State Auto Financial Corporation (NASDAQ:STFC) capped off a so-so year with a nice quarter.

The past couple of years have been great for auto insurers, thanks to an unexpected decline in the number of loss events. The common explanation is that the general age of drivers has increased, leading to more conservative driving patterns, while cars' improved safety features further help to avoid accidents.

However, auto insurance is still largely a commodity, and the increased profitability eventually leads to greater price competition as industry participants, flush with profits, rush in to do more business. As we've seen with other auto insurers such as Mercury General (NYSE:MCY) and Progressive (NYSE:PGR), growth was rather lackluster in 2006 because of increased pricing pressure.

This pricing pressure has hurt premium growth. For the quarter, State Auto's net premiums earned decreased 2% to $255 million, and net investment income was about flat at $21.5 million. Most of the quarter's improvement was due to an easy comparison versus the prior year period. Catastrophe (cat) losses in the fourth quarter of 2005 added 7.6% to the company's loss ratio; in Q4 of 2006 it decreased 700 basis points to 0.6% worth of cat losses. This helped the overall combined ratio fall 700 basis points to 83.5% in Q4 of 2006 versus 90.5% in the prior-year period. The sharp drop in the combined ratio lifted net income 52% to $45 million.

During the quarter, the expense ratio increased nearly 4%. Management noted in the earnings call that this was largely due to declining net premiums, higher compensation costs, and higher stock options expenses. In addition, book value per share declined to $20.32 at year-end. The company took a $1.56 hit to book value when it recognized a deficit in its benefit plan -- this was a non-cash expense and largely an accounting event.

Looking ahead, the management remarked that retention levels (the percentage of customers who renew their policies) have held up well, in the high 70% range for commercial auto, and in the 80% range for personal auto insurance.

However, management noted that it was experiencing either a deceleration in pricing increases or a net decline in pricing -- so far, no major red flags, but industry comments point to a coming slowdown. This doesn't bode well for the future, but State Auto has traditionally been a pretty good underwriter. I would expect them to safely weather any possible storms, should pricing take a prolonged downturn.

For some additional insurance commentary:

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.

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