 % 32.8 % Combined ratio 101.9 % 89.2 % 100.0 % 32 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) The following tables set forth, on a SAP and pro forma basis, certain of our key performance indicators before and after the impact of the HO QS Arrangement cession for the three and six months ended June 30, 2014 and 2013: Reconciliation Tables 5 - 6 ($ millions) SAP HO QS Arrangement Cession - Overall Results Pro-Forma without HO QS Three months ended June 30, 2014 As Reported HO QS Cession Cession Net written premiums $ 295.1 $ 48.6 $ 343.7 Earned premiums 268.3 44.1 312.4 Losses and LAE incurred: Cat loss and ALAE 21.2 15.6 36.8 Non-cat loss and ALAE 152.5 18.3 170.8 Total Loss and ALAE 173.7 33.9 207.6 ULAE 17.5 - 17.5 Total Loss and ALAE incurred 191.2 33.9 225.0 Underwriting expenses 105.8 14.1 119.9 Net underwriting loss $ (28.7 ) $ (3.9 ) $ (32.6 ) Cat loss and ALAE ratio 7.9 % 35.3 % 11.8 % Non-cat loss and ALAE ratio 56.9 % 41.7 % 54.7 % Total loss and ALAE ratio 64.8 % 77.0 % 66.5 % ULAE ratio 6.5 % - 5.6 % Total loss and LAE ratio 71.3 % 77.0 % 72.1 % Expense ratio 35.8 % 29.0 % 34.9 % Combined ratio 107.1 % 106.0 % 107.0 % ($ millions) SAP HO QS Arrangement Cession - Overall Results Pro-Forma without HO QS Three months ended June 30, 2013 As Reported HO QS Cession Cession Net written premiums $ 285.1 $ 49.4 $ 334.5 Earned premiums 263.5 43.5 307.0 Losses and LAE incurred: Cat loss and ALAE 21.2 12.2 33.4 Non-cat loss and ALAE 147.9 22.0 169.9 Total Loss and ALAE 169.1 34.2 203.3 ULAE 17.8 - 17.8 Total Loss and ALAE incurred 186.9 34.2 221.1 Underwriting expenses 93.9 14.3 108.2 Net underwriting loss $ (17.3 ) $ (5.0 ) $ (22.3 ) Cat loss and ALAE ratio 8.1 % 28.0 % 10.9 % Non-cat loss and ALAE ratio 56.0 % 50.6 % 55.4 % Total loss and ALAE ratio 64.1 % 78.6 % 66.3 % ULAE ratio 6.8 % - 5.8 % Total loss and LAE ratio 70.9 % 78.6 % 72.1 % Expense ratio 33.0 % 29.0 % 32.4 % Combined ratio 103.9 % 107.6 % 104.5 % 33 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Reconciliation Tables 7 - 8 ($ millions) SAP HO QS Arrangement Cession - Overall Results Pro-Forma without HO QS Six months ended June 30, 2014 As Reported HO QS Cession Cession Net written premiums $ 560.5 $ 86.5 $ 647.0 Earned premiums 530.8 88.3 619.1 Losses and LAE incurred: Cat loss and ALAE 27.5 18.0 45.5 Non-cat loss and ALAE 302.9 38.8 341.7 Total Loss and ALAE 330.4 56.8 387.2 ULAE 33.4 - 33.4 Total Loss and ALAE incurred 363.8 56.8 420.6 Underwriting expenses 199.6 25.1 224.7 Net underwriting (loss) gain $ (32.6 ) $ 6.4 $ (26.2 ) Cat loss and ALAE ratio 5.2 % 20.4 % 7.3 % Non-cat loss and ALAE ratio 57.0 % 43.9 % 55.2 % Total loss and ALAE ratio 62.2 % 64.3 % 62.5 % ULAE ratio 6.3 % - 5.4 % Total loss and LAE ratio 68.5 % 64.3 % 67.9 % Expense ratio 35.6 % 29.0 % 34.7 % Combined ratio 104.1 % 93.3 % 102.6 % ($ millions) SAP HO QS Arrangement Cession - Overall Results Pro-Forma without HO QS Six months ended June 30, 2013 As Reported HO QS Cession Cession Net written premiums $ 548.8 $ 87.3 $ 636.1 Earned premiums 524.8 88.9 613.7 Losses and LAE incurred: Cat loss and ALAE 25.8 14.2 40.0 Non-cat loss and ALAE 300.4 39.3 339.7 Total Loss and ALAE 326.2 53.5 379.7 ULAE 34.5 - 34.5 Total Loss and ALAE incurred 360.7 53.5 414.2 Underwriting expenses 187.1 25.3 212.4 Net underwriting (loss) gain $ (23.0 ) $ 10.1 $ (12.9 ) Cat loss and ALAE ratio 4.9 % 16.0 % 6.5 % Non-cat loss and ALAE ratio 57.2 % 44.2 % 55.4 % Total loss and ALAE ratio 62.1 % 60.2 % 61.9 % ULAE ratio 6.6 % - 5.6 % Total loss and LAE ratio 68.7 % 60.2 % 67.5 % Expense ratio 34.1 % 29.0 % 33.4 % Combined ratio 102.8 % 89.2 % 100.9 % 34 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) See additional pro forma reconciliation tables for the impact of the HO QS Arrangement cession on our homeowners' line of business at Reconciliation Tables 5 and 6. Use of Non-GAAP Financial Measures In discussing the results of our insurance segments, we sometimes refer to GAAP financial measures in the context of "as reported" and to non-GAAP financial measures in the context of "pro forma." These pro forma, or non-GAAP financial measures, exclude the impact of the HO QS Arrangement cession for the three and six months ended June 30, 2014 and 2013. We believe the use of these non-GAAP financial measures will enable investors to (a) better understand the impact of the reinsurance arrangement cession on our reported results for the three and six months ended June 30, 2014 and 2013, and (b) perform a meaningful comparison of our results of operations for the three and six months ended June 30, 2014 and 2013. We have also included Reconciliation Tables 1 - 12 and Tables 1 - 9 for readers to better understand the use and calculation of these non-GAAP financial measures. Insurance Segments The insurance segments market a broad line of property and casualty insurance products throughout the United States through independent insurance agencies, which include retail agents and wholesale brokers. The personal insurance segment provides primarily personal automobile and homeowners coverages to the personal insurance market. The business insurance segment provides primarily commercial automobile, commercial multi-peril, fire & allied and general liability insurance covering small-to-medium sized commercial exposures in the business insurance market. The specialty insurance segment provides commercial coverages requiring specialized product underwriting, claims handling or risk management services through a distribution channel of retail agents and wholesale brokers, which may include program administrators and other specialty sources. We measure top-line growth for our insurance segments based on net written premiums, which represent the premiums on the policies we have issued for a period, net of reinsurance. Net written premiums provide us with an indication of how well we are doing in terms of revenue growth before it is actually earned. Our policies provide a fixed amount of coverage for a stated period of time, often referred to as "the policy term." As such, our net written premiums are recognized as earned ratably over the policy term. The unearned portion of net 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 "Critical Accounting Policies - Deferred Acquisition Costs" section included in Item 7 of our 2013 Form 10-K. The accounting for pension benefits also contributes to the difference between our GAAP loss and expense ratios and our SAP loss and expense ratios. At January 1, 2013, we adopted new SAP pension guidance, which required the recognition of service costs for non-vested participants. In accordance with GAAP, service costs related to non-vested participants were recognized over the vesting period. See "Critical Accounting Policies - Pension and Postretirement Benefit Obligations section included in Item 7 of our 2013 Form 10-K. All references to financial measures or components thereof in this discussion are calculated on a GAAP basis, unless otherwise noted. 