Back to GetFilings.com
FORM 10-K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended: December 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from: _____________to _____________
Commission file number: 1-13754
ALLMERICA FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 04-3263626
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
440 Lincoln Street, Worcester, Massachusetts 01653
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (508) 855-1000
Securities registered pursuant to Section 12(b) of the Act:
Title of each class of securities Name of Exchange on
which Registered
Common Stock, $.01 par value,
together with Stock
Purchase Rights New York Stock Exchange
75/8% Senior Debentures due 2025 New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: NONE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [ ]
Based on the closing sales price of June 30, 2002 the aggregate market
value of the voting and non-voting stock held by nonaffiliates of the registrant
was $2,396,831,976.
The number of shares outstanding of the registrant's common stock, $.01 par
value, was 53,185,821 shares outstanding as of March 21, 2003.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of Allmerica Financial Corporation's Proxy Statement of Annual
Meeting of Shareholders to be held May 13, 2003 are incorporated by reference in
Part III.
Total number of pages, including cover page: 120
Exhibit Index is on pages 103-106
PART I
ITEM 1 - BUSINESS
ORGANIZATION
Allmerica Financial Corporation ("AFC" or the "Company") is a non-insurance
holding company organized as a Delaware corporation in 1995. The consolidated
financial statements of AFC include the accounts of AFC; Allmerica Financial
Life Insurance and Annuity Company ("AFLIAC"); First Allmerica Financial Life
Insurance Company ("FAFLIC"); The Hanover Insurance Company ("Hanover");
Citizens Insurance Company of America ("Citizens"); and certain other insurance
and non-insurance subsidiaries.
FINANCIAL INFORMATION ABOUT OPERATING SEGMENTS
The Company offers financial products and services in two major areas: Risk
Management and Asset Accumulation. Within these broad areas, the Company
conducts business principally in three operating segments. These segments are
Risk Management, Allmerica Financial Services and Allmerica Asset Management.
In addition to the three operating segments, the Company has a Corporate
segment, which consists primarily of cash, investments, corporate debt, Capital
Securities (mandatorily redeemable preferred securities of a subsidiary trust
holding solely junior subordinated debentures of the Company) and corporate
overhead expenses. Corporate overhead expenses reflect costs not attributable to
a particular segment, such as those related to certain officers and directors,
technology, finance, human resources and legal.
Information with respect to each of the Company's segments is included in
"Results of Operations" on pages 22 to 41 in Management's Discussion and
Analysis of Financial Condition and Results of Operations and in Note 16 on
pages 92 to 94 of the Notes to the Consolidated Financial Statements included in
Financial Statements and Supplementary Data of this Form 10-K.
DESCRIPTION OF BUSINESS BY SEGMENT
Following is a discussion of each of the Company's operating segments.
RISK MANAGEMENT
General
The Company's Risk Management segment consists primarily of its property and
casualty operations, which are principally generated through Hanover and
Citizens. For the year ended December 31, 2002, the Risk Management segment
accounted for $2.5 billion, or 71.9%, of consolidated segment revenues and
provided $184.3 million of segment income before federal income taxes and
minority interest. The Company underwrites personal and commercial property and
casualty insurance primarily through an independent agent network concentrated
in the Northeast, Midwest and Southeast United States.
The Company's strategy focuses on the fundamentals of the business, namely
disciplined underwriting, pricing, quality claim handling, active agency
management, effective expense management and quality customer service. Risk
Management continues to have strong regional focus and places emphasis on
underwriting profitability and loss reserve adequacy in each major product line.
The Risk Management segment of AFC was the 28th largest property and casualty
insurance group in the United States based on 2001 direct premiums written,
according to A.M. Best.
Risks
The industry's profitability can be significantly affected by: price;
competition; volatile and unpredictable developments such as extreme weather
conditions and natural disasters; legal developments affecting insurer and
insureds' liability; extracontractual liability; size of jury awards; acts of
terrorism; fluctuations in interest rates and other factors that may affect
investment returns; and other general economic conditions and trends, such as
inflationary pressures, that may affect the adequacy of reserves.
Lines of Business
The Company underwrites personal and commercial property and casualty insurance
coverage.
PERSONAL LINES
Personal lines comprise 65% of the Risk Management segment's net written premium
in 2002. Personal automobile and homeowners accounted for 73% and 24%,
respectively, of total personal lines' net written premium in 2002.
Personal automobile coverage insures individuals against losses incurred
from personal bodily injury, bodily injury to third parties, property damage to
an insured's vehicle, and property damage to other vehicles and other property.
2
Homeowners coverage insures individuals for losses to their residences and
personal property, such as those caused by fire, wind, hail, water damage
(except for flooding), theft and vandalism, and against third party liability
claims.
Other personal lines is comprised of miscellaneous policies including:
inland marine, umbrella, fire, allied lines and earthquake.
Personal lines' net written premium in Michigan and Massachusetts
represented approximately 41% and 20% of the Company's total personal lines'
net written premium in 2002.
According to A.M. Best, based upon direct written premium as of December
31, 2001, the Company is the largest writer of property and casualty insurance
in Michigan through independent agents. In Michigan, AFC also ranked fourth in
the industry for personal lines business, with 9% of the total market. The
Michigan personal lines business represented approximately 41% of the Company's
personal lines business in 2002, of which approximately 70% was in the personal
automobile line. In Michigan, AFC is a principal provider with many of its
agencies, averaging more than $1 million of total written premiums per agent.
In addition, in 2002, approximately 23% of AFC's personal automobile
business was written in Massachusetts. The Massachusetts Division of Insurance
sets the rates for personal automobile business in the state. Effective January
1, 2003, rates increased 2.7%; rates were not changed in 2002. The Massachusetts
Division of Insurance allows companies to offer discounts for sponsoring
organizations and safe drivers. The Company adjusts these discounts annually.
The Company anticipates that these discounts will be, in large part, eliminated
during 2003.
COMMERCIAL LINES
Commercial lines comprise 35% of the Risk Management segment's net written
premium. Commercial multiple peril net written premium accounted for 43%,
commercial automobile 25% and workers' compensation 19% of total commercial
lines' net written premium in 2002.
Commercial multiple peril coverage insures businesses against third party
liability from accidents occurring on their premises or arising out of their
operations, such as injuries sustained from products sold. It also insures
business property for damage, such as that caused by fire, wind, hail, water
damage (except for flooding), theft and vandalism.
Commercial automobile coverage insures businesses against losses incurred
from personal bodily injury, bodily injury to third parties, property damage to
an insured's vehicle, and property damage to other vehicles and other property.
Workers' compensation coverage insures employers against employee medical
and indemnity claims resulting from injuries related to work. Workers'
compensation policies are often written in conjunction with other commercial
policies.
Other commercial lines is comprised of miscellaneous policies including:
umbrella, ocean marine, inland marine, general liability, allied lines, fire
and other coverages.
In 2002, approximately 26%, 13% and 10% of the Company's commercial lines'
net premiums written was generated in the states of Michigan, Massachusetts and
New York, respectively.
Commercial lines maintains an underwriting discipline which emphasizes
quality control as a means to writing and retaining the best business for the
best agents. This is monitored through a formalized monthly review in each
branch for each underwriter, as well as by an annual audit conducted in each
branch. Accountability for quality underwriting is shared locally, regionally
and corporately.
Marketing and Distribution
The Company is licensed to sell property and casualty insurance in all fifty
states in the United States, as well as the District of Columbia. As of December
31, 2002, approximately 36% and 17% of AFC's net written premium is generated in
the states of Michigan and Massachusetts, respectively. The Company's other
primary markets include New York, New Jersey, Maine and Illinois.
AFC, in its Risk Management segment, maintains eighteen local branch sales
and underwriting offices in fifteen states. In addition, three regional business
centers in Atlanta, Georgia, Worcester, Massachusetts, and Howell, Michigan
provide processing support. Administrative functions are centralized in its
headquarters in Worcester, Massachusetts. This regional strategy allows the
Company to maintain a strong focus on local markets and the flexibility to
respond to specific market concerns. It also is a predominant factor in the
establishment and maintenance of long-term relationships with larger,
well-established independent agencies.
Independent agents provide specialized knowledge of property and casualty
products, local market conditions and customer demographics. Independent agents
account for a significant amount of sales of the Company's property and casualty
products. The Company's growth strategy is closely aligned to its relationship
with the independent agency force; agents are compensated both on a regular
commission schedule and on profitability. This method encourages agents to
select customers whose risk characteristics are aligned with the Company's
underwriting philosophy.
3
Agencies are appointed based on profitability record, financial stability,
staff experience and professionalism, and demonstrated business strategy. Once
appointed, each agency's performance is carefully monitored and, in accordance
with applicable legal and regulatory requirements, the Company takes actions as
necessary to change these business relationships, such as by discontinuing the
authority of the agent to underwrite certain products or revising commissions or
profit sharing opportunities. Recent implementation of an agency monitoring
system has facilitated business and results analysis and helps indicate
appropriate action.
The Risk Management segment sponsors local and national agent advisory
councils as forums to enhance relationships between AFC and its agents. These
councils work with the Company to provide products and services that help
clients better manage the risks they face and to coordinate marketing efforts,
support implementation of the Company's strategies and enhance local market
presence.
During the fourth quarter of 2001, the Company completed an extensive
review of its agency relationships, which resulted in the termination of 377
agencies and the withdrawal of commercial lines' underwriting authority from an
additional 314 agencies. These actions affected approximately 27% of
approximately 2,500 active agencies representing the Company in 2001. These
agencies had consistently produced unsatisfactory loss ratios. In addition, the
Company terminated virtually all of its specialty commercial programs, which
accounted for $54.4 million of net premiums written in 2001, and discontinued a
number of special marketing arrangements. The total earned premium associated
with the exited business was $164.6 million and $252.9 million in 2002 and 2001,
respectively, and is estimated to be approximately $82 million in 2003. The
Company is contractually or under statutory regulations obligated to renew
policies with certain agents; these policies will continue to be in runoff in
2003. As noted in "Risk Management, Product Line Results - Commercial Lines",
discussed on pages 27 and 28 in Management's Discussion and Analysis of this
Form 10-K, these actions have resulted in improved underwriting results,
primarily in commercial lines. The Company believes these actions will continue
to result in improved underwriting results. In connection with these actions,
the Company performed an actuarial review of outstanding reserves with
segregated loss history on the exited business. Based on this review, losses and
expenses totaling $68.3 million were recorded in 2001. Actual future losses from
the exited business may vary from the Company's estimate.
The Company utilizes the independent agents and brokers to offer discounted
personal lines insurance products to employer and affinity groups, which include
credit unions, clubs and associations ("Sponsored Markets"). The program, which
is generally considered a voluntary employee or member benefit, is provided to
those groups that the Company believes provide a higher potential for better
underwriting results. In addition, the Company offers discounted personal lines
products in Michigan through the Citizens Best program. This program is offered
to any resident in Michigan who is a member of a qualified retirement or senior
citizens organization. Each discounted policy issued through Sponsored Markets
is individually underwritten, and even though provided at a discount, generally
produces better underwriting results. The payroll deduction feature, which
offers employee-group policyholders the option of having insurance premium paid
electronically from the employers' payroll system, is frequently used in these
programs. The processing efficiencies obtained by this option result in lower
billing costs per transaction for the Company. Sponsored Markets experienced 11%
growth, with net written premiums of approximately $739 million in 2002. The
Citizens Best program accounts for $268.5 million in written premiums in 2002,
approximately 35% of all Sponsored Markets' written premiums.
A significant portion of the segment's discounted group business, including
the Citizens Best program, are open to any agent who has a policyholder that
meets the required criteria of the group. Marketing initiatives for 2003 will
include expansion of open group options in active markets, actions to grow the
affinity aspect of the business and efforts to increase utilization of the
payroll deduction program.
Residual Markets and Pooling Arrangements
As a condition of its license to do business in various states, the Company is
required to participate in mandatory property and casualty shared market
mechanisms or pooling arrangements which provide various insurance coverages to
individuals or other entities that otherwise are unable to purchase such
coverage. Such mechanisms include assigned risk plans, reinsurance facilities
and pools, joint underwriting associations, fair access to insurance
requirements plans, and commercial automobile insurance plans. For example,
since most states compel the purchase of a minimal level of automobile liability
insurance, states have developed shared market mechanisms to provide the
required coverages and in many cases, optional coverages, to those drivers who,
because of their driving records or other factors, cannot find insurers who will
write them voluntarily. The Company's participation in such shared markets or
pooling mechanisms is generally proportional to the Risk Management segment's
direct writings for the type of coverage written by the specific pooling
mechanism in the applicable state. The Company incurred an underwriting loss
from participation in these mechanisms, mandatory pools and underwriting
associations
4
of $30.8 million, $20.1 million and $26.1 million in 2002, 2001 and 2000,
respectively, relating primarily to coverages for personal and commercial
automobile, personal and commercial property, and workers' compensation. The
increase in the underwriting loss in 2002, compared to 2001, is primarily the
result of an increase in Hanover's participation in the Massachusetts
Commonwealth Automobile Reinsurers ("CAR") pool. The decrease in the
underwriting loss in 2001, compared to 2000, is primarily related to a decrease
in Hanover's participation in the CAR pool. The Company also participates in
certain voluntary pools.
ASSIGNED RISK PLANS
Assigned risk plans are the most common type of shared market mechanism. Many
states, including Illinois, New Jersey and New York, operate assigned risk
plans. Such plans assign applications from drivers who are unable to obtain
insurance in the voluntary market to insurers licensed in the applicant's state.
Each insurer is required to accept a specific percentage of applications based
on its market share of voluntary business in the state. Once an application has
been assigned to an insurer, the insurer issues a policy under its own name and
retains premiums and pays losses as if the policy was voluntarily written. The
Company has elected to transfer its assignments under The New York Automobile
Insurance Plan ("NYAIP") to a servicing carrier under a limited assignment
distribution ("LAD") agreement. Under this LAD agreement, the servicing carrier
retains the assigned underwriting results of the NYAIP for which it receives a
fee from the Company. This fee was $20 million in 2002.
REINSURANCE FACILITIES AND POOLS
Reinsurance facilities are currently in operation in various states that require
an insurer to write all applications submitted by an agent. As a result, an
insurer could be writing policies for applicants with a higher risk of loss than
it would normally accept. The reinsurance facility allows the insurer to cede
this high risk business to the reinsurance facility, thus sharing the
underwriting experience with all other insurers in the state. If a claim is paid
on a policy issued in this market, the facility will reimburse the insurer.
Typically, reinsurance facilities operate at a deficit, which is then recouped
by levying assessments against the same insurers.
As a servicing carrier in Massachusetts, the Company cedes a portion of its
personal and commercial automobile premiums to the CAR pool. Net premiums earned
and losses and loss adjustment expenses ("LAE") ceded to CAR were $46.8 million
and $59.4 million in 2002, $34.2 million and $38.0 million in 2001, $37.3
million and $44.5 million in 2000. At December 31, 2002, CAR represented at
least 10% of the Company's reinsurance activity.
A reinsurance mechanism that exists in Michigan, the Michigan Catastrophic
Claims Association ("MCCA"), covers no-fault first party medical losses of
retentions in excess of $300,000. All automobile insurers in this state are
required to participate in this reinsurance mechanism. Insurers are reimbursed
for their covered losses in excess of this threshold. This threshold increased
from $250,000 to $300,000 on July 1, 2002 and will continue to increase in
scheduled amounts over the next ten years until it reaches $500,000. Funding for
MCCA comes from assessments against automobile insurers based upon their
proportionate market share of the state's automobile liability insurance market.
The Company ceded to the MCCA premiums earned and losses and LAE of $32.6
million and $49.8 million in 2002, $7.2 million and $44.5 million in 2001, $3.7
million and $31.1 million in 2000. At December 31, 2002, the MCCA represented
at least 10% of the Company's reinsurance activity.
At December 31, 2002 and 2001, the Company, in the Risk Management segment,
had reinsurance recoverables on paid and unpaid losses from CAR of $54.8 million
and $40.4 million, respectively, and from MCCA of $349.1 million and $320.2
million, respectively. Management believes that the Company is unlikely to
incur any material loss as a result of nonpayment of amounts owed to it by CAR,
because CAR is a mandated pool supported by all insurance companies licensed to
write automobile insurance in the Commonwealth of Massachusetts. In addition,
with respect to MCCA (i) it is currently in a surplus position, (ii) the payment
obligations of the MCCA are extended over many years, resulting in relatively
small current payment obligations in terms of MCCA total assets, and (iii) the
MCCA is supported by assessments permitted by statute.
Reference is made to Note 18 on pages 94 and 95 and Note 21 on pages 98
and 99 of the Notes to Consolidated Financial Statements included in Financial
Statements and Supplementary Data of this Form 10-K.
JOINT UNDERWRITING ASSOCIATIONS
A joint underwriting association ("JUA") is similar to a reinsurance pool.
Generally, a JUA allows an insurer to share with other insurers the underwriting
experience of drivers that reflect a higher risk of loss than the insurer would
normally accept. Under a JUA, a limited number of insurers are designated as
"servicing carriers." The servicing carrier is responsible for collecting
premiums and paying claims for the policies issued in the JUA, and such insurers
receive a fee for these administrative services. The underwriting results of the
servicing carrier are then shared with all insurers in the state. Like
reinsurance facilities, JUA's typically operate at a deficit, and fund that
deficit by levying assessments on insurers.
5
VOLUNTARY POOLS
The Company has terminated its participation in virtually all of its voluntary
pool business; however, the Company continues to be subject to claims related to
years in which it was a participant. The Company was a participant in a
voluntary excess and casualty reinsurance pool (Excess and Casualty Reinsurance
Association, "ECRA") from 1950 to 1982. In 1982, the pool was dissolved and
since that time the business has been in runoff. The Company's participation in
this pool has resulted in average paid losses of $2.3 million annually over the
past ten years. During 2001, the pool commissioned an independent actuarial
review of the current reserve position, which noted a range of reserve
deficiency primarily as a result of adverse development of asbestos claims. As a
result of this study, the Company recorded an additional $33.0 million of
losses. Management believes that this item is not indicative of overall
operating trends of this pool or other voluntary pools in which the Company
participates. Because of the inherent uncertainty regarding the types of claims
in this pool, there can be no assurance that these additional reserves will be
sufficient. Loss and LAE reserves for the Company's voluntary pools were $80.1
million and $73.1 million at December 31, 2002 and 2001, respectively, including
$49.9 million and $45.3 million related to ECRA as of December 31, 2002 and
2001, respectively.
OTHER INVOLUNTARY POOLS
The principal shared market mechanisms for property insurance are the Fair
Access to Insurance Requirements Plans ("FAIR Plans"), the formation of which
was required by the federal government as a condition to an insurer's ability to
obtain federal riot reinsurance coverage following the riots and civil disorder
that occurred during the 1960s. These plans, created as mechanisms similar to
automobile assigned risk plans, were designed to increase the availability of
property insurance in urban areas. The federal government reinsures those
insurers participating in FAIR Plans against excess losses sustained from riots
and civil disorders. The individual state FAIR Plans are created pursuant to
statute or regulation. The property shared market mechanisms provide basic fire
insurance and extended coverage protection for dwellings and certain commercial
properties that could not be insured in the voluntary market. A few states also
include a basic homeowners form of coverage in their shared market mechanism.
Approximately 30 states have FAIR Plans including, North Carolina, New York and
Massachusetts.
With respect to commercial automobile coverage, another pooling mechanism,
a Commercial Auto Insurance Plan ("CAIP"), uses a limited number of servicing
carriers to handle assignments from other insurers. The CAIP servicing carrier
is paid a fee by the insurer who otherwise would be assigned the responsibility
of handling the commercial automobile policy and paying claims. Approximately 40
states have CAIP mechanisms, including New Jersey, Maine, New York and New
Hampshire.
Competition and Pricing
The property and casualty industry is a competitive market with national agency
companies, direct writers, and regional and local insurers competing for
business on the basis of both price and service. National agency companies sell
insurance through independent agents and usually concentrate on commercial
lines. Direct writers, including those with exclusive agent representation,
dominate the personal lines of property and casualty insurance and operate on a
national, regional or single-state basis. Regional and local companies sell
through independent agents in one or several states in the same region and
usually compete in both personal and commercial lines. The Company markets
through independent agents and, therefore, competes with other independent
agency companies for business in each of the agencies representing them.
The Risk Management segment seeks to achieve a targeted combined ratio (the
sum of the ratio of incurred claims and claim expense to premiums earned and the
ratio of underwriting expenses incurred to premiums written) in each of its
product lines regardless of market conditions. The targets also reflect current
investment yield expectations. This strategy is intended to better enable the
Company to achieve measured growth and consistent profitability. The Company
concentrates on its established major product lines, and accordingly, does not
typically pursue the development of products with relatively unpredictable risk
profiles. In addition, the Company seeks to utilize its extensive knowledge of
local markets, including knowledge of regulatory requirements, to achieve
superior underwriting results. The Risk Management segment relies on market
information provided by its local agents and on the knowledge of its staff in
the local branch offices. Since the Risk Management segment maintains a strong
regional focus and a significant market share in a number of states, the Company
can apply its extensive knowledge and experience in making underwriting and rate
setting decisions.
Net written premium in the states of Michigan, Massachusetts, New York and
New Jersey represented, in total, 69% and 68% of the Company's total net written
premium in 2002 and 2001, respectively.
In Michigan, the Company competes in personal lines with a number of
national direct writers and regional and local companies. Principal personal
lines competitors are Auto Club of Michigan, State Farm Group and Allstate. The
Company believes its agency relationships, Citizens Insurance brand recognition
and the Citizens Best program enable the Company to distribute its products
competitively in Michigan.
6
Due to the regulatory environment in Massachusetts, New York and New
Jersey, there is less competition in the personal lines market. The stricter
regulatory pricing guidelines within these states have had an adverse effect on
profitability in personal lines. The Company believes pricing actions in less
regulated states, new insurance scoring underwriting guidelines, and improved
insurance to value pricing will favorably affect personal lines' profitability.
The announcement last year by the New Jersey Department of Banking and Insurance
that State Farm Indemnity Company, which writes approximately 15% of the
personal automobile market in New Jersey, would be permitted to gradually
withdraw from the market, could further adversely affect profitability of New
Jersey personal automobile business.
In commercial lines, the Company faces competition primarily from national
agency companies and regional and local companies. Management believes that its
emphasis on maintaining a local presence in its markets, coupled with
investments in operating and client technologies, will enable it to compete
effectively. The Risk Management segment of the Company is not dependent on a
single customer or even a few customers, for which the loss of any one or more
would have an adverse effect upon the segment's insurance operation.
Claims
The Company employs experienced claims adjusters, appraisers, medical
specialists, managers and attorneys in order to manage its claims. The Risk
Management segment has field claims adjusters strategically located throughout
its operating territories. All claims staff members work closely with the agents
and seek to settle claims rapidly and in a cost-effective manner.
Claims office adjusting staff are supported by general adjusters for large
property and large casualty losses, by automobile and heavy equipment damage
appraisers for automobile material damage losses, and by medical specialists
whose principal concentration is on workers' compensation and no-fault
automobile injury cases. In addition, the claims offices are supported by staff
attorneys who specialize in litigation defense and claim settlements. The Risk
Management segment also maintains a special investigative unit which
investigates suspected insurance fraud and abuse.
The Company, in the Risk Management segment, utilizes claims processing
technology which allows most of the smaller and more routine personal lines
claims to be processed at centralized locations. The centralization helps to
increase efficiency and minimize operating costs.
The Risk Management segment has a program under which participating agents
have settlement authority for many property loss claims. Based upon the
program's experience, the Company believes that this program contributes to
lower loss adjustment expense experience and to higher customer satisfaction
ratings by permitting the early and direct settlement of these small claims.
Approximately 30% of the total number of paid claims reported in the Midwest
were settled under this program in 2002.
In response to the Federal Terrorism Risk Insurance Act of 2002 ("TRIA"),
the Company has recognized that prior terrorism exclusions are void for
certified terrorist events. As required, the Company is notifying policyholders
of their option to elect the terrorism coverage and the cost of this coverage.
The Company is actively managing its exposures on an individual line of business
basis and in the aggregate by zip code and, as available, street address. At
this time, no additional specific terrorism-only reinsurance coverage has been
purchased by the Company. However, some terrorism coverage is provided within
existing Property per Risk and Casualty Excess of Loss corporate treaties. Under
TRIA, the Company's retention limit in 2003 is estimated to be $66.5 million,
representing 8% of year-end 2002 statutory policyholder surplus.
Property and casualty insurers are subject to claims arising out of
catastrophes, which may have a significant impact on their results and financial
condition. The Risk Management segment may experience catastrophe losses in the
future which could have a material adverse impact on the Company. Catastrophes
can be caused by various events, including snow, ice storms, hurricanes,
earthquakes, tornadoes, wind, hail, terrorism, fires and explosions. The
incidence and severity of catastrophes are inherently unpredictable. The Company
manages its catastrophe risks through underwriting procedures, including the use
of specific exclusions for floods, terrorism, as allowed, and other factors,
through geographic exposure management and through reinsurance programs. The
catastrophe reinsurance program is structured to protect the Company on a
per-occurrence basis, as well as to limit losses in the event of multiple
catastrophic events. The Company has focused efforts on evaluating aggregation
of exposures and high concentrations of insured property values and number of
covered employees in order to determine exposure to loss from terrorist events.
AFC will continue to actively monitor geographic location and coverage
concentrations in order to manage corporate exposure to all catastrophic events.
Although catastrophes can cause losses in a variety of property and casualty
lines, homeowners and commercial multi peril insurance have in the past
generated the majority of catastrophe-related claims.
State Regulation
The Company's property and casualty insurance subsidiaries are subject to
extensive regulation in the various states and jurisdictions in which they
transact business and are also supervised by the individual state insurance
departments. Numerous aspects of the Company's business are subject to
regulatory standards, including capital adequacy, premium
7
rates, mandatory risks that must be covered, prohibited exclusions, licensing of
agents, investments, restrictions on the size of risks that may be insured under
a single policy, reserves and provisions for unearned premiums, losses and other
obligations, deposits of securities for the benefit of policyholders, policy
forms, and other conduct, including the use of credit information in
underwriting as well as other underwriting and claims practices. States also
regulate various aspects of the contractual relationships between insurers and
independent agents. In addition, as a condition to writing business in certain
states, insurers are required to participate in various pools or risk sharing
mechanisms or to accept certain classes of risk, regardless of whether such
risks meet the Company's underwriting requirements for voluntary business. Some
states also limit or impose restrictions on the ability of an insurer to
withdraw from certain classes of business. For example, Massachusetts, New
Jersey and New York each impose restrictions on a Company's ability to withdraw
from the personal automobile line in their respective states. Furthermore,
certain states prohibit an insurer from withdrawing one or more lines of
insurance business from the state, except pursuant to a plan that is approved by
the state insurance department. The state insurance departments can refuse to
approve these plans on the grounds that they could lead to market disruption.
Laws and regulations that limit cancellation and non-renewal and that subject
withdrawal plans to prior approval requirements may restrict an insurer's
ability to exit unprofitable markets.
The Company is subject to periodic examinations conducted by state
insurance departments. AFC is also required to file annual and other reports
relating to the financial condition of its insurance subsidiaries and other
matters.
Reserve for Unpaid Losses and
Loss Adjustment Expenses
Reference is made to "Reserve for Losses and Loss Adjustment Expenses" on pages
28 to 32 of Management's Discussion and Analysis of Financial Condition and
Results of Operations of this Form 10-K.
The Company's actuaries, in the Risk Management segment, review the
reserves each quarter and certify the reserves annually as required for
statutory filings. Significant periods of time often elapse between the
occurrence of an insured loss, the reporting of the loss to the Company and the
Company's settlement and payment of that loss. To recognize liabilities for
unpaid losses, the Company establishes reserves as balance sheet liabilities
representing estimates of amounts needed to pay reported and unreported losses
and LAE.
The Risk Management segment regularly reviews its reserving techniques, its
overall reserving position and its reinsurance. Based on (i) review of
historical data, legislative enactments, judicial decisions, legal developments
in impositions of damages, changes in political attitudes and trends in general
economic conditions, (ii) review of per claim information, (iii) historical loss
experience of the Risk Management segment and the industry, (iv) the relatively
short-term nature of most policies and (v) internal estimates of required
reserves, management believes that adequate provision has been made for loss
reserves. However, establishment of appropriate reserves is an inherently
uncertain process and there can be no certainty that current established
reserves will prove adequate in light of subsequent actual experience. A
significant change to the estimated reserves could have a material effect on the
results of operations or financial condition of the Company.
The Company does not use discounting techniques in establishing reserves
for losses and LAE, nor has it participated in any loss portfolio transfers or
other similar transactions.
The following table reconciles reserves determined in accordance with
accounting principles and practices prescribed or permitted by insurance
statutory authorities ("Statutory") to reserves determined in accordance with
generally accepted accounting principles ("GAAP") at December 31, as follows:
2002 2001 2000
- ------------------------------------------------------------------------------
(In millions)
Statutory reserve for losses
and LAE $ 2,083.4 $ 2,057.5 $ 1,906.5
GAAP adjustments:
Reinsurance recoverable on
unpaid losses 877.9 864.6 816.9
Other 0.4 (0.6) (4.3)
- ------------------------------------------------------------------------------
GAAP reserve for losses
and LAE $ 2,961.7 $ 2,921.5 $ 2,719.1
==============================================================================
8
Analysis of Losses and Loss Adjustment Expenses Reserve Development
The following table sets forth the development of GAAP reserves (net of
reinsurance recoverables) for unpaid losses and LAE from 1992 through 2002 for
the Company.
YEAR ENDED DECEMBER 31 2002 2001 2000 1999 1998 1997
- -------------------------------------------------------------------------------------------------------------------
(In millions)
Net reserve for losses
and LAE /(1)/ $ 2,083.8 $ 2,056.9 $ 1,902.2 $ 1,924.5 $ 2,005.5 $ 2,038.7
Cumulative amount
paid as of /(2)/:
One year later -- 763.6 780.3 703.8 638.0 643.0
Two years later -- -- 1,180.1 1,063.8 996.0 967.4
Three years later -- -- -- 1,298.2 1,203.0 1,180.7
Four years later -- -- -- -- 1,333.0 1,301.5
Five years later -- -- -- -- -- 1,375.5
Six years later -- -- -- -- -- --
Seven years later -- -- -- -- -- --
Eight years later -- -- -- -- -- --
Nine years later -- -- -- -- -- --
Ten years later -- -- -- -- -- --
Net reserve re--estimated
as of /(3)/:
End of year 2,083.8 2,056.9 1,902.2 1,924.5 2,005.5 2,038.7
One year later -- 2,063.3 2,010.8 1,837.1 1,822.1 1,911.5
Two years later -- -- 2,028.2 1,863.3 1,781.4 1,796.8
Three years later -- -- -- 1,863.0 1,818.6 1,734.9
Four years later -- -- -- -- 1,823.5 1,762.9
Five years later -- -- -- -- -- 1,770.9
Six years later -- -- -- -- -- --
Seven years later -- -- -- -- -- --
Eight years later -- -- -- -- -- --
Nine years later -- -- -- -- -- --
Ten years later -- -- -- -- -- --
- -------------------------------------------------------------------------------------------------------------------
(Deficiency) redundancy,
net /(4,5)/ $ -- $ (6.4) $ (126.0) $ 61.5 $ 182.0 $ 267.8
===================================================================================================================
YEAR ENDED DECEMBER 31 1996 1995 1994 1993 1992
- ----------------------------------------------------------------------------------------------------
(In millions)
Net reserve for losses
and LAE /(1)/ $ 2,117.2 $ 2,132.5 $ 2,109.3 $ 2,019.6 $ 1,936.9
Cumulative amount
paid as of /(2)/:
One year later 732.1 627.6 614.3 566.9 564.3
Two years later 1,054.3 1,008.3 940.7 884.4 862.7
Three years later 1,235.0 1,217.8 1,172.8 1,078.1 1,068.4
Four years later 1,365.9 1,325.9 1,300.4 1,210.9 1,184.1
Five years later 1,439.8 1,408.8 1,369.9 1,289.5 1,267.5
Six years later 1,486.3 1,459.8 1,427.6 1,353.3 1,323.1
Seven years later -- 1,492.5 1,466.1 1,377.2 1,355.8
Eight years later -- -- 1,492.1 1,408.3 1,387.7
Nine years later -- -- -- 1,429.4 1,413.3
Ten years later -- -- -- -- 1,431.3
Net reserve re-estimated
as of/(3)/:
End of year 2,117.2 2,132.5 2,109.3 2,019.6 1,936.9
One year later 1,989.3 1,991.1 1,971.7 1,891.5 1,868.1
Two years later 1,902.8 1,874.3 1,859.4 1,767.4 1,762.8
Three years later 1,832.5 1,826.8 1,780.3 1,691.5 1,703.3
Four years later 1,783.7 1,780.7 1,766.2 1,676.3 1,658.9
Five years later 1,810.9 1,740.1 1,735.6 1,653.7 1,637.3
Six years later 1,824.4 1,771.3 1,699.2 1,630.3 1,650.5
Seven years later -- 1,787.5 1,733.1 1,603.9 1,627.2
Eight years later -- -- 1,747.3 1,637.2 1,607.4
Nine years later -- -- -- 1,656.6 1,637.6
Ten years later -- -- -- -- 1,650.4
- ----------------------------------------------------------------------------------------------------
(Deficiency) redundancy,
net/(4,5)/ $ 292.8 $ 345.0 $ 362.0 $ 363.0 $ 286.5
====================================================================================================
(1) Sets forth the estimated net liability for unpaid losses and LAE recorded at
the balance sheet date for each of the indicated years; represents the estimated
amount of net losses and LAE for claims arising in the current and all prior
years that are unpaid at the balance sheet date, including incurred but not
reported ("IBNR") reserves.
(2) Cumulative loss and LAE payments made in succeeding years for losses
incurred prior to the balance sheet date.
(3) Re-estimated amount of the previously recorded liability based on experience
for each succeeding year; increased or decreased as payments are made and more
information becomes known about the severity of remaining unpaid claims.
(4) Cumulative deficiency or redundancy at December 31, 2002 of the net reserve
amounts shown on the top line of the corresponding column. A redundancy in
reserves means the reserves established in prior years exceeded actual losses
and LAE or were reevaluated at less than the original reserved amount. A
deficiency in reserves means the reserves established in prior years were less
than actual losses and LAE or were reevaluated at more than the original
reserved amount.
(5) The following table sets forth the development of gross reserve for unpaid
losses and LAE from 1993 through 2002 for the Company:
9
YEAR ENDED DECEMBER 31 2002 2001 2000 1999 1998 1997
- --------------------------------------------------------------------------------------------------------------------------
(In millions)
Reserve for losses and LAE:
Gross liability $ 2,961.7 $ 2,921.5 $ 2,719.1 $ 2,618.7 $ 2,597.2 $ 2,615.4
Reinsurance recoverable 877.9 864.6 816.9 694.2 591.7 576.7
- --------------------------------------------------------------------------------------------------------------------------
Net liability $ 2,083.8 $ 2,056.9 $ 1,902.2 $ 1,924.5 $ 2,005.5 $ 2,038.7
==========================================================================================================================
One year later:
Gross re-estimated liability -- $ 2,926.4 $ 2,882.0 $ 2,553.4 $ 2,432.9 $ 2,472.6
Re-estimated recoverable -- 863.1 871.2 716.3 610.8 561.1
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- $ 2,063.3 2,010.8 $ 1,837.1 $ 1,822.1 $ 1,911.5
==========================================================================================================================
Two years later:
Gross re-estimated liability -- -- $ 2,913.0 $ 2,640.8 $ 2,379.6 $ 2,379.3
Re-estimated recoverable -- -- 884.8 777.5 598.2 582.5
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- -- $ 2,028.2 $ 1,863.3 $ 1,781.4 $ 1,796.8
==========================================================================================================================
Three years later:
Gross re-estimated liability -- -- -- $ 2,658.0 $ 2,439.7 $ 2,305.2
Re-estimated recoverable -- -- -- 795.0 621.1 570.3
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- -- -- $ 1,863.0 $ 1,818.6 $ 1,734.9
==========================================================================================================================
Four years later:
Gross re-estimated liability -- -- -- -- $ 2,458.4 $ 2,351.0
Re-estimated recoverable -- -- -- -- 634.9 588.1
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- -- -- -- $ 1,823.5 $ 1,762.9
==========================================================================================================================
Five years later:
Gross re-estimated liability -- -- -- -- -- $ 2,368.2
Re-estimated recoverable -- -- -- -- -- 597.3
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- -- -- -- -- $ 1,770.9
==========================================================================================================================
Six years later:
Gross re-estimated liability -- -- -- -- -- --
Re-estimated recoverable -- -- -- -- -- --
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- -- -- -- -- --
==========================================================================================================================
Seven years later:
Gross re-estimated liability -- -- -- -- -- --
Re-estimated recoverable -- -- -- -- -- --
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- -- -- -- -- --
==========================================================================================================================
Eight years later:
Gross re-estimated liability -- -- -- -- -- --
Re-estimated recoverable -- -- -- -- -- --
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- -- -- -- -- --
==========================================================================================================================
Nine years later:
Gross re-estimated liability -- -- -- -- -- --
Re-estimated recoverable -- -- -- -- -- --
- --------------------------------------------------------------------------------------------------------------------------
Net re-estimated liability -- -- -- -- -- --
==========================================================================================================================
YEAR ENDED DECEMBER 31 1996 1995 1994 1993
- --------------------------------------------------------------------------------------------
(In millions)
Reserve for losses and LAE:
Gross liability $ 2,744.1 $ 2,896.0 $ 2,821.7 $ 2,717.3
Reinsurance recoverable 626.9 763.5 712.4 697.7
- --------------------------------------------------------------------------------------------
Net liability $ 2,117.2 2,132.5 $ 2,109.3 $ 2,019.6
============================================================================================
One year later:
Gross re-estimated liability $ 2,541.9 $ 2,587.8 $ 2,593.5 $ 2,500.5
Re-estimated recoverable 552.6 596.7 621.8 609.0
- --------------------------------------------------------------------------------------------
Net re-estimated liability $ 1,989.3 $ 1,991.1 $ 1,971.7 $ 1,891.5
============================================================================================
Two years later:
Gross re-estimated liability $ 2,424.5 $ 2,427.7 $ 2,339.2 $ 2,333.3
Re-estimated recoverable 521.7 553.4 479.8 565.9
- --------------------------------------------------------------------------------------------
Net re-estimated liability $ 1,902.8 $ 1,874.3 $ 1,859.4 $ 1,767.4
============================================================================================
Three years later:
Gross re-estimated liability $ 2,395.3 $ 2,358.6 $ 2,227.0 $ 2,145.5
Re-estimated recoverable 562.8 531.8 446.7 454.0
- --------------------------------------------------------------------------------------------
Net re-estimated liability $ 1,832.5 $ 1,826.8 $ 1,780.3 $ 1,691.5
============================================================================================
Four years later:
Gross re-estimated liability $ 2,336.3 $ 2,359.5 $ 2,220.9 $ 2,102.0
Re-estimated recoverable 552.6 578.8 454.7 425.7
- --------------------------------------------------------------------------------------------
Net re-estimated liability $ 1,783.7 $ 1,780.7 $ 1,766.2 $ 1,676.3
============================================================================================
Five years later:
Gross re-estimated liability $ 2,380.8 $ 2,299.8 $ 2,215.2 $ 2,091.7
Re-estimated recoverable 569.9 559.7 479.6 438.0
- --------------------------------------------------------------------------------------------
Net re-estimated liability $ 1,810.9 $ 1,740.1 $ 1,735.6 $ 1,653.7
============================================================================================
Six years later:
Gross re-estimated liability $ 2,405.0 $ 2,351.2 $ 2,158.9 $ 2,096.6
Re-estimated recoverable 580.6 579.9 459.7 466.3
- --------------------------------------------------------------------------------------------
Net re-estimated liability $ 1,824.4 $ 1,771.3 $ 1,699.2 $ 1,630.3
============================================================================================
Seven years later:
Gross re-estimated liability -- $ 2,380.2 $ 2,210.5 $ 2,050.3
Re-estimated recoverable -- 592.7 477.4 446.4
- --------------------------------------------------------------------------------------------
Net re-estimated liability -- $ 1,787.5 $ 1,733.1 $ 1,603.9
============================================================================================
Eight years later:
Gross re-estimated liability -- -- $ 2,231.5 $ 2,099.9
Re-estimated recoverable -- -- 484.2 462.7
- --------------------------------------------------------------------------------------------
Net re-estimated liability -- -- $ 1,747.3 $ 1,637.2
============================================================================================
Nine years later:
Gross re-estimated liability -- -- -- $ 2,128.7
Re-estimated recoverable -- -- -- 472.1
- --------------------------------------------------------------------------------------------
Net re-estimated liability -- -- -- $ 1,656.6
============================================================================================
10
Reinsurance
The Company maintains a reinsurance program designed to protect against large or
unusual losses and LAE activity. This includes both excess of loss reinsurance
and catastrophe reinsurance. Catastrophe reinsurance serves to protect the
ceding insurer from significant aggregate losses arising from a single event
such as snow, ice storms, windstorm, hail, hurricane, tornado, riot or other
extraordinary events. In addition, the Company, in the Risk Management segment,
has reinsurance for casualty business. The Company determines the appropriate
amount of reinsurance based on the Company's evaluation of the risks accepted
and analyses prepared by consultants and reinsurers and on market conditions,
including the availability and pricing of reinsurance.
Under the Company's 2002 catastrophe reinsurance program, AFC retained
$45.0 million of loss per hurricane occurrence and $30.0 million of loss per
occurrence for all other exposures, 15% of all loss amounts in excess of $45.0
million, or $30.0 million for non-hurricane losses, up to $230.0 million, and
all amounts in excess of $230.0 million. Effective January 1, 2003, the Company
modified its catastrophe reinsurance program. Under this new program, AFC
retains $45.0 million of loss per hurricane occurrence and $30.0 million of loss
per occurrence for all other exposures, 15% of all aggregate loss amounts in
excess of $45.0 million, or $30.0 million for non-hurricane losses, up to $300.0
million and all amounts in excess of $300.0 million. Personal lines' losses due
to fire or collapse as a result of an act of terrorism are not excluded from
coverage under this treaty, except for those losses that result from biological,
chemical or nuclear terrorism. The 2003 program covers non-certified terrorist
events for commercial lines but offers no coverage for certified events, as
defined by the TRIA, for commercial lines.
Under the Company's 2002 property catastrophe aggregate treaty, catastrophe
losses were calculated cumulatively, in the aggregate, at the end of each
quarter during the term of the contract and were subject to a retention limit
based on property lines' net earned premium. This limit equaled 13.26% of the
net earned premium at March 31, 2002, subject to a minimum net earned premium of
$158.0 million and a maximum of $165.0 million, 13.21% of the net earned premium
at June 30, 2002, subject to a minimum net earned premium of $318.0 million and
a maximum of $328.0 million, 11.60% of the net earned premium at September 30,
2002, subject to a minimum net earned premium of $483.0 million and a maximum of
$498.0 million, and 10.70% of the net earned premium at December 31, 2002
subject to a minimum net earned premium of $654.3 million and a maximum of
$680.0 million. Effective January 1, 2003, catastrophe losses will be calculated
cumulatively, in the aggregate, at the end of each quarter during the term of
the contract and will be subject to a retention limit based on property lines'
net earned premium. This limit equals 18.79% of the net earned premium at March
31, 2003, subject to a minimum net earned premium of $165.0 million and a
maximum of $172.0 million, 15.52% of the net earned premium at June 30, 2003,
subject to a minimum net earned premium of $335.0 million and a maximum of
$345.0 million, 13.04% of the net earned premium at September 30, 2003, subject
to a minimum net earned premium of $506.0 million and a maximum of $521.0
million, and 11.85% of the net earned premium at December 31, 2003, subject to a
minimum net earned premium of $675.0 million and a maximum of $700.0 million.
The 2003 property catastrophe aggregate treaty excludes terrorist related
activities for commercial lines' events. Personal lines' losses due to fire or
collapse as a result of an act of terrorism are also not excluded from coverage
under this treaty, except for those losses that result from biological, chemical
or nuclear terrorism.
Effective July 1, 2002, the Company maintains a property reinsurance
program in which the reinsurers are responsible for 100% of each loss in excess
of $0.5 million per occurrence up to $20.0 million for monoline inland marine
and commercial automobile physical damage. All other property business is 100%
covered by reinsurers for each loss in excess of $2.0 million per occurrence up
to $20.0 million. Amounts in excess of $20.0 million for all property lines
including monoline inland marine and commercial automobile physical damage, are
100% retained by the Company. This treaty also includes provisions which limit
terrorism coverage.
Under the 2002 casualty reinsurance program, the reinsurers were
responsible for 45% of the amount of each loss in excess of $0.5 million per
occurrence up to $1.0 million and 100% of the amount of each loss in excess of
$1.0 million per occurrence up to $30.5 million for general liability and
workers' compensation. Amounts in excess of $30.5 million were retained 100% by
the Company. Effective January 1, 2003, under the Company's casualty reinsurance
program, the reinsurers are responsible for 40% of the amount of each loss in
excess of $0.5 million per occurrence up to $1.0 million and 100% of the amount
of each loss in excess of $1.0 million per occurrence up to $30.5 million for
general liability and workers' compensation. Amounts in excess of $30.5 million
are retained 100% by the Company. In addition, the 2003 program excludes
terrorism claims in excess of $3.0 million and includes annual aggregate limits.
The Company, in 1999, entered into a whole account aggregate excess of loss
reinsurance agreement, which provides coverage for accident year 1999. The
program covered losses and allocated LAE, including those incurred but not yet
reported, in excess of a specified whole account loss and allocated LAE ratio.
The coverage limit for losses and allo-
11
cated LAE is $150.0 million. The effect of this agreement on results of
operations in each reporting period is based on losses and allocated LAE ceded,
reduced by a sliding scale premium of 50-67.5% depending on the size of the
loss, and increased by a ceding commission of 20% of ceded premium. In addition,
net investment income is reduced for amounts credited to the reinsurer. As a
result of this agreement, the Company recognized a net expense of $3.9 million
for the year ended December 31, 2002 and net benefits of $0.2 million and $9.8
million for the years ended December 31, 2001 and 2000, respectively, based on
estimates of losses and allocated LAE for accident year 1999. The 2001 impact
from this treaty includes a $1.1 million net benefit related to the exit of
selected property and casualty agencies, policies, groups and programs, as
discussed in "Risk Management - Reserve for Losses and Loss Adjustment Expense"
on pages 28 to 32 in Management Discussion and Analysis of Financial Condition
and Results of Operations of this Form 10-K. The effect of this agreement on the
results of operations in future periods is not currently determinable, as it
will be based both on future losses and allocated LAE for accident year 1999.
The Company, in the Risk Management segment, cedes to reinsurers a portion
of its risk and pays a fee based upon premiums received on all policies subject
to such reinsurance. Reinsurance contracts do not relieve the Company from its
obligations to policyholders. Failure of reinsurers to honor their obligations
could result in losses to the Company. The Company believes that the terms of
its reinsurance contracts are consistent with industry practice in that they
contain standard terms with respect to lines of business covered, limit and
retention, arbitration and occurrence. Based on its review of its reinsurers'
financial statements and reputations in the reinsurance marketplace, the Company
believes that its reinsurers are financially sound.
The Company is subject to concentration of risk with respect to reinsurance
ceded to various residual market mechanisms. As a condition to the ability to
conduct certain business in various states, the Company is required to
participate in various residual market mechanisms and pooling arrangements which
provide various insurance coverages to individuals or other entities that are
otherwise unable to purchase such coverage. These market mechanisms and pooling
arrangements include CAR and MCCA.
Reference is made to "Reinsurance" in Note 18 on pages 94 and 95 of the
Notes to Consolidated Financial Statements included in Financial Statements and
Supplementary Data of this Form 10-K.
Reference is also made to "Reinsurance Facilities and Pools" on page 5 of
this Form 10-K.
ASSET ACCUMULATION
The Asset Accumulation Group consists of the Allmerica Financial Services and
Allmerica Asset Management segments, each of which is described below.
ALLMERICA FINANCIAL SERVICES
The Allmerica Financial Services segment includes the individual financial
products and the group retirement products and services businesses of AFLIAC and
its wholly-owned subsidiary, FAFLIC, as well as the Company's broker/dealer and
registered investment advisor affiliates. These affiliates include VeraVest
Investments, Inc., formerly known as "Allmerica Investments, Inc." ("VeraVest"),
as well as VeraVest Investment Advisors, Inc., formerly known as "Allmerica
Investment Management Company, Inc". For the year ended December 31, 2002, the
Allmerica Financial Services segment accounted for $854.7 million, or 24.6% of
consolidated segment revenues and accounted for $625.0 million of the segment
loss before federal income taxes and minority interest.
OVERVIEW
Allmerica Financial Services markets non-proprietary insurance and retirement
savings products and services primarily to individuals through VeraVest and
manages an existing portfolio of proprietary life insurance and annuity products
previously issued through the Company's two life insurance subsidiaries, AFLIAC
and FAFLIC.
Prior to September 30, 2002, the Allmerica Financial Services segment
manufactured and sold variable annuities, variable universal life and
traditional life insurance products, as well as certain group retirement
products. On September 27, 2002, the Company announced plans to consider
strategic alternatives, including a significant reduction of sales of
proprietary variable annuities and variable life insurance products. This
resulted from the effect of the significant, persistent decline in the equity
market, culminating in the third quarter of 2002, that followed the decline in
the second quarter, as well as the ratings downgrades. Subsequently, the
Company ceased all new sales of proprietary variable annuities and life
insurance products. Reference is made to "Rating Agency Actions" discussed on
pages 57 to 59 of Management's Discussion and Analysis of Financial Condition
and Results of Operations of this Form 10-K.
VERAVEST
General
The Company's strategy is to transform the prior agency channel into an
independent distributor of non-proprietary products offering its registered
representatives key services that help them generate leads and partnerships and
improve their productivity. VeraVest has formed strategic alliances with two
major insurance carriers to deliver high quality variable products and services
and intends to pursue an additional strategic alliance in 2003 for annuity
products. In addi-
12
tion, the Company is pursuing strategic alliances with insurance carriers
related to life insurance products. The products will be supported by internal
VeraVest wholesalers. VeraVest is comprised of a growing advisor system that
totaled approximately 750 financial planning advisors as of December 31, 2002.
VeraVest recruits primarily experienced, productive registered
representatives by offering them an attractive commission payout similar to
other independent broker/dealers, while providing them with services such as
lead generation, partnerships and group insurance.
As of December 31, 2002, VeraVest has formed strategic alliances with two
major insurance carriers. With these partnerships in place, VeraVest can deliver
quality, variable life insurance and annuity products to the Company's
registered representatives. By concentrating the Company's proven distribution
capacity and support on a small number of manufacturers, VeraVest can create
broad and beneficial partnerships with these companies and earn improved
margins.
The securities industry is subject to extensive regulation under federal
and state law. In general, broker/dealers are required to register with the
Securities and Exchange Commission ("SEC") and to be members of the National
Association of Securities Dealers, Inc. ("NASD"). As such, the Company is
subject to the requirements of the Securities Exchange Act of 1934 and the rules
promulgated thereunder relating to broker/dealers and to the Rules of Fair
Practice of the NASD. These regulations establish, among other things, minimum
net capital requirements for the related operating subsidiaries, and regulate
sales and compensation practices. The Company is also subject to regulation
under various state laws in all 50 states and the District of Columbia,
including registration requirements.
Competition
The Company's broker/dealer competitors vary in size, scope and breadth of
services offered. VeraVest competes with national and regional brokerage firms,
as well as insurance companies with securities brokerage subsidiaries, financial
institutions, mutual fund sponsors and others who utilize financial planning
representatives. Its primary competitors are those broker/dealers that focus on
independent financial planning advisors, such as Commonwealth Financial, Lincoln
Financial Advisors and Linsco Private Ledger.
Some competitors have greater financial, technical and marketing resources.
Some also offer a wider range of financial products, have greater name
recognition and more extensive client bases. These competitors may be able to
respond more quickly to new or changing opportunities and technologies. They
also may be able to undertake more extensive promotional activities or offer
higher payouts to their representatives.
The Company believes that its ability to compete depends upon many factors
both within and outside its control, including its ability to attract and retain
a network of registered representatives, the effectiveness of lead generation
programs, ease of use, performance and features of VeraVest's technology and
services, and its ability to provide other services to the Company's registered
representatives.
PROPRIETARY LIFE INSURANCE AND ANNUITY PRODUCTS
Products
Prior to September 30, 2002, the Company offered a diverse line of
products, including variable annuities and variable universal life. Sales of
variable products represented approximately 98.5%, 98.4% and 98.2% of this
segment's statutory premiums and deposits in 2002, 2001 and 2000, respectively.
Statutory premiums and deposits, a common industry benchmark for sales
achievement, totaled $3,129.4 million, $3,378.1 million and $3,877.0 million in
2002, 2001 and 2000, respectively. The following table reflects total reserves
held, including universal life and investment-oriented contract reserves, for
the segment's major product lines, including the Closed Block (see Note 1,
"Summary of Significant Accounting Policies - Closed Block" on page 68 of the
Notes to Consolidated Financial Statements included in Financial Statements and
Supplementary Data of this Form 10-K), for the years ended December 31, 2002 and
2001.
