TEXT-S&P affirms State Auto Group

-- Ohio-based State Auto Group has entered into a three-year quota share reinsurance program with a syndicate of reinsurers and eliminated post retirement health benefits for most active employees and certain retirees.

-- These initiatives have resulted in improved consolidated capital adequacy as a result of increased surplus and lower capital charges.

-- We are removing the ratings on the operating insurance companies of State Auto Group from CreditWatch and affirming them at 'BBB+', and removing the rating on State Auto Financial Corp. from CreditWatch and affirming it at 'BB+'.

-- The negative outlook reflects the uncertainty as to whether the actions taken by management will improve underwriting performance materially in the next two years.

Feb 8 - Standard & Poor's Ratings Services said today that it removed its counterparty credit and financial strength ratings on the operating insurance companies of State Auto Group from CreditWatch, where we placed the ratings on Nov. 9, 2011, with negative implications. We are affirming the ratings at 'BBB+'. At the same time, we removed our counterparty credit rating on State Auto Financial Corp. (NASDAQ:STFC) from CreditWatch and affirmed it at 'BB+'. The outlook on the ratings is negative. "The rating action reflects the improvement in capital adequacy, mainly because of increased consolidated surplus and lower capital charges as result of the capital initiatives the company pursued," said Standard & Poor's credit analyst Pablo Feldman.

These capital initiatives included a three-year quota share reinsurance program with a syndicate of reinsurers with 75% cession of State Auto's homeowners business subject to certain annual limits on catastrophe losses and the elimination of post retirement health benefits for most active employees and certain retirees. Even though capital adequacy has improved, earnings as measured by pretax operating income, return on revenue (ROR), and fixed charge coverage ratios are still below what we typically expect for the current rating level. However, in our opinion, earnings are likely to improve prospectively as a result of the underwriting and pricing actions the company has been taking both in personal and commercial lines, the improved geographic and product diversification, and the relative protection that the recently implemented quota share reinsurance program will likely provide State Auto in the next three years.

The outlook on State Auto Group is negative.

The negative outlook means that there is a 1-in-3 chance that we may lower the ratings on the group by one or two notches in the next 12-24 months. In 2012, assuming four percentage points of catastrophe losses and no abnormal reserve releases, we expect the statutory combined ratio to be 105% or lower with a ROR more in line with the current rating level. We expect gross premiums written to increase by a low-single-digit rate in 2012. We expect financial leverage for the consolidated group to be about 30% and the fixed charge coverage ratio to be at least 2x. We expect capital adequacy to remain at the 'A' level, mostly as a result of reduced capital model charges, increased surplus, and lower double leverage adjustments. We could lower the ratings if the group underwriting performance does not improve materially in 2012 (assuming average catastrophe losses of 4% per year and excluding the benefit of any abnormal reserve releases), if catastrophe exposure is not managed appropriately to reduce earnings volatility, if capital deteriorates materially from the 'A' level, or if there is any substantial deterioration in the personal automobile segment's performance.

Assuming no further deterioration in capital adequacy below current levels, a key factor for us to affirm the ratings would be substantial earnings improvement from operating activities as measured by ROR, pretax operating income, and fixed charge coverage metrics. State Auto's management team has been taking a series of steps to bring the company back to a profitable path, and if we believe the initiatives are successful and its enterprise risk management program is effective, we could affirm the ratings.