35-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) The following table sets forth our insurance segments' SAP underwriting gain (loss) and SAP combined ratio for the three and six months ended June 30, 2014 and 2013: ($ millions) Three months ended June 30, 2014 % % % % Personal Ratio Business Ratio Specialty Ratio Total Ratio Net written premiums $ 116.3 $ 107.0 $ 71.8 $ 295.1 Earned premiums 113.7 95.9 58.7 268.3 Cat loss and ALAE 12.0 10.5 8.2 8.6 1.0 1.8 21.2 7.9 Non-cat loss and ALAE 64.6 56.8 46.9 48.9 41.0 69.8 152.5 56.9 ULAE 11.2 9.8 4.8 4.9 1.5 2.7 17.5 6.5 Underwriting expenses 36.6 31.5 41.9 39.1 27.3 38.0 105.8 35.8 SAP underwriting loss and SAP combined ratio $ (10.7 ) 108.6 $ (5.9 ) 101.5 $ (12.1 ) 112.3 $ (28.7 ) 107.1 ($ millions) Three months ended June 30, 2013 % % % % Personal Ratio Business Ratio Specialty Ratio Total Ratio Net written premiums $ 121.7 $ 100.1 $ 63.3 $ 285.1 Earned premiums 117.2 89.6 56.7 263.5 Cat loss and ALAE 8.6 7.4 9.5 10.5 3.1 5.5 21.2 8.1 Non-cat loss and ALAE 71.6 61.1 41.2 46.1 35.1 61.6 147.9 56.0 ULAE 11.1 9.4 4.7 5.3 2.0 3.5 17.8 6.8 Underwriting expenses 32.7 26.9 38.7 38.6 22.5 35.5 93.9 33.0 SAP underwriting loss and SAP combined ratio $ (6.8 ) 104.8 $ (4.5 ) 100.5 $ (6.0 ) 106.1 $ (17.3 ) 103.9 36 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) ($ millions) Six months ended June 30, 2014 % % % % Personal Ratio Business Ratio Specialty Ratio Total Ratio Net written premiums $ 225.9 $ 201.6 $ 133.0 $ 560.5 Earned premiums 228.0 189.4 113.4 530.8 Cat loss and ALAE 12.4 5.4 13.4 7.1 1.7 1.5 27.5 5.2 Non-cat loss and ALAE 129.7 56.9 102.9 54.3 70.3 62.0 302.9 57.0 ULAE 21.3 9.4 8.6 4.5 3.5 3.1 33.4 6.3 Underwriting expenses 69.2 30.6 79.8 39.6 50.6 38.0 199.6 35.6 SAP underwriting loss and SAP combined ratio $ (4.6 ) 102.3 $ (15.3 ) 105.5 $ (12.7 ) 104.6 $ (32.6 ) 104.1 ($ millions) Six months ended June 30, 2013 % % % % Personal Ratio Business Ratio Specialty Ratio Total Ratio Net written premiums $ 236.2 $ 192.0 $ 120.6 $ 548.8 Earned premiums 231.9 178.1 114.8 524.8 Cat loss and ALAE 9.2 4.0 13.7 7.7 2.9 2.6 25.8 4.9 Non-cat loss and ALAE 140.3 60.5 87.4 49.0 72.7 63.2 300.4 57.2 ULAE 21.3 9.2 9.9 5.6 3.3 2.9 34.5 6.6 Underwriting expenses 66.6 28.2 76.9 40.0 43.6 36.2 187.1 34.1 SAP underwriting loss and SAP combined ratio $ (5.5 ) 101.9 $ (9.8 ) 102.3 $ (7.7 ) 104.9 $ (23.0 ) 102.8 37 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Personal Insurance Segment The following table sets forth the net written premiums by major product line of business for our personal insurance segment for the three and six months ended June 30, 2014 and 2013: Table 1 ($ millions) Net Written Premiums Three months ended June 30 Six months ended June 30 Personal insurance % % segment: 2014 2013 Change 2014 2013 Change Personal auto $ 92.0 $ 97.4 (5.5 ) $ 181.5 $ 191.3 (5.1 ) Homeowners 16.3 16.4 (0.6 ) 28.8 29.4 (2.0 ) Other personal 8.0 7.9 1.3 15.6 15.5 0.6 Total personal $ 116.3 $ 121.7 (4.4 ) $ 225.9 $ 236.2 (4.4 ) The following tables set forth the SAP loss and ALAE ratios by major product line of business for our personal insurance segment with the catastrophe and non-catastrophe impact shown separately for the three and six months ended June 30, 2014 and 2013: Table 2 Statutory Loss and LAE Ratios ($ millions) % Non-Cat Loss & Total Loss Three months ended Earned Non-Cat Loss Statutory Loss Cat loss ALAE and LAE June 30 Premium Cat Loss & ALAE & ALAE & LAE Ratio Ratio Ratio 2014 Personal insurance segment: Personal auto $ 91.4 $ 5.3 $ 56.4 $ 61.7 5.9 61.5 67.4 Homeowners 14.8 4.8 4.2 9.0 31.8 28.8 60.6 Other personal 7.5 1.9 4.0 5.9 25.5 53.9 79.4 Total personal 113.7 12.0 64.6 76.6 10.5 56.8 67.3 ULAE - - - 11.2 - - 9.8 Total Loss and LAE $ 113.7 $ 12.0 $ 64.6 $ 87.8 10.5 56.8 77.1 2013 Personal insurance segment: Personal auto $ 95.3 $ 3.2 $ 61.5 $ 64.7 3.4 64.5 67.9 Homeowners 14.5 3.9 6.3 10.2 27.2 43.6 70.8 Other personal 7.4 1.5 3.8 5.3 20.0 52.0 72.0 Total personal 117.2 8.6 71.6 80.2 7.4 61.1 68.5 ULAE - - - 11.1 - - 9.4 Total Loss and LAE $ 117.2 $ 8.6 $ 71.6 $ 91.3 7.4 61.1 77.9 38 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Table 3 Statutory Loss and LAE Ratios ($ millions) % Non-Cat Loss & Total Loss Six months ended June Earned Non-Cat Loss Statutory Loss Cat loss ALAE and LAE 30 Premium Cat Loss & ALAE & ALAE & LAE Ratio Ratio Ratio 2014 Personal insurance segment: Personal auto $ 183.8 $ 5.2 $ 112.1 $ 117.3 2.9 60.9 63.8 Homeowners 29.4 5.4 11.4 16.8 18.2 39.0 57.2 Other personal 14.8 1.8 6.2 8.0 12.2 41.9 54.1 Total personal 228.0 12.4 129.7 142.1 5.4 56.9 62.3 ULAE - - - 21.3 - - 9.4 Total Loss and LAE $ 228.0 $ 12.4 $ 129.7 $ 163.4 5.4 56.9 71.7 2013 Personal insurance segment: Personal auto $ 190.2 $ 3.6 $ 122.6 $ 126.2 1.9 64.4 66.3 Homeowners 27.0 4.4 12.1 16.5 16.3 45.1 61.4 Other personal 14.7 1.2 5.6 6.8 8.2 38.0 46.2 Total personal 231.9 9.2 140.3 149.5 4.0 60.5 64.5 ULAE - - - 21.3 - - 9.2 Total Loss and LAE $ 231.9 $ 9.2 $ 140.3 $ 170.8 4.0 60.5 73.7 Personal auto net written premiums for the three and six months ended June 30, 2014 decreased 5.5% and 5.1%, respectively, compared to the same 2013 periods (Table 1). The decrease in premiums is due to continued efforts to improve personal auto profitability, as well as our homeowners' remediation efforts including, among other things, pricing and agency management actions. The actions taken as a result of the homeowners' remediation plan have lead to a reduction in companion automobile policies as a high percentage of our auto and homeowners' policies are cross-sold. In an effort to attract new personal auto business, we introduced a new "Start-up Discount", which recognizes longevity with the previous carrier, in Indiana in April 2014 and plan to introduce the Start-up Discount in 19 additional states by the end of 2014; however, there can be no assurance that this action will attract new personal auto business. The impact of fewer policies was partially offset by rate increases. The personal segment's SAP non-catastrophe loss and ALAE ratios for the three and six months ended June 30, 2014 were 56.8% and 56.9% compared to 61.1% and 60.5% for the same 2013 periods (Tables 2 - 3). The three and six month 2014 improvements were primarily driven by personal auto SAP non-catastrophe loss & ALAE ratio improvements of 3.0 points and 3.5 points, respectively, compared to the same 2013 periods (Tables 2 - 3). Improved personal injury protection results and the impact of prior year rate increases contributed to the improvement. In addition, our pricing and agency management actions in Arizona, Colorado, Georgia, Illinois and Michigan have begun to reverse the unfavorable loss ratio trends in those states. Our remediation efforts in these five states will continue throughout 2014. 