2002 2001
- ---------------------------------------------------------------------------
(In millions)
General Account Reserves:
Insurance
Traditional life $ 854.2 $ 861.3
Universal life /(1)/ 642.1 743.5
Variable universal life 211.1 186.7
Individual health /(2)/ 265.4 274.1
Group variable universal life 11.8 12.4
- ---------------------------------------------------------------------------
Total insurance 1,984.6 2,078.0
- ---------------------------------------------------------------------------
Annuities
Individual annuities 1,716.0 1,811.8
Group annuities 615.0 682.9
- ---------------------------------------------------------------------------
Total annuities 2,331.0 2,494.7
- ---------------------------------------------------------------------------
Total general account reserves $ 4,315.6 $ 4,572.7
===========================================================================
Separate Account Liabilities:
Variable individual life $ 977.9 $ 1,143.8
Variable individual annuities 10,611.9 12,834.5
- ---------------------------------------------------------------------------
Total individual 11,589.8 13,978.3
Group variable universal life 349.7 346.7
Group annuities 403.9 513.4
- ---------------------------------------------------------------------------
Total group 753.6 860.1
- ---------------------------------------------------------------------------
Total separate account liabilities $ 12,343.4 $ 14,838.4
===========================================================================
(1) Universal life reserves include reinsured balances of $620.7 million and
$29.8 million at December 31, 2002 and 2001, respectively.
(2) Individual health reserves include reinsured balances of $264.0 million and
$271.1 million at December 31, 2002 and 2001, respectively.
13
VARIABLE PRODUCTS
The Company's variable products previously offered through this segment included
variable universal life insurance and variable annuities. The Company's variable
universal life insurance products combined the flexible terms of the Company's
universal life insurance policy with separate account investment opportunities.
The Company also offered a variable joint life product through this segment. The
Company's variable annuities offered the investment opportunities of the
Company's separate accounts and provided a vehicle for tax-deferred savings.
These products were sold pursuant to registration statements under the
Securities Act or exemptions from registration thereunder.
The Company's variable universal life and annuity products continue to
offer existing policyholders a variety of account investment options with
choices ranging from money market funds to international equity funds. For
management of these separate accounts, the Company supplements its in-house
expertise in managing fixed income assets with the equity management expertise
of well-known mutual fund advisors, such as Fidelity Investments, as well as
other independent management firms who specialize in the management of
institutional assets. Additionally, the Company utilizes the services of
experienced investment consultants to assist it in the selection of these
institutional managers and in the ongoing monitoring of their performance.
RETIREMENT PRODUCTS
In addition to the above, the Company provides consulting and investment
services to defined benefit retirement plans of corporate employers. The Company
also offers participant recordkeeping and administrative services to defined
benefit retirement plans. As of December 31, 2002, the Company provides
administration and recordkeeping for approximately 93 qualified pension and
profit sharing plans, which have assets totaling approximately $576 million.
During the first quarter of 2003, the Company informed its clients that it will
no longer be providing recordkeeping and administrative services; management
expects these services to cease by June 30, 2003. The Company does not plan to
continue marketing efforts for its defined benefit business.
On July 1, 2001, the Company sold its defined contribution business, in
which it had provided consulting services to defined contribution benefit
retirement plans, to Minnesota Life Insurance Company, as a result of the
Company's conclusion that this business lacked scale to compete effectively in
the 401(k) market.
TRADITIONAL PRODUCTS
The Company's primary insurance products contained in this segment are
traditional life insurance products, including whole life and universal life. In
addition, the Company's insurance products include fixed annuities and
retirement plan funding products. The Company sold, through a 100% coinsurance
agreement, substantially all of its universal life insurance business effective
December 31, 2002, as discussed in "Significant Transactions - Sale of Universal
Life Insurance Business" on page 50 of Management's Discussion and Analysis of
Financial Condition and Results of Operations and "Reinsurance" on page 15 of
this Form 10K.
Distribution
Prior to September 30, 2002, the Company's life insurance and annuity products
were distributed primarily through three distribution channels: (1) "Agency",
which consisted of the Company's career agency force; (2) "Select", which
consisted of a network of third party broker/dealers; and (3) "Partners", which
included distributors of the mutual funds advised by Scudder Investments
("Scudder"), Pioneer Investment Management, Inc. ("Pioneer"), and Delaware
Management Company ("Delaware"). The Company no longer manufactures or
distributes its proprietary products.
During 2002, total statutory premiums and deposits from sales of variable
annuities through the agency sales force totaled $613.3 million, compared to
$679.9 million and $885.7 million in 2001 and 2000, respectively. Total
statutory premiums from sales of variable life insurance through the agency
sales force totaled $27.0 million in 2002, compared to $48.3 million and $49.9
million in 2001 and 2000, respectively.
Products sold through the Select and Partner channels included Allmerica
Select life and annuity products, which were distributed through independent
broker/dealers and financial planners, as well as annuity products sold through
alliances with mutual fund partners. During 2002, total statutory premiums and
deposits from sales of variable annuities through the Select and Partner
distribution channels totaled $2,135.8 million, compared to $2,170.0 million and
$2,194.1 million in 2001 and 2000, respectively. In addition, total statutory
premiums from sales of variable life insurance through the Select and Partner
distribution channels totaled $101.4 million in 2002, compared to $68.2 million
and $64.5 million in 2001 and 2000, respectively.
Underwriting
Life insurance underwriting involves a determination of the type and amount of
risk which an insurer is willing to accept and the price charged to do so. The
Company's insurance underwriting standards for this segment attempted to produce
mortality results consistent with the assumptions used in product pricing.
Underwriting also determined the amount and type of reinsurance levels
appropriate for a particular risk profile and allowed competitive risk
selection. Underwriting rules and guidelines were based on the mortality
experience of the Company, as well as of the insurance industry and the general
population. The Company used a
14
variety of medical tests to evaluate certain policy applications, based on the
size of the policy, the age of the applicant and other factors.
The Company's product specifications were designed to prevent
anti-selection. Mortality assumptions were thoroughly communicated and
monitored.
INSURANCE RESERVES
The Company has established liabilities for policyholders' account balances and
future policy benefits, included in the Consolidated Balance Sheets, to meet
obligations on various policies and contracts. Reserves for policyholders'
account balances for universal life and investment-type policies are equal to
cumulative account balances: deposits plus credited interest, less expense and
mortality charges and withdrawals. Future policy benefits for traditional
products are computed on the basis of assumed investment yields, mortality,
persistency, morbidity and expenses (including a margin for adverse deviation),
which are established at the time of issuance of a policy and generally vary by
product, year of issue and policy duration. The Company periodically reviews
both reserve assumptions and policyholder liabilities.
REGULATION OF LIFE INSURANCE SUBSIDIARIES
The Company's life insurance subsidiaries are subject to the laws and
regulations of the Commonwealth of Massachusetts governing insurance companies,
and to the insurance laws and regulations of the various jurisdictions where
they are licensed to operate. The extent of regulation varies, but most
jurisdictions have laws and regulations governing the financial aspects of
insurers, including standards of solvency, reserves, reinsurance and capital
adequacy, and the business conduct of insurers. In addition, variable product
business is subject to extensive regulation at both the state and federal level,
including regulation under state insurance laws and federal and state securities
laws. The Companies' variable annuity and variable life insurance products are
subject to registration with the SEC, and the conduct of our variable product
business is subject to regulation by the SEC and the NASD. Also, after the
ratings downgrades and the Company's announcement that it would cease selling
new annuity and life insurance products, several states have prohibited the
Company's life insurance subsidiaries from selling new business without the
approval of such states' insurance departments. In addition, the agreement to
reduce the required risk based capital levels for the life insurance
subsidiaries from 225% to 100% is contingent on the Company not engaging in new
sales. Reference is made to "Statutory Capital of Insurance Subsidiaries" on
pages 52 to 54 of Management's Discussion and Analysis of Financial Condition
and Results of Operations of this Form 10-K.
REINSURANCE
Consistent with the general practice in the life insurance industry, the Company
has reinsured portions of the coverage provided by this segment's insurance
products with other insurance companies. Insurance is ceded principally to
reduce net liability on individual risks, to provide protection against large
losses and to obtain a greater diversification of risk. Although reinsurance
does not legally discharge the ceding insurer from its primary liability for the
full amount of policies reinsured, it does make the reinsurers liable to the
insurer to the extent of the reinsurance ceded. The Company maintains a gross
reserve for reinsurance liabilities. The Company ceded approximately 21.5% of
this segment's statutory individual life insurance premiums in 2002.
In order to manage the mortality risk of its individual variable universal
life business, the Company established a reinsurance program. Under this
reinsurance program, approximately 90% of variable universal life mortality risk
is reinsured. The Company's retention ranges from 0 - 20%, subject to a maximum
retention limit of $2.0 million per life.
The Company effectively sold, through a 100% coinsurance agreement,
substantially all of its fixed universal life insurance product business
effective December 31, 2002. Under the agreement, the Company ceded
approximately $660 million of universal life insurance reserves in exchange for
the transfer of investment assets with a market value of approximately $550
million and an amortized cost of approximately $525 million.
The Company implemented a guaranteed minimum death benefit mortality
reinsurance program effective December 1, 2002, with unaffiliated reinsurers,
covering the incidence of mortality on variable annuity policies. Under this
program, the Company pays the reinsurers monthly premiums based on the net
amount at risk on the variable annuity business (see Segment Results - Allmerica
Financial Services, Guaranteed Minimum Death Benefits on pages 35 and 36 of
Management's Discussion and Analysis of Financial Condition and Results of
Operations of this Form 10-K). The reinsurers reimburse the Company for the net
amount at risk portion of qualified variable annuity claims. The Company retains
the market risk associated with the net amount at risk on the variable annuity
business.
In addition, the Company maintains coinsurance agreements to reinsure
substantially all of its individual disability income business and yearly
renewable term business.
The Company seeks to enter into reinsurance treaties with highly rated
reinsurers. The Company's policy is to utilize reinsurers which have received an
A.M. Best rating of "A- (Excellent)" or better (Best's Insurance Reports, 2001
edition). The Company believes that it has established appropriate reinsurance
coverage for this segment based upon its net retained insured liabilities
compared to its surplus. Based on its review of its reinsurers' financial
positions and reputations in the reinsurance marketplace, the Company believes
that its reinsurers are financially sound.
15
The Company also participated in a catastrophe accident pool. The maximum
pool reinsurance available per company is $50.0 million and the maximum pool
reinsurance available for a single event is $125.0 million. Any amounts in
excess of these limits are the responsibility of the company suffering the loss.
Each participant in the pool pays a premium based on the share of claims paid by
the pool. The Company's share of pool losses is approximately 0.6%. There have
been several claims for which the Company's share was approximately $1.2 million
since the Company entered the pool on January 1, 1989. The Company's share in
the pool, due to the events of September 11, 2001, was $1.1 million. The Company
was reimbursed $0.5 million for September 11, 2001 claims which it submitted to
the pool. Approximately 122 companies currently participate in this pool.
Effective January 1, 2003, the Company no longer participates in the pool;
however, this does not relieve the Company of its obligations in these pools for
years in which the Company was a participant.
ALLMERICA ASSET MANAGEMENT
GENERAL
Prior to September 2002, the Company offered Stable Value Products, such as
Guaranteed Investment Contracts ("GICs"), funding agreements and Euro-GICs, to
ERISA-qualified retirement plans as well as other non-ERISA institutional
buyers, such as banks, insurance companies, money market funds, and securities
lending collateral reinvestment programs. Due to the decline in financial
strength ratings from various rating agencies, the Company no longer offers
Stable Value Products. This segment also includes a Registered Investment
Advisor, which provides investment advisory services to affiliates and to other
institutions, such as insurance companies, retirement plans and mutual funds.
Additionally, this segment includes the Company's premium financing subsidiary,
which was previously included in the Risk Management segment.
For the year ended December 31, 2002, this segment accounted for $127.2
million, or 3.7%, of consolidated segment revenues, and provided $24.4 million
of segment income before federal income taxes and minority interest.
PRODUCTS AND SERVICES
STABLE VALUE PRODUCTS
The Company offered its customers the option of investing in Stable Value
Products, comprised of both traditional GICs and non-qualified GICs, often
referred to as funding agreements. The traditional GIC was issued to
ERISA-qualified retirement plans, and provided a fixed guaranteed interest rate
and fixed maturity for each contract. The funding agreement is similar to the
traditional GIC, except that it was issued to non-ERISA institutional buyers.
Short-term funding agreements sold in this market typically had variable
interest rates, based on an index such as LIBOR, and a put/call feature which
permits the policy to be terminated prior to maturity. Long-term funding
agreements, with maturities of 1 to 10 years, were offered to institutional
buyers such as banks, insurance companies and money managers. Funding agreements
sold in this market may have either fixed or variable interest rates. In
addition, funding agreements sold through the Company's Euro-GIC program may be
denominated in either U.S. dollars or foreign currencies.
During 2002, funding agreement deposits were approximately $211.9 million,
as compared to $1.2 billion and $1.1 billion in 2001 and 2000, respectively.
Long-term funding agreements, including Euro-GICs, accounted for 100% of these
deposits in both 2002 and 2001, compared to 71% in 2000. Short-term funding
agreements accounted for 28% of the deposits in 2000. The decreasing volume of
short-term funding agreement deposits reflects the overall decline in this
market, as well as the Company's decision to cease selling short-term funding
agreements, in addition to withdrawals which resulted from ratings downgrades.
The decreasing volume of long-term funding agreement deposits reflects the
Company's decision to cease selling long-term funding agreements which resulted
from the aforementioned ratings downgrades.
Declining financial strength ratings from various rating agencies during
2002 resulted in the termination of all remaining short-term funding agreements.
Similar concerns affected holders of the Company's long-term funding agreements.
Although these funding agreements do not provide for early termination prior to
maturity, during the fourth quarter of 2002, the Company was able to retire
certain of these instruments at discounts. The Company retired approximately
$296.3 million through open market purchases, and an additional $252.6 million
through a formal tender offer. At December 31, 2002, the Company held $1.4
billion of these long-term funding agreements.
Reference is made to "Rating Agency Actions" on pages 57 to 59 of
Management's Discussion and Analysis of Financial Condition and Results of
Operations of this Form 10-K. Additionally, reference is made to "Significant
Transactions - Gain on Retirement of Funding Agreement Obligations" on page 50
of Management's Discussion and Analysis of Financial Condition and Results of
Operations of this Form 10-K.
INVESTMENT ADVISORY SERVICES
Through its registered investment advisor, Opus Investment Management, Inc.,
(formerly "Allmerica Asset Management, Inc."), the Company provides investment
advisory services to affiliates and to other institutions, including
unaffiliated insurance companies, retirement plans, foundations and mutual
funds. At December 31, 2002, Opus Investment
16
Management had assets under management of approximately $18.4 billion, of which
approximately $7.1 billion represented assets managed for third party clients
(i.e. entities unaffiliated with the Company). One institutional money market
fund represents approximately 81% of assets managed for third party clients.
Assets under management for third party clients grew by approximately $900
million during 2002.
PREMIUM FINANCING SERVICES
Through its premium financing company, AMGRO, Inc. ("AMGRO"), the Company is
engaged in the business of financing property and casualty insurance premiums to
its commercial customers. Generally, these installment finance receivables are
secured by the related unearned insurance premiums on such polices. The
customers of AMGRO are those persons or firms that borrow from AMGRO to finance
insurance premiums.
DISTRIBUTION
The Company distributed Stable Value Products through brokers, investment
bankers, GIC investment managers and directly from the Company's home office.
Investment advisory services are marketed directly, while premium financing
services are generally marketed through independent insurance agents.
COMPETITION
Since 1999, increased sensitivity to the Company's financial strength ratings
has resulted in significant withdrawals of its short-term funding agreements and
has caused the Company to cease selling both short-term and long-term funding
agreements. Reference is made to "Products and Services - Stable Value Products"
on page 16 of this Form 10-K.
There is strong competition among providers of investment advisory
services. In general, competition is based on a number of factors, including
investment performance, pricing and client service. There are few barriers to
entry by new investment advisory firms.
Opus Investment Management, Inc. derives a significant portion of its
revenue from investment adviser fees received from Allmerica Investment Trust
Funds (i.e. funds in which the separate accounts of the Company's life insurance
subsidiaries invest premiums received from variable life insurance and annuity
deposit), Merrimac Funds (an institutional money market fund), and other
separately managed accounts. As a result, the Company is dependent upon the
relationships it maintains with these funds and separately managed accounts. In
the event that any of the relationships are discontinued, the segment's
financial results may be adversely affected.
INVESTMENT PORTFOLIO
GENERAL
At December 31, 2002, the Company held $9.2 billion of investment assets. These
investments are generally of high quality and broadly diversified across asset
classes and individual investment risks. The major categories of investment
assets are: fixed maturities, which includes both investment grade and below
investment grade public and private debt securities; equity securities; mortgage
loans, principally on commercial properties; policy loans and other long-term
investments. The remainder of the investment assets are comprised of cash and
cash equivalents.
Management has an integrated approach to developing an investment strategy
for the Company that maximizes income, while incorporating overall asset
allocation, business segment objectives, and asset/liability management tailored
to specific insurance or investment product requirements. The Company's
integrated approach and the execution of the investment strategy are founded
upon a value orientation. The Company's investment professionals seek to
identify undervalued securities in the markets through extensive fundamental
research and credit analysis. Management believes this research-driven, value
orientation is a key to achieving the overall investment objectives of producing
superior rates of return, preserving capital and meeting the financial goals of
the Company's business segments.
The appropriate asset allocation for the Company (the selection of broad
investment categories such as fixed maturities, equity securities and mortgage
loans) is determined by management initially through a process that focuses
overall on the types of businesses in each segment in which the Company engages,
and the level of surplus (net worth) required to support these businesses.
The Company has developed an asset/liability management approach tailored
to specific insurance, investment product and income objectives. The investment
assets of the Company are then managed in over 20 portfolio segments consistent
with specific products or groups of products having similar liability
characteristics. As part of this approach, management develops investment
guidelines for each portfolio consistent with the return objectives, risk
tolerance, liquidity, time horizon, tax and regulatory requirements of the
related product or business segment. Specific investments frequently meet the
requirements of, and are acquired by, more than one investment portfolio (or
investment segment of the general account of FAFLIC or AFLIAC, with each
investment segment holding a pro rata interest in such investments and the cash
flows therefrom). Management has a general policy of diversifying investments
both within and across all portfolios. The Company monitors the credit quality
of its investments and its exposure to individual markets, borrowers,
industries, sectors and in the case of mortgages, proper-
17
ty types and geographic locations. All investments held by the Company's
insurance subsidiaries are subject to diversification requirements under
insurance laws.
Consistent with this management approach, portfolio managers maintain close
working relationships with the managers of related product lines within the Risk
Management, Allmerica Financial Services and Allmerica Asset Management
segments.
Reference is made to "Investment Portfolio" on pages 41 to 43 and
"Derivative Instruments" on page 43 of Management's Discussion and
Analysis of Financial Condition and Results of Operations of this Form 10-K.
RATING AGENCIES
Insurance companies are rated by rating agencies to provide both industry
participants and insurance consumers information on specific insurance
companies. Higher ratings generally indicate the rating agencies' opinion
regarding financial stability and a stronger ability to pay claims.
Management believes that strong ratings are important factors in marketing
the Company's products to its agents and customers, since rating information is
broadly disseminated and generally used throughout the industry. Insurance
company financial strength ratings are assigned to an insurer based upon factors
deemed by the rating agencies to be relevant to policyholders and are not
directed toward protection of investors. Such ratings are neither a rating of
securities nor a recommendation to buy, hold or sell any security.
See "Rating Agency Actions" on pages 57 to 59 in Management's Discussion
and Analysis of Financial Condition and Results of Operations of this Form 10-K.
EMPLOYEES
The Company has approximately 5,300 employees located throughout the country as
of December 31, 2002. Management believes relations with employees and agents
are good.
AVAILABLE INFORMATION
The Company files its annual report on Form 10-K, its quarterly reports on Form
10-Q, periodic information on Form 8-K, its proxy statement, its variable
product filings and other required information with the SEC. Shareholders may
read and copy any materials on file with the SEC at the SEC's Public Reference
Room at 450 Fifth Street, NW, Washington, DC 20549. Shareholders may obtain
information on the operation of the Public Reference Room by calling the SEC at
1-800-SEC-0330. In addition, the SEC maintains an Internet website,
http://www.sec.gov, that contains reports, proxy and information statements and
other information with respect to the Company's filings.
The Company's website address is http://www.allmerica.com. AFC makes
available free of charge on or through its website its annual report on Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable
after the Company electronically files such material with, or furnishes it to,
the SEC.
ITEM 2 - PROPERTIES
The Company's headquarters are located at 440 Lincoln Street, Worcester,
Massachusetts, and consist primarily of approximately 758,387 rentable square
feet of office and conference space owned in fee and includes the headquarters
of Hanover.
Citizens owns its home office, located at 645 W. Grand River, Howell,
Michigan, which is approximately 103,652 rentable square feet. Citizens also
owns a three-building complex located at 808 North Highlander Way, Howell,
Michigan, with approximately 157,354 rentable square feet, where various
business operations are conducted.
The Company leases office space for its registered representatives
throughout the United States. The leased property houses agency offices. Hanover
and Citizens also lease offices throughout the country for its field employees.
The Company believes that its facilities are adequate for its present needs
in all material respects. Certain of the Company's properties may be available
for lease.
ITEM 3 - LEGAL PROCEEDINGS
Reference is made to Note 21 on pages 98 and 99 of the Notes to the Consolidated
Financial Statements included in Financial Statements and Supplementary Data of
this Form 10-K.
Item 4 - SUBMISSION OF MATTERS TO A VOTE
OF SECURITY HOLDERS
No matters were submitted to a vote of security holders in the fourth quarter of
the fiscal year covered by this Annual Report on Form 10-K.
18
PART II
Item 5 - MARKET FOR THE REGISTRANT'S
COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS
COMMON STOCK AND SHAREHOLDER OWNERSHIP
The common stock of Allmerica Financial Corporation is traded on the New York
Stock Exchange under the symbol "AFC". On March 21, 2003, the Company had 38,719
shareholders of record and 53,185,821 million shares outstanding. On the same
date, the trading price of the Company's common stock was $14.43 per share.
COMMON STOCK PRICES AND DIVIDENDS
High Low Dividends
2002
First Quarter $ 45.17 $ 40.60 -
Second Quarter $ 50.33 $ 44.20 -
Third Quarter $ 45.85 $ 12.00 -
Fourth Quarter $ 11.51 $ 7.16 -
2001
First Quarter $ 67.25 $ 47.63 -
Second Quarter $ 57.50 $ 48.01 -
Third Quarter $ 56.35 $ 40.62 -
Fourth Quarter $ 46.10 $ 38.17 $ 0.25
2002 DIVIDEND SCHEDULE
Dividends paid by the Company may be funded from dividends paid to the Company
from its subsidiaries. Dividends from insurance subsidiaries are subject to
restrictions imposed by state insurance laws and regulations. See "Liquidity and
Capital Resources" on pages 55 and 56 of Management's Discussion and Analysis of
Financial Condition and Results of Operations and Note 15 on page 92 of the
Notes to Consolidated Financial Statements included in Financial Statements and
Supplementary Data of this Form 10-K. In recent years, the Company has paid an
annual dividend of $0.25 per share. The Company decided, in 2002, to suspend
payment of its annual common stock dividend and does not expect to pay a
dividend in 2003. The payment of future dividends, if any, on the Company's
common stock will be a business decision made by the Board of Directors from
time to time based upon the results of operations and financial condition of the
Company and such other factors as the Board of Directors considers relevant.
19
Item 6 - SELECTED FINANCIAL DATA
FIVE YEAR SUMMARY OF SELECTED FINANCIAL HIGHLIGHTS
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000 1999 1998
- ----------------------------------------------------------------------------------------------------------------------------
(In millions, except per share data)
STATEMENTS OF INCOME
REVENUES
Premiums $ 2,320.1 $ 2,254.7 $ 2,118.8 $ 2,002.6 $ 2,026.0
Universal life and investment
product policy fees 409.8 391.6 421.1 359.3 296.6
Net investment income 590.2 655.2 645.5 669.5 657.7
Net realized investment (losses) gains (162.3) (123.9) (140.7) 90.4 59.3
Other income 158.8 134.2 138.0 116.9 94.4
- ----------------------------------------------------------------------------------------------------------------------------
Total revenues 3,316.6 3,311.8 3,182.7 3,238.7 3,134.0
- ----------------------------------------------------------------------------------------------------------------------------
BENEFITS, LOSSES AND EXPENSES
Policy benefits, claims, losses and
loss adjustment expenses 2,202.0 2,167.2 1,981.8 1,861.6 1,900.6
Policy acquisition expenses 1,080.4 479.2 456.6 432.4 452.3
Gain from retirement of trust
instruments supported by funding
obligations (102.6) -- -- -- --
Loss from sale of universal life business 31.3 -- -- -- --
Restructuring costs 14.8 2.7 20.7 (1.9) 9.0
(Gains) losses on derivative instruments (40.3) 35.2 -- -- --
Sales practice litigation (benefit) expense (2.5) (7.7) -- -- 31.0
Loss from selected property and casualty
exited agencies, policies, groups
and programs -- 68.3 -- -- --
Voluntary pool losses -- 33.0 -- -- --
Other operating expenses 654.7 593.3 505.0 478.6 441.0
- ----------------------------------------------------------------------------------------------------------------------------
Total benefits, losses and expenses 3,837.8 3,371.2 2,964.1 2,770.7 2,833.9
- ----------------------------------------------------------------------------------------------------------------------------
(Loss) income from continuing operations
before federal income taxes (521.2) (59.4) 218.6 468.0 300.1
Federal income tax (benefit) expense (234.8) (75.5) 2.7 106.9 56.1
- ----------------------------------------------------------------------------------------------------------------------------
(Loss) income from continuing operations
before minority interest (286.4) 16.1 215.9 361.1 244.0
Minority interest (16.0) (16.0) (16.0) (16.0) (29.3)
- ----------------------------------------------------------------------------------------------------------------------------
(Loss) income from continuing operations
before cumulative effect of change in
accounting principle (302.4) 0.1 199.9 345.1 214.7
Discontinued operations:
Loss from operations of discontinued
group life and health business, net
of taxes -- -- -- (18.8) (13.5)
Loss from disposal of group life and
health business, net of taxes -- -- -- (30.5) --
- ----------------------------------------------------------------------------------------------------------------------------
(Loss) income before cumulative effect
of change in accounting principle (302.4) 0.1 199.9 295.8 201.2
Cumulative effect of change in accounting
principle (3.7) (3.2) -- -- --
- ----------------------------------------------------------------------------------------------------------------------------
Net (loss) income $ (306.1) $ (3.1) $ 199.9 $ 295.8 $ 201.2
============================================================================================================================
(Loss) earnings per common share
(diluted) /(1)/ $ (5.79) $ (0.06) $ 3.70 $ 5.33 $ 3.33
Dividends declared per common share
(diluted) $ -- $ 0.25 $ 0.25 $ 0.25 $ 0.15
============================================================================================================================
BALANCE SHEET (AT DECEMBER 31)
Total assets $ 26,578.9 $ 30,336.1 $ 31,588.0 $ 30,769.6 $ 27,653.1
Long-term debt 199.5 199.5 199.5 199.5 199.5
Total liabilities 24,206.7 27,645.0 28,878.9 28,229.4 24,894.5
Minority interest 300.0 300.0 300.0 300.0 300.0
Shareholders' equity 2,072.2 2,391.1 2,409.1 2,240.2 2,458.6
(1) Per share data for the year ended December 31, 2002 represents basic loss
per share due to antidilution.
20
ITEM 7 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following analysis of the consolidated results of operations and financial
condition of the Company should be read in conjunction with the Consolidated
Financial Statements included elsewhere herein.
INTRODUCTION
The results of operations for Allmerica Financial Corporation and subsidiaries
("AFC" or "the Company") include the accounts of Allmerica Financial Life
Insurance and Annuity Company ("AFLIAC") and First Allmerica Financial Life
Insurance Company ("FAFLIC"), AFC's principal life insurance and annuity
companies; The Hanover Insurance Company ("Hanover") and Citizens Insurance
Company of America ("Citizens"), AFC's principal property and casualty
companies; and certain other insurance and non-insurance subsidiaries. AFLIAC
and FAFLIC are both domiciled in the Commonwealth of Massachusetts, while
Hanover and Citizens are domiciled in the states of New Hampshire and Michigan,
respectively. Prior to December 30, 2002, AFLIAC was domiciled in the state of
Delaware.
DESCRIPTION OF OPERATING SEGMENTS
The Company offers financial products and services in two major areas: Risk
Management and Asset Accumulation. Within these broad areas, the Company
conducts business principally in three operating segments. These segments are
Risk Management, Allmerica Financial Services ("AFS"), and Allmerica Asset
Management ("AAM"). The separate financial information of each segment is
presented consistent with the way results are regularly evaluated by the chief
operating decision makers in deciding how to allocate resources and in assessing
performance. A summary of the Company's reportable segments is included below.
The Risk Management Segment manages property and casualty operations
through two lines of business based upon product and identified as Personal
Lines and Commercial Lines. Personal Lines include property and casualty
coverages such as personal automobile, homeowners and other personal policies,
while Commercial Lines include property and casualty coverages such as workers'
compensation, commercial automobile, commercial multiple peril and other
commercial policies. Prior to 2002, the Risk Management segment managed its
business through three distribution channels identified as Standard Markets,
Sponsored Markets and Specialty Markets.
The Asset Accumulation group includes two segments: Allmerica Financial
Services and Allmerica Asset Management. Prior to September 30, 2002, the AFS
segment manufactured and sold variable annuities, variable universal life and
traditional life insurance products, as well as certain group retirement
products. On September 27, 2002, the Company announced plans to consider
strategic alternatives, including a significant reduction of sales of
proprietary variable annuities and life insurance products. This resulted from
the cumulative effect of the significant, persistent decline in the equity
market, culminating in the third quarter of 2002, that followed the decline in
the second quarter, as well as the ratings downgrades (see Rating Agency
Actions). Subsequently, the Company ceased all new sales of proprietary variable
annuities and life insurance products.
In the future, the AFS business will consist of two components. First, the
Company plans to transform its former Agency distribution channel (see Allmerica
Financial Services - Statutory Premiums and Deposits for a description of its
former distribution channels) into an independent broker/dealer, VeraVest
Investments, Inc., formerly "Allmerica Investments, Inc." ("VeraVest"), to
distribute non-proprietary investment and insurance products. The Company has
entered into agreements with leading investment product and insurance providers
and is seeking additional alliances whereby these providers would compensate the
Company for non-proprietary product sales by VeraVest's registered
representatives. Second, the Company plans to retain and service existing
customer accounts. These include variable annuity and variable universal life
accounts, as well as certain remaining traditional life and group retirement
accounts, which were issued by its life insurance subsidiaries, AFLIAC and
FAFLIC. However, the Company expects that the persistency of its existing
customer policies and contracts will be substantially less than its historical
experience.
Through its Allmerica Asset Management segment, prior to September 2002,
FAFLIC offered Guaranteed Investment Contracts ("GICs"). GICs, also referred to
as funding agreements, are investment contracts, which can contain either
short-term or long-term maturities and are issued to institutional buyers or to
various business or charitable trusts. Declining financial strength ratings from
various rating agencies during 2002 resulted in GIC contractholders terminating
all remaining short-term funding agreements and made it impractical to continue
selling new long-term funding agreements. Furthermore, the Company retired
certain long-term funding agreements, at discounts, during the fourth quarter of
2002. This segment continues to provide investment advisory services, primarily
to affiliates and to third parties, such as money market and other fixed income
clients through its subsidiary, Opus Investment Management, Inc. (formerly
"Allmerica Asset Management, Inc."). Additionally, during 2002, the Company
transferred management of AMGRO, Inc. ("AMGRO"), the Company's property and
casualty insurance premium financing business, to this segment. AMGRO was
previously part of the Risk Management segment.
21
In addition to the three operating segments, the Company has a Corporate
segment, which consists primarily of cash, investments, corporate debt, Capital
Securities (mandatorily redeemable preferred securities of a subsidiary trust
holding solely junior subordinated debentures of the Company) and corporate
overhead expenses. Corporate overhead expenses reflect costs not attributable to
a particular segment, such as those related to certain officers and directors,
technology, finance, human resources and legal.
RESULTS OF OPERATIONS
CONSOLIDATED OVERVIEW
Consolidated net (loss) income includes the results of each segment of the
Company, which management evaluates on a pre-tax and pre-minority interest
basis. In addition, net (loss) income is adjusted for certain items which
management believes are not indicative of the Company's core operations.
Adjusted net (loss) income excludes items such as net realized investment gains
and losses, including certain gains or losses on derivative instruments, because
fluctuations in these gains and losses are determined by interest rates,
financial markets and the timing of sales. Also, adjusted net (loss) income
excludes net gains and losses on disposals of businesses, discontinued
operations, restructuring and reorganization costs, extraordinary items, the
cumulative effect of accounting changes and certain other items, which in each
case, are neither normal nor recurring. Although the items excluded from
adjusted net (loss) income may be significant components in understanding and
assessing the Company's financial performance, management believes adjusted net
(loss) income enhances an investor's understanding of the Company's results of
operations by highlighting net (loss) income attributable to the normal,
recurring operations of the business, consistent with industry practice.
However, adjusted net (loss) income should not be construed as a substitute for
net (loss) income determined in accordance with generally accepted accounting
principles ("GAAP").
The Company's consolidated net loss increased $303.0 million, to $306.1
million in 2002, compared to $3.1 million in 2001. The increase in net loss
resulted primarily from a decrease in adjusted net income of $439.9 million,
principally the result of a significant segment loss in AFS. Also contributing
to this decline was a $20.3 million loss from the sale of the universal life
business and a $12.3 million increase in restructuring and reorganization costs,
net of taxes. Partially offsetting these items were a $66.7 million gain from
the retirement of trust instruments supported by funding obligations and a $49.1
million increase in gains on derivative instruments, net of taxes. In 2001, the
Company's consolidated net income decreased $203.0 million, or 101.6%, to a net
loss of $3.1 million, compared to net income of $199.9 million in 2000. The
reduction in net income in 2001 primarily resulted from a decrease in adjusted
net income of $136.7 million and a loss from selected property and casualty
exited agencies, policies, groups, and programs of $44.4 million, net of taxes.
In addition, the reduction in net income in 2001 also resulted from derivative
and voluntary pool losses of $22.9 million and $21.5 million, respectively, net
of taxes. These decreases in 2001 were partially offset by lower after-tax
restructuring costs.
The following table reflects adjusted net (loss) income and a
reconciliation to consolidated net (loss) income. Adjusted net (loss) income
consists of segment (loss) income, federal income tax benefit (expense) on
segment (loss) income and minority interest on Capital Securities.
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- --------------------------------------------------------------------------------------------
(In millions)
Segment (loss) income before federal
income taxes and minority interest:
Risk Management $ 184.3 $ 93.5 $ 190.0
Asset Accumulation:
Allmerica Financial Services (625.0) 143.0 222.8
Allmerica Asset Management 24.4 20.7 22.5
- --------------------------------------------------------------------------------------------
(600.6) 163.7 245.3
Corporate (63.5) (63.8) (60.8)
- --------------------------------------------------------------------------------------------
Segment (loss) income before
federal income tax benefit
(expense) and minority interest (479.8) 193.4 374.5
- --------------------------------------------------------------------------------------------
Federal income tax benefit (expense)
on segment (loss) income 220.4 (12.9) (57.3)
Minority interest on Capital Securities (16.0) (16.0) (16.0)
- --------------------------------------------------------------------------------------------
Adjusted net (loss) income (275.4) 164.5 301.2
Adjustments (net of taxes and
amortization, as applicable):
Net realized investment losses (89.4) (78.8) (87.8)
Gains (losses) on derivative
instruments 26.2 (22.9) --
Gain from retirement of trust
instruments supported by
funding obligations 66.7 -- --
Additional consideration received
from sale of defined contribution
business 2.3 -- --
Sales practice litigation 1.6 5.0 --
Loss from sale of universal
life business (20.3) -- --
Restructuring costs (9.6) (1.8) (13.5)
Other reorganization costs (4.5) -- --
Loss from selected property and
casualty exited agencies, policies,
groups and programs -- (44.4) --
Voluntary pool losses -- (21.5) --
- --------------------------------------------------------------------------------------------
(Loss) income before cumulative
effect of change in accounting
principle (302.4) 0.1 199.9
Cumulative effect of change in
accounting principle (net of taxes) (3.7) (3.2) --
- --------------------------------------------------------------------------------------------
Net (loss) income $ (306.1) $ (3.1) $ 199.9
============================================================================================
22
2002 Compared to 2001
The Company's segment (loss) income before federal income taxes and minority
interest was a $479.8 million loss in 2002, compared to income of $193.4 million
in 2001. This decline is attributable to a decrease of $768.0 million from the
AFS segment, partially offset by an increase from the Risk Management segment of
$90.8 million.
The decrease in the AFS segment reflects net charges of $698.3 million
resulting from additional declines in equity market values during 2002, ratings
downgrades (see Rating Agency Actions), and the Company's decision to cease
sales of proprietary life insurance and annuity products (see Description of
Operating Segments). These charges include $629.4 million of additional
amortization of the deferred policy acquisition cost ("DAC") asset and $39.1
million due to a change in the assumptions related to the long-term cost of
guaranteed minimum death benefits ("GMDB") for variable annuity products, net of
the related DAC amortization. In addition, the Company recognized impairments of
capitalized technology costs associated with variable products totaling $29.8
million.
The increase in Risk Management segment income is primarily attributable to
an estimated benefit of approximately $80 million related to net premium rate
increases, a $27.2 million decrease in the adverse development of prior years'
reserves and a $19.7 million decrease in catastrophe losses. Additionally,
segment income increased due to approximately $17 million of decreased current
accident year non-catastrophe claims. Partially offsetting these items were
increased policy acquisition expenses of $22.8 million and lower net investment
income of $14.0 million.
The federal income tax benefit was $220.4 million for 2002, compared to an
expense of $12.9 million in 2001. This tax benefit is primarily the result of
the significant loss recognized by the AFS segment in 2002.
Net realized investment losses, after taxes and amortization, were $89.4
million during 2002, primarily due to $145.3 million of fixed maturity
impairments, net of taxes, and $35.9 million of after-tax losses related to the
termination of certain derivative instruments. These losses were partially
offset by $73.4 million of after-tax net realized gains from the sale of
approximately $3.1 billion of fixed income securities. During 2001, net realized
losses on investments, after taxes and amortization, were $78.8 million,
primarily due to after-tax realized losses from impairments of fixed maturities
of $116.4 million. These losses were partially offset by $37.5 million of
after-tax net realized gains from the sale of approximately $2.2 billion of
fixed income securities.
Gains (losses) on derivative instruments, net of taxes, increased $49.1
million to a net gain of $26.2 million in 2002 as a result of the termination of
certain derivative instruments which previously were recognized as ineffective
hedges. During 2001, the Company recognized losses on derivatives, net of taxes,
of $22.9 million. These losses primarily represent an accounting charge for
hedge ineffectiveness on certain derivatives in accordance with Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("Statement No. 133") (see Derivative Instruments).
In the fourth quarter of 2002, the Company recognized a gain on the
retirement of trust instruments supported by funding obligations of $66.7
million, net of taxes. This gain resulted from the retirement of certain
long-term funding obligations at discounts (see Significant Transactions - Gain
on Retirement of Funding Obligations).
During the third quarter of 2002, the Company received additional
consideration of $2.3 million, net of taxes, from the sale of the defined
contribution business in 2001.
The Company sold, through a 100% coinsurance agreement, the fixed universal
life insurance block of business effective December 31, 2002, which resulted in
the recognition of a $20.3 million after-tax loss (see Significant Transactions
- - Sale of Universal Life Business).
The Company recognized a benefit of $1.6 million and $5.0 million, net of
taxes, in 2002 and 2001, respectively, as a result of refining cost estimates
related to the sales practice class action lawsuit that was settled in 1998.
In the fourth quarter of 2002, the Company recognized an after-tax charge
of $9.6 million related to the restructuring of its AFS segment. This
restructuring cost consisted of severance and other employee-benefit related
expenses, as well as the cancellation of certain lease agreements and contracted
services. In addition, the Company recognized other reorganization costs of $4.5
million, net of taxes, primarily related to the forgiveness of interest on
certain loans to AFS agents. During the fourth quarter of 2001, the Company
recognized an after-tax charge of $1.8 million for severance and other employee
related costs resulting from the reorganization of its technology support group.
During the fourth quarter of 2001, the Company recognized an after-tax loss
of $44.4 million related to the exit of selected property and casualty agencies,
policies, groups, and programs. This loss primarily reflects an increase in loss
reserves for both the current and prior accident years. This resulted from a
process whereby the Company evaluated its approximately 2,500 agencies in the
Risk Management segment and identified 691 agencies that did not meet certain
profitability standards or were not strategically aligned with the Company. For
these agents, the Company either terminated the relationship or restricted the
agent's ability to offer commercial lines policies. Certain groups and specialty
programs were also discontinued (see Risk Management - Selected Property &
Casualty Exited Agencies, Policies, Groups & Programs).
Voluntary pool losses reflect the Company's participation in a reserve
deficiency of a voluntary excess and casualty rein-
23
surance pool. From 1950 to 1982, the Company voluntarily participated in this
reinsurance pool along with several other property and casualty carriers. The
pool was dissolved in 1982 and since that time has been in run-off. During the
fourth quarter of 2001, the pool obtained results from an independent actuarial
review of its current reserve position, which noted a range of reserve
deficiency, primarily as a result of adverse development of asbestos claims. As
a result of this study, the Company recognized losses, net of taxes, of $21.5
million, based on the Company's participation in the reserve deficiency.
During 2002, the Company recognized a $3.7 million loss, net of taxes, upon
adoption of Statement of Financial Accounting Standards No. 142, "Goodwill and
Other Intangible Assets." During 2001, the Company recognized a $3.2 million
loss, net of taxes, upon adoption of Statement No. 133.
2001 Compared to 2000
The Company's segment income before federal taxes and minority interest
decreased $181.1 million, or 48.4%, to $193.4 million during 2001. This decrease
is primarily attributable to a decrease in income from the Risk Management and
AFS segments of $96.5 million and $79.8 million, respectively. The decrease in
Risk Management's segment income was primarily attributable to decreased
favorable loss and loss adjustment expenses ("LAE") reserve development related
to prior years of $121.0 million and to an increase of approximately $62 million
in current accident year losses and LAE, primarily in the personal automobile,
commercial multiple peril and homeowners lines. These decreases were partially
offset by net premium rate increases of approximately $101 million. AFS' segment
income decreased $79.8 million principally due to lower asset-based fees,
primarily resulting from a decrease in the market value of assets under
management in the variable product lines, and to lower investment management
fees and brokerage income. The decrease in AFS' segment income is also
attributable to higher policy benefits and other operating expenses, partially
offset by lower deferred policy acquisition costs.
The effective tax rate for segment income was 6.7% for 2001, as compared to
15.3% in 2000. The decrease in the tax rate was primarily due to lower
underwriting income resulting in an increase in the proportion of tax-exempt
investment income and low income housing credits to pre-tax income.
Net realized losses on investments, after taxes and amortization, were
$78.8 million during 2001, primarily due to after-tax realized losses from
impairments of fixed maturities of $116.4 million. These losses were partially
offset by $37.5 million of after-tax net realized gains from the sale of
approximately $2.2 billion of fixed income securities. During 2000, net realized
losses on investments, after taxes and amortization, were $87.8 million,
primarily attributable to after-tax realized losses of $54.7 million resulting
from the sale of approximately $2.2 billion of fixed income securities. In
addition, the Company recognized $43.0 million in after-tax realized losses, due
to impairments of fixed maturities.
The Company recognized losses on derivatives, net of taxes, of $22.9
million during the fourth quarter of 2001. These losses primarily represent the
aforementioned accounting charge for hedge ineffectiveness on certain
derivatives in accordance with Statement No. 133.
During the fourth quarter of 2001, the Company recognized an after-tax loss
of $44.4 million related to the aforementioned exit of selected property and
casualty agencies, policies, groups and programs.
The Company recognized a charge, net of taxes, in the fourth quarter of
2001, of $21.5 million related to the aforementioned voluntary pool losses.
The Company recognized a benefit of $5.0 million, net of taxes, in 2001, as
a result of refining cost estimates related to the aforementioned class action
lawsuit that was settled in 1998.
In the fourth quarter of 2001, the Company recognized an after-tax charge
of $1.8 million related to severance and other employee related costs resulting
from the reorganization of its technology support group. During 2000, the
Company recognized an after-tax restructuring charge of $13.5 million. This
charge is the result of a formal company-wide restructuring plan, intended to
reduce expenses and enhance revenues. This plan consisted of various
initiatives, including a series of internal reorganizations, consolidations in
home office operations, consolidations in field offices, changes in distribution
channels and product changes.
During 2001, the Company recognized a $3.2 million loss, net of taxes, upon
adoption of Statement No. 133. This loss resulted from recognizing derivative
instruments held by the Company on January 1, 2001, at their fair values. This
adjustment represents net losses that were previously deferred in other
comprehensive income on derivative instruments that do not qualify for hedge
accounting. The Company recorded an offsetting gain in other comprehensive
income of $3.3 million, net of taxes, to recognize these derivative instruments.
SEGMENT RESULTS
The following is management's discussion and analysis of the Company's results
of operations by business segment. The segment results are presented before
taxes and minority interest and other items which management believes are not
indicative of overall operating trends, including realized gains and losses.
24
RISK MANAGEMENT
The following table summarizes the results of operations for the Risk Management
segment:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ------------------------------------------------------------------------------------------
(In millions)
Segment revenues
Net premiums written $ 2,267.3 $ 2,285.0 $ 2,153.4
- ------------------------------------------------------------------------------------------
Net premiums earned $ 2,272.0 $ 2,205.7 $ 2,066.7
Net investment income 202.0 216.0 218.4
Other income 24.7 33.1 22.6
- ------------------------------------------------------------------------------------------
Total segment revenues 2,498.7 2,454.8 2,307.7
Losses and LAE 1,683.5 1,753.1 1,563.0
Policy acquisition expenses 424.5 401.7 373.2
Other operating expenses 206.4 206.5 181.5
- ------------------------------------------------------------------------------------------
Segment income $ 184.3 $ 93.5 $ 190.0
==========================================================================================
2002 Compared to 2001
Risk Management's segment income increased $90.8 million, or 97.1%, to $184.3
million for the year ended December 31, 2002, compared to $93.5 million in 2001.
The increase in segment income is primarily attributable to an estimate of
approximately $80 million of net premium rate increases. Net premium rate
increases reflect rate actions, discretionary pricing adjustments, inflation and
changes in exposure, net of the estimated impact of loss inflation and policy
acquisition costs. In addition, development on prior years' reserves improved
$27.2 million, to $6.4 million of adverse development, for the year ended
December 31, 2002 from $33.6 million of adverse development for the year ended
December 31, 2001. The favorable change in reserve development in 2002 is
primarily the result of improving commercial lines claim frequency, partially
offset by adverse development in the personal automobile line. Net catastrophe
losses decreased $19.7 million, to $31.3 million for the year ended December 31,
2002. In addition, losses and LAE decreased during 2002 due to approximately $17
million of decreased current accident year claims frequency primarily in the
workers compensation, commercial automobile, commercial multi peril and
homeowners lines. Partially offsetting these items is a decrease in net
investment income of $14.0 million and a 2.7% decrease of policies in force
since December 31, 2001, resulting in decreased segment income of approximately
$14 million. Policy acquisition expenses increased as a result of the variable
expenses related to the aforementioned premium rate increases, primarily
commissions and premium taxes. In addition, policy acquisition expenses
increased $10.7 million as a result of higher premium tax and commission rates
during 2002. Other income decreased $8.4 million for the year ended December 31,
2002, primarily due to the decline in finance charge income as a result of the
transfer of AMGRO from the Risk Management segment to the AAM segment.
2001 Compared to 2000
Risk Management's segment income decreased $96.5 million, or 50.8%, to $93.5
million for the year ended December 31, 2001, compared to $190.0 million in
2000. The decline in segment income is primarily attributable to increased
losses and LAE resulting from a $121.0 million decrease in favorable development
on prior years' reserves. The unfavorable change in reserve development is
primarily the result of an increase in personal automobile loss frequency and
severity, and the Company having captured, in 1999 and 2000, the accumulated
benefits of its claims redesign efforts. Other operating expenses increased
during 2001 primarily due to increased technology costs and premium charge-offs.
Partially offsetting these items are an estimate of approximately $32 million of
net rate increases, primarily in commercial lines. In addition, net catastrophe
losses decreased $19.2 million, to $51.0 million for the year ended December 31,
2001. Net catastrophe losses include $10.5 million of incurred losses related to
the events of September 11, 2001. A net loss of $0.9 million and a net benefit
of $9.8 million are included in segment income in 2001 and 2000, respectively,
as a result of a whole account aggregate excess of loss reinsurance agreement
("aggregate excess of loss reinsurance treaty"), which provides coverage for the
1999 accident year.
PRODUCT LINE RESULTS
Underwriting results are reported using statutory accounting principles, which
are prescribed by state insurance regulators. The primary difference between
statutory accounting principles and GAAP is the deferral of certain underwriting
costs under GAAP that are amortized over the life of the policy. Under statutory
accounting principles, these costs are recognized when incurred or paid.
Management reviews the operations of this business based upon statutory results.
In 2002, the Company reorganized its Risk Management segment. Under the new
structure, the Risk Management segment manages its operations through two lines
of business based upon product offerings and identified as Personal Lines and
Commercial Lines. Personal Lines include personal automobile, homeowners and
other personal policies, while Commercial Lines include workers' compensation,
commercial automobile, commercial multiple peril and other commercial policies.
25
The following table summarizes the results of operations for the Risk
Management segment:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------------------------------
(In millions, except ratios)
Statutory Net Statutory Statutory Net Statutory Statutory Net Statutory
Premiums Loss Premiums Loss Premiums Loss
Written Ratio /(1)/ Written Ratio /(1)/ Written Ratio /(1)/
- -----------------------------------------------------------------------------------------------------------------------------------
Personal Lines:
Personal automobile $ 1,090.1 73.2 $ 1,031.0 73.1 $ 975.8 66.4
Homeowners 351.9 63.1 311.5 70.3 275.9 70.0
Other personal 43.3 46.7 43.9 36.4 41.9 39.9
- -----------------------------------------------------------------------------------------------------------------------------------
Total personal 1,485.3 70.1 1,386.4 71.3 1,293.6 66.3
- -----------------------------------------------------------------------------------------------------------------------------------
Commercial Lines:
Workers' compensation 152.0 64.6 194.5 77.9 214.0 80.7
Commercial automobile 197.9 59.9 246.3 71.2 231.2 74.0
Commercial multiple peril 333.8 54.7 352.2 72.0 311.5 64.5
Other commercial 99.4 57.6 103.8 48.1 99.1 34.8
- -----------------------------------------------------------------------------------------------------------------------------------
Total commercial 783.1 58.4 896.8 70.5 855.8 67.8
- -----------------------------------------------------------------------------------------------------------------------------------
Total $ 2,268.4 65.8 $ 2,283.2 71.0 $ 2,149.4 66.9
===================================================================================================================================
Statutory combined ratio /(2)/:
Personal lines 105.2 103.2 98.8
Commercial lines 99.2 111.4 109.2
Total 103.1 106.1 102.0
Statutory underwriting (loss) gain:
Personal lines $ (85.7) $ (55.2) $ 6.5
Commercial lines 15.1 (99.2) (69.8)
- -----------------------------------------------------------------------------------------------------------------------------------
Total (70.6) (154.4) (63.3)
Reconciliation to segment income:
Net investment income 202.0 216.0 218.4
Other income and expenses, net 17.4 17.8 12.1
Corporate overhead expenses(3) 28.4 26.3 23.4
Net deferred acquisition expenses 16.1 15.3 16.6
Provision for uncollectible accounts (12.9) (18.9) (8.3)
Policyholders' dividends 6.6 (0.9) (3.4)
Other Statutory to GAAP adjustments (2.7) (7.7) (5.5)
- -----------------------------------------------------------------------------------------------------------------------------------
Segment income $ 184.3 $ 93.5 $ 190.0
===================================================================================================================================
(1) Statutory loss ratio is a common industry measurement of the results of
property and casualty insurance underwriting. This ratio reflects incurred
claims compared to premiums earned. The 2001 ratios exclude the effect of agency
actions discussed in "Selected Property & Casualty Exited Agencies, Policies,
Groups & Programs" and the voluntary pool losses discussed in "Asbestos and
Environmental Reserves".
(2) Statutory combined ratio is a common industry measurement of the results of
property and casualty insurance underwriting. This ratio is the sum of the ratio
of incurred claims and claim expenses to premiums earned and the ratio of
underwriting expenses incurred to premiums written. Federal income taxes, net
investment income and other non-underwriting expenses are not reflected in the
statutory combined ratio.
