S&P Lowers State Auto Group’s Operating Company Ratings to ‘BBB+’

November 10, 2011

Standard & Poor’s Ratings Services has lowered its counterparty credit and financial strength ratings on the operating insurance companies of State Auto Group to ‘BBB+’ from ‘A-‘. S&P also lowered its counterparty credit rating on State Auto Financial Corp. to ‘BB+’ from ‘BBB-‘.

“The downgrade reflects primarily the substantial decline in capital adequacy from historical levels, mostly because of poor earnings from 2008 to 2010 and a considerable operating loss for the first nine months of 2011, coupled with the establishment of a valuation allowance against a substantial amount of net deferred tax assets,” explained credit analyst Pablo Feldman.

S&P noted that on a pro forma basis as of Sept. 30 2011, “we expect financial leverage to increase to about 30 percent at year-end 2011 from 24 percent at the end of 2010, taking into account the company’s decision to discontinue most retiree medical coverage.

“The reduced level of capital has also resulted in debt leverage modestly exceeding our tolerance level for debt funded double leverage, limiting the credit given in our capital analysis for insurance company statutory capital funded through debt issuance. We expect fixed charge coverage to be negative for 2011. Our negative assessment of management and corporate strategy at State Auto Group and our weak assessment of the company’s enterprise risk management program (ERM) also support lowering the ratings.

“We believe that the deterioration in capitalization and operating performance is primarily the result of poor strategic decisions, such as an ineffective catastrophe management program and late pricing and underwriting actions.”

S&P added that, barring any further catastrophes for the rest of the year, it projects a combined ratio for 2011 at around 14.5 to 118.5 percent with a negative return on revenue (ROR).

In 2012, assuming eight percentage points of catastrophe losses and no abnormal reserve releases, it expects the statutory combined ratio to be 100 to 105 percent with an ROR in the low single digits and positive net income.

S&P also said it expects premium volume to increase by a low-single-digit rate in 2011 and similar amount in 2012. “We expect financial leverage for the consolidated group to be between 30 and 40 percent and fixed charge coverage of at least 2x,” the report added. “We expect capital adequacy to improve back to the ‘A’ level by year end 2012, reflecting initiatives the company is taking or considering, including a multiyear reinsurance arrangement for its homeowners book and improved earnings assuming a return to a more normal level of catastrophe losses.”

S&P also explained that it had placed State Auto Group’s ratings on CreditWatch with negative implications “because there is at least a 50 percent chance we could lower the ratings within the next three months. We expect to resolve the CreditWatch status once we know the outcome of State Auto Group’s negotiations with various reinsurers to put in place a multiyear reinsurance arrangement for State Auto’s homeowners book, which management discussed during its third-quarter earnings call, and once we can assess the mitigating impact on State Auto Group’s catastrophe exposure profile, earnings volatility, and capital adequacy. We anticipate that any further ratings change will be no more than two notches.”

Source: Standard & Poor’s

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