39-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) The following tables set forth, on a SAP and pro forma basis, certain of our key performance indicators for the homeowners' line of business before and after the impact of the HO QS Arrangement cession for the three and six months ended June 30, 2014 and 2013: Reconciliation Table 9 ($ millions) SAP HO QS Arrangement Cession - Homeowners Pro-Forma without HO QS Three months ended June 30, 2014 As Reported HO QS Cession Cession Net written premiums $ 16.3 $ 48.6 $ 64.9 Earned premiums 14.8 44.1 58.9 Losses and ALAE incurred: Cat loss and ALAE 4.8 15.6 20.4 Non-cat loss and ALAE 4.2 18.3 22.5 Total Loss and ALAE incurred $ 9.0 $ 33.9 $ 42.9 Cat loss and ALAE ratio 31.8 % 35.3 % 34.4 % Non-cat loss and ALAE ratio 28.8 % 41.7 % 38.5 % Total Loss and ALAE ratio 60.6 % 77.0 % 72.9 % Reconciliation Table 10 ($ millions) SAP HO QS Arrangement Cession - Homeowners Pro-Forma without HO QS Three months ended June 30, 2013 As Reported HO QS Cession Cession Net written premiums $ 16.4 $ 49.4 $ 65.8 Earned premiums 14.5 43.5 58.0 Losses and ALAE incurred: Cat loss and ALAE 3.9 12.2 16.1 Non-cat loss and ALAE 6.3 22.0 28.3 Total Loss and ALAE incurred $ 10.2 $ 34.2 $ 44.4 Cat loss and ALAE ratio 27.2 % 28.0 % 27.8 % Non-cat loss and ALAE ratio 43.6 % 50.6 % 48.8 % Total Loss and ALAE ratio 70.8 % 78.6 % 76.6 % 40 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Reconciliation Table 11 ($ millions) SAP HO QS Arrangement Cession - Homeowners Pro-Forma without HO QS Six months ended June 30, 2014 As Reported HO QS Cession Cession Net written premiums $ 28.8 $ 86.5 $ 115.3 Earned premiums 29.4 88.3 117.7 Losses and ALAE incurred: Cat loss and ALAE 5.4 18.0 23.4 Non-cat loss and ALAE 11.4 38.8 50.2 Total Loss and ALAE incurred $ 16.8 $ 56.8 $ 73.6 Cat loss and ALAE ratio 18.2 % 20.4 % 19.8 % Non-cat loss and ALAE ratio 39.0 % 43.9 % 42.8 % Total Loss and ALAE ratio 57.2 % 64.3 % 62.6 % Reconciliation Table 12 ($ millions) SAP HO QS Arrangement Cession - Homeowners Pro-Forma without HO QS Six months ended June 30, 2013 As Reported HO QS Cession Cession Net written premiums $ 29.4 $ 87.3 $ 116.7 Earned premiums 27.0 88.9 115.9 Losses and ALAE incurred: Cat loss and ALAE 4.4 14.2 18.6 Non-cat loss and ALAE 12.1 39.3 51.4 Total Loss and ALAE incurred $ 16.5 $ 53.5 $ 70.0 Cat loss and ALAE ratio 16.3 % 16.0 % 16.0 % Non-cat loss and ALAE ratio 45.1 % 44.2 % 44.3 % Total Loss and ALAE ratio 61.4 % 60.2 % 60.3 % 41 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Business Insurance Segment The following table sets forth the net written premiums by major product line of business for our business insurance segment for the three and six months ended June 30, 2014 and 2013: Table 4 ($ millions) Net Written Premiums Three months ended June 30 Six months ended June 30 % % Business insurance segment: 2014 2013 Change 2014 2013 Change Commercial auto $ 28.7 $ 27.1 5.9 $ 53.1 $ 50.5 5.1 Commercial multi-peril 31.5 28.9 9.0 61.7 56.8 8.6 Fire & allied lines 20.2 20.5 (1.5 ) 38.6 39.0 (1.0 ) Other & product liability 21.6 18.6 16.1 38.8 36.2 7.2 Other commercial 5.0 5.0 - 9.4 9.5 (1.1 ) Total business $ 107.0 $ 100.1 6.9 $ 201.6 $ 192.0 5.0 The following table sets forth the SAP loss and ALAE ratios by major product line of business for our business insurance segment with the catastrophe and non-catastrophe impact shown separately for the three and six months ended June 30, 2014 and 2013: Table 5 Statutory Loss and LAE Ratios ($ millions) % Non-Cat Loss & Total Loss Three months ended Earned Non-Cat Loss Statutory Loss ALAE and LAE June 30 Premium Cat Loss & ALAE & ALAE & LAE Cat loss Ratio Ratio Ratio 2014 Business insurance segment: Commercial auto $ 24.5 $ 0.4 $ 12.7 $ 13.1 1.9 51.7 53.6 Commercial multi-peril 29.4 3.4 15.6 19.0 11.3 53.4 64.7 Fire & allied lines 19.5 4.5 11.2 15.7 23.1 57.1 80.2 Other & product liability 18.1 - 6.2 6.2 - 34.2 34.2 Other commercial 4.4 (0.1 ) 1.2 1.1 (1.3 ) 26.9 25.6 Total business 95.9 8.2 46.9 55.1 8.6 48.9 57.5 ULAE - - - 4.8 - - 4.9 Total Loss and LAE $ 95.9 $ 8.2 $ 46.9 $ 59.9 8.6 48.9 62.4 2013 Business insurance segment: Commercial auto $ 23.1 $ 0.5 $ 14.0 $ 14.5 2.3 60.6 62.9 Commercial multi-peril 26.8 5.5 12.4 17.9 20.2 46.8 67.0 Fire & allied lines 19.2 3.5 5.4 8.9 18.0 28.2 46.2 Other & product liability 16.0 - 7.5 7.5 - 46.7 46.7 Other commercial 4.5 - 1.9 1.9 0.7 41.0 41.7 Total business 89.6 9.5 41.2 50.7 10.5 46.1 56.6 ULAE - - - 4.7 - - 5.3 Total Loss and LAE $ 89.6 $ 9.5 $ 41.2 $ 55.4 10.5 46.1 61.9 42 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Table 6 Statutory Loss and LAE Ratios ($ millions) % Non-Cat Loss & Total Loss Six months ended June Earned Non-Cat Loss Statutory Loss ALAE and LAE 30, 2014 Premium Cat Loss & ALAE & ALAE & LAE Cat loss Ratio Ratio Ratio 2014 Business insurance segment: Commercial auto $ 48.5 $ 0.5 $ 25.8 $ 26.3 1.1 53.1 54.2 Commercial multi-peril 58.1 5.4 35.0 40.4 9.2 60.4 69.6 Fire & allied lines 38.9 7.6 23.1 30.7 19.5 59.3 78.8 Other & product liability 35.1 - 16.2 16.2 - 46.1 46.1 Other commercial 8.8 (0.1 ) 2.8 2.7 (1.1 ) 31.6 30.5 Total business 189.4 13.4 102.9 116.3 7.1 54.3 61.4 ULAE - - - 8.6 - - 4.5 Total Loss and LAE $ 189.4 $ 13.4 $ 102.9 $ 124.9 7.1 54.3 65.9 2013 Business insurance segment: Commercial auto $ 45.5 $ 0.7 $ 27.3 $ 28.0 1.6 59.9 61.5 Commercial multi-peril 52.7 7.9 27.1 35.0 15.0 51.4 66.4 Fire & allied lines 38.3 5.1 11.1 16.2 13.2 29.1 42.3 Other & product liability 32.5 - 17.3 17.3 - 53.0 53.0 Other commercial 9.1 - 4.6 4.6 0.3 50.6 50.9 Total business 178.1 13.7 87.4 101.1 7.7 49.0 56.7 ULAE - - - 9.9 - - 5.6Total Loss and LAE $ 178.1 $ 13.7 $ 87.4 $ 111.0 7.7 49.0 62.3 Net written premiums for the business insurance segment for the three and six months ended June 30, 2014 increased 6.9% and 5.0%, respectively, compared to the same 2013 periods (Table 4). The increase in premiums was primarily due to growth in our other & product liability, commercial multi-peril and commercial auto units as a result of writing policies with larger average premiums for new business accounts and achieving price increases in the mid-single digits. We have developed and implemented several strategies in order to capitalize on opportunities to grow our business insurance segment. With the implementation of Business Insurance Evolution ("BIE") in 2013, our ongoing initiative to automate our small commercial accounts with premiums less than $25,000, we have been able to shift our underwriting focus from smaller to larger commercial accounts. Through our practice group initiative, we