(3) Statutory underwriting results include certain overhead expenses, which on a
GAAP basis are reflected in the Corporate Segment.
26
2002 Compared to 2001
PERSONAL LINES
Personal lines' net premiums written increased $98.9 million, or 7.1%, to
$1,485.3 million for the year ended December 31, 2002. This is primarily the
result of increases of $59.1 million, or 5.7%, and $40.4 million, or 13.0%, in
the personal automobile and homeowners lines, respectively. The increase in the
personal automobile line is primarily the result of 6.1%, 5.9% and 4.4% net
premium rate increases in Michigan, New York and New Jersey, respectively, since
December 31, 2001. The increase in the homeowners line resulted primarily from
net premium rate increases of 25.5% and 9.7% in Michigan and New York,
respectively. Policies in force for all personal lines decreased 1.4% since
December 31, 2001.
Personal lines' underwriting results declined $30.5 million to an
underwriting loss of $85.7 million for the year ended December 31, 2002. The
decline in underwriting results is primarily attributable to increased
underwriting expenses, principally related to the increased expenses for
mandatory assigned risk personal automobile business in New York. In addition,
underwriting expenses increased due to higher premium tax expenses and increases
in agents' contingent commissions. Underwriting results were also unfavorably
affected by increased current year claims frequency in the personal automobile
line for the year ended December 31, 2002 and by an $8.3 million increase in
adverse development during 2002 in the personal automobile line. Partially
offsetting these items is an estimate of approximately $35 million of net rate
increases. In addition, catastrophe losses decreased $6.6 million, to $25.7
million for the year ended December 31, 2002, compared to $32.3 million for the
same period in 2001.
COMMERCIAL LINES
Commercial lines' net premiums written decreased $113.7 million, or 12.7%, to
$783.1 million for the year ended December 31, 2002. This decrease is primarily
the result of the Company's termination of 377 agencies and the withdrawal of
commercial lines' underwriting capacity from an additional 314 agencies during
the fourth quarter of 2001. As a group, these agencies historically produced
unsatisfactory loss ratios. In addition, the Company has seen a reduction in
premium levels from active agents as re-underwriting efforts to target specific
classes of business and strengthen underwriting guidelines continue (see
Selected Property & Casualty Exited Agencies, Policies, Groups & Programs). As a
result of these actions, policies in force decreased 22.5%, 15.9% and 8.4% in
the commercial automobile, workers' compensation, and commercial multiple peril
lines, respectively, since December 31, 2001. Management believes the impact of
the agency actions will have a diminishing effect on policies in force, since
the agency actions are substantially complete. Partially offsetting these
decreases in policies in force were rate increases in all of the commercial
lines since December 31, 2001.
Commercial lines' underwriting results improved $114.3 million to an
underwriting gain of $15.1 million for the year ended December 31, 2002. The
improvement in underwriting results is primarily attributable to approximately
$45 million of net premium rate increases during the year ended December 31,
2002. Development on prior years' reserves improved $32.4 million to $14.3
million of favorable development for the year ended December 31, 2002 from $18.1
million of adverse development for the same period in 2001. In addition,
catastrophe losses decreased $13.1 million, to $5.6 million for the year ended
December 31, 2002, compared to $18.7 million for the same period in 2001. In
2002, underwriting results also included a net benefit, when compared to 2001,
as the result of exiting historically unprofitable business under the
aforementioned agency management actions.
2001 Compared to 2000
PERSONAL LINES
Personal lines' net premiums written increased $92.8 million, or 7.2%, to
$1,386.4 million for the year ended December 31, 2001. This is primarily the
result of increases of $55.2 million, or 5.7%, and $35.6 million, or 12.9%, in
the personal automobile and homeowners lines, respectively. The increase in the
personal automobile line is primarily the result of 3.8% and 2.9% net premium
rate increases in New York and Michigan, respectively, and an overall increase
of 4.0% in policies in force since December 31, 2000. Partially offsetting these
favorable items in the personal automobile line is a 5.4% Massachusetts net rate
reduction in 2001. The increase in the homeowners line resulted primarily from
rate increases of 16.8% in Michigan and an overall 2.1% increase in policies in
force in 2001. Net premiums written reflected ceded premiums of $3.0 million and
$10.3 million under the aforementioned aggregate excess of loss reinsurance
treaty for 2001 and 2000, respectively.
Personal lines' underwriting results decreased $61.7 million to an
underwriting loss of $55.2 million for the year ended December 31, 2001. The
decline in underwriting results is primarily the result of a decrease in
favorable development on prior years' reserves of $74.2 million, to $13.6
million of adverse development for the year ended December
27
31, 2001, from $60.6 million of favorable development for the same period in
2000. The unfavorable trend in reserve development is primarily the result of an
increase in personal automobile loss frequency and severity. Partially
offsetting the unfavorable effect of prior years' reserve development was a
decrease in catastrophe losses of $16.7 million, to $32.3 million for the year
ended December 31, 2001, compared to $49 million for the same period in 2000.
Net benefits of $1.6 million and $5.7 million are included in underwriting
results relating to the aforementioned aggregate excess of loss reinsurance
treaty in 2001 and 2000, respectively.
COMMERCIAL LINES
Commercial lines' net premiums written increased $41.0 million, or 4.8%, to
$896.8 million for the year ended December 31, 2001. This is primarily the
result of increases of $40.7 million, or 13.1% and $15.1 million, or 6.5%, in
the commercial multiple peril and the commercial automobile lines, respectively.
The increase in the commercial multiple peril line is primarily the result of
rate increases of 12.3% and 8.8% in Michigan and New York, respectively. In
addition, the commercial automobile line experienced rate increases of 6.4%,
7.6% and 16.5% in Michigan, Massachusetts, and New York, respectively, since
December 31, 2000. Net premiums written reflected ceded premiums of $4.4 million
and $14.7 million under the aforementioned aggregate excess of loss reinsurance
treaty in 2001 and 2000.
Commercial lines' underwriting results deteriorated $29.4 million to an
underwriting loss of $99.2 million for the year ended December 31, 2001. The
decrease in underwriting results is primarily attributable to a deterioration of
development on prior years' reserves of $44.9 million, to $18.1 million of
adverse development for the year ended December 31, 2001, from $26.8 million of
favorable development for the same period in 2000. The decline in underwriting
results is also attributable to an increase in policy acquisition and other
underwriting expenses since December 31, 2000 primarily related to an absence of
ceding commission income from specialty market business that has not been
renewed. Partially offsetting these items was a decrease in catastrophe losses
of $2.5 million, to $18.7 million for the year ended December 31, 2001, compared
to $21.2 million for the same period in 2000. Also, net premium rates increased
by approximately $20 million during the year ended December 31, 2001. Net
benefits of $2.2 million and $8.2 million are included in underwriting results
relating to the aforementioned aggregate excess of loss reinsurance treaty in
2001 and 2000, respectively.
INVESTMENT RESULTS
Net investment income before tax was $202.0 million, $216.0 million and $218.4
million for the years ended December 31, 2002, 2001 and 2000, respectively. The
decrease in net investment income in 2002, compared to 2001, primarily reflects
a reduction in average pre-tax yields on fixed securities. The decrease in net
investment income also reflects a reduction in average invested assets as a
result of a $92.1 million dividend from the property and casualty companies to
the holding company and the transfer of $55.5 million to fund the property and
casualty companies' portion of the additional minimum pension liability recorded
by AFC at December 31, 2001 pursuant to the cost allocation policy under the
Company's Consolidated Service Agreement. In addition, net investment income
decreased due to the impact of defaults on certain high yield fixed maturities.
Average pre-tax yields on fixed maturities decreased to 6.4% in 2002, compared
to 6.9% in 2001, due to the lower prevailing fixed maturity investment rates
since first quarter of 2001. Management expects its investment results to be
negatively affected by lower prevailing fixed maturity investment rates in 2003,
defaults in the fixed maturities portfolio and by the transfer of $76.0 million
to fund the property and casualty companies' portion of the additional minimum
pension liability recorded by AFC at December 31, 2002.
The decrease in net investment income in 2001, compared to 2000, primarily
reflects the impact of fixed maturities that defaulted and a reduction in
average invested assets, partially offset by an increase in average pre-tax
yields on fixed maturities. Average invested assets decreased $23.7 million, or
0.7%, to $3,378.1 million in 2001, compared to $3,401.8 million in 2000. Average
pre-tax yields on fixed maturities increased to 6.9% in 2001, compared to 6.8%
in 2000, due to the shift in investment strategy providing for investments in
taxable securities instead of tax exempt securities, to maximize after-tax
investment yields.
RESERVE FOR LOSSES AND LOSS
ADJUSTMENT EXPENSES
OVERVIEW OF LOSS RESERVE ESTIMATION PROCESS
The Risk Management segment maintains reserves for its property and casualty
products to provide for the Company's ultimate liability for losses and loss
adjustment expenses with respect to reported and unreported claims incurred as
of the end of each accounting period. These reserves are estimates, involving
actuarial projections at a given point in time, of what management expects the
ultimate settlement and administration of claims will cost based on facts and
circumstances then known, estimates of future trends in claim severity and
frequency, judicial theories of liability and policy coverage, and other
factors.
28
The amount of loss and LAE reserves is determined based on an estimation
process that is very complex and uses information obtained from both company
specific and industry data, as well as general economic information. The
estimation process is judgmental, and requires the Company to continuously
monitor and evaluate the life cycle of claims on type-of-business and
nature-of-claim bases. Using data obtained from this monitoring and assumptions
about emerging trends, the Company develops information about the size of
ultimate claims based on its historical experience and other available market
information. The most significant assumptions, which vary by line of business,
used in the estimation process include determining the trend in loss costs, the
expected consistency in the frequency and severity of claims incurred but not
yet reported to prior year claims, changes in the timing of the reporting of
losses from the loss date to the notification date, and expected costs to settle
unpaid claims. Because the amount of the loss and LAE reserves are sensitive to
the Company's assumptions, the Company does not completely rely on only one
estimate to determine its loss and LAE reserves. Rather, the Company develops
several estimates using generally recognized actuarial projection methodologies
that result in a range of possible loss and LAE reserve outcomes; the Company's
best estimate is within that range. Because certain projection methodologies may
not result in a reasonable reserve estimate for a particular line of business
due to certain underlying data assumptions, the Company may determine that the
low or high end range estimate calculated by the method does not represent a
reasonable estimate. When trends emerge that the Company believes affect the
future settlement of claims, the Company will adjust its reserves accordingly.
MANAGEMENT'S REVIEW OF JUDGEMENTS AND KEY ASSUMPTIONS
The inherent uncertainty of estimating insurance reserves is greater for certain
types of property and casualty insurance lines, particularly workers'
compensation and other liability lines, where a longer period of time may elapse
before a definitive determination of ultimate liability may be made, and where
the technological, judicial and political climates involving these types of
claims are changing. The Company has maintained a historical practice to
significantly limit the issuance of certain long-tailed other liability
policies, including directors and officers ("D&O") liability, errors and
omissions ("E&O") liability and medical malpractice liability, in which the
industry has experienced recent adverse loss trends.
The Company regularly updates its reserve estimates as new information
becomes available and further events occur which may impact the resolution of
unsettled claims. Reserve adjustments are reflected in results of operations as
adjustments to losses and LAE. Often these adjustments are recognized in periods
subsequent to the period in which the underlying loss event occurred. These
types of subsequent adjustments are described as "prior year reserve
development". Such development can be either favorable or unfavorable on the
financial results of the Company.
Inflation generally increases the cost of losses covered by insurance
contracts. The effect of inflation on the Company varies by product. Property
and casualty insurance premiums are established before the amount of losses and
LAE, and the extent to which inflation may affect such expenses are known.
Consequently, the Company attempts, in establishing rates and reserves, to
anticipate the potential impact of inflation in the projection of ultimate
costs. Recently, the Company has experienced increasing medical costs associated
with personal automobile personal injury protection claims. This increase is
reflected in the Company's reserve estimates, but continued increases could
contribute to increased losses and LAE in the future.
The Company regularly reviews its reserving techniques, its overall
reserving position and its reinsurance. Based on (i) review of historical data,
legislative enactments, judicial decisions, legal developments in impositions of
damages and policy coverage, political attitudes and trends in general economic
conditions, (ii) review of per claim information, (iii) historical loss
experience of the Company and the industry, (iv) the relatively short-term
nature of most policies and (v) internal estimates of required reserves,
management believes that adequate provision has been made for loss reserves.
However, establishment of appropriate reserves is an inherently uncertain
process and there can be no certainty that current established reserves will
prove adequate in light of subsequent actual experience. A significant change to
the estimated reserves could have a material impact on the results of
operations.
LOSS RESERVES BY LINE OF BUSINESS
The Company performs actuarial reviews on certain detailed line of business
coverages. These individual estimates are summarized into six broader lines of
business, personal automobile, homeowners, workers' compensation, commercial
automobile, commercial multiple peril, and other lines.
29
The table below provides a reconciliation of the beginning and ending
reserve for unpaid losses and LAE as follows:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ------------------------------------------------------------------------------------------
(In millions)
Reserve for losses and LAE,
beginning of year $ 2,921.5 $ 2,719.1 $ 2,618.7
Incurred losses and LAE, net of
reinsurance recoverable:
Provision for insured events
of current year 1,682.1 1,708.3 1,634.9
Increase (decrease) in
provision for insured
events of prior years /(1)/ 6.4 107.4 (87.4)
Losses related to selected
property & casualty exited
agencies, policies, groups
& programs for current year -- 12.1 --
- ------------------------------------------------------------------------------------------
Total incurred losses and LAE 1,688.5 1,827.8 1,547.5
- ------------------------------------------------------------------------------------------
Payments, net of reinsurance
recoverable:
Losses and LAE attributable to
insured events of current year 898.0 892.8 870.2
Losses and LAE attributable to
insured events of prior years 763.6 780.3 703.8
- ------------------------------------------------------------------------------------------
Total payments 1,661.6 1,673.1 1,574.0
- ------------------------------------------------------------------------------------------
Change in reinsurance
recoverable on unpaid losses 13.3 47.7 126.9
- ------------------------------------------------------------------------------------------
Reserve for losses and LAE,
end of year $ 2,961.7 $ 2,921.5 $ 2,719.1
==========================================================================================
(1) The increase in provision for insured events of prior years in 2001 includes
$40.8 million of losses related to selected property and casualty exited
agencies, policies, groups and programs and $33.0 million of losses related to
voluntary pool claims.
As part of an ongoing process, the reserves have been re-estimated for all prior
accident years and were increased by $6.4 million and $107.4 million in 2002 and
2001, respectively, and decreased by $87.4 million in 2000.
The table below summarizes the reserve for losses and LAE by line of
business.
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ------------------------------------------------------------------------------------------
(In millions)
Personal Automobile $ 1,018.5 $ 937.3 $ 896.4
Homeowners and other 246.3 263.3 201.1
- ------------------------------------------------------------------------------------------
Total Personal 1,264.8 1,200.6 1,097.5
Workers' Compensation 637.7 675.7 654.6
Commercial Automobile 327.4 355.1 316.0
Commercial Multiple Peril 566.3 591.3 526.1
Other Commercial 165.5 98.8 124.9
- ------------------------------------------------------------------------------------------
Total Commercial 1,696.9 1,720.9 1,621.6
- ------------------------------------------------------------------------------------------
Total reserve for losses and LAE $ 2,961.7 $ 2,921.5 $ 2,719.1
==========================================================================================
PRIOR YEAR DEVELOPMENT BY LINE OF BUSINESS
When trends emerge that the Company believes affect the future settlement of
claims, the Company will adjust its reserves accordingly. Reserve adjustments
are reflected in the Consolidated Statements of Income as adjustments to losses
and loss adjustment expenses. Often, these adjustments are recognized in periods
subsequent to the period in which the underlying loss event occurred. These
types of subsequent adjustments are disclosed and discussed separately as "prior
year reserve development". Such development can be either favorable or
unfavorable to the financial results of the Company.
The table below summarizes the change in provision for insured events of
prior years by line of business.
2002 2001 2000
- --------------------------------------------------------------------------------------------
(In millions)
Increase (decrease) in loss provision
for insured events of prior years:
Personal Automobile $ 22.4 $ 33.7 $ (22.0)
Homeowners and other 6.5 10.2 0.5
- --------------------------------------------------------------------------------------------
Total Personal 28.9 43.9 (21.5)
- --------------------------------------------------------------------------------------------
Workers' Compensation (5.5) 6.6 2.6
Commercial Automobile (1.0) 20.6 (4.0)
Commercial Multiple Peril 0.5 29.0 2.2
Other Commercial 14.0 46.5 (5.2)
- --------------------------------------------------------------------------------------------
Total Commercial 8.0 102.7 (4.4)
- --------------------------------------------------------------------------------------------
Increase (decrease) in loss provision
for insured events of prior years 36.9 146.6 (25.9)
Decrease in LAE provision for insured
events of prior years (30.5) (39.2) (61.5)
- --------------------------------------------------------------------------------------------
Increase (decrease) in total loss and
LAE provision for insured events
of prior years $ 6.4 $ 107.4 $ (87.4)
============================================================================================
During the year ended December 31, 2002 and 2001, estimated loss reserves for
claims occurring in prior years developed unfavorably by $36.9 million and
$146.6 million, respectively. During the year ended December 31, 2000, estimated
loss reserves for claims occurring in prior years developed favorably by $25.9
million. The adverse development in both 2002 and 2001, is primarily the result
of increased claim severity related to personal automobile medical settlements
for Citizens. Since these settlements have risen beyond previous estimates,
reserve increases have been recognized in the period in which the information is
obtained. The increase in the prior year reserve estimates for other commercial
lines during 2002 is primarily due to the recognition of approximately $5
million in additional reserves for asbestos claims in the Excess and Casualty
Reinsurance Association ("ECRA") voluntary pool.
30
In addition, the Company experienced adverse development in 2001 as a
result of the $40.8 million reserve increase on prior years resulting from the
agency management actions discussed in "Selected Property & Casualty Exited
Agencies, Policies, Groups & Programs". This reserve increase affected primarily
the commercial multiple peril, personal automobile, commercial automobile and
workers' compensation lines. Additionally, other commercial lines' prior year
reserves developed adversely due to a $33.0 million reserve increase in the ECRA
voluntary pool. Personal automobile prior year reserves developed adversely due
to the aforementioned increased claim severity related to medical settlements
for Citizens. In addition to the effect from the agency management actions, the
commercial automobile and commercial multiple peril lines experienced adverse
development. The increased reserves in these lines is primarily attributable to
increased claim payments in the 2000 and 1999 accident years. As these payments
have increased above historical amounts, actuarial projections of future
settlements have increased the estimated ultimate reserves on prior years.
During 2000, the favorable loss development is primarily the result of a
decrease in prior year reserves in the personal automobile line. The Company
began to experience an improvement in the Northeast in the personal automobile
line as claim payment severity began to decrease in accident years 1999 and
1998. As the certainty of the improvement in claim payment severity for accident
years 1999 and 1998 increased, ultimate losses for those accident years were
reduced and favorable development was recorded during calendar year 2000.
During the years ended December 31, 2002, 2001 and 2000, estimated LAE
reserves for claims occurring in prior years developed favorably by $30.5
million, $39.2 million and $61.5 million, respectively. The favorable
development in all the periods is primarily attributable to claims process
improvement initiatives taken by the Company during the 1997 to 2001 calendar
year period. Since 1997, the Company has lowered claim settlement costs through
increased utilization of in-house attorneys and consolidation of claim offices.
As actual experience begins to establish certain trends inherent within the
claim settlement process, the actuarial process recognizes these trends within
the reserving methodology impacting future claim settlement assumptions. As
these measures improved average settlement costs, the actuarial estimate of
future settlement costs are reduced and favorable development is recorded. These
measures are complete.
Reserves established for current year losses and LAE in 2002 and 2001
consider the factors that resulted in the favorable development of prior years'
loss and LAE reserves during 2000 and earlier years. Accordingly, current year
reserves are modestly lower, relative to those initially established for similar
exposures in years prior to 2001.
ASBESTOS AND ENVIRONMENTAL RESERVES
Although the Company does not specifically underwrite policies that include
asbestos, environmental damage and toxic tort liability, the Company may be
required to defend such claims. The table below summarizes direct business
asbestos and environmental reserves (net of reinsurance and excluding pools):
2002 2001 2000
- ---------------------------------------------------------------------------------------------------------------------------------
(In millions)
Environ- Environ- Environ-
Asbestos mental Total Asbestos mental Total Asbestos mental Total
- ---------------------------------------------------------------------------------------------------------------------------------
Beginning reserves $ 10.1 $ 16.6 $ 26.7 $ 11.0 $ 14.5 $ 25.5 $ 10.2 $ 24.5 $ 34.7
Incurred losses & LAE 4.8 (5.6) (0.8) (0.4) 4.6 4.2 1.4 (0.7) 0.7
Paid losses & LAE 2.3 (2.0) 0.3 0.5 2.5 3.0 0.6 9.4 10.0
- ---------------------------------------------------------------------------------------------------------------------------------
Ending reserves $ 12.6 $ 13.0 $ 25.6 $ 10.1 $ 16.6 $ 26.7 $ 11.0 $ 14.4 $ 25.4
=================================================================================================================================
31
Ending loss and LAE reserves for all direct business written by its property and
casualty companies related to asbestos, environmental damage and toxic tort
liability, included in the reserve for losses and LAE, were $25.6 million, $26.7
million and $25.4 million, net of reinsurance of $16.0 million, $13.0 million
and $15.9 million in 2002, 2001 and 2000, respectively. The outstanding reserves
for direct business asbestos and environmental damage have remained relatively
consistent for the three-year period ended December 31, 2002. As a result of the
Company's historical direct underwriting mix of commercial lines policies toward
smaller and middle market risks, past asbestos, environmental damage and toxic
tort liability loss experience has remained minimal in relation to the Company's
total loss and LAE incurred experience. The Company estimates its ultimate
liability for these claims based upon currently known facts, reasonable
assumptions where the facts are not known, current law and methodologies
currently available. Although these outstanding claims are not significant,
their existence gives rise to uncertainty and are discussed because of the
possibility that they may become significant. The Company believes that,
notwithstanding the evolution of case law expanding liability in asbestos and
environmental claims, recorded reserves related to these claims are adequate. In
addition, the Company is not aware of any litigation or pending claims that are
expected to result in additional material liabilities in excess of recorded
reserves. The environmental liability could be revised in the near term if the
estimates used in determining the liability are revised.
In addition, the Company has established loss and LAE reserves for assumed
reinsurance and pool business with asbestos, environmental damage and toxic tort
liability of $45.2 million, $39.3 million, and $10.6 million in 2002, 2001 and
2000, respectively. These reserves relate to pools in which the Company has
terminated its participation; however, the Company continues to be subject to
claims related to years in which it was a participant. The Company was a
participant in ECRA from 1950 to 1982. In 1982, the pool was dissolved and since
that time the business has been in runoff. The Company's participation in this
pool has resulted in average paid losses of $2.3 million annually over the past
ten years. During 2001, the pool commissioned an independent actuarial review of
its then current reserve position, which noted a range of reserve deficiency
primarily as a result of adverse development of asbestos claims. As a result of
this study, the Company recorded an additional $33.0 million of losses in the
fourth quarter of 2001. This reserving action has been presented as a separate
line item in the Consolidated Statements of Income and has been excluded from
adjusted net income due to management's belief that this item is not indicative
of overall operating trends. Because of the inherent uncertainty regarding the
types of claims in these pools, there can be no assurance that these reserves
will be sufficient. During 2002, the Company recorded an additional $5.0 million
of loss reserves related to ECRA.
SELECTED PROPERTY & CASUALTY EXITED AGENCIES,
POLICIES, GROUPS & PROGRAMS
During the fourth quarter of 2001, the Company completed an extensive review of
its agency relationships which resulted in the termination of 377 agencies and
the withdrawal of commercial lines' underwriting authority from an additional
314 agencies. These actions affected approximately 27% of approximately 2,500
active agencies representing the Company in 2001. These agencies had
consistently produced unsatisfactory loss ratios. In addition, the Company
terminated virtually all of its specialty commercial programs and discontinued a
number of special marketing arrangements. The total earned premium associated
with the exited business was $164.6 million and $252.9 million in 2002 and 2001,
respectively, and is estimated to be approximately $82 million in 2003. The
Company is contractually or under statutory regulations obligated to renew
policies with certain agents that will continue to be in runoff in 2003. The
estimated future premium deficiency on these policies is $7.2 million and this
loss was recorded during 2001. In connection with these actions, the Company
performed an actuarial review of outstanding reserves with segregated loss
history on the exited business. Based on this review, an increase to reserves of
$52.9 million was recorded in the fourth quarter of 2001. This increase includes
$12.1 million of adverse development in the current year and $40.8 million of
adverse development on prior year reserves, which is net of a $5.9 million
benefit from the aforementioned aggregate excess of loss reinsurance treaty.
Under the aggregate excess of loss reinsurance treaty, the Company recognized a
net benefit of $1.1 million, including the aforementioned $5.9 million benefit
related to prior year reserves. In addition, as a result of projected future
losses on the exited business, the Company recorded an impairment to the DAC
asset of $3.4 million. This resulted in an increase in policy acquisition
expenses and a decrease in the Company's DAC asset balance as of December 31,
2001. The total charge of $68.3 million has been presented as a separate line
item in the Consolidated Statements of Income and has been excluded from
adjusted net income due to management's belief that this item is not indicative
of overall operating trends. Actual future losses from the exited business may
vary from the Company's estimate.
32
REINSURANCE
The Risk Management segment maintains a reinsurance program designed to protect
against large or unusual losses and allocated LAE activity. This includes excess
of loss reinsurance and catastrophe reinsurance. The Company determines the
appropriate amount of reinsurance based on the Company's evaluation of the risks
accepted and analyses prepared by consultants and reinsurers and on market
conditions including the availability and pricing of reinsurance. Reinsurance
contracts do not relieve the Company from its obligations to policyholders.
Failure of reinsurers to honor their obligations could result in losses to the
Company. The Company believes that the terms of its reinsurance contracts are
consistent with industry practice in that they contain standard terms with
respect to lines of business covered, limit and retention, arbitration and
occurrence. Based on its review of its reinsurers' financial statements and
reputations in the reinsurance marketplace, the Company believes that its
reinsurers are financially sound.
Catastrophe reinsurance serves to protect the ceding insurer from
significant losses arising from a single event such as windstorm, hail,
hurricane, tornado, riot or other extraordinary events. Under the Company's
catastrophe reinsurance agreements, the Company ceded $1.1 million of losses in
2002 as the result of deterioration in the 2001 accident year and $20.3 million
of losses in 2001.
The Company, in 1999, entered into a whole account aggregate excess of loss
reinsurance agreement, which provides coverage for accident year 1999 for the
Company's property and casualty business. The program covered losses and
allocated LAE, including those incurred but not yet reported, in excess of a
specified whole account loss and allocated LAE ratio. The coverage limit for
losses and allocated LAE is $150.0 million. The effect of this agreement on
results of operations in each reporting period is based on losses and allocated
LAE ceded, reduced by a sliding scale premium of 50-67.5% depending on the size
of the loss, and increased by a ceding commission of 20% of ceded premium. In
addition, net investment income is reduced for amounts credited to the
reinsurer. As a result of this agreement, the Company recognized a net expense
of $3.9 million for the year ended December 31, 2002 and net benefits of $0.2
million and $9.8 million for the years ended December 31, 2001 and 2000,
respectively, based on estimates of losses and allocated LAE for accident year
1999. The 2001 impact from this treaty includes a $1.1 million net benefit
related to the aforementioned exit of selected property and casualty agencies,
policies, groups and programs. The effect of this agreement on the results of
operations in future periods is not currently determinable, as it will be based
both on future losses and allocated LAE for accident year 1999.
The Company, in the Risk Management segment, is subject to concentration of
risk with respect to reinsurance ceded to various residual market mechanisms. As
a condition to the ability to conduct certain business in various states, the
Company is required to participate in various residual market mechanisms and
pooling arrangements which provide various insurance coverage to individuals or
other entities that are otherwise unable to purchase such coverage. These market
mechanisms and pooling arrangements include the Massachusetts Commonwealth
Automobile Reinsurers and the Michigan Catastrophic Claims Association.
ASSET ACCUMULATION
ALLMERICA FINANCIAL SERVICES
Prior to September 30, 2002, the Allmerica Financial Services segment
manufactured and sold variable annuities, variable universal life and
traditional life insurance products, as well as certain group retirement
products. On September 27, 2002, the Company announced plans to consider
strategic alternatives, including a significant reduction of sales of
proprietary variable annuities and variable life insurance products. This
resulted from the effect of the significant, persistent decline in the equity
market, culminating in the third quarter of 2002, that followed the decline in
the second quarter, as well as the ratings downgrades (see Rating Agency
Actions). Subsequently, the Company ceased all new sales of proprietary variable
annuities and life insurance products (see Description of Operating Segments).
As a result of the changes with AFS, the factors that affect this segment's
results of operations after September 27, 2002 are substantially different from
those in effect prior to that date. The substantial changes in DAC and other
assumptions resulting from the segment's change in operations are reflected in
the results for the year, discussed in subsequent paragraphs. In addition, the
fourth quarter 2002 results of operations are substantially different from
results achieved by this segment in the past, and, in fact, the Company believes
these results are more indicative of results of operations to be expected in the
near term; therefore, a separate discussion of the last three months of the year
is included immediately following the year over year discussion below.
33
The following table summarizes the results of operations for the Allmerica
Financial Services segment.
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- --------------------------------------------------------------------------------
(In millions)
Segment revenues
Premiums $ 48.1 $ 49.0 $ 52.1
Fees:
Fees from surrenders 61.9 31.6 35.3
Other proprietary product fees 347.9 360.0 385.8
Net investment income 283.9 288.9 283.6
Brokerage and investment
management income/(1)/ 79.8 73.8 88.2
Other income 33.1 23.2 22.2
- --------------------------------------------------------------------------------
Total segment revenues 854.7 826.5 867.2
- --------------------------------------------------------------------------------
Policy benefits, claims and losses 501.6 346.8 315.1
Policy acquisition costs 674.1 77.8 88.7
Brokerage and investment
management variable expenses/(1)/ 49.8 41.8 47.7
Other operating expenses 254.2 217.1 192.9
- --------------------------------------------------------------------------------
Segment (loss) income $ (625.0) $ 143.0 $ 222.8
================================================================================
(1) Brokerage and investment management income primarily reflects fees earned
from the distribution and management of non-proprietary insurance and investment
products. Variable expenses related to this business primarily consist of
commissions.
2002 Compared to 2001
Segment results deteriorated $768.0 million, to a loss of $625.0 million during
2002. This loss reflects net charges of $698.3 million resulting from the effect
of the significant, persistent decline in equity market values during the most
recent three years, culminating in the third quarter, as well as ratings
downgrades (see Rating Agency Actions), and the Company's decision to cease new
sales of proprietary life insurance and annuity products. These charges include
$629.4 million of additional amortization of the DAC asset, a change in the
assumptions related to the long-term cost of GMDB for variable annuity products
resulting in a reserve increase of $106.7 million, partially offset by a
reduction in DAC amortization of $67.6 million, and the recognition of
impairments of capitalized technology costs associated with variable products
totaling $29.8 million.
The following table summarizes the aforementioned charges and benefits for
2002. Each is explained in subsequent paragraphs.
(In millions)
Additional DAC Amortization:
Revision of surrender rate assumptions $ 171.1
Equity market depreciation 202.8
Revision of market-related appreciation assumptions 43.3
Revision of GMDB long-term cost assumptions 61.7
Revision of future fees assumption (8.5)
Impairment of DAC asset 159.0
- -------------------------------------------------------------------
629.4
- -------------------------------------------------------------------
GMDB:
Revision of long-term cost assumptions 106.7
Reduction of DAC amortization (67.6)
- -------------------------------------------------------------------
39.1
- -------------------------------------------------------------------
Impairment of capitalized technology costs 29.8
- -------------------------------------------------------------------
Total $ 698.3
===================================================================
DEFERRED ACQUISITION COSTS
As discussed further in "Critical Accounting Policies", DAC for variable life
products and variable annuities consists of commissions, underwriting costs and
other costs which are amortized in proportion to the total gross profits that
the Company estimates will be earned over the expected life of the insurance
contracts to which such costs relate. To estimate the profitability of its
insurance contracts, the Company establishes and applies certain assumptions
relating to, among other matters, appreciation of account assets, contract
persistency and contract costs (such as those relating to any GMDB feature and
fees payable to distributors). The Company regularly evaluates these assumptions
to determine whether recent experience or anticipated trends merit adjustments
to such assumptions.
The substantial and sustained decline in the equity market, culminating in
the third quarter, precipitated a number of significant events which caused the
Company to incur large increases in DAC amortization. These included, in large
part, substantial ratings downgrades, which contributed to the Company's
decision to cease new sales of proprietary variable annuity and life products.
The Company believes that this business decision will adversely affect the
profitability of its existing policies and contracts by significantly decreasing
the persistency of customer accounts. Decreased persistency also will increase
the cost of the GMDB feature of variable annuity contracts, further reducing
profitability. This results from a reduction of revenues in future periods due
to a decline in average invested assets, whereby the revenues will not be
sufficient to offset GMDB claims in the near term. In addition, the 2002 market
decline resulted in significant differences in actual account value investment
returns
34
from those assumed. This required the Company to substantially increase the
level of DAC amortization and GMDB expense under existing assumptions and to
reassess the appropriate long-term assumptions on account appreciation and GMDB
cost. As a result, the Company revised downward its assumptions regarding future
account appreciation and increased its expectations regarding the long-term cost
of the GMDB feature. Finally, the Company's evaluation of the compounding
effects of the market decline and AFS business model changes on the anticipated
profitability of its distribution channels caused the Company to determine that
there had been a permanent impairment of the remaining DAC asset related to its
former Partners distribution channel (see Statutory Premiums and Deposits for a
description of the former distribution channels). Each of these increased costs
and changed assumptions are discussed further below.
The aforementioned $629.4 million of additional DAC amortization consists
of six separate items. First, the Company anticipates that the ratings
downgrades (see Rating Agency Actions) and the Company's decision to cease new
sales of proprietary life insurance and annuity products will unfavorably affect
the persistency of the existing customer accounts, as customers seek to transfer
their accounts to companies who are active in the marketplace and have higher
ratings. This reduces expected future profits, resulting in $171.1 million of
additional DAC amortization.
Second, significant declines in equity market values resulted in additional
amortization of $202.8 million in 2002. This resulted from application of the
Company's reversion-to-the-mean accounting methodology. The Company considers
the recent declines to be suggestive of a permanent, partial reduction in future
profitability.
Third, as of September 30, 2002, the Company reviewed and reset its
assumptions regarding future market-related appreciation of separate account
assets and its application of the reversion-to-the-mean accounting methodology.
In view of the additional market declines in the third quarter, as well as the
reduced time horizon resulting from the revised persistency expectations, the
Company reduced its expected rate of annual appreciation to 8% (2% per quarter),
starting with September 30, 2002 asset levels. This reduces expected future
profits, resulting in $43.3 million of additional DAC amortization.
Fourth, the Company increased its assumptions related to the long-term cost
of GMDB for variable annuity products as of September 30, 2002 (see the
discussion of the GMDB reserve below). The increased cost estimates affected the
Company's expectation of future gross profits, resulting in additional DAC
amortization of $61.7 million in 2002.
Fifth, the Company changed its estimate of future fees from certain annuity
products in the second quarter of 2002. This decreased DAC amortization by $8.5
million in that quarter.
Finally, the Company recognized additional amortization of $159.0 million
related to its Partners distribution channel (see Statutory Premiums and
Deposits for a description of the former distribution channels). After reviewing
all assumptions affecting future profits assumed in its DAC methodology,
including the effect of the aforementioned adjustments, the Company determined
that the remaining DAC asset related to Partners exceeded the present value of
total expected gross profits by $159.0 million as of September 30, 2002.
Accordingly, the Company recognized a permanent impairment to its DAC asset of
this amount. It should be noted that a permanent impairment is not required for
the other distribution channels because of their higher expected profitability.
Relative to the other distribution channels, Partners has the highest GMDB costs
and the lowest fees from its underlying mutual funds.
After September 30, 2002, the Company expects that DAC amortization will
be, in general, higher than historical levels as a percentage of gross profits.
This is due to lower future gross profits, because of poorer persistency, lower
expected market-related appreciation and higher expected GMDB costs. In the
fourth quarter of 2002, the Company experienced higher DAC amortization than in
prior periods. The Company expects a similar level of amortization as a
percentage of gross profits in 2003. However, as a result of resetting the
long-term assumption for market-related appreciation and applying the
reversion-to-the-mean accounting methodology, the Company believes that DAC
amortization will be less sensitive to short-term market movements than in the
first nine months of 2002. The Company is exposed to further impairments to the
DAC asset if actual experience is worse than the current assumptions. In
particular, the Select DAC asset would be subject to impairment should actual
gross profits be moderately less than anticipated. Impairments would increase
DAC amortization in the period that they are recognized.
GUARANTEED MINIMUM DEATH BENEFITS
As noted above, as of September 30, 2002, the Company increased its assumptions
related to the long-term cost of GMDB for variable annuity products. The GMDB
feature provides annuity contract holders with a guarantee that the benefit
received at death will be no less than a prescribed minimum amount. This minimum
amount is based on the net deposits paid into the contract, the net deposits
accumulated at a specified rate, the highest historical account value on a
contract anniversary, or more typically the greatest of these values. To the
extent that the GMDB is higher than the current account value at the time of
death, the Company incurs
35
a cost. As of December 31, 2002, the difference between the GMDB and the current
account value (the "net amount at risk") for all existing contracts was
approximately $4.6 billion. For each one percent change, either increase or
decrease from December 31, 2002 levels in the S&P 500 Index, the net amount at
risk is estimated to increase or decrease by approximately $50 million to $70
million. This amount will gradually decline as surrenders also reduce the net
amount at risk.
To estimate the cost of the GMDB feature with respect to the profitability
of the related insurance contract, the Company establishes and applies certain
assumptions relating to the appreciation of related account assets, mortality
and contract persistency, among other matters. The Company regularly evaluates
these assumptions to determine whether recent experience or anticipated trends
merit adjustments to such assumptions. The compounding effects of the
significant third quarter market decline, the ratings downgrades, increased
annuity surrenders and related AFS strategic business changes resulted in
significantly decreased account values and persistency assumptions which
required the Company to reassess, and increase, its assumptions related to the
long-term cost of GMDB.
The Company has had a consistent policy of providing reserves for GMDB
based on its best estimate of the long-term cost of GMDB. As of September 30,
2002, the Company reassessed its expectation of the long-term cost of GMDB in
view of the current net amount at risk and the revised persistency expectations,
as well as the absence of additional deposits at current market levels. This
resulted in revised expectations for the long-term cost of GMDB. The Company
calculated a reserve at September 30, 2002 of $106.7 million, and recognized
this amount in policy benefits. This was partially offset by a reduction in DAC
amortization of $67.6 million. It should be noted that in addition to the
reserve increase, policy benefits during 2002 include $77.1 million of
additional GMDB expense, versus $22.0 million in the prior year. These amounts
were partially offset by reduced DAC amortization of $38.2 million and $10.0
million, respectively.
Based on account values as of December 31, 2002, the estimated annual GMDB
expense would be approximately $45 million. In the near term, cash costs will
likely exceed the annual expense, thereby reducing the reserve. Expected
appreciation in asset levels would gradually reduce, and eventually reverse,
this difference over time. There can be no assurance that the existing reserve
will be sufficient, or that the Company's estimate of long-term GMDB costs is
accurate or sufficient. Future changes in market levels, persistency of existing
accounts, mortality and other factors may result in material changes to GMDB
costs and related expenses.
TECHNOLOGY COSTS
The Company also recognized $29.8 million of asset impairments related to
technology used in its variable annuity and variable universal life business,
reflected in other operating expenses. Of this amount, $29.1 million relates to
capitalized software development costs. The remaining $0.7 million relates to
technology hardware. During the past five years, the Company has incurred costs
to develop technology platforms for its variable products. This includes the
technology used to underwrite, issue and maintain customer accounts,
incorporating disparate and complex product attributes. As a result of the
ratings downgrades (see Rating Agency Actions), and the Company's decision to
cease new sales of proprietary life insurance and annuity products, the Company
determined that expected future cash flows do not support continued
capitalization of the entire cost of the technology assets. Accordingly, the
Company recognized the aforementioned permanent impairment in other operating
expenses.
FEES
During 2002, fees from surrenders increased $30.3 million, or 95.9%, to $61.9
million as a result of increased annuity surrenders, primarily in the fourth
quarter as a result of the ratings downgrades. This increase was partially
offset by a $12.1 million decline in all other fees related to the proprietary
products,primarily resulting from lower average invested assets.
2001 Compared to 2000
Segment income decreased $79.8 million, or 35.8%, to $143.0 million in 2001.
This decrease primarily reflects lower asset-based fees and other income, as
well as an increase in policy benefits and other operating expenses, net of
lower deferred acquisition costs. The decline in asset-based fees and other
income is principally attributable to a decrease in the market value of assets
under management in the variable product lines, and to lower brokerage income.
Segment revenues decreased $40.7 million, or 4.7%, in 2001, primarily due
to lower asset-based fees and other income. Fee income decreased $29.5 million,
or 7.0%, to $391.6 million, primarily due to variable annuity fees which
decreased $21.3 million, or 9.0%. This was primarily due to a decline in the
market value of average variable annuity assets under management. In addition,
group annuity and non-variable universal life policy fees decreased $9.3 million
and $8.4 million, respectively, during 2001. These declines were primarily due
to lower average invested assets resulting from the Company's decision to exit
its defined contribution group retirement business and from the continued shift
in
36
focus to variable life insurance and annuity products. Additionally, the decline
in non-variable universal life fees included approximately $4 million due to
changes in certain actuarial assumptions in 2000. These decreases in fees were
partially offset by a $9.5 million increase in variable universal life fees
principally due to additional deposits. Other income decreased $13.4 million, or
12.1%, to $97.0 million. This decline was primarily due to lower investment
management fees of $8.3 million resulting from depreciation and reduced deposits
in variable product assets under management as well as to lower brokerage income
of $6.1 million resulting from a decrease in mutual fund and general securities
transaction volumes.
Net investment income increased $5.3 million primarily due to additional
income from the investment of higher general account deposits, partially offset
by the impact of defaulted bonds, lower average mortgage investments and yields,
and to the aforementioned decision to exit the defined contribution group
retirement business.
Policy benefits, claims and losses increased $31.7 million, or 10.1%, to
$346.8 million in 2001, primarily due to increased interest credited of
approximately $22 million related to an increase in general account deposits.
Additionally, during 2001, the GMDB expense increased $10.5 million, primarily
due to the sustained decline in the financial markets in the second half of
2001.
Policy acquisition and other operating expenses increased $7.4 million, or
2.2%, to $336.7 million in 2001. Other operating expenses increased
approximately $18.3 million, primarily due to increases in technology and
distribution costs, partially offset by lower brokerage commissions and
administrative expenses due to the aforementioned decrease in trading volumes
for mutual fund and general securities transactions. In addition, other
operating expenses in 2000 included a $4.7 million net reduction in premium tax
and guaranty fund reserves.
Policy acquisition expenses decreased $10.9 million, or 12.3%, to $77.8
million. In 2001, policy acquisition expense reflects a refinement in the
methodology used by the Company's deferred policy acquisition cost valuation
system which decreased amortization expense by approximately $6 million.
Included in policy acquisition expenses in 2000 were several unusual items,
particularly approximately $36.3 million of reduced expenses related to a change
in certain life products actuarial assumptions and an increase in policy
acquisition expenses of approximately $25.0 million in the annuity line of
business, resulting from an increase in assumed lapse rates. Excluding the
effects of the aforementioned unusual items, policy acquisition costs declined
approximately $15.2 million, primarily due to lower variable annuity profits.
Since variable products' deferred policy acquisition costs are amortized in
proportion to gross profits, the lower annuity gross profits in 2001 resulted in
less amortization expense.
Quarter Ended December 31, 2002 Compared to Quarter Ended December 31, 2001
The following table summarizes the results of operations for the Allmerica
Financial Services segment for the quarter ended December 31, 2002 compared to
the quarter ended December 31, 2001. As previously mentioned, the factors that
affect this segment's results of operations after September 27, 2002 are
substantially different from those in effect prior to that date. Accordingly,
the Company believes that the results of operations for the last three months of
the year are more indicative of results of operations to be expected in 2003.
FOR THE QUARTER ENDED DECEMBER 31 2002 2001
- ---------------------------------------------------------------------------
(In millions)
Segment revenues
Premiums $ 8.9 $ 8.5
Fees:
Fees from surrenders 34.5 8.9
Other fees from proprietary products 83.4 88.1
Net investment income 63.9 69.4
Brokerage and investment
management income(1) 28.1 16.2
Other income 11.9 5.4
- ---------------------------------------------------------------------------
Total segment revenues 230.7 196.5
- ---------------------------------------------------------------------------
Policy benefits, claims and losses 87.5 88.5
Policy acquisition costs 64.9 19.2
Brokerage and investment
management variable expenses(1) 19.2 10.3
Other operating expenses 59.8 56.8
- ---------------------------------------------------------------------------
Segment (loss) income $ (0.7) $ 21.7
===========================================================================
(1) Brokerage and investment management income primarily reflects fees earned
from the distribution and management of non-proprietary insurance and investment
products. Variable expenses related to this business primarily consist of
commissions.
Segment results deteriorated $22.4 million, to a loss of $0.7 million in the
fourth quarter of 2002. The approximate break-even result in 2002 resulted from
substantially higher amortization of DAC, partially offset by increased
surrender fees and net fees earned from sales of non-proprietary products.
The Company's decision to cease sales of proprietary products and the
aforementioned ratings downgrades resulted in an expected substantial increase
in surrenders of variable annuities in the fourth quarter. Annuity surrenders in
the fourth quarter of 2002 were $1.2 billion versus $391.6
37
million in the fourth quarter of the prior year. The increased surrenders
resulted in additional surrender fees of $25.6 million in 2002, representing all
of the increase in fees during the quarter. However, the additional fees were
substantially offset by additional related DAC amortization of approximately $23
million, reflecting the Company's current DAC assumptions mandating a higher
amortization level as a percentage of gross annuity profits. The remainder of
the increase in DAC amortization of approximately $23 million, to $64.9 million,
during the quarter results from applying this higher amortization percentage to
current profits generated by existing annuity accounts (see Deferred Acquisition
Costs above).
During the fourth quarter of 2002, AFS increased its sales of
non-proprietary products, consistent with its new strategy. Such sales are made
through VeraVest. An increase to $413.5 million, versus $215.1 million in the
prior year, resulted in additional brokerage and investment management income of
$11.9 million in the quarter, reflected in brokerage and investment management
income. These fees were substantially offset by additional commissions paid to
the segment's registered representatives of $8.9 million, reflected in other
brokerage and investment management variable operating expenses. The increase in
other operating expenses reflects primarily acquisition costs that had been
deferred in 2001, as they related to proprietary annuity and insurance sales
that are no longer offered by the Company. Since distribution efforts have
shifted to the development of non-proprietary sales, these costs are no longer
eligible for deferral under GAAP.
Policy benefits in the fourth quarter of 2002 were relatively consistent
with the prior year. Expenses related to GMDB declined modestly, from $13.3
million to $12.2 million in the quarter ended December 31, 2002.
Finally, net investment income declined $5.5 million in the fourth quarter
of 2002, to $63.9 million. This resulted from lower average general account
assets and the effect of defaults and non-income producing investments in the
Company's portfolio of fixed income securities.
Given the changes in the AFS business, the Company believes the factors
affecting profitability in the past are not indicative of how the future
earnings of this segment will be generated. The future profitability of the AFS
segment, including that of VeraVest, is dependent upon, among other things, the
ability to generate profitable non-proprietary sales, the ability to rationalize
its expense structure for the non-proprietary business and existing insurance
business consistent with its new business strategy, equity market levels and the
persistency of existing insurance customer accounts. The Company does not expect
this segment to be a significant source of earnings in the near term.
Effective December 31, 2002, the Company sold its universal life insurance
business (see Significant Transactions - Sale of Universal Life Insurance
Business). During the fourth quarter of 2002, the universal life business
contributed incremental income of $4.9 million.
STATUTORY PREMIUMS AND DEPOSITS
The following table sets forth statutory premiums and deposits by product for
the Allmerica Financial Services segment.
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ---------------------------------------------------------------------------
(In millions)
Insurance
Traditional life $ 36.4 $ 39.9 $ 50.6
Universal life 11.7 15.4 17.2
Variable universal life 210.8 204.1 209.1
Individual health 0.2 0.3 0.2
Group variable universal life 35.8 64.8 47.7
- ---------------------------------------------------------------------------
Total insurance 294.9 324.5 324.8
- ---------------------------------------------------------------------------
Annuities
Separate account annuities 1,892.4 1,923.1 2,555.1
General account annuities 856.7 926.8 524.7
Retirement investment accounts 5.8 6.0 9.3
- ---------------------------------------------------------------------------
Total individual annuities 2,754.9 2,855.9 3,089.1
Group annuities 79.6 197.7 463.1
- ---------------------------------------------------------------------------
Total annuities 2,834.5 3,053.6 3,552.2
- ---------------------------------------------------------------------------
Total premiums and deposits $ 3,129.4 $ 3,378.1 $ 3,877.0
===========================================================================
2002 Compared to 2001
For the year ended December 31, 2002, total premiums and deposits decreased
$248.7 million, or 7.4%, to $3.1 billion. These decreases were primarily due to
lower group annuity deposits resulting from the Company's decision to cease
marketing activities for new group retirement business and to lower individual
annuity deposits, entirely in the fourth quarter of 2002, resulting from the
aforementioned ratings downgrades and decision to cease all new sales of
proprietary products. Group variable universal life deposits decreased due to
the cessation of marketing activities for this product. During the fourth
quarter of 2002, total premiums and deposits declined significantly compared to
the same period in 2001 (see Statutory Premiums and Deposits - Quarter ended
December 31, 2002 Compared to Quarter Ended December 31, 2001 below). Effective
December 31, 2002, the Company sold substantially all of its fixed universal
life insurance business (see Significant Transactions - Sale of Universal Life
Insurance Business).
Prior to the cessation of sales of the Company's proprietary products,
annuity products were distributed primarily through three distribution channels:
(1) "Agency", which consisted of the Company's former career agency force; (2)
38
"Select", which consisted of a network of third party broker/ dealers; and (3)
"Partners", which included distributors of the mutual funds advised by Scudder
Investments ("Scudder"), Pioneer Investment Management, Inc. and Delaware
Management Company ("Delaware"). Agency, Select, and Partners represented,
respectively, approximately 22%, 33%, and 45% of individual annuity deposits in
2002, and Scudder represented 39% of all individual annuity deposits. During
2001, Agency, Select, and Partners represented, respectively, approximately 24%,
38%, and 38% of individual annuity deposits, and Scudder represented 28% of all
individual annuity deposits.
2001 Compared to 2000
For the year ended December 31, 2001, total premiums and deposits decreased
$498.9 million, or 12.9%, to $3,378.1 million. These decreases are primarily due
to lower separate account and group annuity deposits, partially offset by higher
general account deposits. In addition, group annuity deposits decreased due to
the Company's decision to exit its defined contribution retirement plan business
and to cease marketing activities for new defined benefit retirement business.
Partially offsetting these decreases were higher annuity deposits into the
Company's general account resulting, in part, from the introduction of a
promotional annuity program, which offered an enhanced initial crediting rate
for new general account deposits.
Quarter Ended December 31, 2002 Compared to Quarter Ended December 31, 2001
The following table sets forth statutory premiums and deposits by product for
the AFS segment for the quarter ended December 31, 2002 compared to the quarter
ended December 31, 2001.
FOR THE QUARTER ENDED DECEMBER 31 2002 2001
- --------------------------------------------------------------
(In millions)
Insurance
Traditional life $ 7.4 $ 8.1
Universal life 2.0 3.2
Variable universal life 24.2 55.0
Individual health 0.1 0.1
Group variable universal life (3.2) (2.6)
- --------------------------------------------------------------
Total insurance 30.5 63.8
- --------------------------------------------------------------
Annuities
Separate account annuities 73.2 508.5
General account annuities 63.0 189.6
Retirement investment accounts 1.1 0.8
- --------------------------------------------------------------
Total individual annuities 137.3 698.9
Group annuities 23.1 12.7
- --------------------------------------------------------------
Total annuities 160.4 711.6
- --------------------------------------------------------------
Total premiums and deposits $ 190.9 $ 775.4
==============================================================
The substantial decline in statutory premiums and deposits from 2001 to 2002 is
due to the aforementioned decision to cease all new sales of proprietary
variable annuities and life insurance products. The Company implemented this
decision during the month of October 2002; implementation was substantially
complete by the end of that month. Accordingly, statutory premiums and deposits
during the fourth quarter of 2002 reflect primarily new sales during the month
of October. Future statutory premiums and deposits will be substantially less,
since they will only include additional premiums and deposits either allowed or
required by existing contracts. Effective December 31, 2002, the Company sold
substantially all of its fixed universal life insurance business (see
Significant Transactions - Sale of Universal Life Insurance Business).