provide expertise for all lines of insurance solutions for niche or target markets, with a focus on writing premiums in excess of $25,000. For example, in 2013, we launched our food industry practice group, focused on food manufacturing and processing risks. We continue to identify industries and areas of focus where we believe we have underwriting expertise and look to expand into those markets through 2015. BIE has proven successful as approximately 52% of the renewal business is processed without human intervention. Our next BIE focus is to automate new business processes, providing more consistent pricing, underwriting and greater service to our agents, while improving our efficiency. The business insurance segment's SAP non-catastrophe loss and ALAE ratios for the three and six months ended June 30, 2014 increased 2.8 points and 5.3 points, respectively, compared to the same 2013 periods (Tables 5 - 6). The three and six month 2014 increases in the SAP non-catastrophe loss and ALAE ratios were primarily driven by fire & allied lines and commercial multi-peril, respectively, compared to the same 2013 periods (Tables 5 - 6). The three and six month 2014 fire & allied lines and commercial multi-peril increases were driven by large fire losses, as well as the extreme cold weather during the first quarter of 2014. In addition, the six month 2014 commercial multi-peril SAP non-catastrophe loss and ALAE ratio increase was driven by wind events that occurred during the first quarter of 2014. The three and six month 2014 SAP non-catastrophe loss and ALAE ratio increases were partially offset by improvements in other & product liability and commercial auto, respectively, compared to the same 2013 periods (Tables 5 - 6). These improvements were the result of prior period rate increases. 43-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Specialty Insurance Segment The following table sets forth the net written premiums by unit for our specialty insurance segment for the three and six months ended June 30, 2014 and 2013. Table 7 ($ millions) Net Written Premiums Three months ended June 30 Six months ended June 30 Specialty insurance % % segment: 2014 2013 Change 2014 2013 Change Excess & Surplus property $ 18.2 $ 13.6 33.8 $ 25.8 $ 23.0 12.2 Excess & Surplus casualty 14.1 10.8 30.6 26.0 20.8 25.0 Programs 19.2 20.0 (4.0 ) 39.7 39.0 1.8 Workers' compensation 20.3 18.9 7.4 41.5 37.8 9.8 Total specialty $ 71.8 $ 63.3 13.4 $ 133.0 $ 120.6 10.3 The following table sets forth the SAP loss and ALAE ratios for our specialty insurance segment with the catastrophe and non catastrophe impact shown separately for the three and six months ended June 30, 2014 and 2013: Table 8 Statutory Loss and LAE Ratios ($ millions) % Non-Cat Loss & Total Loss Three months ended Earned Cat Loss Non-Cat Loss Statutory Loss Cat loss ALAE and LAE June 30 Premium & ALAE & ALAE & LAE Ratio Ratio Ratio 2014 Specialty insurance segment: Excess & Surplus property $ 10.6 $ 1.0 $ 1.3 $ 2.3 9.6 12.0 21.6 Excess & Surplus casualty 11.1 - 5.2 5.2 - 46.5 46.5 Programs 18.3 - 23.5 23.5 0.2 128.7 128.9 Workers' compensation 18.7 - 11.0 11.0 - 59.1 59.1 Total specialty 58.7 1.0 41.0 42.0 1.8 69.8 71.6 ULAE - - - 1.5 - - 2.7 Total Loss and LAE $ 58.7 $ 1.0 $ 41.0 $ 43.5 1.8 69.8 74.3 2013 Specialty insurance segment: Excess & Surplus property $ 7.4 $ 2.5 $ 1.3 $ 3.8 34.8 16.4 51.2 Excess & Surplus casualty 9.5 - 4.3 4.3 - 45.3 45.3 Programs 22.0 0.6 18.0 18.6 2.6 81.3 83.9 Workers' compensation 17.8 - 11.5 11.5 - 64.5 64.5 Total specialty 56.7 3.1 35.1 38.2 5.5 61.6 67.1 ULAE - - - 2.0 - - 3.5 Total Loss and LAE $ 56.7 $ 3.1 $ 35.1 $ 40.2 5.5 61.6 70.6 44 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Table 9 Statutory Loss and LAE Ratios ($ millions) % Non-Cat Loss & Total Loss Six months ended June Earned Cat Loss Non-Cat Loss Statutory Loss Cat loss ALAE and LAE 30, 2014 Premium & ALAE & ALAE & LAE Ratio Ratio Ratio 2014 Specialty insurance segment: Excess & Surplus property $ 18.7 $ 1.7 $ 1.7 $ 3.4 9.2 8.9 18.1 Excess & Surplus casualty 21.6 - 10.2 10.2 - 47.2 47.2 Programs 36.2 - 35.5 35.5 0.1 98.0 98.1 Workers' compensation 36.9 - 22.9 22.9 - 62.1 62.1 Total specialty 113.4 1.7 70.3 72.0 1.5 62.0 63.5 ULAE - - - 3.5 - - 3.1 Total Loss and LAE $ 113.4 $ 1.7 $ 70.3 $ 75.5 1.5 62.0 66.6 2013 Specialty insurance segment: Excess & Surplus property $ 15.2 $ 2.5 $ 2.7 $ 5.2 16.9 17.0 33.9 Excess & Surplus casualty 18.7 - 9.3 9.3 - 49.7 49.7 Programs 45.9 0.4 39.1 39.5 0.8 85.2 86.0 Workers' compensation 35.0 - 21.6 21.6 - 61.8 61.8 Total specialty 114.8 2.9 72.7 75.6 2.6 63.2 65.8 ULAE - - - 3.3 - - 2.9 Total Loss and LAE $ 114.8 $ 2.9 $ 72.7 $ 78.9 2.6 63.2 68.7 Net written premiums for the specialty insurance segment for the three and six months ended June 30, 2014 increased 13.4% and 10.3%, respectively, compared to the same 2013 periods (Table 7). The increase in premiums was primarily due to (i) new business growth in our Excess & Surplus property unit, (ii) growth in umbrella and general liability policies in our Excess & Surplus casualty unit, and (iii) rate increases and new business growth in our workers' compensation unit. The specialty insurance segment's SAP non-catastrophe loss and ALAE ratios for the three and six months ended June 30, 2014 were 69.8% and 62.0%, respectively, compared to 61.6% and 63.2%, respectively, for the same 2013 periods (Tables 8 - 9). The 8.2 point increase in the SAP non-catastrophe loss and ALAE ratio for the three months ended June 30, 2014, when compared to the same 2013 period, was primarily driven by reserve strengthening of $11.4 million for terminated RED programs. The improvement in the SAP non-catastrophe loss and ALAE ratio for the six months ended June 30, 2014, when compared to the same 2013 period, was primarily due to (i) improvement in the Programs SAP non-catastrophe loss and ALAE ratio, not including the impact of RED reserve strengthening, resulting primarily from the impact of prior underwriting actions taken on the largest active program, (ii) favorable prior accident year development in our Excess & Surplus property unit, and (iii) changes in our business mix. We have increased our involvement in managing litigated and higher severity terminated RED program claim files since third quarter 2013, and plan to take over full file management from certain third party administrators prior to year end. We plan on completing a detailed, ground up analysis of RED program claims by year end. 45 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Losses and loss expenses payable The following table sets forth losses and loss expenses payable by major line of business at June 30, 2014 and December 31, 2013: ($ millions) December 31, June 30, 2014 2013 Change Personal insurance segment: Personal auto $ 182.9 $ 188.8 $ (5.9 ) Homeowners 24.3 24.3 - Other personal 11.6 10.6 1.0 Total personal 218.8 223.7 (4.9 ) Business insurance segment: Commercial auto 81.5 83.4 (1.9 ) Commercial multi-peril 96.5 91.5 5.0 Fire & allied lines 30.8 22.1 8.7 Other & product liability 156.9 159.8 (2.9 ) Other business 2.8 2.8 - Total business 368.5 359.6 8.9 Specialty insurance segment: Excess & Surplus property 8.0 7.4 0.6 Excess & Surplus casualty 61.9 61.1 0.8 Programs 145.1 150.7 (5.6 ) Workers' compensation 151.9 148.3 3.6 Total specialty 366.9 367.5 (0.6 ) Total losses and loss expenses payable net of reinsurance recoverable on losses and loss expenses payable $ 954.2 $ 950.8 $ 3.4 We conduct quarterly reviews of loss development reports and make judgments in determining the reserves for ultimate losses and loss expenses payable. Several factors are considered by us when estimating ultimate liabilities including consistency in relative case reserve adequacy, consistency in claims settlement practices, recent legal developments, historical data, actuarial projections, accounting projections, exposure changes, anticipated inflation, current business conditions, catastrophe developments, late reported claims, and other reasonableness tests. The risks and uncertainties inherent in our estimates include, but are not limited to, actual settlement experience different from historical data, trends, changes in business and economic conditions, court decisions creating unanticipated liabilities, ongoing interpretation of policy provisions by the courts, inconsistent decisions in lawsuits regarding coverage and additional information discovered before settlement of claims. Our results of operations and financial condition could be impacted, perhaps significantly, in the future if the ultimate payments required for claims settlement vary from the liability currently recorded. For a discussion of our reserving methodologies as well as a measure of sensitivity discussion see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Losses and Loss Expenses Payable" in Item 7 of the 2013 Form 10-K. Acquisition and Operating Expenses Our GAAP acquisition and operating expense ratios were 36.3% and 33.0% for the three months ended June 30, 2014 and 2013, respectively, and 35.0% and 33.5% for the six months ended June 30, 2014 and 2013, respectively. Acquisition and operating expenses for the three and six months ended June 30, 2014 increased $10.3 million and $10.0 million, respectively, when compared to the same 2013 periods, primarily due to (i) expenses recognized as a result of the reorganization of our IT department, which affected the expense ratios by 1.6 points and 0.8 points, respectively, for three and six 46-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) months ended June 30, 2014 (see Note 7 of our condensed consolidated financial statements included in Item 1 of this report, for additional information) and (ii) estimates of contingent commissions and incentive compensation. Investment Operations Segment Our investments in fixed maturities, equity securities and certain other invested assets are reported as available-for-sale and carried at fair value. The unrealized holding gains or losses, 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. We have investment policy guidelines with respect to purchasing fixed maturity investments for our insurance subsidiaries which preclude investments in bonds that are rated below investment grade by a recognized rating service. For the insurance subsidiaries, the maximum investment in any single note or bond is limited to 5.0% or less of statutory assets, other than obligations of the U.S. government or government agencies, for which there is no limit. Our fixed maturity portfolio is composed of high quality, investment grade issues, comprised almost entirely of debt issues rated AAA or AA. We obtain investment ratings from Moody's, Standard & Poor's and Fitch. If there is a split rating, we assign the lowest rating obtained. At June 30, 2014, there were no fixed maturity investments rated below investment grade in our available-for-sale investment portfolio. For further discussion regarding the management of our investment portfolio, see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - Investment Operations Segment" in Item 7 of the 2013 Form 10-K. Composition of Investment Portfolio The following table sets forth the composition of our investment portfolio at carrying value at June 30, 2014 and December 31, 2013: ($ millions) June 30, 2014 % of Total December 31, 2013 % of Total Cash and cash equivalents $ 71.5 3.0 $ 80.3 3.4 Fixed maturities, at fair value: Fixed maturities 1,648.3 69.2 1,630.6 69.9 Treasury inflation-protected securities 201.0 8.4 199.5 8.6 Total fixed maturities 1,849.3 77.6 1,830.1 78.5 Notes receivable from affiliate (a) 70.0 2.9 70.0 3.0 Equity securities, at fair value: Large-cap securities 235.4 9.9 194.4 8.4 Small-cap securities 65.0 2.7 70.9 3.0 Total equity securities 300.4 12.6 265.3 11.4 Other invested assets, at fair value: International funds 80.1 3.4 74.2 3.2 Other invested assets 7.2 0.3 6.7 0.3 Total other invested assets, at fair value 87.3 3.7 80.9 3.5 Other invested assets, at cost 5.3 0.2 5.0 0.2 Total portfolio $ 2,383.8 100.0 $ 2,331.6 100.0 (a) In May 2009, we entered into two separate Credit Agreements with State Auto Mutual. Under these Credit Agreements, State Auto Mutual borrowed a total of $70.0 million from us on an unsecured basis. Interest is payable semi-annually at a fixed annual interest rate of 7.00%. Principal is payable May 2019. 47 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) The following table sets forth the amortized cost and fair value of available-for-sale fixed maturities by contractual maturity at June 30, 2014: ($ millions) Fair Amortized cost value Due in 1 year or less $ 39.5 $ 40.0 Due after 1 year through 5 years 355.2 372.9 Due after 5 years through 10 years 326.5 345.0 Due after 10 years 604.1 616.2 U.S. government agencies residential mortgage-backed securities 463.9 475.2 Total $ 1,789.2 $ 1,849.3 Expected maturities may differ from contractual maturities as the issuers may have the right to call or prepay the obligations with or without call or prepayment penalties. The duration of the fixed maturity portfolio was approximately 4.66 and 4.83 as of June 30, 2014 and December 31, 2013, respectively. Investment Operations Revenue The following table sets forth the components of net investment income for the three and six months ended June 30, 2014 and 2013: ($ millions) Three months ended Six months ended June 30 June 30 2014 2013 2014 2013 Gross investment income: Fixed maturities $ 17.9 $ 17.2 $ 33.3 $ 32.0 Equity securities 1.7 1.6 3.1 2.8 Other 1.4 1.4 2.7 2.8 Total gross investment