The Company plans to retain and service its existing customer accounts,
including variable annuity, variable life, and certain traditional life and
group retirement accounts. As of December 31, 2002, Agency, Select, Partners and
other distribution channels represented, respectively, 44%, 16%, 24% and 16% of
the segment's total general and separate account assets.
ANNUITY ACCOUNT VALUES AND SURRENDERS
2002 Compared to 2001
The following table summarizes annuity account values and surrender activity,
including partial surrenders, for the AFS segment.
2002 2001
- --------------------------------------------------------------------------------
(In millions)
Account Account
Values/(1)/ Surrenders/(2)/ Values/(1)/ Surrenders/(2)/
- --------------------------------------------------------------------------------
Agency $ 5,993.8 $ 791.3 $ 6,728.4 $ 516.9
Select 3,406.0 799.8 3,074.6 326.5
Scudder 2,840.5 558.4 2,611.7 244.7
Pioneer 1,038.5 177.0 1,073.6 109.7
Delaware 1,134.0 191.0 1,405.4 169.7
Other 110.3 20.7 36.7 30.0
- --------------------------------------------------------------------------------
Total $ 14,523.1 $ 2,538.2 $ 14,930.4 $ 1,397.5
================================================================================
(1) Account values reflect market values as of January 1 of the year indicated.
(2) Surrenders reflect annual activity for the year indicated.
Surrenders increased $1.1 billion in 2002, primarily during the fourth quarter,
due to the aforementioned ratings downgrades and the Company's decision to cease
all new sales of proprietary variable annuities and life insurance products.
Management expects high surrender levels related to its annuity business in
2003.
39
Quarter Ended December 31, 2002 Compared to Quarter Ended December 31, 2001
The following table summarizes annuity surrender activity for the AFS segment
for the quarter ended December 31, 2002 compared to the quarter ended December
31, 2001.
2002 2001
- --------------------------------------------------------------------------------
(In millions)
Account Account
Values/(1)/ Surrenders/(2)/ Values/(1)/ Surrenders/(2)/
- --------------------------------------------------------------------------------
Agency $ 4,762.2 $ 396.9 $ 5,500.7 $ 124.6
Select 3,279.7 414.6 3,002.4 101.7
Scudder 2,951.5 235.5 2,517.6 88.0
Pioneer 847.7 66.5 957.9 29.1
Delaware 819.8 85.6 1,049.8 42.8
Other 102.9 7.4 103.7 5.4
- --------------------------------------------------------------------------------
Total $ 12,763.8 $ 1,206.5 $ 13,132.1 $ 391.6
================================================================================
(1) Account values reflect market values as of October 1 of the year indicated.
(2) Surrenders reflect fourth quarter activity for the year indicated.
Surrenders increased substantially in the fourth quarter of 2002 due to the
aforementioned ratings downgrades and the Company's decision to cease all new
sales of proprietary variable annuities and life insurance products. The fourth
quarter 2002 level of surrender activity is consistent with management's
expectations and with the surrender rate assumptions included in the Company's
calculation of its DAC asset and its GMDB reserve at December 31, 2002.
ALLMERICA ASSET MANAGEMENT
The following table summarizes the results of operations for the Allmerica Asset
Management segment.
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ----------------------------------------------------------------------------
(In millions)
Interest margins on GICs:
Net investment income $ 100.2 $ 144.3 $ 137.8
Interest credited 85.7 127.5 119.7
- ----------------------------------------------------------------------------
Net interest margin 14.5 16.8 18.1
- ----------------------------------------------------------------------------
Premium financing business:
Fees 13.5 - -
Operating expenses 9.8 - -
- ----------------------------------------------------------------------------
Net premium financing income 3.7 - -
- ----------------------------------------------------------------------------
Fees and other income:
External 8.1 6.5 6.3
Internal 5.9 5.2 5.1
Other operating expenses (7.8) (7.8) (7.0)
- ----------------------------------------------------------------------------
Segment income $ 24.4 $ 20.7 $ 22.5
============================================================================
Average GIC deposits
outstanding $ 2,122.7 $ 2,737.9 $ 1,887.9
============================================================================
Outstanding GIC deposits,
end of year $ 1,410.0 $ 2,689.7 $ 2,258.0
============================================================================
2002 Compared to 2001
Segment income increased $3.7 million, or 17.9%, to $24.4 million in 2002
primarily due to the inclusion of $3.7 million of earnings related to the
Company's premium financing subsidiary, AMGRO, in 2002, which was previously
included in the Risk Management segment. In addition, segment income increased
due to an increase in fees and other income related to external clients, offset
by lower earnings on GICs. New external assets under management resulted in an
increase in earnings from asset management services provided to external
clients. Earnings on GICs decreased $2.3 million primarily due to lower net
investment income and to withdrawals of short-term funding agreements. Net
investment income declined primarily due to lower prevailing fixed maturity
investment rates, and to the effect of defaults on certain fixed maturities
supporting GIC obligations.
Declining financial strength ratings from various rating agencies during
2002 (see Rating Agency Actions) resulted in the termination of all remaining
short-term funding agreements, and ultimately, the Company ceased selling new
long-term funding agreements. Furthermore the Company retired certain funding
agreements at discounts during the fourth quarter of 2002. Although these
retirements resulted in a gain for the Company (see Consolidated Overview),
income from the GIC product line will be unfavorably affected in future periods
due to the declining balance of outstanding GIC deposits.
The Company uses derivative instruments to hedge its GIC portfolio (see
Derivative Instruments). For floating rate GIC liabilities that are matched with
fixed rate securities, the Company manages the interest rate risk by hedging
with interest rate swap contracts designed to pay fixed and receive floating
interest. In addition, certain funding agreements are denominated in foreign
currencies. To mitigate the short-term effect of changes in currency exchange
rates, the Company regularly hedges this risk by entering into foreign exchange
swap, futures and options contracts, as well as compound foreign
currency/interest rate swap contracts to hedge its net foreign currency
exposure. These hedges resulted in a $37.7 million and a $48.0 million reduction
in net investment income during 2002 and 2001, respectively, offset by similar
reductions in GIC interest credited during the respective periods. The decreased
effect of derivative instruments was due to a decrease in average outstanding
GIC deposits and the associated hedges. Although the Company believes its
exposure to foreign currency and interest rate fluctuations are currently
economically hedged, there can be no assurance that the Company will not
experience losses from ineffective hedges in the future.
40
2001 Compared to 2000
Segment income decreased $1.8 million, or 8.0%, to $20.7 million in 2001
primarily due to decreased earnings on GICs and to lower earnings related to
external clients. Earnings on GICs decreased $1.3 million primarily due to a
shift from short-term funding agreements to lower margin long-term funding
agreements in 2001 and to lower investment income due to defaults on certain
bonds supporting GIC obligations. These declines were partially offset by
increased earnings from higher net GIC deposits during the year. The decrease in
earnings related to external clients resulted from a decrease in management fees
from a securitized investment portfolio, partially offset by an increase in new
external assets under management.
In the fourth quarter of 2001, the Company was notified of short-term
funding agreement withdrawals of approximately $380 million which resulted from
uncertainty regarding the rating agency actions when Moody's Investors Service
placed the Company's "A2" senior debt rating, "a2" Capital Securities rating,
and "P1" short-term debt rating on review for possible downgrade and revised the
outlook for the life insurance companies' ratings to negative from stable. These
withdrawals precipitated losses from related interest rate swap contracts as
described in "Derivative Instruments".
As noted above, the Company uses derivative instruments to hedge interest
rate and currency exchange rate risks related to its GIC portfolio. These hedges
resulted in a $48.0 million and a $5.6 million reduction in net investment
income during 2001 and 2000, respectively, offset by similar reductions in GIC
interest credited during the respective periods. The increased effect of
derivative instruments in 2001 was due to an increase in average outstanding GIC
deposits and the associated hedges.
CORPORATE
The following table summarizes the results of operations for the Corporate
segment for the periods indicated.
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ----------------------------------------------------------------------------
(In millions)
Segment revenues
Investment and other income $ 5.0 $ 6.7 $ 6.3
Interest expense 15.3 15.3 15.3
Other operating expenses 53.2 55.2 51.8
- ----------------------------------------------------------------------------
Segment loss $ (63.5) $ (63.8) $ (60.8)
============================================================================
2002 Compared to 2001
Segment loss decreased $0.3 million, or 0.5%, to $63.5 million in 2002,
primarily as a result of decreased corporate overhead costs of $2.1 million,
including lower costs due to forfeited stock grants by the Company's President
as a result of his resignation, partially offset by a $1.7 million decrease in
net investment income. The decrease in net investment income is principally due
to lower average invested assets and to lower investment yields.
Interest expense for both periods relates to the interest paid on the
Senior Debentures of the Company.
2001 Compared to 2000
Segment loss increased $3.0 million, or 4.9%, to $63.8 million in 2001,
primarily as a result of increased corporate overhead costs, including
technology costs and certain corporate overhead expenses previously allocated to
other operating segments, partially offset by state tax credits recognized by
the holding company.
INVESTMENT PORTFOLIO
The Company held general account investment assets diversified across several
asset classes, as follows:
DECEMBER 31 2002 2001
- ----------------------------------------------------------------------------
(in millions)
% OF TOTAL % of Total
CARRYING CARRYING Carrying Carrying
VALUE VALUE Value Value
- ----------------------------------------------------------------------------
Fixed maturities/(1)/ $ 8,003.1 87.1 $ 9,401.7 88.1
Equity securities/(1)/ 52.8 0.6 62.1 0.6
Mortgages 259.8 2.8 321.6 3.0
Policy loans/(1)/ 361.4 3.9 379.6 3.5
Cash and cash
equivalents/(1)/ 389.8 4.2 350.2 3.3
Other long-term
investments 129.7 1.4 161.2 1.5
- ----------------------------------------------------------------------------
Total $ 9,196.6 100.0 $ 10,676.4 100.0
============================================================================
(1) The Company carries these investments at fair value.
Total investment assets decreased $1.5 billion, or 13.9%, to $9.2 billion during
2002, primarily as a result of a decrease in fixed maturities of $1.4 billion.
Fixed maturities decreased primarily due to short-term funding agreement
withdrawals and the retirement of certain long-term funding agreements in the
AAM segment. In addition, fixed maturities decreased in the AFS segment due to
annuity surrenders from the general account, as well as transfers to the
separate accounts from the general account, which together more than offset
$856.7 million of new deposits in the general account in 2002. During 2003,
approximately $550 million of investment assets will be used for the settlement
of the net payable associated with the sale of the Company's universal life
insurance business (see Significant Transactions - Sale of Universal Life
Insurance Business).
41
The Company's fixed maturity portfolio is comprised primarily of investment
grade corporate securities, tax-exempt issues of state and local governments,
U.S. government and agency securities and other issues. Based on ratings by the
National Association of Insurance Commissioners ("NAIC"), investment grade
securities comprised 90.5% and 90.7% of the Company's total fixed maturity
portfolio at December 31, 2002 and 2001, respectively. Although management
expects that new funds will be invested primarily in cash, cash equivalents and
investment grade fixed maturities, the Company may invest a portion of new funds
in below investment grade fixed maturities or equity securities. The average
yield on fixed maturities was 6.7% and 7.3% for December 31, 2002 and 2001,
respectively. This decline reflects lower prevailing fixed maturity investment
rates since the first quarter of 2001. Due to the current interest rate
environment, management expects its investment yield to be negatively affected
by lower prevailing fixed maturity investment rates in 2003.
As of December 31, 2002 and 2001, $423.1 million and $509.8 million,
respectively, of the Company's fixed maturities were invested in non-publicly
traded securities. Fair values of non-publicly traded securities are determined
by either a third party broker or by internally developed pricing models,
including the use of discounted cash flow analyses.
Principally as a result of the Company's exposure to below investment grade
securities, the Company recognized $223.6 million and $179.0 million of realized
losses on other-than-temporary impairments of fixed maturities for the years
ended December 31, 2002 and 2001, respectively. Other-than-temporary impairments
of fixed maturities in 2002 included $66.1 million related to the communication
sector, $49.6 million related to the airline sector, $25.9 million related to
the utility sector, $23.9 million related to securitized investments, and $19.3
million related to the energy sector. Other-than-temporary impairments of fixed
maturities in 2001 included $50.8 million related to the communication sector,
$32.3 million related to securitized investments, $19.4 million related to the
industrial sector, $16.9 million related to the metals sector, and $15.9 million
related to the energy sector. The losses reflect the continued deterioration of
high-yield securities in the Company's portfolio. In addition, the Company
recognized $14.9 million and $6.3 million of realized losses on
other-than-temporary impairments of equity securities and other long-term
investments for the years ended December 31, 2002 and 2001, respectively. In the
Company's determination of other-than-temporary impairments, management
considers several factors and circumstances, including the issuer's overall
financial condition, the issuer's credit and financial strength ratings, the
issuer's financial performance, including earnings trends, dividend payments,
and asset quality, a weakening of the general market conditions in the industry
or geographic region in which the issuer operates, a prolonged period (typically
six months or longer) in which the fair value of an issuer's securities remains
below the Company's cost, and with respect to fixed maturity investments, any
factors that might raise doubt about the issuer's ability to pay all amounts due
according to the contractual terms. The Company applies these factors to all
securities. Other-than-temporary impairments are recorded as a realized loss,
which serves to reduce net income and earnings per share. Temporary losses are
recorded as unrealized losses, which do not affect net income and earnings per
share but reduce other comprehensive income. No assurance can be given that the
other-than-temporary impairments will, in-fact, be adequate to cover future
losses or that substantial additional impairments will not be required in the
future.
The following table for the years ended December 31, 2002 and 2001 provides
information about the Company's fixed maturities and equity securities that are
in a gross unrealized loss position.
DECEMBER 31 2002 2001
- ----------------------------------------------------------------------------
(In millions)
GROSS Gross
UNREALIZED FAIR Unrealized Fair
LOSSES VALUE Losses Value
- ----------------------------------------------------------------------------
For greater than
6 months $ 85.7 $ 542.3 $ 85.3 $ 603.4
For less than
6 months 21.0 351.0 67.2 2,013.1
- ----------------------------------------------------------------------------
Total fixed maturities
and equity securities $ 106.7 $ 893.3 $ 152.5 $ 2,616.5
============================================================================
The gross unrealized losses of fixed maturities and equity securities are viewed
as being temporary as it is management's assessment that these securities will
recover in the near-term. Furthermore, as of December 31, 2002, the Company has
the intent and ability to retain such investments for a period of time
sufficient to allow for this anticipated recovery in fair value. Of the $85.7
million and $85.3 million of gross unrealized losses of fixed maturities and
equity securities at December 31, 2002 and 2001, respectively, that have been in
such a position for greater than 6 months, $14.1 million and $16.6 million have
been in a significant unrealized loss position (typically those securities with
a fair value less than 80% of amortized cost) as of December 31, 2002 and 2001,
respectively. The risks inherent in the assessment methodology include the risk
that, subsequent to the balance sheet date, market factors may differ from
management's expectations; management may decide to subsequently sell a security
for unforeseen business needs; or changes in the
42
credit assessment or equity characteristics from the Company's original
assessment may lead the Company to determine that a sale at the current value
would maximize recovery on such investments. To the extent that there are such
adverse changes, the unrealized loss would then be realized and the Company
would record a charge to earnings.
The following table sets forth gross unrealized losses for fixed maturities
by maturity period, and for equity securities. Actual maturities may differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties, or the Company may
have the right to put or sell the obligations back to the issuers. Mortgage
backed securities are included in the category representing their ultimate
maturity.
DECEMBER 31 2002 2001
- --------------------------------------------------------------------
(In millions)
Due in one year or less $ 3.2 $ 0.9
Due after one year through five years 39.8 38.6
Due after five years through ten years 36.7 51.8
Due after ten years 26.6 52.1
- --------------------------------------------------------------------
Total fixed maturities 106.3 143.4
Equity securities 0.4 9.1
- --------------------------------------------------------------------
Total fixed maturities and equity securities $ 106.7 $ 152.5
====================================================================
Of the $106.7 million and $152.5 million of gross unrealized losses on fixed
maturities and equity securities, approximately $1.8 million and $17.4 million
relates to investment grade fixed maturity obligations of the U.S. Treasury,
U.S. government and agency securities, states and political subdivisions, as of
December 31, 2002 and 2001, respectively. An additional $30.1 million and $66.2
million of gross unrealized losses relates to holdings of investment grade fixed
maturities in a variety of industries and sectors, while approximately $74.8
million and $68.9 million relates to holdings of below investment grade fixed
maturities and equity securities in a variety of industries and sectors as of
December 31, 2002 and 2001, respectively. Substantially all below investment
grade securities with an unrealized loss have been rated by the NAIC, Standard &
Poor's or Moody's as of December 31, 2002 and 2001.
The Company had fixed maturity securities with a carrying value of $39.9
million and $10.7 million on non-accrual status at December 31, 2002 and 2001,
respectively. The effect of non-accruals, compared with amounts that would have
been recognized in accordance with the original terms of the fixed maturities,
was a reduction in net investment income of $19.5 million and $11.3 million for
the years ended December 31, 2002 and 2001, respectively. Management expects
that defaults in the fixed maturities portfolio may continue to negatively
impact investment income.
DERIVATIVE INSTRUMENTS
The Company enters into various types of interest rate swap contracts to hedge
exposure to interest rate fluctuations on floating rate funding agreement
liabilities that are matched with fixed rate securities. The Company also enters
into foreign currency swap, futures and options contracts, as well as compound
foreign currency/interest rate swap contracts, to hedge foreign currency and
interest rate exposure on specific funding agreement liabilities. Finally, from
time to time the Company has entered into other swap contracts for investment
purposes. The Company recognized $53.1 million and $32.9 million of net realized
losses on derivatives for the years ended December 31, 2002 and 2001,
respectively. The realized losses during the year ended December 31, 2002, were
primarily due to the termination of derivative instruments used to hedge funding
agreements, during a declining interest rate environment, in response to
short-term funding agreement withdrawals and the retirement of certain long-term
funding agreements at discounts. The realized losses during the year ended
December 31, 2001 were due primarily to the termination of swap contracts used
to hedge short-term funding agreements, during a declining interest rate
environment, in response to withdrawals.
The Company manages the risk of cash flow variability on floating rate
funding agreements that are matched with fixed rate securities, by hedging with
interest rate swap contracts designed to pay fixed and receive floating
interest. With the adoption of Statement No. 133 on January 1, 2001, the swap
contracts were considered cash flow hedges of the interest rate risk associated
with the floating rate funding agreements, including funding agreements with put
features allowing the policyholder to cancel the contract prior to maturity.
During the fourth quarter of 2001, the Company reviewed the trend in put
activity since inception of the funding agreement business in order to determine
the ongoing effectiveness of the hedging relationship. Based upon the historical
trend in put activity, as well as management's uncertainty about possible future
events, the Company had determined that it was probable that some of the future
variable cash flows of the puttable funding agreements would not occur, and
therefore the hedges were ineffective. During the fourth quarter of 2001, the
Company reclassified losses of $35.8 million to (gains) losses on derivative
instruments in the Consolidated Statements of Income from other comprehensive
income related to the payments that were probable of not occurring on
ineffective interest rate swap contracts. During 2002, the Company reclassified
these losses of $35.8 million to realized investment losses from (gains) losses
on derivative instruments in the Consolidated Statements of Income upon
termination of the ineffective interest rate swap contracts. As of December 31,
2002, the Company no longer has outstanding floating rate funding agreements
with put features. In addition, the Company no longer offers long-term or
short-term funding agreements.
43
MARKET RISK AND RISK MANAGEMENT POLICIES
INTEREST RATE SENSITIVITY
The operations of the Company are subject to risk resulting from interest rate
fluctuations to the extent that there is a difference between the amount of the
Company's interest-earning assets and the amount of interest-bearing liabilities
that are paid, withdrawn, mature or re-price in specified periods. The principal
objective of the Company's asset/liability management activities is to provide
maximum levels of net investment income while maintaining acceptable levels of
interest rate and liquidity risk and facilitating the funding needs of the
Company. The Company has developed an asset/liability management approach
tailored to specific insurance or investment product objectives. The investment
assets of the Company are managed in over 20 portfolio segments consistent with
specific products or groups of products having similar liability
characteristics. As part of this approach, management develops investment
guidelines for each portfolio consistent with the return objectives, risk
tolerance, liquidity, time horizon, tax and regulatory requirements of the
related product or business segment. Management has a general policy of
diversifying investments both within and across all portfolios. The Company
monitors the credit quality of its investments and its exposure to individual
markets, borrowers, industries, sectors, and in the case of mortgages, property
types and geographic locations. In addition, the Company carries long and
short-term debt, as well as mandatorily redeemable preferred securities of a
subsidiary trust holding solely junior subordinated debentures of the Company.
The Company uses derivative financial instruments, primarily interest rate
swaps, with indices that correlate to balance sheet instruments to modify its
indicated net interest sensitivity to levels deemed to be appropriate.
Specifically, for floating rate GIC liabilities that are matched with fixed rate
securities, the Company manages the interest rate risk by hedging with interest
rate swap contracts designed to pay fixed and receive floating interest.
Additionally, the Company uses exchange traded financial futures contracts to
hedge against interest rate risk on the reinvestment of fixed maturities. Prior
to September 2002, the Company used exchange traded financial futures contracts
to hedge against interest rate risk on anticipated GIC sales and other funding
agreements. The Company no longer offers funding agreements (see Description of
Operating Segments).
The following tables for the years ended December 31, 2002 and 2001 provide
information about the Company's financial instruments used for purposes other
than trading that are sensitive to changes in interest rates. The tables present
principal cash flows and related weighted-average interest rates by expected
maturities, unless otherwise noted below. Expected maturities may differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties, or the Company may
have the right to put or sell the obligations back to the issuers. Mortgage
backed and asset backed securities are included in the category representing
their expected maturity. Available-for-sale securities include both U.S. and
foreign-denominated fixed maturities, but exclude interest rate swap contracts
and foreign currency swap contracts, which are disclosed in separate tables.
Foreign-denominated fixed maturities are also shown separately in the table of
financial instruments subject to foreign currency risk. Variable interest rate
GIC liabilities are included in the category representing their contractual
maturity, regardless of whether the liability includes a put feature. For
liabilities that have no contractual maturity, the tables present principal cash
flows and related weighted-average interest rates based on the Company's
historical experience, management's judgment, and statistical analysis, as
applicable, concerning their most likely withdrawal behaviors. Additionally, the
Company has assumed its available-for-sale securities are similar enough to
aggregate those securities for presentation purposes. Specifically, variable
rate available-for-sale securities and mortgage loans comprise an immaterial
portion of the portfolio and do not have a significant impact on weighted
average interest rates. Therefore, the variable rate investments are not
presented separately; instead they are included in the tables at their current
interest rate.
44
FAIR
VALUE
FOR THE YEAR ENDED DECEMBER 31, 2002 2003 2004 2005 2006 2007 THEREAFTER TOTAL 12/31/02
- -----------------------------------------------------------------------------------------------------------------------------------
(Dollars in millions)
RATE SENSITIVE ASSETS:
Available-for-sale securities $ 778.4 $ 436.7 $ 907.6 $ 745.0 $ 581.8 $ 4,420.4 $ 7,869.9 $ 8,120.3
Average interest rate 5.61% 6.89% 7.24% 6.60% 5.03% 6.17% 6.23%
Mortgage loans $ 25.9 $ 65.7 $ 14.7 $ 29.5 $ 17.1 $ 110.0 $ 262.9 $ 276.1
Average interest rate 6.19% 7.36% 7.42% 8.22% 7.75% 7.77% 7.54%
Policy loans $ 75.6 $ - $ - $ - $ - $ 285.8 $ 361.4 $ 361.4
Average interest rate 7.42% - - - - 7.72% 7.66%
Company owned life insurance $ - $ - $ - $ - $ - $ 67.2 $ 67.2 $ 67.2
Average interest rate - - - - - 1.56% 1.56%
RATE SENSITIVE LIABILITIES:
Fixed interest rate GICs $ 3.4 $ 100.0 $ - $ 103.8 $ - $ - $ 207.2 $ 220.4
Average interest rate 3.74% 3.60% - 3.87% - - 3.74%
Supplemental contracts
without life contingencies $ 27.6 $ 13.9 $ 8.4 $ 5.7 $ 0.2 $ 4.2 $ 60.0 $ 60.0
Average interest rate 2.90% 2.97% 3.08% 3.27% 3.81% 3.78% 3.03%
Other individual contract
deposit funds $ 12.2 $ 11.1 $ 9.9 $ 8.6 $ 7.7 $ 85.5 $ 135.1 $ 145.8
Average interest rate 4.38% 4.34% 4.28% 4.23% 4.20% 4.16% 4.28%
Other group contract deposit funds $ 21.0 $ 20.4 $ 20.2 $ 13.6 $ 11.2 $ 10.3 $ 96.7 $ 173.5
Average interest rate 6.04% 5.89% 5.78% 6.04% 6.12% 6.00% 5.98%
Individual annuity contracts - general
account $ 196.3 $ 158.0 $ 137.3 $ 129.0 $ 116.4 $ 738.7 $ 1,475.7 $ 1,434.5
Average interest rate 4.00% 3.90% 3.75% 3.75% 3.75% 3.75% 3.84%
Trust instruments supported
by funding obligations $ 56.7 $ 14.0 $ 661.7 $ 252.1 $ - $ 160.7 $ 1,145.2 $ 1,224.5
Average interest rate 1.64% 2.01% 4.71% 3.50% - 6.24% 4.47%
Long-term debt $ - $ - $ - $ - $ - $ 199.5 $ 199.5 $ 160.4
Average interest rate - - - - - 7.63% 7.63%
Mandatorily redeemable preferred
securities of a subsidiary trust
holding solely junior subordinated
debentures of the Company $ - $ - $ - $ - $ - $ 300.0 $ 300.0 $ 187.5
Average interest rate - - - - - 8.21% 8.21%
45
FAIR
VALUE
FOR THE YEAR ENDED DECEMBER 31, 2001 2002 2003 2004 2005 2006 THEREAFTER TOTAL 12/31/01
- ------------------------------------------------------------------------------------------------------------------------------------
(Dollars in millions)
RATE SENSITIVE ASSETS:
Available-for-sale securities $ 836.5 $ 637.0 $ 692.9 $ 1,424.1 $ 1,123.0 $ 4,657.5 $ 9,371.0 $ 9,484.6
Average interest rate 6.72% 6.00% 7.05% 7.27% 6.70% 6.73% 6.78%
Mortgage loans $ 33.4 $ 29.4 $ 70.5 $ 26.3 $ 30.6 $ 135.6 $ 325.8 $ 335.1
Average interest rate 8.04% 6.34% 7.47% 7.34% 8.27% 7.78% 7.62%
Policy loans $ - $ - $ - $ - $ - $ 379.6 $ 379.6 $ 379.6
Average interest rate - - - - - 7.09% 7.09%
Company owned life insurance $ - $ - $ - $ - $ - $ 67.3 $ 67.3 $ 67.3
Average interest rate - - - - - 2.42% 2.42%
RATE SENSITIVE LIABILITIES:
Fixed interest rate GICs $ 30.5 $ 2.3 $ - $ - $ 105.5 $ - $ 138.3 $ 212.8
Average interest rate 7.53% 7.20% - - 6.87% - 7.02%
Variable interest rate GICs $ 483.6 $ 100.2 $ 223.1 $ 70.2 $ 85.3 $ - $ 962.4 $ 961.3
Average interest rate 2.31% 2.15% 2.50% 2.21% 2.36% - 2.33%
Supplemental contracts without
life contingencies $ 26.1 $ 13.2 $ 8.0 $ 5.4 $ 0.2 $ 4.4 $ 57.3 $ 57.3
Average interest rate 2.91% 2.99% 3.10% 3.30% 3.81% 3.78% 3.05%
Other individual contract deposit funds $ 13.3 $ 11.8 $ 10.4 $ 9.0 $ 8.0 $ 86.7 $ 139.2 $ 139.2
Average interest rate 4.35% 4.30% 4.26% 4.21% 4.17% 4.14% 4.25%
Other group contract deposit funds $ 33.6 $ 30.1 $ 21.8 $ 19.1 $ 15.1 $ 93.7 $ 213.4 $ 212.4
Average interest rate 5.80% 6.00% 5.92% 5.91% 5.88% 5.98% 5.92%
Individual annuity contracts - general
account $ 234.3 $ 186.5 $ 161.3 $ 145.7 $ 130.9 $ 827.5 $ 1,686.2 $ 1,621.3
Average interest rate 4.00% 3.90% 3.75% 3.75% 3.75% 3.75% 3.84%
Trust instruments supported
by funding obligations $ 100.2 $ 126.4 $ 49.3 $ 716.4 $ 228.6 $ 297.7 $ 1,518.6 $ 1,534.0
Average interest rate 2.22% 3.03% 2.57% 4.58% 3.50% 6.00% 4.35%
Long-term debt $ - $ - $ - $ - $ - $ 199.5 $ 199.5 $ 204.4
Average interest rate - - - - - 7.63% 7.63%
Mandatorily redeemable preferred
securities of a subsidiary trust
holding solely junior subordinated
debentures of the Company $ - $ - $ - $ - $ - $ 300.0 $ 300.0 $ 286.0
Average interest rate - - - - - 8.21% 8.21%
The following tables for the years ended December 31, 2002 and 2001 provide
information about the Company's derivative financial instruments used for
purposes other than trading that are sensitive to changes in interest rates. The
tables present notional amounts and, as applicable, weighted-average interest
rates by expected maturity date. Notional amounts are used to calculate the
contractual payments to be exchanged under the contracts. Weighted-average
variable rates are indicated by the applicable floating rate index. The
significant decrease in notional amount of swaps outstanding at December 31,
2002 compared to December 31, 2001 is primarily due to short-term funding
agreement withdrawals, as well as the retirement of certain long-term funding
agreements at discounts. As these funding agreements were extinguished, the swap
contracts hedging them were terminated.
46
FAIR
VALUE
FOR THE YEAR ENDED DECEMBER 31, 2002 2003 2004 2005 2006 2007 THEREAFTER TOTAL 12/31/02
- -----------------------------------------------------------------------------------------------------------------------------------
(Dollars in millions)
Rate Sensitive Derivative
Financial Instruments:
Pay fixed/ receive 3 month
LIBOR swaps $ - $ 14.0 $ - $ - $ - $ - $ 14.0 $ (0.3)
Average pay rate - 3.20% - - - - 3.20%
Average receive rate - 3 Mo.LIBOR - - - - 3 Mo. LIBOR
FAIR
VALUE
FOR THE YEAR ENDED DECEMBER 31, 2001 2002 2003 2004 2005 2006 THEREAFTER TOTAL 12/31/02
- -----------------------------------------------------------------------------------------------------------------------------------
(Dollars in millions)
Rate Sensitive Derivative
Financial Instruments:
Pay fixed/receive 3 month
LIBOR swaps $ 295.8 $ - $ 150.0 $ 225.0 $ - $ - $ 670.8 $ (30.4)
Average pay rate 6.66% - 5.58% 7.21% - - 6.60%
Average receive rate 3 Mo.LIBOR - 3 Mo.LIBOR 3 Mo.LIBOR - - 3 Mo.LIBOR
Pay fixed/receive 1 month
LIBOR swaps $ - $ - $ - $ 50.0 $ - $ - $ 50.0 $ (4.4)
Average pay rate - - - 7.37% - - 7.37%
Average receive rate - - - 1 Mo.LIBOR - - 1 Mo.LIBOR
Pay fixed/receive Fed
Funds rate swaps $ 75.0 $ 50.0 $ 35.0 $ 50.0 $ - $ - $ 210.0 $ (11.8)
Average pay rate 5.60% 5.91% 5.52% 7.18% - - 6.03%
Average receive rate FED FUNDS FED FUNDS FED FUNDS FED FUNDS - - FED FUNDS
FOREIGN CURRENCY SENSITIVITY
A portion of the Company's investments consists of securities denominated in
foreign currencies. A portion of the Company's liabilities consists of trust
instruments supported by funding obligations denominated in foreign currencies.
The Company's operating results are exposed to changes in exchange rates between
the U.S. dollar and the Swiss Franc, Japanese Yen, British Pound and Euro. From
time to time, the Company may also have exposure to other foreign currencies. To
mitigate the short-term effect of changes in currency exchange rates, the
Company regularly hedges by entering into foreign exchange swap, futures and
options contracts, as well as compound foreign currency/interest rate swap
contracts to hedge its net foreign currency exposure. The following tables for
the years ended December 31, 2002 and 2001 provide information about the
Company's derivative financial instruments and other financial instruments, used
for purposes other than trading, by functional currency and presents fair value
information in U.S. dollar equivalents. The tables summarize information on
instruments that are sensitive to foreign currency exchange rates, including
securities denominated in foreign currencies, compound foreign currency/
interest rate swap contracts, foreign currency forward exchange agreements,
foreign currency futures contracts, and foreign currency options contracts. For
foreign currency denominated securities and liabilities, the tables present
principal cash flows and applicable current forward foreign currency exchange
rates by contractual maturity. For foreign currency derivative instruments, the
tables present the notional amounts and weighted-average exchange rates by
expected (contractual) maturity dates. These notional amounts are used to
calculate the contractual payments to be exchanged under the contracts. The
significant decrease in the notional amount of swaps outstanding at December 31,
2002 compared to December 31, 2001 is primarily due to short-term funding
agreement withdrawals, as well as the retirement of certain long-term funding
agreements at discounts. As these funding agreements were extinguished, the swap
contracts hedging them were terminated.
47
FAIR
VALUE
FOR THE YEAR ENDED DECEMBER 31, 2002 2003 2004 2005 2006 2007 THEREAFTER TOTAL 12/31/02
- -------------------------------------------------------------------------------------------------------------------------------
(Currencies in millions)
FIXED INTEREST SECURITIES DENOMINATED
IN FOREIGN CURRENCIES:
Fixed interest rate securities denominated
in British Pounds - - - 9.5 - - 9.5 $ 20.4
Current forward foreign exchange rate - - - 1.6100 - - 1.6100
CURRENCY SWAP AGREEMENTS RELATED TO
FIXED INTEREST SECURITIES:
Pay British Pounds
Notional amount in foreign currency - - - 9.5 - - 9.5 $ (1.1)
Average contract rate - - - 1.980 - - 1.980
Current forward foreign exchange rate - - - 1.6100 - - 1.6100
LIABILITIES DENOMINATED IN FOREIGN CURRENCIES:
Trust instruments supported by funding
obligations denominated in Euros 11.0 - 200.7 - - - 211.7 $ 236.9
Current forward foreign exchange rate 1.0492 - 1.0492 - - - 1.0492
Trust instruments supported by funding
obligations denominated in Japanese Yen 3,000.0 - 53,000.0 30,000.0 - 1,500.0 87,500.0 $ 812.6
Current forward foreign exchange rate 0.0084 - 0.0084 0.0084 - 0.0084 0.0084
Trust instruments supported by funding
obligations denominated in British Pounds - - - - - 80.0 80.0 $ 142.1
Current forward foreign exchange rate - - - - - 1.6100 1.6100
CURRENCY SWAP AGREEMENTS RELATED TO
TRUST OBLIGATIONS:
Pay Euros
Notional amount in foreign currency - - 200.8 - - - 200.8 $ (8.1)
Average contract rate - - 0.952 - - - 0.952
Current forward foreign exchange rate - - 1.0492 - - - 1.0492
Pay Japanese Yen
Notional amount in foreign currency 3,000.0 - - - - 1,500.0 4,500.0 $ (4.3)
Average contract rate 0.009 - - - - 0.010 0.009
Current forward foreign exchange rate 0.0084 - - - - 0.0084 0.0084
Pay British Pounds
Notional amount in foreign currency - - - - - 80.0 80.0 $ 2.7
Average contract rate - - - - - 1.442 1.442
Current forward foreign exchange rate - - - - - 1.6100 1.6100
YEN FUTURES CONTRACTS (LONG) RELATED
TO TRUST OBLIGATIONS:
Notional Amount in U.S. Dollars 734.3 - - - - - 734.3 $ 30.2
Number of Contracts 7,240.0 - - - - - 7,240.0
Average opening price 0.008 - - - - - 0.008
EURO OPTIONS CONTRACTS RELATED TO
TRUST OBLIGATIONS:
Notional Amount in U.S. Dollars 1.6 - - - - - 1.6 $ 2.4
Number of Contracts (in millions) 11.0 - - - - - 11.0
Average strike price 0.835 - - - - - 0.835
48
FAIR
VALUE
FOR THE YEAR ENDED DECEMBER 31, 2001 2002 2003 2004 2005 2006 THEREAFTER TOTAL 12/31/01
- -------------------------------------------------------------------------------------------------------------------------------
(Currencies in millions)
FIXED INTEREST SECURITIES DENOMINATED
IN FOREIGN CURRENCIES:
Fixed interest rate securities denominated
in British Pounds - - - - 9.5 - 9.5 $ 18.4
Current forward foreign exchange rate - - - - 1.4546 - 1.4546
CURRENCY SWAP AGREEMENTS RELATED TO
FIXED INTEREST SECURITIES:
Pay British Pounds
Notional amount in foreign currency - - - - 9.5 - 9.5 $ (1.0)
Average contract rate - - - - 1.980 - 1.980
Current forward foreign exchange rate - - - - 1.4546 - 1.4546
LIABILITIES DENOMINATED IN FOREIGN CURRENCIES:
Trust instruments supported by funding
obligations denominated in Euros - 50.0 - 262.3 - - 312.3 $ 286.3
Current forward foreign exchange rate - 0.8895 - 0.8895 - - 0.8895
Trust instruments supported by funding
obligations denominated in Japanese Yen - 5,000.0 - 56,000.0 30,000.0 1,500.0 92,500.0 $ 784.9
Current forward foreign exchange rate - 0.0076 - 0.0076 0.0076 0.0076 0.0076
Trust instruments supported by funding
obligations denominated in Swiss Francs - - 40.0 70.0 - - 110.0 $ 67.1
Current forward foreign exchange rate - - 0.6023 0.6023 - - 0.6023
Trust instruments supported by funding
obligations denominated in British
Pounds - 30.0 - - - 175.0 205.0 $ 307.0
Current forward foreign exchange rate - 1.4546 - - - 1.4546 1.4546
CURRENCY SWAP AGREEMENTS RELATED TO
TRUST OBLIGATIONS:
Pay Euros
Notional amount in foreign currency - 50.0 - 262.3 - - 312.3 $ (26.1)
Average contract rate - 0.879 - 0.951 - - 0.940
Current forward foreign exchange rate - 0.8895 - 0.8895 - - 0.8895
Pay Japanese Yen
Notional amount in foreign currency - 5,000.0 - 56,000.0 30,000.0 1,500.0 92,500.0 $ (21.9)
Average contract rate - 0.009 - 0.009 0.008 0.010 0.009
Current forward foreign exchange rate - 0.0076 - 0.0076 0.0076 0.0076 0.0076
Pay Swiss Francs
Notional amount in foreign currency - - 40.0 70.0 - - 110.0 $ (2.1)
Average contract rate - - 0.591 0.596 - - 0.594
Current forward foreign exchange rate - - 0.6023 0.6023 - - 0.6023
Pay British Pounds
Notional amount in foreign currency - 30.0 - - - 175.0 205.0 $ (10.8)
Average contract rate - 1.500 - - - 1.442 1.450
Current forward foreign exchange rate - 1.4546 - - - 1.4546 1.4546
49
INCOME TAXES
AFC and its domestic subsidiaries (including certain non-insurance operations)
file a consolidated United States federal income tax return. Entities included
within the consolidated group are segregated into either a life insurance or a
non-life insurance company subgroup. The consolidation of these subgroups is
subject to certain statutory restrictions on the percentage of eligible non-life
tax losses that can be applied to offset life company taxable income.
The provision for federal income taxes before minority interest and the
effect of a change in accounting principle was a benefit of $234.8 million
during 2002, compared to a benefit of $75.5 million during 2001. These benefits
resulted in consolidated effective federal tax rates of 45.0% and 127.1% of
pre-tax losses for 2002 and 2001, respectively. The large benefit in the current
period is primarily due to the significant loss recognized by the AFS segment.
The benefit also reflects an $11.6 million favorable settlement of certain prior
years' federal income tax returns.
The provision for federal income taxes before minority interest and the
effect of a change in accounting principle was a $75.5 million benefit during
2001. This benefit resulted in a consolidated effective federal tax rate of
127.1% of pre-tax losses. During 2000, the provision for federal income taxes
before minority interest was a $2.7 million expense and resulted in a
consolidated effective federal tax rate of 1.3%. The change in the rate is
primarily due to lower underwriting income in 2001 resulting in an increase in
the proportion of tax-exempt investment income, the dividends received deduction
associated with the Company's variable products and low income housing credits
to pre-tax income.
Included in the Company's deferred tax net asset as of December 31, 2002 is
an approximately $78 million asset related to federal income tax net operating
loss carryforwards ("NOL"). This NOL may be utilized in future years to offset
taxable income of approximately $222 million, subject to certain limitations. In
addition, there is an asset of approximately $150 million related to alternative
minimum and other tax credit carryforwards at December 31, 2002. These credits
may be utilized to offset regular federal income taxes due from future income.
Although the Company believes that these assets are fully recoverable, there can
be no certainty that future events will not affect their recoverability.
SIGNIFICANT TRANSACTIONS
GAIN ON RETIREMENT OF FUNDING OBLIGATIONS
In the fourth quarter of 2002, the Company retired $548.9 million of its
long-term funding agreement obligations at discounts. This resulted in a gain of
$102.6 million, which is reported as gain from retirement of trust instruments
supported by funding obligations in the Consolidated Statements of Income.
Certain amounts related to the termination of derivative instruments used to
hedge the retired funding agreements were reported in separate line items in the
Consolidated Statements of Income. The net foreign currency transaction loss on
the retired foreign-denominated funding agreements, which was partially offset
by foreign exchange gains on derivative instruments used to hedge the retired
funding agreements, of $12.2 million was recorded as other income in the
Consolidated Statements of Income. The net market value loss on the early
termination of derivative instruments used to hedge the retired funding
agreements of $14.1 million was recorded as net realized investment losses in
the Consolidated Statements of Income.
SALE OF UNIVERSAL LIFE INSURANCE BUSINESS
Historically, AFS offered fixed universal life insurance products through
its Agency distribution channel (see Allmerica Financial Services - Statutory
Premiums and Deposits for a description of its former distribution channels).
The Company sold substantially all of this business through a 100% coinsurance
agreement which was effective December 31, 2002. Under the agreement, the
Company ceded approximately $660 million of universal life insurance reserves in
exchange for the transfer of approximately $550 million of investment assets
with an amortized cost of approximately $525 million. At December 31, 2002, the
Company recorded a loss from this transaction of $20.3 million, net of taxes.
This loss consisted primarily of the aforementioned ceded reserves, asset
transfers, a permanent impairment of the universal life deferred acquisition
cost asset of $155.9 million and administrative expenses of approximately $10
million. On a statutory accounting basis, this transaction produced an increase
in statutory surplus of approximately $109 million (see Statutory Capital of
Insurance Subsidiaries).
50
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of the Company's financial condition and results of
operations are based upon the consolidated financial statements. These
statements have been prepared in accordance with GAAP which requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amount of revenues and expenses during
the reporting period. Actual results could differ from those estimates. The
following critical accounting policies, among others, are those which management
believes affect the more significant judgments and estimates used in the
preparation of the Company's financial statements. Additional information about
the Company's significant accounting policies may be found in Note 1, "Summary
of Significant Accounting Policies" on pages 68 to 74 of the Notes to
Consolidated Financial Statements included in this Form 10-K.
PROPERTY & CASUALTY INSURANCE LOSS RESERVES
The amount of loss and loss adjustment expense reserves (the "loss reserves"),
as discussed in "Segment Results - Risk Management, Reserve for Losses and Loss
Adjustment Expenses" is determined based on an estimation process that is very
complex and uses information obtained from both company specific and industry
data, as well as general economic information. The estimation process is
judgmental, and requires the Company to continuously monitor and evaluate the
life cycle of claims on type-of-business and nature-of-claim bases. Using data
obtained from this monitoring and assumptions about emerging trends, the Company
develops information about the size of ultimate claims based on its historical
experience and other available market information. The most significant
assumptions, which vary by line of business, used in the estimation process
include determining the trend in loss costs, the expected consistency in the
frequency and severity of claims incurred but not yet reported to prior year
claims, changes in the timing of the reporting of losses from the loss date to
the notification date, and expected costs to settle unpaid claims. Because the
amount of the loss reserves is sensitive to the Company's assumptions, the
Company does not completely rely on only one estimate to determine its loss
reserves. Rather, the Company develops several estimates using generally
recognized actuarial projection methodologies that result in a range of
reasonably possible loss reserve outcomes; the Company's best estimate is within
that range. When trends emerge that the Company believes affect the future
settlement of claims, the Company will adjust its reserves accordingly. Reserve
adjustments are reflected in the Consolidated Statements of Income as
adjustments to losses and loss adjustment expenses. Often, these adjustments are
recognized in periods subsequent to the period in which the underlying loss
event occurred. These types of subsequent adjustments are disclosed and
discussed separately as "prior year reserve development". Such development can
be either favorable or unfavorable to the financial results of the Company.
PROPERTY & CASUALTY REINSURANCE RECOVERABLES
The Company shares a significant amount of insurance risk of the primary
underlying contracts with various insurance entities through the use of
reinsurance contracts (see Segment Results - Risk Management, Reinsurance). As a
result, when the Company experiences loss events that are subject to the
reinsurance contract, reinsurance recoveries are recorded. The amount of the
reinsurance recoverable can vary based on the size of the individual loss or the
aggregate amount of all losses in a particular line, book of business or an
aggregate amount associated with a particular accident year. The valuation of
losses recoverable depends on whether the underlying loss is a reported loss, or
an incurred but not reported loss. For reported losses, the Company values
reinsurance recoverables at the time the underlying loss is recognized, in
accordance with contract terms. For incurred but not reported losses, the
Company estimates the amount of reinsurance recoverable based on the terms of
the reinsurance contracts and historical reinsurance recovery information and
applies that information to the gross loss reserve estimates. The most
significant assumption the Company uses is the average size of the individual
losses for those claims that have occurred but have not yet been recorded by the
Company. The reinsurance recoverable is based on what the Company believes are
reasonable estimates and is disclosed separately on the financial statements.
However, the ultimate amount of the reinsurance recoverable is not known until
all losses are settled.
VARIABLE PRODUCTS' DEFERRED POLICY ACQUISITION COSTS
Deferred policy acquisition costs consist of commissions, underwriting costs and
other costs, which vary with, and are primarily related to, the production of
insurance deposits. Acquisition costs related to the Company's variable products
(variable universal life and variable annuities) are recorded on the balance
sheet and amortized through the income statement in proportion to total
estimated gross profits over the expected life of the contracts (see Segment
Results - Allmerica Financial Services, Deferred Acquisition Costs). The
Company's estimated gross profits are based on assumptions including mortality,
persistency, asset growth rates and expenses associated with policy maintenance.
The principal source of earnings for these policies is from asset-based fees,
which can vary in relation to changes in the equity market.
51
At each balance sheet date, the Company evaluates the historical and
expected future gross profits. Any adjustment in estimated profit requires that
the amortization rate be revised retroactively to the date of policy/annuity
issuance. The cumulative difference related to prior periods is recognized as a
component of the current periods' amortization, along with amortization
associated with the actual gross profits of the period. Lower actual gross
profits would typically result in less amortization expense. The converse would
also be true. However, if lower gross profits were to continue into the future,
a partial permanent impairment of the existing DAC asset may occur.
The Company periodically reviews the DAC asset to determine if it is
recoverable from future income. If DAC is determined to be unrecoverable, such
costs are expensed at the time of determination. The amount of DAC considered
recoverable would be reduced in the near term if the estimate of ultimate or
future gross profits is reduced. The amount of DAC amortization would be revised
if any of the estimates discussed above are revised. In addition, the
disposition of a line of business can result in the permanent impairment of the
related DAC asset.
OTHER-THAN-TEMPORARY IMPAIRMENTS
The Company employs a systematic methodology to evaluate declines in fair values
below amortized cost for all investments. This methodology ensures that
available evidence concerning the declines is evaluated in a disciplined manner.
In determining whether a decline in fair value below amortized cost is
other-than-temporary, the Company evaluates the length of time (typically six
months or longer) and the extent to which the fair value has been less than
amortized cost; the financial condition and near-term prospects of the issuer;
the issuer's credit and financial strength ratings; the issuer's financial
performance, including earnings trends, dividend payments, and asset quality;
any specific events which may influence the operations of the issuer; general
market conditions; and, the financial condition and prospects of the issuer's
market and industry. The Company applies judgment in assessing whether the
aforementioned factors have caused an other-than-temporary decline in value.
When an other-than-temporary decline in value is deemed to have occurred, the
Company reduces the cost basis of the investment to fair value. This reduction
is permanent and is recognized as a realized investment loss (see Investment
Portfolio).
STATUTORY CAPITAL OF INSURANCE SUBSIDIARIES
The NAIC prescribes an annual calculation regarding risk based capital ("RBC").
RBC is a method of measuring the minimum amount of capital appropriate for an
insurance company to support its overall business operations in consideration of
its size and risk profile. The RBC ratio for regulatory purposes is calculated
as total adjusted capital divided by required risk based capital. Total adjusted
capital for life insurance companies is defined as capital and surplus, plus
asset valuation reserve, plus 50% of dividends apportioned for payment. Total
adjusted capital for property and casualty companies is capital and surplus. The
Company Action Level is the first level at which regulatory involvement is
specified based upon the level of capital. Regulators may take action for
reasons other than triggering various RBC action levels. The various action
levels are summarized as follows:
.. The Company Action Level, which equals 200% of the Authorized Control
Level, requires the Company to prepare and submit a RBC plan to the
commissioner of the state of domicile. A RBC plan proposes actions which a
company may take in order to bring statutory capital above the Company
Action Level. After review, the commissioner will notify the Company if the
plan is satisfactory.
.. The Regulatory Action Level, which equals 150% of the Authorized Control
Level, requires the insurer to submit to the commissioner of the state of
domicile a RBC plan, or if applicable, a revised RBC plan. After
examination or analysis, the commissioner will issue an order specifying
corrective actions ("Corrective Order") to be taken.
.. The Authorized Control Level authorizes the commissioner of the state of
domicile to take whatever regulatory actions considered necessary to
protect the best interest of the policyholders and creditors of the
insurer.
.. The Mandatory Control Level, which equals 70% of the Authorized Control
Level, authorizes the commissioner of the state of domicile to take actions
necessary to place the Company under regulatory control (i.e.
rehabilitation or liquidation).
.. Life and health companies whose Total Adjusted Capital is between 200% and
250% of the Authorized Control Level are subject to a trend test. The trend
test calculates the greater of the decrease in the margin between the
current year and the prior year and the average of the past three years. It
assumes that the decrease could occur again
52
in the coming year. Any company that trends below 190% of the Authorized
Control Level (i.e. demonstrates a negative trend) would trigger the
Company Action Level. As of December 31, 2002, both AFLIAC and FAFLIC had
adjusted capital levels well above 250% of the Authorized Control Level
risk based capital and; therefore, were not subject to the trend test.
RBC ratios for regulatory purposes, as described above, are expressed as a
percentage of the capital required to be above the Authorized Control Level (the
"Regulatory Scale"); however, in the insurance industry RBC ratios are widely
expressed as a percentage of the Company Action Level (without regard to the
application of the negative trend test). Set forth below are RBC ratios for the
Companies' life insurance subsidiaries and for Hanover as of December 31, 2002,
expressed both on the Industry Scale (Total Adjusted Capital divided by the
Company Action Level) and Regulatory Scale (Total Adjusted Capital divided by
Authorized Control Level):
- --------------------------------------------------------------------------------
(In millions, except ratios)
Total Company Authorized RBC Ratio RBC Ratio
Adjusted Action Control Industry Regulatory
Capital Level Level Scale Scale
- --------------------------------------------------------------------------------
AFLIAC/(1)/ $ 481.9 $ 197.2 $ 98.6 244% 489%
FAFLIC 200.0 96.2 48.2 207% 415%
Hanover/(2)/ 830.3 388.0 194.0 214% 428%
/(1)/ AFLIAC's Total Adjusted Capital includes $200.0 million related to
its subsidiary, FAFLIC.
/(2)/ Hanover's Total Adjusted Capital includes $484.9 million related to
its subsidiary, Citizens.
On December 30, 2002, AFLIAC, previously a Delaware domiciled life insurance
company, became a Massachusetts domiciled life insurance company. On December
31, 2002, AFLIAC became a direct subsidiary of AFC, as well as the immediate
parent of FAFLIC. Under the previous internal ownership structure, FAFLIC was
the immediate parent of AFLIAC and a direct subsidiary of AFC. As a result of
this internal reorganization, the statutory surplus of AFLIAC substantially
increased since it includes FAFLIC's capital. This allows for a greater
tolerance of equity market volatility. In turn, the statutory surplus of FAFLIC
substantially decreased since it no longer includes AFLIAC's capital. However,
FAFLIC's statutory surplus is no longer as susceptible to equity market
volatility since AFLIAC, which holds approximately 90% of the Company's annuity
products that are most sensitive to changes in the equity market, is no longer
consolidated into FAFLIC.