income 21.0 20.2 39.1 37.6 Less: Investment expenses 0.5 0.5 1.0 1.0 Net investment income $ 20.5 $ 19.7 $ 38.1 $ 36.6 Average invested assets (at cost) $ 2,139.2 $ 2,138.8 $ 2,134.8 $ 2,140.7 Annualized investment yield 3.8 % 3.7 % 3.6 % 3.4 % Annualized investment yield, after tax 2.9 % 2.8 % 2.7 % 2.7 % Net investment income, after tax $ 15.4 $ 15.2 $ 28.9 $ 28.5 Effective tax rate 25.0 % 23.0 % 24.0 % 22.2 % 48 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) The following table sets forth realized gains and the proceeds received on sale for our investment portfolio for the three and six months ended June 30, 2014 and 2013: ($ in millions) Three months ended June 30 Six months ended June 30 2014 2013 2014 2013 Proceeds Proceeds Proceeds Proceeds Realized gains received on Realized gains received on Realized gains received on Realized gains received on (losses) sale (losses) sale (losses) sale (losses) sale Realized gains: Fixed maturities $ 0.4 $ 30.5 $ 0.7 $ 19.7 $ 2.5 $ 101.8 $ 1.2 $ 58.2 Equity securities 5.2 29.5 3.4 12.8 14.7 62.6 10.0 40.3 Other invested assets - - - - 0.1 0.1 - - Total realized gains 5.6 60.0 4.1 32.5 17.3 164.5 11.2 98.5 Realized losses: Equity securities: Sales - 0.7 (0.6 ) 3.6 (0.1 ) 2.3 (0.7 ) 4.2 OTTI (0.3 ) - (2.0 ) - (1.2 ) - (2.3 ) - Total realized losses (0.3 ) 0.7 (2.6 ) 3.6 (1.3 ) 2.3 (3.0 ) 4.2 Net realized gain on investments $ 5.3 $ 60.7 $ 1.5 $ 36.1 $ 16.0 $ 166.8 $ 8.2 $ 102.7 During the first half of 2014, equity sales were executed for various reasons, including: (i) the achievement of our price target, (ii) in response to changes in business conditions, which in our opinion diminished the future business prospects on these securities, and (iii) in order to manage our equity holdings consistent with our investment objectives. When a fixed maturity security has been determined to have an other-than-temporary decline in fair value, the impairment charge is separated into an amount representing the credit loss, which is recognized in earnings, and the amount related to non-credit factors, which is recognized in accumulated other comprehensive income. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Investments" included in Item 7 of the 2013 Form 10-K for other-than-temporary impairment ("OTTI") indicators. Future increases or decreases in fair value, if not other-than-temporary, are included in accumulated other comprehensive income. We did not recognize OTTI on our fixed maturity portfolio for the three and six months ended June 30, 2014 and 2013. When an equity security or other invested asset has been determined to have a decline in fair value that is other-than-temporary, we adjust the cost basis of the security to fair value. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Investments" included in Item 7 of the 2013 Form 10-K for OTTI impairment indicators. This results in a charge to earnings as a realized loss, which is not reversed for subsequent recoveries in fair value. Future increases or decreases in fair value, if not other-than-temporary, are included in accumulated other comprehensive income. The following table sets forth the realized losses related to OTTI on our investment portfolio recognized for the three and six months ended June 30, 2014: ($ millions, except # of positions) Three months ended Six months ended Number of Number of positions Total impairment positions Total impairment Equity securities: Large-cap securities - $ - 1 $ (0.3 ) Small-cap securities 7 (0.3 ) 17 (0.9 ) Total other-than-temporary impairments 7 $ (0.3 ) 18 $ (1.2 ) 49 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Gross Unrealized Investment Gains and Losses Based upon our review of our investment portfolio at June 30, 2014, 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 June 30, 2014: ($ millions, except # of Cost or Number of Gross unrealized Number of positions) amortized Gross unrealized gain holding loss cost holding gains positions losses positions Fair value Fixed maturities: U.S. treasury securities and obligations of U.S. government agencies $ 297.9 $ 19.5 33 $ (3.2 ) 20 $ 314.2 Obligations of states and political subdivisions 708.7 26.0 214 (3.1 ) 65 731.6 Corporate securities 318.7 12.8 69 (3.2 ) 15 328.3 U.S. government agencies residential mortgage-backed securities 463.9 13.9 96 (2.6 ) 27 475.2 Total fixed maturities 1,789.2 72.2 412 (12.1 ) 127 1,849.3 Equity securities: Large-cap securities 182.4 53.0 34 - - 235.4 Small-cap securities 47.6 17.4 78 - - 65.0 Total equity securities 230.0 70.4 112 - - 300.4 Other invested assets 49.7 37.6 3 - - 87.3 Total available-for-sale investments $ 2,068.9 $ 180.2 527 $ (12.1 ) 127 $ 2,237.0 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 (loss) at June 30, 2014 and December 31, 2013, and the change in unrealized holding gains, net of deferred tax, for the six months ended June 30, 2014: ($ millions) $ June 30, 2014 December 31, 2013 Change Available-for-sale investments: Unrealized holding gains: Fixed maturities $ 60.1 $ 26.1 $ 34.0 Equity securities 70.4 68.7 1.7 Other invested assets 37.6 31.4 6.2 Unrealized gains 168.1 126.2 41.9 Net deferred federal income tax liability (less valuation allowance) (49.3 ) (41.6 ) (7.7 ) Unrealized gains, net of tax $ 118.8 $ 84.6 $ 34.2 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 3, "Fair Value of Financial Instruments" to our condensed consolidated financial statements included in Item 1 of this Form 10-Q for a presentation of our available-for-sale investments within the fair value hierarchy at June 30, 2014 and December 31, 2013. As of June 30, 2014, Level 3 assets as a percentage of total assets were 0.4% which we have determined to be insignificant. 50-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Other Items Income Taxes Deferred income tax assets and liabilities represent the tax effect of the differences between the financial statement carrying value of existing assets and liabilities and their respective tax bases. In accordance with the Financial Accounting Standards Board's Accounting Standards Codification 740, Income Taxes (ASC 740), we periodically evaluate our deferred tax assets, which requires significant judgment, to determine if they are realizable based upon weighing all available evidence, both positive and negative, including our historical and anticipated future taxable income. In making such judgments, significant weight is given to evidence that can be objectively verified. The following table sets forth the components of our federal income tax expense for the three and six months ended June 30, 2014 and 2013, respectively. ($ millions) Three months ended June 30 Six months ended June 30 2014 2013 2014 2013 Income before federal income taxes $ 3.1 $ 6.3 $ 30.8 $ 26.3 Current tax expense 0.1 0.1 0.7 0.4 Deferred