AFC has entered into an agreement with the Massachusetts Commissioner of
Insurance, (the "Massachusetts Commissioner"), in consideration of the decision
not to write new business, whereby it will indefinitely maintain the RBC ratio
of AFLIAC at a minimum of 100% of the Company Action Level (on the Industry
Scale). This agreement, which was previously with FAFLIC, replaced an earlier
commitment that FAFLIC maintain a 225% RBC ratio (on the Industry Scale).
AFC has also entered into several transactions that significantly improved the
statutory capital positions of both AFLIAC and FAFLIC as of December 31, 2002.
These transactions include selling, through a 100% coinsurance agreement,
effective December 31, 2002, the fixed universal life insurance block of
business which produced an increase in statutory surplus of approximately $109
million. In addition, FAFLIC successfully completed a tender offer through which
it retired additional long-term funding agreements at amounts less than
statutory accounting carrying values. This transaction, together with open
market repurchases of long-term funding agreements in the fourth quarter,
resulted in the retirement of approximately $550 million of funding agreements
at amounts below face value. These actions produced a net increase in FAFLIC's
statutory surplus of approximately $84 million.
During 2002, AFC made capital contributions to its then subsidiary FAFLIC, which
in turn contributed capital to its then subsidiary, AFLIAC. Such contributions
were necessary due to the negative impact on statutory surplus of increased
sales commissions, the effect of declines in the equity market on GMDB reserves
and an increased level of realized investment losses. Such contributions were
also made in consideration of the ratings of the life companies and the 225% RBC
agreement described above, which has since been superseded. For each
contribution made, the amount was accrued as of the end of the prior quarter and
was; therefore, reflected in the previous quarter's surplus balance in the
corresponding Company's statutory quarterly or annual statement. Hanover also
paid an ordinary dividend to AFC in July, 2002.
53
Contributions pertaining to 2002 were as follows:
- --------------------------------------------------------------------------------
Date of Path of Amount Effective
Contribution Contribution (in millions) Date/(1)/
- --------------------------------------------------------------------------------
February, 2002 AFC to FAFLIC $ 30 December 31, 2001
FAFLIC to AFLIAC 30
May, 2002 AFC to FAFLIC 10 March 31, 2002
FAFLIC to AFLIAC 18
July, 2002 Hanover to AFC 92 July, 2002
August, 2002 AFC to FAFLIC 158 June 30, 2002
FAFLIC to AFLIAC 35
October, 2002 FAFLIC to AFLIAC 171 September 30, 2002
January, 2003 AFC to FAFLIC 20 December 31, 2002
FAFLIC to AFLIAC 20
/(1)/ The effective date represents the date which these transactions were
reflected in the Company's statutory surplus balance.
The Company does not expect the life insurance subsidiaries to require levels of
capital contributions from AFC as in prior years, due to the expectation of
sufficient statutory capital and earnings; therefore, the Company does not
expect that it will be necessary to dividend significant funds from its property
and casualty companies to AFC during 2003 (see Liquidity and Capital Resources).
The statutory surplus of the life companies, particularly AFLIAC, which
holds approximately 90% of the annuity deposits with the GMDB feature, is highly
sensitive to movements in the equity market. This is due, in large part, to the
required methodology for calculating GMDB ("Actuarial Guideline 34") reserves
for statutory accounting purposes. As of December 31, 2002, the level of net
GMDB reserves in the life companies was approximately $203 million. An increase
of these reserves does not result directly in cash losses to the Company, but it
does result in a reduction in statutory surplus. For each one percent decline in
the S&P 500 Index, the expected increase in required statutory GMDB reserves is
approximately $3 million to $4 million. Any increase in required reserves would
result in an equal decrease in the statutory surplus. Any increase in the S&P
500 Index would result in a decrease in required statutory GMDB reserves, as
well as an increase in surplus due to the impact of the GMDB reinsurance. The
DAC amortization adjustments described earlier do not have an impact on
statutory surplus, as DAC is not a concept recognized under statutory accounting
principles.
AFLIAC entered into a reinsurance agreement, in 2001, with an independent
reinsurer, to cede up to $40 million of its GMDB costs annually based upon
contract date, in excess of $40 million, for a three year period. As described
under "Liquidity and Capital Resources" below, AFC entered into a related
agreement to reimburse costs incurred by this independent reinsurer.
The above mentioned agreement was superseded by the implementation of a new
GMDB mortality reinsurance program. Effective December 1, 2002, AFLIAC and
FAFLIC entered into a new mortality reinsurance program with unaffiliated
reinsurers covering the incidence of mortality on variable annuity policies.
This transaction reduced required statutory net GMDB reserves and resulted in an
increase in statutory capital and surplus of approximately $20 million for the
life companies at December 31, 2002.
For the year ended December 31, 2002, AFLIAC and FAFLIC incurred GMDB costs
of $92.3 million and $2.9 million, respectively, and ceded $34.4 million and
$0.1 million, respectively, of GMDB costs under the aforementioned reinsurance
programs.
The actuarial profession is currently examining issues surrounding the
development of a reserve methodology for variable annuity products. Although no
specific recommendations have been made at this time, such changes could
potentially have a material negative effect on the Company's statutory surplus
and RBC ratio.
54
LIQUIDITY AND CAPITAL RESOURCES
Liquidity describes the ability of a company to generate sufficient cash flows
to meet the cash requirements of business operations. As a holding company,
AFC's primary source of cash is dividends from its insurance subsidiaries.
However, dividend payments to AFC by its insurance subsidiaries are subject to
limitations imposed by state regulators, such as the requirement that cash
dividends be paid out of unreserved and unrestricted earned surplus and
restrictions on the payment of "extraordinary" dividends, as defined. As
mentioned above (see Statutory Capital of Insurance Subsidiaries), AFC has
entered into an agreement with the Massachusetts Insurance Commissioner, in
consideration of the decision not to write new life insurance and annuity
business, whereby it partially offset by cash provided by sales of mortgage
loans, and year over year declines in purchases of mortgages and will
indefinitely maintain the RBC ratio of AFLIAC at a minimum of 100% of the
Company Action Level (on the Industry Scale).
During 2002, AFC received $92 million of dividends from its property and
casualty businesses. Additional dividends from the Company's property and
casualty insurance subsidiaries prior to July, 2003 would be considered
"extraordinary" and would require prior approval from the respective state
regulators. The Company does not expect dividend payments from its life
insurance subsidiaries in 2003.
During 2002, AFC contributed $188 million to its life insurance
subsidiaries. Such capital contributions were made due to the negative impact on
statutory surplus of increased sales commissions, GMDB reserves, an increased
level of realized investment losses, the level of premiums and deposits and in
consideration of the ratings of the life companies and the 225% RBC agreement,
as described above, which has since been superseded. The Company does not expect
that its life insurance subsidiaries will require the levels of capital
contributions as in prior years due to the expectation of sufficient statutory
capital and earnings; therefore, the Company does not expect it will be
necessary to dividend funds from the property and casualty companies in 2003.
However, there can be no guarantee that future dividends will not be necessary
in order to maintain these surplus levels.
In 2001, AFLIAC entered into an agreement to cede a portion of its GMDB
obligations to an independent reinsurer (see Statutory Capital of Insurance
Subsidiaries). Under a related agreement, AFC agreed to reimburse these costs to
the reinsurer. In 2002, AFLIAC incurred GMDB costs of approximately $92 million.
Since 2001, AFLIAC ceded $33.6 million under the agreement, of which AFC has
reimbursed $33.6 million through December 2002. Management expects that
reimbursements related to this agreement will not be significant in the future
due to the aforementioned additional GMDB reinsurance program.
Sources of cash for the Company's insurance subsidiaries are from premiums
and fees collected, investment income and maturing investments. Primary cash
outflows are paid benefits, claims, losses and loss adjustment expenses, policy
acquisition expenses, other underwriting expenses and investment purchases. Cash
outflows related to benefits, claims, losses and loss adjustment expenses can be
variable because of uncertainties surrounding settlement dates for liabilities
for unpaid losses and because of the potential for large losses either
individually or in the aggregate. Management expects that, due to the decision
to cease new sales of life and annuity products, the expectation of high policy
surrenders in AFS products and the retirement of funding obligations in AAM,
additional cash outflows will occur in 2003. These outflows will be funded with
existing cash and with proceeds from sales of cash equivalents and fixed
maturities. The Company periodically adjusts its investment policy to respond to
changes in short-term and long-term cash requirements.
Net cash provided by operating activities was $43.8 million, $658.4 million
and $318.0 million in 2002, 2001 and 2000, respectively. The decrease in cash
during 2002 primarily reflects net payments from the general account as a result
of increased annuity contract withdrawals in the AFS segment as a result of
ratings downgrades and the Company's decision to cease new sales, compared to
net deposits in 2001 which included funds received from the aforementioned
promotional annuity program. Additionally, premium collections in the property
and casualty business decreased as compared to 2001, principally due to timing
of cash receipts. The Company also made approximately $60 million of payments
related to funds held for the aggregate excess of loss reinsurance contract as a
result of the ratings downgrades (see Rating Agency Actions). These net cash
outflows were partially offset by decreased loss and LAE payments in the
property and casualty business, as well as increased federal income tax refunds.
The increase in 2001 is primarily the result of higher general account deposits,
including funds received from the aforementioned promotional annuity program
with enhanced crediting rates and to an increase in premiums received from the
property and casualty business. These increases in cash were partially offset by
increased loss and LAE payments in the property and casualty business.
Net cash provided by investing activities was $1.5 billion in 2002, while
net cash used in investing activities was $1.0 billion and $899.5 million in
2001 and 2000, respectively. The $2.5 billion increase in cash provided in 2002
from 2001 resulted primarily from net sales of fixed maturities in 2002,
compared to net purchases of fixed maturities in 2001. The increase in net sales
of fixed maturities in 2002 was primarily a result of short-term funding
agreement withdrawals, the retirement of certain long-term funding agreements,
and payments made related to annuity surrenders in the AFS segment. The $107.7
million increase in cash used in 2001 is primarily the result of higher net
purchases of fixed maturities,
55
partially offset by cash provided by sales of mortgage loans, and year over year
declines in purchases of mortgages and company owned life insurance. Net
purchases of fixed maturities in 2001 increased principally due to additional
deposits into the general account, including those related to the aforementioned
promotional annuity program.
Net cash used in financing activities was $1.5 billion in 2002, while net
cash provided by financing activities was $417.9 million and $397.8 million in
2001 and 2000, respectively. The decrease in cash provided by financing
activities is primarily due to net funding agreement withdrawals, including the
retirement of the trust instruments supported by funding obligations, of $1.4
billion versus net deposits of $399.2 million in 2001 and to the re-payment of
the Company's short-term debt obligation of $83.3 million in 2002. The decrease
in cash provided in 2001 compared to 2000 is primarily due to lower net funding
agreement deposits, including trust instruments supported by funding
obligations, partially offset by the absence of common stock repurchases in
2001.
At December 31, 2002, AFC, as a holding company, held $64.6 million of cash
and investments. Historically, funds provided to the holding company were from
its property and casualty insurance subsidiaries. Management believes the
holding company of AFC has the ability to meet its obligations through 2003,
including annual interest on Senior Debentures and Capital Securities of $39.9
million and the $20 million capital contribution paid in January 2003 to its
life insurance subsidiaries (see Statutory Capital of Insurance Subsidiaries).
Therefore, the Company currently does not expect it will be necessary to
dividend funds from the property and casualty companies in 2003 in order to fund
2003 holding company obligations as discussed above. However, the Company
believes the holding company will require additional funding in 2004 in order to
meet its obligations, which will include obligations consistent with those
expected for 2003 and may include certain federal income tax liabilities. The
Company decided, in 2002, to suspend payment of its annual common stock
dividend. Whether the Company will pay dividends in the future depends upon the
earnings and financial condition of AFC, although the Company does not expect to
pay a dividend in 2003.
The Company expects to continue to generate sufficient positive cash to
meet all short-term and long-term cash requirements. The Company's insurance
subsidiaries maintain a high degree of liquidity within their respective
investment portfolios in fixed maturity investments, common stock and short-term
investments. AFC has $150 million available under a committed syndicated credit
agreement which expires May 2003. Borrowings under this agreement are unsecured
and incur interest at a rate per annum equal to, at the Company's option, a
designated base rate or the eurodollar rate plus applicable margin. The
agreement provides covenants, including, but not limited to, requirements that
the Company maintain adjusted statutory surplus in certain of its insurance
subsidiaries totaling in excess of $1 billion. At December 31, 2002, the Company
was in compliance with all debt covenants. At December 31, 2002, no amounts were
outstanding under this agreement. In addition, the Company had no commercial
paper borrowing as of December 31, 2002. Ratings downgrades have adversely
affected the cost and availability of additional debt and equity financing and
will continue to do so in the future should ratings remain at current levels or
decrease further (see Rating Agency Actions). The Company does not expect to
renew this credit agreement.
The Company's financing obligations generally include debt, minority
interest on and repayment of the Company's Capital Securities, operating lease
payments, trust instruments supported by funding obligations and funding
agreements. The following table represents the Company's annual payments related
to the principal payments of these financing obligations as of December 31, 2002
and operating lease payments reflect expected cash payments based upon lease
terms:
- ----------------------------------------------------------------------------------------------------------
(In millions)
Maturity
less than Maturity Maturity in excess
1 year 1-3 years 4-5 years of 5 years Total
- -----------------------------------------------------------------------------------------------------------
Long-term debt(1) $ - $ - $ - $ 200.0 $ 200.0
Capital Securities(2) - - - 300.0 300.0
Trust instruments supported by funding obligations(3) 56.7 675.7 252.1 160.7 1,145.2
Funding agreements(4) 3.4 100.0 103.8 - 207.2
Operating lease commitments(5) 22.8 29.3 9.7 1.7 63.5
- -----------------------------------------------------------------------------------------------------------
/(1)/ Long-term debt relates to the senior debentures due in 2025, which
pay annual interest at a rate of 7 5/8%.
/(2)/ Capital Securities of the Company, due in 2027, pay cumulative
dividends at an annual rate of 8.207%.
/(3)/ Trust instruments supported by funding obligations payments are
reflected in the category representing their contractual maturity.
/(4)/ Funding agreements are reflected in the category representing their
contractual maturity.
/(5)/ The Company has operating leases in FAFLIC, Hanover and Citizens.
56
CONTINGENCIES
The Company's insurance subsidiaries are routinely engaged in various legal
proceedings arising in the normal course of business, including claims for
extracontractual or punitive damages. Additional information on other litigation
and claims may be found in Note 21, "Contingencies - Litigation," on pages 98
and 99 the Notes to Consolidated Financial Statements included in Financial
Statements and Supplementary Data of this Form 10-K. In the opinion of
management, none of such contingencies are expected to have a material effect on
the Company's consolidated financial position, although it is possible that the
results of operations in a particular quarter or annual period could be
materially affected by an unfavorable outcome.
RATING AGENCY ACTIONS
Insurance companies are rated by rating agencies to provide both industry
participants and insurance consumers information on specific insurance
companies. Higher ratings generally indicate the rating agencies' opinion
regarding financial stability and a stronger ability to pay claims.
Management believes that strong ratings are important factors in marketing the
Company's products to its agents and customers, since rating information is
broadly disseminated and generally used throughout the industry. Insurance
company financial strength ratings are assigned to an insurer based upon factors
deemed by the rating agencies to be relevant to policyholders and are not
directed toward protection of investors. Such ratings are neither a rating of
securities nor a recommendation to buy, hold or sell any security.
The following tables provide information about the Company's ratings at December
31, 2000, 2001 and 2002, and rating agency actions that occurred in 2002 and,
where applicable, 2003:
Standard & Poor's Ratings
- ----------------------------------------------------------------------------------------------------------------------------
End of End of
Year Rating 2002 Rating Agency Actions Year Rating
December 2000 December 2001 August 2002 September 2002 October 2000 December 2000
- ----------------------------------------------------------------------------------------------------------------------------
Financial Strength Ratings
Property and Casualty Companies AA- AA- A+ A- BBB+ BBB+
(Very Strong) (Very Strong) (Strong) (Strong) (Good) (Good)
with a with a
negative negative
outlook outlook
Life Companies AA- AA- A BB B+ B+
(Very Strong) (Very Strong) (Strong) (Marginal) (Weak) (Weak)
with a with a
negative negative
outlook outlook
DEBT RATINGS
AFC Senior Debt A- A- BBB BB BB- BB-
(Strong) (Strong) (Good) (Marginal) (Marginal) (Marginal)
AFC Capital Securities BBB BBB BBB B- B- B-
(Good) (Good) (Good) (Weak(Weak) (Weak) (Weak)
AFC Short-term Debt A1+ A2 A2 B1 B B
(Strong) (Good) (Good) (Weak) (Weak) (Weak)
with a with a
negative negative
outlook outlook
FAFLIC Short-term Debt and
Financial Strength Ratings A1+ A1+ A1+ B B B
(Strong) (Strong) (Strong)(Vulnerable) (Vulnerable) (Vulnerable)
57
MOODY'S RATINGS
- ------------------------------------------------------------------------------------------------------------------------------------
End of 2003 Rating
End of Year Rating 2002 Rating Agency Actions Year Rating Agency Action
December 2000 December 2001 March 2002 July 2002 September 20O0 October 2002 December 2002 January 2003
- ------------------------------------------------------------------------------------------------------------------------------------
FINANCIAL STRENGTH RATINGS
Property and Casualty
Companies A1 A1 A1 A2 A3 Baa3 Baa3 Baa2
(Good) (Good) (Good) (Good) (Good) (Adequate) Adequate) (Adequate)
with with
direction direction
uncertain uncertain
Life Companies A1 A1 A1 A3 Ba1 Ba3 Ba3 Ba2
(Good) (Good) (Good) (Good) (Questionable)(Questionable)(Questionable)(Questionable)
with with
direction direction
uncertain uncertain
DEBT RATINGS
AFC Senior Debt A2 A2 A3 Baa2 Ba1 B2 B2 B1
(Good) (Good) (Good) (Adequate) (Questionable) (Poor) (Poor) (Poor)
AFC Capital Securities a2 A3 Baa1 Baa3 Ba2 Caa1 Caa1 B3
(Good) (Good) (Adequate) (Adequate) (Questionable) (Very Poor) (Very Poor) (Poor)
with with
direction direction
uncertain uncertain
AFC Short-term Debt P1 P1 P2 P2 NP NP NP NP
(Superior) (Superior) (Strong) (Strong) (Not Prime) (Not Prime) (Not Prime) (Not Prime)
FAFLIC Short-term
Debt and Financial
Strength Ratings P1 P1 P1 P2 NP NP NP NP
(Superior) (Superior) (Superior) (Strong) (Not Prime) (Not Prime) (Not Prime) (Not Prime)
A.M. BEST'S RATINGS
- --------------------------------------------------------------------------------------------------------------------------
End of Year Rating Rating Agency Actions End of Year Rating
December 2000 December 2001 July 2002 September 20O2 October 2002 December 2002
- --------------------------------------------------------------------------------------------------------------------------
Financial Strength Ratings
Property and Casualty Companies A A A A- B++ B++
(Excellent) (Excellent) (Excellent) (Excellent) (Very Good) (Very Good)
under review under review
with negative with negative
implications implications
Life Companies A A A- B+ C++ C++
(Excellent) (Excellent) (Excellent) (Very Good) (Marginal) (Marginal)
under review under review
with negative with negative
implications implications
DEBT RATINGS
AFC Senior Debt Not Rated a- bbb+ bbb- bb+ bb+
under review under review
with negative with negative
implications implications
AFC Capital Securities Not Rated bbb+ bbb bb bb- bb-
under review under review
with negative with negative
implications implications
AFC Short-term Debt Not Rated AMB-1 AMB-2 AMB-3 AMB-4 AMB-4
under review under review
with negative with negative
implications implications
58
As a result of the rating downgrades in 2002 of the life insurance companies,
the Company is no longer able to generate new sales of proprietary products in
its AFS segment and experienced increased surrender rates in the life insurance
and annuity business in the fourth quarter. In addition, the Company is no
longer able to sell its GIC products. These downgrades have also caused
counterparties to terminate certain swap agreements, which have been replaced
with alternative derivative instruments.
The decrease in the property and casualty ratings, in particular the A.M.
Best rating, could continue to negatively impact earnings and growth in this
business, primarily in the Company's commercial lines. In the fourth quarter,
the Company secured third party guarantees, which expire in August 2003, in an
effort to minimize the loss of commercial lines business as a result of the
downgrades. These measures are primarily intended to reduce the risk of
cancellation or non-renewal of these commercial policies in the near term. The
Company believes that the longer the ratings remain at the current level, the
greater the adverse effect of the lower ratings on the operating results of the
Risk Management segment. There can be no assurance that these downgrades, or any
further downgrades that may occur, will not have a material adverse effect on
the results of operations and financial position of the Company.
Rating downgrades have also adversely affected the cost and availability of
any additional debt or equity financing and will continue to do so in the future
should ratings remain at current levels or decrease further.
RECENT DEVELOPMENTS
The Company recognized net periodic pension expenses from its employee pension
plans of $16.8 million and $0.3 million in 2002 and 2001, respectively. In 2000,
the Company recognized a net periodic pension benefit of $12.5 million related
to these plans. The expense or benefit related to the pension plans results from
several factors, including changes in the market value of plan assets, interest
rates and employee compensation levels. The net expense in 2002 and 2001
primarily reflects decreased market values of plan assets as compared to prior
years, while the net benefit in 2000 primarily reflects increases in the market
value of plan assets. In addition, during 2002, the Company recognized $5.4
million of additional pension expenses associated with the restructuring of the
AFS segment. In 2003, management expects an increase of approximately $27
million in net periodic pension expenses due to declines in the market value of
plan assets and interest rates in 2002.
OTHER CONSIDERATIONS/
FORWARD-LOOKING STATEMENTS
The Company wishes to caution readers that the following important factors,
among others, in some cases have affected and in the future could affect, the
Company's actual results and could cause the Company's actual results for 2003
and beyond to differ materially from historical results and from those expressed
in any forward-looking statements made by, or on behalf of, the Company. When
used in Management's Discussion and Analysis, the words "believes",
"anticipates", "expects" and similar expressions are intended to identify
forward looking statements. See "Important Factors Regarding Forward-Looking
Statements" filed as Exhibit 99-2 to the Company's Annual Report on Form 10-K
for the period ended December 31, 2002. Such factors could also cause future
results to differ from historical results.
Factors that may cause actual results to differ materially from historical
results and from those contemplated or projected, forecast, estimated or
budgeted in such forward looking statements include among others, the following
possibilities: (i) lower appreciation on or decline in value of the Company's
managed investments or the investment markets in general, resulting in reduced
variable product assets and related variable product management and brokerage
fees, lapses and increased surrenders, increased DAC amortization, as well as
increased cost of guaranteed minimum death benefits/decreased account balances
supporting our guaranteed benefits products; (ii) adverse catastrophe experience
and severe weather; (iii) adverse loss development for events the Company has
insured in either the current or in prior years or adverse trends in mortality
and morbidity; (iv) heightened competition, including the intensification of
price competition, the entry of new competitors, and the introduction of new
products by new and existing competitors, or as the result of consolidation
within the financial services industry and the entry of additional financial
institutions into the insurance industry; (v) adverse state and federal
legislation or regulation, including decreases in rates, limitations on premium
levels, increases in minimum capital and reserve requirements, benefit mandates,
limitations on the ability to manage care and utilization, requirements to write
certain classes of business and recent and future changes affecting the tax
treatment of insurance and annuity products, as well as continued compliance
with state and federal regulations; (vi) changes in interest rates causing a
reduction of investment
59
income or in the market value of interest rate sensitive investments; (vii)
failure to obtain new customers, retain existing customers or reductions in
policies in force by existing customers; (viii) difficulties in recruiting new
or retaining existing registered representatives and wholesalers to support the
sale of non-proprietary investment and insurance products; (ix) higher service,
administrative, or general expense due to the need for additional advertising,
marketing, administrative or management information systems expenditures; (x)
loss or retirement of key executives; (xi) our success in hiring a new President
and Chief Executive Officer (xii) increases in costs, particularly those
occurring after the time our products are priced and including construction,
automobile, and medical and rehabilitation costs; (xiii) changes in the
Company's liquidity due to changes in asset and liability matching, including
the effect of defaults of debt securities; (xiv) restrictions on insurance
underwriting; (xv) adverse changes in the ratings obtained from independent
rating agencies, such as Moody's, Standard and Poor's and A.M. Best, or the
inability to restore the property and casualty subsidiaries' A.M.Best rating to
the "A-" level or higher; (xvi) possible claims relating to sales practices for
insurance and investment products; (xvii) failure of a reinsurer of the
Company's policies to pay its liabilities under reinsurance or coinsurance
contracts or adverse effects on the cost and availability of reinsurance;
(xviii) earlier than expected withdrawals from the Company's general account
annuities, GICs (including funding agreements), and other insurance products;
(xix) changes in the mix of assets comprising the Company's investment portfolio
and the fluctuation of the market value of such assets; (xx) losses resulting
from the Company's participation in certain reinsurance pools; (xxi) losses due
to foreign currency fluctuations; (xxii) defaults of debt securities held by the
Company; (xxiii) higher employee benefit costs due to changes in market values
of plan assets, interest rates and employee compensation levels, and (xxiv) the
effect of the Company's restructuring actions.
In addition, with respect to the Allmerica Financial Services segment, the
Company has provided forward looking information relating to the impact of
equity market values on certain financial metrics, including among other things,
GMDB expenses, net amount at risk, DAC amortization and Actuarial Guideline 34
reserves for statutory accounting purposes. This information is an estimation
only and is based upon matters as in effect on December 31, 2002. Actual amounts
of these certain financial metrics would vary based upon numerous other factors,
including but not limited to, variable product account values, allocation
between separate and general accounts, mortality experience, surrender and
withdrawal rates and patterns, investment experience and performance of equity
and financial markets throughout the period, as well as from period to period.
Item 7A - QUANTATATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Reference is made to "Market Risk and Risk Management Policies" on pages 44 to
49 of Management's Discussion and Analysis of Financial Condition and Results of
Operations in this Form 10-K.
60
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT ACCOUNTANTS
[PRICEWATERHOUSECOOPERS LLP LOGO]
To the Board of Directors and Shareholders of Allmerica Financial Corporation:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, comprehensive income, shareholders' equity
and cash flows present fairly, in all material respects, the financial position
of Allmerica Financial Corporation and its subsidiaries at December 31, 2002 and
2001, and the results of their operations and their cash flows for each of the
three years in the period ended December 31, 2002 in conformity with accounting
principles generally accepted in the United States of America. These financial
statements are the responsibility of the Company's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with
auditing standards generally accepted in the United States of America, which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, the
Company changed its method of accounting for goodwill in 2002 and derivative
instruments in 2001.
/s/ PRICEWAERHOUSECOOPERS LLP
Boston, Massachusetts
January 30, 2003
61
MANAGEMENT'S REPORT ON RESPONSIBILITY FOR FINANCIAL REPORTING
The management of Allmerica Financial Corporation has the responsibility for
preparing the accompanying consolidated financial statements and for their
integrity and objectivity. The statements were prepared in conformity with
generally accepted accounting principles and include amounts based on
management's informed estimates and judgments. We believe that these statements
present fairly the Company's financial position and results of operations and
that the other information contained in the annual report is accurate and
consistent with the financial statements.
Allmerica Financial Corporation's Board of Directors annually appoints
independent accountants to perform an audit of its consolidated financial
statements. The financial statements have been audited by PricewaterhouseCoopers
LLP, independent accountants, in accordance with generally accepted auditing
standards. Their audit included consideration of the Company's system of
internal control in order to determine the audit procedures required to express
their opinion on the consolidated financial statements.
Management of Allmerica Financial Corporation has established and maintains
a system of internal control that provides reasonable assurance that assets are
safeguarded and that transactions are properly authorized and recorded. The
system of internal control provides for appropriate division of responsibility
and is documented by written policies and procedures that are communicated to
employees with significant roles in the financial reporting process and updated
as necessary. Management continually monitors the system of internal control for
compliance. Allmerica Financial Corporation and its subsidiaries maintain a
strong internal audit program that independently assesses the effectiveness of
the internal controls and recommends possible improvements thereto. Management
recognizes the inherent limitations in all internal control systems and believes
that our system of internal control provides an appropriate balance between the
costs and benefits desired. Management believes that the Company's system of
internal control provides reasonable assurance that errors or irregularities
that would be material to the financial statements are prevented or detected in
the normal course of business.
The Audit Committee of the Board of Directors, composed solely of outside
directors, oversees management's discharge of its financial reporting
responsibilities. The committee meets periodically with management, our internal
auditors and our independent accountants, PricewaterhouseCoopers LLP. Both our
internal auditors and PricewaterhouseCoopers LLP have direct access to the Audit
Committee.
Management recognizes its responsibility for fostering a strong ethical
climate. This responsibility is reflected in the Company's policies which
address, among other things, potential conflicts of interest; compliance with
all domestic and foreign laws including those relating to financial disclosure
and the confidentiality of proprietary information. Allmerica Financial
Corporation maintains a systematic program to assess compliance with these
policies.
/s/ J. Kendall Huber
Executive Officer of the Chairman
/s/ Edward J. Parry, III
Executive Officer of the Chairman,
Chief Financial Officer and
Principal Accounting Officer
/s/ Robert P. Restrepo, Jr.
Executive Officer of the Chairman,
62
CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------
(In millions, except per share data)
REVENUES
Premiums $ 2,320.1 $ 2,254.7 $ 2,118.8
Universal life and investment product policy fees 409.8 391.6 421.1
Net investment income 590.2 655.2 645.5
Net realized investment losses (162.3) (123.9) (140.7)
Other income 158.8 134.2 138.0
- ----------------------------------------------------------------------------------------------------------
Total revenues 3,316.6 3,311.8 3,182.7
- ----------------------------------------------------------------------------------------------------------
BENEFITS, LOSSES AND EXPENSES
Policy benefits, claims, losses and loss adjustment expenses 2,202.0 2,167.2 1,981.8
Policy acquisition expenses 1,080.4 479.2 456.6
Gain from retirement of trust instruments supported by
funding obligations (102.6) -- --
Loss from sale of universal life business 31.3 -- --
Restructuring costs 14.8 2.7 20.7
(Gains) losses on derivative instruments (40.3) 35.2 --
Loss from selected property and casualty exited agencies,
policies, groups, and programs -- 68.3 --
Voluntary pool losses -- 33.0 --
Other operating expenses 652.2 585.6 505.0
- ----------------------------------------------------------------------------------------------------------
Total benefits, losses and expenses 3,837.8 3,371.2 2,964.1
- ----------------------------------------------------------------------------------------------------------
(Loss) income before federal income taxes (521.2) (59.4) 218.6
- ----------------------------------------------------------------------------------------------------------
Federal income tax (benefit) expense:
Current (6.8) (12.4) 1.2
Deferred (228.0) (63.1) 1.5
- ----------------------------------------------------------------------------------------------------------
Total federal income tax (benefit) expense (234.8) (75.5) 2.7
- ----------------------------------------------------------------------------------------------------------
(Loss) income before minority interest (286.4) 16.1 215.9
Minority interest:
Distributions on mandatorily redeemable preferred securities
of a subsidiary trust holding solely junior subordinated
debentures of the Company (16.0) (16.0) (16.0)
- ----------------------------------------------------------------------------------------------------------
(Loss) income before cumulative effect of change in
accounting principle (302.4) 0.1 199.9
Cumulative effect of change in accounting principle (3.7) (3.2) --
- ----------------------------------------------------------------------------------------------------------
Net (loss) income $ (306.1) $ (3.1) $ 199.9
==========================================================================================================
EARNINGS PER COMMON SHARE:
BASIC:
(Loss) income before cumulative effect of change in accounting
principle $ (5.72) $ -- $ 3.75
Cumulative effect of change in accounting principle (0.07) (0.06) --
- ----------------------------------------------------------------------------------------------------------
Net (loss) income per share $ (5.79) $ (0.06) $ 3.75
Weighted average shares outstanding 52.9 52.7 53.3
==========================================================================================================
DILUTED:
(Loss) income before cumulative effect of change in accounting
principle $ (5.72) $ -- $ 3.70
Cumulative effect of change in accounting principle (0.07) (0.06) --
- ----------------------------------------------------------------------------------------------------------
Net (loss) income per share $ (5.79) $ (0.06) $ 3.70
Weighted average shares outstanding 52.9 53.1 54.0
==========================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements.
63
CONSOLIDATED BALANCE SHEETS
DECEMBER 31 2002 2001
- ---------------------------------------------------------------------------------------------------
(In millions, except per share data)
ASSETS
Investments:
Fixed maturities-at fair value (amortized cost of $7,715.9
and $9,294.0) $ 8,003.1 $ 9,401.7
Equity securities-at fair value (cost of $49.1 and $61.2) 52.8 62.1
Mortgage loans 259.8 321.6
Policy loans 361.4 379.6
Other long-term investments 129.7 161.2
- ---------------------------------------------------------------------------------------------------
Total investments 8,806.8 10,326.2
- ---------------------------------------------------------------------------------------------------
Cash and cash equivalents 389.8 350.2
Accrued investment income 138.3 152.3
Premiums, accounts and notes receivable, net 564.7 628.4
Reinsurance receivable on paid and unpaid losses, benefits and
unearned premiums 2,075.8 1,426.8
Deferred policy acquisition costs 1,242.2 1,784.2
Deferred federal income taxes 413.2 168.1
Goodwill 131.2 139.2
Other assets 473.5 522.3
Separate account assets 12,343.4 14,838.4
- ---------------------------------------------------------------------------------------------------
Total assets $ 26,578.9 $ 30,336.1
===================================================================================================
LIABILITIES
Policy liabilities and accruals:
Future policy benefits $ 3,900.1 $ 4,099.6
Outstanding claims, losses and loss adjustment expenses 3,066.5 3,029.8
Unearned premiums 1,047.0 1,052.5
Contractholder deposit funds and other policy liabilities 772.8 1,693.5
===================================================================================================
Total policy liabilities and accruals 8,786.4 9,875.4
- ---------------------------------------------------------------------------------------------------
Expenses and taxes payable 1,115.5 934.1
Reinsurance premiums payable 559.1 125.3
Trust instruments supported by funding obligations 1,202.8 1,589.0
Short-term debt -- 83.3
Long-term debt 199.5 199.5
Separate account liabilities 12,343.4 14,838.4
- ---------------------------------------------------------------------------------------------------
Total liabilities 24,206.7 27,645.0
- ---------------------------------------------------------------------------------------------------
Minority Interest:
Mandatorily redeemable preferred securities of a
subsidiary trust holding solely junior subordinated
debentures of the Company 300.0 300.0
- ---------------------------------------------------------------------------------------------------
Commitments and contingencies (Notes 17 and 21)
SHAREHOLDERS' EQUITY
Preferred stock, $0.01 par value, 20.0 million shares
authorized, none issued -- --
Common stock, $0.01 par value, 300.0 million shares
authorized, 60.4 million shares issued 0.6 0.6
Additional paid-in capital 1,768.4 1,758.4
Accumulated other comprehensive loss (37.4) (13.7)
Retained earnings 746.2 1,052.3
Treasury stock at cost (7.5 million shares) (405.6) (406.5)
- ---------------------------------------------------------------------------------------------------
Total shareholders' equity 2,072.2 2,391.1
- ---------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 26,578.9 $ 30,336.1
===================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements.
64
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -------------------------------------------------------------------------------------------------------------------
(In millions)
PREFERRED STOCK $ -- $ -- $ --
- -------------------------------------------------------------------------------------------------------------------
COMMON STOCK
Balance at beginning and end of year 0.6 0.6 0.6
- -------------------------------------------------------------------------------------------------------------------
ADDITIONAL PAID-IN CAPITAL
Balance at beginning of year 1,758.4 1,765.3 1,770.5
Unearned compensation related to restricted stock and other 10.0 (6.9) (5.2)
- -------------------------------------------------------------------------------------------------------------------
Balance at end of year 1,768.4 1,758.4 1,765.3
- -------------------------------------------------------------------------------------------------------------------
ACCUMULATED OTHER COMPREHENSIVE LOSS
NET UNREALIZED APPRECIATION (DEPRECIATION) ON INVESTMENTS
AND DERIVATIVE INSTRUMENTS:
Balance at beginning of year 28.4 (5.2) (75.3)
Appreciation during the period:
Net appreciation on available-for-sale securities
and derivative instruments 84.6 51.7 107.9
Provision for deferred federal income taxes (29.6) (18.1) (37.8)
- -------------------------------------------------------------------------------------------------------------------
55.0 33.6 70.1
- -------------------------------------------------------------------------------------------------------------------
Balance at end of year 83.4 28.4 (5.2)
- -------------------------------------------------------------------------------------------------------------------
MINIMUM PENSION LIABILITY:
Balance at beginning of year (42.1) -- --
Increase during the period:
Increase in minimum pension liability (121.1) (64.8) --
Benefit for deferred federal income taxes 42.4 22.7 --
- -------------------------------------------------------------------------------------------------------------------
(78.7) (42.1) --
- -------------------------------------------------------------------------------------------------------------------
Balance at end of year (120.8) (42.1) --
- -------------------------------------------------------------------------------------------------------------------
Total accumulated other comprehensive loss (37.4) (13.7) (5.2)
- -------------------------------------------------------------------------------------------------------------------
RETAINED EARNINGS
Balance at beginning of year 1,052.3 1,068.7 882.2
Net (loss) income (306.1) (3.1) 199.9
Dividends to shareholders -- (13.3) (13.4)
- -------------------------------------------------------------------------------------------------------------------
Balance at end of year 746.2 1,052.3 1,068.7
- -------------------------------------------------------------------------------------------------------------------
TREASURY STOCK
Balance at beginning of year (406.5) (420.3) (337.8)
Shares purchased at cost -- -- (105.0)
Shares reissued at cost 0.9 13.8 22.5
- -------------------------------------------------------------------------------------------------------------------
Balance at end of year (405.6) (406.5) (420.3)
- -------------------------------------------------------------------------------------------------------------------
Total shareholders' equity $ 2,072.2 $ 2,391.1 $ 2,409.1
===================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements.
65
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------
(In millions)
Net (loss) income $ (306.1) $ (3.1) $ 199.9
- ----------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income:
Available-for-sale securities:
Net appreciation during the period 143.1 50.3 107.9
Provision for deferred federal income taxes (50.1) (17.6) (37.8)
- ----------------------------------------------------------------------------------------------------------------
Total available-for-sale securities 93.0 32.7 70.1
- ----------------------------------------------------------------------------------------------------------------
Derivative instruments:
Net (depreciation) appreciation during the period (58.5) 1.4 --
Benefit (provision) for deferred federal income taxes 20.5 (0.5) --
- ----------------------------------------------------------------------------------------------------------------
Total derivative instruments (38.0) 0.9 --
- ----------------------------------------------------------------------------------------------------------------
55.0 33.6 70.1
- ----------------------------------------------------------------------------------------------------------------
Minimum pension liability:
Increase in minimum pension liability (121.1) (64.8) --
Benefit for deferred federal income taxes 42.4 22.7 --
- ----------------------------------------------------------------------------------------------------------------
(78.7) (42.1) --
- ----------------------------------------------------------------------------------------------------------------
Other comprehensive (loss) income (23.7) (8.5) 70.1
- ----------------------------------------------------------------------------------------------------------------
Comprehensive (loss) income $ (329.8) $ (11.6) $ 270.0
================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements.
66
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -------------------------------------------------------------------------------------------------------------------
(In millions)
CASH FLOWS FROM OPERATING ACTIVITIES
Net (loss) income $ (306.1) $ (3.1) $ 199.9
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
Net realized investment losses 162.3 123.9 140.7
(Gains) losses on derivative instruments (40.3) 35.2 --
Impairment of capitalized technology 29.8 -- --
Net amortization and depreciation 20.6 23.0 22.8
Interest credited to contractholder deposit funds and trust
instruments supported by funding obligations 84.4 126.7 144.7
Gain from retirement of trust instruments supported by
funding obligations (102.6) -- --
Loss from disposal of universal life insurance business 31.3 -- --
Deferred federal income taxes (228.1) (63.1) 1.5
Change in deferred acquisition costs 370.4 (183.7) (227.6)
Change in premiums and notes receivable, net of reinsurance
premiums payable 5.6 20.5 26.3
Change in accrued investment income 14.0 3.1 (6.7)
Change in policy liabilities and accruals, net (196.5) 688.1 172.4
Change in reinsurance receivable (0.4) (3.0) (143.1)
Change in expenses and taxes payable 215.5 (141.1) (21.6)
Other, net (16.1) 31.9 8.7
- -------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 43.8 658.4 318.0
- -------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from disposals and maturities of available-for-sale
fixed maturities 4,881.5 3,420.1 3,024.8
Proceeds from disposals of equity securities 15.4 42.7 15.1
Proceeds from disposals of other investments 79.0 48.3 48.5
Proceeds from mortgages sold, matured or collected 62.9 307.1 116.2
Proceeds from collections of installment finance and notes receivables 271.5 212.1 164.9
Purchase of available-for-sale fixed maturities (3,421.0) (4,698.4) (3,844.3)
Purchase of equity securities (2.1) (12.9) (19.8)
Purchase of other investments (31.3) (28.8) (147.2)
Capital expenditures (13.1) (32.1) (13.7)
Payments related to terminated swap agreements (72.0) (27.4) (3.8)
Disbursements to fund installment finance and notes receivables (304.9) (239.9) (175.4)
Purchase of company owned life insurance -- -- (64.9)
Other investing activities, net 2.7 2.0 0.1
- -------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) investing activities 1,468.6 (1,007.2) (899.5)
- -------------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES
Deposits to contractholder deposit funds 100.0 101.3 848.0
Withdrawals from contractholder deposit funds (1,023.7) (621.0) (936.7)
Deposits to trust instruments supported by funding obligations 112.0 1,109.5 568.5
Withdrawals from trust instruments supported by funding obligations (578.9) (190.6) --
Change in short-term debt (83.3) 26.7 11.6
Net proceeds from issuance of common stock -- -- 0.6
Dividends paid to shareholders -- (13.3) (13.4)
Treasury stock purchased at cost -- -- (104.1)
Treasury stock reissued at cost 1.1 5.3 23.3
- -------------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by financing activities (1,472.8) 417.9 397.8
- -------------------------------------------------------------------------------------------------------------------
Net change in cash and cash equivalents 39.6 69.1 (183.7)
Cash and cash equivalents, beginning of year 350.2 281.1 464.8
- -------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year $ 389.8 $ 350.2 $ 281.1
===================================================================================================================
SUPPLEMENTAL CASH FLOW INFORMATION
Interest payments $ 16.4 $ 19.5 $ 21.6
Income tax net refunds $ (55.5) $ (14.1) $ (8.8)
The accompanying notes are an integral part of these consolidated financial
statements.
67
ONE
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
A. BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION
The consolidated financial statements of Allmerica Financial Corporation ("AFC"
or the "Company") include the accounts of Allmerica Financial Life Insurance and
Annuity Company ("AFLIAC"); First Allmerica Financial Life Insurance Company
("FAFLIC"); The Hanover Insurance Company ("Hanover"); Citizens Insurance
Company of America ("Citizens"), and other insurance and non-insurance
subsidiaries. These legal entities conduct their operations through several
business segments discussed in Note 16. All significant intercompany accounts
and transactions have been eliminated.
The preparation of financial statements in conformity with generally
accepted accounting principles requires the Company to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amount of revenues and expenses during the reporting
period. Actual results could differ from those estimates.
B. CLOSED BLOCK
FAFLIC established and began operating a closed block (the "Closed Block") for
the benefit of the participating policies included therein, consisting of
certain individual life insurance participating policies, individual deferred
annuity contracts and supplementary contracts not involving life contingencies
which were in force as of FAFLIC's demutualization on October 16, 1995; such
policies constitute the "Closed Block Business". The purpose of the Closed Block
is to protect the policy dividend expectations of such FAFLIC dividend paying
policies and contracts. Unless the Commonwealth of Massachusetts Insurance
Commissioner consents to an earlier termination, the Closed Block will continue
to be in effect until the date none of the Closed Block policies are in force.
FAFLIC allocated to the Closed Block assets in an amount that is expected to
produce cash flows which, together with future revenues from the Closed Block
Business, are reasonably sufficient to support the Closed Block Business,
including provision for payment of policy benefits, certain future expenses and
taxes and for continuation of policyholder dividend scales payable in 1994 so
long as the experience underlying such dividend scales continues. The Company
expects that the factors underlying such experience will fluctuate in the future
and policyholder dividend scales for Closed Block Business will be set
accordingly.
Although the assets and cash flow generated by the Closed Block inure
solely to the benefit of the holders of policies included in the Closed Block,
the excess of Closed Block liabilities over Closed Block assets as measured on a
GAAP basis represent the expected future post-tax income from the Closed Block
which may be recognized in income over the period the policies and contracts in
the Closed Block remain in force.
If the actual income from the Closed Block in any given period equals or
exceeds the expected income for such period as determined at the inception of
the Closed Block, the expected income would be recognized in income for that
period. Further, cumulative actual Closed Block income in excess of the expected
income would not inure to the shareholders and would be recorded as an
additional liability for policyholder dividend obligations. This accrual for
future dividends effectively limits the actual Closed Block income recognized in
income to the Closed Block income expected to emerge from operation of the
Closed Block as determined at inception.
If, over the period the policies and contracts in the Closed Block remain
in force, the actual income from the Closed Block is less than the expected
income from the Closed Block, only such actual income (which could reflect a
loss) would be recognized in income. If the actual income from the Closed Block
in any given period is less than the expected income for that period and changes
in dividend scales are inadequate to offset the negative performance in relation
to the expected performance, the income inuring to shareholders of the Company
will be reduced. If a policyholder dividend liability had been previously
established in the Closed Block because the actual income to the relevant date
had exceeded the expected income to such date, such liability would be reduced
by this reduction in income (but not below zero) in any periods in which the
actual income for that period is less than the expected income for such period.
C. VALUATION OF INVESTMENTS
In accordance with the provisions of Statement of Financial Accounting Standards
No. 115, "Accounting for Certain Investments in Debt and Equity Securities",
("Statement No. 115"), the Company is required to classify its investments into
one of three categories: held-to-maturity, available-for-sale or trading. The
Company determines the appropriate classification of debt securities at the time
of purchase and re-evaluates such designation as of each balance sheet date.
Fixed maturities and equity securities are classified as
available-for-sale. Available-for-sale securities are carried at fair value,
with the unrealized gains and losses, net of tax, reported in a separate
component of shareholders' equity. The amortized cost of fixed maturities is
adjusted for amortization of premiums and accretion of discounts to maturity.
Such amortization is included in investment income.
Mortgage loans on real estate are stated at unpaid principal balances, net
of unamortized discounts and reserves. Reserves on mortgage loans are based on
losses expected by the Company to be realized on transfers of mortgage loans to
real estate (upon foreclosure), on the disposition or settle-
68
ment of mortgage loans and on mortgage loans which the Company believes may not
be collectible in full. In establishing reserves, the Company considers, among
other things, the estimated fair value of the underlying collateral.
Fixed maturities and mortgage loans that are delinquent are placed on
non-accrual status, and thereafter interest income is recognized only when cash
payments are received.
Policy loans are carried principally at unpaid principal balances.
Realized investment gains and losses, other than those related to separate
accounts for which the Company does not bear the investment risk, are reported
as a component of revenues based upon specific identification of the investment
assets sold. When an other-than-temporary decline in value of a specific
investment is deemed to have occurred, the Company reduces the cost basis of the
investment to fair value. This reduction is permanent and is recognized as a
realized investment loss. Changes in the reserves for mortgage loans are
included in realized investment gains or losses.
D. FINANCIAL INSTRUMENTS
In the normal course of business, the Company enters into transactions involving
various types of financial instruments, including debt, investments such as
fixed maturities, mortgage loans and equity securities, investment and loan
commitments, swap contracts, option contracts and futures contracts. These
instruments involve credit risk and are also subject to risk of loss due to
interest rate and foreign currency fluctuation. The Company evaluates and
monitors each financial instrument individually and, when appropriate, obtains
collateral or other security to minimize losses.
E. DERIVATIVES AND HEDGING ACTIVITIES
All derivatives are recognized on the balance sheet at their fair value. On the
date the derivative contract is entered into, the Company designates the
derivative as (1) a hedge of the fair value of a recognized asset or liability
("fair value" hedge); (2) a hedge of a forecasted transaction or of the
variability of cash flows to be received or paid related to a recognized asset
or liability ("cash flow" hedge); (3) a foreign-currency fair value or cash flow
hedge ("foreign currency" hedge); or (4) "held for trading". Changes in the fair
value of a derivative that is highly effective and that is designated and
qualifies as a fair value hedge, along with the gain or loss on the hedged asset
or liability that is attributable to the hedged risk, are recorded in current
period earnings. Changes in the fair value of a derivative that is highly
effective and that is designated and qualifies as a cash flow hedge are recorded
in other comprehensive income, until earnings are affected by the variability of
cash flows (i.e., when periodic settlements on a variable-rate asset or
liability are recorded in earnings). Changes in the fair value of derivatives
that are highly effective and that are designated and qualify as foreign
currency hedges are recorded in either current period earnings or other
comprehensive income, depending on whether the hedge transaction is a fair value
hedge or a cash flow hedge. Lastly, changes in the fair value of derivative
trading instruments are reported in current period earnings.
The Company may hold financial instruments that contain "embedded"
derivative instruments. The Company assesses whether the economic
characteristics of the embedded derivative are clearly and closely related to
the economic characteristics of the remaining component of the financial
instrument, or host contract, and whether a separate instrument with the same
terms as the embedded instrument would meet the definition of a derivative
instrument. When it is determined that (1) the embedded derivative possesses
economic characteristics that are not clearly and closely related to the
economic characteristics of the host contract, and (2) a separate instrument
with the same terms would qualify as a derivative instrument, the embedded
derivative is separated from the host contract, carried at fair value, and
designated as a fair value, cash flow, or foreign currency hedge, or as a
trading derivative instrument.
The Company formally documents all relationships between hedging
instruments and hedged items, as well as its risk-management objective and
strategy for undertaking various hedge transactions. This process includes
linking all derivatives that are designated as fair value, cash flow, or foreign
currency hedges to specific assets and liabilities on the balance sheet or to
specific forecasted transactions. The Company also formally assesses, both at
the hedge's inception and on an ongoing basis, whether the derivatives that are
used in hedging transactions are highly effective in offsetting changes in fair
values or cash flows of hedged items. When it is determined that a derivative is
not highly effective as a hedge or that it has ceased to be a highly effective
hedge, the Company discontinues hedge accounting prospectively, as discussed
below.
The Company discontinues hedge accounting prospectively when (1) it is
determined that the derivative is no longer effective in offsetting changes in
the fair value or cash flows of a hedged item, including forecasted
transactions; (2) the derivative expires or is sold, terminated, or exercised;
(3) the derivative is no longer designated as a hedge instrument, because it is
unlikely that a forecasted transaction will occur; or (4) management determines
that designation of the derivative as a hedge instrument is no longer
appropriate.
When hedge accounting is discontinued because it is determined that the
derivative no longer qualifies as an effective fair value hedge, the derivative
will continue to be carried on the balance sheet at its fair value, and the
hedged asset or liability will no longer be adjusted for changes in fair value.
When hedge accounting is discontinued because the derivative used in a cash flow
hedge expires or is sold, terminated, or exercised, the gain or loss on the
derivative will continue to be deferred in accumulated other comprehensive
69
income and reclassified to earnings when the hedged forecasted transaction
affects earnings. When hedge accounting is discontinued because it is probable
that a forecasted transaction will not occur, the derivative will continue to be
carried on the balance sheet at its fair value, and gains and losses that were
accumulated in other comprehensive income will be recognized immediately in
earnings. In all other situations in which hedge accounting is discontinued, the
derivative will be carried at its fair value on the balance sheet, with changes
in its fair value recognized in current period earnings.
F. CASH AND CASH EQUIVALENTS
Cash and cash equivalents includes cash on hand, amounts due from banks and
highly liquid debt instruments purchased with an original maturity of three
months or less.
G. DEFERRED POLICY ACQUISITION COSTS
Acquisition costs consist of commissions, underwriting costs and other costs,
which vary with, and are primarily related to, the production of revenues.
Property and casualty insurance business acquisition costs are deferred and
amortized over the terms of the insurance policies. Acquisition costs related to
variable annuities and contractholder deposit funds that were deferred in 2002
and prior, are amortized in proportion to total estimated gross profits from
investment yields, mortality, surrender charges and expense margins over the
expected life of the contracts. This amortization is reviewed periodically and
adjusted retrospectively when the Company revises its estimate of current or
future gross profits to be realized from this group of products, including
realized and unrealized gains and losses from investments. Acquisition costs
related to fixed annuities and other life insurance products which were deferred
in 2002 and prior are amortized, generally in proportion to the ratio of annual
revenue to the estimated total revenues over the contract periods based upon the
same assumptions used in estimating the liability for future policy benefits.