tax (benefit) expense (0.4 ) (0.2 ) 6.8 4.4 (0.3 ) (0.1 ) 7.5 4.8 Valuation allowance 0.4 0.2 (6.8 ) (4.4 ) Total federal income tax expense 0.1 0.1 0.7 0.4 Net income $ 3.0 $ 6.2 $ 30.1 $ 25.9 For the three and six month periods ended June 30, 2014, we recorded current tax expense of $0.1 million and $0.7 million, respectively, compared to $0.1 million and $0.4 million for the same 2013 periods, related to the Alternative Minimum Tax ("AMT"). AMT is an alternative tax system whereby we calculate our tax and if it is greater than regular tax, we provide for the AMT. While we currently have both regular tax and AMT tax net operating loss ("NOL") carryforwards, the Internal Revenue Code only permits a 90% offset of the AMT obligation; compared to a 100% offset of the regular tax obligation. The disallowed utilization of the 10% portion of the AMT NOL represents our current tax expense. The deferred tax benefit for the AMT was offset by the tax valuation allowance, which resulted in a net tax provision for the three and six month periods ended June 30, 2014 and 2013. In future periods we will re-assess our judgments and assumptions regarding the realization of our net deferred tax assets, but until such time as the positive evidence exceeds the negative evidence we will maintain a valuation allowance against our net deferred tax assets. Based on ASC 740 intraperiod tax allocation guidelines, the following sets forth the change in valuation allowance attributable to continuing operations and other comprehensive income for the three and six months ended June 30, 2014 and 2013 is as follows: ($ millions) Three months ended Six months ended 2014 2013 2014 2013 Continuing operations $ 0.4 $ 0.2 $ (6.8 ) $ (4.4 ) Other comprehensive income (6.6 ) 16.5 (6.8 ) 11.4 Change in valuation allowance $ (6.2 ) $ 16.7 $ (13.6 ) $ 7.0 See Note 5 of our condensed consolidated financial statements included in Item 1 of this Form 10-Q. 51 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) 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 catastrophic 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-term 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, the STFC Pooled Companies do not have the daily liquidity concerns normally associated with an insurance company due to their participation in, and the terms of, the Pooling Arrangement. Under the terms of the Pooling Arrangement, State Auto Mutual receives all premiums 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. When settling the intercompany balances, State Auto Mutual provides the pool participants with full credit for the premiums written net of losses paid during the quarter, retaining all receivable amounts from insureds and agents and reinsurance recoverable on paid losses from unaffiliated reinsurers. Any receivable amounts that are ultimately deemed to be uncollectible are charged-off by State Auto Mutual and allocated to the pool participant on the basis of its pooling percentage. As a result, we have an off-balance sheet credit risk related to the balances due to State Auto Mutual from insureds, agents and reinsurers, which are offset by the unearned premiums from the respective policies. 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. Based on historical data, this credit risk exposure is not considered to be material to our financial position, though the impact to income on a quarterly basis may be material. 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. The amounts deemed uncollectible by State Auto Mutual and allocated to the STFC Pooled Companies are included in the other expenses line item in the accompanying consolidated statements of income. 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, we may need to liquidate investments at losses in order to meet our cash obligations. This action was not necessary for the three and six months ended June 30, 2014. 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 June 30, 2014 and December 31, 2013, we had $71.5 million and $80.3 million, respectively, in cash and cash equivalents, and $2,237.0 million and $2,176.3 million, respectively, of total available-for-sale investments. Included in our fixed maturities available-for-sale were $8.8 million and $8.7 million, respectively, of securities on deposit with insurance regulators as required by law at June 30, 2014 and December 31, 2013; in addition, substantially all of our fixed maturity and equity securities are traded on public markets. For a further discussion regarding investments, see "Investments Operations Segment" included in this Item 2. Net cash provided by operating activities was $4.8 million and $11.6 million for the six months ended June 30, 2014 and 2013, respectively. Net cash from operations will vary from period to period if there are significant changes in underwriting results, primarily a combination of the level of premiums written and loss and loss expenses paid, changes in cash flows from investment income or federal income tax activity. Net cash used in investing activities was $7.3 million for the six months ended June 30, 2014 compared to net cash provided by investing activities of $4.5 million for the six months ended . The change can generally be attributed to the level of purchases, sales and maturities in our investment portfolio in the first six months of 2014 when compared to the same 2013 period. Net cash used in financing activities was $6.3 million and $6.6 million for the six months ended June 30, 2014 and 2013, respectively. The decrease was due to an increase in option exercises in the first six months of 2014 compared to the same 2013 period. 52 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Borrowing Arrangements Credit Facility State Auto P&C has a $100.0 million five-year revolving credit facility (the "Credit Facility") maturing in July 2018 with a syndicate of lenders. During the term of the Credit Facility, State Auto P&C has the right to increase the total facility to a maximum amount of $150.0 million, provided that no event of default has occurred and is continuing. The Credit Facility is available for general corporate purposes and provides for interest-only payments during its term, with principal and interest due in full at maturity. Interest is based on LIBOR or a base rate plus a calculated margin amount. All advances under the Credit Facility are to be fully secured by a pledge of specific investment securities of State Auto P&C. The Credit Facility includes certain covenants and requirements, including financial requirements that State Auto Financial maintain a minimum net worth and a certain debt to capitalization ratio. As of June 30, 2014, State Auto P&C had not made any borrowings under the Credit Facility and State Auto P&C and State Auto Financial were in compliance with all covenants and requirements of the Credit Facility. FHLB Loan State Auto P&C has outstanding an $85.0 million loan ("FHLB loan") from the Federal Home Loan Bank of Cincinnati. The FHLB Loan is a 20-year term loan, callable after three years with no prepayment penalty thereafter. The FHLB Loan 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 5.03%. The 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 June 30, 2014 and 2013 were 4.43% and 4.47%, respectively. 