Deferred acquisition costs for each life product and property and casualty
line of business are reviewed to determine if they are recoverable from future
income, including investment income. If such costs are determined to be
unrecoverable, they are expensed at the time of determination. Although
recoverability of deferred policy acquisition costs is not assured, the Company
believes it is more likely than not that all of these costs will be recovered.
The amount of deferred policy acquisition costs considered recoverable, however,
could be reduced in the near term if the estimates of gross profits or total
revenues discussed above are reduced or permanently impaired as a result of the
disposition of a line of business. The amount of amortization of deferred policy
acquisition costs could be revised in the near term if any of the estimates
discussed above are revised.
H. REINSURANCE RECEIVABLES
The Company shares certain insurance risks it has underwritten through the use
of reinsurance contracts with various insurance entities. Reinsurance accounting
is followed for ceded transactions when the risk transfer provisions of
Statement of Financial Accounting Standards No. 113, "Accounting and Reporting
for Reinsurance of Short-Duration and Long-Duration Contracts", have been met.
As a result, when the Company experiences loss or claims events, or unfavorable
mortality or morbidity experience that are subject to a reinsurance contract,
reinsurance recoveries are recorded. The amount of the reinsurance recoverable
can vary based on the terms of the reinsurance contract, the size of the
individual loss or claim, or the aggregate amount of all losses or claims in a
particular line, book of business or an aggregate amount associated with a
particular accident year. The valuation of losses or claims recoverable depends
on whether the underlying loss or claim is a reported loss or claim, an incurred
but not reported loss or a future policy benefit. For reported losses and
claims, the Company values reinsurance recoverables at the time the underlying
loss or claim is recognized, in accordance with contract terms. For incurred but
not reported losses and future policy benefits, the Company estimates the amount
of reinsurance recoverable based on the terms of the reinsurance contracts and
historical reinsurance recovery information and applies that information to the
gross loss reserve and future policy benefit estimates. The reinsurance
recoverables are based on what the Company believes are reasonable estimates and
the balance is disclosed separately in the financial statements. However, the
ultimate amount of the reinsurance recoverable is not known until all losses and
claims are settled.
I. PROPERTY, EQUIPMENT AND CAPITALIZED SOFTWARE
Property, equipment, leasehold improvements and capitalized software are stated
at cost, less accumulated depreciation and amortization. Depreciation is
provided using the straight-line or accelerated method over the estimated useful
lives of the related assets which generally range from 3 to 30 years. The
estimated useful life for capitalized software is generally 5 years.
Amortization of leasehold improvements is provided using the straight-line
method over the lesser of the term of the leases or the estimated useful life of
the improvements.
The Company tests for the recoverability of long-lived assets whenever
events or changes in circumstances indicate that the carrying amounts may not be
recoverable. The Company recognizes impairment losses only to the extent that
the carrying amounts of long-lived assets exceed the sum of the undiscounted
cash flows expected to result from the use and eventual disposition of the
assets. When an impairment loss has been deemed to have occurred, the Company
reduces the carrying value of the asset to fair value. Fair values are estimated
using discounted cash flow analysis.
70
J. GOODWILL
In accordance with the provisions of Statement of Financial Accounting Standards
No. 142, "Goodwill and Other Intangible Assets" ("Statement No. 142"), the
Company ceased amortizing its goodwill beginning in 2002 and carries it at the
January 1, 2002 amortized cost balance, net of impairments. The Company tests
for the recoverability of goodwill annually or whenever events or changes in
circumstances indicate that the carrying amounts may not be recoverable. The
Company recognizes impairment losses only to the extent that the carrying
amounts of reporting units with goodwill exceed the fair value. The amount of
the impairment loss that is recognized is determined based upon the excess of
the carrying value of goodwill compared to the implied fair value of the
goodwill, as determined with respect to all assets and liabilities of the
reporting unit.
K. SEPARATE ACCOUNTS
Separate account assets and liabilities represent segregated funds administered
and invested by the Company for the benefit of variable annuity and variable
life insurance contractholders and certain pension funds. Assets consist
principally of mutual funds, bonds, common stocks, and short-term obligations at
market value. The investment income and gains and losses of these accounts
generally accrue to the contractholders and, therefore, are not included in the
Company's net income. Appreciation and depreciation of the Company's interest in
the separate accounts, including undistributed net investment income, is
reflected in shareholders' equity or net investment income.
L. POLICY LIABILITIES AND ACCRUALS
Future policy benefits are liabilities for life, health and annuity products.
Such liabilities are established in amounts adequate to meet the estimated
future obligations of policies in force. The liabilities associated with
traditional life insurance products are computed using the net level premium
method for individual life and annuity policies, and are based upon estimates as
to future investment yield, mortality and withdrawals that include provisions
for adverse deviation. Future policy benefits for individual life insurance and
annuity policies are computed using interest rates ranging from 2 1/2% to 6.0%
for life insurance and 2% to 9 1/2% for annuities. Mortality, morbidity and
withdrawal assumptions for all policies are based on the Company's own
experience and industry standards. Liabilities for universal life, variable
universal life and variable annuities include deposits received from customers
and investment earnings on their fund balances, less administrative charges.
Universal life fund balances are also assessed mortality and surrender charges.
Liabilities for variable annuities include a reserve for guaranteed minimum fund
values in excess of contract values.
Liabilities for outstanding claims, losses and loss adjustment expenses
("LAE") are estimates of payments to be made on property and casualty and health
insurance contracts for reported losses and LAE and estimates of losses and LAE
incurred but not reported. These liabilities are determined using case basis
evaluations and statistical analyses and represent estimates of the ultimate
cost of all losses incurred but not paid. These estimates are continually
reviewed and adjusted as necessary; such adjustments are reflected in current
operations. Estimated amounts of salvage and subrogation on unpaid property and
casualty losses are deducted from the liability for unpaid claims.
Premiums for property and casualty insurance are reported as earned on a
pro-rata basis over the contract period. The unexpired portion of these premiums
is recorded as unearned premiums.
Contractholder deposit funds and other policy liabilities include
investment-related products such as guaranteed investment contracts, deposit
administration funds and immediate participation guarantee funds and consist of
deposits received from customers and investment earnings on their fund balances.
Trust instruments supported by funding obligations consist of deposits
received from customers, investment earnings on their fund balance and the
effect of changes in foreign currencies related to these deposits.
All policy liabilities and accruals are based on the various estimates
discussed above. Although the adequacy of these amounts cannot be assured, the
Company believes that it is more likely than not that policy liabilities and
accruals will be sufficient to meet future obligations of policies in force. The
amount of liabilities and accruals, however, could be revised in the near term
if the estimates discussed above are revised.
M. MANDATORILY REDEEMABLE PREFERRED SECURITIES OF A SUBSIDIARY TRUST HOLDING
SOLELY JUNIOR SUBORDINATED DEBENTURES OF THE COMPANY
Mandatorily redeemable preferred securities of a subsidiary trust holding solely
junior subordinated debentures of the Company reflects the issuance, through a
subsidiary business trust, of $300.0 million of Series B Capital Securities,
which are registered under the Securities Act of 1933, and related Junior
Subordinated Deferrable Interest Debentures due 2027. These capital securities
pay cumulative dividends at a rate of 8.207% semiannually. Through certain
guarantees, these subordinated debentures and the terms of related agreements,
AFC has irrevocably and unconditionally guaranteed the obligations of the
subsidiary business trust under these capital securities.
N. PREMIUM AND FEE REVENUE AND RELATED EXPENSES
Premiums for individual life insurance and individual and group annuity
products, excluding universal life and investment-related products, are
considered revenue when due. Property and casualty insurance premiums are
recognized as revenue over the related contract periods. Benefits, losses
71
and related expenses are matched with premiums, resulting in their recognition
over the lives of the contracts. This matching is accomplished through the
provision for future benefits, estimated and unpaid losses and amortization of
deferred policy acquisition costs. Revenues for investment-related products
consist of net investment income and contract charges assessed against the fund
values. Related benefit expenses include annuity benefit claims for guaranteed
minimum fund values in excess of contract values, and net investment income
credited to the fund values after deduction for investment and risk charges.
Revenues for universal life products consist of net investment income, with
mortality, administration and surrender charges assessed against the fund
values. Related benefit expenses include universal life benefit claims in excess
of fund values and net investment income credited to universal life fund values.
Certain policy charges that represent compensation for services to be provided
in future periods are deferred and amortized over the period benefited using the
same assumptions used to amortize deferred acquisition costs.
O. FEDERAL INCOME TAXES
AFC and its domestic subsidiaries (including certain non-insurance operations)
file a consolidated United States federal income tax return. Entities included
within the consolidated group are segregated into either a life insurance or a
non-life insurance company subgroup. The consolidation of these subgroups is
subject to certain statutory restrictions on the percentage of eligible non-life
tax losses that can be applied to offset life company taxable income.
Deferred income taxes are generally recognized when assets and liabilities
have different values for financial statement and tax reporting purposes, and
for other temporary taxable and deductible differences as defined by Statement
of Financial Accounting Standards No. 109, "Accounting for Income Taxes"
("Statement No. 109"). These differences result primarily from policy
acquisition expenses, loss and LAE reserves, policy reserves, tax credit
carryforwards, net operating loss carryforwards, employee benefit plans and
unrealized appreciation or depreciation on investments.
P. NEW ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board ("FASB") issued
Interpretation No. 46, "Consolidation of Variable Interest Entities - an
interpretation of ARB No. 51" ("FIN 46"). FIN 46 provides guidance regarding the
application of Accounting Research Bulletin No. 51, Consolidated Financial
Statements, specifically as it relates to the identification of entities for
which control is achieved through a means other than voting rights ("variable
interest entities") and the determination of which party is responsible for
consolidating the variable interest entities (the "primary beneficiary"). In
addition to mandating that the primary beneficiary consolidate the variable
interest entity, FIN 46 also requires disclosures by companies that hold a
significant variable interest, even if they are not the primary beneficiary.
Certain financial statement disclosures are applicable immediately for those
entities for which it is reasonably possible that the enterprise will
consolidate any variable interest entities. This interpretation also applies
immediately to variable interest entities created after January 31, 2003, and to
variable interest entities in which an enterprise obtains an interest after that
date. For those variable interest entities in which an enterprise holds a
variable interest that it acquired before February 1, 2003, the provisions of
this interpretation shall be applied no later than the first reporting period
after June 15, 2003. The Company is currently assessing the effect that adoption
of FIN 46 will have on it's financial position and results of operations.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure" ("Statement No. 148"). This statement amends FASB Statement No. 123,
"Accounting for Stock-Based Compensation" ("Statement No. 123"), to provide
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. In addition, this
statement amends the disclosure requirements of Statement No. 123 to require
more prominent disclosures, in both annual and interim financial statements,
regarding the proforma effects of using the fair value method of accounting for
stock-based compensation. The provisions of this statement are effective for
fiscal years ending after December 15, 2002. As of December 31, 2002, the
Company has elected to continue applying the provisions of Accounting Principles
Board Opinion No. 25 for stock-based employee compensation.
In November 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others - an interpretation of FASB Statements No.
5, 57, and 107 and rescission of FASB Interpretation No. 34" ("FIN 45"). FIN 45
provides guidance regarding financial statement disclosure requirements for
guarantors related to obligations under guarantees. FIN 45 also clarifies the
requirements related to the recognition of a liability by the guarantor, at the
inception of a guarantee, for these obligations under guarantees. This
interpretation also incorporates, without change, the guidance in FASB
Interpretation No. 34, "Disclosure of Indirect Guarantees of Indebtedness of
Others," which is being superseded. The initial recognition and measurement
provisions of this interpretation are required to be applied only on a
prospective basis to guarantees issued or modified after December 31, 2002. The
disclosure requirements are effective for financial statements of reporting
periods ending after December 15, 2002. The adoption of FIN 45 did not have a
material effect on the Company's financial position or results of operations.
72
In June 2002, the FASB issued Statement of Financial Accounting Standards
No. 146, "Accounting for Costs Associated with Exit or Disposal Activities"
("Statement No. 146"). This statement requires that a liability for costs
associated with an exit or disposal activity is recognized and measured
initially at its fair value in the period the liability is incurred. This
statement supersedes Emerging Issues Task Force Issue No. 94-3, "Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit an
Activity (including Certain Costs Incurred in a Restructuring)". Additionally,
the statement requires financial statement disclosures about the description of
the exit or disposal activity, including for each major type of cost, the total
amount expected to be incurred and a reconciliation of the beginning and ending
liability balances. The provisions of this statement are effective for all exit
and disposal activities initiated after December 31, 2002. The adoption of
Statement No. 146 is not expected to have a material effect on the Company's
financial statements.
In August 2001, the FASB issued Statement of Financial Accounting Standards
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets"
("Statement No. 144"). This statement addresses significant issues relating to
the implementation of Statement of Financial Accounting Standards No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of" ("Statement No. 121"), by developing a single accounting model,
based on the framework established in Statement No. 121, for long-lived assets
to be disposed of by sale, whether previously held and used or newly acquired.
In addition, Statement No. 144 supersedes the accounting and reporting
provisions of Accounting Principles Board Opinion No. 30 ("APB No. 30"),
"Reporting the Results of Operations - Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," for the disposal of a segment of a business and amends
Accounting Research Bulletin No. 51, "Consolidated Financial Statements," to
eliminate the exception to consolidation for a subsidiary for which control is
likely to be temporary. The provisions of this statement are effective for
fiscal years beginning after December 15, 2001. The adoption of Statement No.
144 did not have a material effect on the Company's financial statements.
In June 2001, the FASB issued Statement of Financial Accounting Standards
No. 142, which requires that goodwill and intangible assets that have indefinite
useful lives no longer be amortized over their useful lives, but instead be
tested at least annually for impairment. Intangible assets that have finite
useful lives will continue to be amortized over their useful lives. In addition,
the statement provides specific guidance for testing the impairment of
intangible assets. Additional financial statement disclosures about goodwill and
other intangible assets, including changes in the carrying amount of goodwill,
carrying amounts by classification of amortized and non-amortized assets, and
estimated amortization expenses for the next five years, are also required. This
statement became effective for fiscal years beginning after December 15, 2001
for all goodwill and other intangible assets held at the date of adoption. The
Company adopted Statement No. 142 on January 1, 2002. In accordance with the
transition provisions of this statement, the Company recorded a $3.7 million
charge, net-of-taxes, in earnings, to recognize the impairment of goodwill
related to two of its non-insurance subsidiaries. The Company utilized a
discounted cash flow model to value these subsidiaries.
In June 2001, the FASB issued Statement of Financial Accounting Standards
No. 141, "Business Combinations" ("Statement No. 141"), which requires that all
business combinations initiated after June 30, 2001 be accounted for using the
purchase method of accounting. It further specifies the criteria that intangible
assets must meet in order to be recognized and reported apart from goodwill. The
implementation of Statement No. 141 is not expected to have a material effect on
the Company's financial statements.
In March 2000, the FASB issued Interpretation No. 44, "Accounting for
Certain Transactions Involving Stock Compensation - an interpretation of APB
Opinion No. 25" ("FIN 44"). FIN 44 clarifies the application of APB Opinion No.
25 regarding the definition of an employee, the criteria for determining a
noncompensatory plan, the accounting for changes to the terms of a previously
fixed stock option or award, the accounting for an exchange of stock
compensation awards in a business combination, and other stock compensation
related issues. FIN 44 became effective July 1, 2000 with respect to new awards,
modifications to outstanding awards, and changes in grantee status that occur on
or after that date. In addition, FIN 44 covers certain events occurring between
December 16, 1998 and the July effective date, as well as certain other events
occurring between January 13, 2000 and the July effective date. To the extent
that applicable events occurred in those periods, the effects of applying FIN 44
are recognized on a prospective basis beginning July 1, 2000. The adoption of
FIN 44 did not have a material impact on the Company's financial position or
results of operations.
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133, "Accounting for Derivative Instruments and Hedging Activities"
("Statement No. 133"), which establishes accounting and reporting standards for
derivative instruments. Statement No. 133 requires that all derivative
instruments be recorded on the balance sheet at their fair value. Changes in the
fair value of derivatives are recorded each period in current earnings or other
comprehensive income, depending on the type of hedge transaction. For fair value
hedge transactions in which the Company is hedging changes in an asset's,
liability's or firm commitment's fair value, changes in the fair value of the
derivative instruments will generally be offset in the income statement by
73
changes in the hedged item's fair value. For cash flow hedge transactions, in
which the Company is hedging the variability of cash flows related to a variable
rate asset, liability, or a forecasted transaction, changes in the fair value of
the derivative instrument will be reported in other comprehensive income. The
gains and losses on the derivative instrument that are reported in other
comprehensive income will be reclassified into earnings in the periods in which
earnings are impacted by the variability of the cash flows of the hedged item.
To the extent any hedges are determined to be ineffective, all or a portion of
the change in value of the derivative will be recognized currently in earnings.
This statement was effective for fiscal years beginning after June 15, 2000. The
Company adopted Statement No. 133 on January 1, 2001. In accordance with the
transition provisions of the statement, the Company recorded a $3.2 million
charge, net of taxes, in earnings to recognize all derivative instruments at
their fair values. This adjustment represents net losses that were previously
deferred in other comprehensive income on derivative instruments that do not
qualify for hedge accounting. The Company recorded an offsetting gain in other
comprehensive income of $3.3 million, net of taxes, to recognize these
derivative instruments.
Q. EARNINGS PER SHARE
Earnings per share ("EPS") for the years ended December 31, 2002, 2001, and 2000
are based on a weighted average of the number of shares outstanding during each
year. The Company's EPS is based on net income for both basic and diluted
earnings per share. The weighted average shares outstanding which were utilized
in the calculation of basic earnings per share differ from the weighted average
shares outstanding used in the calculation of diluted earnings per share due to
the effect of dilutive employee stock options and nonvested stock grants. If the
effect of such stock options and grants are antidilutive, the weighted average
shares outstanding utilized in the calculation of diluted earnings per share
equal those utilized in the calculation of basic earnings per share.
Options to purchase shares of common stock whose exercise prices are
greater than the average market price of the common shares are not included in
the computation of diluted earnings per share because the effect would be
antidilutive.
R. RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the current year
presentation.
TWO
DISCONTINUED OPERATIONS
During 1999, the Company approved a plan to exit its group life and health
insurance business, consisting of its Employee Benefit Services ("EBS")
business, its Affinity Group Underwriters ("AGU") business and its accident and
health assumed reinsurance pool business ("reinsurance pool business"). During
1998, the Company ceased writing new premiums in the reinsurance pool business,
subject to certain contractual obligations. Prior to 1999, these businesses
comprised substantially all of the former Corporate Risk Management Services
segment. Accordingly, the operating results of the discontinued segment,
including its reinsurance pool business, have been reported in accordance with
Accounting Principles Board Opinion No. 30, "Reporting the Results of Operations
- - Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB
Opinion No. 30"). In 1999, the Company recorded a $30.5 million loss, net of
taxes, on the disposal of this segment, consisting of after-tax losses from the
run-off of the group life and health business of approximately $46.9 million,
partially offset by net proceeds from the sale of the EBS business of
approximately $16.4 million. Subsequent to the measurement date of June 30,
1999, approximately $7.4 million of the aforementioned $46.9 million loss has
been generated from the operations of the discontinued business.
In March of 2000, the Company transferred its EBS business to Great-West
Life and Annuity Insurance Company of Denver. As a result of this transaction,
the Company has received consideration of approximately $27 million, based on
renewal rights for existing policies. The Company retained policy liabilities
estimated at $69.6 million at December 31, 2002 related to this business.
As permitted by APB Opinion No. 30, the Consolidated Balance Sheets have
not been segregated between continuing and discontinued operations. At December
31, 2002 and 2001, the discontinued segment had assets of approximately $290.4
million and $397.6 million, respectively, consisting primarily of invested
assets and reinsurance recoverables, and liabilities of approximately $347.5
million and $369.3 million, respectively, consisting primarily of policy
liabilities. Revenues for the discontinued operations were $23.3 million, $34.4
million and $207.7 million for the years ended December 31, 2002, 2001 and 2000,
respectively.
74
THREE
SIGNIFICANT TRANSACTIONS
Effective December 31, 2002, the Company effectively sold, through a 100%
coinsurance agreement, substantially all of its fixed universal life insurance
business. Under the agreement, the Company ceded approximately $660 million of
universal life insurance reserves in exchange for the transfer of approximately
$550 million of investment assets with an amortized cost of approximately $525
million, subject to certain post-closing adjustments. At December 31, 2002, the
Company recorded a pre-tax loss from this transaction of $31.3 million. This
loss consisted primarily of the aforementioned ceded reserves, asset transfers,
a permanent impairment of the universal life deferred acquisition cost ("DAC")
asset of $155.9 million and administrative expenses of approximately $10
million. This loss is reflected as a separate line item in the Consolidated
Statements of Income. During 2003, approximately $550 million of investment
assets will be used for the settlement of the net payable associated with this
transaction.
In the fourth quarter of 2002, the Company retired $548.9 million of its
long-term funding agreement obligations at discounts. This resulted in a pre-tax
gain of $102.6 million, which is reported as gain from retirement of trust
instruments supported by funding obligations in the Consolidated Statements of
Income. Certain amounts related to the termination of derivative instruments
used to hedge the retired funding agreements were reported in separate line
items in the Consolidated Statements of Income. The net foreign currency
transaction loss on the retired foreign-denominated funding agreements, which
was partially offset by foreign exchange gains on derivative instruments used to
hedge the retired funding agreements, of $12.2 million was recorded as other
income in the Consolidated Statements of Income. The net market value loss on
the early termination of derivative instruments used to hedge the retired
funding agreements of $14.1 million was recorded as net realized investment
losses in the Consolidated Statements of Income.
In the fourth quarter of 2002, the Company recognized a pre-tax charge of
$15.0 million related to the restructuring of its AFS segment (see Note 16 for a
description of the Company's operating segments). Approximately $11.7 million of
this charge relates to severance and other employee and agent related costs
resulting from the elimination of approximately 475 positions, of which 366
employees have been terminated as of December 31, 2002 and 63 vacant positions
have been eliminated. All levels of employees, from staff to senior management,
were affected by the restructuring. Additionally the Company terminated all life
insurance and annuity agent contracts effective December 31, 2002. In addition,
approximately $3.3 million of this charge relates to other restructuring costs,
consisting of lease and contract cancellations and the present value of idle
leased space. As of December 31, 2002, the Company has made payments of
approximately $4.7 million related to this restructuring plan, of which
approximately $4.3 million relates to severance and other employee related
costs.
During the fourth quarter of 2001, the Company completed an extensive
review of its agency relationships which resulted in the termination of 377
agencies and the withdrawal of commercial lines' underwriting authority in an
additional 314 agencies. These actions affected approximately 27% of the
approximately 2,500 active agencies representing the Company in 2001. These
agencies have consistently produced unsatisfactory loss ratios. In addition, the
Company terminated virtually all of its specialty commercial programs and
discontinued a number of special marketing arrangements. As a result of these
actions, the Company has recorded a total charge of $68.3 million which has been
presented as a separate line item in the Consolidated Statements of Income. The
total charge consists of a $52.9 million increase in reserves, a $7.2 million
estimated future premium deficiency, $4.8 million of cost associated with ceding
certain losses, and a $3.4 million impairment to the deferred acquisition cost
asset. In connection with these actions, the Company performed an actuarial
review of outstanding reserves with segregated loss history on the exited
business. Based on this review, an increase to reserves of $52.9 million was
recorded in the fourth quarter of 2001. The Company is contractually or under
statutory regulations obligated to renew policies with certain agents that will
be in runoff in 2002 and 2003. The estimated future premium deficiency on these
policies is $7.2 million and this loss was recorded during 2001. Under the
aggregate excess of loss reinsurance treaty, the Company ceded $5.9 million of
additional losses included in the aforementioned $52.9 million reserve increase,
the cost of ceding these losses into the treaty of $4.8 million was recorded in
the fourth quarter of 2001. In addition, as a result of projected future losses
on the exited business, the Company recorded an impairment to the DAC asset of
$3.4 million. This resulted in an increase in policy acquisition expenses and a
decrease in the Company's DAC asset balance as of December 31, 2001. Actual
future losses from the exited business may vary from the Company's estimate.
In the fourth quarter of 2001, the Company recognized a pre-tax charge of
$2.7 million related to severance and other employee related costs resulting
from the reorganization of its technology support group. Approximately 82
posi-
75
tions have been eliminated as a result of this restructuring plan, of which all
82 employees have been terminated as of December 31, 2002. In 2002, the Company
recognized a pre-tax benefit of $0.1 million related to this restructuring. The
Company made payments of $2.1 million and $0.5 million in 2002 and 2001,
respectively, related to this restructuring plan. This plan has been
implemented.
During 2000, the Company adopted a formal company-wide restructuring plan.
This plan was the result of a corporate initiative that began in the fall of
1999, intended to reduce expenses and enhance revenues. This plan consisted of
various initiatives including a series of internal reorganizations,
consolidations in home office operations, consolidations in field offices,
changes in distribution channels and product changes. As a result of the
Company's restructuring plan, it recognized a pre-tax charge of $21.4 million
during 2000. Approximately $5.7 million of this charge relates to severance and
other employee related costs resulting from the elimination of approximately 360
positions, of which 240 employees have been terminated as of December 31, 2001
and 120 vacant positions have been eliminated. All levels of employees, from
staff to senior management, were affected by the restructuring. In addition,
approximately $15.7 million of this charge relates to other restructuring costs,
consisting of one-time project costs, lease cancellations and the present value
of idle leased space. In 2002, the Company recognized a pre-tax benefit of $0.1
million related to this restructuring. As of December 31, 2002, the Company has
made payments of approximately $21.3 million related to this restructuring plan,
of which approximately $5.7 million relates to severance and other employee
related costs. This plan has been implemented.
As of December 31, 2002, the Company has repurchased $436.3 million, or
approximately 8 million shares, of its common stock under programs authorized by
the Board of Directors (the "Board"). As of December 31, 2002, the Board had
authorized total stock repurchases of $500.0 million, leaving $63.7 million
available to the Company for future repurchases. There were no share repurchases
in 2002 and 2001. The Company repurchased 1.9 million shares at a cost of $103.4
million in 2000.
FOUR
INVESTMENTS
A. FIXED MATURITIES AND EQUITY SECURITIES
The Company accounts for its investments in fixed maturities and equity
securities, all of which are classified as available-for-sale, in accordance
with the provisions of Statement No. 115.
The amortized cost and fair value of available-for-sale fixed maturities
and equity securities were as follows:
DECEMBER 31 2002
- -----------------------------------------------------------------------------
(In millions)
Gross Gross
Amortized Unrealized Unrealized Fair
Cost /(1)/ Gains Losses Value
- -----------------------------------------------------------------------------
U.S. Treasury securities
and U.S. government
and agency securities $ 570.5 $ 22.8 $ 0.8 $ 592.5
States and political
subdivisions 1,448.3 53.7 2.3 1,499.7
Foreign governments 14.1 0.8 0.1 14.8
Corporate fixed
maturities 4,424.5 251.1 102.9 4,572.7
Mortgage-backed
securities 1,258.5 65.1 0.2 1,323.4
- -----------------------------------------------------------------------------
Total fixed maturities $ 7,715.9 $ 393.5 $ 106.3 $ 8,003.1
=============================================================================
Equity securities $ 49.1 $ 4.1 $ 0.4 $ 52.8
=============================================================================
DECEMBER 31 2001
- -----------------------------------------------------------------------------
(In millions)
Gross Gross
Amortized Unrealized Unrealized Fair
Cost /(1)/ Gains Losses Value
- -----------------------------------------------------------------------------
U.S. Treasury securities
and U.S. government
and agency securities $ 280.5 $ 4.9 $ 3.1 $ 282.3
States and political
subdivisions 1,830.5 16.4 17.1 1,829.8
Foreign governments 34.3 2.4 0.2 36.5
Corporate fixed
maturities 6,145.0 195.4 119.2 6,221.2
Mortgage-backed
securities 1,003.7 32.0 3.8 1,031.9
- -----------------------------------------------------------------------------
Total fixed maturities $ 9,294.0 $ 251.1 $ 143.4 $ 9,401.7
=============================================================================
Equity securities $ 61.2 $ 10.0 $ 9.1 $ 62.1
=============================================================================
/(1)/ Amortized cost for fixed maturities and cost for equity securities.
76
In connection with AFLIAC's voluntary withdrawal of its license in New York,
AFLIAC agreed with the New York Department of Insurance in 1994 to maintain,
through a custodial account in New York, a security deposit, the market value of
which will equal 102% of all outstanding liabilities of AFLIAC for New York
policyholders, claimants and creditors. At December 31, 2002, the amortized cost
and market value of these assets on deposit in New York were $180.1 million and
$189.9 million, respectively. At December 31, 2001, the amortized cost and
market value of these assets on deposit were $180.0 million and $182.9 million,
respectively. In addition, fixed maturities, excluding those securities on
deposit in New York, with an amortized cost of $137.4 million and $140.5 million
were on deposit with various state and governmental authorities at December 31,
2002 and 2001, respectively. Market values related to these securities were
$148.1 million and $145.2 million at December 31, 2002 and 2001, respectively.
At December 31, 2002, there were contractual investment commitments of
$12.3 million.
The amortized cost and fair value by maturity periods for fixed maturities
are shown below. Actual maturities may differ from contractual maturities
because borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties, or the Company may have the right to put
or sell the obligations back to the issuers. Mortgage backed securities are
included in the category representing their ultimate maturity.
DECEMBER 31 2002
- ------------------------------------------------------------------
(In millions)
Amortized Fair
Cost Value
- ------------------------------------------------------------------
Due in one year or less $ 299.6 $ 298.7
Due after one year through five years 2,497.6 2,580.4
Due after five years through ten years 2,235.1 2,332.6
Due after ten years 2,683.6 2,791.4
- ------------------------------------------------------------------
Total $ 7,715.9 $ 8,003.1
==================================================================
B. MORTGAGE LOANS AND REAL ESTATE
The Company's mortgage loans are diversified by property type and location.
Mortgage loans are collateralized by the related properties and generally do not
exceed 75% of the property's value at the time of origination. No mortgage loans
were originated during 2002 and 2001. The carrying values of mortgage loans, net
of applicable reserves, were $259.8 million and $321.6 million at December 31,
2002 and 2001, respectively. Reserves for mortgage loans were $2.8 million and
$3.8 million at December 31, 2002 and 2001, respectively. During 2001, the
Company received proceeds of $194.3 million as a result of the sale of $182.2
million of its mortgage loan portfolio.
There was no real estate held at December 31, 2002 in the Company's
investment portfolio. At December 31, 2001, the Company held one real estate
investment with a carrying value of $1.9 million which was acquired through the
foreclosure of a mortgage loan. This investment represented the one non-cash
investing activity in 2001. There were no non-cash investing activities,
including real estate acquired through foreclosure of mortgage loans in 2002 and
2000.
There were no contractual commitments to extend credit under commercial
mortgage loan agreements at December 31, 2002.
Mortgage loan investments comprised the following property types and
geographic regions:
DECEMBER 31 2002 2001
- -------------------------------------------------------------------
(In millions)
Property type:
Office building $ 142.0 $ 177.0
Industrial / warehouse 62.2 68.3
Retail 51.0 67.9
Residential 6.9 11.5
Other 0.5 0.7
Valuation allowances (2.8) (3.8)
- -------------------------------------------------------------------
Total $ 259.8 $ 321.6
===================================================================
Geographic region:
Pacific $ 72.3 $ 78.2
South Atlantic 63.3 91.8
New England 45.1 50.5
East North Central 38.3 40.0
West South Central 18.6 33.3
Middle Atlantic 11.1 16.8
Other 13.9 14.8
Valuation allowances (2.8) (3.8)
- -------------------------------------------------------------------
Total $ 259.8 $ 321.6
===================================================================
At December 31, 2002, scheduled mortgage loan maturities were as follows: 2003 -
$25.7 million; 2004 - $64.9 million; 2005 - $14.6 million; 2006 - $29.2 million;
2007 - $16.9 million and $108.5 million thereafter. Actual maturities could
differ from contractual maturities because borrowers may have the right to
prepay obligations with or without prepayment penalties and loans may be
refinanced. During 2002, the Company did not refinance any mortgage loans based
on terms which differed from current market rates.
Mortgage loans investment valuation allowances of $2.8 million and $3.8
million at December 31, 2002 and 2001, respectively, have been deducted in
arriving at investment carrying values as presented in the Consolidated Balance
Sheets. There were no impaired loans or related reserves as of December 31, 2002
and 2001. Those mortgage loans that were impaired during a portion of 2001 had
an average carrying value of $2.2 million as of December 31, 2001. Related
interest income while such loans were impaired was $1.4 million in 2000. There
was no interest income received in 2002 and 2001 related to impaired loans.
77
C. DERIVATIVE INSTRUMENTS
The Company maintains an overall risk management strategy that incorporates the
use of derivative instruments to minimize significant unplanned fluctuations in
earnings that are caused by interest rate or foreign currency volatility. The
operations of the Company are subject to risk resulting from interest rate
fluctuations to the extent that there is a difference between the amount of the
Company's interest-earning assets and the amount of interest-bearing liabilities
that are paid, withdrawn, mature or re-price in specified periods. The principal
objective of the Company's asset/liability management activities is to provide
maximum levels of net investment income while maintaining acceptable levels of
interest rate and liquidity risk and facilitating the funding needs of the
Company. The Company has developed an asset/liability management approach
tailored to specific insurance or investment product objectives. The investment
assets of the Company are managed in over 20 portfolio segments consistent with
specific products or groups of products having similar liability
characteristics. As part of this approach, management develops investment
guidelines for each portfolio consistent with the return objectives, risk
tolerance, liquidity, time horizon, tax and regulatory requirements of the
related product or business segment. Management has a general policy of
diversifying investments both within and across all portfolios. The Company
monitors the credit quality of its investments and its exposure to individual
markets, borrowers, industries, and sectors.
The Company uses derivative financial instruments, primarily interest rate
swaps and futures contracts, with indices that correlate to balance sheet
instruments to modify its indicated net interest sensitivity to levels deemed to
be appropriate. Specifically, for floating rate funding agreements that are
matched with fixed rate securities, the Company manages the risk of cash flow
variability by hedging with interest rate swap contracts designed to pay fixed
and receive floating interest. Under interest rate swap contracts, the Company
agrees to exchange, at specified intervals, the difference between fixed and
floating interest amounts calculated on an agreed-upon notional principal
amount. Additionally, the Company uses exchange traded financial futures
contracts to hedge against interest rate risk on the reinvestment of fixed
maturities. The Company is exposed to interest rate risk on fixed maturity
reinvestments from the time of maturity until the purchase of new fixed
maturities. Prior to September 2002, the Company used exchange traded futures
contracts to hedge against interest rate risk on anticipated sales of guaranteed
investment contracts ("GIC") and other funding agreements. The Company was
exposed to interest rate risk from the time of sale of the GIC until the receipt
of the deposit and purchase of the underlying asset to back the liability. The
Company only trades derivative instruments with nationally recognized brokers,
which the Company believes have adequate capital to ensure that there is minimal
risk of default.
As a result of the Company's issuance of trust instruments supported by
funding obligations denominated in foreign currencies, as well as the Company's
investment in securities denominated in foreign currencies, the Company's
operating results are exposed to changes in exchange rates between the U.S.
dollar and the Swiss Franc, Japanese Yen, British Pound and Euro. From time to
time, the Company may also have exposure to other foreign currencies. To
mitigate the short-term effect of changes in currency exchange rates, the
Company regularly enters into foreign exchange swap, futures and options
contracts to hedge its net foreign currency exposure. Additionally, the Company
enters into compound currency/interest rate swap contracts to hedge foreign
currency and interest rate exposure on specific trust instruments supported by
funding obligations.
By using derivative instruments, the Company is exposed to credit risk. If
the counterparty fails to perform, credit risk is equal to the extent of the
fair value gain (including any accrued receivable) in a derivative. The Company
regularly assesses the financial strength of its counterparties and generally
enters into derivative instruments with counterparties rated "A" or better by
nationally recognized rating agencies. Depending on the nature of the derivative
transaction, the Company maintains bilateral Collateral Standardized
Arrangements ("CSA") with each counterparty. In general, the CSA sets a minimum
threshold of exposure that must be collateralized, although thresholds may vary
by CSA. At December 31, 2002 and 2001, respectively, collateral of $23.7 million
and $69.7 million, in the form of cash, bonds and US Treasury notes were held by
our counterparties related to these agreements.
The Company's derivative activities are monitored by management, who review
portfolio activities and risk levels. Management also oversees all derivative
transactions to ensure that the types of transactions entered into and the
results obtained from those transactions are consistent with the Company's risk
management strategy and with Company policies and procedures.
D. FAIR VALUE HEDGES
The Company enters into compound foreign currency/interest rate swaps to convert
its foreign denominated fixed rate trust instruments supported by funding
obligations to U.S. dollar floating rate instruments. For the years ended
December 31, 2002 and 2001, the Company recognized net gains of $0.3 million,
reported in (gains) losses on derivative instruments in the Consolidated
Statements of Income, which represented the ineffective portion of all fair
value hedges. All components of each derivative's gain or loss are included in
the assessment of hedge effectiveness, unless otherwise noted.
78
E. CASH FLOW HEDGES
The Company enters into various types of interest rate swap contracts to hedge
exposure to interest rate fluctuations. Specifically, for floating rate funding
agreement liabilities that are matched with fixed rate securities, the Company
manages the risk of cash flow variability by hedging with interest rate swap
contracts. Under these swap contracts, the Company agrees to exchange, at
specified intervals, the difference between fixed and floating interest amounts
calculated on an agreed-upon notional principal amount. The Company also
purchases long futures contracts and sells short futures contracts on margin to
hedge against interest rate fluctuations associated with the reinvestment of
fixed maturities. The Company is exposed to interest rate risk on reinvestments
of fixed maturities from the time of maturity until the purchase of new fixed
maturities. The Company uses U.S. Treasury Note futures to hedge this risk.
Additionally, prior to September 2002, the Company used exchange traded futures
contracts to hedge against interest rate fluctuations associated with the sale
of GICs and other funding agreements. The Company was exposed to interest rate
risk from the time of sale of the GIC until receipt of the deposit and purchase
of the underlying asset to back the liability.
The Company also enters into foreign currency forward contracts to hedge
foreign currency exposure on specific fixed income securities. Additionally, the
Company enters into compound foreign currency/interest rate swap contracts to
hedge foreign currency and interest rate exposure, and foreign exchange futures
and options contracts to hedge foreign currency exposure on specific trust
instruments supported by funding obligations. Under the swap contracts, the
Company agrees to exchange interest and principal related to trust obligations
payable in foreign currencies, at current exchange rates, for the equivalent
payment in U.S. dollars translated at a specific currency exchange rate. Under
the foreign exchange forward, futures and options contracts, the Company has the
right to purchase the hedged currency at a fixed strike price in U.S. dollars.
For the years ended December 31, 2002 and 2001, respectively, the Company
recognized a net gain of $65.1 million and a net loss of $35.5 million,
representing the total ineffectiveness of all cash flow hedges. The net gain
reflects total ineffectiveness in 2002, of which $40.0 million related to
ineffective swap contracts and was reported in (gains) losses on derivative
instruments in the Consolidated Statements of Income, and $25.1 million related
to ineffective futures and options contracts, which was reported in other income
in the Consolidated Statements of Income. The 2001 net loss of $35.5 million,
representing total ineffectiveness on all cash flow hedges, was reported in
(gains) losses on derivative instruments in the Consolidated Statements of
Income. The Company did not hold any ineffective futures or options contracts
during 2001. All components of each derivative's gain or loss are included in
the assessment of hedge effectiveness, unless otherwise noted.
The net loss in 2001 included a total loss of $35.8 million, related to
ineffective hedges of floating rate funding agreements with put features
allowing the policyholder to cancel the contract prior to maturity. During the
fourth quarter of 2001, the Company reviewed the trend in put activity since
inception of the funding agreement business in order to determine the ongoing
effectiveness of the hedging relationship. Based upon the historical trend in
put activity, as well as management's uncertainty about possible future events,
the Company determined that it was probable that some of the future variable
cash flows of the funding agreements would not occur, and therefore the hedges
were ineffective. The Company analyzed the future payments under each
outstanding funding agreement, and determined the amount of payments that were
probable of occurring versus those that were probable of not occurring. The
total accumulated losses deferred in other comprehensive income related to the
payments that were probable of not occurring, which totaled $35.8 million, was
reclassified to earnings during the fourth quarter of 2001 and reflected in
(gains) losses on derivative instruments in the Consolidated Statements of
Income. During 2002, all of the Company's floating rate funding agreements with
put features were terminated; therefore, the total accumulated losses of $35.8
million were reclassified from (gains) losses on derivative instruments to net
realized investment losses in the Consolidated Statements of Income.
As of December 31, 2002, $5.9 million of the deferred net gains on
derivative instruments accumulated in other comprehensive income could be
recognized in earnings during the next twelve months depending on the forward
interest rate and currency rate environment. Transactions and events that (1)
are expected to occur over the next twelve months and (2) will necessitate
reclassifying to earnings these derivatives gains (losses) include (a) the
re-pricing of variable rate trust instruments supported by funding obligations,
(b) the interest payments (receipts) on foreign denominated trust instruments
supported by funding obligations and foreign securities, (c) the possible
repurchase of other funding agreements, and (d) the anticipated reinvestment of
fixed maturities. The maximum term over which the Company is hedging its
exposure to the variability of future cash flows, for all forecasted
transactions, excluding interest payments on variable-rate funding agreements,
is 12 months.
F. TRADING ACTIVITIES
The Company entered into insurance portfolio-linked, credit default, and other
swap contracts for investment purposes. These products were not linked to
specific assets and liabilities on the balance sheet or to a forecasted
transaction, and therefore did not qualify for hedge accounting. Under the
insurance portfolio-linked swap contracts, the Company agreed to exchange cash
flows according to the performance of a specified underwriter's portfolio of
insurance business.
79
Under the terms of the credit default swap contracts, the Company assumed the
default risk of a specific high credit quality issuer in exchange for a stated
annual premium. In the case of default, the Company would have paid the
counterparty par value for a pre-determined security of the issuer. The primary
risk associated with these transactions was the default risk of the underlying
companies. Under the other swap contract entered into for investment purposes,
the Company agreed to exchange the difference between fixed and floating
interest amounts calculated on an agreed upon notional principal amount.
As of December 31, 2001, the Company no longer held insurance or credit
default swap contracts, although final payment related to the insurance
portfolio-linked swap contract was recorded in 2002, in accordance with contract
terms. Net realized investment gains related to insurance portfolio-linked
contracts were $2.1 million in 2002, while net realized investment losses
related to these contracts were $4.3 million and $0.7 million for the years
ended December 31, 2001 and 2000, respectively.
The stated annual premium under credit default swap contracts was
recognized in net investment income. There were no net increases to investment
income related to credit default swap contracts for the years ended December 31,
2002 and 2001; however, there was a net increase of $0.2 million for the year
ended December 31, 2000.
As of December 31, 2002 the Company no longer held any other swap contracts
for investment purposes. The fair value of the other swap contract held for
investment purposes was $(2.1) million at December 31, 2001. The net decrease in
net investment income related to this contract was $0.4 million, $0.7 million
and $0.1 million for the years ended December 31, 2002, 2001 and 2000,
respectively.
G. VARIABLE INTEREST ENTITY
The Company holds an investment in the Allmerica CBO I, Ltd., which was formed
in 1998 as a collateralized bond obligation, to issue secured notes to various
investors and use the proceeds to purchase high yield fixed income securities.
The note holders own beneficial interests in the cash flows of the high yield
securities. The interests are classified based upon priority of payments, and
consist of the following par values as of December 31:
2002 2001
- ------------------------------------------------------------------
(In millions)
Floating Rate Secured Notes $ 241.6 $ 249.4
Second Priority Senior Notes 65.3 60.7
Senior Subordinated Notes 32.9 32.9
Junior Subordinated Notes 21.9 21.9
- ------------------------------------------------------------------
Total Allmerica CBO Capital $ 361.7 $ 364.9
==================================================================
At both December 31, 2002 and 2001, the Company owned a $36.9 million par value
investment in the Allmerica CBO I, Ltd., consisting of $30.9 million of Senior
Subordinated Notes and $6.0 million of Junior Subordinated Notes. The Company's
investment in Allmerica CBO I, Ltd. was considered to be other-than-temporarily
impaired and therefore completely written off during 2001. Through the Company's
ownership of the Junior Subordinated Notes, it is entitled to 27.4% of the
residual value, if any, of the CBO. The Company has no remaining exposure to
loss because its investment in the non-recourse notes has already been
completely written off.
H. UNREALIZED GAINS AND LOSSES
Unrealized gains and losses on available-for-sale, other securities, and
derivative instruments are summarized as follows:
FOR THE YEARS ENDED DECEMBER 31
- --------------------------------------------------------------------------------------------
(In millions)
Equity
Fixed Securities
2002 Maturities/(1)/ And Other/(2)/ Total
- --------------------------------------------------------------------------------------------
Net appreciation, beginning of year $ 23.7 $ 4.7 $ 28.4
Net appreciation on
available-for-sale securities and
derivative instruments 121.0 2.9 123.9
Net depreciation from the effect on
deferred policy acquisition costs
and on policy liabilities (39.3) -- (39.3)
Provision for deferred federal
income taxes (28.6) (1.0) (29.6)
- --------------------------------------------------------------------------------------------
53.1 1.9 55.0
- --------------------------------------------------------------------------------------------
Net appreciation, end of year $ 76.8 $ 6.6 $ 83.4
============================================================================================
2001
- --------------------------------------------------------------------------------------------
Net (depreciation) appreciation,
beginning of year $ (26.5) $ 21.3 $ (5.2)
Net appreciation (depreciation) on
available-for-sale securities and
derivative instruments 96.9 (25.5) 71.4
Net depreciation from the effect on
deferred policy acquisition costs
and on policy liabilities (19.7) -- (19.7)
(Provision) benefit for deferred
federal income taxes (27.0) 8.9 (18.1)
- --------------------------------------------------------------------------------------------
50.2 (16.6) 33.6
- --------------------------------------------------------------------------------------------
Net appreciation, end of year $ 23.7 $ 4.7 $ 28.4
============================================================================================
80
2000
- -----------------------------------------------------------------------------
Net (depreciation) appreciation,
beginning of year $ (97.0) $ 21.7 $ (75.3)
Net appreciation (depreciation) on
available-for-sale securities 144.6 (0.6) 144.0
Net depreciation from the effect on
deferred policy acquisition costs
and on policy liabilities (36.1) -- (36.1)
(Provision) benefit for deferred
federal income taxes (38.0) 0.2 (37.8)
- -----------------------------------------------------------------------------
70.5 (0.4) 70.1
- -----------------------------------------------------------------------------
Net (depreciation) appreciation,
end of year $ (26.5) $ 21.3 $ (5.2)
=============================================================================
/(1)/ Includes net depreciation on derivative instruments of $58.5 million and
net appreciation on derivative instruments of $1.4 million in 2002 and 2001,
respectively. Balances at December 31, 2002 and 2001 include net depreciation
from derivative instruments of $101.2 million and $42.7 million, respectively.
/(2)/ Includes net appreciation on other investments of $0.1 million, $0.5
million, and $1.8 million in 2002, 2001 and 2000, respectively.
I. OTHER
At December 31, 2002, AFC had no concentration of investments in a single
investee exceeding 10% of shareholders' equity except for investments with
Federal National Mortgage Association and Federal Home Loan Mortgage Corporation
with carrying values of $440.0 million and $259.7 million, respectively. At
December 31, 2001, AFC had no concentration of investments in a single investee
exceeding 10% of shareholders' equity.
FIVE
INVESTMENT INCOME AND GAINS AND LOSSES
A. NET INVESTMENT INCOME
The components of net investment income were as follows:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -----------------------------------------------------------------
(In millions)
Fixed maturities $ 567.9 $ 614.0 $ 564.6
Mortgage loans 23.9 42.7 52.1
Equity securities 1.6 2.3 2.0
Policy loans 24.8 27.1 26.1
Derivative instruments (37.7) (48.0) (5.6)
Other long-term investments 14.0 16.5 7.2
Short-term investments 9.5 17.3 14.5
- -----------------------------------------------------------------
Gross investment income 604.0 671.9 660.9
Less investment expenses (13.8) (16.7) (15.4)
- -----------------------------------------------------------------
Net investment income $ 590.2 $ 655.2 $ 645.5
=================================================================
The Company had fixed maturities with a carrying value of $39.9 million and
$10.7 million on non-accrual status at December 31, 2002 and 2001, respectively.
The Company had mortgage loans with a carrying value of $7.4 million on
non-accrual status at December 31, 2002. There were no mortgage loans on
non-accrual status at December 31, 2001. The effect of non-accruals, compared
with amounts that would have been recognized in accordance with the original
terms of the investments, was a reduction in net investment income of $19.9
million, $11.3 million, and $3.6 million in 2002, 2001, and 2000, respectively.
The payment terms of mortgage loans may from time to time be restructured
or modified. There were no restructured mortgage loans at December 31, 2002 and
2001. Interest income on restructured mortgage loans that would have been
recorded in accordance with the original terms of such loans amounted to $1.7
million in 2000. Actual interest income on these loans included in net
investment income aggregated $1.4 million in 2000.
There were no mortgage loans which were non-income producing at December
31, 2002 and 2001. There were, however, fixed maturities with a carrying value
of $7.2 million and $2.9 million at December 31, 2002 and 2001, respectively,
which were non-income producing during 2002 and 2001.
Included in other long-term investments is income from limited partnerships
of $5.3 million, $9.4 million, and $7.8 million in 2002, 2001, and 2000,
respectively.
B. NET REALIZED INVESTMENT GAINS AND LOSSES
Realized (losses) gains on investments were as follows:
For the Years Ended December 31 2002 2001 2000
- -----------------------------------------------------------------
(In millions)
Fixed maturities $ (110.8) $ (121.1) $ (151.7)
Mortgage loans 1.0 10.7 1.3
Equity securities 1.3 28.4 3.8
Derivative instruments (53.1) (32.9) 3.1
Other long-term investments (0.7) (9.0) 2.8
- -----------------------------------------------------------------
Net realized investment losses $ (162.3) $ (123.9) $ (140.7)
=================================================================
81
The proceeds from voluntary sales of available-for-sale securities and the gross
realized gains and gross realized losses on those sales were as follows:
FOR THE YEARS ENDED DECEMBER 31
- ----------------------------------------------------------------------------
(In millions)
Proceeds from Gross Gross
2002 Voluntary Sales Gains Losses
- ----------------------------------------------------------------------------
Fixed maturities $ 3,128.9 $ 152.7 $ 40.4
Equity securities $ 13.4 $ 13.0 $ 0.1
============================================================================
2001
- ----------------------------------------------------------------------------
Fixed maturities $ 2,165.7 $ 114.3 $ 57.5
Equity securities $ 40.1 $ 30.0 $ --
============================================================================
2000
- ----------------------------------------------------------------------------
Fixed maturities $ 1,997.0 $ 11.0 $ 99.5
Equity securities $ 13.1 $ 4.0 $ 0.2
============================================================================
The Company recognized losses of $238.5 million, $185.3 million and $66.1
million in 2002, 2001 and 2000, respectively, related to other-than-temporary
impairments of fixed maturities and other securities.
C. OTHER COMPREHENSIVE INCOME RECONCILIATION
The following table provides a reconciliation of gross unrealized gains (losses)
to the net balance shown in the Statements of Comprehensive Income:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -----------------------------------------------------------------------------
(In millions)
Unrealized appreciation (depreciation)
on available-for sale securities:
Unrealized holding gains (losses)
arising during period, (net of taxes
(benefit) of $11.4 million,
$(18.3) million and $(12.9) million
in 2002, 2001 and 2000) $ 21.1 $ (34.0) $ (24.1)
Less: reclassification adjustment for
losses included in net income
(net of tax benefits of $38.7 million,
$35.9 million and $50.7 million
in 2002, 2001 and 2000) (71.9) (66.7) (94.2)
- -----------------------------------------------------------------------------
Total available-for-sale securities 93.0 32.7 70.1
- -----------------------------------------------------------------------------
Unrealized depreciation on
derivative instruments:
Unrealized holding gains (losses)
arising during period, (net of taxes
(benefit) of $4.7 and $(63.4)
million in 2002 and 2001) 8.9 (117.7) --
Less: reclassification adjustment
for gains (losses) included in net
income (net of taxes (benefit) of
$25.2 million and $(63.9)
million in 2002 and 2001) 46.9 (118.6) --
- -----------------------------------------------------------------------------
Total derivative instruments (38.0) 0.9 --
- -----------------------------------------------------------------------------
Net unrealized appreciation
on investments $ 55.0 $ 33.6 $ 70.1
=============================================================================
SIX
FAIR VALUE DISCLOSURES OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures about Fair
Value of Financial Instruments," requires disclosure of fair value information
about certain financial instruments (insurance contracts, real estate, goodwill
and taxes are excluded) for which it is practicable to estimate such values,
whether or not these instruments are included in the balance sheet. The fair
values presented for certain financial instruments are estimates which, in many
cases, may differ significantly from the amounts which could be realized upon
immediate liquidation. In cases where market prices are not available, estimates
of fair value are based on discounted cash flow analyses which utilize current
interest rates for similar financial instruments which have comparable terms and
credit quality.
The following methods and assumptions were used to estimate the fair value
of each class of financial instruments:
Cash and Cash Equivalents
For these short-term investments, the carrying amount approximates fair value.
Fixed Maturities
Fair values are based on quoted market prices, if available. If a quoted market
price is not available, fair values are estimated using independent pricing
sources or internally developed pricing models using discounted cash flow
analyses.
Equity Securities
Fair values are based on quoted market prices, if available. If a quoted market
price is not available, fair values are estimated using independent pricing
sources or internally developed pricing models.
Mortgage Loans
Fair values are estimated by discounting the future contractual cash flows using
the current rates at which similar loans would be made to borrowers with similar
credit ratings. The fair values are limited to the lesser of the present value
of the cash flows or book value.
Policy Loans
The carrying amount reported in the Consolidated Balance Sheets approximates
fair value since policy loans have no defined maturity dates and are inseparable
from the insurance contracts.
82
Derivative Instruments
Fair values are estimated using independent pricing sources.
Company Owned Life Insurance
Fair values are based on the current cash surrender value of the policy. This
value is dependent on the fair value of the underlying securities which is based
on quoted market prices, if available. If a quoted market price is not
available, fair values are estimated using independent pricing sources or
internally developed pricing models.
Investment Contracts (Without Mortality Features)
Fair values for the Company's liabilities under guaranteed investment type
contracts are estimated using discounted cash flow calculations using current
interest rates for similar contracts with maturities consistent with those
remaining for the contracts being valued. Liabilities under supplemental
contracts without life contingencies are estimated based on current fund
balances and other individual contract funds represent the present value of
future policy benefits. Other liabilities are based on current surrender values.
Trust Instruments Supported by Funding Obligations
Fair values are estimated using discounted cash flow calculations using current
interest rates for similar contracts with maturities consistent with those
remaining for the contracts being valued.
Debt
The carrying value of short-term debt reported in the Consolidated Balance
Sheets approximates fair value. The fair value of long-term debt was estimated
using market quotes, when available, and when not available, discounted cash
flow analyses.
Mandatorily Redeemable Preferred Securities of a Subsidiary Trust Holding Solely
Junior Subordinated Debentures of the Company
Fair values are based on quoted market prices, if available. If a quoted market
price is not available, fair values are estimated using independent pricing
sources.
The estimated fair values of the financial instruments were as follows:
DECEMBER 31 2002 2001
- --------------------------------------------------------------------------------------------------------
(In millions)
Carrying Fair Carrying Fair
Value Value Value Value
- --------------------------------------------------------------------------------------------------------
Financial Assets
Cash and cash equivalents $ 389.8 $ 389.8 $ 350.2 $ 350.2
Fixed maturities 8,003.1 8,003.1 9,401.7 9,401.7
Equity securities 52.8 52.8 62.1 62.1
Mortgage loans 259.8 276.1 321.6 335.1
Policy loans 361.4 361.4 379.6 379.6
Derivative instruments 44.7 44.7 70.2 70.2
Company owned life insurance 67.2 67.2 67.3 67.3
- --------------------------------------------------------------------------------------------------------
$ 9,178.8 $ 9,195.1 $ 10,652.7 $ 10,666.2
========================================================================================================
Financial Liabilities
Guaranteed investment contracts $ 207.2 $ 220.4 $ 1,100.7 $ 1,174.1
Derivative instruments 24.6 24.6 180.3 180.3
Supplemental contracts without life contingencies 60.0 60.0 57.3 57.3
Dividend accumulations 87.6 87.6 88.8 88.8
Other individual contract deposit funds 58.3 58.3 50.4 50.4
Other group contract deposit funds 164.6 173.5 213.4 212.4
Individual annuity contracts - general account 1,493.0 1,434.6 1,686.2 1,621.3
Trust instruments supported by funding obligations 1,202.8 1,224.5 1,589.0 1,534.0
Short-term debt -- -- 83.3 83.3
Long-term debt 199.5 160.4 199.5 204.4
Mandatorily redeemable preferred securities of a
subsidiary trust holding solely junior
subordinated debentures of the Company 300.0 187.5 300.0 286.0
- --------------------------------------------------------------------------------------------------------
$ 3,797.6 $ 3,631.4 $ 5,548.9 $ 5,492.3
========================================================================================================
83
SEVEN
CLOSED BLOCK
Summarized financial information of the Closed Block as of December 31, 2002 and
2001 and for the periods ended December 31, 2002, 2001 and 2000 is as follows:
DECEMBER 31 2002 2001
- -----------------------------------------------------------------------
(In millions)
Assets
Fixed maturities, at fair value (amortized
cost of $517.4 and $498.1) $ 542.4 $ 504.2
Mortgage loans 46.6 55.7
Policy loans 167.4 182.1
Cash and cash equivalents 0.3 9.2
Accrued investment income 13.1 14.6
Deferred policy acquisition costs 8.2 10.4
Deferred federal income taxes 5.4 3.4
Other assets 4.7 2.8
- -----------------------------------------------------------------------
Total assets $ 788.1 $ 782.4
=======================================================================
Liabilities
Policy liabilities and accruals $ 767.5 $ 798.2
Policyholder dividends 57.1 30.7
Other liabilities 23.8 7.0
- -----------------------------------------------------------------------
Total liabilities $ 848.4 $ 835.9
=======================================================================
Excess of Closed Block liabilities over
assets designated to the Closed Block $ 60.3 $ 53.5
Amounts included in accumulated other
comprehensive income:
Net unrealized investment losses, net of
deferred federal income tax benefits of
$5.2 million and $2.3 million (9.6) (4.3)
- -----------------------------------------------------------------------
Maximum future earnings to be recognized
from Closed Block assets and liabilities $ 50.7 $ 49.2
=======================================================================
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -----------------------------------------------------------------------------
(In millions)
Revenues
Premiums and other income $ 46.2 $ 47.2 $ 49.9
Net investment income 51.3 54.1 53.6
Realized investment losses (8.3) (2.2) (5.4)
- -----------------------------------------------------------------------------
Total revenues 89.2 99.1 98.1
- -----------------------------------------------------------------------------
Benefits and expenses
Policy benefits 79.4 83.1 89.5
Policy acquisition expenses 2.2 0.6 2.1
Other operating expenses 0.7 -- 0.2
- -----------------------------------------------------------------------------
Total benefits and expenses 82.3 83.7 91.8
- -----------------------------------------------------------------------------
Contribution from the Closed Block $ 6.9 $ 15.4 $ 6.3
=============================================================================
Cash flows
Cash flows from operating activities:
Contribution from the Closed
Block $ 6.9 $ 15.4 $ 6.3
Adjustment for net realized
investment losses 8.3 2.2 5.4
Change in:
Deferred policy acquisition costs 2.2 0.6 2.1
Policy liabilities and accruals (31.2) (12.3) (12.0)
Other assets (0.5) 2.1 5.3
Expenses and taxes payable 9.6 (0.2) (10.1)
Other, net (0.8) 0.3 (0.1)
- -----------------------------------------------------------------------------
Net cash (used in) provided by
operating activities (5.5) 8.1 (3.1)
- -----------------------------------------------------------------------------
Cash flows from investing activities:
Sales, maturities and
repayments of investments 176.1 136.8 133.3
Purchases of investments (194.2) (147.2) (160.3)
Other, net 14.7 9.6 9.4
- -----------------------------------------------------------------------------
Net cash used in
investing activities (3.4) (0.8) (17.6)
- -----------------------------------------------------------------------------
Net (decrease) increase in cash
and cash equivalents (8.9) 7.3 (20.7)
Cash and cash equivalents,
beginning of year 9.2 1.9 22.6
- -----------------------------------------------------------------------------
Cash and cash equivalents,
end of year $ 0.3 $ 9.2 $ 1.9
=============================================================================
There were no reserves on mortgage loans at December 31, 2002 and 2001.
Many expenses related to Closed Block operations are charged to operations
outside the Closed Block; accordingly, the contribution from the Closed Block
does not represent the actual profitability of the Closed Block operations.
Operating costs and expenses outside of the Closed Block are, therefore,
disproportionate to the business outside the Closed Block.
84
EIGHT
GOODWILL
On January 1, 2002, the Company adopted Statement No. 142. Upon implementation,
the Company recorded an impairment charge of $3.7 million, net of taxes, and
ceased its amortization of goodwill. Amortization expense in 2001 and 2000 was
$4.0 million and $3.8 million, respectively, net of taxes. In accordance with
Statement No. 142, the following table provides (loss) income before the
cumulative effect of a change in accounting principle, net (loss) income, and
related per-share amounts as of December 31, 2002, 2001, and 2000 as reported
and adjusted as if the Company had ceased amortizing goodwill effective January
1, 2000.
DECEMBER 31, 2002 2001 2000
- -----------------------------------------------------------------------------
(In millions, except per share data)
Reported (loss) income before
cumulative effect of change in
accounting principle $ (302.4) $ 0.1 $ 199.9
Goodwill amortization -- 4.0 3.8
- -----------------------------------------------------------------------------
Adjusted (loss) income before
cumulative effect of change in
accounting principle $ (302.4) $ 4.1 $ 203.7
=============================================================================
Reported net (loss) income $ (306.1) $ (3.1) $ 199.9
Goodwill amortization -- 4.0 3.8
- -----------------------------------------------------------------------------
Adjusted net (loss) income $ (306.1) $ 0.9 $ 203.7
=============================================================================
Per Share Information:
Basic
Reported (loss) income before
cumulative effect of change in
accounting principle $ (5.72) $ -- $ 3.75
Goodwill amortization -- 0.08 0.07
- -----------------------------------------------------------------------------
Adjusted (loss) income before
cumulative effect of change in
accounting principle $ (5.72) $ 0.08 $ 3.82
- -----------------------------------------------------------------------------
Reported net (loss) income $ (5.79) $ (0.06) $ 3.75
Goodwill amortization -- 0.08 0.07
- -----------------------------------------------------------------------------
Adjusted net (loss) income $ (5.79) $ 0.02 $ 3.82
=============================================================================
Diluted
Reported (loss) income before
cumulative effect of change in
accounting principle $ (5.72) $ -- $ 3.70
Goodwill amortization -- 0.08 0.07
- -----------------------------------------------------------------------------
Adjusted (loss) income before
cumulative effect of change in
accounting principle $ (5.72) $ 0.08 $ 3.77
=============================================================================
Reported net (loss) income $ (5.79) $ (0.06) $ 3.70
Goodwill amortization -- 0.08 0.07
- -----------------------------------------------------------------------------
Adjusted net (loss) income $ (5.79) $ 0.02 $ 3.77
=============================================================================
In accordance with the provisions of Statement No. 142, the Company performed
its annual review of its goodwill for impairment in the fourth quarter of 2002
and determined that no further impairments were required.
NINE
DEBT
Short and long-term debt consisted of the following:
DECEMBER 31 2002 2001
- ----------------------------------------------------------
(In millions)
Short-term
Commercial paper $ - $ 83.3
Long-term
Senior Debentures (unsecured) $ 199.5 $ 199.5
==========================================================
During 2002 and 2001, AFC issued commercial paper primarily to manage imbalances
between operating cash flows and existing commitments primarily in its premium
financing business. Commercial paper borrowing arrangements are supported by a
credit agreement.
At December 31, 2002, the Company had $150.0 million available for
borrowing under a committed syndicated credit agreement which expires on May 24,
2003. Borrowings under this agreement are unsecured and incur interest at a rate
per annum equal to, at the Company's option, a designated base rate or the
eurodollar rate plus applicable margin.
Senior Debentures of the Company have a $200.0 million face value, pay
interest semiannually at a rate of 7 5/8%, and mature on October 16, 2025. The
Senior Debentures are subject to certain restrictive covenants, including
limitations on issuance of or disposition of stock of restricted subsidiaries
and limitations on liens. The Company is in compliance with all covenants.
Interest expense was $17.1 million, $19.5 million and $21.4 million in
2002, 2001 and 2000, respectively. Interest expense included $15.3 million
related to the Company's Senior Debentures for each year. In 2002 and 2001,
there was no interest expense related to borrowings under the credit agreements.
Interest expense related to borrowings under the credit agreements was
approximately $0.1 million in 2000. All interest expense is recorded in other
operating expenses.
85
TEN
FEDERAL INCOME TAXES
Provisions for federal income taxes have been calculated in accordance with the
provisions of Statement No. 109. A summary of the federal income tax (benefit)
expense in the Consolidated Statements of Income is shown below:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- --------------------------------------------------------------------------------
(In millions)
Federal income tax
(benefit) expense
Current $ (6.8) $ (12.4) $ 1.2
Deferred (228.0) (63.1) 1.5
- --------------------------------------------------------------------------------
Total $ (234.8) $ (75.5) $ 2.7
================================================================================
The federal income taxes attributable to the consolidated results of operations
are different from the amounts determined by multiplying income before federal
income taxes by the statutory federal income tax rate. The sources of the
difference and the tax effects of each were as follows:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -----------------------------------------------------------------------------
(In millions)
Expected federal income tax
(benefit) expense $ (182.4) $ (20.8) $ 76.5
Tax-exempt interest (24.3) (30.3) (33.2)
Prior years' federal income tax
settlement (11.6) -- --
Tax credits (10.8) (10.8) (10.3)
Dividend received deduction (9.8) (12.6) (10.8)
Changes in estimates for prior
years dividend received deduction -- -- (13.3)
Changes in other tax estimates 3.0 (1.4) (7.5)
Other, net 1.1 0.4 1.3
- -----------------------------------------------------------------------------
Federal income tax (benefit) expense $ (234.8) $ (75.5) $ 2.7
=============================================================================
The deferred income tax net asset represents the tax effects of temporary
differences attributable to the Company's consolidated federal tax return group.
Its components were as follows:
DECEMBER 31 2002 2001
- ---------------------------------------------------------------------
(In millions)
Deferred tax (assets) liabilities
Insurance reserves $ (421.9) $ (381.6)
Deferred acquisition costs 361.2 518.7
Tax credit carryforwards (149.8) (105.3)
Employee benefit plans (113.3) (72.7)
Loss carryforwards (77.7) (94.4)
Discontinued operations (22.4) (20.2)
Software capitalization 19.0 23.7
Investments, net 6.9 (32.0)
Bad debt reserves (4.9) (3.0)
Restructuring reserves (3.9) (1.1)
Litigation reserves (0.9) (3.3)
Other, net (5.5) 3.1
- ---------------------------------------------------------------------
Deferred tax asset, net $ (413.2) $ (168.1)
=====================================================================
Gross deferred income tax assets totaled approximately $1.7 billion and $1.9
billion at December 31, 2002 and 2001, respectively. Gross deferred income tax
liabilities totaled approximately $1.3 billion and $1.7 billion at December 31,
2002 and 2001, respectively.
The Company believes, based on its earnings history and its future
expectations, that the Company's taxable income in future years will be
sufficient to realize all deferred tax assets. In determining the adequacy of
future income, the Company considered the future reversal of its existing
temporary differences and available tax planning strategies that could be
implemented, if necessary. At December 31, 2002, there are available alternative
minimum tax credit carryforwards, low income housing credit carryforwards and
certain other tax credit carryforwards of $93.5 million, $49.2 million and $7.1
million, respectively. The alternative minimum tax credit carryforwards have no
expiration date and the low income housing credit carryforwards will expire
beginning in 2018. The Company also has net operating loss carryforwards of
$222.0 million expiring in 2016.
The Company's federal income tax returns are routinely audited by the IRS,
and provisions are routinely made in the financial statements in anticipation of
the results of these audits. The IRS has examined the FAFLIC/AFLIAC consolidated
group's federal income tax returns through 1994. The IRS has also examined the
former Allmerica Property and Casualty Companies, Inc. ("Allmerica P&C")
consolidated group's federal income tax returns through 1994. Certain
adjustments proposed by the IRS with respect to FAFLIC/AFLIAC's federal income
tax returns for 1982 and 1983 remain unresolved. In the Company's opinion,
adequate tax liabilities have been established for all years. However, the
amount of these tax liabilities could be revised in the near term if estimates
of the Company's ultimate liability are revised.
86
ELEVEN
PENSION PLANS
AFC provides retirement benefits to substantially all of its employees under
defined benefit pension plans. These plans are based on a defined benefit cash
balance formula, whereby the Company annually provides an allocation to each
covered employee based on a percentage of that employee's eligible salary,
similar to a defined contribution plan arrangement. The allocation was based on
3.0%, 5.0% and 7.0% of each covered employee's eligible salary for 2002, 2001
and 2000, respectively. In addition to the cash balance allocation, certain
transition group employees, who have met specified age and service requirements
as of December 31, 1994, are eligible for a grandfathered benefit based
primarily on the employees' years of service and compensation during their
highest five consecutive plan years of employment. The Company's policy for the
plans is to fund at least the minimum amount required by the Employee Retirement
Income Security Act of 1974.
In order to measure the expense associated with these plans, management
must make various estimates and assumptions, including discount rates used to
value liabilities, assumed rates of return on plan assets, compensation
increases, employee turnover rates and anticipated mortality rates, for example.
The estimates used by management are based on the Company's historical
experience, as well as current facts and circumstances. In addition, the Company
uses outside actuaries to assist in measuring the expense and liability
associated with these plans.
Components of net periodic pension cost were as follows:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -------------------------------------------------------------------------------
(In millions)
Service cost - benefits earned
during the year $ 11.1 $ 14.7 $ 18.5
Interest cost 32.6 30.9 28.6
Expected return on plan assets (33.4) (39.6) (43.1)
Recognized net actuarial loss(gain) 11.3 (0.4) (11.2)
Amortization of transition asset (2.2) (2.2) (2.2)
Amortization of prior service cost (2.6) (3.1) (3.1)
Curtailment loss and special
termination benefits 5.4 -- --
- -------------------------------------------------------------------------------
Net periodic pension cost (benefit) $ 22.2 $ 0.3 $ (12.5)
===============================================================================
The curtailment loss and special termination benefits in 2002 of $4.3 million
and $1.1 million, respectively, relate to the AFS restructuring (see Note 3 -
Significant Transactions). The curtailment loss primarily reflects the
elimination of future expected years of service for agents terminated pursuant
to the aforementioned AFS restructuring, while special termination benefit costs
reflect acceleration of retirement criteria under the plan for transition group
participants terminated due to the restructuring.
The following table summarizes the status of the plans. At December 31,
2002 and 2001, the projected benefit obligations exceeded the plans' assets.
During 2002 and 2001, the Company recorded increases in its minimum pension
liability related to its pension plans of $121.1 million and $64.8 million,
respectively. This is reflected as an adjustment to accumulated other
comprehensive income and is primarily comprised of the difference between the
present value of accumulated benefit obligations and the market value of assets
funding the plan. This liability resulted primarily from a decrease in the
market value of assets held by the plan due to a general decline in the equity
markets.
DECEMBER 31 2002 2001
- -------------------------------------------------------------------------------
(In millions)
Change in benefit obligations:
Projected benefit obligation, beginning
of year $ 483.2 $ 450.9
Service cost - benefits earned
during the year 11.1 14.7
Interest cost 32.6 30.9
Actuarial losses 28.6 12.4
Benefits paid (30.1) (25.7)
- -------------------------------------------------------------------------------
Projected benefit obligation, end of year 525.4 483.2
===============================================================================
Change in plan assets:
Fair value of plan assets, beginning of year 364.3 441.5
Actual return on plan assets (65.2) (51.5)
Benefits paid (30.1) (25.7)
- -------------------------------------------------------------------------------
Fair value of plan assets, end of year 269.0 364.3
===============================================================================
Funded status of the plan (256.4) (118.9)
Unrecognized transition obligation (15.0) (17.2)
Unamortized prior service cost (3.5) (1.7)
Unrecognized net actuarial gains 26.3 27.6
- -------------------------------------------------------------------------------
Net pension liability $ (248.6) $ (110.2)
===============================================================================
As a result of the Company's merger with Allmerica P&C in 1997, certain pension
liabilities were reduced to reflect their fair value as of the merger date.
These pension liabilities were reduced by $4.7 million and $6.1 million in 2002
and 2001 respectively, which reflects fair value, net of applicable
amortization.
Determination of the projected benefit obligations was based on weighted
average discount rates of 6.25% and 6.88% in 2002 and 2001, respectively, and
the assumed long-term rate of return on plan assets was 9.5% in 2002 and
87
2001. For 2003, the projected benefit obligation will be based on a weighted
average discount rate and assumed long-term rate of return on plan assets of
6.25% and 8.5% respectively. The actuarial present value of the projected
benefit obligations is determined using assumed rates of increase in future
compensation levels of 4.0% for 2003, 2002 and 2001. Plan assets are invested
primarily in various separate accounts and the general account of FAFLIC. Plan
assets also include 796,462 shares of AFC common stock at December 31, 2002 and
2001 with a market value of $8.0 million and $35.5 million, respectively.
The Company has a defined contribution 401(k) plan for its employees,
whereby the Company matches employee elective 401(k) contributions, up to a
maximum percentage determined annually by the Board of Directors. During 2002,
2001 and 2000, the Company matched 50% of employees' contributions up to 6.0% of
eligible compensation. The total expense related to this plan was $5.0 million,
$5.7 million, and $6.1 million in 2002, 2001 and 2000, respectively. In addition
to this plan, the Company has a defined contribution plan for substantially all
of its agents. The plan expense in 2002, 2001, and 2000 was $3.1 million, $3.3
million, and $3.2 million, respectively. There will be no future agent or
employer contributions to this plan due to the termination of all agent
contracts as of December 31, 2002 pursuant to the AFS restructuring (see Note 3
- - Significant Transactions).
TWELVE
OTHER POSTRETIREMENT BENEFIT PLANS
In addition to the Company's pension plans, the Company currently provides
postretirement medical and death benefits to certain full-time employees,
agents, retirees and their dependents, under welfare benefit plans sponsored by
FAFLIC. Generally, active employees and agents become eligible at age 55 with at
least 15 years of service. Spousal coverage is generally provided for up to two
years after death of the retiree. Benefits include hospital, major medical and a
payment at death equal to retirees' final compensation up to certain limits.
Effective January 1, 1996, the Company revised these benefits so as to establish
limits on future benefit payments to beneficiaries of retired employees and to
restrict eligibility to then current employees. The medical plans have varying
copayments and deductibles, depending on the plan. These plans are unfunded.
The plans' funded status reconciled with amounts recognized in the
Company's Consolidated Balance Sheets were as follows:
DECEMBER 31 2002 2001
- ---------------------------------------------------------------
(In millions)
Change in benefit obligations:
Accumulated postretirement benefit
obligation, beginning of year $ 77.2 $ 75.5
Service cost 2.2 2.3
Interest cost 5.0 4.9
Actuarial losses (gains) 4.7 (1.2)
Benefits paid (4.2) (4.3)
Curtailment gain and special termination
benefits (9.0) --
- ---------------------------------------------------------------
Accumulated postretirement benefit
obligation, end of year 75.9 77.2
- ---------------------------------------------------------------
Fair value of plan assets, end of year -- --
===============================================================
Funded status of the plan (75.9) (77.2)
Unamortized prior service cost (2.8) (5.4)
Unrecognized net actuarial gains (6.0) (8.4)
- ---------------------------------------------------------------
Accumulated postretirement benefit costs $ (84.7) $ (91.0)
===============================================================
The components of net periodic postretirement benefit cost were as follows:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ----------------------------------------------------------------------------
(In millions)
Service cost $ 2.2 $ 2.3 $ 1.9
Interest cost 5.0 4.9 4.9
Recognized net actuarial gain (0.3) (0.4) (0.5)
Amortization of prior service cost (2.2) (2.2) (2.2)
Curtailment gain and special
termination benefits (6.8) -- --
- ----------------------------------------------------------------------------
Net periodic postretirement
(benefit) cost $ (2.1) $ 4.6 $ 4.1
============================================================================
As a result of the AFS restructuring in 2002 (see Note 3 - Significant
Transactions), the Company recognized a curtailment gain and special termination
benefit costs related to its postretirement benefit plans. The curtailment gain
resulted from the effect of agent terminations related to those not fully
eligible for benefits, while the special termination benefit costs reflect
acceleration of retirement criteria for selected terminated employees.
As a result of the Company's merger with Allmerica P&C in 1997, certain
postretirement liabilities were reduced to reflect their fair value as of the
merger date. These postretirement liabilities were reduced by $2.4 million and
$3.2 million 2002 and 2001, respectively, which reflects fair value, net of
applicable amortization.
For purposes of measuring the accumulated postretirement benefit obligation
at December 31, 2002, health care costs were assumed to increase 9.0% in 2003,
declining
88
thereafter until the ultimate rate of 5.0% is reached in 2010 and remains at
that level thereafter. The health care cost trend rate assumption has a
significant effect on the amounts reported. For example, increasing the assumed
health care cost trend rates by one percentage point in each year would increase
the accumulated postretirement benefit obligation at December 31, 2002 by $3.5
million, and the aggregate of the service and interest cost components of net
periodic postretirement benefit expense for 2002 by $0.6 million. Conversely,
decreasing the assumed health care cost trend rates by one percentage point in
each year would decrease the accumulated postretirement benefit obligation at
December 31, 2002 by $3.1 million, and the aggregate of the service and interest
cost components of net periodic postretirement benefit expense for 2002 by $0.5
million.
The weighted-average discount rate used in determining the accumulated
postretirement benefit obligation was 6.25% and 6.88% at December 31, 2002 and
2001, respectively. In addition, the actuarial present value of the accumulated
postretirement benefit obligation was determined using an assumed rate of
increase in future compensation levels of 4.0% for FAFLIC agents.
THIRTEEN
STOCK-BASED COMPENSATION PLANS
The Company has elected to apply the provisions of APB No. 25 (Accounting
Principles Board Opinion No. 25) in accounting for its stock-based compensation
plans, and thus compensation cost is not generally required to be recognized for
the Company's stock options in the financial statements. Net loss and loss per
share after the pro forma effect of recognizing compensation cost based on an
instrument's fair value at the date of grant, consistent with Statement No. 123,
were as follows:
2002 2001 2000
- ------------------------------------------------------------------------------
Net (loss) income after effect of
Statement No. 123 $ (318.5) $ (13.2) $ 190.8
(Loss) income per share - diluted $ (6.03) $ (0.25) $ 3.54
(Loss) income per share - basic $ (6.03) $ (0.25) $ 3.58
Since options vest over several years and additional awards generally are made
each year, the aforementioned pro forma effects are not likely to be
representative of the effects on reported net income for future years.
In March 2000, the FASB issued FIN 44, which clarifies the application of
APB Opinion No. 25 regarding the definition of employee, the criteria for
determining a noncompensatory plan, the accounting for changes to the terms of a
previously fixed stock option or award, the accounting for an exchange of stock
compensation awards in a business combination, and other stock compensation
related issues. Costs associated with the issuance of stock options to certain
agents who did not qualify as an employee as defined in FIN 44 were recognized
in 2002, 2001 and 2000 and were not material to the results of operations or
financial position of the Company.
Effective June 17, 1996, the Company adopted a Long-Term Stock Incentive
Plan for employees of the Company (the "Employees' Plan"). Key employees of the
Company and its subsidiaries are eligible for awards pursuant to the Plan
administered by the Compensation Committee of the Board of Directors (the
"Committee") of the Company. Under the terms of the Employees' Plan, the maximum
number of shares authorized for grants over the life of the Plan is equal to
7,162,086 shares as of December 31, 2002, increasing annually by 1.25% of the
Company's outstanding stock. Additionally, the maximum number of shares
available for award in any given year is equal to 3.25% of the outstanding
common stock of the Company at the beginning of the year, plus any awards
authorized but unused from prior years.
Options may be granted to eligible employees or agents at a price not less
than the market price of the Company's common stock on the date of grant. Option
shares may be exercised subject to the terms prescribed by the Committee at the
time of grant, otherwise options granted in 2002 vest over three years with a
25% vesting rate in the first two years and a 50% vesting rate in the final
year. For those options granted prior to 2002, all vest at the rate of 20%
annually for five consecutive years. Options must be exercised not later than
ten years from the date of grant.
Stock grants may be awarded to eligible employees at a price established by
the Committee (which may be zero). Under the Employees' Plan, stock grants may
vest based upon performance criteria or continued employment. Stock grants which
vest based on performance vest over a minimum one year period. Stock grants
which vest based on continued employment vest at the end of a minimum of three
consecutive years.
89
Information on the Company's stock option plan is summarized below:
2002 2001 2000
- ----------------------------------------------------------------------------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
(In whole shares and dollars) Options Exercise Price Options Exercise Price Options Exercise Price
- ----------------------------------------------------------------------------------------------------------------------------------
Outstanding, beginning of year 3,878,710 $ 49.91 3,198,421 $ 46.94 2,793,779 $ 46.76
Granted 1,723,275 44.02 1,286,075 56.74 938,013 45.60
Exercised 30,058 34.14 135,175 36.80 256,835 38.73
Forfeited 1,037,927 47.41 470,611 51.39 276,536 48.16
- ----------------------------------------------------------------------------------------------------------------------------------
Outstanding, end of year 4,534,000 $ 48.35 3,878,710 $ 49.91 3,198,421 $ 46.94
==================================================================================================================================
Options exercisable, end of year 1,728,730 $ 47.24 1,306,159 $ 45.12 816,264 $ 43.82
==================================================================================================================================
No options expired during 2002, 2001, or 2000. The fair value of each option is
estimated on the date of grant or date of conversion using the Black-Scholes
option-pricing model. For options granted through 2002, the exercise price
equaled the market price of the stock on the grant date. The weighted average
fair value of all options granted in 2002, 2001, and 2000 was $14.48 per share,
$19.49 per share, and $17.11 per share, respectively.
The following significant assumptions were used to determine fair value for
2002 options granted and converted:
WEIGHTED AVERAGE ASSUMPTIONS
FOR OPTIONS AWARDED DURING 2002 2001 2000
- ------------------------------------------------------------------------
Dividend yield -- 0.4% 0.5%
Expected volatility/(1)/ 24.38% to 61.09% 40.16% 37.60%
Risk-free interest rate/(1)/ 1.65% to 1.81% 1.74% 5.03%
Expected lives range
(in years) 2.5 to 5 2.5 to 7 2.5 to 7
(1) During 2002, due to increased variations in the monthly expected
volatility and risk-free interest rates, the Company utilized averages as of the
date of each grant in 2002 for the expected volatility and risk-free interest
rate assumptions. This change resulted in a range of assumptions. Prior to 2002,
the Company utilized an annual estimate for these assumptions.
The following table summarizes information about employee options outstanding
and exercisable at December 31, 2002.
Options Outstanding Options Currently Exercisable
Weighted
Average Weighted Weighted
Remaining Average Average
Contractual Exercise Exercise
Range of Exercise Prices Number Lives Price Number Price
- ------------------------------------------------------------------------------------------------
$12.00 to $30.66 118,600 3.55 $ 27.38 113,100 $ 27.57
$35.375 to $39.35 341,760 4.41 $ 35.41 341,760 $ 35.41
$41.20 to $44.05 1,244,926 9.01 $ 44.02 11,500 $ 43.49
$44.56 to $51.00 673,947 7.24 $ 45.02 268,609 $ 44.89
$51.125 to $52.4375 688,428 6.17 $ 52.06 422,575 $ 52.06
$52.50 to $56.75 362,980 5.22 $ 52.76 284,478 $ 52.69
$57.00 to $59.8125 994,859 8.10 $ 57.05 214,108 $ 57.12
$60.375 to $72.50 108,500 6.13 $ 64.34 72,600 $ 64.39
90
During 2002, 2001 and 2000, the Company granted shares of nonvested stock to
eligible employees, which vest after three years of continuous employment.
During 2002, 2001 and 2000, the Company also granted shares of nonvested stock
to certain agents, which vest 60% after three years, and 20% per year thereafter
or after three years of continuous service. The following table summarizes
information about employee and agent nonvested stock.
STOCK AWARDS 2002 2001 2000
- ---------------------------------------------------------------------------
Common stock granted 70,982 269,690 190,141
Weighted average fair value per
share at the date of grant $ 39.22 $ 52.08 $ 38.01
The Company recognizes compensation expense related to nonvested shares over the
vesting period on a pro rata basis. As a result, the Company recognized $0.9
million, $7.2 million and $5.3 million of compensation cost in 2002, 2001 and
2000 respectively. The expense in 2002 reflects net benefits of $6.0 million
resulting from the termination of nonvested stock grants which were previously
granted to the President of the Company and other employees whose positions were
eliminated in 2002 (see Note 3 - Significant Transactions).
In October 2000, the Company granted 500,250 stock appreciation rights to
certain employees, payable after December 31, 2001. These rights provided for
stock or cash awards to participants based upon the appreciation, if any, of the
Company's stock from October 2, 2000 through December 31, 2001, the vesting
period. Compensation costs associated with these rights were recorded over the
vesting period and were $(0.7) million and $0.7 million in 2001 and 2000,
respectively.
FOURTEEN
EARNINGS PER SHARE
The following table provides share information used in the calculation of the
Company's basic and diluted earnings per share:
DECEMBER 31 2002 2001 2000
- -------------------------------------------------------------------------------
(In millions, except per share data)
Basic shares used in the calculation
of earnings per share 52.9 52.7 53.3
Dilutive effect of securities/(1)/:
Employee stock options -- 0.2 0.4
Non-vested stock grants -- 0.2 0.3
- -------------------------------------------------------------------------------
Diluted shares used in the
calculation of earnings per share 52.9 53.1 54.0
- -------------------------------------------------------------------------------
Per share effect of dilutive securities
on income before cumulative effect
of change in accounting principle
and net income $ -- $ -- $ 0.05
===============================================================================
Per share effect of dilutive securities
on net (loss) income $ -- $ -- $ 0.05
===============================================================================
(1) Excludes 0.2 million shares due to antidilution for the year ended December
31, 2002.
Options to purchase 4.6 million shares and 3.4 million shares of common stock
were outstanding during 2002 and 2001, respectively, but were not included in
the computation of diluted earnings per share because the option's exercise
prices were greater than the average market price of the common shares and,
therefore, the effect would be antidilutive. In 2000, all options to purchase
shares of common stock were included in the computation of diluted earnings per
share.
91
FIFTEEN
DIVIDEND RESTRICTIONS
Massachusetts, New Hampshire and Michigan have enacted laws governing the
payment of dividends to stockholders by insurers. Massachusetts' laws affect the
dividend paying ability of AFLIAC and FAFLIC, while New Hampshire and Michigan
laws affect the dividend paying ability of Hanover and Citizens, respectively.
Massachusetts' statute limits the dividends a life insurer may pay in any
twelve month period, without the prior permission of the Commonwealth of
Massachusetts Insurance Commissioner, to the greater of (i) 10% of its statutory
policyholder surplus as of the preceding December 31 or (ii) the individual
company's statutory net gain from operations for the preceding calendar year. In
addition, under Massachusetts law, no domestic insurer may pay a dividend or
make any distribution to its shareholders from other than unassigned funds
unless the Commissioner has approved such dividend or distribution. Effective
December 30, 2002, AFLIAC, previously a Delaware domiciled life insurance
company, became a Massachusetts domiciled life insurance company. On December
31, 2002, AFLIAC became a direct subsidiary of AFC as well as the immediate
parent of FAFLIC, which remains a Massachusetts domiciled life insurance
company. As a result of this transaction, and in consideration of the decision
not to write new business, AFC agreed with the Massachusetts Insurance
Commissioner to maintain total adjusted capital levels at a minimum of 100% of
AFLIAC's Company Action Level, which was $197.2 million at December 31, 2002.
Total adjusted capital for life insurance companies is defined as capital and
surplus, plus asset valuation reserve, plus 50% of dividends apportioned for
payment and was $481.9 million at December 31, 2002 for AFLIAC. The Company
Action Level is the first level in which the Massachusetts Insurance
Commissioner would mandate regulatory involvement based solely upon levels of
risk based capital. There can be no assurance that AFLIAC would not require
additional capital contributions from AFC. No dividends were declared by FAFLIC
or AFLIAC to their parent during 2002, 2001, or 2000. AFLIAC and FAFLIC cannot
pay dividends to their parent without prior approval from the Commissioner for
the forseeable future.
Pursuant to New Hampshire's statute, the maximum dividends and other
distributions that an insurer may pay in any twelve month period, without prior
approval of the New Hampshire Insurance Commissioner, is limited to 10% of such
insurer's statutory policyholder surplus as of the preceding December 31.
Hanover declared dividends to its parent totaling $92.1 million, $100.0 million
and $108 million in 2002, 2001 and 2000, respectively. Prior to July 2003,
Hanover cannot declare dividends to its parent without prior approval of the New
Hampshire Insurance Commissioner. The allowable dividend without prior approval
will increase to approximately $83.0 million on July 11, 2003.
Pursuant to Michigan's statute, the maximum dividends and other
distributions that an insurer may pay in any twelve month period, without prior
approval of the Michigan Insurance Commissioner, is limited to the greater of
10% of policyholders' surplus as of December 31 of the immediately preceding
year or the statutory net income less realized gains, for the immediately
preceding calendar year. Citizens declared dividends to its parent totaling
$48.2 million, $50.0 million and $55 million in 2002, 2001, and 2000,
respectively. Prior to July 2003, Citizens cannot declare dividends to its
parent without prior approval of the Michigan Insurance Commissioner. The
allowable dividend without prior approval will increase to approximately $48.5
million on July 11, 2003.
SIXTEEN
SEGMENT INFORMATION
The Company offers financial products and services in two major areas: Risk
Management and Asset Accumulation. Within these broad areas, the Company
conducts business principally in three operating segments. These segments are
Risk Management, Allmerica Financial Services, and Allmerica Asset Management.
In accordance with Statement of Financial Accounting Standards No. 131,
"Disclosures About Segments of an Enterprise and Related Information," the
separate financial information of each segment is presented consistent with the
way results are regularly evaluated by the chief operating decision makers in
deciding how to allocate resources and in assessing performance. A summary of
the Company's reportable segments is included below.
The Risk Management Segment manages property and casualty operations
through two lines of business based upon product and identified as Personal
Lines and Commercial Lines. Personal Lines include property and casualty
coverages such as personal automobile, homeowners and other
92
personal policies, while Commercial Lines include property and casualty
coverages such as workers' compensation, commercial automobile, commercial
multiple peril and other commercial policies. Prior to 2002, the Risk Management
segment managed its business through three distribution channels identified as
Standard Markets, Sponsored Markets and Specialty Markets.
The Asset Accumulation group includes two segments: Allmerica Financial
Services and Allmerica Asset Management. Prior to September 30, 2002, the
Allmerica Financial Services segment manufactured and sold variable annuities,
variable universal life and traditional life insurance products, as well as
certain group retirement products. On September 27, 2002, the Company announced
plans to consider strategic alternatives, including a significant reduction of
sales of proprietary variable annuities and life insurance products.
Subsequently, the Company ceased all new sales of proprietary variable annuities
and life insurance products.
After September 30, 2002, the AFS business consists of two components.
First, the segment includes its independent broker dealer, VeraVest Investments,
Inc., formerly "Allmerica Investments, Inc." ("VeraVest"), which distributes
third-party investment and insurance products. The Company has entered into
agreements with leading investment product and insurance providers and is
seeking additional alliances whereby these providers would compensate the
Company for non-proprietary product sales by VeraVest's registered
representatives. Second, this segment will retain and service existing variable
annuity and variable universal life accounts, as well as its remaining
traditional life and group retirement accounts, which were issued by its life
insurance subsidiaries, AFLIAC and FAFLIC.
Through its Allmerica Asset Management segment, prior to September 2002,
FAFLIC offered GICs. GICs, also referred to as funding agreements, are
investment contracts with either short-term or long-term maturities, which are
issued to institutional buyers or to various business or charitable trusts.
Declining financial strength ratings from various rating agencies during 2002
resulted in GIC contractholders terminating all remaining short-term funding
agreements and made it impractical to continue selling new long-term funding
agreements. Furthermore, the Company retired certain long-term funding
agreements, at discounts, during the fourth quarter of 2002 (see Note 3 -
Significant Transactions). This segment continues to be a Registered Investment
Advisor providing investment advisory services, primarily to affiliates and to
third parties, such as money market and other fixed income clients through its
subsidiary, Opus Investments, Inc. (formerly "Allmerica Asset Management,
Inc."). Additionally, during 2002, the Company transferred management of AMGRO,
Inc., the Company's property and casualty insurance premium financing business,
to this segment, which was previously part of the Risk Management segment.
In addition to the three operating segments, the Company has a Corporate
segment, which consists primarily of cash, investments, corporate debt, Capital
Securities and corporate overhead expenses. Corporate overhead expenses reflect
costs not attributable to a particular segment, such as those related to certain
officers and directors, technology, finance, human resources and legal.
Management evaluates the results of the aforementioned segments based on a
pre-tax and pre-minority interest basis. Segment (loss) income is determined by
adjusting net income for net realized investment gains and losses, including
certain gains or losses on derivative instruments, because fluctuations in these
gains and losses are determined by interest rates, financial markets and the
timing of sales. Also, segment (loss) income excludes net gains and losses on
disposals of businesses, discontinued operations, restructuring and
reorganization costs, extraordinary items, the cumulative effect of accounting
changes and certain other items, which in each case, are neither normal nor
recurring. While these items may be significant components in understanding and
assessing the Company's financial performance, management believes that the
presentation of segment (loss) income enhances understanding of the Company's
results of operations by highlighting net (loss) income attributable to the
normal, recurring operations of the business. However, segment (loss) income
should not be construed as a substitute for net (loss) income determined in
accordance with generally accepted accounting principles.
93
Summarized below is financial information with respect to business segments:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -------------------------------------------------------------------------------
(In millions)
Segment revenues:
Risk Management $ 2,498.7 $ 2,454.8 $ 2,307.7
Asset Accumulation
Allmerica Financial Services 854.7 826.5 867.2
Allmerica Asset Management 127.2 155.2 149.2
- -------------------------------------------------------------------------------
Subtotal 981.9 981.7 1,016.4
- -------------------------------------------------------------------------------
Corporate 5.0 6.7 6.3
Intersegment revenues (10.3) (7.5) (7.0)
- -------------------------------------------------------------------------------
Total segment revenues 3,475.3 3,435.7 3,323.4
- -------------------------------------------------------------------------------
Adjustments to segment revenues:
Net realized losses (162.3) (123.9) (140.7)
Other item 3.6 -- --
- -------------------------------------------------------------------------------
Total revenues $ 3,316.6 $ 3,311.8 $ 3,182.7
===============================================================================
Segment income (loss) before
federal income taxes and
minority interest:
Risk Management $ 184.3 $ 93.5 $ 190.0
Asset Accumulation
Allmerica Financial Services (625.0) 143.0 222.8
Allmerica Asset Management 24.4 20.7 22.5
- -------------------------------------------------------------------------------
Subtotal (600.6) 163.7 245.3
- -------------------------------------------------------------------------------
Corporate (63.5) (63.8) (60.8)
- -------------------------------------------------------------------------------
Segment (loss) income
before federal income taxes and
minority interest (479.8) 193.4 374.5
- -------------------------------------------------------------------------------
Adjustments to segment income:
Net realized investment losses,
net of amortization (137.4) (121.3) (135.2)
Gain from retirement of trust
instruments supported by
funding obligations 102.6 -- --
Loss from sale of universal
life business (31.3) -- --
Losses from selected property
and casualty exited agencies,
policies, groups, and programs -- (68.3) --
Gains (losses) on derivative
instruments 40.3 (35.2) --
Voluntary pool losses -- (33.0) --
Restructuring costs (14.8) (2.7) (20.7)
Other items (0.8) 7.7 --
- -------------------------------------------------------------------------------
(Loss) income from continuing
operations before federal
income taxes and minority
interest $ (521.2) $ (59.4) $ 218.6
===============================================================================
DECEMBER 31 2002 2001 2002 2001
- -------------------------------------------------------------------------------
(In millions)
Identifiable Assets Deferred Acquisition Costs
- -------------------------------------------------------------------------------
Risk Management/(1)/ $ 6,056.1 $ 6,239.8 $ 215.1 $ 199.0
Asset Accumulation
Allmerica
Financial Services 18,910.7 21,113.0 1,027.1 1,585.2
Allmerica Asset
Management 1,559.8 2,829.3 -- --
- --------------------------------------------------------------------------------
Subtotal 20,470.5 23,942.3 1,027.1 1,585.2
Corporate and
intersegment
eliminations (8.6) 154.0 -- --
- --------------------------------------------------------------------------------
Total $ 26,518.0 $ 30,336.1 $ 1,242.2 $ 1,784.2
================================================================================
(1) Includes assets related to the Company's discontinued operations of
$290.4 million and $397.6 million at December 31, 2002 and 2001, respectively.
SEVENTEEN
LEASE COMMITMENTS
Rental expenses for operating leases amounted to $30.8 million, $32.7 million,
and $32.8 million in 2002, 2001 and 2000, respectively. These expenses relate
primarily to building leases of the Company. At December 31, 2002, future
minimum rental payments under non-cancelable operating leases were approximately
$63.5 million, payable as follows: 2003 - $22.8 million; 2004 - $17.7 million;
2005 - $11.6 million; 2006 - $6.4 million; and $5.0 million thereafter. It is
expected that, in the normal course of business, leases that expire may be
renewed or replaced by leases on other property and equipment; thus, it is
anticipated that future minimum lease commitments may not be less than the
amounts shown for 2003.
EIGHTEEN
REINSURANCE
In the normal course of business, the Company seeks to reduce the losses that
may arise from catastrophes or other events that cause unfavorable underwriting
results by reinsuring certain levels of risk in various areas of exposure with
other insurance enterprises or reinsurers. Reinsurance transactions are
accounted for in accordance with the provisions of Statement No. 113,
"Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration
Contracts".
Amounts recoverable from reinsurers are estimated in a manner consistent
with the claim liability associated with the reinsured policy. Reinsurance
contracts do not relieve the Company from its obligations to policyholders.
Failure of
94
reinsurers to honor their obligations could result in losses to the Company;
consequently, allowances are established for amounts deemed uncollectible. The
Company determines the appropriate amount of reinsurance based on evaluation of
the risks accepted and analyses prepared by consultants and reinsurers and on
market conditions (including the availability and pricing of reinsurance). The
Company also believes that the terms of its reinsurance contracts are consistent
with industry practice in that they contain standard terms with respect to lines
of business covered, limit and retention, arbitration and occurrence. Based on
its review of its reinsurers' financial statements and reputations in the
reinsurance marketplace, the Company believes that its reinsurers are
financially sound.
Effective December 31, 2002, the Company entered into a 100% coinsurance
agreement related to substantially all of the Company's universal life business
(see Note 3 - Significant Transactions). Reinsurance recoverables related to
this agreement were $648.4 million at December 31, 2002. This balance represents
approximately 31.2% of the Company's reinsurance recoverables at December 31,
2002.
Effective January 1, 1999, the Company entered into a whole account
aggregate excess of loss reinsurance agreement, which provides coverage for the
1999 accident year for the Company's property and casualty business. The program
covered losses and allocated LAE expenses, including those incurred but not yet
reported, in excess of a specified whole account loss and allocated LAE ratio.
The annual coverage limit for losses and allocated LAE is $150.0 million. The
Company is subject to concentration of risk with respect to this reinsurance
agreement. Net premiums earned under this agreement during 2002, 2001 and 2000
for accident year 1999 were $3.2 million, $12.1 million and $25.0 million,
respectively, while net losses and LAE ceded during 2002, 2001 and 2000 were
$3.9 million, $15.8 million and $34.1 million, respectively. The effect of this
agreement on the results of operations in future periods is not currently
determinable, as it will be based on future losses and allocated LAE for
accident year 1999. In addition, the Company is subject to concentration of risk
with respect to reinsurance ceded to various residual market mechanisms. As a
condition to the ability to conduct certain business in various states, the
Company is required to participate in various residual market mechanisms and
pooling arrangements which provide various insurance coverages to individuals or
other entities that are otherwise unable to purchase such coverage voluntarily
provided by private insurers. These market mechanisms and pooling arrangements
include the Massachusetts Commonwealth Automobile Reinsurers ("CAR"), and the
Michigan Catastrophic Claims Association ("MCCA"). At December 31, 2002, CAR
represented 10% or more of the Company's reinsurance activity. As a servicing
carrier in Massachusetts, the Company cedes a significant portion of its private
passenger and commercial automobile premiums to CAR. Net premiums earned and
losses and loss adjustment expenses ceded to CAR in 2002, 2001 and 2000 were
$46.8 million and $59.4 million, $34.2 million and $38.0 million, and $37.3
million and $44.5 million, respectively. Additionally, the Company ceded to MCCA
premiums earned and losses and loss adjustment expenses in 2002, 2001 and 2000
of $32.6 million and $49.8 million, $7.2 million and $44.5 million, and $3.7
million and $31.1 million, respectively.
Because the MCCA is supported by assessments permitted by statute, and all
amounts billed by the Company to CAR and MCCA have been paid when due, the
Company believes that it has no significant exposure to uncollectible
reinsurance balances from these two entities.
The effects of reinsurance were as follows:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -------------------------------------------------------------------------------
(In millions)
Life and accident and health
insurance premiums:
Direct $ 85.7 $ 89.1 $ 94.3
Assumed 0.6 0.7 0.7
Ceded (36.7) (38.2) (41.0)
- -------------------------------------------------------------------------------
Net premiums $ 49.6 $ 51.6 $ 54.0
===============================================================================
Property and casualty premiums
written:
Direct $ 2,478.8 $ 2,510.6 $ 2,391.7
Assumed 66.6 52.7 63.5
Ceded (279.6) (285.6) (303.6)
- -------------------------------------------------------------------------------
Net premiums $ 2,265.8 $ 2,277.7 $ 2,151.6
===============================================================================
Property and casualty premiums
earned:
Direct $ 2,487.4 $ 2,438.6 $ 2,297.8
Assumed 61.7 53.5 66.8
Ceded (278.6) (293.7) (299.8)
- -------------------------------------------------------------------------------
Net premiums $ 2,270.5 $ 2,198.4 $ 2,064.8
===============================================================================
Life and accident and health
insurance and other individual
policy benefits, claims, losses
and loss adjustment expenses:
Direct $ 542.0 $ 463.0 $ 455.3
Assumed 6.1 0.3 0.3
Ceded (31.8) (46.1) (35.1)
- -------------------------------------------------------------------------------
Net policy benefits, claims, losses
and loss adjustment expenses $ 516.3 $ 417.2 $ 420.5
===============================================================================
Property and casualty benefits,
claims, losses and loss
adjustment expenses:
Direct $ 1,817.2 $ 2,026.4 $ 1,819.5
Assumed 79.2 91.4 68.1
Ceded (210.7) (281.9) (326.3)
- -------------------------------------------------------------------------------
Net policy benefits, claims, losses
and loss adjustment expenses $ 1,685.7 $ 1,835.9 $ 1,561.3
===============================================================================
95
NINETEEN
DEFERRED POLICY ACQUISITION COSTS
The following reflects the changes to the deferred policy acquisition asset:
For the Years Ended December 31 2002 2001 2000
- ----------------------------------------------------------------------------
(In millions)
Balance at beginning of year $ 1,784.2 $ 1,608.2 $ 1,399.9
Acquisition expenses deferred 710.0 688.8 684.1
Amortized to expense during
the year (921.4) (479.2) (456.6)
Impairment of DAC asset
related to annuity business (159.0) -- --
Impairment of DAC asset
related to sale of universal
life insurance business (155.9) -- --
Adjustment to equity during
the year (15.7) (2.0) (19.2)
Adjustment for commission
buyout program -- (31.6) --
- ----------------------------------------------------------------------------
Balance at end of year $ 1,242.2 $ 1,784.2 $ 1,608.2
============================================================================
Prior to September 30, 2002, the Company manufactured and sold variable
annuities, variable universal life and traditional life insurance products.
Subsequently, the Company ceased all new sales of proprietary variable annuities
and life insurance products. As a result, the Company determined that the DAC
asset related to one distribution channel for its annuity business exceeded the
present value of its total expected gross profits. Therefore, the Company
recognized a permanent impairment of its DAC asset of $159.0 million related to
this item. Additionally, the Company recognized approximately $203 million of
additional amortization related to the impact of the equity market on future
gross profits of the Company's life insurance and annuity products and
approximately $200 million of additional amortization related to the changes in
several actuarial estimates related to the Company's life insurance and annuity
products. Also, in 2002, the Company recognized a permanent impairment related
to its universal life DAC asset of $155.9 million due to the sale of that
business.
During 2001, the Company implemented an in-force trail commission program
on certain annuity business previously written by qualifying agents. This
program provided for the election of a trail commission on in-force business in
exchange for the buyout of deferred commissions.
TWENTY
LIABILITIES FOR OUTSTANDING CLAIMS, LOSSES AND LOSS
ADJUSTMENT EXPENSES
The Company regularly updates its estimates of liabilities for outstanding
claims, losses and loss adjustment expenses as new information becomes available
and further events occur which may impact the resolution of unsettled claims for
its property and casualty and its accident and health lines of business. Changes
in prior estimates are recorded in results of operations as adjustments to
losses and LAE in the year such changes are determined to be needed. Often these
adjustments are recognized in periods subsequent to the period in which the
underlying loss event occurred. These types of subsequent adjustments are
described as "prior year reserve development". Such development can be either
favorable or unfavorable on the financial results of the Company.