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 and 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. 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 premium 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. 53 -------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) Property Catastrophe 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. As of June 1, 2014, this property catastrophe reinsurance agreement was revised to increase the treaty limit. Under this agreement, the State Auto Group retains the first $55.0 million of catastrophe loss, each occurrence, with a 5.0% co-participation on the next $285.0 million (previously $265.0 million) of covered loss, each occurrence. The reinsurers are responsible for 95% of the excess over $55.0 million up to $340.0 million (previously $320.0 million) of covered losses, each occurrence. Under this agreement, our companies are responsible for losses above $340.0 million (previously $320.0 million). The State Auto Group also maintains a separate property catastrophe excess of loss reinsurance agreement covering Excess & Surplus property and Programs catastrophe related events affecting at least two risks. Under this agreement, the State Auto Group retains the first $15.0 million of catastrophe loss, each occurrence, and the reinsurers are responsible for 100% of the excess over $15.0 million up to $55.0 million of covered loss, each occurrence. Property Per Risk At June 1, 2014, the State Auto Group renewed the property per risk excess of loss reinsurance agreement. This reinsurance agreement provides that the State Auto Group is responsible for the first $1.0 million of each covered loss for Excess & Surplus property and Programs units, and the first $3.0 million of each covered loss for other property business. The State Auto Group is also responsible for an additional $2.0 million in aggregate retention per treaty year for losses exceeding $3.0 million. The reinsurers are responsible for 75% of the loss in excess of $1.0 million for the Excess and Surplus property and Programs units and 100% of the loss excess of $3.0 million for other property business up to $20.0 million of covered loss. The rates for this reinsurance are negotiated annually. Casualty and Workers' Compensation As of July 1, 2014, the State Auto Group renewed our casualty excess of loss reinsurance agreement. Under this agreement, the State Auto Group is responsible for the first $1.0 million of workers' compensation losses, each loss occurrence, subject to an additional $1.0 million in annual aggregate retention, and $2.0 million of losses that involve auto liability, other liability and umbrella liability policies, subject to an additional $2.0 million in annual aggregate retention. The reinsurance agreement provides coverage up to $10.0 million, except for umbrella policies which are covered for limits up to $15.0 million. Excess & Surplus casualty and Programs units risks are not subject to this casualty excess of loss reinsurance agreement. Also, certain unusual claim situations involving bodily injury liability, property damage, uninsured motorist and personal injury protection are covered by an arrangement that provides for $30.0 million of coverage in excess of $10.0 million retention for each loss occurrence. This reinsurance sits above the $8.0 million excess of $2.0 million arrangement. The rates for this reinsurance are negotiated annually. Policies underwritten by the Excess & Surplus casualty and Programs units are not subject to this casualty excess of loss reinsurance agreement. In addition to the workers' compensation reinsurance described above, each company in the State Auto Group is party to a workers' compensation catastrophe reinsurance 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% 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. The rates for the workers' compensation catastrophe reinsurance agreement are negotiated annually. For Excess & Surplus casualty and Programs unit risks, the State Auto Group has a combined casualty treaty whereby under Section A, we retain the first $1.0 million of covered loss and the reinsurers are responsible for 90.0% (previously 87.0%) of loss in excess of $1.0 million up to $10.0 million for all primary business and excess business written directly above a primary policy, at policy limits above $1.0 million. Under Section B, as respects excess policies over another carrier's primary policy, we have a $10.0 million proportional agreement where we retain $1.0 million of each risk and the reinsurers are responsible for 90.0% (previously 87.0%) of loss for each risk based on the percentage the $1.0 million we retain bears to the total policy limit. Under Section C, as respects policies at $1.0 million or less, we retain the first $1.25 million of Extra Contractual Obligations/Excess of Policy Limits ("ECO/XPL") and LAE coverage for policies with limits of $1.0 million or less, and the reinsurers are responsible for 100% of ECO/XPL and LAE coverage in excess of $1.3 million up to $4 million. 54-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) For a discussion of our other reinsurance arrangements see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Reinsurance Arrangements" in Item 7 of the 2013 Form 10-K. Regulatory Considerations At June 30, 2014, all of our insurance subsidiaries were in compliance with statutory requirements relating to capital adequacy. ADOPTION OF RECENT ACCOUNTING PRONOUNCEMENTS None. MARKET RISK With respect to Market Risk, see the discussion regarding this subject at "Management's Discussion and Analysis of Financial Condition and Results of Operations -Investment Operations Segment - Market Risk" in Item 7 of the 2013 Form 10-K. There have been no material changes from the information reported regarding Market Risk in the 2013 Form 10-K. Item 3. Quantitative and Qualitative Disclosure of Market Risk The information called for by this item is provided in this Form 10-Q under the caption "Market Risk" under Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations. 55-------------------------------------------------------------------------------- Table of Contents STATE AUTO FINANCIAL CORPORATION AND SUBSIDIARIES (a majority-owned subsidiary of State Automobile Mutual Insurance Company) |