The liability for future policy benefits and outstanding claims, losses and
loss adjustment expenses, excluding the effect of reinsurance, related to the
Company's accident and health business, consisting of the Company's exited
individual health business and its discontinued group accident and health
business, was $434.8 million, $463.5 million and $519.3 million at December 31,
2002, 2001 and 2000, respectively. Reinsurance recoverables related to this
business were $329.3 million, $343.0 million and $335.9 million in 2002, 2001
and 2000, respectively. The decreases in 2002 and 2001 were primarily
attributable to the continued run-off of the group accident and health business.
Also, the decrease in 2000 was impacted by the Company's entrance into a
reinsurance agreement which provided for the cession of the Company's long-term
group disability reserves, partially offset by reserve strengthening in the
reinsurance pool business.
96
The table below provides a reconciliation of the beginning and ending
reserve for unpaid losses and LAE as follows:
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- ----------------------------------------------------------------------------
(In millions)
Reserve for losses and LAE,
beginning of year $ 2,921.5 $ 2,719.1 $ 2,618.7
Incurred losses and LAE, net of
reinsurance recoverable:
Provision for insured events
of current year 1,682.1 1,708.3 1,634.9
Increase (decrease) in
provision for insured events
of prior years/(1)/ 6.4 107.4 (87.4)
Losses related to selected
property & casualty exited
agencies, policies, groups &
programs, for current year -- 12.1 --
- ----------------------------------------------------------------------------
Total incurred losses and LAE 1,688.5 1,827.8 1,547.5
- ----------------------------------------------------------------------------
Payments, net of reinsurance
recoverable:
Losses and LAE attributable
to insured events of
current year 898.0 892.8 870.2
Losses and LAE attributable
to insured events of
prior years 763.6 780.3 703.8
- ----------------------------------------------------------------------------
Total payments 1,661.6 1,673.1 1,574.0
- ----------------------------------------------------------------------------
Change in reinsurance
recoverable on unpaid losses 13.3 47.7 126.9
- ----------------------------------------------------------------------------
Reserve for losses and LAE,
end of year $ 2,961.7 $ 2,921.5 $ 2,719.1
============================================================================
(1) The increase in provision for insured events of prior years in 2001 includes
$40.8 million of losses related to selected property and casualty exited
agencies, policies, groups and programs and $33.0 million of losses related to
voluntary pool claims.
As part of an ongoing process, the reserves have been re-estimated for all prior
accident years and were increased by $6.4 million and $107.4 million in 2002 and
2001, respectively, and decreased by $87.4 million in 2000.
During the year ended December 31, 2002 and 2001, estimated loss reserves
for claims occurring in prior years developed unfavorably by $36.9 million and
$146.6 million, respectively. During the year ended December 31, 2000 estimated
loss reserves for claims occurring in prior years developed favorably by $25.9
million. The adverse development in both 2002 and 2001 is primarily the result
of increased claim severity for personal automobile medical settlements for
Citizens. As these settlements have risen beyond previous estimates, reserve
increases have been recognized in the period in which the information is
obtained. The increase in the prior year reserve estimates for other commercial
lines during 2002 is primarily due to the recognition of approximately $5
million in additional reserves for asbestos claims in the Excess and Casualty
Reinsurance Association ("ECRA") voluntary pool.
In addition, the Company experienced adverse development in 2001 as a
result of the $40.8 million reserve increase on prior years resulting from the
agency management actions discussed in Note 3 - "Significant Transactions". This
reserve increase affected primarily the commercial multiple peril, personal
automobile, commercial automobile and workers' compensation lines. Additionally,
other commercial lines' prior year reserves developed adversely due to a $33.0
million reserve increase in the ECRA voluntary pool. Personal automobile prior
year reserves developed adversely due to the aforementioned increased claim
severity related to medical settlements for Citizens. In addition to the effect
from the agency management actions, the commercial automobile and commercial
multiple peril lines experienced adverse development. The increased reserves in
these lines is primarily attributable to increased claim payments in the 2000
and 1999 accident years. As these payments have increased above historical
amounts, actuarial projections of future settlements have increased the
estimated ultimate reserves on prior years.
During 2000, the favorable loss development is primarily the result of a
decrease in prior year reserves in the personal automobile line. The Company
began to experience an improvement in the Northeast in the personal automobile
line as claim payment severity began to decrease in accident years 1999 and
1998. As the certainty of the improvement in claim payment severity for accident
years 1999 and 1998 increased, ultimate losses for those accident years were
reduced and favorable development was recorded during calendar year 2000.
During the years ended December 31, 2002, 2001 and 2000, estimated loss
adjustment expense reserves for claims occurring in prior years developed
favorably by $30.5 million, $39.2 million and $61.5 million, respectively. The
favorable development in all the periods is primarily attributable to claims
process improvement initiatives taken by the Company during the 1997 to 2001
calendar year period. Since 1997, the Company has lowered claim settlement costs
97
through increased utilization of in-house attorneys and consolidation of claim
offices. As actual experience begins to establish certain trends inherent within
the claim settlement process, the actuarial process recognizes these trends
within the reserving methodology impacting future claim settlement assumptions.
As these measures improved average settlement costs, the actuarial estimate of
future settlement costs are reduced and favorable development is recorded. These
measures are complete.
Reserves established for current year losses and LAE in 2002 and 2001
consider the factors that resulted in the favorable development of prior years'
loss and LAE reserves during 2000 and earlier years. Accordingly, current year
reserves are modestly lower, relative to those initially established for similar
exposures in years prior to 2001.
Although the Company does not specifically underwrite policies that include
asbestos, environmental damage and toxic tort liability, the Company may be
required to defend such claims. The table below summarizes direct business
asbestos and environmental reserves (net of reinsurance and excluding pools):
2002 2001 2000
- -------------------------------------------------------------------
(In millions)
Reserves for losses and LAE,
beginning of year $ 26.7 $ 25.5 $ 34.7
Incurred losses & LAE (0.8) 4.2 0.7
Paid losses & LAE 0.3 3.0 10.0
- -------------------------------------------------------------------
Reserves for losses and LAE,
end of year $ 25.6 $ 26.7 $ 25.4
===================================================================
Ending losses and LAE reserves for all direct business written by its property
and casualty companies related to asbestos, environmental damage and toxic tort
liability, included in the reserve for losses and LAE, were $25.6 million, $26.7
million and $25.4 million, net of reinsurance of $16.0 million, $13.0 million
and $15.9 million in 2002, 2001 and 2000, respectively. The outstanding reserves
for direct business asbestos and environmental damage have remained relatively
consistent for the three-year period ended December 31, 2002. The Company
estimates its ultimate liability for these claims based upon currently known
facts, reasonable assumptions where the facts are not known, current law and
methodologies currently available. Although these outstanding claims are not
significant, their existence gives rise to uncertainty and are discussed because
of the possibility that they may become significant. The Company believes that,
notwithstanding the evolution of case law expanding liability in environmental
claims, recorded reserves related to these claims are adequate. In addition, the
Company is not aware of any litigation or pending claims that may result in
additional material liabilities in excess of recorded reserves. The
environmental liability could be revised in the near term if the estimates used
in determining the liability are revised.
In addition, the Company has established loss and LAE reserves for assumed
reinsurance and pool business with asbestos, environmental damage and toxic tort
liability of $45.2 million, $39.3 million and $10.6 million in 2002, 2001 and
2000, respectively. These reserves relate to pools that the Company has
terminated its participation; however, the Company continues to be subject to
claims related to years in which it was a participant. The Company was a
participant in ECRA from 1950 to 1982. In 1982, the pool was dissolved and since
that time the business has been in runoff. The Company's participation in this
pool has resulted in average paid losses of $2.3 million annually over the past
ten years. During 2001, the pool commissioned an independent actuarial review of
the current reserve position, which noted a range of reserve deficiency
primarily as a result of adverse development of asbestos claims. As a result of
this study, the Company recorded an additional $33.0 million of losses in the
fourth quarter of 2001. This reserving action has been presented as a separate
line item in the Consolidated Statements of Income. Because of the inherent
uncertainty regarding the types of claims in these pools, there can be no
assurance that these reserves will be sufficient. During 2002, the Company
recorded an additional $5.0 million of loss reserves related to ECRA.
TWENTY-ONE
CONTINGENCIES
REGULATORY AND INDUSTRY DEVELOPMENTS
Unfavorable economic conditions may contribute to an increase in the number of
insurance companies that are under regulatory supervision. This may result in an
increase in mandatory assessments by state guaranty funds, or voluntary payments
by solvent insurance companies to cover losses to policyholders of insolvent or
rehabilitated companies. Mandatory assessments, which are subject to statutory
limits, can be partially recovered through a reduction in future pre-
98
mium taxes in some states. The Company is not able to reasonably estimate the
potential impact of any such future assessments or voluntary payments.
LITIGATION
In 1997, a lawsuit on behalf of a putative class was instituted against the
Company alleging fraud, unfair or deceptive acts, breach of contract,
misrepresentation, and related claims in the sale of life insurance policies. In
November 1998, the Company and the plaintiffs entered into a settlement
agreement and in May 1999, the Federal District Court in Worcester,
Massachusetts approved the settlement agreement and certified the class for this
purpose. AFC recognized a $31.0 million pre-tax expense in 1998 related to this
litigation. The Company recognized pre-tax benefits of $2.5 million and $7.7
million in 2002 and 2001, respectively, resulting from the refinement of cost
estimates. Although the Company believes that it has appropriately recognized
its obligation under the settlement, this estimate may be revised based on the
amount of reimbursement actually tendered by AFC's insurance carriers.
The Company has been named a defendant in various other legal proceedings
arising in the normal course of business. In the Company's opinion, based on the
advice of legal counsel, the ultimate resolution of these proceedings will not
have a material effect on the Company's consolidated financial statements.
RESIDUAL MARKETS
The Company is required to participate in residual markets in various states.
The results of the residual markets are not subject to the predictability
associated with the Company's own managed business, and are significant to the
workers' compensation line of business and both the personal and commercial
automobile lines of business.
TWENTY-TWO
STATUTORY FINANCIAL INFORMATION
The Company's insurance subsidiaries are required to file annual statements with
state regulatory authorities prepared on an accounting basis prescribed or
permitted by such authorities (statutory basis). Statutory surplus differs from
shareholders' equity reported in accordance with generally accepted accounting
principles primarily because policy acquisition costs are expensed when
incurred, statutory accounting principles require asset valuation and interest
maintenance reserves, postretirement benefit costs are based on different
assumptions and reflect a different method of adoption, life insurance reserves
are based on different assumptions and the recognition of deferred tax assets is
based on different recoverability assumptions.
Effective January 1, 2001, the Company's insurance subsidiaries adopted the
National Association of Insurance Commissioners' uniform statutory accounting
principles, or Codification, in accordance with requirements prescribed by state
authorities. A cumulative effect of the change in accounting principle resulted
from the adoption of Codification and was reflected as an adjustment to surplus
in 2001. This adjustment represents the difference between total capital and
surplus as of January 1, 2001 and the amount total capital and surplus would
have been had the accounting principles been applied retroactively for all prior
periods. As of January 1, 2001, the property and casualty and life and health
insurance subsidiaries recorded cumulative effect adjustments of $82.4 million
and $45.0 million, respectively. The adjustment reflected by the property and
casualty insurance subsidiaries consisted of an increase in surplus of $141.9
million related to the establishment of deferred tax assets and reductions in
surplus of $59.5 million related to changes in valuations of other invested
assets and non-admitted assets. The adjustment reflected by the life and health
insurance subsidiaries included an increase in surplus of $49.7 million related
to the establishment of deferred tax assets and the change in valuation of
pension liabilities. Reductions in surplus reflected by the life and health
insurance subsidiaries totaled $4.7 million and resulted from the change in
valuations of post-employment benefits and non-admitted assets.
99
Statutory net income (loss) and surplus are as follows:
2002 2001 2000
- --------------------------------------------------------------------------
(In millions)
Statutory Net Income
(Loss) - Combined
Property and Casualty Companies $ 11.8 $ (7.9) $ 111.8
Life and Health Companies (296.0) (44.9) (43.6)
- --------------------------------------------------------------------------
Statutory Shareholders'
Surplus - Combined
Property and Casualty Companies $ 834.0 $ 926.1 $ 1,036.2
Life and Health Companies 427.1 377.9 528.5
==========================================================================
TWENTY-THREE
QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The quarterly results of operations for 2002 and 2001 are summarized below:
FOR THE THREE MONTHS ENDED
- ----------------------------------------------------------------------------------------
(In millions, except per share data)
2002 March 31 June 30 Sept. 30 Dec. 31
- ----------------------------------------------------------------------------------------
Total revenues $ 849.3 $ 798.4 $ 854.9 $ 814.0
Net income (loss) $ 47.9 $ (55.5) $ (313.4) $ 14.9
Net income (loss) per share:
Basic $ 0.91 $ (1.05) $ (5.93) $ 0.28
Diluted $ 0.90 $ (1.05) $ (5.93) $ 0.28
Dividends declared
per share $ -- $ -- $ -- $ --
========================================================================================
2001
- ----------------------------------------------------------------------------------------
Total revenues $ 845.9 $ 795.2 $ 853.0 $ 817.7
Net income (loss) $ 23.2 $ 13.2 $ 31.2 $ (70.7)
Net income (loss) per share:
Basic $ 0.44 $ 0.25 $ 0.59 $ (1.34)
Diluted $ 0.44 $ 0.25 $ 0.59 $ (1.34)
Dividends declared
per share $ -- $ -- $ -- $ 0.25
========================================================================================
Note: Due to the use of weighted average shares outstanding when calculating
earnings per common share, the sum of the quarterly per common share data may
not equal the per common share data for the year. Diluted net loss per share for
the three months ended June 30 and September 30, 2002 and for December 31, 2001
represents basic loss per share due to antidilution.
During the fourth quarter of 2002, the Company recognized a gain from the
retirement of trust instruments supported by funding obligations of $66.7
million, net of taxes (see Note 3 - Significant Transactions). In addition, the
Company recognized after-tax charges of $20.3 million and $9.6 million related
to the loss from the sale of its universal life insurance business and the
restructuring of its AFS segment, respectively (see Note 3 - Significant
Transactions).
During the fourth quarter of 2001, the Company recognized after-tax charges
of $44.4 million and $21.5 million related to the exit of selected property and
casualty agencies, policies, groups and programs, and to voluntary pool
environmental losses, respectively. (see Note 20 - Liabilities for Outstanding
Claims, Losses and Loss Adjustment Expenses). In addition, the Company
recognized losses on derivative instruments of $24.4 million, net of taxes, in
the fourth quarter of 2001, primarily as a result of hedge ineffectiveness (see
Note 4 - Investments, Cash Flow Hedges).
Item 9 -- CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
100
PART III
Item 10 -- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS OF THE REGISTRANT
Information regarding Directors of the Company is incorporated herein by
reference from the Proxy Statement for the Annual Meeting of Shareholders to be
held May 13, 2003, to be filed pursuant to Regulation 14A under the Securities
Exchange Act of 1934.
EXECUTIVE OFFICERS OF THE REGISTRANT
Set forth below is biographical information concerning the executive officers of
the Company.
Bruce C. Anderson, 58
Vice President of the Company since February 1995
Mr. Anderson has been Vice President of AFC since February 1995. Mr.
Anderson has been employed by FAFLIC since 1967 and has been Vice President and
Director of FAFLIC since October 1984 and April 1996, respectively.
J. Kendall Huber, 48
Senior Vice President and Executive Officer of the Chairman since October 2002
Vice President and General Counsel of the Company since March 2000
Mr. Huber has been Vice President, General Counsel and Assistant Secretary
of AFC and FAFLIC since March 2000. Prior to joining AFC, Mr. Huber was
Executive Vice President, General Counsel, and Secretary of Promus Hotel
Corporation from February 1999 to January 2000. Previously, Mr. Huber was Vice
President and Deputy General Counsel of Legg Mason, Inc., from November 1998 to
January 1999. He has also served as Vice President and Deputy General Counsel of
USF&G Corporation, where he was employed from March 1990 to August 1998.
Mark Hug, 45
Vice President of the Company since October 2001
Mr. Hug has been Vice President of AFC since October 2001. He has been
President and Chief Executive Officer of AFLIAC since December 2001, of FAFLIC
since October 2002, and was Vice President of FAFLIC from April 2000 to October
2002. Prior to joining AFC, Mr. Hug was Senior Vice President, Product and
Marketing of Equitable Life Insurance Company from April 1997 to April 2000.
Previously, Mr. Hug was Vice President, Sales of Aetna Insurance Company from
April 1992 to April 1997.
John P. Kavanaugh, 48
Vice President and Chief Investment Officer of the Company since September 1996
Mr. Kavanaugh has been Vice President and Chief Investment Officer of AFC
since September 1996, has been employed by FAFLIC since 1983, and has been Vice
President of FAFLIC since December 1991.
Edward J. Parry, III, 43
Senior Vice President and Executive Officer of the Chairman since October 2002
President of Allmerica Asset Accumulation since October 2002
Chief Financial Officer of the Company since December 1996
Mr. Parry has been Chief Financial Officer of AFC and FAFLIC since December
1996. He has also been Vice President of AFC since February 1995 and was
Treasurer from February 1995 to March 2000. He has been a Vice President of
FAFLIC since February 1993 and was Treasurer from February 1993 until March
2000.
Robert P. Restrepo, Jr., 52
Senior Vice President and Executive Officer of the Chairman since October 2002
President of Allmerica Property & Casualty Companies since May 1998
Vice President of the Company since May 1998
Mr. Restrepo has been Vice President of AFC and FAFLIC since May 1998. He
has been President and Chief Executive Officer of the Hanover Insurance Company
since December 2001. He was President and Chief Executive Officer of Allmerica
Property and Casualty Companies, Inc. from May 1998 to December 2000. Prior to
joining AFC, Mr. Restrepo was Chief Executive Officer, Personal Lines at
Travelers Property and Casualty, a member of the Travelers Group from January
1996 to May 1998. Additionally, Mr. Restrepo was the Senior Vice President,
Personal Lines at Aetna Life & Casualty Company from March 1991 to January 1996.
Gregory D. Tranter, 46
Vice President and Chief Information Officer of the Company since October 2000
Mr. Tranter has been Vice President and Chief Information Officer of AFC
since October 2000. Mr. Tranter has been Vice President and Chief Information
Officer of AFC's insurance subsidiaries since August 1998. Prior to joining AFC,
Mr. Tranter was Vice President, Automation Strategy of Travelers Property &
Casualty Company from April 1996 to July 1998. Mr. Tranter was employed by Aetna
Life & Casualty Company from 1983 to 1996.
101
Item 11 -- EXECUTIVE COMPENSATION
Incorporated herein by reference from the Proxy Statement for the Annual Meeting
of Shareholders to be held May 13, 2003, to be filed pursuant to Regulation 14A
under the Securities Exchange Act of 1934.
Item 12 -- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
Reference is made to the Proxy Statement for the Annual Meeting of Shareholders
to be held May 13, 2003, to be filed pursuant to Regulation 14A under the
Securities Exchange Act of 1934, which is incorporated herein by reference.
Item 13 -- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Incorporated herein by reference from the Proxy Statement for the Annual Meeting
of Shareholders to be held May 13, 2003, to be filed pursuant to Regulation 14A
under the Securities Exchange Act of 1934.
102
PART IV
Item 14 -- CONTROLS AND PROCEDURES
Based on their evaluation, as of a date within 90 days of the filing of this
Form 10-K, the Company's Executive Office of the Chairman and Chief Financial
Officer have concluded the Company's disclosure controls and procedures are
effective. There have been no significant changes in internal controls or in
other factors that could significantly affect these controls subsequent to the
date of their evaluation.
Item 15 -- EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a)(1) FINANCIAL STATEMENTS
The consolidated financial statements and accompanying notes thereto are
included on pages 61 to 100 of this Form 10-K.
Page No. in
this Report
Report of Independent Accountants...........................................61
Consolidated Statements of Income for the years ended
December 31, 2002, 2001 and 2000...........................................63
Consolidated Balance Sheets as of December 31, 2002 and 2001................64
Consolidated Statements of Shareholders' Equity for the years
ended December 31, 2002, 2001 and 2000.....................................65
Consolidated Statements of Comprehensive Income for the years
ended December 31, 2002, 2001 and 2000.....................................66
Consolidated Statements of Cash Flows for the years ended
December 31, 2002, 2001 and 2000...........................................67
Notes to Consolidated Financial Statements..............................68-100
(a)(2) FINANCIAL STATEMENT SCHEDULES
Page No. in
Schedule this Report
Report of Independent Accountants on Financial
Statement Schedules................................................112
I Summary of Investments-Other than Investments in
Related Parties....................................................113
II Condensed Financial Information of Registrant...................114-116
III Supplementary Insurance Information.................................117
IV Reinsurance.........................................................118
V Valuation and Qualifying Accounts...................................119
VI Supplemental Information Concerning
Property/Casualty Insurance Operations.............................120
103
(a)(3) EXHIBIT INDEX
Exhibits filed as part of this Form 10-K are as follows:
2.1 Plan of Reorganization. +
2.2 Stock and Asset Purchase Agreement by an among State Mutual Life
Assurance Company of America, 440 Financial Group of Worcester, Inc.,
and The Shareholder Services Group, Inc. dated as of March 9, 1995.++
3.1 Certificate of Incorporation of AFC.+
3.2 Amended By-Laws of AFC.
4 Specimen Certificate of Common Stock.+
4.1 Form of Indenture relating to the Debentures between the Registrant and
State Street Bank & Trust Company, as trustee.++
4.2 Form of Global Debenture.++
4.3 Amended and Restated Declaration of Trust of AFC Capital Trust I dated
February 3, 1997.+++
4.4 Indenture dated February 3, 1997 relating to the Junior Subordinated
Debentures of AFC.+++
4.5 Series A Capital Securities Guarantee Agreement dated February 3,
1997.+++
4.6 Common Securities Guarantee Agreement dated February 3, 1997.+++
4.8 Rights Agreement dated as of December 16, 1997, between the Registrant
and First Chicago Trust Company of New York as Rights Agent, filed as
Exhibit 1 to the Company's Form 8-A dated December 17, 1997 is
incorporated herein by reference.
10.3 Administrative Services Agreement between State Mutual Life Assurance
Company of America and The Hanover Insurance Company, dated July 19,
1989.+
10.4 First Allmerica Financial Life Insurance Company Employees' 401(k)
Matched Savings Plan incorporated by reference to Exhibit 10.1 to the
Allmerica Financial Corporation Registration Statement on Form S-8 (No.
333-576) and incorporated herein by reference originally filed with the
Commission on January 24, 1996.
10.5 State Mutual Life Assurance Company of America Excess Benefit Retirement
Plan.+
10.6 State Mutual Life Assurance Company of America Supplemental Executive
Retirement Plan.+
10.7 State Mutual Incentive Compensation Plan.+
10.9 Indenture of Lease between State Mutual Life Assurance Company of
America and The Hanover Insurance Company dated July 3, 1984 and
corrected First Amendment to Indenture of Lease dated December 20,
1993.+
10.12 Lease dated March 23, 1993 by and between Aetna Life Insurance Company
and State Mutual Life Assurance Company of America, including amendments
thereto, relating to property in Atlanta, Georgia.+
10.13 Stockholder Services Agreement dated as of January 1, 1992 between
Private Healthcare Systems, Inc. and State Mutual Life Assurance Company
of America, the successor to its wholly-owned subsidiary, Group
Healthcare Network, Inc.+
10.16 Trust Indenture for the State Mutual Life Assurance Company of America
Employees' 401(k) Matched Savings Plan between State Mutual Life
Assurance Company of America and Bank of Boston/ Worcester.+
10.17 State Mutual Life Assurance Company of America Non-Qualified Executive
Retirement Plan.+
10.18 State Mutual Life Assurance Company of America Non-Qualified Executive
Deferred Compensation Plan.+
10.19 The Allmerica Financial Cash Balance Pension Plan incorporated by
reference to Exhibit 10.19 to the Allmerica Financial Corporation
September 30, 1995 report on Form 10-Q and incorporated herein by
reference.
10.20 Amended Allmerica Financial Corporation Employment Continuity
Plan.++++++
10.21 Amended and Restated Form of Non-Solicitation Agreement executed by
substantially all of the executive officers of AFC incorporated by
reference to Exhibit 10.21 to the Allmerica Financial Corporation June
30, 1997 report on Form 10-Q and incorporated herein by reference.
10.23 Amended Allmerica Financial Corporation Long-Term Stock Incentive
Plan.++++++
10.24 The Allmerica Financial Corporation Non-Employee Director Stock
Ownership Plan incorporated by reference to Exhibit 10.21 to the
Allmerica Financial Corporation June 30, 1996 report on Form 10-Q and
incorporated herein by reference.
104
10.25 Reinsurance Agreement dated September 29, 1997 between First Allmerica
Financial Life Insurance Company and Metropolitan Life Insurance
Company.++++
10.27 Deferral Agreement, dated April 4, 1997, between Allmerica Financial
Corporation and John F. O'Brien. ++++
10.29 Credit Agreement dated as of June 17, 1998 between the Registrant and
the Chase Manhattan Bank.+++++
10.30 Form of Deferral Agreement executed by substantially all of the
executive officers of AFC dated January 30, 1998.+++++
10.31 Form of Restricted Stock Agreement, dated January 30, 1998 and executed
by substantially all of the executive officers of AFC.+++++
10.32 Form of Converted Stock Agreement, dated January 30, 1998 and executed
by substantially all of the executive officers of AFC.+++++
10.34 Restricted Stock Agreement, dated May 26, 1998, between Allmerica
Financial Corporation and Robert P. Restrepo, Jr.+++++
10.35 Credit Agreement dated as of December 1, 1998 between the Registrant and
the Chase Manhattan Bank.+++++
10.36 Amendment to the Credit Agreement dated as of June 17, 1998 between the
Registrant and the Chase Manhattan Bank incorporated by reference to
Exhibit to the Allmerica Financial Corporation June 30, 1999 report on
Form 10-Q and incorporated herein by reference.
10.37 Allmerica Financial Corporation Short-Term Incentive Compensation Plan
incorporated herein by reference to Exhibit A contained in the
Registrant's Proxy Statement (Commission File No. 001-13754) originally
filed with the Commission on March 31, 1999.
10.38 Amendment to the Credit Agreement dated as of May 27, 2002 between the
Registrant and JPMorgan Chase Bank.*
10.39 Stock Pledge and Loan Agreement dated as of February 5, 2001 between
AMGRO, Inc., a subsidiary of the Registrant, and Robert P. Restrepo, Jr.
incorporated by reference to Exhibit 10.39 to the Allmerica Financial
Corporation June 30, 2001 report on Form 10-Q and incorporated herein by
reference.
10.40 Severance Agreement, dated November 19, 2001, between First Allmerica
Life Insurance Company and Eric A. Simonsen.++++++
10.41 Stop/Loss Reinsurance Agreement effective September 30, 2001, between
Allmerica Financial Life Insurance and Annuity Company and Lincoln
National Reassurance Company.*
10.42 Amended and Restated Put Option Agreement dated September 30, 2001
between Allmerica Financial Corporation and Old Fort Insurance Company,
Ltd.*
10.43 Agreement dated October 24, 2002 with the Massachusetts Division of
Insurance.**
10.44 Section 83(b) Agreement, dated March 21, 2000, between First Allmerica
Financial Life Insurance Company and John F. O'Brien.**
10.45 Section 83(b) Agreement, dated March 21, 2000, between First Allmerica
Financial Life Insurance Company and Richard M. Reilly.**
10.46 Section 83(b) Agreement, dated March 21, 2000, between First Allmerica
Financial Life Insurance Company and J. Kendall Huber.**
10.47 Consulting Agreement, dated October 25, 2002, between the Registrant and
John F. O'Brien.**
10.48 Employment Agreement, dated November 1, 2002, between First Allmerica
Financial Life Insurance Company and Bruce C. Anderson.
10.49 Employment Agreement, dated November 1, 2002, between First Allmerica
Financial Life Insurance Company and J. Kendall Huber.
10.50 Employment Agreement, dated November 1, 2002, between First Allmerica
Financial Life Insurance Company and Edward J. Parry, III.
10.51 Employment Agreement, dated November 1, 2002, between First Allmerica
Financial Life Insurance Company and Robert P. Restrepo, Jr.
10.52 Agreement, dated November 6, 2002, between the Registrant and Michael P.
Angelini.
10.53 Agreement, dated December 23, 2002, between the Registrant and the
Massachusetts Division of Insurance.
10.54 Asset Transfer and Acquisition Agreement, effective as of December 31,
2002, by and among Allmerica Financial Life Insurance and Annuity
Company, First Allmerica Financial Life Insurance Company and John
Hancock Life Insurance Company.***
10.55 Amended and Restated Non-Employee Director Stock Ownership Plan.
105
21 Subsidiaries of AFC.
23 Consent of Independent Accountants.
24 Power of Attorney.
99.1 Internal Revenue Service Ruling dated April 15, 1995.+
99.2 Important Factors Regarding Forward Looking Statements.
99.3 Certification of J. Kendall Huber, Executive Officer of the Chairman,
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to section 906
of the Sarbanes-Oxley Act of 2002.
99.4 Certification of Edward J. Parry III, Executive Officer of the Chairman
and Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002.
99.5 Certification of Robert P. Restrepo, Jr., Executive Officer of the
Chairman, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
section 906 of the Sarbanes-Oxley Act of 2002.
- ------------
+ Incorporated herein by reference to the correspondingly numbered exhibit
contained in the Registrant's Registration Statement on Form S-1 (No.
33-91766) originally filed with the Commission on May 1, 1995.
++ Incorporated herein by reference to the correspondingly numbered exhibit
contained in the Registrant's Registration Statement on Form S-1 (No.
33-96764) originally filed with the Commission on September 11, 1995.
+++ Incorporated herein by reference to Exhibits 2, 3, 4, 5 and 6,
respectively, contained in the Registrant's Current Report on Form 8-K
filed on February 5, 1997.
++++ Incorporated herein by reference to the correspondingly numbered exhibit
contained in the Registrant's 1997 Annual Report on Form 10-K originally
filed with the Commission on March 27, 1998
+++++ Incorporated herein by reference to the correspondingly numbered exhibit
contained in the Registrant's 1998 Annual Report Form 10-K originally
filed with the Commission on March 29, 1999.
++++++ Incorporated herein by reference to the correspondingly numbered exhibit
contained in the Registrant's 2001 Annual Report on Form 10-K originally
filed with the Commission on April 1, 2002.
* Incorporated herein by reference to the correspondingly numbered exhibit
contained in the Registrant's June 30, 2002 Report on Form 10-Q
originally filed with the Commission on August 14, 2002.
** Incorporated herein by reference to the correspondingly numbered exhibit
contained in the Registrant's September 30, 2002 Report on Form 10-Q
originally filed with the Commission on November 14, 2002.
*** Confidential treatment requested as to certain portions of the exhibit.
(b) REPORTS ON FORM 8-K
On February 3, 2003, Allmerica Financial Corporation announced net operating
income and net income for the fourth quarter of 2002 and a net operating loss
and a net loss for the full-year 2002.
On January 8, 2003, Allmerica Financial Corporation announced a series of
transactions which will significantly improve the statutory capital positions of
its life insurance companies. The benefits of these actions will be reflected in
the statutory capital of the Company's life insurance subsidiaries as of
December 31, 2002.
106
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
ALLMERICA FINANCIAL CORPORATION
REGISTRANT
Date: March 24, 2003 By: /s/ J. Kendall Huber
-----------------------------------
J. Kendall Huber,
Executive Officer of the Chairman
Date: March 24, 2003 By: /s/ Edward J. Parry III
-----------------------------------
Edward J. Parry III,
Executive Officer of the Chairman,
Chief Financial Officer and
Principal Accounting Officer
Date: March 24, 2003 By: /s/ Robert P. Restrepo, Jr.
-----------------------------------
Robert P. Restrepo, Jr.,
Executive Officer of the Chairman
Pursuant to the requirements of the Securities and Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Date: March 24, 2003 By: /s/ J. Kendall Huber
-----------------------------------
J. Kendall Huber,
Executive Officer of the Chairman
Date: March 24, 2003 By: /s/ Edward J. Parry III
-----------------------------------
Edward J. Parry III,
Executive Officer of the Chairman,
Chief Financial Officer and
Principal Accounting Officer
Date: March 24, 2003 By: /s/ Robert P. Restrepo, Jr.
-----------------------------------
Robert P. Restrepo, Jr.,
Executive Officer of the Chairman
Date: March 24, 2003 By: *
-----------------------------------
Michael P. Angelini,
Chairman
Date: March 24, 2003 By:
-----------------------------------
E. Gordon Gee,
Director
Date: March 24, 2003 By:
-----------------------------------
Samuel J. Gerson,
Director
107
Date: March 24, 2003 By: *
-----------------------------------
Gail L. Harrison,
Director
Date: March 24, 2003 By:
-----------------------------------
Robert P. Henderson,
Director
Date: March 24, 2003 By: *
-----------------------------------
M Howard Jacobson,
Director
Date: March 24, 2003 By: *
-----------------------------------
Wendell J. Knox,
Director
Date: March 24, 2003 By: *
-----------------------------------
Robert J. Murray,
Director
Date: March 24, 2003 By:
-----------------------------------
Terrence Murray,
Director
Date: March 24, 2003 By: *
-----------------------------------
John F. O'Brien,
Director
Date: March 24, 2003 By: *
-----------------------------------
John R. Towers,
Director
Date: March 24, 2003 By: *
-----------------------------------
Herbert M. Varnum,
Director
*By: /s/ Edward J. Parry III
-----------------------------------
Edward J. Parry III,
Attorney-in-fact
108
CERTIFICATIONS
I, J. Kendall Huber, certify that:
1. I have reviewed this annual report on Form 10-K of Allmerica Financial
Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 24, 2003
/s/ J. Kendall Huber
-----------------------------------
J. Kendall Huber,
Executive Officer of the Chairman
109
I, Edward J. Parry III, certify that:
1. I have reviewed this annual report on Form 10-K of Allmerica Financial
Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 24, 2003
/s/ Edward J. Parry III
-----------------------------------
Edward J. Parry III,
Executive Officer of the Chairman
and Chief Financial Officer
110
I, Robert P. Restrepo, Jr., certify that:
1. I have reviewed this annual report on Form 10-K of Allmerica Financial
Corporation;
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this annual
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this annual
report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
annual report whether there were significant changes in internal controls or in
other factors that could significantly affect internal controls subsequent to
the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 24, 2003
/s/ Robert P. Restrepo, Jr.
-----------------------------------
Robert P. Restrepo, Jr.,
Executive Officer of the Chairman
111
REPORT OF INDEPENDENT ACCOUNTANTS ON
FINANCIAL STATEMENT SCHEDULES
To the Board of Directors
of Allmerica Financial Corporation:
Our audits of the consolidated financial statements referred to in our report
dated January 30, 2003, which contains an explanatory paragraph with respect to
the change in the Company's method of accounting for goodwill in 2002 and
derivative instruments in 2001, appearing in the 2002 Annual Report on Form 10-K
also included an audit of the financial statement schedules listed in Item
15(a)(2) of this Form 10-K. In our opinion, these financial statement schedules
present fairly, in all material respects, the information set forth therein when
read in conjunction with the related consolidated financial statements.
/s/ PricewaterhouseCoopers LLP
- ------------------------------
PricewaterhouseCoopers LLP
Boston, Massachusetts
January 30, 2003
112
SCHEDULE I
ALLMERICA FINANCIAL CORPORATION
SUMMARY OF INVESTMENTS-OTHER THAN INVESTMENTS IN RELATED PARTIES
DECEMBER 31, 2002
- -----------------------------------------------------------------------------------------------------------------
(In millions)
Amount at
which shown
in the balance
Type of Investment Cost/(1)/ Value sheet
- -----------------------------------------------------------------------------------------------------------------
Fixed maturities:
Bonds:
United States Government and government agencies and authorities $ 614.3 $ 638.6 $ 638.6
States, municipalities and political subdivisions 1,448.3 1,499.7 1,499.7
Foreign governments 14.1 14.8 14.8
Public utilities 601.6 623.8 623.8
All other corporate bonds 4,870.9 5,056.7 5,056.7
Redeemable preferred stocks 166.7 169.5 169.5
- -----------------------------------------------------------------------------------------------------------------
Total fixed maturities 7,715.9 8,003.1 8,003.1
- -----------------------------------------------------------------------------------------------------------------
Equity securities:
Common stocks:
Banks, trust and insurance companies 33.4 34.7 34.7
Industrial, miscellaneous and all other 0.6 2.7 2.7
Nonredeemable preferred stocks 15.1 15.4 15.4
- -----------------------------------------------------------------------------------------------------------------
Total equity securities 49.1 52.8 52.8
- -----------------------------------------------------------------------------------------------------------------
Mortgage loans on real estate 259.8 XXXXX 259.8
Policy loans 361.4 XXXXX 361.4
Other long-term investments 127.5 XXXXX 129.7
- -----------------------------------------------------------------------------------------------------------------
Total investments $ 8,513.7 XXXXX $ 8,806.8
=================================================================================================================
(1) Original cost of equity securities and, as to fixed maturities, original
cost reduced by repayments and adjusted for amortization of premiums and
accretion of discounts.
113
SCHEDULE II
ALLMERICA FINANCIAL CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
PARENT COMPANY ONLY
STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- -----------------------------------------------------------------------------------------------------------
Revenues
Net investment income $ 1.8 $ 1.1 $ 3.6
Net realized investment gains (losses) 0.7 (6.1) 2.6
- -----------------------------------------------------------------------------------------------------------
Total revenues 2.5 (5.0) 6.2
- -----------------------------------------------------------------------------------------------------------
Expenses
Interest expense, net 40.6 40.6 40.6
Expense pursuant to a subsidiary reinsurance agreement 30.6 -- --
Operating expenses 4.3 4.9 2.7
- -----------------------------------------------------------------------------------------------------------
Total expenses 75.5 45.5 43.3
- -----------------------------------------------------------------------------------------------------------
Net loss before federal income taxes and equity in net income of
unconsolidated subsidiaries (73.0) (50.5) (37.1)
Income tax benefit:
Federal 24.9 15.3 13.2
State 1.3 1.2 --
Equity in net (loss) income of unconsolidated subsidiaries (259.3) 30.9 223.8
- -----------------------------------------------------------------------------------------------------------
Net (loss) income $ (306.1) $ (3.1) $ 199.9
===========================================================================================================
The condensed financial information should be read in conjunction with the
consolidated financial statements and notes thereto.
114
SCHEDULE II (CONTINUED)
ALLMERICA FINANCIAL CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
PARENT COMPANY ONLY
BALANCE SHEETS
DECEMBER 31 2002 2001
- ------------------------------------------------------------------------------------------------------------------------
(In millions, except share and per share data)
Assets
Fixed maturities - at fair value (amortized cost of $47.6 and $11.3) $ 49.2 $ 11.1
Cash and cash equivalents 15.4 16.9
Investment in unconsolidated subsidiaries 2,633.8 2,954.0
Net receivable from subsidiaries -- 62.2
Other assets 3.7 2.3
- ------------------------------------------------------------------------------------------------------------------------
Total assets $ 2,702.1 $ 3,046.5
- ------------------------------------------------------------------------------------------------------------------------
Liabilities
Federal income taxes payable $ 72.6 $ 18.9
Expenses and state taxes payable 12.4 30.7
Interest and dividends payable 14.2 13.9
Net payable to subsidiaries 21.9 --
Short-term debt -- 83.1
Long-term debt 508.8 508.8
- ------------------------------------------------------------------------------------------------------------------------
Total liabilities 629.9 655.4
- ------------------------------------------------------------------------------------------------------------------------
Shareholders' Equity
Preferred stock, par value $0.01 per share, 20.0 million shares authorized, none issued -- --
Common stock, par value $0.01 per share, 300.0 million shares authorized, 60.4 million
shares issued 0.6 0.6
Additional paid-in capital 1,768.4 1,758.4
Accumulated other comprehensive loss (37.4) (13.7)
Retained earnings 746.2 1,052.3
Treasury stock at cost (7.5 million shares) (405.6) (406.5)
- ------------------------------------------------------------------------------------------------------------------------
Total shareholders' equity 2,072.2 2,391.1
- ------------------------------------------------------------------------------------------------------------------------
Total liabilities and shareholders' equity $ 2,702.1 $ 3,046.5
========================================================================================================================
The condensed financial information should be read in conjunction with the
consolidated financial statements and notes thereto.
115
SCHEDULE II (CONTINUED)
ALLMERICA FINANCIAL CORPORATION
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
PARENT COMPANY ONLY
STATEMENT OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31 2002 2001 2000
- --------------------------------------------------------------------------------------------------------------------------
(In millions)
Cash flows from operating activities
Net (loss) income $ (306.1) $ (3.1) $ 199.9
Adjustments to reconcile net income to net cash provided by operating activities:
Equity in net loss (income) of unconsolidated subsidiaries 259.3 (30.9) (223.8)
Dividend received from unconsolidated subsidiaries 101.0 41.1 109.8
Net realized investment (gains) losses (0.7) 6.1 (2.6)
Change in expenses and state taxes payable (19.1) 11.6 0.8
Change in federal income taxes payable (receivable) 65.3 2.4 21.7
Change in interest and dividends payable 0.3 0.3 0.3
Change in payable (receivable) from subsidiaries 94.1 (26.9) (18.1)
Other, net (1.1) 5.9 (1.5)
- --------------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 193.0 6.5 86.5
- --------------------------------------------------------------------------------------------------------------------------
Cash flows from investing activities
Capital contributed to unconsolidated subsidiaries (80.2) (23.9) (16.9)
Proceeds from disposals and maturities of available-for-sale fixed maturities 8.8 -- 33.5
Purchase of available-for-sale fixed maturities (41.1) (11.3) --
- --------------------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by investing activities (112.5) (35.2) 16.6
- --------------------------------------------------------------------------------------------------------------------------
Cash flow from financing activities
Net proceeds from issuance of commercial paper (83.1) 27.0 11.5
Net proceeds from issuance of common stock -- -- 0.6
Treasury stock purchased at cost -- -- (104.1)
Treasury stock reissued at cost 1.1 5.3 23.3
Dividends paid to shareholders -- (13.3) (13.4)
- --------------------------------------------------------------------------------------------------------------------------
Net cash (used in) provided by financing activities (82.0) 19.0 (82.1)
- --------------------------------------------------------------------------------------------------------------------------
Net change in cash and cash equivalents (1.5) (9.7) 21.0
Cash and cash equivalents, beginning of year 16.9 26.6 5.6
- --------------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents, end of year $ 15.4 $ 16.9 $ 26.6
==========================================================================================================================
The condensed financial information should be read in conjunction with the
consolidated financial statements and notes thereto.
116
SCHEDULE III
ALLMERICA FINANCIAL CORPORATION
SUPPLEMENTARY INSURANCE INFORMATION
DECEMBER 31, 2002
- ---------------------------------------------------------------------------------------------------------------------------------
(In millions)
Future
policy
benefits, Other Benefits Amortization
Deferred losses, policy claims, of deferred
policy claims claims and Net losses and policy
acquisition and loss Unearned benefits Premium investment settlement acquisition
costs expenses premiums payable revenue income expenses costs
- ---------------------------------------------------------------------------------------------------------------------------------
Risk Management $ 215.1 $ 3,142.4 $1,045.2 $ 14.2 $ 2,272.0 $ 202.0 $ 1,683.5 $ 424.5
Asset Accumulation
Allmerica Financial
Services 1,027.1 3,824.2 1.8 550.5 48.1 283.9 495.0 655.8
Allmerica Asset
Management -- -- -- 208.1 -- 100.3 23.5 0.1
Corporate -- -- -- -- -- 5.0 -- --
Eliminations -- -- -- -- -- (1.0) -- --
- ---------------------------------------------------------------------------------------------------------------------------------
Total $ 1,242.2 $ 6,966.6 $1,047.0 $ 772.8 $ 2,320.1 $ 590.2 $ 2,202.0 $ 1,080.4
=================================================================================================================================
Other
operating Premiums
expenses written
- --------------------------------------------------
Risk Management $ 206.4 $ 2,267.3
Asset Accumulation
Allmerica Financial
Services 354.4 --
Allmerica Asset
Management 79.3 --
Corporate 68.5 --
Eliminations (10.3) --
- --------------------------------------------------
Total $ 698.3 $ 2,267.3
==================================================
DECEMBER 31, 2001
- ---------------------------------------------------------------------------------------------------------------------------
(In millions)
Future
policy
benefits, Other Benefits
Deferred losses, policy claims,
policy claims claims and Net losses and
acquisition and loss Unearned benefits Premium investment settlement
costs expenses premiums payable revenue income expenses
- ---------------------------------------------------------------------------------------------------------------------------
Risk Management $ 199.0 $ 3,126.3 $ 1,049.9 $ 24.9 $ 2,205.7 $ 216.0 $ 1,753.1
Asset Accumulation
Allmerica Financial
Services 1,585.2 4,003.1 2.6 567.1 49.0 288.9 344.6
Allmerica Asset
Management -- -- -- 1,171.9 -- 144.5 69.5
Corporate -- -- -- -- -- 6.7 --
Eliminations -- -- -- -- -- (0.9) --
- ---------------------------------------------------------------------------------------------------------------------------
Total $ 1,784.2 $ 7,129.4 $ 1,052.5 $ 1,763.9 $ 2,254.7 $ 655.2 $ 2,167.2
===========================================================================================================================
Amortization
of deferred
policy Other
acquisition operating Premiums
costs expenses written
- ---------------------------------------------------------------------
Risk Management $ 401.7 $ 309.7 $ 2,285.0
Asset Accumulation
Allmerica Financial
Services 77.4 252.0 --
Allmerica Asset
Management 0.1 100.1 --
Corporate -- 70.5 --
Eliminations -- (7.5) --
- ---------------------------------------------------------------------
Total $ 479.2 $ 724.8 $ 2,285.0
=====================================================================
DECEMBER 31, 2000
- ----------------------------------------------------------------------------------------------------------------------
(In millions)
Future
policy
benefits, Other Benefits
Deferred losses, policy claims,
policy claims claims and Net losses and
acquisition and loss Unearned benefits Premium investment settlement
costs expenses premiums payable revenue income expenses
- ----------------------------------------------------------------------------------------------------------------------
Risk Management $ 187.2 $ 3,017.5 $ 978.8 $ 25.1 $ 2,066.7 $ 218.4 $ 1,563.0
Asset Accumulation
Allmerica Financial
Services 1,420.8 3,480.8 2.8 531.5 52.1 283.6 315.1
Allmerica Asset
Management 0.2 -- -- 1,636.5 -- 138.1 103.7
Corporate -- -- -- -- -- 6.3 --
Eliminations -- -- -- -- -- (0.9) --
- ----------------------------------------------------------------------------------------------------------------------
Total $ 1,608.2 $ 6,498.3 $ 981.6 $ 2,193.1 $ 2,118.8 $ 645.5 $ 1,981.8
======================================================================================================================
Amortization
of deferred
policy Other
acquisition operating Premiums
costs expenses written
- -------------------------------------------------------------------
Risk Management $ 373.2 $ 184.9 $ 2,153.4
Asset Accumulation
Allmerica Financial
Services 83.2 242.5 --
Allmerica Asset
Management 0.2 23.0 --
Corporate -- 82.3 --
Eliminations -- (7.0) --
- -------------------------------------------------------------------
Total $ 456.6 $ 525.7 $ 2,153.4
===================================================================
117
SCHEDULE IV
ALLMERICA FINANCIAL CORPORATION
REINSURANCE
DECEMBER 31
- ------------------------------------------------------------------------------------------------------
(In millions)
Assumed Percentage
Ceded to from of amount
Gross other other Net assumed
amount companies companies amount to net
- ------------------------------------------------------------------------------------------------------
2002
Life insurance in force $ 29,413.3 $ 20,365.0 $ 413.4 $ 9,461.7 4.37%
======================================================================================================
Premiums:
Life insurance $ 57.2 $ 9.9 $ 0.6 $ 47.9 1.25%
Accident and health insurance 28.5 26.8 -- 1.7 --
Property and casualty insurance 2,487.4 278.6 61.7 2,270.5 2.72%
- ------------------------------------------------------------------------------------------------------
Total premiums $ 2,573.1 $ 315.3 $ 62.3 $ 2,320.1 2.69%
======================================================================================================
2001
Life insurance in force $ 30,550.4 $ 21,108.8 $ 454.1 $ 9,895.7 4.59%
======================================================================================================
Premiums:
Life insurance $ 58.3 $ 10.3 $ 0.7 $ 48.7 1.44%
Accident and health insurance 30.8 27.9 -- 2.9 --
Property and casualty insurance 2,438.6 293.7 53.5 2,198.4 2.43%
- ------------------------------------------------------------------------------------------------------
Total premiums $ 2,527.7 $ 331.9 $ 54.2 $ 2,250.0 2.41%
======================================================================================================
2000
Life insurance in force $ 33,752.4 $ 19,375.5 $ 488.3 $ 14,865.2 3.28%
======================================================================================================
Premiums:
Life insurance $ 62.6 $ 11.4 $ 0.7 $ 51.9 1.35%
Accident and health insurance 31.7 29.6 -- 2.1 --
Property and casualty insurance 2,297.8 299.8 66.8 2,064.8 3.24%
- ------------------------------------------------------------------------------------------------------
Total premiums $ 2,392.1 $ 340.8 $ 67.5 $ 2,118.8 3.19%
======================================================================================================
118
SCHEDULE V
ALLMERICA FINANCIAL CORPORATION
VALUATION AND QUALIFYING ACCOUNTS
DECEMBER 31
- ------------------------------------------------------------------------------------------------------------------
(In millions)
Additions
--------------------------
Deductions
Balance at Charged to Charged to from Balance
beginning of costs and other allowance at end of
period expenses accounts account period
- ------------------------------------------------------------------------------------------------------------------
2002
Mortgage loans $ 3.8 $ (1.0) $ -- $ -- $ 2.8
Allowance for doubtful accounts 10.3 13.6 -- 11.7 12.2
- ------------------------------------------------------------------------------------------------------------------
$ 14.1 $ 12.6 $ -- $ 11.7 $ 15.0
==================================================================================================================
2001
Mortgage loans $ 4.4 $ 0.6 $ -- $ 1.2 $ 3.8
Allowance for doubtful accounts 6.9 18.8 -- 15.4 10.3
- ------------------------------------------------------------------------------------------------------------------
$ 11.3 $ 19.4 $ -- $ 16.6 $ 14.1
==================================================================================================================
2000
Mortgage loans $ 5.8 $ (1.3) $ -- $ 0.1 $ 4.4
Allowance for doubtful accounts 5.8 8.4 -- 7.3 6.9
- ------------------------------------------------------------------------------------------------------------------
$ 11.6 $ 7.1 $ -- $ 7.4 $ 11.3
==================================================================================================================
119
SCHEDULE VI
ALLMERICA FINANCIAL CORPORATION
SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY INSURANCE OPERATIONS
FOR THE YEARS ENDED DECEMBER 31
- ------------------------------------------------------------------------------------------------------------------------------------
(In millions)
Reserves for Discount, if
Deferred losses and any, deducted
policy loss from Net Net
acquisition adjustment previous Unearned premiums investment
Affiliation with Registrant costs expenses /(2)/ column /(1)/ premiums /(2)/ earned income
- ------------------------------------------------------------------------------------------------------------------------------------
Consolidated Property and
Casualty Subsidiaries
2002 $ 212.1 $ 2,961.7 $ -- $ 1,043.1 $ 2,270.5 $ 201.7
====================================================================================================================================
2001 $ 195.8 $ 2,921.5 $ -- $ 1,047.7 $ 2,198.4 $ 215.4
====================================================================================================================================
2000 $ 183.9 $ 2,719.1 $ -- $ 975.9 $ 2,064.8 $ 217.9
====================================================================================================================================
Amortization
Losses and loss of deferred Paid losses
adjustment expenses policy and loss Net
------------------------------- acquisition adjustment premiums
Current Year Prior Years expenses expenses written
- -------------------------------------------------------------------------------------------------------------------
2002 $ 1,682.1 $ 6.4 $ 424.5 $ 1,661.6 $ 2,265.8
===================================================================================================================
2001 $ 1,720.4 $ 107.4 $ 401.7 $ 1,673.1 $ 2,277.7
===================================================================================================================
2000 $ 1,634.9 $ (87.4) $ 373.2 $ 1,574.0 $ 2,151.6
===================================================================================================================
(1) The Company does not employ any discounting techniques.
(2) Reserves for losses and loss adjustment expenses are shown gross of $877.9
million, $864.6 million and $816.9 million of reinsurance recoverable on unpaid
losses in 2002, 2001 and 2000, respectively. Unearned premiums are shown gross
of prepaid premiums of $55.7 million, $55.6 million and $63.2 million in 2002,
2001 and 2000, respectively.
120